Intro to Collateral Management & Blockchain

Blockchain technology development has made new forms of electronic value exchange possible. Escrow and collateral management services have high operational costs, complexity, and asset illiquidity. Asset tokenization and process execution by smart contracts can overcome them.

Context

Escrow is the placing of assets with a third party against an exchange of value in progress. Henceforth, we’ll call this the “deal”. No later modifications to the amount of economic value in escrow are possible. If the deal finishes as planned, the value goes to either of the two exchange counterparties. If the deal ends unexpectedly, it may remain in escrow during dispute resolution.

Collateral management is modifiable escrow which must maintain specific criteria at all times. This can mean modifying collateralized assets. Typical criteria are value, quality, liquidity and risk consolidation (i.e. if I have 100 different deals all collateralized with the same asset, I effectively have one such deal).

Problems therein

Counterparties seeking to establish an escrow or collateralized trading relationships face two significant challenges:

Escrow and collateral management are expensive, complicate and need risk absorption.

Lack of trust is a barrier to business between economic actors regardless of their history together. Trading counterparties need assurance that the other side makes good on their promises. Reputations help, as does legal recourse after the fact for disagreements. Economic actors can also request escrow or collateral management to improve trust.

Despite a clear value premise, escrow and Collateral Management are not currently functions of everyday commerce. This is due to three main pain points:

Complexity — collateralized position management is hard. Operations consolidate different information to perform complex calculations across portfolios of positions. Then they adjust collateralized positions in as close to real time as possible. This makes collateral management the preserve of large organizations only.

Cost — it’s expensive to run collateral management. It needs experts and complicated software. These demands render it too expensive for significant volumes of trading relationships.

Trust — most collateralization takes place via a third party (generally a bank), introducing more elements of risk such as third-party insolvency, misbehaviour, and others.

Many stores of value are impractical for use in escrow an collateral agreements.

Traditional common means of exchange (cash, securities) represent a fraction of the total of economic wealth. These stores of value are de facto vehicles for trade and are easy to include in complicated escrow and collateral management. Typically, the value stored outside of this paper system is illiquid and excluded from collateralized trading. Illiquidity means counterparties prefer cash or financial securities in collateral or escrow. A massive amount of economic value is therefore underutilized. The only means of realizing gains from ownership is through capital gains delivered at the moment of sale.

Blockchains like Ethereum can store assets like securities (e.g. shares in a company). The Tokenisation process is similar to securitization. It creates a tokenized denotation of ownership of goods, which is exchangeable on-chain. This suggests a solution to the problems of liquidity.