Risk Management with Position Information from the Blockchain

The financial system architecture has grown organically over the last decades - individual steps of settlement of financial transactions have been computerized, but the workflow remained unchanged as if processing of transactions is still done manually. That implies the delivery and settlement of transactions is batch-based and occurs with a time delay of two or more days. Every financial institution has its own bookkeeping system and is an island from an audit point of view, where verification of trades is cumbersome and prone to errors. This regime contributes to a high degree of fragmentation and uncertainty, multiplication of risk factors, high transaction costs for financial assets, lack of liquidity and transparency, presenting a nightmare for participants of financial markets.

The new technology of Blockchain is a genius invention that will introduce a new level of transparency to the financial markets. The Blockchain is an universally accessible distributed ledger - a decentralized notary service that ensures immediate global consensus about completed transactions and asset ownership. Like the Internet, the ledger is not controlled by a single entity, but an emergent phenomenon consisting of many participants. Blockchain is a seminal discovery and addresses a core of issue of no-trust problem and prevents double spending. It is still in early days and the community that invented it has hardly grasped the scope of the innovation, how its discovery will change the financial system. But the genie has been released out of the bottle and it cannot be stopped...

Blockchain makes it possible for every financial instrument to be a listed security in the form of a digital token, the so-called Colored Coin. Colored Coins follow the idea of ''coloring'' a specific Bitcoin - the issuer guarantees to hand out the underlying assets to whoever returns the Colored Coin. For example the FED could issue a Colored Coin in the same way as it prints paper money; it would take a fraction of a Bitcoin and then insert the ''I Owe You'' statement of the FED, like a regular bank note. The same mechanism can be used for any financial claim. Colored coins are different in nature to crypto-currencies, because they have a specific issuer and are backed by a real financial asset. Exchange, bookkeeping and risk management of Colored Coins is straightforward for traditional financial institutions since every Colored Coin can contain International Securities Identification Number (ISIN), thus Colored Coins can be treated as any other financial instrument, fully compatible with existing back-office systems. Financial institutions will be able to conduct business with Colored Coins on the Blockchain without incurring additional costs of integration.

Colored Coins address many of the risk management issues that regulators and financial institutions are faced in today’s financial system. Since every transaction of Colored Coins is recorded on the Blockchain, the public ledger becomes a valuable source of trading data. While it is not possible to identify the traders, any observer can deduct quantity and prices from the public data visible in the Blockchain. Unlike in traditional financial markets, the Blockchain includes detailed position data - by tracking tick-by-tick transaction data from Blockchain, we can infer how market participants build and close positions. We can map the size of positions and infer what positions have been established at the various price levels – and what profits and losses different groups of traders and investors are incurring. The position information indicates which groups of traders and investors are most likely to run into losses. We can then create “weather maps” of the positions that traders have established and the circumstances that would force them to close their positions, causing a cascade of further price moves. This is especially relevant for markets with highly leveraged traders where a small price move can cause a cascade of margin calls that further move the price, leading to instability, lack of liquidity and increased volatility. Finally, we can use position information to show the Blockchain provides predictive information for future price movement. Regulators will welcome the innovations provided by the Blockchain and we anticipate that position information of the Blockchain will become part of standard risk management toolbox in the near future.

Lykke is a movement to build a global marketplace atop the Blockchain for all assets and instruments. Our marketplace will use distributed ledger technology to offer immediate settlement and direct ownership. The ultimate goal of Lykke is to enable every person in the world to have market access and issue his or her own currencies. If we succeed, we can establish human rights for market access and issuance of means of payment. The distributed ledger technology offers a unique opportunity to rewire the existing financial system and create a highly efficient one. All our software is open source. Our goal is to build the most efficient marketplace possible.