The Gateway to Algorithmic and Automated Trading

Dr. Strangecoin or: How I learned to stop worrying and love the blockchain

Published in Automated Trader Magazine Issue 38 Autumn 2015

Who is trying to shape the future of bitcoin infrastructure adoption? Augustin Eden reports.

Richard Olsen, CEO, Olsen Invest

Richard Olsen, CEO, Olsen Invest

In its short life, bitcoin has become the longest established and most closely followed cryptocurrency, with a flourishing industry built up around it.

By 2014, the brokering and buying of bitcoins from merchants had given birth to exchanges on which derivatives could be traded by hedgers and speculators while arbitrageurs were able to take advantage of sometimes large discrepancies between exchanges battling to keep up with a volatile bitcoin price.

Its value as a tradable asset meanwhile has been punctuated by being classified as a commodity by US regulator, the CFTC.

But as volatility has subsided into 2015, so too have the opportunities.

Options and non-deliverable futures now dominate, still relevant in institutional structured products and another string in the bow of the retail sector. Yet, with the plunging bitcoin price and general reduction in the computer resource-intensive mining activity that brings bitcoins into being, the cryptocurrency finds itself drifting out of fashion.

When the Bank of England addressed bitcoin, it concluded that the cryptocurrency 'does not pose a threat to the UK's financial stability'. Of course, bitcoin's designers and developers never had that sort of intent. What they do want to do, however, is present a new system that doesn't rely on one trusted entity to ensure the execution of transactions.

Bitcoin is dead. Long live the blockchain...

And just as bitcoin is down, this new system, the underlying protocol, is on its way up - the blockchain.

Processing transactions requires protocols or payment systems. The most basic transaction is walking into a shop and exchanging goods for cash. For anything more complicated, like cross border deliveries paid for with a note, there needs to be a means of recording the transfer of ownership at each stage, a ledger.

What bitcoin has brought to the table is a ledger-based system that does not rely on the authority of the central bank. It is decentralised and, crucially, based on just the right amount of mistrust.

The blockchain essentially flips the trust model on its head by creating community-wide scrutiny of the individual user.

This makes it possible to consider a new kind of financial marketplace in which batch-based clearing and settlement is eliminated. It could even make intra-day interest rates for intra-day trade positions possible.

Richard Olsen, co-founder of FX market making firm Oanda and founder of hedge fund Olsen Invest, said the inefficiencies of batch-based processes drive up transaction costs and hinder the timely transfer of ownership, while day traders avoid any penalties for going short in the markets.

Why, then, with the advent of the enabler that is the blockchain, has this not gone global? Olsen hasn't the foggiest. "No other platform enables second by second interest rate payments, or the same terms for any deal size… and I haven't a clue why. I literally don't understand. This infrastructure enables lower spreads and a lower average ticket size, which is vastly beneficial to the trader."

He thinks the problem could be one of 'paradigm shift.' It's such a big idea that it's bound to be met with a kind of defensive scepticism both from those wary of its open-source nature giving rise to security concerns, and arguably those who would write it off as merely idealistic.

"People don't understand," Olsen said. "But if you explain the mechanics to them then maybe their outlook will change. If you talk to some very senior people in the banking sector...they also would like to do work which is beneficial to everyone but they don't know how."


R&D

Interest is growing steadily for traditional financial market players. Nasdaq is using the blockchain, in partnership with US tech start-up Chain, on its private market to facilitate almost instant trade settlement without the need for a third party clearing house.

Former JP Morgan commodities head, Blythe Masters, joined bitcoin trading platform Digital Asset Holdings as its CEO, citing the elimination of counterparty risk, and reducing cost and risk in settlement as major benefits.

JP Morgan meanwhile is throwing in with eight other banks (Goldman Sachs, Credit Suisse, Barclays, Commonwealth Bank of Australia, State Street, RBS, BBVA, UBS) to develop common standards for blockchain technology. The Financial Times reports that the group is looking to channel data, ideas and financial backing to a start-up called R3CEV, a New York-based group of trading and technology executives.

Hugh Cumberland, vice president in the capital markets unit at Colt Technology Services, said: "This backing from nine investment banks shows us that the blockchain won't simply replace the current infrastructure. Existing systems and processes will need to be re-engineered to incorporate this technology and it's here that the real challenge lies."

Some newcomers looking to commoditise the underlying infrastructure have pitched for a better way, with dubious levels of success.

Ripple Labs altered the theme somewhat with its own 'distributed-yet-centralised' ledger - The Ripple Protocol. The banks loved it, but it proved not much different to what already existed: a trust-based, centralised system.

Five servers controlled by Ripple keep the system running, as opposed to the thousands of independent computers or 'nodes' that run blockchain. Also, Ripple users cultivate trust-based relationships with each other and the firm's back office. This creates point-of-failure risk, exactly what we have in the wider financial system today, and which Ripple addresses by linking its own protocol to the bitcoin blockchain for riskier transactions.

Blockchain is decentralised so that there is no point-of-failure risk, and while there will always be the 'back office' of blockchain, in a trade / post trade sense, you won't need one. Front office is everything. No trade initiation followed by the whole settlement and delivery process. It's all integrated.

BTC exchange trade volume chart

At the other end of the scale sits Ethereum. Ethereum gives a complete, standalone platform on which to write decentralised software programs.

That Etherium is one of many companies beginning to argue that any contract between two parties, including escrow accounts, can be transferred onto the blockchain with the help of some special software laid on top, merits some attention.

Ethereum allows the user to draw up his or her own 'smart contracts,' electronic certificates that enable instant transfer of ownership. HitFin has been using such contracts to develop a trading platform that eliminates third parties, long transaction times and high costs in the OTC derivatives market.

Sitting in the middle, and perhaps the most interesting of all is a concept known as Colored Coin that is currently being built out by Open Assets. The protocol enables bitcoins to be broken up into many pieces and each piece 'colored,' before being associated with a formal or informal promise known as a Ricardian Contract, developed in the 1990s, as a means of capturing, identifying and describing electronically traded bonds.

With this, one can leverage the blockchain distributed ledger for absolutely any type of financial instrument. For instance, an institution buys a bitcoin and then draws up a Ricardian Contract that could represent any kind of IOU - a share in the company, a skyscraper in New York, a promise to pay an amount of euros on a given date. Its bitcoin is then split up into many, many Colored Coins, each of which contain the identifier of the Ricardian Contract as a message digest or hash.

By 'coloring' the coin (splitting it up into thousands or millions of fragments), you guarantee virtual immunity from bitcoin price volatility while the Ricardian Contract provides certainty as to the terms and conditions.

What's more, the contracts can have ISIN numbers within them that map directly into the risk management and back office systems of institutions so that the Colored Coin protocol is compatible with existing architecture, if that's what someone really wants.

The point is that blockchain requires something like a Ricardian Contract added onto it so that it can represent any medium of exchange, store of value or unit of account. Open Assets is currently working on developing the protocol for things as diverse as share trading, just plain money and even unlocking your front door - all based on the bitcoin blockchain.

Richard Olsen explains: "Blockchain enables us to use anything as currency. You can use Tesco coupons, Facebook shares or land you inherited from your grandfather to pay for things. Market makers then have the job of converting Tesco coupons into cash for the end user, should they require it."

Such variations on the blockchain theme could challenge the current financial system, while also allowing it to remain largely as is, with front and back office staying put. But the only advantage of Ripple, it seems, is the reduction in transaction times and costs, and even then we simply haven't heard much about it this year because institutions are perhaps a little nervous of Ripple's now more intimate relationship with the blockchain.

Checking out the competition

Joram Borenstein, Vice President, Marketing, Nice Actimize

Joram Borenstein, Vice President, Marketing, Nice Actimize

Joram Borenstein, vice president at NICE Actimize, a financial crime consultancy and compliance software provider, said that only a year ago he'd be discussing the blockchain and related technology to clients and peers only to be met with the sort of look you'd give someone who 'had three heads.'

"While interest is now picking up, it's doing so largely because the institutions are reading one another's press releases," he said. "I don't think they're yet committing significant resources - if you look at the size of some of the institutions - but I do think it's symbolically very important.

"Many of these financial services providers do believe that this technology has the potential to really up-end the way that things are done currently."

That breeds a certain amount of concern among those that would be disrupted, and if the plain weirdness of a new idea is one concern then information security must be another, more pressing, issue.

The verification method and the 51% rule laid out in Satoshi Nakamoto's original paper on bitcoin makes attempts to take control of the system, to shut it down, all but completely pointless. While this might seem a counterintuitive concept, the underlying mechanism is the same conventional cryptography that secures our online banking and general online privacy today.

Financial cryptographer, and developer of Ricardian Contracts, Ian Grigg, sets the record straight on blockchain safety.

"Hackers can still get in and take Richard's wallet or Joram's escrow account, or spy on transactions in the open blockchain. But for individual security there are defences both existent and developing such as multisig, HD wallets and cold storage."

Ian Grigg Financial Cryptographer

Ian Grigg, Financial Cryptographer

Presumably these have their complimentary, working cousins in the World Wide Web today.

In fact, concerns about security may actually be the easiest to explain. The real issue is that many see a shady world of geeks and coders behind bitcoin and the blockchain - the sorts of people one might associate with hacking and general tech-mischief. Grigg sees this as the major hurdle to widespread acceptance.


What's become increasingly clear is that the geeks aren't just geeks anymore. No longer just "three guys on a laptop" as Borenstein puts it. "They're established players using both bitcoins and the blockchain for moving money around and building ledgers and shared value frameworks.""Banks are still for most people safer than bitcoin," he told me. "On the other hand there will always be a rebel minority saying loudly that bitcoin is safer than the banks. So the essential battle will be one of market noise - who can provide the most noise? The banks, who nobody trusts, or the geeks who nobody understands?"

Nasdaq's success with Chain will surely be watched closely, perhaps giving insight into whether it will it be the upstarts or institutions that lead us forward from here, and how well the two work together.

Trader's view - source requested anonymity

In 2014 a significant portion of my trades were brokering and buying bitcoin from merchants, thus the need to hedge excess inventory until liquidated.

Two ways to hedge the excess inventory were investigated, the first with options via Atlas ATS and the second by using non deliverable futures on Tera exchange.

Other activities where hedges were necessary was the cross exchange arbitrage business.

In 2015 the broker trades disappeared and I am not trying to get involved with merchants. My primary flow now consists of OTC retail trades, as cross exchange arbitrage trades are few and far between due to the reduced volatility.

In early 2015 we also explored carry trades on OK Coin - as the futures traded they were in contango and often go into backwardation before expiry. Even though that is a consistent way to make money, we went off the idea due to OK Coin banking issues and bad press.

In my personal view bitcoin is a disruptive technology and as such just trying to jam it into existing paradigms and models will be met with limited success.

Derivatives would have their place for desks such as institutional structured products or for retail to make cheap leveraged bets, however bitcoin is like physical gold, if you don't have the private key you don't own it.

Buy side view - Quant Hedge, Victor Lebreton, Director and Investment Manager

Companies offering blockchain currency trading are brokerage business classic. They charge fees for spread, fees for execution, for the listing of products.

But it's more about the blockchain. And not only on the payment side, or the B2B side, but also for internal IT corporate services, like tracking project funding. You can imagine the blockchain technology like an augmented certification, with many, many applications.

A big corporate may embed it, and not involve clients in the process. Large companies could buy small technology providers, transform their business and say it is better for the client, but the client still has to pay money for the service.