With the advent of Bitcoin, Ethereum, and blockchain-based financial applications, questions arise as to how the financial sector will develop in the future and what this means for global capital markets. Smart financial contracts play a central role in this.
Blockchains and tokenization are considered modern marvels that provide the financial community and its infrastructure a new lease of life. In addition to what this will mean for some 1.7 billion people unbanked and underbanked individuals worldwide, the finance world is also set to be reinvented through Decentralized Finance (DeFi).
Unfortunately, the prospects for rapid progress remain bleak. While the financial sector and institutional investors have been contributing to the growth of this technology for years, we won’t see the replacement of outdated core banking systems anytime soon.
Current developments in areas such as risk management and financial analysis are primarily driven by regulators and are no longer driving forces to develop new strategies.
The DeFi sector — made up of services based entirely on autonomous virtual machines that negate the need for central financial intermediaries — is currently limited to the areas of payment and over-collateralized lending of digital assets such as Bitcoin, Ethereum, and Non-Fungible Tokens (which are comparable to commodities in traditional finance). But the brave new financial world will remain an illusion, even with greater investments from banks in technology and in DeFi projects until the core problem in finance will be addressed.
The decisive question is, therefore, what the basic task of banks, brokers, insurance companies, pension funds, private equity funds, and other players in the financial sector is: the exchange of cash flows over time defined by financial contracts.
Focus on Financial Contracts
The crucial component of finance is therefore the financial contract. These financial contracts are agreements that the parties arrange among themselves with the purpose to exchange future payments or cash flows. These exchanges of payments follow well defined, universally applicable algorithms. The payments can entirely be represented by pure numbers, e.g. dollars, euros, francs, or bitcoin.
Although currently written in plain English, the cash flow obligations of all financial contracts can be fully and accurately represented by machine-executable code. Financial contracts are mathematical in nature.
Financial contracts can therefore be presented in digital form — in fact, this is the ideal scenario since completely and exclusively in digital form. The good news here is that financial contracts are much easier to categorize and understand than is commonly assumed. A financial contract is, by its nature,
- Digital: The exchange of Cash Flows is defined in numbers
- Algorithmic: The calculation/computation of the obligations follows mathematical formulae and
- Standardizable: The exchange of Cash Flows follows a limited number of patterns, which are universally applicable and the same globally.
In essence, it is not about the names of financial instruments that are driven by legal considerations or marketing efforts, but about the cash flow exchange pattern that results from the respective contractual obligations.
The patterns of these cash flows are the same all over the world and can be described with formulas, or algorithms. Almost all financial contracts follow fewer than three dozen patterns that can be represented with precisely defined algorithms and describe more than 98% of all financial transactions carried out worldwide.
The ACTUS standard as a resolution
The ACTUS standard (Algorithmic Contract Type Unified Standard) defines terminology, algorithms, and data models to describe these patterns of cash flows.
This enables fully consistent digital processing of financial contracts in life-cycle management and analysis. The focus of this classification scheme is an intelligent, machine-readable, and machine-executable algorithmic representation of all legal financial agreements as well as a strict separation of the known from the unknown.
The legal agreements and, if applicable, the current status of risk factors (for example, with a view to the slope of the interest rate curve or the exchange rate of a currency) are known.
The unknowns are the future states of these risk factors; especially when it comes to market risk, counterparty risk, and behavioral risk.
As the graphic below for the ACTUS standard illustrates, the agreements in a financial contract and the current state of the risk factors are the central input elements for such a model:
Source: actusfrf.org/methodology
The important key elements are:
- Counterparties: Financial contracts represent hard facts. However, compliance with their agreements is not guaranteed, because a counterparty could fail to comply with the terms of the contract. In this respect, a standard was established at the regulatory level in the aftermath of the financial crisis, called Legal Entity Identifier or LEI for short.
- Markets: Financial contracts such as floating rate bonds, options, etc. contain calculations that depend on market conditions (e.g. foreign exchange rates, yield curves, indices).
- Behavior: Certain terms in financial contracts are not deterministic. For example, cash deposits in a savings account can be withdrawn by the customer at any time, or a mortgage can be repaid early.
The contractual events, such as interest payments or amortization, can be derived from the contract status and a scenario of risk factors, which then generate the expected cash flows.
From the expected cash flows, the analytical results of interest such as liquidity (LaR), profit (EaR) and value (VaR) can then be calculated with the help of risk models. The ACTUS standard provides starting points for risk models, but not the models themselves.
Conclusion
Traditional banks need not fear blockchain technology, but they should be aware of its transformative and potentially disruptive qualities. Still, in order to enable real digitization of the financial sector, the industry has to reclaim the essential component: the financial contract, the agreement which defines patterns of the cash flow exchange between the parties.
Since financial contracts are by their nature digital, algorithmic and standardized, they can be optimally processed by machines. By defining attributes and algorithms for financial contracts, real innovations are possible again in traditional finance. Today's chaos in the financial sector can only be overcome by putting the standardized algorithmic financial contract into the centre of any architecture.
Equally, blockchain technology can only prevail with the same core architecture: real digitization of cash flows on which financial instruments are based. Standardized, machine readable and machine executable algorithms are indispensable for this new technology to compete with the established institutions in the financial sector in the first place — and that still requires a lot of work.
About The Author
Ralf Kubli is Board Member at Casper Association and an experienced executive with a strong background in blockchain, cryptocurrencies, and decentralized technology. Ralf’s career spans roles in M&A, sales and executive management positions in large corporations and technology startups. He discovered Blockchain through a Fintech investment in 2015. Since then, Ralf cannot unsee the transformative potential of this technology and has been involved in the blockchain space as an investor, advisor and board member.
Ralf holds an MBA from Cornell and an M.A. in History from the University of Zurich.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.