The blockchain technology will revolutionize the world of financial services, and lead to substantial savings as well.
Ten years from now, business historians will be able to offer a number of reasons financial services had changed so radically since 2016, from general advances in technology to the regulatory reaction to the crash of 2008. But one factor appears likely to stand out above all the others: the blockchain.
Last year, the blockchain was just a rumor, the sort of gizmo that technology writers generally glide over before getting back to fun and more easily-told stories about Bitcoin-stealing pirates. Today, financial services are investing billions in blockchain technology. Many bank executives now believe it will lead to a radical simplification of banking and payment systems everywhere—a world where money and many other kinds of assets take nanoseconds to transfer, cannot be lost or stolen, and require no intermediaries to process.
The blockchain is a distributed database invented in 2008 by an unknown mathematician, the pseudonymous Satoshi Nakamoto, as the backend of a new virtual currency he called Bitcoin.
The distributed ledger system Nakamoto invented solves what economists call the double spending problem, explains Erik Olofsson, a business development executive at Chain.com, a blockchain development company with offices in San Francisco and New York that works with Orange, Visa and other major companies on blockchain applications.
“If I take a photo and send you that photo, what I actually do is I send you a copy of that photo, I don’t send the photo itself. If I have a dollar and I want to send you a dollar, it’s very important that I don’t send a copy of that dollar,” he says.
In the past, people turned to trusted intermediaries, such as banks and payment networks, to guard against digital double-spending, according to Olofsson. A distributed ledger eliminates that risk by making as many copies of that same record as there are nodes on the network. Copying encrypted, time-stamped copies of a unique record to every node of the network make fraud impossible.
One Singapore start-up is already taking advantage of this ability to speed up currency exchanges. CoinPip, a money transfer service built on the Bitcoin protocol, moves money across borders for a 2% flat fee. “‘We can do transfers and settle in five minutes. I think that can already beat a lot of the banks,” says Anson Zeall, CEO.
Banks could do this, he says, but they won’t. “They’re too comfortable with what they have,” he says.
But that may change.
Initially, Bitcoin boosters saw the blockchain as an innovation that would cut banks and even central governments out of the money business. In the end, however, just as Napster gave way to iTunes, global banks may have another act left as gatekeepers in a streamlined global payments network.
One venture in particular seems to be gaining some early traction. R3, a New York start-up, has already organized a consortium of 42 of the world’s largest financial institutions to build a private distributed ledger network. In January, 11 members, including Barclays and Wells Fargo, tested the system, which runs on Microsoft’s Azure platform.
$20 Billion Saved
The savings could be substantial. In a research paper published by Santander InnoVentures, the innovation arm of the Spanish bank, along with Oliver Wyman, the New York management consultancy, and the Anthemis Group, a London-based digital financial services investment and advisory firm, analysts estimated that banks could save as much as $20 billion a year in costs.
The post-trade process in the securities market, for example, could be dramatically compressed, reduced from a six-step process—matching; clearing; lifecycle management; collateral management and valuation; settlement, and custody—to one, according to the Santander report.
Olofson agrees that the compression could have a dramatic impact. “Trade on the Nasdaq exchange takes three days to settle, which means capital is tied up. With instant settlement, you take those cost out,” he says.
Being distributed adds more security too. “You do not have to have a single point of failure in the network,” says Udayan Goyal, a partner and co-founder of Apis, a London-based private equity fund focused on FinTech in emerging markets. “….This takes out an enormous amount of cost and friction from the system.”
For regulators too, the blockchain is likely to have advantages as well, as they will have real-time information on the interconnectedness of different balance sheets within the financial system, says John Dwyer, a senior analyst in Celent’s Securities & Investments practice in London. “That can accrue significant benefits to a regulator who is trying to understand or monitor systemic risk,” he notes.
However, Dwyer isn’t convinced that the R3 consortium, or its leading competitor, Digital Asset in New York, will be the ultimate beneficiaries of these cost savings. “We’re still likely to see game-changing input from other parts of the blockchain/distributed ledger ecosystem that don’t fit inside investment banks, don’t want to fit inside investment banks, and are currently not part of the various consortia or collaborations that have emerged,” he says.
What should consumers expect from the blockchain? “The first thing that is going to happen for the end consumer is, probably not a lot,” predicts Olofsson. “In the beginning, there will be decreased cost and increased speed in sending assets around.
The comparison Olofsson likes to use is Voice over Internet Protocol. “The telco operators, back in the day, when you made a phone call, they used the switch networks…. The infrastructure was pretty expensive, it was dedicated to making phone calls and cost a lot to maintain and uphold. Then suddenly you were able to route these voice packages through Cisco routers that used the internet.”
“For end users, this was nothing, you picked up your phone and you called your buddy, but it was a lot cheaper because you used that type of infrastructure.”
Later on, however, distributed ledgers may have more revolutionary implications. Perhaps the most important for the developing world will be the fact that each token is unique means that ledgers can be used for other purposes as well as exchanging money, such as exchanging property or securities. Establishing title is a huge source of cost and a major source of economic friction in the developing world.
Developing World Gains
Distributed ledgers may open up many new opportunities as well in the many parts of the world that lack the kind of infrastructure needed to establish ownership in an asset, whether that’s a security, a loan or a parcel of real estate.
A number of start-ups in Latin America and Africa are working on this problem already. Two Austin, Texas start-ups, Factom and Epigraph, are reportedly developing a system that will make it possible to track property ownership. In Ghana, a non-profit named Bitland is developing just such a title registry.
As for the prospect of the distributed ledger giving rise to a universal currency, such as Bitcoin, skeptics still abound, but the number of transactions made in Bitcoin per day is growing. It doubled between 2014 and 2015, from approximately 50,000 to 150,000. Certainly, the Bank of International Settlements, a Basel, Switzerland, bank owned by the world’s central banks, takes the prospects of digital currency seriously: a November 2015 report warned that if digital currency catches on, central banks could face a decline in “seigniorage revenue” – the profits they make printing money.
In the end, governments may decide to get into the game. Olofsson says he has discussed the possibility of a native crypto-currency with the US Federal Reserve. If that happens, the need for intermediaries that trade virtual chips into cash might displace those bank networks. “It’s like the Federal Reserve handing out poker chips. You don’t need these cashier windows open,” he says. “You just get them, straight away.”
But Celent’s Dwyer warns that the distributed ledger revolution may take a while. “If you take a step back and then form this 10 years’ view of what the capital markets will look like, this blockchain utopia that people may have in their minds, that might all look incredibly attractive, but how we get from where we are to that utopia, the change management calculus around that is significant. The transition from existing legacy systems into a collection of distributed ledger systems is likely to be a significant challenge.”
One reason, Dwyer says, is that it’s difficult to test financial technology. “There are technical challenges around getting the technology to work and to be valid, and I think also, at the risk of sounding like an American politician, there are ‘unknown unknowns’. It’s very difficult to beta-test technology within finance. You can do it in other industries, you can do it in media and music and so on because if people don’t like MP3, it’s no big deal. But it’s very different when you’re talking about global finance,” he points out.
A number of problems remain to be solved, Dwyer cautions. For example, how would people short stocks in this brave new payment world? “I’m not saying it can’t happen—it absolutely will happen—but it needs to be thought through…. How do you prove you own something when you specifically don’t?” he says.
Finally, the intermediaries at risk are very large, important institutions that may not be easily budged. “If the future is one where their role is deeply subordinated, fundamentally changed, and less remunerative, then how does all that play out?” Dwyer asks. “Watching the game theory here evolve is going to be interesting.”