Blockchain is a technology that creates a distributed ledger. Originally developed to facilitate Bitcoin transactions, many in financial services view it as a technology that could revolutionize transaction processing. It can represent a universal truth as it makes ledgers transparent, trustworthy and efficient.
According to Larry Tabb, “The interest in blockchain from the financial community has been tremendous. The thought of decentralized trust, greater transactional transparency, an immutable transaction record, compacted settlement periods, and the freeing up of capital as we reduce settlement counterparty risk has many both outside and inside the capital markets salivating.”
Dozens of banks and exchanges are beginning to experiment with the technology. More than 40 financial institutions have joined the R3 consortium to collaborate on creating standards and developing solutions. Meanwhile, Digital Asset Holdings, led by Blythe Masters, has raised $60M from 13 global banks plus IBM and the Australian Stock Exchange (ASX).
Blockchain companies have already attracted around $1B in investment, and interest continues to grow. “We’re all looking at it, we’re all working to get to a solution for our client base,” said Phuphinder Gill, chief executive officer of CME Group at the November 2015 FIA conference.
Blockchain Hype Cycle
But deploying Blockchain for the financial industry is not simple. The technology is still in its infancy, and there are many hurdles to overcome. As David Donovan from Sapient Global Markets wrote on TabbFORUM, Blockchain is probably at the peak of its hype cycle right now. “Blockchain will evolve over the next 12 to 18 months, and like any new technology innovation, it will get past its hype cycle. In the meantime, separating the reality from the hype of what blockchain can do for you requires a strong framework that fits within your organizational goals and creates a successful partnership ecosystem internally and externally.”
Financial Industry Blockchain Proof of Concepts
To move past the hype, we need to talk about real use cases and practical applications of the technology. There are quite a few proof of concept trials, using Blockchain for various use cases around the financial industry. Some were just recently completed, and some are ongoing. I’ve collected stories on a few of the most recent pilots below.
Cross Border Securities Settlement
Problem: Currently the process for settling securities transactions takes 3 days. The system is complex and requires time spent checking the settlement instructions and transaction content for inconsistencies. The 3-day period leaves asset managers vulnerable to failures to settle due to errors, fraud, or even counterparty bankruptcy
Goal: The goal of this Mizuho pilot was to build a blockchain-based system that can almost instantly share matched trade information in the post-trade process. In addition to speeding up the process, the pilot should ensure that the data that cannot be tampered with.
Approach: The teams involved in the pilot built a blockchain-forming system in Fujitsu’s cloud environment. It recorded the information contained in a confirmation as one linked block. Continuously generated blocks containing trade information were chronologically linked as blockchains, becoming information that could not be tampered.
Result: The firms say the experiment confirmed that the system is able to shorten settlement times and they are now looking into how blockchains can be put to practical use.
Commercial Paper Trading
Problem: There are many different implementations of Blockchain, and it’s difficult to understand how they’ll perform in the real world where different institutions have different infrastructure. The participants also wanted to test the ability to unite multiple institutions to work together in parallel to manage real-world financial transactions.
This is not a simple problem and is critical to moving forward with the adoption of Blockchain.
At the November 2015 FIA Expo, Jeff Sprecher, CEO of ICE pointed out some of the challenges. For example, there are several different ways a single credit swap contract is referred to across the industry. So institutions will have to come to agreement on how to standardize transactions.
Goal: The objective of this pilot was two-fold. The banks modeled a series of smart contracts – essentially coded rules – that manage commercial paper transactions. The objective was to test and compare the approaches of different blockchain offerings on the market today.
The banks evaluated how well each technology ran smart contracts (computer programs in blockchain that execute financial transactions) that helped issue, secondarily trade and redeem commercial paper; which is a fixed-income security that corporations issue to raise short-term funds.
Approach: The participants modeled the commercial paper instrument. The lifecycle of these short-term debt instruments is relatively short. Apparently, this makes them a good use case for the pilot.
According to International Business Times, “Each of the distributed ledgers ran a smart contract based on identical business logic to enable the banks to accurately compare the difference in performance between them.”
Results: According to Chain CEO Adam Ludwin, “We gave all 40 banks a separate node which formed a network for this use case, and each node had an application for a user interface and login and web browser to issue, trade, transfer and redeem commercial paper.”
James Wallis, IBM Vice-President of Blockchain, Global Industries, said using IBM blockchain services the banks deployed a network within minutes, “allowing the developers to rapidly focus on building a sample application for trading unsecured promissory notes within hours”.
Private Securities Issuance
Problem: Currently, settlement for equities trades takes three days, increasing settlement exposure risk and increasing capital costs and systemic risk. The settlement process is largely manual requiring multiple steps and substantial administrative resources.
Goal: Experts believe that Blockchain could be used to expedite the clearing and settlement process, reducing it from three days down to as little as ten minutes. According to Nasdaq, this could potentially reduce settlement risk exposure by more than 99 percent. It would also reduce the administrative burden, processing costs, and capital costs.
Nasdaq has launched its own Blockchain technology called Linq. They ran a pilot to use the Linq blockchain ledger to complete and record a private securities transaction.
Approach: For this transaction, Nasdaq enabled the issuer to digitally represent a record of ownership using Linq. The approach significantly reduced settlement time and eliminated the need for paper stock certificates. In addition to its equity management function, Nasdaq Linq also provided issuers and investors an ability to complete and execute subscription documents online.
Result: In late December 2015, Chain.com, an inaugural Nasdaq Linq client and Blockchain developer, documented its issuance of shares to a private investor using Nasdaq’s blockchain-enabled technology.
Overstock Issuance of Digital Securities
Problem: According to Overstock CEO Patrick Byrne, “There are all kinds of ways to rig the market. We want to make it un-rig-able.”
Goal: Overstock set out to do a proof-of-concept demonstrating the safety and efficiency of exchanging financial instruments via a cryptographically secured, public ledger. It intends to issue digital securities recorded in a distributed ledger instead of paper certificates in order to shorten settlement periods.
Byrne believes the transparency afforded by the digital ledger can close loopholes that disrupt markets and allow manipulative trading.
Approach: Overstock issued its bond on the bitcoin blockchain using “colored coins.” According to an article on David Floyd in an article published on the Nasdaq blog, “This technique involves making a transaction with a de minimis amount of bitcoin and adding other information, in this case a bond trade, to the transaction. When that transaction is added to the blockchain, the parties involved benefit from the bitcoin network’s public, trustless verification, without exposure to the crypto-currency.”
Result: Overstock successfully issued a bond in Blockchain in July 2015. Then in December, 2015, it obtained approval by SEC to do the same thing with equities. According to Overstock’s SEC filing, it plans to “offer up to $500 million in common stock, preferred stock, depositary shares, warrants and units, in addition to debt securities, using blockchain technology.”
Not the Recommended Approach: It’s important to note that the use of the bitcoin Blockchain and colored coins is not the approach most firms in the financial industry are taking. There are fundamental flaws in this approach described in this article by Matt Hatch, Angus Champion de Crespigny, and Nikhil Lele from Ernst & Young.
Addressing Liquidity Mismatches in Loan Funds
Problem: According to David Pinto, head of JPMorgan’s investment bank, “To sell a loan is a very cumbersome, time-consuming process; settlement can take weeks.” He explained that testing approaches with blockchain “makes all the sense in the world; it’s easier and faster operationally, and you get fewer mistakes. The [standard] settlement process is complex with lots of manual intervention and multiple parties.”
Goal: JPMorgan provides a service to investors that allows them to withdraw their money on short notice, absorbing the risk of selling the underlying assets, even though that process can require much more time and risk.
Approach: According to Financial Times, JP Morgan plans to examine several use cases for blockchain technology, including addressing liquidity mismatches in loan funds.
The investment bank is partnering with New York-based Digital Asset and plans to use their private or permissioned blockchain technology to streamline syndicated loans, US Treasury repo, foreign exchange, securities settlement, and derivatives.
Results: This project was announced in January 2016, and the pilot is still in progress.
Streamlining Post-Trade Clearing and Settlement in Cash Equities
Problem: The settlement process in securities trading is expensive, inefficient and vulnerable to both operational failure and cyber attack. Transactions are recorded separately by all the counterparties and intermediaries involved in a transaction. The counterparties have to go through a slow and cumbersome reconciliation process to ensure that the transactions match across these disparate systems. The process introduces the opportunity for errors that have to be resolved before a transaction can settle. Latency in the settlement process increases counterparty risk.
Regulators are focusing on increasing transparency and reducing counterparty risk. Expediting settlement time can help, but existing infrastructure can’t support this without heavy investment.
Goal: The Australian Stock Exchange (ASX) and Digital Asset plan to materially improve post-trade processing efficiency, reducing costs, latency, errors, risk and capital requirements.
According to ASX, “Distributed Ledger Technology provides the opportunity to radically simplify and speed-up post-trade processing. For ASX clients it could remove risk and reduce back-office administration and compliance costs, while investors could experience significantly faster settlement of equity transactions – potentially in near real-time.”
Approach: The pilot will use a private permissioned network. Digital Asset’s software utilizes smart contracts when the underlying distributed ledger can serve as the data source (e.g. hashlock, locktime) while requiring only stakeholders in a transaction to compute and validate transactions. It also allows external data source integration via a “trusted signatory” which allows automated authorization with discretion to intervene.
Result: This pilot is still in progress. It was announced in January 2016 and will run for 6-12 months.
What’s Next for Blockchain
Given the heavy investment and enthusiasm in the financial industry, it’s clear that there is a future for blockchain. But there are many hurdles to overcome, so it remains to be seen how soon we’ll see large scale deployments. ESMA (European Securities and Markets Authority) spent a year reviewing the technology and brought up these shortcomings that need to be addressed:
Privacy – Blockchain’s distributed ledger was originally developed to be public, so banks will need to figure out how to manage privacy, even in permissioned networks.
Volume and Throughput – distributed ledgers can’t currently keep up with the volume and throughput demands required by electronic trading.
Difficulty Interacting with External Systems – Currently, there are limitations in allowing external systems to securely interact with the distributed ledgers.
Interoperability of Various Blockchain Networks – ESMA is concerned that the complex encryption techniques could allow for the emergence of a monopolistic environment.
Regulatory Environment – ESMA points out that less regulated segments of the financial markets would allow easier implementation of distributed ledger technology. Deployment is likely to be significantly more complicated for those areas with heavier regulation requiring centralized infrastructures like centralized clearing
But ESMA did see the this technology as a promising approach for reducing counterparty and operational risk. They also think it could reduce risk of cybercrime since the industry would no longer be dependent on single, centralized ledgers.
While there is still a great deal of research and development to be done, the initial pilots are very promising. Banks and fin-tech companies had better prepare for some major technological disruption in the next few years. Blockchain is coming, whether you’re ready or not.
I’ve been curating articles about blockchain in financial services. Click below to access my Flipboard: