By Edith Rigler, Senior Consultant, Payments Advisory Group
The terms “bitcoin” and “blockchain” technology have gone mainstream over the last few years. There is hardly a day without news about a “revolution in financial services”, the “next evolutionary jump”, and about “the next big thing” totally changing our lives. The World Economic Forum has lauded the blockchain as a global “mega-trend”.
What is behind all this?
Bitcoins grabbed the headlines when they emerged onto the market in 2009 as a cryptocurrency. But the real story is likely to be the blockchain, the distributed ledger technology on which bitcoins are based. The blockchain has the potential to radically change how transactions between different parties will be conducted: allowing secure transactions without the need for a central authority such as banks, clearing & settlement mechanisms or exchanges. Thus the blockchain promises many benefits, including speedier, near real-time transaction delivery, lower cost, irrevocability and a high level of pseudonymity. That in turn will reduce risk, free up collateral and lower capital at both banks and financial market infrastructures.
The hype about bitcoins
For a time enthusiasts predicted that bitcoins could become an alternative currency for payments and store of value for investment purposes. However, in the payments space consumer interest and merchant acceptance in using bitcoins rather than fiat currencies such as USD, GBP, Euro and others just has not materialised so far. Neither the demand nor the supply reached forecast levels predicted by bitcoin enthusiasts. Today, payments made via bitcoins represent only a miniscule part of global payment volumes. As a result, “currency” companies such as wallets, exchanges, payment processors and other financial services companies that principally focus on bitcoin as an alternative payment method or investment asset have reduced staff, some have closed down. Investment in payment processors has slowed.
The blockchain is the real innovation
Although interest in bitcoins may be fading, interest in the underlying technology has increased. A dramatic shift in focus, from “currency” to “non-currency” use cases, has taken place. Bitcoin’s use as a means of payment is only receiving limited attention now. Rather, the distributed ledger technology, or blockchain, is commanding mindshare.
Currently it is the securities industry – rather than the payments industry – which is extensively reviewing, experimenting with, investing in and testing the “agnostic” blockchain, i.e. a technology which is not tied to the original bitcoins. What is the underlying challenge? Unlike the payments industry which over the last decades has harmonised payments across regions (an example is SEPA, the Single Euro Payments Area), upgraded, modernized and automated infrastructures (e.g. TARGET2) and is now moving to real-time payments (e.g. the current euro Instant Payments initiative), the securities industry is still fraught with many cumbersome administrative processes. Many of these have not changed for decades. There´s paper, faxes, huge reconciliation challenges and resulting costs. Settlement in securities markets is handled by clearing houses wherein a settlement time of minimum one business day (in case of listed options and government securities) to three business days (for marketable securities) after the execution of trade is required. Using the blockchain promises a whole new approach, moving from the complex and cumbersome to the fast and simple. The benefits of the blockchain would result from cutting out infrastructures such as exchanges and central securities depositaries as well as from having a unique and shared (“distributed”) ledger that always shows in near real-time who is the owner of a particular share, making reconciliation processes redundant and virtually eliminating the potential for “breaks and fails”.
Not surprisingly, there is growing interest from many financial institutions in setting up new operational and business models on the basis of the blockchain, across assets and markets. More than 40 large banks have joined a consortium led by financial tech firm R3CEV that is working on a framework for using the blockchain technology in markets. To date, several different blockchains have been tested to issue, trade and redeem a fixed-income product. The company believes that this is the largest trial on blockchain technology of a real-world process in the financial markets. The goal is to develop common standards for the blockchain to facilitate its wider use in financial services.
And infrastructures themselves are rising to the challenge. Rather than risking the danger of being cut out as the “middle man”, they are reviewing the potential of the blockchain. These include Nasdaq (which is working towards leveraging the technology for the issuance, trading, and settlement of private market securities), the New York Stock Exchange, the Australian Stock Exchange, and Deutsche Börse, just to name a few. The Depositary Trust and Clearing Company (DTCC) is making a significant investment in exploring how the firm can build solutions that address key industry pain points where automation is limited or non-existent.
Regulators such as the US Securities and Exchange Commission (SEC) are analysing the potential of the blockchain; earlier last year, the European Securities and Markets Authority (ESMA) issued a call for evidence to understand how the blockchain could be used for issuing, transacting in and transferring ownership of securities in a way that bypasses the traditional infrastructure for public offer and issuance of securities, trading venues like exchanges and central securities depositaries or other typical means of recording ownership. Some central banks have set up working groups to analyse whether they could issue digital currencies of their own, using the blockchain as the underlying technology. And just a few days ago the Dutch Central Bank announced that it would develop an internal blockchain prototype dubbed “DNBCoin”.
The blockchain in the securities industry
It seems there are no definite answers yet as to the primary areas in which the blockchain offers potential. After all, the reviews, analyses, experiments, pilots and tests are still in their infancy. Some proponents of the blockchain see a natural application in securities issuance and transfer, securities lending and securities trading. Others perceive the potential in asset servicing, and asset registries without the need for a central administrative authority. The blockchain could also be used for enforcing derivatives contracts and improving derivatives clearing through smart contracts. Yet other stakeholders bet on securities clearing & settlement. Proxy voting, an extremely cumbersome process, is yet another potential use case. So is issuing company stocks and offering the stocks directly to the general public while skipping intermediaries such as banks. At least one large bank has built cryptobonds to simplify the process of issuing and administering corporate bonds.
In late 2015, Goldman Sachs filed a patent application for a securities settlement system based on a cryptographic currency protocol, which introduces its own cryptographic currency – the SETLcoin. Settlement procedures are carried out via a cryptographic currency which enables rapid, secure and confirmed transactions via a network. There is no need for a third party, resulting in improved efficiency and speed.
Technology may be simple, but implementation is not
As with most major projects, the devil is in the detail. Proponents of the blockchain claim that while technological challenges exist, these may turn out to be the simplest variable in the equation. What will be very difficult to handle are business and implementation issues. These include challenges such as participation in a blockchain: for example, will all business units within a firm participate in the blockchain? Questions of accountability and responsibility are critical: who leads, who manages, who is permitted to make changes to the blockchain? How is consensus handled? There´s the regulatory dimension: how to fit AML and KYC processes into the blockchain, how to ensure the regulator is comfortable with new blockchain models? A myriad of legal questions arises: a smart contract (i.e. computer programmes which automatically execute the terms of a contract) are not legal contracts. How does one incorporate them into the current legal environment? Cost is an important factor: how can banks or infrastructures transition from today to tomorrow without incurring massive new amounts of cost? Can you really move all processes onto the new infrastructure or will there be residual processes that force participants to keep their legacy set-ups? And let us not forget the customer: can or should customers become “nodes” of the blockchain as well?
Though there is general agreement that the application of the blockchain could deliver considerable benefits, there is also considerable consensus that potential risks might arise. These include monopolising markets, undermining competition, committing data breaches, lack of sufficient scalability, inability to reach consensus and others. Other risks may not yet be understood. However, addressing and mitigating them will be indispensable. For that reason a number of regulatory bodies have already undertaken work to review the blockchain technology: the Bank of England, the Monetary Authority of Singapore, and the US Federal Reserve have all been fielding inquiries into the industry.
The next big thing?
Venture capital invested in blockchain-related companies has grown significantly over the past three years. Most likely this trend will continue and even accelerate. So will the new technology be implemented and become widespread soon? Opinions differ widely: some
stakeholders suggest that the blockchain should first centre on improving existing processes. The development of truly innovative applications and services that were previously not possible should happen in a second stage. Thus opinions on the time frame vary: some stakeholders see the blockchain at its inflection point and predict swift adoption by the financial services industry. Others are more cautious and believe that widespread use of the blockchain is still five to ten years off.
Yet while the blockchain is currently being termed “the next big thing”, another “big thing” is already around the corner. Just a little while ago an announcement about the emergence of a quantum super-computing system, developed jointly by Google and NASA, informed the world that “if quantum computing were to work, it is truly a disruptive technology and it could change how we do everything, almost.” Even the blockchain? That’s just one more issue developers will need to consider.
A similar article was published by Financial World in its February/March 2016 issue.