Not Seeing the Financial Forest for the Trees: How CDOs Could Benefit From Cryptocurrencies
The average financial worker spends 40% of the work week in meetings and filling out forms and reports. That’s about 3.5 hours a day. Did you ever wonder if all those reports and forms were read by anyone? And did it get so bad that you investigated and discovered that in fact no one read your reports? It’s happened to me. Go back far enough in the development of those formats and you will see that there was initially some use for them, but they took on a life of their own. They were a means which became an end. At some point in the office, no one knew exactly why to fill them out – you just did it. And over time, you couldn’t see the forest for the trees.
In the financial realm, things like that have happened. The subprime bubble caused by rotten CDO trading was one of those things.
CDOs are packaged debts in the form of investments divided into tranches that bring different returns, but serve to bring an overall higher return. Selling CDOs brought capital back into banks and brought the debts off their books. The idea was to reduce risk by diversifying the investments. Rather than reducing risk through diversification, CDOs and other derivatives had spread risk and uncertainty about the value of the underlying assets more widely. It got to a point where no one really knew what was being sold. If certain CDOs were rated AAA, more inquisitive investors knew they could very well be BBB. Warren Buffet warned in 2002 that CDOs “are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Risk wasn’t being transparently passed along, and everyone got used to the sugar-coated roulette.
A creative way to minimize the risk of inflated values and ratings for CDOs would be to have an independent and infallible rating system based on a distributed ledger value. If enough of the public had access to the source and real value of certain securities and financial tools, then it would be nearly impossible to rate them differently than realistic. Blockchain technology could offer this creative solution.
More radically, banks could begin lending with the sole use of cryptocurrencies. Converting debts into blockchain-based cryptocurrencies would enable lending banks to follow up on debtors, since the record of their debts would be indelible on the blockchain. This would offer more realistic ratings for investors. BBB debts could not be bundled and sold as AAA debts.
Basing debts on blockchain would hinder any form of bubble that could spiral out of control. Bubbles will always be a part of human investment behavior, but these would not run their own course. They could be monitored and leveraged responsibly, using blockchain-based cryptocurrencies.
There’s a big forest out there which banks lose sight of every once in a while, for the trees standing in their way. A bit more transparency and public access could grant banks a greater credibility, and rating agencies a better grasp on reality.