Bitcoin is dead; long live blockchain.
To be fair, bitcoin, the much-hyped virtual currency, is hardly ready to fade into oblivion. The technology underlying those online exchanges, however, is poised to, on its own, become the hottest technology to hit the financial world in years, albeit not without significant business and regulatory challenges.
Blockchain technology is basically a peer-to-peer, distributed “open ledger." Rather than a traditional, centralized server or clearing process, blockchain relies upon decentralized, consensus-based authentication protocols. Any item that can be securitized or represented as an item of value can be transferred with an immediate settlement process.
Among those heralding the potential of the technology is J. Christopher Giancarlo, a member of the Commodity Futures Trading Commission. “The 20th century underpinnings of the current ‘closed ledger’ financial system are inefficient and unstable,” he said during a December speech, describing a process where third parties authenticate financial information in three-day settlement timeframes that “add undue risk, cost, and volatility to the marketplace. The 2008 financial crisis revealed that “a portion of the recordkeeping infrastructure of the multitrillion dollar swaps market was recorded on handwritten tickets faxed nightly to the back offices of market counterparties.”
Distributed open ledgers “have the potential to revolutionize the modern financial ecosystem,” Giancarlo said. “Distributed ledgers will have enormous implications for financial markets in payments, banking, securities settlement, title recording, cyber-security, and the process of collateral management that is made infinitely more complex by new regulations.” His bold prediction: new “smart” securities and derivatives that can value themselves in real time, automatically calculate and perform margin payments, and even terminate themselves in the event of a counterparty default.
“Banks aren’t necessarily known for being early adopters of new technologies. There is a lot of risk involved in switching over a system.”
Stephen Quinlivan, Partner, Stinson Leonard Street
Giancarlo is not alone in his enthusiasm. The Bank of England has called blockchain the “first attempt at an ‘internet of finance.’ ” More than 40 global banks formed a consortium, R3CEN, to develop a framework for its use. The Securities and Exchange Commission recently approved Overstock.com's registration statement to sell securities using blockchain technology. JPMorgan Chase is experimenting with blockchain transactions for international monetary transfers. D+H, a leading provider of technology solutions to financial institutions globally, has successfully integrated blockchain-distributed ledger technology into its global payments services hub and is in active discussions with banks to implement it.
Late last year, NASDAQ announced that an issuer was able to use its in-house blockchain ledger technology to, for the first time, successfully complete a private securities transaction. It has also worked with the Republic of Estonia to facilitate a blockchain-based e-voting service for companies listed on that country’s Tallinn Stock Exchange.
“Banks aren’t necessarily known for being early adopters of new technologies. There is a lot of risk involved in switching over a system,” says Stephen Quinlivan, a partner with the law firm Stinson Leonard Street. Nevertheless, in a world of increasing regulation, cross-border transactions, and demands for a faster, more secure settlement process for payments and stock transfers alike, blockchain has intriguing potential for them. “You can use it for anything you can transfer title to,” he says. “You can use it for a car; you can use it for real estate. People talk about using it for artwork and music royalties.”
VIEW FROM THE CFTC
The following comments on blockchain technology were made by Commissioner J. Christopher Giancarlo of the Commodity Futures Trading Commission during remarks at Harvard Law School on Dec. 1.
The 20th century underpinnings of the current “closed ledger” financial system are inefficient and unstable. At present, centralized third parties authenticate financial information in generally three-day settlement timeframes that add undue risk, cost and volatility to the marketplace. The 2008 financial crisis revealed that a portion of the recordkeeping infrastructure of the multi-trillion dollar swaps market was recorded on handwritten tickets faxed nightly to the back offices of market counterparties.
Distributed open ledgers have the potential to revolutionize modern financial ecosystems. Unlike current settlement processes, distributed ledgers use open, decentralized, consensus-based authentication protocols. They allow people “who have no particular confidence in each other [to] collaborate without having to go through a neutral central authority.” Distributed ledgers will have enormous implications for financial markets in payments, banking, securities settlement, title recording, cyber security and the process of collateral management that is made infinitely more complex by new regulations. Open ledgers may make possible new “smart” securities and derivatives that can value themselves in real time, automatically calculate and perform margin payments and even terminate themselves in the event of a counterparty default.
Enormous resources are being invested in developing the distributed open ledger known as the blockchain. Over two dozen major global banks have joined together in a consortium to build a framework for using blockchain technology in markets. The London Stock Exchange, CME Group, Euroclear, Societe Generale and UBS have set up the Post Trade Distributed Ledger Working Group to look into how blockchain technology can be used in clearing, settlement and reporting of trades.
The Bank of England has called the blockchain the “first attempt at an ‘Internet of finance’” with the potential to de-centralize legal recordkeeping the same way the Internet de-centralized data and information. This transformation will not come without consequences, however, including a greatly disruptive impact on the human capital that supports the recordkeeping of contemporary financial markets. On the other hand, the blockchain will help reduce some of the enormous cost of the increased financial system infrastructure required by new laws and regulations, including Dodd-Frank.
Blockchain could enable business models that were not previously available, according to Angus Champion de Crespigny, a financial services consultant for EY. As blockchain decouples from virtual currency, the million-dollar-question is what else it can do, do well, and do safely. The real strength of the technology is establishing trust in an untrustworthy environment. “We see huge opportunities in the ability of this technology for integrating finance directly into devices and essentially getting to the point where if you can digitize it, you can securitize it.” Champion de Crespigny says. “Think about financing cars directly rather than financing the people who buy these cars. Think about digital rights for music and films and being able to securitize and sell those off, being able to fund intellectual property directly, and funding decentralized energy markets.”
There are, however, unprecedented regulatory implications, Champion de Crespigny warns. How do you file a Suspicious Activity Report on a car? “The regulators will regulate, and should regulate, products,” he says. “But what blockchain is, at the moment, is a technology; and for them to develop a regulatory framework around it is the same as expecting them to regulate around relational databases. It is difficult to say the least.”
The technology must get certain things right in order to deliver on its transformative promise, says Moti Porath, executive vice president, global pre-sales, for D+H. “One of the things with bitcoin was anonymity, and we know in the banking world anonymity is not a very good trait. You can maintain privacy, but not anonymity,” he says.
The challenge is achieving regulatory compliance, without necessarily direct regulatory oversight. “You can do Know Your Customer and sanctions screens. You can do liquidity limits monitoring,” he says. “You can restrict the types of operations that you allow an entity to do. Once you add a layer of regulatory compliance without strict direct oversight, you have the best of both worlds.”
Blockchain has entered the “Wall Street phase,” where banks and other financial institutions form consortiums and partnerships to explore its possibilities and upsides,” says Robert Henry a director for business change and technology consultant GFT’s North American finance business consulting practice. “They cannot sit on the sidelines, but I would never say they are not cautious.”
Henry describes some of the unique applications blockchain could enable, including the shareholder voting process. “The proxy voting process is pretty archaic,” he says. “You get this big package in the mail, and you have to go through reams of paper before you can actually cast a vote. This information should be shared instantaneously and the blockchain, the distributed ledger, will allow you to do that.” Blockchain can also mean instantaneous vote tallies. Financial statements could similarly benefit from a distributed, shared ledger.
Regulators, Henry hopes, will tread into this new arena carefully. “The regulators should embrace the potential opportunities and utilize the rules they currently have in place for banking and financial services, but adjust, revise, or create new rules to mitigate the risks of this new technology,” he says. “This is an opportunity where the regulators will not have to be reactive because they see it as an emerging technology and can instead partner with businesses. You don’t want to put a heavy hand on it and stifle innovation.”
“You have to look at the natural next steps,” says Alan Morley, GFT’s compliance and AML practice lead for North America. “What products or businesses are a natural first step? Who is going to be the first mover and what do they expect to get out of it? That is when the regulators will really start to take notice. As soon as it moves out of its niche play of the moment, where it is still very much in an incubator, that’s when the attention will be exponential and accelerate. We are not there yet. This is going to take time, but that doesn’t mean it is not going to happen, nor does it mean that when it does happen adoption is going to continue being slow. Each step will accelerate the curve.”