Margin reform, uses for blockchain and interdealer survival

The week on Risk.net, September 9–15, 2016

MARGIN RULES push interdealer inflation swaps to clearing

BLOCKCHAIN promises safeguard for commodity investors

BROKERS face a difficult balancing act

COMMENTARY: The universal solvent

Despite its creator's – or creators' – hopes, Bitcoin has so far failed to set the world on fire, although it has found a use as a convenient way for ransomware writers to collect their loot. But the blockchain technology that underpins it has been seized on by the financial industry as a solution to many problems in identification, record-keeping and settlement.

In the past few months, blockchain has been touted as: the answer to the need for segregated accounts; as a way to deal with the high cost of liquidity at clearing houses; as a solution to the lack of a coherent system for collecting reference data; as a replacement for central securities depositories; as the idea that will make central counterparties unnecessary; and even as the way to make back offices largely obsolete with the introduction of smart contracts.

The latest idea is to use blockchain technology to handle problems of ownership in the physical commodities business. Fraud involving faked proof of ownership is as old as civilisation – blockchain proponents argue a distributed ledger would be open to inspection by all, with any transactions or changes of ownership requiring open consent. They cite in particular the Qingdao warehouse fraud of 2014, when several banks lost hundreds of millions of dollars after the discovery that traders had used the same stocks of copper as collateral on multiple loans. It has also been suggested as the underlying technology for a reliable ledger not just of commodities but of land, diamonds, art and even fine wine.

Sounds good, but there are a couple of important caveats. First, with any form of physical property comes the problem of attachment – it may be possible to create a bulletproof open ledger that records the movement of digital representations of commodities, but the weak link remains the people on the ground – or rather in the warehouse – who must check the billets of aluminium or copper actually exist and are where they ought to be. If the system depends ultimately on the honesty of the warehouse keeper, then it doesn't really solve the problem exposed so dramatically by the Qingdao fraud two years ago.

The second problem is one that has dogged blockchain technologies since their inception: transaction cost. Dreams of using blockchain to track micropayments in a peer-to-peer electricity grid are worthy, but at present, the proof of work involved in each transaction is costly in terms of computing power, and therefore in terms of electrical power, and money. Nor is there much hope of the cost coming down, and the fact that it is costly and difficult to confirm each transaction is central to bitcoin's viability as a reliable distributed ledger technology.

 

STAT OF THE WEEK

AIG was ordered to pay $230 million to shareholders in MedPartners this month, after a judge criticised the insurer for concealing the existence of an unlimited coverage policy on the troubled medical management company. An earlier suit against MedPartners sought $750 million, but settled for $56 million when the company claimed it was near bankruptcy – neither AIG nor MedPartners mentioned the unlimited coverage, which would have allowed plaintiffs in the earlier suit to get much more in damages.

 

QUOTE OF THE WEEK

"Machine-learning algorithms have become superhuman at tactical game-playing, but do not have the capability yet of true open-ended, long-term strategic planning. The problem is retaining long-term memories: deep-learning computer scientists haven't figured it out yet" – Chi Lee, CIO of institutional investment office Agenda Invest.

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