I still don't understand what "Smart Contracts" are and what benefit they provide over the existing settlement system.
Can someone help me out with an explanation?
Every time someone tries to explain it to me the explanation seems to be "We embed contracts into the blockchain so there is no counterparty risk." and then they stare at me like they're Eminem at the end of 8 mile.
EDIT I should point out, I get the speed of settlement argument, though as I've said in other comments T+3 is a feature not a bug to many funds. I just have no idea about the mechanics of it.
Securities and exchanges professional here, although based in Europe (no affiliation with T0 or any related platform).
Settlement is the process by which securities are delivered against payment, from one counter-party to another (the seller delivers the securities, the buyer delivers the cash).
What happens today is that both clearing and settlement are necessary because the speed of trading is much faster than the cycle time for completing an underlying transaction (delivery versus payment), usually in T+2 or T+3 days.
At the middle is the CSD - Central Securities Counterparty - that intermediates the delivery versus payment transactions and guarantees that when shit hits the fan (when one of the parties fails to deliver) the money is on the table for the other.
Settlement is costly: the CSD charges both parties for this "matching & insurance" service; sometimes the settlement operation represents the largest share of the costs involved in a transaction (trading + clearing + settlement; and after that you have also custody costs).
And usually settlement is only available for very liquid, exchange traded securities. Because the CSD my have to put money on the table they can do it only in securities they know they can get their money back. If you are a broker and there is no CSD you have to trust in the counterparties you deal with to minimize fail-to-deliver risk. Which brings a lot of inefficiency to these markets.
With smart contracts, if "the trade is the settlement" (which is a very neat way of expressing it!) it seems you no longer need to use traditional settlement services. The trade only occurs when you deliver the securities. And you have no limitation in the number of securities you can trade. Less costs, less time to deliver, same level of risks as in with a CSD.(EDIT: broader, unfulfilled markets). Seems like a wining proposition to me.
I completely understand settlement and grasp how the blockchain can be used to make the paper work more efficient and transparent.
What I don't understand is how it reduced the counter party risk to the trade? The counter party risk isn't mitigated until cash has traded hands. This is the expensive part of being the CSD (and the reason big firms want to self clear).
How does an open ledger help this problem without someone to guarantee the step between block chain acceptance and "cash in my hand with which I can use at the club".
Most (all?) open ledgers are marketing scams. The blockchain reduces counterparty risk because it escrows value, is immutable, etc. Private blockchains do none of this and are typically attempts by huckster Bitcoiners to sell software to decision makers at large companies who want to buy into a buzzword.
Suppose you had a single broker that held all of its customers' shares in-house (i.e. street name) and that broker represented all the owners of one particular stock. Then it could do low price, high speed settlement because it always knows where all the shares are and moving them around just requires changing a line in a database.
The idea with blockchain settlement is to simulate this in a distributed fashion by having a public auditable record of where all the shares of a security are at any moment in time.
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I don't see that either scenario would solve all delivery problems, for example it would do nothing to prevent claw backs if a legal regime demanded it, but I could see how it could speed things up and prevent some game playing.
The analogy I like to use to think about possible repercussions of smart contracts is this: smart contracts are to agreement as the internet is to communication.
Think about the criticisms of the internet in its early days. You essentially /only/ had the unprecendented communications wizardry when you tied yourself to one of several oversized devices in universities or big companies. But now, every person has a platform for communication in their pockets and embedded into most other devices.
So right now, we don't have a ubiquitous platform for permissionless agreements that can operate outside government and corporation. The most tech-savvy among us are experimenting, but the real exciting possibilities come when people start building tools for managing agreements without requiring privileged third-parties specializing in the management of that trust transaction. Then, lots of businesses start being decoupled -- the bread and butter of most businesses are just the bundling a few specific trusted transaction types in accordance with legal requirements.
ie Uber = reputation + geospatial routing + messaging/agreements between drivers and passengers. Having an agreement platform allows the monopoly of coordination for these types of trust transactions to be wrested away from organizations like Uber. The same goes for lots of other types of organizations :)
Smart contracts are about programmable money and shifting the business logic for financial instruments from pages-long ISDA agreements to cryptographically-secured and -enforced transactions on a blockchain. Today, settlement usually requires a trusted third party (TTP) and tedious, inefficient, expensive processes like netting, novation, moving money around, and keeping track of who owns what. Smart contracts holds out the possibility of being able to do away with the TTP and do pretty much everything on a blockchain.
They could pay with a crypto-currency like Bitcoin or a fiat currency issued onto the blockchain (although the latter would require a TTP like a bank to issue the currency and allow holders to turn it back into "real world" money).
Part of the confusion may come from the idea that it reduces counterparty risk. Using bitcoin to track non-bitcoin assets does not reduce counterparty risk.
A blockchain allows using digital signatures for determining ownership and solves the double spending problem without a central ledger.
"Smart contracts go beyond the vending machine in proposing to embed contracts in all sorts of property that is valuable and controlled by digital means."
> Using a bitcoin-based system offers several potential benefits. First off, it is faster. A bitcoin transaction clears in about 10 minutes, compared to three days for a traditional debt instrument to clear. The costs are lower.
Speed and cost is really where the advantage is. T+1 to T+3 is the usual range. 10 minutes is ridiculously fast and the cost savings appears to be notable.
Counterparty risk is reduced but the 51% attack exists + various security issues so its non-0 and really represents risk shifting rather than a lack of risk.
If you replaced "bitcoin" with "exchange-N-coin" and had N exchanges with fixed miner pools controlled by Y institutions roughly equally, you could scale horizontally. Whether that is cost effective with a bitcoin architecture, idk. It'd be relatively easy to do this and you only need 5 institutions with 20% of the pool each and SEC oversight to prevent them from colluding.
> It'd be relatively easy to do this and you only need 5 institutions with 20% of the pool each and SEC oversight to prevent them from colluding.
If I understand correctly, you're saying that this architecture might not only [possibly] not be cost-effective, but also effectively reintroduces centralisation and counterparty risk with the fixed miner pools as the SEC is needed to prevent AltExchanges from being manipulated or failing?
So it might not even be a solution to a problem the financial services industry (which throws millions at low latency connections for monitoring and executing trades but cares little about T+3 settlement) doesn't think it has?
Its the flaw in the horizontal scaling suggestion I made.
Scaling Bitcoin requires everyone to agree on bigger machines/faster pipes and/or use the lightning option [which may or may not work]. Both of those options don't have the problem I stated.
You offer suggestions on ways to handle such transaction volumes. Does that mean it is currently an unsolved problem? What volume can the current bitcoin blockchain implementation absorb?
I think they use the mutisig feature of bitcoin and a hash of the contract.
The first party would send that transaction to a 3rd party that would then (when whatever requirements are met) would publish it the network.
Someone correct me if I'm wrong and lets to talk in lower level terms as per ops request.
Smart contract is basically a small script with defined triggering criteria and defined results. The main benefit - contract is executed by network, not by machine controlled by person or organisation. This minimises trust.
What it'll be in practice: the Underhanded C Contest http://www.underhanded-c.org/ but as applied to whatever language is used in the system in question.
A smart contract is a contract that can be executed with the trust parameters you set, these parameters are less limited than typical contracts have since they don't have an inherent necessity to trust a government or even a counterparty.
Some contracts don't require anyone's trust. The most basic "smart contract" is a Bitcoin payment, the contract says "pay this to anyone who can produce a signature corresponding to the public key I have hashed in this contract"[1].
The less used smart contract involving cryptography can be "pay this amount to anyone who can find any sha256 collision"[2], or "flip a trustless N-sided coin and pay someone based on the outcome"[3], or in the future we could play more complex games and trustlessly pay the winner as long as we can create a trustless proof that the winner is in fact the winner.
There are also possible smart contracts that may allow individuals to move their money to another system, be they trustless like a sidechain or lightning hub, or trusty like Open Transactions, which has federated trust between a set of individuals.
Another form of trusty transaction is multisig escrow, where you can have individuals vote on who gets the money. Unlike giving an intermediary money they can run off with, you give an intermediary or set of intermediaries a vote on where the money ends up[4]. With multisig combined with nlocktime you can have money spendable by you if you verify your identity (usually through email) to an authority. If the authority refuses to let you spend, then you can get your funds back when your nlocktime transaction expires. They cannot spend your money though[5].
In short, when you have programmable money you can create a smart contract that allows funds to be redeemed by getting information from trusted external sources or internal trustless cryptography.
I dont see how counterparty risk is reduced... especially if these products are OTC products with regularly scheduled payment legs, you will always have counterparty risk. It is an inherent part of trading.
counterparty risk is still there, but you have a verifiable public record of the transactions. Would take regulators and court cases to set precedence after a transaction has happened. The ability to undo a transaction would have to be there as well (fraud).
This is also something that needs to happen. "unregistered public offering in accordance with Rule 506(c) of Regulation D". Cuts out a lot of the market, as many can not trade in unregistered offerings.
Once you're confirmed on the Bitcoin network - you're immutable. This is completely unlike incumbent systems. Even in the case that Bitcoin 'went down' the account information isn't changing. Risk is normalized under a huge swath of actors from across the world who are burning energy to attest to truth. As opposed to a single company who has complete authority over the data and/or value.
These issues are fairly rare, and in this case, it was due to some miners who did not upgrade their bitcoind (when everyone was made very clear that there were a number of large changes). Bitcoin is a WIP. If you're not a wizard, use a bank such as coinbase or circle who will happily insure you against such rare events.
Currently they're not fungible enough to reduce counterparty risk. The entire Bitcoin community is progressing towards complete fungibility, at which time, the risk is completely reduced.
I don't really understand what they are proposing...
"Settlement of securities is a business process whereby securities or interests in securities are delivered, usually against (in simultaneous exchange for) payment of money" [1]
How are the securities being managed here? Is some entity holding them in trust for whatever party controls an entry in the bitcoin ledger? What is the form of that entry?
Are bitcoins being used as the medium for payment?
Bitcoin can transfer any tokenized scarce resource, just like Amex can transfer any fiat currency. In these cases, the bitcoin network is transferring bearer bonds. (arguably registered securities)
I wonder how exactly it works. t0 are not very specific about implementation details. If they are using the bitcoin blockchain it should be possible to point out the actual transactions there.
I still don't understand what "Smart Contracts" are and what benefit they provide over the existing settlement system.
Can someone help me out with an explanation?
Every time someone tries to explain it to me the explanation seems to be "We embed contracts into the blockchain so there is no counterparty risk." and then they stare at me like they're Eminem at the end of 8 mile.
EDIT I should point out, I get the speed of settlement argument, though as I've said in other comments T+3 is a feature not a bug to many funds. I just have no idea about the mechanics of it.