CUTTING THROUGH THE NOISE.
Lynn Strongin Dodds explains how Blockchain is emerging from the Bitcoin shadow and forging its own disruptive path.
There had been murmurings in the background but 2015 was the year that blockchain came into its own. The prospect of the technology became a firm fixture on the conference circuit as well as a hot topic for columnists, bloggers, journalists and consultants. However, as with any new innovation, there is always the need to distinguish between the revolutionary and the reality.
The first step though is to get a better understanding of the origins. The modern day version is that it was originally designed as a computer protocol by the pseudonymous Satoshi Nakamoto, the mysterious creator of bitcoin. A closer look though reveals that its roots can be traced back twenty years ago to consultancy Z/Yen which developed a decentralised electronic ledger for a client who wanted a shared database to provide an indelible and secure record of conversations and dates.
Professor Michael Mainelli, co-founder of Z/Yen, which has built over 40 blockchains for a variety of organisations over nearly two decades, notes there is a great deal of confusion between bitcoin and blockchain. “Often when people talk about blockchain technology, they come at it from a bitcoin perspective. However, to us, blockchain technology is merely one form of mutual distributed ledger, a tamper-proof, replicated, authoritative, immutable ledger whereby groups of people can log onto and validate, record, and track transactions across a network of decentralised computer systems.”
One of the main attractions is the cost savings. A recent report by Santander InnoVentures in conjunction with co-authors Oliver Wyman and Anthemis, estimates the technology has the potential to reduce banks’ infrastructure spend attributable to cross-border payments, securities trading and regulatory compliance by between $15-20bn per annum by 2022. It not only can help lift the legislative burden by automating back office functions but it also has the capability to speed settlements, enhance clearing processes as well as streamline stock exchanges.
Add all this together and it is no wonder that Goldman Sachs sung its praises in its latest Emerging Theme Radar report. The US-based investment bank noted that “while the bitcoin hype cycle has gone quiet, Silicon Valley and Wall Street are betting that the underlying technology behind it, the blockchain, can change… well everything.” There is the promise to usher in a new set of tools to reduce costs and make centralised institutions obsolete by cutting the “trusted middleman” who sits in between parties in a transaction, such as a bank or clearinghouse.
One of the blockchain tools creating the most buzz is smart contracts which are not exactly binding agreements but scripts – pieces of computer code that can be assembled to make very complex systems of rules to govern how a group of users interact with a blockchain database. They can perform similar complex jobs, typically associated with internet-based applications, but in this case it is the ordinary computers rather than a huge central server doing the work.
To date, the blockchain has mainly been used in the payments space, especially cross border, but Mariano Belinky, managing partner of Santander InnoVentures, expects its reach to extend wider next year into the realm of securities, syndicated lending, trade finance, swaps, derivatives, real time settlement or post-trade reconciliation processes. If you take the latter, “it is a time consuming and manual process and a mutually distributed ledger creates a goldensource or one point where everyone has the same information,” he says. “This is a much more efficient process from a back office perspective.”
Jockeying for position
Not surprisingly, there are a plethora of initiatives exploring the various avenues both on an individual firm basis as well as through consortiums. According to consultancy firm Aite, capital-market spending on blockchain research and development could reach $400m by 2019, from $30m last year. One recent example is Deutsche Bank’s successful testing of a corporate bond platform using blockchain to issue and redeem bonds, which are programmed to pay out coupons automatically, through smart contracts technology. This follows on from a similar smart bond platform from UBS that was built on a type of blockchain called Ethereum where bonds would be programmed to issue interest and principal automatically. Neither though have any plans to bring the platform to market anytime soon.
This is not the case with SETL, which recently hired Sir David Walker, former Barclays chairman to take on the same role at the new venture. Launched in July 2015, the London-based group founded by a group of hedge fund investors and trading executives, has created a blockchain engine and simulated real-world payments based on data from the UK payment system, including networks such as Link, CHAPS, BACS and CLS, which settles foreign exchange deals.
“We were the first to demonstrate how the technology could handle the volumes required by the financial services industry,” says Peter Randall, chief operating officer. “We have a demo and can show real world volumes working in real time. The other difference is that it settles payments in central bank money and not a cryptocurrency.”
Randall believes though that the most critical piece is not the technology but the combination of “regulatory approval and adoption.” However, as founder of European trading venue Chi-X, he can leverage his experience navigating the legislative landscape. He adds, “I am optimistic that the regulators will be more inclined to engage once they understand the significant benefits a distributed ledger can bring to the operations of a large financial services firm or bank.”
Meanwhile, on the group front, around 24 of the world’s largest banks, including JP Morgan, UBS and Barclays, have thrown their weight behind R3 CEV, a start-up venture which aims to set up a private blockchain open only to invited participants who between them maintain and run the network. It forms part of an effort to build an industry-wide platform to standardise use of the technology. Separately, chief executives from CME, ICE and Eurex are exploring the possibilities of applying the technology in the derivatives world.
Cracks in the road
Looking ahead, the blockchain arena is likely to become even more crowded, although as Camron Miraftab, an analyst and co-author of a report on the subject at consultancy GreySpark puts it, “there will inevitably be winners and losers among the fintech companies competing with each other to develop an optimal capital markets digital ledger technology infrastructure or protocol.”
Ron Quaranta, chairman of Wall Street Blockchain Alliance and CEO of Digital Currency Labs predicts that next year “we will see companies more than just dipping their toes in the water. They will be leveraging the technology in both private and public blockchain, starting with leveraged loans and trade finance as well as clearing and settlement. The biggest challenge will be on the education curve and helping people gain a better understanding of how to create a framework and apply the technology in the broader market.”
Another hurdle is scaleability, according to Terry Roche, Principal, Head of FinTech at TABB Group and co-author of the report Blockchain Technology: Pushing the Envelope in FinTech with Shagun Bali, “At the moment, blockchain does not have the capacity to handle the volume of messaging needed for financial services. It is not a structural inhibitor as this issue has been addressed in other places but it will take time.”
In his report, Roche notes that DTCC currently handles about 10,000 transactions per second whereas the blockchain technology can process only a small percentage of this amount. In terms of cost, the clearinghouse charges 1/10 of a penny for trades and it will be a long while until blockchain reaches that level of cost efficiency. He also believes syndicated loans will be first in line – as early as the second quarter 2016 – while derivatives may take at least two to five years and equity cash settlement could be a decade away.
Diana Chan, chief executive of EuroCCP, the largest cash equities clearer in Europe, argues that some of the advantages offered by the blockchain – IT redundancy and a robust audit trail – already exist in the current structure: “The question that should be asked is what are the real added benefits compared to the costs? For example, with today’s central securities depositories (CSDs), you can be sure the records are authentic, transactions are recorded properly for settlement and there is a single source of information that can easily be accessed by different parties if needed.”
As for helping achieve T0, Chan notes, “it sounds attractive and valuable, but the question here is how much would the market have to invest and would it be worth the cost?”