Blockchain and the capital markets
“Are you guys putting Origin on the Blockchain?”
It’s a question we get almost weekly. While I can still remember the initial scepticism / excitement amongst trading floor friends surrounding the first Bitcoin bubble 4 years ago, these days the word “Blockchain” is everywhere. Its rising popularity seems inexorable, and, especially for those of us in fintech, its adoption is apparently inevitable.
Investments of hundreds of millions of dollars are being made into blockchain starts ups and technologies by traditional players who are seemingly gun-shy about simpler technologies. Some of the fintech companies that have attracted the largest funding rounds are focused on blockchain, and nearly all boast investment from major banks, including Blythe Masters’ Digital Asset Holdings and this recent investment by Goldman, JP Morgan and ICAP into blockchain startup, Axoni. But, as seen by the recent troubles faced by one of the largest Blockchain startups, R3, initial investment doesn’t automatically imply adoption.
Today, we take a look at what blockchain’s impact could be and when it will occur. Before we look forward, let’s look back at its origins.
The ‘blockchain’ is a digital ledger distributed across computers around the world.
The first public blockchain was engineered in 2009 to support the crypto-currency, Bitcoin. To be verified, each Bitcoin solves encrypted and computationally intensive puzzles. Blockchain is the technology that records this process.
Blockchain is designed to make transactions and records transparent and secure. As people realised its value, uses extended beyond managing crypto-currencies. Blockchain 2.0 arrived in 2014, offering a broader range of services.
Investment in blockchain between 2014 and 2015 doubled. Start-ups appeared that used blockchain to target inefficiencies in finance, especially in trading and settlement. This led to an increase in investment over the past 24 months, with forward-thinking financial services firms exploring ways to process transactions, settlements and implement digital currencies with blockchain.
As blockchain entered the mainstream, it decoupled from crypto-currencies. It now stands apart, attracting increasing excitement from large institutions; it is estimated that spending by financial institutions on Blockchain will exceed $1bn in 2017.
Here are five areas where participants hope for blockchain to have a significant impact on financial markets:
- Distributed Ledger Technology (DLT)
The most impactful advancement will be the adoption of distributed ledger technology (DLT), removing inefficiencies inherent in today’s market infrastructure.
DLT locally records any action taken by participants, then updates the central blockchain in real time, with all participants informed and their actions verified. As it happens on a real time basis, it makes data management and record keeping far more efficient, with a transaction snapshot being available on one system to all participants. This massively reduces friction, time and cost.
More on the background of DLT and its implementation can be found here.
- Settlement and clearing
Implementation of DLT will lead to efficient settlement of transactions, as participants see the same data and updates are automatically circulated.
Cash transactions will settle in real-time, with ownership embedded in the trade. It also removes any need for post-trade confirmation and central clearing. Speaking about his vision for the future of securities settlement on the back of their investment in Digital Asset Holdings, the CEO of the Australia Stock Exchange said, “A retail investor in Australia should be able to sell their shares, go to the nearest ATM and get their cash out.”
- Smart Contracts
DLT functionality includes centrally stored, online, smart contracts, which would replace the thousands of paper contracts that circulate in the capital markets today.
Smart contracts are created using code, which executes actions agreed by participants. A smart contract would typically be maintained on DLT reducing communications and cost.
- Asset servicing
DLT will soon be used to process everyday financial administrative tasks and responsibilities, such as issuance, corporate actions, proxy votes, and portfolio administration.
What has previously involved numerous systems, records and legal admin can be migrated to the blockchain, handled by DLT, with smart contracts ensuring efficient processing.
- Reporting and Reconciliation
Reporting and reconciliation of balances and transactions between counter parties will be eliminated. Blockchain allows for balances to be available in real time so reports and reconciliations will be priced and reconciled up-to-the-minute. Regulatory reporting can also be done on this basis.
Blockchain hasn’t broken into the capital markets mainstream just yet. But its successful integration could lead to massive cost savings. Goldman Sachs projects blockchain could streamline the clearing and settlement of cash securities, saving $2bn in the US and $6bn globally on an annual basis.
However, today, there has yet to be any meaningful adoption of blockchain technology. The challenges of moving an entire ecosystem off of one infrastructure and onto another one are easy to underestimate, especially when you’re in the midst of the peak stages of the hype cycle. So while there is plenty of investment being funnelled into the technology, we are all familiar with how easy it is for investor euphoria to deviate materially from reality, particularly when it comes to technology.
But, as with any great technology, we believe that Amara’s law firmly applies to Blockchain. While we may be overestimating the impact of technology in the short term, we are likely underestimating its effect in the long term.