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Applications of Blockchain in Precious Metals

Calvin Lee, Product Manager, Paxos

 

What portion of readers here, the attendees of this second Asia Pacific Precious Metals Conference in 2018, have not heard of blockchain technology and its most famous implementation, Bitcoin? If this article was presented even just three years ago, it would be futile to approach any discussion of applications of the technology, and one could only hope to manage a cursory introduction to the topic. Today, not only has Bitcoin become a household term, but one can find a plethora of public resources from commercial and academic sources on the topic (the original Bitcoin Whitepaper written in 2008 remains an excellent introduction). Here, let us skip such an introduction to blockchain that is better served elsewhere, and instead discuss a few potential applications in precious metals.

 

Provenance and the Chain of Custody

In today’s precious metals market, producers, refiners, inspectors, regulators, vaults, owners, and others collect different kinds of data about a bar, but there is no system to weave this disparate information into a comprehensive storyline to give a complete view of where a bar came from and where it has been. Blockchain can provide a profound feature toward this effort: immutable timestamping. That means that history can’t be rewritten or exaggerated to fit a particular firm’s agenda.

 

Today, buyers must beware of the metal they are purchasing. They must take the seller’s word on the nature of the metal they are buying, and its origins and journey to his particular ownership. Inter-dealer trust is the current solution: a dealer will simply not transact with a disreputable counterparty.

 

A blockchain system could include immutable data from the entire lifecycle of a bar or coin. A seller of metal could prove that it was refined at a certain time and refinery, that the refiner was in good standing, and that the source of raw material was not sanctioned. Additionally, the buyer could verify that the bar was in the possession of trusted custodians since production.

 

Supply Chain Management

Similarly, a blockchain can be used to record and track events related to metal, not for the purpose of provenance, but to enable inter-firm supply chains to become more efficient. Imagine if we could track every gram of gold from the moment it is mined to when it is part of a ring that sits on a newlywed's finger, through multiple suppliers, jurisdictions, and inventory systems. When the order for the ring is placed, every supplier in the supply chain becomes aware of the sale and can adjust their operations according to aggregate demand.

 

One limitation to harnessing market forces to increase efficiency in an industry is the cost of inter-firm coordination. A vertically-integrated company hopes that its ability to communicate and coordinate up and down its internal supply chain creates more value than the inefficiency generated from a lack of competition within the company. While transfer pricing is a common practice that attempts to mimic the information value of market forces that exist between firms in competitive markets, typically there is no real “internal market” competitive dynamic amongst departments within a firm. A blockchain supply chain tool could reduce the costs of inter-firm coordination and increase efficiency as a result.

 

Trade Financing

How can a financier be certain that the client he is financing has a clear and unencumbered title to the metal being financed? With a blockchain ledger tracking the ownership of metals, there is single, real-time version of truth to which all parties can refer for title. Transfers could be bilateral (counterparties do not need to instruct third parties to commit the transfer), real-time (counterparties do not need to wait for a third-party to process instructions), and final (once executed, there can be no “take-backs”).

 

Once again, trust is an institution on which this industry relies today. Due to the lack of a transparent, certain, and final ledger, trade financiers must instead underwrite their clients to mitigate the risk that title is misrepresented by their clients. With a blockchain solution, client underwriting need not be required, and financiers would be able to finance with no risk or ambiguity in the title.

 

Post-Trade Risk

When two dealers engage in a trade, there are two types of post-trade risk that they must address: “Herstatt Risk”, and “Settlement Risk”. Blockchain settlements could reduce and eliminate both.

 

Settlement Risk is where a counterparty becomes unable to settle a trade after a trade has already been confirmed. In other words, the counterparty becomes insolvent or illiquid between trade and settlement. Today, OTC spot/forward trades typically settle T+2, and over these two days credit and debit positions build up between the traders due to changes in the market value of the traded assets. A blockchain settlement system could reduce the settlement period to zero, meaning trades settle immediately at execution, thereby reducing the Settlement Risk to zero. In a market with real-time settlement, there is no Settlement Risk.

 

Herstatt Risk occurs at settlement, where a dealer delivers one leg to the counterparty, but fails to receive the other leg from the counterparty. In other words, the counterparty becomes insolvent or illiquid between payment initiation and payment finality. For example, this could be caused by a payment failure due to insufficient balance. The two sets of transfer instructions are not in any way mutually contingent (most likely they occur in entirely separate ledger systems, such as the US Fedwire and the LPMCL’s Aurum). In some jurisdictions and scenarios, payment finality may not occur until weeks after the “settlement date”. Blockchain systems solve this problem with an atomic swap: a simultaneous and mutual commitment to changes in multiple blockchain ledgers in a single transaction.

 

Once again, inter-dealer trust is relied upon to mitigate risk: dealers are forced to underwrite their counterparties and employ tactics such as delivery-versus-payment. Blockchain settlements could eliminate the need for these practices.

 

Title Mobilization

Instant transfers not only reduce settlement risk, they can enable a higher utilization rate of precious metals as collateral. Metals could be pledged, rehypothecated, un-pledged, and re-pledged in very short periods of time, multiple times a day. The beneficiary of a pledge can be fully certain of the pledge and see in real-time all other pledges.

 

Conclusion

We have reviewed just a few applications here, and undoubtedly there are unmentioned other ways blockchain technology will influence our market over the coming years. The technology will be combined with other new innovations and will help the market become more efficient and more accessible.

 

Disclaimer: Views are personal and not the views of the publisher.