There has been much talk about how proof of reserves(PoR) should be required for crypto exchanges. Less talked about is a how proof of reserve systems may also bring benefits to traditional banks. Here you’ll uncover and explore the proof of reserve use case in the context of open banking smart contracts.
Open banking, facilitated by APIs, allows banks to provide third-party access of their data feeds. This can streamline the auditing and due diligence process by allowing auditors or creditors to directly verify the securities held by a bank in real-time. Quarterly reviews, reporting, and decision making cycles are often not fast enough to react to rapid market developments. This is where smart contracts and open banking can make a difference by acting programmatically.
Proof of Off-Chain Reserves is the general term to use for normal lending banks, since dollar denominated bank deposits are off-chain. However, bank deposits can be backed by a variety of loans, securities and bonds with different maturities. These diverse assets are what banks call their “bank reserves”. These are unlike crypto exchange reserves, which are very simple by comparison: a 1:1 ratio with the exact assets stated. Thus, a PoR implementation in a bank will be more complex than a PoR implementation for a crypto exchange. The premier PoR system is made by Chainlink.
Real-time proof-of-reserves (RTPoR) is an even closer term for what our use case aims to achieve. It means a dynamic and continual flow of reserve data is made available for attestation. Coined by Fluent, who’ve created Plus, a fiat-backed stablecoin infrastructure featuring 100% provable, verifiable cash reserves. With their first consortium, dollar reserves are able to be verified with high frequency among not just one, but many bank members. Fluent’s stablecoin infrastructure is unique in that it’s decentralized at not only the oracle level(thanks to Chainlink) but also the banking level. These banks are independent and integrated with Fluent core systems ensuring they cannot create a supply of US Plus unequal to the reserves held. This enclave of banks mitigates the risk of a single point of failure, as the custody of reserves backing US Plus is distributed. Later, you’ll see that Fluent is only the tip of the iceberg for RTPoR.
With these definitions in mind, let’s proceed to how open banking and smart contracts can help manage duration risk in an SVB-style failure. By integrating APIs with broker-dealer and custodian accounts, banks can offer real-time access to data on their assets for stakeholders. This allows for better risk management, transparency, automated compliance reporting, informed decision-making, and customer trust.
The Duration Risk Problem
An imbalanced portfolio duration contributed to the downfall of SVB. Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. A measure of the average time it takes for the cash flows from a bond to be received by the investor and expressed in years. Duration risk is the potential loss an investor faces due to these rate fluctuations.
When interest rates rise rapidly, banks that hold long-term bonds suffer an unrealized loss because those bonds held previously are locked in at the less attractive rate, and the bond price must come down to compensate. This isn’t normally a big problem, because the bank can just hold the bond until it matures and get its money back. However, if the bank suddenly needs extra cash to fulfill customer withdrawals, it could be forced to sell the bonds and realize the loss. The bank then has less reserves than what was planned for. This problem could become a downward spiral as more depositors withdraw and the bank is forced to realize more losses to cover short term cash needs.
To understand from another perspective, you can look at the duration risk issue through the lens of interest payments. Banks have inherent interest rate risk due to the mismatch between their assets (like long-term loans) and liabilities (like short-term deposits). If interest rates rise, the cost of their liabilities may increase faster than the income from their assets, squeezing their net interest margin.
Investors who catch wind of the balance sheet issues may suddenly make large withdrawals, forcing the banks to sell securities like bonds to cover them. A vicious downward spiral ensues.
Next, here are some tools banks use avoid duration risk.
Hedging
Interest Rate Swaps
If detected early enough, banks can hedge with financial instruments to prevent a bond duration blunder. Banks often use interest rate swaps as a hedging tool. An interest rate swap is a financial derivative allowing two parties to exchange interest rate obligations, typically one fixed for one floating, over a set period.
Futures
Banks also use futures contracts to hedge duration risk. Futures contracts, specifically interest rate futures, can be used to manage this risk. An interest rate future is a contract between two parties where the buyer agrees to take delivery of a specific amount of a specific financial instrument at a set price on a future date. The financial instrument involved is often a government bond or other interest-bearing security.
Here’s how it works in different scenarios:
- Hedging against rising interest rates: When a bank expects interest rates to rise, it faces the risk of its assets (like loans) decreasing in value. To hedge this risk, the bank can sell (or enter a short position) in Treasury futures. If interest rates rise as expected, the value of Treasury bonds will fall (since bond prices and interest rates move inversely). The bank can then take profit from the short treasury trade, offsetting the long duration portfolio.
- Hedging against falling interest rates: Conversely, when a bank expects interest rates to fall, it faces the risk of any previous fixed-rate liabilities still remaining high. If the bank doesn’t have corresponding fixed rate income producing assets to match, it will have an imbalance that negatively effects interest income. To hedge this risk, the bank can buy Treasury futures. If interest rates fall as expected, the value of Treasury bonds will rise. The bank can then sell the bonds at this higher market price, and make up for the adverse effect of falling rates.
Where Banks Hold Their Treasuries
In order to connect a bank to a smart contract implementing RTPoR, we need to understand where the reserve data will come from. Banks can acquire Treasury securities and other types of securities through several channels:
- Directly from the U.S. Treasury via auctions conducted through the TreasuryDirect system.
- From broker-dealers such as Goldman Sachs, Morgan Stanley, and J.P. Morgan.
- Through inter-dealer brokers that facilitate transactions between broker-dealers.
- Via custodian banks like Bank of New York Mellon, and State Street
Even banks with their own brokerage or custodial services may use external services for certain transactions to manage risk, access certain markets, or for strategic reasons. In any case, we can imagine a future where API access is made available to a bank’s broker-dealer or custodian, maybe even with an attestation from the TreasuryDirect.
Since Chainlink allows for decentralized oracle networks that ensure secure bridges to a blockchain, it’s good practice to expand that decentralized ethos to off-chain systems as well. Fluent finance has made a step in that direction with their federated custody system. Their reserves are stored at multiple institutions, increasing access while eliminating the risk of a single point of failure. Dollars backing the US Plus stablecoin are distributed among the many member banks. This could reduce the risk of bank runs effecting the stablecoin, as we have seen with Silicon Valley Bank and USDC.
A real-time proof of reserves contract that calls not only dollar holdings, but also securities holdings from various financial institutions like those mentioned above, is a great leap forward. Chainlink excels at aggregating data from a variety of sources in a decentralized manner and it could also be effective at aggregating Tradfi assets as well.
Privacy
A bank would not want to broadcast to the world all of its financial holdings of course. This is especially true for a bank that could face a bank run. For our RTPoR use case, the bank may only want to prove that the holdings backing customer deposits meet certain risk, regulatory, and strategic parameters. Also, it may want to be selective about who receives this information. Besides the low hanging fruit of regulators and creditors, it may also want to enable say, board members or large shareholders to receive data more regularly with smart contract feeds.
Chainlink’s DECO enables proving the authenticity of data and claims about it without revealing the data itself. For example, an advanced DECO implementation on chainlink might one day be set up with parameters from the bank’s risk management department in alignment with industry best practices & standards. After Chainlink aggregates the holdings data from the bank’s multiple custodian accounts, DECO could calculate and prove the portfolio’s average duration to a creditor or prospective investor without disclosing specific securities held.
Chainlink can also assist with making sure only the right parties gain access to the bank’s data. Companies like KYC chain, Coinfirm, and Dock are working on enabling this using decentralized systems. Additionally, accredited investor verification with this technology can unlock huge markets on chain by allowing users the ability to prove they have a bank balance in access of $1 million or above 200k yearly salary, per regulation D.
Implementation of this technology can lower the cost of due diligence, may greatly increase a bank’s efficiency and access to capital. There really is something to be said for how much Chainlink can reduce friction, overhead, and blockages in today’s financial markets. It will have a profound effect on the economy that is underrated. The network effect acting on these advantages for banks will mean an exponential increase in benefits for the economy as a whole. Better GDP growth is destined for countries that embrace real time proof of reserves & other smart contract technologies.
Automation
If the bank wants to access even more robust functionality, it could pair its RTPoR with Chainlink automation. This infrastructure enables conditional execution of smart contract functions through a hyper-reliable and decentralized automation platform that uses the same external network of node operators that secures billions in value. It includes time-based and custom logic automation once again, without any single point of failure. This means in our example, the bank that wants to trigger a portfolio duration calculation can be confident in its regular operation despite outages or errors with it’s own servers. It also gains additional security assurance from exploits and hackers.
Advanced smart contracts using Chainlink automation can act swiftly in a rapidly changing environment. On the other hand, traditional bank operations are often slow moving as is the case of executing hedging trades. Staff must first become aware of the need, obtain approvals, go through tedious procedures and maybe even engage in a bit of office politics before action is taken. Anyone who has worked in a corporate finance office can attest to this in varying degrees. Staff are generally available only within banking hours which further delay portfolio adjustments. Treasury bond futures trade 24 hours a day except for Saturday. Even within regular markets, west coast banks are not ideally positioned for standard trading hours. In an adverse environment, banks will want to be able to execute hedging trades efficiently and as soon as possible.
All of these headaches can be overcome by an automated execution via smart contract. This is what Chainlink calls non-custodial “smart portfolios” that automatically re-balance portfolios by executing trades on a user’s behalf based on preset conditions.
One might argue that this sort of automation could already be done with internal bank systems. This view fails to realize the infrastructure and network benefits from doing this on a smart contract. Assuming the bank already utilizes a Real Time Proof of Reserves implementation, this would remove an unnecessary step separating the aggregation and re balancing logic from the execution. Furthermore, many corporations are already using private blockchains like JPMorgan’s Quorum, based on Ethereum. Quorum is officially being used for securities settlement between banks. It’s easy to imagine a future in which most public securities will be tokenized into cross-chain tokens. This will allow investors to hold tokenized stock in companies like Google and Apple in their own custody, eliminating the need for a traditional brokerage account. With Chainlink automation along with the other functionality, you have a turnkey system ready to integrate & leverage all the new blockchains coming online, both public and private. It’s also highly likely that Chainlink’s CCIP will be the protocol standard for communication between corporate private blockchains.
Scenario
In this theoretical scenario, a bank on the cutting edge of smart contract technology has given API access to stakeholders to verify its Treasury security holdings. The bank has also implemented a smart contract for trading functionality within specific parameters. This smart contract is designed to monitor the bank’s balance sheet and to take action if it detects certain imbalances arise.
Stakeholders such as board members and large shareholders of the bank are subscribed to the bank’s Real Time Proof of Reserves contract using Chainlink. The contract is able to notify key members and regulators of a rising issue with Duration risk. At an early stage, this could prevent the bank from investing too heavily in long duration bonds before it becomes an issue in the first place.
As interest rates rise further, the smart contract checks our bank’s broker-dealer and custodian APIs and detects an overexposure to long-duration Treasury bonds. Recognizing the risk this poses in a rising interest rate environment, the smart contract begins a contingency operation.
It executes a futures hedging trade to mitigate the interest rate risk associated with the bank’s long-duration Treasury bond holdings. This could involve selling Treasury futures or buying interest rate swaps, effectively locking in the current interest rates and protecting the bank from further deterioration.
Second, the smart contract initiates a small capital raise within via the smart contract network. This could involve drawing upon a line of credit, issuing new shares or issuing debt. Private placements are an ideal match for blockchain and smart contract technology, because the aforementioned accredited investor verification ability, in combination with the higher risk appetite of investors in crypto as a whole. The additional capital serves as a buffer, strengthening the bank’s balance sheet and providing additional liquidity in case the interest rate risk materializes. This is where speed is key.
Once these actions are taken, the smart contract sends a notification to the bank’s executives. The notification informs them of the actions taken and advises them to consider further measures. This could include re balancing the bank’s portfolio, raising additional capital, or implementing other risk management strategies.
Thanks to the smart contract’s fast and programmatic response, the bank is able to quickly address the risk posed by its overexposure to long-duration Treasury bonds and the rising interest rates. This allows the bank to navigate the challenging financial environment more effectively, reducing the potential impact on its balance sheet and ensuring its ongoing stability. This scenario illustrates the potential benefits of combining open banking with smart contracts. However, it’s important to note that implementing such a system would require careful planning, robust security measures, and a clear understanding of the regulatory implications. Furthermore, while smart contracts can automate certain actions, human oversight and decision-making remain crucial, particularly in complex and rapidly changing financial environments.
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