In 2015 we have seen a huge explosion of the use of Blockchain as a buzzword in finance. Funnily enough even with the huge hype and excitement there have been few companies (startups and larger firms) pursuing truly innovative work in this space. One of the problems is that as this is such a new area, any new work requires building new technology and libraries from the ground up. Many agree that this is what the web was like in the 90s. This is probably an understatement, as the Blockchain has an added complexity of a deep mathematical foundation, which is difficult to grasp but can be necessary for some fundamental development and innovative endeavors. This is a world where if you want to engage in cutting edge work you need to develop the tools and services to do that first, hence any real innovation takes time, effort and patience! For this reason we expect most of the Blockchain noise of 2015 to die down as many startups realize that they are unable to monetize their basic Blockchain products. However, in 2016 we will see the emergence of startups led by highly technical individuals that will work on building and enhancing the core Blockchain infrastructure forming the basis of innovations for the next five years at least. In the article below we have provided a little overview of the work our team has been performing in finance, and how we believe that open collaboration in these areas will lead to real innovation in the application of Blockchain technology in finance and beyond.

Simple Blockchain Financial Assets:

Many companies have talked extensively about utilizing a Blockchain network to issue, trade and manage real world assets such as financial securities. However, while there is a lot of discussion about this there is very little (useful) real word implementation. One of the most prominent and interesting applications so far has been developed by Overstock/t0, for which the company also received SEC approval for a plan to issue company stock using their technology. Overstock’s work will definitely pave the way for more widespread use of basic Blockchain functionality (without smart contracts) to execute clearing, settlement and depository services. This will be one of the areas where there will be most of the ‘quick wins’ and real world financial applications due to significant cost and transparency benefits, and most of this initial activity will likely take place on a public/open chain over 2016. Our engineers are also working on a robust (open source) application layer that can utilize a public Blockchain such as Bitcoin (or Ethereum), to issue securities and enable tradability within a particular niche of the financial markets, but more importantly execute DVP (Delivery Versus Payment) settlement and coupon/dividend administration using fiat currency.

Proof of Work (PoW):

The debate about open versus closed ledgers in financial services has inevitably spurred discussion around PoS (Proof of Stake) being the best option for closed networks. Even so, we think PoW should not be excluded from the discussion as there are possible use cases for mining that could be useful within a financial services environment. For example, we have been investigating how hashes generated by the mining nodes could be utilized as random number inputs for risk management processes e.g. Monte Carlo path generation for CCR models.

Our team is testing approaches to deploy private chains where the byproducts of mining (for example the hashes) are collected and utilized for other operations within the financial services organization. This is a little like useful byproducts (such as hydrocarbon gas liquids) in petroleum refinement that can be used to make plastics.

This example is just to highlight that we are at an early stage of development in this technology and nothing should be excluded. We are confident that over 2016 as more teams from various backgrounds start working together there will be some clever methods designed and developed to secure current and future Blockchain network deployments, and some of this innovation will come from finding useful applications of PoW or by combining PoW and PoS.

Block Hash:

Currently in Ethereum you can only access block hashes that are 256 blocks deep, which is understandable as this ensures scalability and efficiency of the network, but this shouldn’t be an issue for private networks based on Etherium. As an example we are looking at a private chain deployment that enables access to hashes over an entire chain, giving greater random number access to contracts which could prove useful in finance, for example in on-chain Monte Carlo modelling - far fetched I know, but so were web applications in 1995 and now we have entire web based computers such as chrome book.

Bond Price Fluctuations:

At present most of the contracts that can be created on Ethereum are simple cash flow or matching mechanisms where actual assets issued have static value on the chain. This means that you cannot account for changes in the credit risk of issuing parties and the products can only be traded at the clean price. The latter is not an issue as the coupons can be distributed pro-rata so trading at clean price is fine, and in some ways this Blockchain approach is more refined. However, the credit risk part is less elegant on the Blockchain and would require off-chain work and calculation, hence destroying the whole concept of disintermediation. To improve efficiency in this area our team is working on structuring contracts which would potentially only need a feed from an oracle providing credit spreads, thereby requiring no off-chain calculations. An example of an oracle is one offered by Oraclize, which can provide data to the Ethereum or Bitcoin networks from specific data sources though a provably honest ETL mechanism.

One of the biggest limitations for pricing using smart contracts is a lack of floating point arithmetic on Solidity and also the lack of math libraries, which are both areas that we are working on as we progress. However, we are sure that with more and more technical people being involved over 2016, pricing on the Blockchain will become a major area of advancement.

Embedded Optionality:

Apart from simple bonds that can be priced on the chain, we are also working on a more complex debt contract with embedded optionality e.g. a callable bond. Compared to a basic bond this is more complex as it requires more sophisticated pricing methods (and math libraries), and again the lack of floating point arithmetic in Ethereum is a big challenge. We are attempting to work around most of this by splitting math functions down in order to overcome stack compile errors, and also performing calculations in the lowest possible units (e.g. pence and seconds). Issues then emerge when dealing with large volumes. We believe with further core developments in Ethereum over 2016 this kind of work will become easier, more accurate and more feasible for real world applications. By 2017 such contracts will likely be easy and cost effective to deploy on closed Blockchains (and maybe even on public chains if cost of execution is not an issue).

Vanilla Options:

We are also looking at constructing a complete on-chain tradable option contract. At the moment this is very inaccurate (again due to lack of floating point arithmetic) and expensive in terms of Gas (due to cumbersome and non-optimal math functions). Nevertheless, we think tradable options on the Blockchain will be a game changer for the financial services industry in general and risk management specifically. We believe that as more finance experts start jumping into Ethereum and similar Blockchain protocols (such as Rootstock, that is scheduled for release in February 2016), the core development and exploration over 2016 will skyrocket and we will see many more advanced use cases.

Where will all of this lead? What is the point of pushing the boundaries of Blockchain to have on-chain pricing engines and risk management tools? Well one important factor is just pure scientific curiosity (geeky as that may sound). But what if we can have a number of pricing engines that can be openly called for pricing of options (or other more exotic and structured products)? Such pricing engines can be securely and transparently ranked though usage and consensus i.e. those that are called more often will be seen as the most secure and reliable, and other less secure, ineffective and inefficient engines will disappear into obscurity. This also means that developers of such on-chain tools for finance will easily be able to compete with much larger organizations, which is always beneficial as competition drives greater innovation. (The benefits/risks of such a pricing engine model can fill an entire article in itself so we will leave that for next-time).

Another important reason to research on-chain pricing and risk management is that as we start pushing the boundaries of what is possible on the Blockchain with simple and smart contracts, this exploration will lead to more robust and secure chain infrastructure for everyday use, which will be beneficial to a much wider community even outside of investment banking e.g. insurance, ownership deeds, health care, retail etc.

As a result, we expect more collaborative work in 2016, and hence much more sophisticated innovations to emerge within the Blockchain world. Whether you are a developer, finance expert or just keen to learn more, please get in touch with us and join our growing open source community of industry and academic professionals who are pioneering this innovation. We look forward to working together in 2016 and beyond.

Feel free to contact me to discussing any of the above.