Distributed Ledger Technologies (part IV)

Distributed Ledger Technologies

The Blockchain and the Bitcoin have already been live for a decade.

We are reviewing in this set of articles the caracteristics of the Blockchain, the changes made to the Blockchain, the alternative distributed ledgers to the Blockchain, the difficulties to run financial services on a distributed ledger without a legal tender.

This third part presents the difficulties to run financial services on a distributed ledger without a legal tender.

Part IV: Legal tender on a DLT

The use of Blockchain or an other Distributed Ledger Technology for traceability and precedence in a public environment is a given, provided the immutability is taken for granted.

The principle is simple. To prove precedence for a patent, a hash of the document explaining the process should be stored on a DLT. The hash proves the authenticity of the document as the hash is unique to the document and the DLT proves the time of the regsitration or its sequential number. The difficulty is then to have it recognized by the national judicial system so that the patent can be enforced, which means that the hash is of good quality (noone can produce a document with a matching hash) and that the DLT can be audited to show that the time or sequential number has not been altered (ie that the proof mechanism guaranteeing the immutability is working properly).

The financial world likes auditability but also privacy. If a supreme instance should be able to be aware, to audit or validate a contract, the contract can or should be private to its two, or more, parties. The role of the supreme instance is to authorize the contract or to be able to enforce if one the parties were to not meet its duties, that is to partially or totally default.

The most basic financial contract is a purchase or a sale of a good. The parties agree on a good, a price and a delivery date. On the delivery date, one party pays the agreed price and takes delivery of the good brought by the second party. This is the principle of the « cash and carry » or of the « Delivery versus Payment » or DvP.

Today most transactions are made in the legal tender of the country or in the legal tender of a ‘reputable’ country which legal tender is known as sound. Such currency, as USD, EUR, JPY, GBP, CHF… that are guaranteed by the central bank of each country or federation, are called fiat currencies in blockchain jargon..

If a DLT records the ownership of a good, it is quite easy to change the ownership on the sgnal that the payment has been made or received..Such external signal that triggers an event is called an oracle in blockchain jargon. However, with this organization, the transfer of ownership and the payment are not concurrent. The transfer of ownership is dependant on the payment, which means that this transaction could not occur, or settle in banking termonology, if the owner of the good has already sold it to a different party.

The idea to guarantee that a transaction will settle is to have the currency on the blockchain. there are currency in the various blockchains called cryptocurrencies. The difficulty with these currencies is that they might not have an issuer, just like the Bitcoin and when they have an issuer, this issuer might not have the balance sheet to gurrantee its value just a supreme instance, a central bank,could., These cryptocurrencies are as good as or lesser than their issuer creditworthiness.

The Estonian state has intented to launched a crypto-euro¸ the est-coin. It was prevented to do so by the President of the European Central Bank.

As for other state recognized crypto-currency, there is the PETRO in Venezuela which is supposed to be backed by oil, and the SOV which was expected to be issued by the Marshall Islands government. The Marshall Islands are also known to the second largest ship registry after Panama as it offers flag of convenience. It was prevnted to do so by the International Monetary Fund (IMF) which threatened to cut subsidies which account for a third of the revenues of the country.

As of February 2019 no central bank has issued a currency on a blockchain. A large very commercial bank, JP Morgan, has announced that it would issue one in the first half of 2019. This currency, if guaranteed by the issuer, could be as good as the company credit rating, and possibly worthless if the company were to go bankrupt.

Buying cryptocurrencies and getting back to fiat currencies

The easiest way to acquire coins or tokens is usually at their introduction, at the famous Initial Coin Offer (ICO), when the company issuing them offers to buy them. It resembles an act of faith as you send money and expect to receive a coin.

The second possibility is to buy them at an ‘Exchange’ which will indicate its price, which may vary sensibly from one “Exchange” to the other, and its commission. ‘Exchanges’ have different practices concerning Know Your Customer and Anti-Money Laundering. In any case, if it is relatively easy to switch ”real” currency for known cryptocurrencies, and exchange between known cryptocurrencies, it may be more difficult to switch back to “real” currencies.There are very few Exchanges that are regulated.

Decentralized Exchanges, or DEX, are an alternative to “Exchanges” for pure cryptocurrency to cryptocurrency, with possibly less counterparty risk,. (paragraph to be expanded)

Keeping keys safe

To hold a cryptocurrency, you need to keep secure a Private Key, basically the key to your account.

(paragraph to be expanded)

Wallets are a security nightmare, and there are at risk when they are stored at an Exchange. Most cryptocurrencies have been stolen at wallets deposited at Exchanges

Stable coin

As today there is no cryptocurrency backed by a supreme instance, the idea is to have a cryptcurrency that has a backing which is more solid than a company or a commercial bank. There are different possibilities like cash held in trust, or money market fund.

For instance holding cash

(paragraph to be expanded: KYC-AML, white list or second KYC…)

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