Chainlink (LINK) introduction, and Decentralized Finance
Chainlink (LINK) is what changed my mind on blockchain. Before I knew about LINK, I was aware of what crypto and blockchain was, but I viewed it as more of a curiosity than a serious asset class—and moreover, I didn’t understand the implications of blockchain technology for decentralized finance, meaning, the uses for blockchain technology outside of just a digital currency perspective. In this post, I will provide an introduction to LINK and what are its real world use cases.
Smart contracts, and sports betting as an analogy
To explain LINK, I first need to give a brief explanation of what smart contracts are in general terms. Smart contracts are self-executing legal agreements that exist on the blockchain. Ethereum was the first platform to have smart contracts, although some competitors have since emerged.
The analogy that I like to give when explaining smart contracts is sports betting. Let’s say for example that I’m betting on the North Carolina Tar Heels to beat the Duke Blue Devils in basketball. We could program a smart contract that pays out a given sum of money, the bet, if the final score for North Carolina is greater than the final score of Duke.
You may be wondering…ok, what’s the point? I don’t need this to make sports bets.
I’m just using betting as an analogy. The point is that we can program legal agreements to automatically execute if a trigger event occurs—in this case, if the final score of one team (a quantitative, definitive value) is greater than the final score of another team (another quantitative, definitive value).
Derivatives—when your bets are multiple billions of dollars and the basketball court is Wall Street
So instead of making a smart contract to check two sports scores, now imagine if instead the smart contract checks financial data and makes payouts accordingly. I’m specifically talking about the derivatives market—financial instruments that have a contracted payout based on a set of inputs, such as LIBOR for interest rate swaps or commodity prices for commodity swaps.
Interest rate swaps are a huge market. You may remember that from the 2008 crisis. You may also remember that a big chunk of this market is over the counter (OTC), meaning not traded on exchanges, and hence not necessarily transparent.
What if we could put this all on the blockchain so investors and regulators could see each others counterparty risk, since everything was out in the open on the blockchain? That is exactly what I see smart contracts doing—not necessarily now, but 10 years from now perhaps. Smart contracts have big potential for the institutional finance space with derivatives.
And, at the same time, we’ll also speed up back office processes. Swaps can be very manual. Contracts are emailed over, meaning lawyers and accountants are involved to review everything, make sure all parties are playing fair, and then a back office process is needed to actually disburse the funds. Meanwhile, we also need someone to keep track of the counterparty risk that I mentioned previously. What happens if we enter into a swap with someone, but then they go bankrupt? Is our contract going to be worth the paper that it’s printed on? And, with all the swaps that our firm is engaged in, what is our market risk—meaning, as prices or interest rates go up and down as the market ebbs and flows, how does that affect the value of our swaps. And, what is our worst case scenario or “value at risk” (VaR) and how can we keep that VaR at an acceptable level?
The reason why I know all of this is because before I joined the US Army, I worked on a market risk desk for a major energy company in Texas.
Smart contracts and blockchain could make the OTC derivatives market, which includes swaps, much more transparent and efficient. Transparency by putting everything on the blockchain would be the first main benefit, since people would be able to assess counterparty risk across firms much more easily. Additionally, this substantially reduces the need for fees on lawyers and accountants, since this is not a system that relies on good faith of humans to act in an honest fashion. Instead, it’s just computer code. The computer just does what it’s told. The risk of fraud is reduced because the computer just simply isn’t smart enough to commit fraud. It just does what the code says, nothing more, nothing less.
Where Chainlink (LINK) comes in
Let’s go back to the sports betting example. The smart contract relies on good data to determine which team one and therefore which side of the bet to pay out. You could perhaps point the smart contract to something like Barstool Sports or ESPN, and this may seem like the obvious answer, but it actually opens you up to risk.
Let’s say the guy at Barstool types the wrong number in by mistake. The smart contract might trigger and pay out before the wrong number is corrected. Remember, it’s just a computer executing its code. Or, worse, let’s say the guy at Barstool placed a bet of his own and then deliberately entered in the wrong score in order to commit fraud.
Here’s where LINK comes in. LINK provides a decentralized, consensus based network to validate the data that goes into smart contracts.
Sports betting is just a convenient example, but the derivatives market involve multiple billions of dollars exchanged. Financial firms cannot afford any screw-ups.
This is why, in my opinion, LINK will be an important part of the financial industry’s use of Web 3.0 and blockchain. Possible use cases:
LIBOR or interbank interest rate data
Commodity prices, especially energy once you get away from the major hubs; e.g. it’s easy to know the price of West Texas Intermediate oil at Cushing Hub, but not necessarily minor locations and different grades of oil
Weather data as an input for weather derivatives (yes, this is a real thing)
Closing prices of stocks/indexes for index swaps or options
Credit default swaps; initiate a payment if a credit ratings agency declares a default
Basically any scenario where you have an instrument that pays out X if Y happens
Conclusion: Blockchain is more than just digital currency
Notice that not once in this article did I mention how much money central banks have printed since 2008 and inflationary risks. That is usually the go-to argument for Bitcoin or cryptocurrencies…but I did not discuss that here!
And, hopefully I didn’t need to in order to get my point across.
The main takeaway that I hope people get from this article is that blockchain tech is more than just cryptocurrency, and that blockchain could have some serious uses for the financial services industry. Cryptocurrency is just one application of blockchain tech.
There is now a term for blockchain’s usage in financial services: decentralized finance, or DeFi as an abbreviation.
Keep in mind also that technology can take time to get moving, but once it does, things can start moving very fast. I encourage you to watch the documentary “Floored” about the Chicago floor traders on the CME before and after electronic trading was introduced. A number of these jobs flat out do not exist anymore, and others were drastically changed—but later, we also saw entirely new jobs created, such as the rise of quantitative trading. Check it out.
The only constant in finance seems to be change. I believe that blockchain and DeFi will be another technological set of changes—maybe not tomorrow, but perhaps 5 to 10 years from now.
-Alex
PS: The vast majority of the growth in my Substack is word of mouth. If you enjoyed this article, maybe send it to a friend or share it on your social media.
Disclosure: This is not financial/investment advice. I cannot tell who is reading this and cannot say what is suitable for you or not; you need to make your own determination on what makes sense from a risk perspective and a suitability perspective.