A perfect illustration of the blockchain hype

Baozou Commentary : The author of this article is a PhD in economics and teaches at a university. He believes that the current hype about blockchain has certain social and psychological factors, and cannot prove the advantages and revolutionary nature of blockchain technology. Therefore, we should face up to its functions. Although blockchain has its unique advantages and functions, it cannot replace the existing system, but as a new method, it can make up for the shortcomings of the existing system. We should fully realize this and should not follow the trend.

Translation: Annie_Xu

If you pay a little attention to the dynamics of the financial market, you will easily understand the significance of blockchain. Entrepreneurs and financial giants claim that blockchain will change every aspect of the financial market.

This techno-utopianism makes me very skeptical. I will explain the source of this skepticism in stages. Here I will only discuss a special example, introducing the strange combination of hype and blindness of many blockchain projects.

An article titled “Blockchain startup aims to replace clearinghouses” excitedly describes a post-trade startup based on Hyperledger technology, describing it as “disintermediating the clearing process and removing the role of central counterparties (CCPs) from the core.”

I often see CCPs provide a lot of services, and maybe some of them can be eliminated. But blockchain cannot replace their core functions.

More importantly, CCPs can share default risks, which is one of the core features of CCPs. Blockchain does not have this feature, which means that the services provided by blockchain are fundamentally different from those provided by CCPs.

CCPs can also hedge and manage customer positions and transfer customer positions held by defaulting intermediaries to a solvent party, which is also a function that blockchain does not have. CCPs can also manage liquidity risk. For example, the defaulter’s margin may not be immediately converted into cash and paid to the counterparty. However, the CCP can maintain liquidity reserves and liquidity in the intermediary market. Blockchain projects cannot do this either. These blockchain projects mention net settlement, but I doubt whether blockchain and hyperledger technology have the function of bilateral net settlement.

Key flaws

Other questions include who determines the margin ratio; who determines the intraday and daily price thresholds that determine the price change margin level and margin calls to fill the original margin ratio; and how the blockchain ledger implements these functions.

Therefore, blockchain projects do contain some functions of CCP, but not all. In fact, they lack the core elements of central clearing. Moreover, the added value and regulatory model of CCP services force market participants to use CCP instead of blockchain. Blockchain is not a perfect substitute for central clearing, nor can it meet the needs of market participants and regulators for certain service items.

Distributed clearing is also known as the bilateral over-the-counter market, where “central clearing becomes distributed clearing.”

By Craig Pirrong

This concept is not new, but a combination of new technology and traditional transaction methods. However, its nature determines that bilateral systems cannot achieve certain functions because they inherently require bilateral cooperation and centralization.

A superfluous move that is like reinventing the wheel

This is one of my main concerns about blockchain technology. Blockchain supporters always talk about innovation and change, but these always have to reinvent the wheel, which is redundant. Maybe this wheel is better than the existing one, but the wheel is still a wheel, and there is no substantial change.

And I have to say that these new wheels may contain flaws that the existing wheels do not have, which is the bilateral over-the-counter market as we know it. In a sense, blockchain brings one of the biggest risks of central clearing into the bilateral market.

And from what I have been studying for a few years, the price variation margin mechanism inherent in central clearing can form a stable correlation, which risks a huge loophole. Operational or funding delays lead to the failure to pay price variation margin in time, which puts the CCP into default mode or forces members to implement unconventional means to increase liquidity at a specific time. The punctuality of the clearing process is very important, otherwise the entire CCP will collapse. In times of market tension (excessive price variation margin), even a slight delay in payment will affect the normal operation of the CCP.

In contrast, traditional bilateral contracts contain more of this feature and are not so closely linked. One party’s failure to make a margin call on time will not affect the entire system. In the event of a crisis, disputes over price thresholds can last for days or even weeks, because there is a buffer period for the deadline to make up the margin call fee, and the specific margin call amount can be negotiated.

Blockchain smart contracts ignore this function. All information is in the form of code, the code determines everything, and it can be executed autonomously. And it can create a tight connection. The market operates according to this law. The smart contract stipulates that Party A must pay Party B a certain amount within a limited time, otherwise Party A will not be able to operate. You can imagine a smart contract with various clauses that can realize all functions and be applied to a bilateral market; but I still think there will be other problems, which I will explain in a later article.

Whenever I think of blockchain smart contracts, I think of wizards’ magic brooms. They execute the wizard’s spell and add so much water that it causes a flood; there is no specific feedback mechanism for the water level. Of course, it is possible to implement smart contracts that include such a feedback mechanism.

However, we have to consider the potential interactions of the smart contract network. How is feedback information transmitted? The simple agent model shows that agent operations are affected by pre-programmed rules, which will generate complex commands during the interaction. Sometimes these commands are efficient, but sometimes they will cause crashes.

Go with the flow

In general, “disintermediating CCP with distributed clearing” shows some flaws of blockchain and too much hype. Although it claims to be something new, it is actually just a new approach to ordinary things. And it is not necessarily better than existing methods because it does not take into account the impact on the system.

So where does all this hype come from? I think there are interesting sociological dynamics at play here. All the cool kids are talking about blockchain, and not joining in is not cool. And once a lot of thought leaders start something, everyone else will jump on board for fear of being left behind. Even if you can’t be the best, you can be with the best. If you don’t join in, you’ll be a fool and you’ll fall behind. So the mainstream trend is to join in and ride the wave.

I believe blockchain has its role. But it won’t be as revolutionary as people say. I am sure that central clearing houses will not be replaced because they have their own unique features and have regulatory support.