Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks:
Here is the short summary. We need:
- More tokenization
- Crypto credit-money
- Wealth management automation
Here is the talk:
Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks: Here is the short summary. We need: More tokenization Crypto credit-money Wealth management automation Here is the talk:
October 16, 2019
Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks: Here is the short summary. We need: More tokenization Crypto credit-money...
Oct 16, 2019 . 20 min read
Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks:
Here is the short summary. We need:
Here is the talk:
Wealth management is a multi-billion-dollar business. As the market capitalization for cryptoassets grows, it will be interesting to apply the concepts of wealth management to cryptocurrency investments. This article looks...
Aug 18, 2017 . 10 min read
Wealth management is a multi-billion-dollar business. As the market capitalization for cryptoassets grows, it will be interesting to apply the concepts of wealth management to cryptocurrency investments.
This article looks at how the traditional wealth management industry works, covering the following areas:
Next, we will synthesize our approach to apply modern portfolio management practices to cryptoassets.
The key principles of portfolio management theory are as follows:
Different types of assets have different characteristics:
So, the basic idea is to combine different assets in order to:
The overarching asset classes in traditional portfolio management are:
Each of the asset classes has its own characteristic return; in the long run, equities have the highest return, then bonds, followed by real estate. Alternative investments exhibit similar returns to equities and additionally they should correlate negatively with other assets (at least in theory). Return and risk are correlated — the higher the returns, the higher the risk. In this context, high risk implies high risk to the downside (losses in portfolio value).
Strategic asset allocation defines the asset allocation between the main asset classes. Strategic asset allocation accounts on average for 92 percent of the variation of returns over time (Brinson, Singer and Beebower).
Tactical asset allocation focuses on the asset allocation within the subcategories of the main asset classes.
For example, in the case of equities the possibilities are investing into the following subcategories:
In the case of bonds, we can choose between:
If interest rates are low, then equities would perform relatively well, and larger parts of the portfolio could be allocated to equities. If the economy is in the phase of recovery, equities of developed countries have potential; the further we move into recovery, the more potential lies in emerging countries’ equities.
If interest rates are declining, it makes sense to invest in bonds — the value of bonds will increase as interest rates fall. Additionally, the longer the duration of these bonds, the higher the performance effect through the declining interest rates.
The main idea is that investors do not need to “pick stocks” or “pick bonds”. Instead, most of their portfolio performance will be delivered through strategic asset allocation and tactical asset allocation.
Each wealth management client will have an investment policy statement comprising:
We assume here that the client has a multi-year time horizon, there are no monthly liquidity requirements and no investment restrictions are applied.
The client risk profile is the key determinant when constructing the client portfolio. The main factors here are:
Risk tolerance is determined by the client’s investment experience in years, their interest to follow market developments, and their loss sensitivity and risk awareness.
Loss sensitivity can be characterized as the way in which the client would react, for example, to the hypothetical scenario of 30-percent losses on the value of their portfolio:
Risk awareness is determined by the following:
Loss sensitivity and risk awareness are determined by psychometric characteristics. In other words, how does the client deal with risk? Some clients are willing to take higher risks for the chance to receive higher rewards, but quite a lot of clients would sleep better if they faced lower risks.
Risk ability is determined by rational factors:
Client risk profile indicates which level of risk the client can take. It is derived from risk tolerance and risk awareness. Both are ranked according to the following levels:
The client risk profile is the lower value of risk tolerance and risk awareness. It is the key determinant for client portfolio construction.
Client risk profiles are divided into five different risk levels, and a standard portfolio will be constructed for each of these risk levels.
At a higher level, cryptocurrencies can be allocated into the following sub-classes:
Standard portfolios are constructed from these sub-classes. The idea is not to have exposure to every specific cryptocurrency, but to have exposure to crypto sub-classes. Some of these sub-classes will have higher returns (and higher risks) and vice versa.
We would calculate the historical returns and volatility for each of these sub-classes and use these values as inputs as part of the standard portfolio management approach. This calculation could look as follows:
The portfolios for different sub- classes could be constructed as follows:
The client would have to:
And that’s all:
The client would pay a monthly or yearly fee to the platform and would be relieved from the day-to-day management of their assets. The client would be able to focus on areas that are most relevant and important to them.
Note: This article is provided for educational purposes only. For actual investment advice, always consult your professional investment advisor. The author accepts no liability for any consequences of decisions taken on the basis of the information contained in this article, nor does the author guarantee the correctness or up-to-dateness of the information contained herein despite the author’s best faith.
In the previous article, we looked at what influences the fiat economy's interest. The focus of this article is the crypto economy. We have three parts here: 1. We look...
Aug 19, 2019 . 10 min read
2. We calculate how much should be the base interest (interest without the credit risk) in the crypto economy.
3. In the end, we compare the fiat monetary system with the crypto monetary system. We see as well, which system benefits which segments of the population.
Consummation preferences are presumably the same as in the fiat economy.
However, crypto users are rather younger generations / Millenials, which are characterized by relatively low saving rates and higher consummation preferences. i.e. the demand for borrowing is bigger than the demand for lending. This factor translates into higher interest.
Time preferences for crypto users are very similar to consummation preferences. This factor translates into higher interest as well.
Rate of base-money production/destruction – Bitcoin, Ether, Dash, Litecoin, etc. have built-in growth mechanisms/inflation mechanisms, where miners are getting paid with the freshly minted crypto-coins for providing the infrastructure for the decentral networks.
These platforms are open source platforms, but the costs for running network infrastructure (hardware, bandwidth, and power) are real and they need to be financed. The built-in inflation mechanisms are the solution for financing the real network infrastructure costs.
This crypto-monetary expansion is at the moment following:
For example – Bitcoin monetary inflation is 4.29% per year and Litecoin monetary inflation is 8.41% per year.
Rate of credit money production/destruction – today’s fiat credit money – the commercial banking money, which is 90% of the total money – this is missing at the moment in the crypto economy. The crypto economy has only base-money. The crypto sector does not have credit-money yet.
The credit money has been around for the last 5’000 years, the first instances of the credit money are known from Mesopotamia and it was created in the peer to peer transactions. Credit money was created in peer to peer way for the first 4’700 years until the commercial banks started to emerge ca 350 years ago.
Then the “private credit money” of the commercial banks emerged and after the introduction of central banking, we arrived into our current “central credit money” incarnation.
Let’s put this in the perspective – our current fiat monetary system is 100 years old; the credit-money exists in different incarnations for the last 5’000 years. As credit-money has been around so long, we support the thesis, that it will emerge as well in the crypto sector.
The store of value is very strong in Bitcoin. It’s called as well the “digital gold”. Store of the value function is present in other crypto-currencies as well, but less strong than in the Bitcoin.
Crypto-currencies are not manipulatable by the central instances as the base-money or credit-money in the fiat economy. This missing manipulation is the basis for the store of value in the crypto monetary system.
As there is no-manipulation compared with the fiat monetary system, then this results in higher demand for the crypto-currencies, which translates into higher interest.
Proximity to money creation – base-money is created by decentral means and it finances the miner’s operations. Decentral credit-money is still missing in the crypto sector, but it should be the only question of time until it will emerge.
If we decentral credit-money will emerge, then the proximity to money creation will equalize between the wealthy and the un-wealthy. It’s not only corporates and wealthy, who will be privileged, but everyone will be privileged to receive crypto credit or credit-money.
Here is the summary of the factors for the crypto-interest:
Results in higher interest than the equilibrium
Results in higher interest than the equilibrium
Rate of base money growth
Bitcoin base-money is growing 4.29% per year; other main crypto-currencies are in the same area. It is less compared to the fiat world.
Rate of credit money growth
Credit money is yet missing in the crypto sphere. The total money growth ratio is therefore equal to the base money growth ratio.
Proximity to money creation
Market participants will have the same proximity to money creation. No-one has an advantage compared to the others
Store of the value function
High store of the value function, especially for the Bitcoin
The following will answer the key question of this article – how much should be the base interest for the crypto sector – we look at this at the example of Bitcoin and Ethereum.
Younger population results in higher interest
Younger population results in higher interest
Younger population results in higher interest
Younger population results in higher interest
Rate of base-money growth
4.29% per year
4.64% per year
Rate of credit-money growth
0.00% – it’s missing at the moment
0.00% – it’s missing at the moment
Store of the value function
High store of the value function drives the interest higher
Medium store of value function has a positive impact on the interest
Base interest per year
7% – 8%
6% – 7%
These would be the estimated base rates for the crypto base interest rates. I.e.if lending crypto, then the interest rate should start from this area.
This table summarizes the above discussion:
Less impact than in the crypto sphere
Rather younger populous implies higher consummation preferences, resulting in higher interest
Less impact than in the crypto sphere
Rather younger populous implies shorter time preferences, resulting in higher interest
Rate of base money growth
300% to 1’000% depending on the central bank in the last 12 years
4% – 8% per year depending on the crypto
Rate of credit money growth
6% of total money growth per year
Proximity to the money creation
The ones with high proximity to the money creation have preferred terms
No preferred segments
Store of the value function
Low store of the value due to continuous monetary inflation
High store of the value
In every monetary system, there is interest - the price to be paid for using someone else money. In this article, we focus on the “base interest” - i.e. how...
Aug 19, 2019 . 10 min read
The drivers for the interest are:
First, we analyze these factors and then we conclude how much should be the base interest in the fiat economy.
The output of the economy is expressed as GDP – Gross Domestic Product. There are multiple ways to define what the GDP is, but for this article, we use the following definition – GDP the sum of all income paid to persons (not to the companies, but the natural persons). So, the persons are receiving an income and then they decide how much to consume or to invest/save.
The interest is the price for the money, it’s the price, which has to be paid to someone else for delaying his consumption.
High interest would imply, that rather a small number of persons would like to delay their consumption – this results in the shortage of money in the economy – therefore the price for money – the interest – will be higher than equilibrium.
Low interest would imply, that rather a big number of persons are confident to delay their consumption – this results in the over-supply of money in the economy – therefore the price for money – the interest – will be lower than equilibrium.
By adding all these different wants of different individuals together we will get the fixed income markets, which intermediate between the “endpoints” – between the natural persons.
The time factor has his influence too:
If the amount of money in the economy would be constant, then the consumption preferences and time preferences would determine the price for the money – the interest – in the economy.
But as we see in the following – the amount of money in today’s fiat economy is not constant, but continuously growing.
Central banks are creating/destroying base-money. It exists:
The amount of base-money is not as stable as you might think. Federal Reserve increased the amount of base money after the 2008 financial crisis by 350%. Swiss National Bank did the same, but by 1’100%. This was called Quantitative Easing. We think Quantitative Perpetuity would be a better term to describe this.
If we look at the total base money growth of all central banks over the last 40 years, then we see the following:
The biggest part of the money is not the base-money but the credit-money. The amount of credit-money is changing even more than the amount of base-money.
Commercial banks create credit money when the loans are issued; commercial banks destroy credit money when the loans are paid back. In the relative terms – 90% – 97% of the money is credit money, created by private organizations – by the commercial banks.
The money that you have on your bank accounts is not the base-money from the central banks, it’s the credit-money created by the commercial banks. The only way for the non-bank-entities to use the base-money is to use the coins or the notes (they are issued by the central banks).
The amount of credit-money can grow and can decline in the economy.
If more loans are issued than paid back – then the amount of the credit-money is growing in the economy. This means there is more money supply, which leads to lower interest – the price for the money.
If more loans are paid back, then issued – then the amount of credit-money is declining in the economy. This means there is a declining money supply, which results in increasing interest – the pice for the money.
The amount of total credit money (so-called M3) is growing by 5% – 6% per year. One could say that every unit of credit-money is then devalued by the same ratio year by year (there is rather a constant amount of the real assets and continuously growing amount of the credit-money).
This continuos devaluation of the money-units means from another side the inflation for the end-users. The interest paid to the lenders should compensate for the continuous devaluation of money.
The store of value function derives from the other parameters. It’s listed here because it’s very different for the fiat monetary system as compared to the crypto monetary systems.
The world economy had mainly deflationary scenario 1870 – 1910. After WWI it’s mainly the inflationary scenario. The deflationary scenario benefitted the savers – their money was worth more and more, the deflationary scenario enabled the middle class to emerge.
The inflationary scenario – our current fiat system scenario – benefits the debtors – they have to pay back less and less real value. This scenario hurts the middle class as well via pension fund mechanisms. The value of the pension funds should grow at least as much as the loss of value through inflation. But as this is not the case, then the pension funds pay-outs will be much smaller as required for keeping the life-standards of the middle-class.
Benefitting the savers is the store of value function of the money. Now, if the amount of credit-money in the economy is growing ca 5% – 6% per year – meaning every unit of credit-money is devaluing by the same ratio – then how is it possible to have a store of the value function in today’s fiat money?
Well, it’s clear, the current fiat monetary system does not possess any store of the value function. It’s an inflationary monetary system, where the wealth creators of the economy – the middle class – will discover latest by their retirement that after working all their life, they have not created any wealth for themselves…
If a debtor has to pay less interest, then the fair interest in the economy, then we have hidden wealth transfer to the debtors. It’s because of the following – if inflationary money is losing more value than the interest, which the debtor has to pay than the debtor is benefitting financially from this transaction.
The wealthy have to pay little interest, which is less than the fair interest in the economy. This results in the hidden wealth transfer to the wealthy.
The non-wealthy have much higher interest, which usually higher than the fair interest in the economy. This results in the hidden wealth transfer away from the non-wealthy.
Why are there different interest rates for the wealthy and for the non-wealthy? Well, it’s the proximity to the money creation, it’s the proximity to the commercial banks’ lending, which counts. The wealthy, which are closer to the commercial banks, will do better and the non-wealthy, which are definitively not close to the commercial banks, will do not so well.
Wealthy individuals and big corporations have easier access to credit creation via commercial banks. They have to pay much lower interest. Consumer segments, however, have reduced access to the credit. They have to pay much higher interest for the same nominal values.
Central banks quantitative easing, which started after the Lehman crisis, set the goals to facilitate the lending. But it didn’t work – the QE landed in the bank accounts of corporations or big banks. Little of this trickled down to the general population, to the non-wealthy.
It’s the proximity to money creation, which counts in the current financial system. If commercial banks don’t want to lend to the Small Medium Enterprises or consumers, then they will not do this. Pushing QE into the economy, will not force private organizations (banks) to do more lending. Pushing QE means only, that the wealthy are becoming more wealthy.
Inflation is defined as a loss of purchasing power of money. Mainstream macroeconomy presents the orthodox view that healthy inflation is always required and healthy for the economy. U.S. Fed for example targets 2% inflation per year.
This struggles us because the productivity increases continuously due to the innovation, which should lead to the decline of the prices, i.e. to the deflation (opposite of the inflation). This healthy deflation is beneficial to the savers because they will be able to consume more real assets (opposite to today’s situation, where money buys less and less).
However, as central banks are using monetary instruments to create inflation, then we have inflation in the economy.
Back to the interest – the base interest in the economy should be at least as much as the inflation, i.e. it should compensate for the loss of the purchasing power of the money.
This leads us to the question – how much is the inflation in today’s economy? We have to distinguish between the:
Official inflation calculation is “kind of optimized” – let’s think here on the transfer costs (health insurance costs are not included) and substitution effects (one should eat chicken if beef prices grow too much). The fact is that the official inflation calculation was changed in the 1990s. It is now circa 2.5% in the U.S.
Real inflation, based on the before 1990’s method, should be around 6% per year in the U.S. (please have a look at the www.shadowstats.com for the backgrounds).
There is a total output of the economy (GDP) and there is a total amount of the money in the economy (so-called M3).
There are two scenarios for the base interest:
The first scenario helps the party’s with huge liabilities – for example, our governments. Having higher inflation allows to reduce nominal liabilities, it allows to “inflate” the debt away.
The second scenario helps anyone, who is borrowing for investing in the real assets – either for buying a house or for the retirement or for the kid’s education. This scenario is the best for the middle class.
The rate of credit money growth is circa 6% in the U.S, based on the discontinued government M3 statistics, however, recalculated by ShadowStats:
This implies the base interest should be as well ca 6%. Otherwise, the money would lose his value just by staying on the bank account.
Central banking is driven by the philosophy that there has to be inflation in the economy. Negative inflation (or deflation), which would be actually beneficial for the savers, is considered something very bad by the central banks…
Central bankers will explain their view in the following way – if the value of money will increase over time, then the consumers start to delay consummation decisions; enterprises will not invest, and all economy will become to the standstill.
Well, central bankers forget that, for example, the U.S. economy before the creation of Fed was a deflationary economy – it was economic boom time and it was the time where the savers become wealthier.
But why then this misconception in today’s central banking? Well, the trigger is the amount of credit money in the economy. Today’s economy is significantly over-leveraged by debt. The pre-Fed economy had much lower debt ratios. There was a clear separation of the base money (gold) and credit money in the pre-Fed area. Credit money was temporary and was always reversed back into the base money (gold). This system didn’t allow to create debt bubbles.
It’s not the fear of deflation, it’s the fear of the debt bubble, which keeps the central bankers inflating the system. Our current system doesn’t have a clear separation between the base-money and credit-money. Credit-money was supposed to be temporary and always reversed back to the base-money. But this is missing – we have not temporary but a permanent credit-money, which leads through inflationary policies to ever-growing bubble.
By lowering the central bank short term interests, by Quantitative Easing, by lowering the balance sheet requirements to the commercial banks – all these instruments are there to create an additional amount of credit-money and via this additional inflation and to prolong the status quo.
Let’s reflect the key points from here:
The current fiat money intermediation system is “kind of de-functional” in the current state.
It is not designed to keep and expand the middle-class. It’s current design and implementation leads to a continuous wealth transfer from the non-wealthy to the wealthy. It leads to a society with 1% and the rest.
We look in this article on the risk management of the custodial crypto lending platforms and of non-custodial crypto lending platforms. The aim is not to say what is right...
Sep 28, 2019 . 10 min read
We look in this article on the risk management of the custodial crypto lending platforms and of non-custodial crypto lending platforms. The aim is not to say what is right or wrong, but to create transparency about both business models from the risk point of view.
We look here on Nexo.io and on Celsius.network. Both systems represent custodial lending systems. Clients transfer their assets into platform wallets and platforms control their assets. Platforms then lend out the assets via marketplace or institutional channels. Platforms receive interest, they keep smaller parts of the interest and the clients receive the bigger part of the interest.
Nexo.io and Celsius.network have bought insurance policies to cover the client asset losses on their platforms. They pay a yearly fee but their coverage is capped at a fixed amount.
We have two key sub-types of lending:
From this moment we have to trust the contracting party and his lending/margin management processes. We have to trust as well, that the contracting party will not be hacked or the assets are not frozen because of regulatory issues (think Bitfinex and 850 mUSD) and many other risks. This lending sub-type has a higher risk than the first sub-type.
The key difference between these sub-channels is the following – in case of the first subtype, the platform can manage the end-to-end process. In the case of the second subtype, the assets are under the legal control of someone else…
Of course, there are contracts in place, but let’s keep in mind two cases from not so distant traditional finance history:
In traditional finance, we have a sector called “prime brokerage”, which is providing services, especially to the hedge funds. Investment banks pool their client assets, which are lent to hedge funds, which pay interest for them. Hedge funds borrow these assets for short selling (you borrow an asset, sell it and hope to buy it back at a lower price).
If the trade works, then you make a nice profit. If the trade is not working, then the margin calls are issued to the hedge funds. If the trade goes totally wrong, then the hedge fund is not losing only the collateral but has to put in additional money, to cover the losses. If they, don’t have this money, then they are bankrupt. The pooled and sliced client assets will be part of bankruptcy proceedings.
That’s why the “primer brokerage” the business has high-interest margins. It’s because of the high risk. That’s the same business that the crypto lending platforms are doing with their institutional clients.
Yes, we have. The vision of the regulations is to create a fair marketplace for service providers. The reality of the regulations is that they create the entry barriers for the non-members of the club. It’s just because of the revolving-door-phenomena – the regulators hire their people from the private companies in the sector, which will by nature protect their sector. And the private companies hire as well people from regulators, let’s call it – for preferred information and access.
The current regulations state (de-facto in all countries) is following – if you control client assets, what the custodial platforms do, then you will need a financial intermediary license. You not only need to apply for this, but you also have to maintain it year by year.
Custodial platforms provide the services in “cross-border mode” to other jurisdictions as well. But that’s where it gets interesting – providing “cross-border service” to other jurisdictions is OK, but doing marketing for a platform is not OK, except when the platform has registered in the respective jurisdiction. In the case of the U.S., it’s even more complicated – it’s enough to have cross-border service clients from the U.S. and the platform will need U.S. licensing (think here on the NY Attorney General versus Bitfinex case because of presumably 1 NY client on Bitfinex platform).
We look here on MakerDAO and Compound.finance as examples. We look only at their AS-IS business model.
Their model is simple:
But what can be the failure points?
Black swans are defined as 3-sigma (standard deviation) events and they should be very seldom events. Funnily there are more black swan events than the statistical theory allows. Are the statistics wrong?
No, it’s just the wrong statistics which are used – the financial markets are modeled based on the random-walk-hypothesis (which has never been scientifically proved, it’s just as the name says – “hypothesis”) and this hypothesis implies using of the standard distribution (as everything is random, then this would be logical conclusion).
But the financial markets act based on the power-law distribution, as most of the things in nature. And by this distribution we have a much higher frequency of the black swans, meaning there are many more risk events than anticipated.
We looked at the risks in two different crypto lending business models – custodial and non-custodial. The custodial business model is rather similar to traditional financial intermediaries. The non-custodial business models are new innovative business models.
Regarding the platform risks – we will not say which platform has fewer risks.
However, we refer to the common-sense hypothesis – if comparing two different models, then:
Traditional fixed income markets have emerged in the last 350 years with: 19 trillion USD base money (central banking created money – M0) 36 trillion USD narrow money (M1) 73...
Sep 29, 2019 . 10 min read
Traditional fixed income markets have emerged in the last 350 years with:
(Source: https://cryptovoices.com/basemoney and http://money.visualcapitalist.com/worlds-money-markets-one-visualization-2017/ )
The M0 money – the base-money – is created by the central banks. The other types of money include M0 plus credit-money, which is created via the commercial banks via lending (every time one takes a loan from the bank new credit-money is created; every time one pays back the loan the credit-money is destroyed). The global debt includes M3 money and bonds (transferable standardized debt obligations).
We see that in traditional finance the debt markets are bigger than the equity markets. They are older as well – let’s think that the laws allowing the creation of corporations are just some hundreds of years old and the laws for debt obligations are thousands of years old.
In parallel the crypto monetary system is developing – it has emerged since the last 10 years:
Our vision is, that crypto fixed income markets, which are 20% of the crypto equity markets at the moment, will become proportionally at least as big as traditional fixed income markets – i.e. crypto fixed income markets will become bigger than crypto equity markets, while crypto equity investments are simultaneously growing.
Let’s look now on Compound.finance. It has become a popular Decentral Finance (DeFi) product and is managing ca 150 million USD of crypto assets as a decentralized money market fund.
Considering the popularity of the Compound and our aim to facilitate fixed income markets emergence in the crypto sector we decided to research the gaps between the Compound and traditional fixed income markets.
This article looks at:
Compound emulates money market funds via smart contracts
The interest rate is set continuously via the following formula
Borrower Annual Interest = Base Rate + (Multiplier * Utilization Rate)
A linear equation is setting the variable interest rate, the “markets invisible hand” is not involved.
How do the fixed income markets work?
Fixed income markets are driven by interest. We have written earlier an extensive analysis of “What drives the interest in the fiat economy and how much should it be?” and “What drives the interest in the crypto economy and how much should it be”.
Let’s recap – the key drivers for the “base interest” are:
Some of these drivers increase interest, others decrease interest. Referenced articles calculated what should be the base interest rate for the fiat economy and for the crypto economy. NB – the interest which we calculated, does not match with the base interest rate in our current central banks driven economy.
The base interest rate in the economy – the “risk-free rate”- is set by the central banks. For example, in the U.S. we have 2%, in the Eurozone -0.4% and in Switzerland -0.75% (yes, these are negative “risk-free rates”).
Loans have different maturities – 1 month, 3 months, 9 months, 1 year and so on. Usually, the loans with longer maturities have higher interest and vice versa. If we plot the interest rates for different maturities and for the same credit quality, then we get the yield curve.
The yield curves are calculated via government bonds – for the Treasuries or for the German Bunds. Government bonds are considered “risk-free” and they do have high liquidity.
Some countries face higher default-risk (some of South-European Countries) and in the case of free markets, their yield curves should be higher if U.S. or Germany’s yield curves.
Different entities have different credit risk ratings (from AAA till BBB – these are investable, and then there are risk ratings below BBB – a.k.a. junk b0nds).
If we speak of specific loans, then the interest for a given maturity is calculated as follows:
If the loans are structured as bonds, then we are creating transferable and tradeable debt instruments. The aggregate of all these bonds creates a global bond market with a size of 100 trillion USD.
Which risks do we have on the fixed income markets?
Credit risk is the risk that the borrower will be late with the payments or will not pay at all. If loans are secured, then the collateral ownership will move over to the lender. If loans are not secured, then the lender will take the borrower into court or will sell the non-performing loan to the loan liquidators.
Interest rate risk exists in case of variable rate loans – in case that the variable rate will go up against the borrower. It exists as well in the case if we want to roll-over the loans and the interest rate has increased in the meantime.
Market risk is a risk that the market moves against the market participants. For example, in collateralized lending is the risk, that market has flash crashes, which will trigger the liquidations.
We note following in Compound business model:
No yield curve, but only the variable interest rate
The Compound has only variable rates (calculated at every new Ethereum block), there is no yield curve. If someone needs to take a loan for 3 months, then he needs to finance this for 90 days with variable rates.
In traditional fixed income, one would take a 90 days loan and fix the interest rate based on the yield curve. His interest rate risk would be mitigated, the interest rates could not go against the borrower.
Algorithmic interest rate
The Compound interest rate is set algorithmically (via linear equation). In traditional markets, we do have the “invisible hand of the market”, which would set the interest rate via the equilibrium of supply and demand for a given maturity and given credit risk.
Compound users are lending/borrowing money at short maturity and are practically rolling over day by day into the new variable interest rate.
Both sides – lenders and borrowers can stop the loans at any time. However, there is no way to call in existing loans from the borrowers. If borrowers like their interest rate, they can stay on their loans for a long time and keep paying the interest. If for example lenders would like to receive their funds, but the fund’s utilization is too high (i.e. that the unallocated funds are not available), then the lenders have to wait till borrowers will pay back funds or new funds are submitted into the fund.
That’s a typical maturity mismatch situation. The loan maturity for the borrowers is unlimited. The loan maturity for the lenders is daily (they can call in their loans at any time). The result is a maturity mismatch, which is 99% of cases not an issue, but it can be an issue if everyone and their grandma are running to the same exit-door at the same time. If this situation happens, the lender will be unable to withdraw his funds.
Which risks exist on Compound:
Following components are required:
The yield curve would show the interest rate for different maturities. I.e. instead of using only variable interest rate, there should be as well 1 week, 1 month, 3 months, 6 months, 12 months, and longer maturity interest rates.
The credit-money itself has existed for 5’000 years. Most of this time as decentral-credit money. Only the last 100 years we did had centralized credit money.
The Compound has addressed key elements of crypto lending, however, it lacks several features required for the fixed income markets. Nevertheless, it’s a step in the right direction.
The Roadmap the Crypto Fixed Income Markets requires several additional components. These components are part of traditional fixed income markets and they will be part of Crypto Fixed Income Markets too.
There is a lot to do!
There are the custodian and non-custodian crypto lending platforms. The key difference between them is who controls the assets - the first ones control your crypto assets, by the second...
Sep 22, 2019 . 10 min read
There are the custodian and non-custodian crypto lending platforms. The key difference between them is who controls the assets – the first ones control your crypto assets, by the second ones it’s you who is controlling your assets.
Both of them propagate the interest rates on their platform, as the key benefit for the borrowers and lenders on their platforms. But is the interest rate really all and everything, what should be followed?
Our answer is – actually not. While interest rates and risk management are the key drivers for the lenders, there is one more parameter to be followed – the capability to borrow for the borrowers.
Here are current interest rates for DAI (they are pretty similar to the USDC)
The interest rates between custodial and non-custodial platforms are more or less the same. Non-custodial platforms are saying that custodial interest rates should be higher because of more risks (hacks, loss of assets, etc). Custodial platforms are saying the non-custodial interest rate should be higher because of potential mistakes in smart contracts.
Therefore, let’s use the https://loanscan.io data as a basis.
Here are for example current DeFi (Decentral Finance) collateral rates:
These collateral ratios are more or less the same on the custodian and non-custodian platforms.
Let’s imagine two scenarios for the borrower:
The interest rates in both scenarios are the same, but the Loan To Value (LTV) is different:
Capability to borrow shows, how much can borrower borrow on his given asset basis. If the borrower would have two similar offers with different LTV’s, then the borrower should choose the one with higher LTV.
What does it mean?
The capability to borrow does not matter to the lenders. Lenders are interested in:
But the capability to borrow matter’s very much to the borrowers:
Let’s imagine further two scenarios for the borrower:
Scenario C (the same as Scenario A)
The Loan to Collateral Value’s (LTV’s) are different. The interest rates are different too. The loan amounts are the same. But which option is better for the borrower?
Scenario C: LTV: 33%; Interest 10%
Scenario D: LTV: 66%; Interest 15%
The borrower will pay in Scenario C for this 50% more interest for 100% higher LTV – the borrower will have higher leverage on his assets. If the borrower needs leverage, then Scenario D is preferable for the borrower – he would pay a little bit more interest for a much bigger loan
Current DeFi and custodial platforms are using very high collateralization ratios. This is protecting the lenders.
However, the borrowers would be interested not only about the interest payable but about lower collateralization ratios, which would lead to the higher capability to borrow.
We analyzed the reasons for high collateralization ratio’s in another blog article. Here is the summary.
SmartCredit.io is funded from 2 CFA’s and ex-Bankers. The risk management is never a one-dimensional approach of over collateralizing the loans, but it’s a network of different measures, which on the end translates into usability:
This results in the least factor 2 – 2.5 smaller collateral requirements as the current standard in the industry. Which results in a higher capability to borrow.
The current collateralization ratios are ca 300% + for the DeFi borrowing/lending protocols. These ratios benefit the lenders on these platforms because over-collateralization protects their loans. However, these ratios reduce...
Sep 18, 2019 . 10 min read
The current collateralization ratios are ca 300% + for the DeFi borrowing/lending protocols. These ratios benefit the lenders on these platforms because over-collateralization protects their loans. However, these ratios reduce borrower’s capability to borrow and therefore the usability of the system.
This article analyses:
These ratios are rather high compared to margin borrowing requirements in traditional finance. Why is it so?
The collateralization approach is directly linked to the risk management framework. The key here is to combine multiple risk management elements, which then leads from one side to the smaller collateralization ratio and from the other side to better risk management.
Here is the list of measures for collateralization reduction:
On Maker and Compound platforms the borrowers do have unlimited maturities.
The platforms protect themselves with the collateral liquidation, if for example, the collateral value sinks to 135% of the loan, then the Maker will liquidate the collateral. The same with Compound (the ratios might be different).
If we would have fixed maturity loan, then we could calculate via standard deviations and loan maturity, how much collateral we should have, so that by given probability we will not hit the liquidation threshold.
Step 1: Calculate 30-day standard deviation of the underlying collateral
Step 2: For calibrating standard deviation to loan maturity we have to multiply standard deviation with the square root of “loan maturity / 30”.
By doing this we can set the amount of collateral so that the liquidation probability will be low.
But Maker and Compound do not have fixed maturities, therefore it’s not possible to calibrate loan collateral to the loan maturity. This results in very high collateral requirements, which then reduces borrower’s capability to borrow.
Could Maker use fixed maturities?
Maker DAO uses Collateral Debt Positions to create the DAI’s – borrower puts Ether into the Smart Contract (CDP) and receives the DAI’s. Having fixed maturities would imply fixed maturity CDP’s – borrowers would need to close these CDP’s before the maturity with paying in DAI’s into the CDP’s and receiving back the collateral. If the borrower forgets to pay in DAI at the right time, then the CDP would go into automated liquidation, independently from the collateral ratio.
Could Compound use fixed maturities?
Compound could introduce fixed maturities exactly in the same way as Maker. As maturities have to match on borrowing and lending side, then lenders should make fixed maturity loans as well (otherwise we get into the maturity mismatch and “bank run” risk on the platform).
Having fixed maturities would imply moving away from the “money market fund with variable interest” rate, which would be quite a change into the Compound’s business model and smart contracts.
Some assets have lower standard deviation and their collateral requirements will be smaller. Other assets have a higher standard deviation, which leads to higher collateral requirements.
Collateralization parameters cannot be something static, which is fixed in the smart contracts, but need to be continuously re-calculated. If this is not the case, then the mitigation is to increase the collateral for any eventuality.
Compounds and Maker’s approach is to over-collateralize for avoiding the worst market dynamics. But the other approach would be to use Loss Provision Funds to protect against adverse market dynamics.
If one can use only over-collateralization, then one has to prepare for the worst-case for every loan – i.e. for the non-paying borrower and for the collateral value flash crash for every loan.
If one would use over-collateralization plus loss provision funds, then the over-collateralization could cover till 2-sigma events and after that, the loss provision fund would take over. The result would be increasing the borrower’s capability to borrow.
Current DeFi systems are not using credit risk ratings for the borrowers. From one side there are no systems available, which would provide this information, from the other side the DeFi systems are avoiding collecting any user data.
However, having credit risk ratings would allow us to separate good risks from less good risks. Good risks would get better collateral requirements and vice versa. Credit risk ratings would be the approach for the users to monetize their data – having good credit risk (and opening up his data) rating would result in better borrowing conditions.
Credit risk ratings would allow as well-diversified approach with the collateral handling. In case of good credit risks, one doesn’t need to rush into the collateral liquidation in flash crashes. However, in case of not good credit risk ratings or not opening up his data, one would need to liquidate the collateral during flash crashes.
In traditional finance we have legal contracts. If the debtor is failing to meet his obligations, then the NPL (Non-Performing Loan process) will be started. Usually, the debt will be sold to the debt collection agencies, which are paying 5% – 20% from the amount owed. Debt collection agencies continue then with the NPL process against the borrowers.
Using the NPL process would require KYC. Many DeFi products see KYC as something that should not be followed. However, as KYC is the law in practically all countries, then we can just forecast that most of DeFi products start to use KYC as well.
Current high collateralization ratios are driven by the respective business models. If we adjust business models, then we will adjust as well the collateralization ratios and increase the usability for the borrowers via increased capability to borrow.
SmartCredit.io collateral requirements are by factor 2 – 2.5 lower than the MakerDAO or Compound requirements.
It’s achieved via:
This results in a higher capability to borrow with equal interest rates to other platforms.
The lenders have unique features as well – the tokenization and transferability of their credit, which enables immediate liquidity to the lenders. And they have as well capability to define private fixed-income funds:
DAI and USDC lending rates on DeFi systems are around 10%. Considering the current low yield on most of the investment classes and upcoming negative interest era, we can just...
Sep 15, 2019 . 5 min read
DAI and USDC lending rates on DeFi systems are around 10%. Considering the current low yield on most of the investment classes and upcoming negative interest era, we can just say that these are good yields.
But why are these lending rates around 10%?
Well, it’s about “following the money”.
The key question is– who are the biggest clients for borrowing. Our suspicion is that these are the margin traders on the central crypto exchanges.
These exchanges with margin lending features have their own P2P margin lending marketplaces, where lenders can lend assets and margin buyers can borrow the assets. These marketplaces have their own interest rates and our thesis is that these margin trading loan interest rates are driving as well the DeFi interest rates.
We look at the following:
After this initial number crunching, we will discuss what it means.
Here are the borrowing rates from the https://loanscan.io for the USDC (asset-backed USD stable coin, issued via Coinbase and Circle) and DAI (algorithmic USD stable coin, smart contracts created by the MakerDAO).
The borrowing rates are for the last 3 months:
Here is the amount of loans outstanding via https://loanscan.io:
So, there are 145 mUSD outstanding loans in the DeFi protocols as per now.
We use for the margin lending rates Bitfinex because this data is publicly available. The following chart shows the USD borrowing rates on the Bitfinex P2P margin lending/borrowing marketplace. The bold line shows the so-called “volume-weighted average” and the blue bars show the marketplace rates.
The interest rates are daily, to translate them to annual interest rates let’s multiply them with 365 and we get circa 10% annualized interest rates.
The margin lending volume for Bitfinex is public. Here is the latest data:
We see ca 400 mUSD open positions. That’s only on Bitfinex. Adding data from other exchanges is difficult because this data is not public. But let’s calculate with 10 active margin lending programs from ca 250 exchanges listed in the CoinMarketCap and we can speculate that the total open position is between 1 bUSD – 4 bUSD.
These are the key findings:
Which leads us to the key question of this article – why are the DeFi interest rates ca 10% for DAI and USDC?
The answer is in “follow the money”. It’s because the leading market is the crypto margin lending market. That’s the market, which sets the interest. The DeFi market just follows.
We speculate as well, that the biggest part of DeFi borrowing will be allocated into the crypto margin trading. Either via the central exchanges or the decentral exchanges.
If interest rates between the crypto exchange margin programs and DeFi would be different, then there would be arbitrage possibilities – the borrowers would borrow on the platforms, which offer less interest and the lenders would lend on the platforms, which offer more interest. This human behavior would move the markets back into equilibrium.
World today is by a big extent influenced by the wealth pyramid, so that to 1% of people own 46% wealth in the world. It is known, that the rich...
Apr 23, 2019 . 3 min read
World today is by a big extent influenced by the wealth pyramid, so that to 1% of people own 46% wealth in the world. It is known, that the rich become richer and we have got somehow used to it. We don’t question it, we see it almost as normal.
But why is it like this? Why is the wealth in the world distributed so unevenly? How did it come that 3.7 billion people have only 2.7% of the world wealth?
One of the main reasons is our current banking system — the fiat money system. It creates the impression that stable money is available in the world, right? But behind the scenes, the amount of money is continuously expanded and the unfortunate side effect is that from the money creation profits rich class and poor class sees only inflation of prices.
Even if the poor class has an impression of stable money, relatively they can buy less and less for their money as profits from the fiat money creation accumulate to the rich class.
Why does it happen so? Key drivers here are the proximity to the money creation (commercial banks do this) and having access to the credit on favorable terms. We can summarize this as follows:
Effect of the fiat money creation system on the wealth pyramid is clear. Rich become richer and the poor become poorer.
What can we do? Cryptocurrencies created non-government controlled money. It is a big step forward. But it is not enough. We need more. We need to distribute profits from money creation (seigniorage) evenly in the world.
Therefore, we created SmartCredit.io. To make the world a better place, to have more even wealth distribution in the world, to give chance to the non-included people in our world and to reduce inequality in our world!
Join the revolution.
In the previous article, we looked at the two dimensions of money — base money and credit money. We also looked at the different kind of monetary systems that existed in the...
Mar 26, 2019 . 5 min read
In the previous article, we looked at the two dimensions of money — base money and credit money. We also looked at the different kind of monetary systems that existed in the last 5’000 years and possible scenarios for the future.
The key question is — will it be different this time? Will we enter a phase of crypto-based money without having some form of crypto-credit money or will credit money be included in the crypto sector?
Here is the summary of the monetary systems from the past 5’000 years.
The first conclusion from the previous article is that monetary systems are not static, but are ever evolving:
The second conclusion is that the decentralized credit money system has existed for thousands of years without central intermediaries.
As we are in the crypto age, let’s analyze how decentralized credit systems worked in the past.
It was all based on the bill of exchange — these are legal documents enforced by the court system. Anyone can issue a bill of exchange, it has only 8 attributes, including the wet signature of the borrower. The borrower has to pay, not to the issuer, but to the owner of the bill of exchange. This gives value to every bill of exchange as they are backed by the borrower’s obligation to pay. This allows the use of bills of exchange as a mean of payment:
Bills of exchange are enforced by the court system — there is no court hearing, there is only validation of the evidence, analysis of who has to pay whom, and a court decision. It is as simple as that.
The bill of exchange system is a P2P system backed by the court system. Every lender can create new credit money — the bills become the credit money, till they are paid back to the holder. One doesn’t need banks to create the credit money, every person can do this via a bill of exchange.
This system works as well today, even without the blockchain. This system has been the basis of all decentralized credit money systems in the last 5’000 years.
But there are limitations to this system:
Bill of exchange networks could become arbitrarily complex, with multiple borrowers, lenders, and holders. But without central middlemen:
Here is a more detailed view of how it could work:
It would work very similar to the bill of exchange system, but it has to address the weaknesses of the previous systems:
Our forecast for the future is the following:
This future does not depend on central bank based money creation or commercial bank credit money creation. Instead, it will be an alternative financial system. However, it’ll not really be a new system as it has existed for the last 5’000 years. Only this time it will be empowered by the blockchain.
Our forecast roadmap:
This time will not be different, there will be crypto credit money as well. It’s not yet there, but it might be there faster than anyone is anticipating.
During presentations about money, we usually hear that money has to be durable, portable, divisible and fungible. We fully agree with this distinction. However, there is a bigger picture. Money...
Mar 26, 2019 . 9 min read
During presentations about money, we usually hear that money has to be durable, portable, divisible and fungible. We fully agree with this distinction.
However, there is a bigger picture. Money doesn’t have just one dimension, it actually has two — the base money and the credit money. The notes and coins in your wallet are the base money. The money what you have in your bank account is actually the credit money.
Below is a picture of the first known credit money, from Mesopotamia, from ca 2’500 B.C., now in the possession of the British Museum in London:
The intuitive answer to the key question of this article will be — yes. Since credit money has been around for so long, it will be around in the future as well.
The crypto sphere today does not have any form of credit money. Bitcoin, Bitcoin Cash, Ether, etc. can only be used as base money because credit money has to be dynamic. Credit money is elastic; it is created and destroyed every time we perform economic transactions.
Let’s start with how they work today. Base money is created by central banks and credit money is created by commercial banks. Base money constitutes about 3% — 7% of today’s money, the rest is credit money.
Credit money is elastic, it’s amount grows and declines together with economic transactions. More economic transactions result in more lending which results in more credit money and vice versa.
This elasticity parameter is the key reason why we say that Bitcoin, Ether, etc. are not a form of credit money, but base money.
The supply of credit money also rises and falls — additional economic activities lead to additional demand for credit and reduced economic activity to reduced demand.
Credit money is, by principle, rather temporary. However, in our current monetary system, we create more credit money than we destroyed, resulting in the continuous growth of the total credit money available circa 5% — 7% per year.
Credit money is created by commercial banks in the lending process (no, commercial banks are not lending your grandma’s deposits, they create credit money by the so-called “balance sheet extension” procedure).
Credit money is created every time you receive a loan from a bank and destroyed every time you pay back a loan. The money, which you have in your bank account, is not as durable as you might have thought — there are continuous cycles of destruction and creation happening in the background.
Banks create credit money and protect it with their reserves (for example, the Deutsche Bank which has a balance sheet to equity ratio of 100:1) and there are national deposit insurances as well (for example, the Swiss deposit insurance, which has reserve funds to cover 4% of all Swiss deposits).
In practical terms, banks do the following:
Banks protect the value of the credit-money which they have created with this mechanism.
Well, what happens if this mechanism fails? No problem, it’s fixed by creating more of the same (creating more credit money):
Obviously, this mechanism will result in inflation (sooner or later) or in deflation (if no-one wants to borrow anymore), but as this happens later, then this is someone else’s problem.
Some people say that this system reminds them a little of the “musical chairs game”. We think that’s wrong — it IS the musical chairs game.
Monetary systems have always been made up of base money and credit money. The differences lie in:
Our current fiat monetary system is actually not very old, it started in the time period between the Federal Reserve creation (1913) and the gradual gold standard abolishment (1933 — nationalizing gold in U.S., 1944 -Bretton Wood agreement, 1971 — removing gold backing from USD base money, 1992 — removing gold backing from CHF base money).
Our fiat system looks as follows:
How did it work before our fiat system? Through the following:
This system started to emerge around the time period of the creation of the first central banks (in Sweden and England in 1660’s) and lasted until the Federal Reserve was created in 1913.
There were several sub-phases during this time — free banking areas, gold-based systems, some countries introduced central banks earlier, some later. In some cases, the central banks were “independent”, in other cases there were state treasuries, etc.
The key to this phase was however
The earlier phase started around 500 B.C. and lasted until 1660. The first coins were created around 500 B.C. — this was the time when the standing armies in Europe, India, and China had to be financed — they were financed with sovereign minted coins.
In the beginning, the coins were usually 100% gold or 100% silver. Then later the kings started to reduce the ratio of precious metals in the coins — this caused hidden inflation in base money. However, the coins were legal tender and one had to accept them.
In the time period when the Phoenicia, Islamic Trading Network, Mediterranean and Hanseatic Trading Networks existed. Decentralized credit money was created, in peer to peer transactions. Obligations to pay were used as bearer notes which could be used to pay third parties, who could pay fourth parties and so on. In the end, the borrower had to pay to the owner of the bearer note.
So, the key to this phase was:
But how did it all work before 500 B.C? There were many blossoming civilizations during that time and the following are common to all of them:
However, governments and sovereigns were not involved in the definition of what the base money had to be — the people decided it. Neither did they define how credit money had to work — the people also decided it. There was no government involvement. But there was a court system for enforcing contracts. And there was a government system for enforcing the court’s decisions.
The first known credit money is from Mesopotamia, from about 5’000 years ago. It was created decentrally, in peer to peer transactions. Mesopotamia used grain as their base money — the unit of account was a barrel of grain. On top of this was the decentralized peer to peer credit money, in this case, clay plates with the stamps of the borrowers.
Obviously, the barrels of grain were not easy to use in daily transactions. This facilitated the usage of clay plates based credit money even more.
By using base money and credit money dimensions we can classify the monetary systems of the last 5’000 years as follows:
The current crypto sphere doesn’t have the credit money approach, but none of the civilizations in the past has survived without credit money. Which leads us to the next question:
The first conclusion is that credit money has been always there. It has been created either as:
The second conclusion is that we are presented with two different possibilities to create base money:
Uncontrolled creation of base money means that a commodity, which cannot be manipulated, will be used as the base currency. The Swiss National Bank has increased its amount of base money by 10x in the last 10 years since the Lehman crisis. One cannot do this with commodity-based base money.
U.S. Courts have defined Bitcoin as a commodity. Some people are unhappy about this. However, we are very satisfied with this — it allows us to move back to the commodity-based monetary systems (which are then by definition, non-manipulatable).
But what’s about the crypto credit-money? If we use the Bitcoin as our base money, who will create crypto credit money? In the end, there are 3 possibilities — decentralized credit money, privatized credit money or centralized credit money.
Credit-money has been around for the last 5’000 years. No key civilization from the last 5’000 years has survived without using elastic credit money of one form or another.
But credit money is currently missing in the crypto sector. Bitcoin, Bitcoin Cash, Ether, etc. have the characteristics of base money. They are missing various characteristics, the elasticity, the continuous creation, and destruction, and more of credit money.
So, who will create elastic credit money for the crypto sector?
Our thesis is that the pendulum will move back to where we started:
It will be the same as it was in Mesopotamia 5’000 years ago. But this time empowered by the blockchain.
Some readers may remember the NASDAQ Dot-com bubble of 2000, but most readers will remember the Crypto bubble of 2018. In this article, we ask if we can leverage our...
Feb 28, 2019 . 5 min read
Some readers may remember the NASDAQ Dot-com bubble of 2000, but most readers will remember the Crypto bubble of 2018. In this article, we ask if we can leverage our knowledge of NASDAQ’s 2000 bubble in forecasting future crypto trends? What are their commonalities? And what will happen next?
NASDAQ composite is a stock market index of securities listed on the NASDAQ stock market. It is heavily tilted toward information technology companies. NASDAQ composite was launched in 1971 with a starting value of 100 and it peaked at 5132 in March 2000. After that, it fell to 1108 in October 2002, a — 78% decline. This was the dot-com bubble.
NASDAQ has recovered from these lows and the current price is around 7400 (in Feb 2019).
Here, we use Bitcoin as a proxy for the crypto markets. It reached a top price of 19500 in Dec 2017, and the current low, 3250, in Dec 2018. This represents an 84% decline.
Many believed, like in the NASDAQ 2000, that “this time it is different” or that it’s “the new economy”. It wasn’t so.
The dot-com bubble was driven by the belief in new technology — the Internet. The NASDAQ Composite was full of stocks which lacked real business potential.
The initial focus was on broadband cable companies, which were seen as a new infrastructure which would eventually generate huge revenues. However, this resulted in the oversupply of broadband infrastructure, internet connectivity prices collapsed and with them the stocks of the respective broadband companies as well. The positive outcome was that Internet broadband became a commodity and became available for most of the population.
The real business models of the Internet were not present before the dot-com bubble. These new, so-called Web 2.0 business models — Amazon, eBay, Facebook, Google,… emerged after the dot-com bubble.
All of them started to generate revenues/benefits compared to brick-and-mortar models, which translated into huge Discounted Cash Flow based valuations thanks to the network effects (value of the network increases in quadrat to the growth of the nodes in the network):
The internet was and is a major disruption enabler. However, interestingly — the initial business models on the Internet tried to mirror the brick-and-mortar world into the Internet. It took 5+ years before the new disruptive revenue generating business models emerged.
The crypto-bubble was driven by the belief in new technology — in this case, the blockchain. CoinmarketCap.com was full of projects without real business potential (remember that it was believed that you didn’t need cash flow/benefit based valuations then).
The initial focus was on the “smart contract platform” systems, which were the key enabler of blockchain disruption. However, being the key enabler doesn’t mean revenue generation. It can mean becoming a commodity as it happened with broadband during the NASDAQ bubble.
Our forecast is that smart contract platforms will consolidate, there will be some global/central platforms and other rather region specific platforms. (Having a smart contract platform could be compared to the importance of having/controlling maritime sea routes two centuries ago).
However, it is not the most technically advanced platform that will win the race, it will be the platform with the most users by now. Winning the race doesn’t mean becoming a cash flow generator, it will rather mean becoming a commodity or standard in the industry.
So, who will be the new eBay’s, Amazon’s, Google’s for the blockchain economy? The answer to this is in the new disruptive business models — it’s about cash flow/benefit generating disruptive business models.
So, what are the real disruptive revenue generating business models on the blockchain? There are the following:
These business models — money, credit, data, supply chain, energy, rights, and assets are by their nature decentralized. Adding a transaction fee per value-added business transactions will allow easy monetization and enables discounted cash flow based valuations. Adding a network effect will multiply these valuations.
The NASDAQ 2000 bubble and the crypto 2018 bubble were similar events. The next similarity will be what will happen afterward.
In both bubbles, the platforms (broadband or smart contract platforms) had the highest valuations. In the case of NASDAQ, broadband became the commodity. We expect the same from the smart contract platforms.
In the case of NASDAQ, the real value adding disruptive business models emerged. Real value-adding transactions drove the discounted cash flow based valuation of these companies.
Our forecast is that the same thing will happen in the crypto sector — new disruptive cash flow generating business models will emerge. The companies behind these models will become the new Facebooks, Googles and Amazons.
How to find these companies — it’s actually pretty easy:
We have heard many people saying “this time will be different”. We don’t think so, we think “this time will be the same”. History will repeat itself. Major disruptions are driven by real value-adding business models. It’s all the same. It’s the economy.
Tokenmarket.net lists more than 270 ICOs (many of them completed, some ongoing and many others upcoming). Some ICOs are supported by lots of PR and advertising, while others less so....
Jul 21, 2017 . min read
Tokenmarket.net lists more than 270 ICOs (many of them completed, some ongoing and many others upcoming). Some ICOs are supported by lots of PR and advertising, while others less so. There is certainly a “get rich quick” hype in the ICO space. How should an ICO investor decide where to invest? This article proposes an unorthodox investment approach: the lazy investment strategy. Of course, read at your discretion; this is not financial advice.
First we compare the market capitalizations after the ICO phase with current market capitalizations (based on the market capitalizations listed on coinmarketcap.com). As coinmarketcap.com does not always show the market capitalizations from the first day, in some cases these figures have to be estimated (applying the following: coin price after issuing X available supply). The current market capitalizations are indicated as at July 20th, 2017. The last column shows the growth factor — by how many multiples has the market capitalization grown since the ICO launch.
This table is not representative for all ICOs but is intended to provide a factual basis for the investment approach below.
The ICOs can be clustered into three groups:
The first group contains the ICOs with good business models, also combined with some effective PR/marketing:
First, let’s look at the coins with good business models (in the author’s opinion). These include the following examples:
Are these coins a good investment? They already have high prices, but there is also market demand. We can short-list them and keep an eye on them during dips.
The “high performers” group also includes PR coins:
The Veritaseum token has only one operation, “assigntoken”. It’s not clear how they would generate revenue for shareholders with only one operation in their contract?
The available supply of Veritaseum is 2 percent of total supply. The market cap of 2 percent of supply is USD 384 million; the market cap of total supply would therefore be USD 19 billion… Time for a reality check — would you invest in a business valued at USD 19 billion without a clear revenue generation scheme and in which key business case topics are not addressed?
Should one invest in Veritaseum? Short answer — No.
We should also keep in mind that Bitfinex carried out an equity offering after a hack with a “post-money” valuation of USD 200 million, and Bitstamp had an equity offering with a total valuation of USD 60 million. Both of them are established exchanges with a proven ability to generate revenue, a stable client basis and functional regulatory compliance (KYC, AML, etc).
The market cap of these coins has increased between 1 and 3 times. Some of them have clear revenue-generating business models and are therefore worth considering as investment candidates:
The last group represents the coins for which the issuing price is higher than the market price.
These are the potentials. For example, NVO, Encryprotel, Mysterium, and Tokencard have clearly defined revenue-generating business models and they are valued below the issuing price:
Instead of dealing with the hassle of investing in ICOs (setting up wallets, trying to submit transactions by a specific time, waiting until the coins are assigned, etc.), you could follow the “ICO pattern”:
The ICO launch phase involves a lot of marketing and PR. As emotions and excitement tend to cool off after the ICO, the question remains: What is the real value of certain ICOs? Without continued PR backing, we will likely see a price correction.
These assumptions can be used to create the following strategy:
Ultimately, the business model is the deciding factor:
– Is there market demand?
– Is there a clear business model?
– Does the business model have a network effect (Metcalfe’s law: the value of a network is O(n2))? If yes, the model is easily scalable. If no, it’s rather a traditional business model that may not require a blockchain.
– Does the business model have a revenue-generating scheme?
– Is the alpha software/alpha product ready? Are there initial beta customers using this product?
Note: This article is provided for educational purposes only. For actual investment advice, always consult your professional investment advisor. The author accepts no liability for any consequences of decisions taken on the basis of the information contained in this article, nor does the author guarantee the correctness or up-to-dateness of the information contained herein despite the author’s best faith.
We were presenting at the Blockercon Conference in Bristol (https://blockercon.com) in June 2019 about our favorite topic - Crypto Credit-Money - Why do we need it? Here are the Slideshare...
Jun 5, 2019 . 2 min read
We were presenting at the Blockercon Conference in Bristol (https://blockercon.com) in June 2019 about our favorite topic – Crypto Credit-Money – Why do we need it?
Here are the Slideshare slides of this presentation
SmartCredit.io is close to launching our platform. This platform shows in real life how to create decentral crypto credit money. Decentral credit money is created in the same way, as it has been created in the last 5’000 years – via the lending process. And it’s destroyed in the same way, as it has been done in the last 5’000 years – via payments of principal and interest. Everything is the same, as it was for thousands of years – but this time it’s empowered by blockchain.
In this scenario there are no banks involved – it’s peer to peer platform. Today’s banks earn high profits from credit money creation, it’s called seigniorage. It is estimated to be 3% of the principal. Now, let’s imagine this seigniorage will not belong to the selected view (commercial banks), but it will be distributed via decentral lending into the society. Just imagine what would be the effect of this for the wealth distribution in society.
We would be very happy if you look at our conference presentation and our pilot demo as well.
I was presenting on 28th of November 2018 at the moontec.io conference in Tallinn, Estonia about the monetary systems and about why one will need credit money in the crypto...
Nov 28, 2018 . 1 min read
I was presenting on 28th of November 2018 at the moontec.io conference in Tallinn, Estonia about the monetary systems and about why one will need credit money in the crypto sector.
I was happy with the participants of the conference, not only could they understand what the others were telling them, but they could as well synthesize new ideas!
Here is a one pager of the presentation:
Here are the slides of the presentation:
In January 2014 we forecasted Bitcoin valuation of 10'000 USD in the Swiss CFA Charter Magazine. The value of Bitcoin reached a record high of $19,850 in December 2017. Given...
Apr 10, 2018 . 7 min read
In January 2014 we forecasted Bitcoin valuation of 10’000 USD in the Swiss CFA Charter Magazine. The value of Bitcoin reached a record high of $19,850 in December 2017. Given the hype surrounding the value of Bitcoin, what could we expect its value to be in the future? The value of Bitcoin can be derived from the following as:
The value of Bitcoin can be derived from the following as:
The following graph shows Bitcoin price on a logarithmic scale
Most users of Bitcoin will use the currency through the use of an ‘internal blockchain wallet” on the Exchange (e.g. Bitfinex, Bitstamp, Coinbase, etc.) rather than an “external bitcoin wallet” in the blockchain. After getting more experienced in Crypto, we expect these users will create their own wallets on the public Bitcoin blockchain. In this situation, they will be real owners of their Bitcoins (as opposed to having a claim with the Exchange who owns the private keys for the Bitcoins).
There are no user numbers available for Bitfinex which is the largest crypto exchange. However, data is is available for Coinbase (also known as GDAX), which is the second largest crypto exchange –. Coinbase is growing at the moment by 50’000–100’000 users per day. The following graph shows the number of Coinbase users. The graph is on a logarithmic scale and so the straight line depicts and exponential growth in a number of grand
Coinbase trades 10% of the total global Bitcoin volume and there are over one hundred exchanges. If Coinbase is growing 50–100,000 users per day and blockchain.info by 50–80,000 users per day, then we estimate conservatively daily growth rate of 200,000–300,000 users per day (users usually register not only on one exchange but on multiple exchanges).
We estimate approximately 20 million direct users of Bitcoin blockchain and an additional 15 million users who use Bitcoin through their exchange wallets. Not all of these users own Bitcoins many of them have moved into other cryptocurrencies. Many of the users own more than one address as well and we estimate 35 million active cryptocurrency users at the moment.
On 11.12.2017 there were approximately 400’000 transactions on the network and the total transaction value was 4.3 Billion USD. The following graph shows transaction volume on a logarithmic scale and exponential growth
One can see exponential growth in Bitcoin Price, in the number of Bitcoin users and in the transaction value over the Bitcoin blockchain.
To consider how to translate the growth into Bitcoin value, I consider the application of Metcalfe’s law, which states that the value of the network is not growing linearly but to the square of the number of users. The number of users has been growing more than two times every year. Currently, the network grows by 200,000–300,000 users per day. If we assume doubling the number of users of Bitcoin per year, this translates into value growth of two and four times.
Many cryptocurrency platforms (like Bitcoin and others) are instances of the “network economy”. These are not like traditional companies which grow through scale but where the value is linear to capital used. The network economy value is not driven by capital used and by scale effects but rather two parameters:
Bitcoin network received major re-design in August this year when the so-called SegWit protocol was initialized. The next step is to initialize the Lightning Network protocol. These protocols increase the throughput of the network by introducing “two-layer” transactions. There are transactions on the main blockchain and light transactions settled later on the main network. This will lead to a massive increase of transactions on Bitcoin network because current transactions fees which can exceed 50 USD are relatively expensive for users.
Every new technology such as fax, e-mail, internet, and even Bitcoin can follow the adoption curve. The following graph shows the Gauss bell-curve and the S-Curve, which both can be used for adaption.
Our analysis above estimates approximately 35 million active cryptocurrency users. Given the world population is 7.6 billion less young children, the elderly and people in state institutions. And if we assume half of the world population would be potential Bitcoin users, this translates into a worldwide adaption rate of 1%.
However, we could expect most of the cryptocurrency users are in OECD countries and contribute to 80% of its use considering that 80% of the number of Bitcoin nodes are deployed in OECD countries. Given the OECD population is 1’154 million, from which the economically active population is 700–800 million people, the OECD adaption rate is 3.5%.
This implies that the Bitcoin network has entered the early adopters phase on the S-Curve in OECD countries. This phase will be characterized by the development of real-world business use cases, by emerging “killer apps” and by increasing rate of adoption.
Bitcoin is a highly secure network, but it does not support “smart contracts”, which are supported by about ten different crypto-platforms. Smart contracts allow to build value-adding business applications on top of the crypto-platforms and generate additional usage on the platform. This translates into higher valuation given the value of the network depends on the number of nodes and on the number of transactions on the network. For example, Ethereum platform has thousands of so-called “decentral apps” which are often financed through Initial Coin Offerings — ICO’s.
However, through emerging sidechain technology it will become possible to connect Bitcoin with Smart Contract platforms such as the “Rootstock project”. This would build “decentral apps” which are connected to Bitcoin blockchain security and translate into a higher number of transactions on the network and higher value.
“Decentral apps” offer the potential to build new business models through disintermediation. Today’s big corporations, which enjoy oligopoly or monopoly positions have been built through solving the coordination problem with hierarchical and process-based methods rather than through a market mechanism outside of the banks.
If one is dealing with digital goods, like in banking, media or insurance sectors, and if coordination mechanisms can be solved through blockchain and decentral app based marketplaces, then the need for big corporations, as we know them today, will reduce.
Adam Smiths’ “Wealth of Nations” describes the model of free market capitalism but was based on companies which would today classify as small companies. However, the coordination problem led to the emergence of large corporations, and through their oligopoly and monopoly market positions have moved away from the concept of free-market capitalism as defined by Adam Smith.
Disintermediation of centralized business models through blockchain and decentral apps will lead to significant value creation in new business models and at the same time to value destruction of today’s big corporations.
We consider the valuation has three components:
Network value as a store of value
The number of Bitcoin users doubles every year and if we take the base price in 2017 at approximately 1’000 USD, then the price by the end of 2018 should be 2’000 and 4’000 USD.
The current price is higher and will lead to a short-term correction over the coming months. However, by taking 3’000 USD as current fair price and projecting exponential growth of the network, the price in four years would be expected to be between 50’000 and 750’000 USD.
Network value based on possibility to execute transactions between the users
Bitcoin network has reached its current throughput limits. However full implementation of Segwit and Lightning protocols will lead to massive enablement of the smaller transactions on the network, which will increase the network’s value.
This allows us adjusting the forecasted price in four years from 50’000 to 80’000 USD.
Network value through value adding services on Bitcoin Network
The Internet boom beginning of this century focused first on technology (telecoms, broadband, etc.) and then emerging companies such as Facebook, Google, and Amazon. The same trend is happening in crypto-sphere. — The current focus on underlying technologies will shift to network-based business models, which will result in newly created applications and lead to the major adoption of the platform.
Bitcoin enrichment with Smart Contract functionality facilitates further applications and will translate into additional Bitcoin network value increase at the same time.
This allows further adjustment in the forecasted price of Bitcoin in four years to 80’000 to 100’000 USD.
Blockchain technologies, which were first implemented with Bitcoin, will enable “Cambrian explosion” of new blockchain based business models, which started with simple use cases like “store of value” and “payment”. Adding “disintermediation” models allows real blockchain based killer-apps , and networked economy based business models. Bitcoin network will be the key beneficiary of this upcoming “Cambrian explosion“.
Our forecast four years ago was that Bitcoin will be 10’000 USD. Our new conservative forecast will be that Bitcoin will reach 100’000 USD in next four years.
Bitcoin is digital currency which enables instant payments to anyone and anywhere in the world. There are many differences to other currencies: · Other currencies are issued by Central Banks...
Jan 10, 2014 . min read
Bitcoin is digital currency which enables instant payments to anyone and anywhere in the world.
There are many differences to other currencies:
· Other currencies are issued by Central Banks and have the role of legal tender. Bitcoins are issued de-centrally; there is no Central Bank, and they are not legal tender.
· Other currencies have some physical representations (bills). Bitcoin exists only digitally.
· Other currencies have central authorities. Bitcoin has no central authority; validation of transactions is done from Bitcoin Network.
· Monetary Base of other Currencies is continuously increased, which translates into inflation in the long term. But in Bitcoin Network will contain only 21 Million Bitcoins (smallest transferable unit being 0.00000001 Bitcoins), which translates into deflation in the long term.
Bitcoins is based on combination of several existing technologies:
· Peer to Peer systems (like bittorrent)
· Private / Public key Cryptography
· Application of this combination for creating a currency
First Private / Public key cryptography algorithms were published in 1977. First famous Peer-to-Peer system was napster, published in 1999. However, it took till 2008 when Satoshi Nakamoto (pseudonym) connected peer to peer systems with state of the art cryptography to create first crypto currency — Bitcoin.
Bitcoin has properties of currency — its unit of account; it’s portable, durable, divisible and fungible. However, Bitcoins are much more just as a simple currency. Satoshi’s ideas went much further — Bitcoin Network is a mean to describe economic contracts and transactions between the participants of the Network. Additionally, the distributed storage of transactions (Blockchain in Bitcoin terminology) can be considered as a public general ledger, where not only simple payment transactions, but many more complex economic contracts can be stored and easily distributed / published to any node of the network.
Bitcoin price development from Aug 2010 till Jan 2014 is described on the following graph. It follows a linear trend on the logarithmic graph.
There have been several price corrections, which have received quite some media attention:
· In 2011 from 31 to 2 USD per BTC
· In 2013 from 266 to 50 USD per BTC
· In 2013 from 1242 to 455 USD per BTC
However, we hardly recognize these price corrections on the logarithmic scale.
Will this logarithmic growth continue? Where will be the price of one Bitcoin in one year? How to calculate the fair value of Bitcoin? This article evaluates approaches for Bitcoin valuation.
Bitcoin Network has currently 2’400’000 addresses. One person can have more than one address.
Value of the network is not growing linearly but in square with the growth of network members (Metcalfe’s law). I.e. if we have 2 times more participants, then the value of the network grows 4 times; if we have 10 times more participants, then the value of the network grows 100 times and so on.
Currently network grows by 7000–8000 addresses per day. If we assume same constant growth for the year, then number of addresses will double in this year, implying the value of Bitcoin Network will grow 4 times this year.
As we are speaking of ca 2 million people using the network then we are still in early phases on the Bitcoin Network development. It can be compared to “pre-Mosaic browser” phase of the Internet — there were many enthusiasts on Internet, but most of them were “techies”. The breakthrough happened when Netscape introduced Mosaic Browser. The rest is history.
There are several discussions about intrinsic value of Bitcoin Network. One side has the opinion that Bitcoin Network does not have any intrinsic value; other side has the opinion that there is high intrinsic value.
Bitcoin Network is like Internet network. It’s not the Internet that has the value, but its diverse products and services on top of Internet network, which create the value of the Internet. It’s the same with Bitcoin Network — it’s the products and services on top of Bitcoin Network, which create value for Bitcoins.
The most exposed intrinsic value is Bitcoin Network as Payment Processor:
Additional intrinsic value of Bitcoin Network is the “base money” functionality and “value added services”.
Bitcoin enables payments just in time between any countries in the world it practically no fees. Bitcoin is current 9th biggest payment processor worldwide. Additional adoption of Bitcoin Network will result in reduced demand for the services of companies like Visa, Mastercard or Western Union.
Visa’s market capitalization is 140 B USD, Mastercard’s capitalization is 100 B USD, and Western Union is 9 B USD.
Let’s assume total market cap of these payment processors is 250 B USD, If Bitcoin Network would replace 1/3 of their businesses, then this result in price of 3929 USD per BTC.
Payment Processors total Market Capitalization (in B USD)250Substitution ratio with Bitcoins 33%Total Bitcoin Network Valuation (in B USD) 82.5Final Number of Bitcoins (in B USD) 21'000'000Value per 1 BTC (in USD) 3'929
Bitcoin can be considered as “base money”, it can be considered as gold — “crypto gold” in this case. One way to value Bitcoins is to compare the money supply of Bitcoins to U.S. money supply.
Current market capitalization of Bitcoins is 12 B USD. Current monetary base of U.S. is 4’000 B USD.
If Bitcoins would substitute U.S. monetary base, then their value should increase 4’000 / 12 times. However, let’s assume 10% of US monetary base will be substituted with Bitcoins. Money velocity of Bitcoins is much higher (let’s say 10 times higher than the velocity of fiat money); this would reduce the demand for the Bitcoin base money. This would result in following valuation:
U.S. Base Money (in B USD) 4'000Substitution ratio with Bitcoins 10%Increase in money velocity (in times) 10Total Bitcoin Network Valuation (in B USD) 40Final number of Bitcoins 21'000'000Value per 1 BTC (in USD) 1'905
However, Bitcoin is not national currency; it’s a supra-national currency. If we repeat the same exercise for the world monetary base and if we use substitution ratio of 5% then we get following valuation:
World Base Money (in B USD) 26'903Substitution ratio with Bitcoins 5%Increase in money velocity (in times) 10Total Bitcoin Network Valuation (in B USD) 135Final number of Bitcoins 21'000'000Value per 1 BTC (in USD) 6'405
Levers for valuation:
Bitcoin is not only payment mechanism; it allows building a stack of additional services and products on top of Bitcoin protocol.
It’s the same as Internet — what started initially as simple web browsing with Netscape Browser, developed into Google search and Web 2.0 — Facebook, LinkedIn and Twitter. All these products are based on Internet stack. However, it took 10+ years, till these Web 2.0 products emerged.
Bitcoin protocol allows moving asset ownerships into Bitcoin network — for example share registries and safe keeping accounts can be implemented as part of Bitcoin network. Ownerships of any assets (real estate, shares and cars) can be stored into Bitcoin network. Most public registries will become obsolete as all this information can be mapped into Bitcoin network.
We are still in very early phase of Bitcoin adoption; we are in “pre-Mosaic Browser” phase. We can expect many new applications on top of Bitcoin network — in the same way as it happened with Internet network. However, we are not able to quantify the value of these additional services. We just say — there will be many additional services.
We looked on three valuation approaches. All of them are complementary.
Ergo Bitcoin valuation is:
Bitcoin as Payment Processor 3'929Bitcoin as Base Money 6'405Bitcoin as Additional Services NAValue per 1 BTC (in USD) > 10'334
We foresee continuing network growth (based on Metcalfe’s law) and we foresee significant potential for Bitcoin price appreciation.
We recommend allocating part of alternate assets in investment portfolios into Bitcoins.
(This article was first published in Swiss CFA Society Magazine 2014 January Edition)
· Bitcoin live market data: https://www.tradingview.com/x/0JIHqWR4/
· Bitcoin Wiki: https://en.bitcoin.it/wiki/Main_Page
· Daily transaction volume of payment networks: http://www.coinometrics.com/bitcoin/btix
· Monetary base of national economies: http://www.coinometrics.com/bitcoin/bmix
· Exchange volume comparison by Currency: http://bitcoincharts.com/charts/volumepie/
Introduction Digital Banking is on everyone’s mind — it’s about automating end-to-end banking processes and offering a digital experience to end clients. The focus on Digital Banking is understandable —...
Nov 10, 2015 . min read
Digital Banking is on everyone’s mind — it’s about automating end-to-end banking processes and offering a digital experience to end clients. The focus on Digital Banking is understandable — we are all witnessing increasing cost pressures, regulatory pressures and a low-interest rate environment. Digital Banking is the answer by the traditional banking system to these pressures. However, Digital Banking per se causes little changes to the banking ecosystem: in principle banks continue as they are, just operate more effectively.
Most of us witnessed the emergence of the Internet and World Wide Web 2.0 and the new network-based business models that were born. Could the same happen with Digital Banking? Could we anticipate the emergence of Digital Banking 2.0? Would it result in widespread changes in the banking landscape and business models in the same way as Web 2.0 did?
I represent the thesis that Bitcoin and its underlying conceptual technology — Blockchain — may enable revolutionary changes to the banking landscape and the emergence of Digital Banking 2.0.
Bitcoin is a digital currency which enables instant payments to anyone, anywhere in the world. It is based on private-public key cryptography, where the owner of the private key can do transactions with his Bitcoins and where a public key allows anyone to see the amount of Bitcoins on a specific address or to send Bitcoins to this address.
The Bitcoin system is based on the Blockchain technology, which is in essence a cryptographically secured, distributed ledger. Old transactions cannot be changed and new transactions are added to the end of the distributed ledger in an unchangeable way. The integrity of the ledger is ensured by a computationally heavy process known as proof of work, which verifies transactions and is executed by a network of anonymous computer owners known as Bitcoin-miners. The Bitcoin Blockchain distributed ledger is available to anyone who participates in the Bitcoin system.
The Bitcoin Blockchain is used to track ownership and transactions between Bitcoin holders, but the Blockchain technology is not limited only to Bitcoins — any transaction with digital assets could be represented with this same Blockchain approach.
Most financial assets have digital representation and hence they could be stored in Blockchain. The transactions between the holders (addresses in Blockchain terminology) could be modelled in Blockchain, and they could be available to anyone using Blockchain technology.
Blockchain represents an innovation that could be compared in its impact to the invention of the double-entry bookkeeping system or of the legal form of doing business, a corporation. These last two innovations shaped the way we do business today. Will Blockchain be the next big invention?
Most of the financial industry is based on ledgers which record who owns which assets, who receives payments from these assets, and how to transfer ownership of these assets from one participant to another. But these ledgers are all private to banking institutions. This creates the need for a new ecosystem of participants whose core business is transferring ownership between asset owners.
For example: If client A sells 10 shares of IBM to client B, we see the following transactions: Client A’s custodian transfers shares and receives money, and Client B’s custodian receives shares and transfers money. The process can take up to 3 banking days and there is a middleman (clearinghouse) validating that all runs properly. The middleman will charge a fee for this service.
However, Blockchain technology allows the creation of distributed ledgers between all market participants. This results in new business models that exclude middlemen. Client A and Client B may interact directly with each other using a public distributed ledger. It is obvious that this public ledger-based approach increases the efficiency, transparency and quality of the transaction execution, and at the same time reduces its total cost.
As I said before, most financial assets can be represented digitally: publicly traded instruments will have ISIN codes, and similar codes are being created for OTC instruments too (UTI from ISDA for example). Digitally represented assets can be stored into Blockchains, including information about who owns how much of which asset. Buy and sell transactions would be as simple as moving a specified number of digital assets from one owner to another in a cryptographically secured way. The transferor of the asset has a private key for the authorization of the transaction; the receiver of the asset has to use his private key for payment authorization. Settlement and clearing of trading transactions would be significantly simplified and speeded up by such an approach.
If all assets of a banking client can be represented digitally, his portfolio can be completely represented by digital asset registry. A client portfolio could contain digitally represented assets and digital money (Bitcoin, Litecoin, Ethereum, etc.). The client could be able to access his portfolio from any place with his private key; he could execute transactions in his digital assets or digital money with his private key; or he can delegate management of his assets to a professional asset manager by assigning him his private key or by using a multi-signature approach in which specific transactions have to be signed by two or more private keys.
In today’s custody business model, the asset manager either has his own custody (if he is a bank) or uses the custody services of another bank. However, by using public ledger-based asset registries, the client will be the real owner of his assets. The client will not run the risk of bank failures. He will not face situations where part of his assets may be converted into bank equity (based on too big to fail provisions, when bank capital ratios are sinking below regulatory targets) or be lent out by the bank — with Blockchain, the client will be the real owner of his assets.
Another business case for distributed ledgers can be collateral management in the lending process. By registering collateral in a distributed ledger and by specifying for whom and how long the collateral is allocated, we create an effective means of collateral management. The speed of collateral management will be increased, the traceability will be available and transparency for regulatory reporting will be created. Additionally, collateral margin calculation would be simplified as it would become transparent how many times specific collateral is already lent out.
These were some examples of the potential uses of distributed ledgers. One can assume that there will be as many new potential uses of distributed ledgers as there are ledgers today.
Blockchain technology also allows for the implementation of “Smart Contracts” where assets are exchanged on certain conditions against payments. Let’s look again at the example “asset in exchange of payment”. If we have a digital asset which represents an IBM share and if we have a digital means of payment (Bitcoin), then the exchange between Client A and Client B can be executed in one transaction. This new transaction will be added to the Blockchain, it will be cryptographically signed and there will be no way to change it after that. There will be no need for complex 3-banking-days long business processes — everything can be completed within 10 minutes.
This is an example of a basic smart contract. The business logic of a smart contract can be extended in arbitrary ways: there can be multiple participants, there can be escrow services, multiple payment terms, etc. These will be digitally executable contracts between digital assets and digital money. All derivative, future or bond contracts could be represented as smart contracts so that their processing can be 100% automated.
Bitcoin Blockchain is a public ledger and thus is available to any member of a Bitcoin system. Asset registries and transactions between holders of these assets on Bitcoin Blockchain are visible to anyone too. Public ledgers do not have any gatekeepers defining who can or cannot participate.
At the same time, there are several technology providers offering Private Blockchains. These are “mini-Bitcoin” systems, where only the participants of the private blockchains can transact with each other. These Private Blockchains can be use-case specific or participant specific — for example private collateral management blockchains for big banks. Private Blockchains would work on the basis of permission, namely there would still be a central instance which will grant or remove memberships to respective blockchains. These gatekeepers would thus have a potential revenue source or even provide new business models.
Every bank has either built or bought their “ledger” systems for managing huge numbers of standardized digital transactions. Middlemen are facilitating the ownership and flows of funds between banks. Both these bank “ledger” systems and middlemen are becoming obsolete.
Both services can be taken over by public or private Blockchain ledgers from new service providers. One bank probably does not want to become a member of another bank’s private Blockchain ledger, where the other bank is gatekeeper to the service. However, the same bank could be ready to become a member of a private Blockchain of an independent service provider. The private Blockchain would have a higher utility as more participants join, which would attract new participants and so on. It’s the same network effect which is core for e-Bay or Facebook business models.
This creates room for new market participants whose core business will be running today’s diverse banking ledgers. The businesses of these new service providers will benefit strongly from network effects however, which will likely lead to the consolidation of these new service providers.
By September 2015 venture capital investments into Bitcoins were USD 921 mio; the number of venture capital-backed startups was 119 and the Bitcoin sector became the fastest growing startup sector. Investments into Bitcoin companies in 2014 and 2015 match investments into early internet companies in 1994 and 1995. Blockchain and Hybrid startups have received USD 285 mio in investments, representing 22% of startups in the Bitcoin sphere.
Additionally, there are a number of big banks experimenting with Blockchain technologies, whose main focus is how to use decentralized ledgers in banking business processes.
Bitcoin may have caused people to overlook the potential of its underlying technology, but based on venture capital investments and on experiments in the major banks, we can say for sure that the Blockchain technology is here to stay.
Digital Banking 2.0, based on Bitcoin and Blockchain technology, will result in revolutionary changes in banking. The role of current players in the ecosystem will change and new players will emerge. Many current services will be provided at a much lower cost basis. Middlemen will lose their positions in value chains in the same way it happened in the music industry about 15 years ago. This will translate into changes in banks’ revenue models, which, together with the entrance of new participants to the market, will trigger changes in business models, and result in complete banking ecosystem changes.
The transactional part of the banking business will change as well. Many of the complexities of ledgers, asset transfers and collateral management will be simplified, and banks will be able to decrease headcount. Transaction management will become a commodity in the banking business.
However, the advisory process, portfolio management, credit management and risk management — the know-how intensive disciplines of modern banking — will stay. Banks will simply focus more on their core competencies and less on transaction processing. This will result in an increased focus on know-how intensive areas, which at the end means real value creation for clients.
(This article was first published in Swiss CFA Society Magazine 2015 November Edition)
The traditional banking business is based on fiat currencies. Conversely, a diverse range of cryptographically secured digital coins underlie the cryptoasset industry. In previous articles, we looked at how traditional...
Aug 19, 2017 . min read
The traditional banking business is based on fiat currencies. Conversely, a diverse range of cryptographically secured digital coins underlie the cryptoasset industry. In previous articles, we looked at how traditional banking revenues will be intermediated with blockchain technologies and how the key banking processes will be impacted by blockchain disintermediation.
Now let’s consider the big question: How will traditional banking react to emerging crypto finance?
Four response strategies are possible and this article will explore these options in greater detail:
· Do nothing — continue to run business without adjusting course
· Wait and see — monitor the situation on an ongoing basis and develop internal capabilities
· Gradual integration — try to selectively integrate crypto-finance products into traditional banking
· All-in commitment to crypto finance — shift fully to crypto finance
These strategies can be positioned on a product offering/capability matrix as follows. Here, the product offering dimension describes how advanced the crypto-product offering is, while the capability dimension indicates the degree to which advanced crypto-finance capabilities have been developed and are available to the banking organization:
This article will explore each of these strategies in further depth.
This strategy involves taking no action at all. Essentially, it represents the delegation of decision-making on an active response strategy to a point in time in the future.
This response strategy can be considered in relation to the client base of a given traditional bank:
· For private banking, i.e. the wealth management branch of traditional banking, most clients are found in the 50+ age group. All private banks have online banking channels, but usually less than a third of the client base are actually using these online channels. Obviously, it could be difficult to explain the benefits of crypto products to technology-adverse clients, which in turn would result in this strategy choice.
· However, retail banking is different . This branch of banking serves everyday needs ; it’s about payments, credit cards and small loans . These are the financial services that 95 percent of people regularly use. The retail client segment also has a greater affinity with technology. For this reason, it is possible to explain to them the benefits of crypto finance , including inexpensive and fast cross-border payments in the remittances use case.
This is also associated with a “copycat” strategy . Sometimes it can be a good idea to let other banks make the first moves — to become the pioneers and also to make costly mistakes. This would allow others to learn from their mistakes and imitate successful strategies. Nonetheless, the total market capitalization of cryptoassets is approaching USD 150 billion; this market cannot remain ignored for much longer.
An extension of the “do nothing” strategy would be the “wait and see” strategy. This entails monitoring the market, analyzing competitors’ strategies and incrementally developing the internal know-how.
This offers a strategic option for traditional banks. If cryptocurrency adoption increases and if clients’ demand for crypto products grows, then a crypto offering can be developed on existing internal capabilities.
Implementing new products in traditional banking is relatively complicated and costly. However, if initial frameworks are already in place in traditional banks, this will result in smoother implementation.
Bridging the gap between the fiat and crypto world and developing these two sectors in concert is key to this strategy.
According to this strategy, crypto products are gradually integrated into the existing offering of respective banks. For instance, this could start with the following simple products:
· The topic of remittances is often discussed, but thus far this service has not been supported by traditional banks. The “cannibalization” of respective strategies is one reason for this. However, offering remittance products would enable banks to include additional client segments as well as profit from additional offerings beyond this segment, for example through credit card revenues.
· International fiat-crypto proxy accounts could be useful products for international companies. International companies need international banking accounts, but transferring funds between these accounts takes time and incurs considerable costs. These transfers could be accelerated while reducing the associated costs by using fiat-crypto proxies.
· Another example of possible products includes smart contract-based lending . Banks would earn revenue from the usual interest rate, but the additional margin on top of this interest rate would be almost zero, since the operating costs of this form of lending would be eliminated. Corporate clients who use this lending facility, would benefit from lower interest rates than usual (due to the eliminated margin).
· Investments products like funds for cryptoassets are also conceivable. Due to the fact that cryptoassets exhibit valuable performance characteristics as well as valuable volatility characteristics, they would represent a useful addition to the alternative assets category within client portfolios.
Examples of this strategy include:
· SwissQuote, a Swiss bank, is cooperating with the fiat/cryptocurrency exchange Bitstamp in order to offer its clients the possibility to trade directly with Bitcoin.
· Falcon Private Bank, likewise a Swiss bank, offers to its wealth management clients the possibility to invest in Bitcoin products.
So far, these are the first two examples in Switzerland — in a country with around 250+ regulated banks. We assume that additional banks will follow suit.
On the one hand, the banks are able to present themselves as innovative and, on the other, they offer meaningful products to their clients, which also generate revenue for the banks. Banks can develop their internal capabilities for crypto-product offerings and achieve quite a competitive advantage in the process.
This would imply dropping traditional banking and converting the bank into a fully fledged crypto institution that would offer the following products:
· Payments (already available in crypto finance)
· Custody (already available in crypto finance)
· Credit cards (already available in crypto finance)
· Lending (not yet fully established in crypto finance)
· Wealth management (not yet available in crypto finance)
At present, this strategy might be challenging for traditional banks, especially in view of their current client base. Around 99 percent of clients do not own any cryptoassets and those who do own cryptoassets would rather not go through the traditional banking system.
However, since several key cornerstones of traditional banking are already available in crypto finance, we can anticipate that solutions for remaining areas will also be developed, which in turn would enable this “all-in” strategy.
The distribution of these strategies are currently as follows:
· Most financial institutions are currently pursuing the “do nothing” strategy
· A limited number of institutions are applying the “wait and see” strategy
· A very small number of institutions are following the “gradual integration” strategy
· The “all-in commitment to crypto finance” strategy cannot be observed currently
We can anticipate the following strategic moves towards increasing blockchain capabilities in traditional banking:
· Progression from the “do nothing” strategy to the “wait and see” strategy
· Progression from the “wait and see” strategy to the “gradual integration” strategy
It will probably take a while until the “all-in commitment to crypto finance” strategy is implemented . The main factor for this will be the mass adoption of cryptoassets. However, if this strategy is implemented, we will see the increasing erosion of traditional banking revenue.
1. Swiss financial center opens up to Bitcoin: https://www.swissinfo.ch/eng/-game-changer-_swiss-private-bank-accepts-bitcoin/43328354
2. How traditional banking business revenues will be impacted with crypto and smart contracts: https://medium.com/smartcredit-io/how-traditional-banking-business-revenues-will-be-impacted-with-crypto-and-smart-contracts-a0b84c7c67df
3. How private banking processes will be impacted by blockchain disintermediation: https://medium.com/smartcredit-io/how-private-banking-processes-will-be-impacted-by-blockchain-disintermediation-5822d70ea612