Technically Speaking
August 1st 2012, as the trading day begins on the New York Stock Exchange, Knight Capital, the largest trader in US equities at the time, goes on a buying spree: within 45 minutes the firm buys 150 different stocks for 7 billion US dollars. There were no special circumstances to suggest such optimism – besides, the company did not have the cash to settle those trades.
The culprit was a computer glitch that resulted in a series of unwanted orders placed in the market.
The Security Exchange Commission did not allow for the orders to be cancelled: Knight had to liquidate the position the same day, racking up a loss of 440 million dollars. The loss ultimately ended the company.
You may be forgiven for not remembering Knight; the events unfolded a long time ago, 5 years prior to the US moving from a three days settlement cycle to two days (the US adopted t+2 in 2017). The SEC must have thought that three days to raise the settlement funds was unacceptably risky. Perhaps, 14 days (the convention in force in Europe in the 18th century) or a fixed liquidation date on the seventh business day preceding the end of the calendar month (the rules introduced by Napoleon) could have helped Knight.
Strictly speaking, Knight had three days to come up with the settlement cash, a route that a manager of a limited liability company may have pondered.
Fast forward 8 years, Yam, a firm promoting an algorithmic stable coin, loses three quarters of a million dollars worth of client funds and erases the 57 million dollars of market value of the governance tokens issued, a few days after launch. A different story: the treasury tokens lost were not really “client” funds, as in the decentralised finance world investors deal directly with an algorithm, and not with the company that launched it. But the underlying cause is the same: a software bug, a divisor omitted in a formula. Same issue but this one mundane, when compared with the bug that affected the complex systems deployed by Knight Capital and the chain of events that unfolded during the days preceding, and on the day of, its debacle.
Indeed the SEC branded Knight’s lack of comprehensive testing, of adequate risk management measures and of issue escalation procedures, unacceptable. What would have they said about Yam, who did not submit its code to the most basic quality assurance control, a code audit – a common, inexpensive and mostly automated service for smart contracts?
The SEC went on to remind markets that the circuit breakers implemented by stock exchanges following the Flash Crash of 2010, halted trading on individual stocks that experienced significant price fluctuations. Knight’s losses could have been far bigger and the impact on markets, greater.
Blockchain does not have circuit breakers, indeed it does not have a central regulatory body and – what is more important – it does not require intermediaries that can act as de facto buffers in the transfer of value. Furthermore, settlement on blockchain is immediate and irrefutable, removing the moral hazard that lagged settlement may introduce.
The Yam case should also refresh the memory of the DAO, a decentralised finance experiment which in April 2016 wiped out 34 million dollars of market value of its token and nearly killed Ethereum, having left Ethers worth over 50 million dollars in the hands of the anonymous attacker who exploited a software bug in the code. The attacker settled a perfectly legitimate transaction – legitimate from her point of view – not in the eyes of the DAO investors.
The escape route taken by the Ethereum community was controversial at best: the “DAO” transaction was erased from the blockchain with a hard fork. Should blockchain be immutable, the purists asked, giving birth – or rather maintaining on life support – the original Ethereum blockchain, re-branded as “Classic”. It was a one-off event that contributed to fuel an interesting debate on decentralisation; the issue is well laid out by the work of Enrico Rossi and Carsten Sørensen of the LSE, “Towards a Theory of Digital Network De/centralization: Platform-Infrastructure Lessons Drawn from Blockchain”.
Grayscale Investments, one of the largest world bitcoin funds, reminded us of the sanctity of settlement finality – at least on blockchain – referring to the resolution of the DAO impasse as the “Death of Principles”.
The principles referred to include this one: once a transaction on blockchain is executed, the new owner is immediately in control of the acquired asset. The other important principle of blockchain is purely peer-to-peer settlement, where no trusted third parties – typically banks – are required to process payments. A recent interpretive letter published by the Office of the Comptroller of the Currency (“OCC”), gave US banks the ability to provide custody services for cryptocurrencies.
Some in the crypto community have welcomed the news, I see a risk of compromising clarity in the ownership of assets. The regulator has to remind banks that assets held in a custodial capacity do not become assets or liabilities of the bank, unlike deposits that from a client perspective are IOUs. The reminder is there to enforce a principle that blockchain naturally ensures, even with articulate financial constructs, by not burying ownership of assets in complex contracts or within an entity balance sheet. The OCC clarification serves to bring cryptocurrencies under existing regulations by amalgamating them with the business of traditional banks. Regulators should continue in their path to bring regulations to a new breed of digital economy intermediaries. The benefits of adapting regulations to the nature of digital assets, rather than bending their principles are far greater as efficient handling of property rights reduces transaction costs and improves market efficiency.
Francesco Roda, CRO of Koine, a digital assets custodian and settlement agent.
For further information visit https://www.koine.com