Question Answered: Blockchain technology

Published: May 2016

This issue’s question

“With recent announcements that several big banks are considering using blockchain technology, how does it work and how could it affect the financial industry?”

Vijay Michalik, Research Analyst, Frost & Sullivan

Vijay Michalik

Research Analyst
Frost & Sullivan

Blockchains are a new solution to a fundamental question in the digital world: how do you establish trust between parties over the internet’s untrusted network? More specifically, how do you get perfect, simultaneous, shared data between a number of different people, devices or businesses?

There are two stages of blockchains, and these impact the financial sector in two distinct ways. The first are cryptocurrencies and the second are blockchain applications. Cryptocurrencies are a new type of asset, currency and value exchange medium. They’re a digital token – secured with cryptography – that can be exchanged in a borderless and completely peer-to-peer way, and managed without need for a bank.

Their relevance to banking institutions is straightforward – the value that goes through cryptocurrency markets could completely circumvent the traditional finance value chain. While their penetration isn’t very high yet, some countries’ central banks are even considering cryptocurrencies as a national standard. Removing banks from this trusted central position requires them to do some real soul-searching and reconsider their value proposition. The most innovative incumbent financial institutions will offer cryptocurrency-based services by absorbing or partnering with service providers like cryptocurrency exchanges, wallets and micropayment services, while responding to challenges of Know Your Customer regulations (KYC) in pseudonymous systems and Anti-Money Laundering (AML) data analysis on blockchains’ new structure.

Blockchain applications are the second wave of blockchain technology, and are based on abstractions of the concept of a blockchain ledger. They address a number of historic challenges in finance. These abstractions are possible using smart contracts, a type of blockchain-enforced code, to define the terms and formats of transactions, and often use cryptocurrencies as the incentive or fuel for the application’s infrastructure. The most basic component of almost every financial service is the transaction, whether it’s of a valuable resource or purely data.

Blockchain applications can lend the power of the data structure’s verifiable history to any number of back office systems and records. The opaque systems that govern settlement and payments, and the challenges of reconciliation between multiple parties can be entirely replaced.

Broadly, the reasons these systems haven’t been updated in the past is one of consensus. Connecting systems from many independent banks to each other scales terribly – each new entrant must connect to each of the myriad existing entrants. Blockchains’ immutability allows the creation of a single shared ledger, for which each institution needs only make one connection to, a smart contract based core which sometimes replaces an old monolith like a traditional clearing house’s systems. Some of the most powerful short-term conceptual proofs being developed are around settlement and clearing, with companies like t0 and SETL offering solutions that would offer uncompromising transparency to audit and regulation.

While there’s still some standardisation yet to take place, institutions like R3’s finance blockchain consortium have demonstrated banks’ willingness to work together towards the common goal of benefiting from this disruptive technology. They have a significant stake in the Hyperledger blockchain protocol being developed by IBM, the Linux Foundation and Digital Asset Holdings amongst others. What’s clear is that participation will be the surest route to setting the agenda and staying at the forefront of blockchain technology’s impact.

Charley Cooper, Managing Director, R3

Charley Cooper

Managing Director

Distributed ledger technology – often referred to as ‘blockchain’ – has received unprecedented attention of late, with everyone from banks and fund managers to exchanges and clearing houses looking to explore how it could streamline processes, reduce costs and improve accuracy and security. In its simplest form, a shared ledger allows for the distribution, verification and record keeping of transaction information more effectively and quickly in a decentralised manner.

At first glance this might not sound like the most revolutionary of technological developments, but building on the broader concept of a distributed ledger and applying it to global financial markets could have a number of positive impacts on the efficiency, cost and risk issues currently associated with corporate treasury. One example is clearing and settlement of transactions – a topic of keen interest to regulators since the financial crisis.

The Bank of England is just one of a number of regulators around the world that has tasked banks to understand how technologies such as cryptography and distributed ledgers can improve the way financial markets operate. When you consider that some of the infrastructure currently used in many aspects of financial services is over 40 years old, it is not wildly revolutionary to consider the idea that they may no longer be appropriate for modern financial markets.

The potential uses of these technologies for corporate treasurers are vast and could transform how financial transactions are recorded, reconciled and reported – all with additional security, lower error rates and significant cost reductions. Treasurers could benefit from more effective management of cash flow and an immutable record of all financial transactions, allowing for improved risk management and liquidity planning.

R3 was early to recognise the promise of distributed ledger technologies and began working in earnest with financial institutions over a year ago to promote understanding of the opportunity presented by them. We believe that the collaborative model is the best way to quickly, efficiently and cost effectively deliver these new technologies to global financial markets, involving participants from across the industry.

Our consortium members understand that the most critical attribute of the successful adoption of distributed ledger-inspired technologies is a powerful network effect. The networks we ultimately develop will be appropriate to the group of counterparties they seek to connect. Corporate treasurers are an important part of that ecosystem, and our aim is to build solutions with applicability to their work as well as on a broader scale.

Nick Weisfeld, Head of Data Practice, GFT

Nick Weisfeld

Head of Data Practice

In the wider understanding, the truly transformational aspect of blockchain is the business process transformation (or disruption) it enables. Having all of the counterparties understanding all of the transactions within that value chain – that view being indisputable, immutable, distributed and trusted by all participants – is driving some truly disruptive thinking and potentially has consequences for a lot of the current manual processes that corporates have to deal with. This increased transparency helps alleviate untrusted interaction between counterparties and for the treasurer, there is also the reduction in settlement risk of transactions.

At GFT, we look at tracing assets from asset production through to the delivery of that asset whether that be a financial asset such as a bond or a physical asset such as a commodity. Understanding where treasury’s assets are located and who owns them will allow the department to operate in a more streamlined way. GFT produced a prototype which allows just this – to track commodities, and provide history of that ownership and location. Advantages could include: fraud avoidance, de-risking of warehouse receipt financing, a reduction in paperwork and increased visibility in the supply chain.

Following this prototype, a lot of our clients were coming to us with different use cases which they felt were relevant for development within a blockchain ecosystem. We feel that some of these would be better served by automation or transformation within a traditional technology such as a shared relational database. Therefore we enhanced Project Jupiter to include a set of quality metrics that allow our clients to identify the right use cases to develop within a blockchain ecosystem and then give them an advisory and technology execution platform for rapidly prototyping those.

GFT has a team of technology and business change experts that can assess the use cases and if they are relevant, send them through our prototyping process so they can quickly, in terms of time to market, see how that would transpose into a blockchain prototype. A ‘blockchain incubator’, if you like. It’s quite early days but some of them are moving through at the moment – there are possibilities around Know Your Customer (KYC) processes and the bond issuance, for instance.

If you take a bond issued by a corporate, the transparency that is delivered by understanding the location of that bond and who owns it will help negate a lot of manual process that currently exists when paying coupons. If you move along the value chain to bond collateralisation ultimately having an indisputable, immutable, distributed and trusted view by all participants of bond location and ownership, will help improve the collateralisation process.

We feel at this stage that asset tracking, servicing and ownership is a good focus for blockchain use cases. We are also beginning to explore uses cases that include a cryptocurrency to transfer value within a private blockchain when the transfer of ownership takes place. Combining both asset tracking and a cyptocurrency for value transfer will ultimately deliver many of the visionary benefits that we believe blockchain has the capability to deliver. The important thing to remember is that although the technology is developing rapidly, it isn’t in all instances fully fit for purpose for large corporates yet.

Next question:

“What are the drivers of change in the payments landscape? There is a lot of talk about innovation, but what does it mean for corporate treasury?”

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