Financial Instruments Via Blockchain

Bitcoin achieves consensus on payments, but currency is not the sole end to which that consensus can be employed.  The settlement and clearance of financial instruments can equally well be achieved via blockchain technology.  The same way a Bitcoin transaction is beyond reproach, a broad array of financial assets (stocks, bonds, derivatives) could possess the same degree of certainty.

Currently underwriters, banks, and large institutional counter-parties extract enormous rents from their role as the trusted nodes of finance.  In a system based on relationships, this is entirely sensible.  Who else could one entrust with vast sums, often amounting to billions of dollars, but the largest, most reputable banks?  It made perfect sense.  Due to the scarcity of such players, and the large amounts at stake, they could command massive fees.  The typical bond underwriter takes 0.5-1% of the principal in fees.  If you compare that against 3% a year in interest, which is the true cost of money, then transactional fees can amount to an enormous fraction of the total cost of capital.

But if bonds were created on a blockchain, they could be directly sold to bond buyers without any counterparty risk.  The bonds would be represented as cryptotokens, colored coins, that have the same properties of bitcoins, without necessarily being pegged to oscillations in the Bitcoin price.  These tokens would directly represent ownership of bonds.  They could be exchanged trustlessly, so anyone, anywhere could buy or sell them without counterparty risk.  Exchanges could allow for vastly superior liquidity of abstruse financial instruments, such as foreign bonds.  One could buy and sell bonds cheaply and with granularity, as stocks are traded today online.

The costs of settlement for certain financial instruments, like bonds, are enormous

Bond payments could also be conducted on the Bitcoin Blockchain.  These would be publicly observable; whoever owned the cryptotokens representing the bonds would receive the mathematically correct amount of bitcoins.  These payments don’t have to be denominated in Bitcoin.  Even though they are paid in bitcoins, the actual amount can be a simple conversion from dollars.  Thus financial contracts fixed to dollars can simply use the Bitcoin Blockchain as a settlement mechanism without dabbling much in the currency itself.  The blockchain is merely a tool.

If interest payments can be tracked historically, the entire credit rating for separate entities could be extracted algorithmically.  Your identity becomes a public key.  One could cryptographically prove one’s identity; post a picture of yourself with a cryptographic signature coming from a particular Bitcoin address.  That address is now you.  The deals it engages it, the contracts it signs (cryptographically), the interest payments it does or doesn’t make, they may all compute towards one’s credit score.  Extracting credit history directly from a blockchain means that there are no gatekeepers of information.

One would not be wise to lend bitcoins to anonymous, unproven Bitcoin addresses.  That would be financial suicide, like trusting strangers on the Internet with your credit card data.  But large institutions could employ bonds on the blockchain and their bonds could become actively traded.  If even one reputable institution issued debts in this form, they could become highly liquid assets.  Whole exchanges could sprout up to service these cryptobond assets.

Lastly, bonds traded on the Blockchain would vastly democratize and flatten credit distribution worldwide.  If Brazilian savers can lend to businesses in Pakistan, pegged to USD, without any currency risk, then interest rates will depend solely on the credit-worthiness of the borrower and nothing else.  This is how credit always should have been.  Instead, in today’s world, lending abroad comes with extraordinary risks: currency volatility and capital controls.

International bond markets are illiquid, high-friction markets.  When bonds must pass through that many intermediaries, and receive ‘trusted’ sanctions so many times, they become overburdened instruments, too heavy to be actively traded, or to fall into the hands of most retail investors.

The benefits of flattening world credit would work both ways.  Savers hungry for yield could get it by having a broader scope of potential borrowers.  Chinese savers starved for yield could lend money to companies in Bulgaria without currency risk and in very small amounts.  People in Africa, who can’t get reliable yield almost at any price, could invest in foreign bonds in a way that is truly permission-less.

Maybe that’s Bitcoin’s killer app, giving people yield.  People around the world want yield.  And many others want to raise debts.  But the settlement and exchange systems underlying that credit are too cumbersome, slow, costly, and restricted by national borders.

I’m passionate about abstracting financial instruments over Bitcoin.  I firmly believe that they are the future.  Expect more to come.