Blockchain to spell the end of financial intermediaries
For much of the latter part of 2015, Blockchains were the talk of the financial services community globally. The promise of a decentralized trust, greater transactional transparency, an immutable transaction record, significantly shortened settlement periods, and the freeing up of capital as we reduce settlement counterparty risks have many gravitating towards the possibility.
Blockchains remain risky business wrote Larry Tabb (photo right), founder of the research and strategic advisory firm TABB Group, on Tabb Forum. In it he wrote that “investments such as blockchain do not come with first-mover advantage; it is the opposite – they have first-mover disadvantage. The first mover makes the investment; however, if no one follows, that investment can be a total write-off. In fact, by not investing, the first mover’s competitors can actually precipitate the first mover’s failure.”
He further writes that “for blockchain technologies to be successfully adopted, one or more of three scenarios must occur: First, investment must be made mutually by some sort of consortium, utility, or external third party with connected and very deep pockets. Second, an outside vendor must bankroll the investment. Or third, solutions must be co-opted from something that already exists.”
The R3CEV consortium, comprising of 42 of the biggest financial institutions in the world, may be one such initiative that fits his point one. While a plethora of financiers from all walks of life are pitching in to bankroll its development, the real interests is in the diversity of applications that the Blockchain can potentially replace, including cryptocurrencies, smart contracts, identity management, international payments, securities trading, wealth management, and the list keeps growing.
The Wyman-Santander paper titled The Fintech 2.0 Paper: rebooting financial services suggests that Blockchain could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between US$15-20 billion per annum by 2022. But the real allure is restoring trust between banks and trust in the banks – something many believe was lost during the global financial crisis of 2008-2009.
In the Blockchain multiple computers share a ledger, hence the term distributed ledger, with transactions or activities recorded simultaneously across the network of computers. This makes fraud difficult to commit as changes must be validated and agreed across all the nodes. Further it uses two cryptographic keys: one public that can be accessed by the computers involved in the transaction, and a private one that only the buyer and seller know.
Having these two elements means the Blockchain does away with fee-charging third parties such as clearers who provide counterparty credit validation and custodian banks that transfer cash from one account to another. It is these intermediary services, including credit-checking, margin-calls and settlement processes that add-up to the costs and delays in the transaction. In the Blockchain, the computers at the participating broker-dealers would be the sole signatories required.
Potentially losing out to Blockchain are the likes of custody banks like BNY Mellon and State Street, as well as private sector clearing houses like LCH.Clearnet, CME Clearing Europe and the Depository Trust & Clearing Corporation (DTCC).
For its part, DTCC claims it has been working on blockchain technology since 2015 citing involvement in the Linux Foundation’s Hyperledger Project and, separately, testing blockchain for credit default swaps.
Rob Palatnick (photo right), DTCC managing director and chief technology architect, confirmed that the company has been evaluating blockchain technology and its potential uses in post-trade processes since early 2015 believing it to hold enormous potential to improve the post-trade process.
“We believe the best opportunities are in white spaces where existing processes are not well automated today. Integrating distributed ledgers into the current post-trade ecosystem could help further mitigate risk, reduce costs and enhance operational efficiencies. We are currently working on two proof-of-concepts to gain a better understanding of how the technology can modernize trade processing.
“We strongly advocate industry-wide collaboration in leveraging blockchain technology to streamline the siloed design of financial industry infrastructure. This is necessary to avoid repeating the past where new solutions were based on different standards, leading to significant reconciliation challenges,” he added.
How blockchain evolves in the commercial space will depend partly on how regulations are amended to reflect the potential of the technology to reduce operating costs, including costs associated with regulatory compliance, while guaranteeing some level of protection for customers and the financial services community.
It is still very early days for blockchain. One notable expert commented that many of the financial services systems in place today took years to build evolving over time. Blockchain is the new kid in the block and its proponents are still only discovering the potential strengths and weaknesses of the technology.