This piece is adapted from my live presentation, “Using Blockchain to Power Better Derivatives Trading.” Please direct all booking inquiries to hello@pixelalpha.io. Join us on Telegram if you want to talk about how tokenized assets are going to be the future of derivatives.

Blockchain, and the transparency that a public immutable ledger provides, would have gone a long way in preventing the 07/08 Financial Crisis. More importantly, applying the technology now can ensure a collapse of that scale never happens again.

We begin with a history lesson. Broadly put, the Crisis was fueled by the abuse of two types of derivative products: Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs). CDOs were sold as highly rated instruments but were backed up of assets that were essentially junk, and CDSs were supposed to be an insurance policy against CDO default.

A basic flowchart for how AAA rated CDOs could be made out of subprime parts. Source: IMF

CDOs therefore carried very low risk on paper, so they became a favored form of inter-bank collateralization. Low risk also meant companies like AIG could insure them with CDSs at a tiny premium, which in turn propped up banks’ appetites for more CDOs.

When the CDO market collapsed, the CDSs insuring them all came due at the same time. The CDSs were priced reflective of perceived risk and not actual risk, and this combination of market factors led to the notorious $125b AIG bailout, the Lehman Brothers bankruptcy, and the Bear Stearns fire sale at 7% of its 52 week high market value.

Lack of transparency was the underlying factor in all of this. If the original mortgage debt had been better reported, the CDOs they were parts of could have been accurately priced. This would have made CDSs more expensive, and probably would have given banks pause in how high they were leveraging their positions. Finally, it would have kept banks from giving low interest loans to relatively high-risk individuals to fuel CDO growth.

Blockchain introduces two revolutionary characteristics to derivatives: history and transparency. While these are certainly complementary, they serve distinct purposes.

History refers to an unchangeable, definitive source of asset performance is available. When a basket derivative like a CDO is created, it contains information about all the assets that make it up. This Merkle tree view creates a much more reliable way of pricing products. Applying blockchain here has incredibly far reaching implications into credit scoring, consumer behavior, and many more fields that will be the subject of their own article, but below is an illustration for how it could work with CDOs:

Alice’s complete history is available for all to view. This means any products made partially or completely from her data will be viewable all the way through her first payment.

Transparency means all the history is public. This accessibility does a tremendous job limiting the greedy tendencies that caused banks to be massively overleveraged during the Crisis. Because no single entity has control over the data, but anyone can read it, it forces them to behave. Not only can they no longer justify the creation of junk CDOs, but they have no excuse to be holding them either. It has the added benefit of creating a repository of more data than any single institution would have had access to before. From the insurance side, smart contract rules can be coded that require insurers post a certain level of collateral with each CDS issued, which can then be verified on-chain.

The combination of history and transparency can make even the most traditionally risky derivatives the responsible risk-hedging mechanisms they were meant to be.

Above we explored how blockchain can improve the inward structure of derivatives products, but another key advantage is how it facilitates the exchange of them. For example, Over-the-counter (OTC) trading represents around 16x the notional value of exchange traded derivatives ($542t vs $33t), partly because OTC contracts require much less regulatory disclosure and partly because they tend to contain very specific terms that make them illiquid by exchange standards. Because blockchain allows for completely transparent product development, it eliminates a lot of the challenge and cost in the regulatory approval process. The decentralized nature of cryptoassets means that there is a wider market available to offer contracts that would have otherwise had to have gone OTC, helping to solve the liquidity problem, and meaning that any remaining risk is diversified amongst more players. Ultimately, these trades no longer need to be owned by a few large institutions that have the power to bring the whole financial system down.

Trading has already proven to be crypto’s killer app, bringing widespread attention and adoption to blockchain technologies. But this is the first time we can hard-code responsible behaviors into the products being traded. Follow PixelAlpha to learn more about what we are doing to ensure that the future of trading includes everyone.