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The Paper Fork

Feb 15, 2019

High Machine Learning Accuracy Rates for CryptocurrenciesHigh Machine Learning Accuracy Rates for Cryptocurrencies
High Machine Learning Accuracy Rates for CryptocurrenciesHigh Machine Learning Accuracy Rates for Cryptocurrencies

 

Is Blockchain the Tool to Gauge Systematic Risk?

My British colleagues in the world of rates loved to use the phrase "my word is my bond" as a way of conveying they could be trusted. Anyone who has worked on Wall St can tell you trust is hard won and often elusive. Banks and the financial industry as a whole have not done their reputations any favors since 2008 with some very public censors from libor rigging scandal to credit card stuffing. While this public shaming always seems so "in the rear-view mirror", the amount of time and data regulators have to work through is daunting. The sheer number of transactions along with derivatives trades that can be 10x the underlying markets, is a tangled web of risk exposures that can't be easily quantified.

Blockchain technology may finally provide regulators with the tools to effectively monitor and police the financial industry in real time. In fact CFTC Chairman Giancarlo has pointed to this as an effective way to protect the system from abuse and over leverage. Why is this technology important to regulators? Because of the decentralization of this technology, it allows for immutability, accountability as well as greater transparency. Although the financial system would not be fully decentralized like say Bitcoin, a permission ledger between financial institutions and regulators would be vastly more effective in assessing risks to the financial system in real time. How so? Collateral is the engine that drives financial instruments and trading which allows risk to be spread across all the different market participants. Healthy capital markets allow multiple participants with different goals and risk exposures to participate in driving business growth. History has shown that without proper parameters, this practice can get to a point of systematic risk such as mortgages turned into multiple IOU's claiming the same collateral.

Turning Equity Into Debt

Wall St is creative at stretching the most value out of any asset whether it theirs, yours or mine. For example, those Apple shares that you own and have treated you so well are held in a custodial account. That equity stake you have becomes a debt instrument (an IOU) in the form that the custodian promises to deliver your shares upon request or trade. Those same shares are then lent out to short sellers or used as collateral several times over in a process called rehypothecation. This business practice, which very often sets up an account of commingled assets is one of the many ways that the financial markets create leverage but also possible systematic risk. Blockchain technology would give regulators an immutable record of where that asset is, who is basing a collateralized transaction on that asset and to identify abuse of over lending.

 

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Where are we Headed? A Familiar Road

NYSE parent ICE announced recently that a new division known as Bakkt will be offering a custodial solution for the digital asset space. While this has been cheered as another step into legitimizing bitcoin and the digital asset space, there comes the caveat of Wall St and their knack for financial engineering. Caitlin Long, President of Symbiont and co-founder of the Wyoming Blockchain Coalition, has argued that this is a double-edged sword. As institutions embrace this technology and enter the market, the network effect and multiplier will accelerate growth for a new asset to emerge. The flip side she argues is bitcoin is algorithmically engineered towards scarcity (21mm total that can be mined/printed) while institutionalization will lead to claims (paper IOU's) with Bitcoin "being manufactured out of thin air" and therefore marginalizing the inelastic supply.

The Paper Fork

Blockchain technology has its own way of upgrading software called “forks."  In a soft fork essentially there is a consensus to upgrade an aspect of the protocol which is compatible with the technology which exists.  Conversely, A hard fork happens when the changes necessary are not compatible with where the governing body wants to take the technology. It changes the rules going forward and generally speaking, creates a new protocol.  If Bakkt and Wall St are successful with an institutional custody solution, could this possibly cause all these paper IOU's to look like synthetic Bitcoin or let's say a "paper fork"?

Bitcoin is the phoenix that grew out of the financial crisis, emerging as a way around trusting centralization and the institutions. By design it creates immutable trust between parties rather than trusting a third party like a bank. The institutional custody solution and rehypothecation will lead to the development of financial tools of lending, forwards and option markets but just might also lead to a "paper fork". This whole idea seems somewhat of an anathema to the origins of bitcoin and its community. However, the underlying blockchain technology which bitcoin is based upon should give regulators the ability to monitor the market and prevent any abuse. And perhaps, the HODL group might say no thanks to the "paper fork" making Bitcoin one expensive borrow.

 

 

*Bakkt CEO Kelly Loefner has recently stated that " Specifically, with our solution, the buying and selling of Bitcoin is fully collateralized or pre-funded. As such, our new daily Bitcoin contract will not be traded on margin, use leverage, or serve to create a paper claim on a real asset."

For more info, some interesting perspectives on the subject:

https://www.forbes.com/sites/caitlinlong/2018/08/03/ice-creating-new-cryptocurrency-market-adouble-edged-sword/#49bf51fc1015 
https://medium.com/bakkt-blog/https-medium-com-kellyloeffler-price-discovery-f9c77885383 
https://medium.com/@john_60161/re-hypothecated-bitcoin-v-on-chain-bitcoin-e33c254153a2

 

Crypto Model PortfoliosCRYPTO INVESTING MADE SIMPLE
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