by Don Tapscott
There are six key reasons why blockchain technology will bring about profound changes to this industry, busting the finance monopoly, and offering individuals and institutions alike real choice in how they create and manage value. Industry participants the world over should take notice.
Attestation: For the first time in history, two parties who neither know nor trust each other can transact and do business. Verifying identity and establishing trust is no longer the right and privilege of the financial intermediary. Moreover, in the context of financial services, the trust protocol takes on a double meaning. The blockchain can also establish trust when trust is needed by verifying the identity and capacity of any counterparty through a combination of past transaction history (on the blockchain), reputation scores based on aggregate reviews, and other social and economic indicators.
Cost: On the blockchain, the network both clears and settles peer-to-peer value transfers, and it does so continually so that its ledger is always up to date. For starters, if banks harnessed that capability, they could eliminate an estimated $20 billion in back-office expenses without changing their underlying business model, according to the Spanish bank Santander, though the actual number is surely much greater.12 With radically lower costs, banks could offer individuals and businesses greater access to financial services, markets, and capital in underserved communities. This can be a boon not only to incumbents but also to scrappy upstarts and entrepreneurs everywhere. Anyone, anywhere, with a smart phone and an Internet connection could tap into the vast arteries of global finance.
Speed: Today, remittances take three to seven days to settle. Stock trades take two to three days, whereas bank loan trades take on average a staggering twenty-three days to settle.13 The SWIFT network handles fifteen million payment orders a day between ten thousand financial institutions globally but takes days to clear and settle them.14 The same is true of the Automated Clearing House (ACH) system, which handles trillions of dollars of U.S. payments annually. The bitcoin network takes an average of ten minutes to clear and settle all transactions conducted during that period. Other blockchain networks are even faster, and new innovations, such as the Bitcoin Lightning Network, aim to dramatically scale the capacity of the bitcoin blockchain while dropping settlement and clearing times to a fraction of a second.15 “In the corresponding banking world, where you have a sender in one network and a receiver in another, you have to go through multiple ledgers, multiple intermediaries, multiple hops. Things can literally fail in the middle. There’s all kinds of capital requirements for that,” said Ripple Labs CEO Chris Larsen.16 Indeed, the shift to instant and frictionless value transfer would free up capital otherwise trapped in transit, bad news for anyone profiting from the float.
Risk Management: Blockchain technology promises to mitigate several forms of financial risk. The first is settlement risk, the risk that your trade will bounce back because of some glitch in the settlement process. The second is counterparty risk, the risk that your counterparty will default before settling a trade. The most significant is systemic risk, the total sum of all outstanding counterparty risk in the system. Vikram Pandit called this Herstatt risk, named after a German bank that couldn’t meet its liabilities and subsequently went under: “We found through the financial crisis one of the risks was, if I’m trading with somebody, how do I know they’re going to settle on the other side?” According to Pandit, instant settlement on the blockchain could eliminate that risk completely. Accountants could look into the inner workings of a company at any point in time and see which transactions were occurring and how the network was recording them. Irrevocability of a transaction and instant reconciliation of financial reporting would eliminate one aspect of agency risk—the risk that unscrupulous managers will exploit the cumbersome paper trail and significant time delay to conceal wrongdoing.
Value Innovation: The bitcoin blockchain was designed for moving bitcoins, not for handling other financial assets. However, the technology is open source, inviting experimentation. Some innovators are developing separate blockchains, known as altcoins, built for something other than bitcoin payments. Others are looking to leverage the bitcoin blockchain’s size and liquidity to create “spin-off” coins on so-called sidechains that can be “colored” to represent any asset or liability, physical or digital—a corporate stock or bond, a barrel of oil, a bar of gold, a car, a car payment, a receivable or a payable, or of course a currency. Sidechains are blockchains that have different features and functions from the bitcoin blockchain but that leverage bitcoin’s established network and hardware infrastructure without diminishing its security features. Sidechains interoperate with the blockchain through a two-way peg, a cryptographic means of transferring assets off the blockchain and back again without a third party exchange. Others still are trying to remove the coin or token altogether, building trading platforms on private blockchains. Financial institutions are already using blockchain technology to record, exchange, and trade assets and liabilities, and could eventually use it to replace traditional exchanges and centralized markets, upending how we define and trade value.
Open Source: The financial services industry is a technology stack of legacy systems standing twenty miles high and on the verge of teetering over. Changes are difficult to make because each improvement must be backward compatible. As open source technology, blockchain can constantly innovate, iterate, and improve, based on consensus in the network.
These benefits—attestation, dramatically lower costs, lightning speed, lower risks, great innovation of value, adaptability—have the potential to transform not only payments, but also the securities industry, investment banking, accounting and audit, venture capital, insurance, enterprise risk management, retail banking, and other pillars of the industry. Read on.
THE GOLDEN EIGHT: HOW THE FINANCIAL SERVICES SECTOR WILL CHANGE
Here are what we believe to be the eight core functions ripe for disruption. They are also summarized in the table here.
1. Authenticating Identity and Value: Today we rely on powerful intermediaries to establish trust and verify identity in a financial transaction. These intermediaries are the ultimate arbiters for access to basic financial services, such as bank accounts and loans. Blockchain lowers and sometimes eliminates trust altogether in certain transactions. The technology will also enable peers to establish identity that is verifiable, robust, and cryptographically secure and to establish trust when trust is needed.
2. Moving Value: Daily, the financial system moves money around the world, making sure that no dollar is spent twice: from the ninety-nine-cent purchase of a song on iTunes to the transfer of billions of dollars to settle an intracompany fund transfer, purchase an asset, or acquire a company. Blockchain can become the common standard for the movement of anything of value—currencies, stocks, bonds, and titles—in batches big and small, to distances near and far, and to counterparties known and unknown. Thus, blockchain can do for the movement of value what the standard shipping container did for the movement of goods: dramatically lower cost, improve speed, reduce friction, and boost economic growth and prosperity.
3. Storing Value: Financial institutions are the repositories of value for people, institutions, and governments. For the average Joe, a bank stores value in a safety deposit box, a savings account, or a checking account. For large institutions that want ready liquidity with the guarantee of a small return on their cash equivalents, so-called risk-free investments such as money market funds or Treasury bills will do the trick. Individuals need not rely on banks as the primary stores of value or as providers of savings and checking accounts, and institutions will have a more efficient mechanism to buy and hold risk-free financial assets.
4. Lending Value: From household mortgages to T-bills, financial institutions facilitate the issuance of credit such as credit card debt, mortgages, corporate bonds, municipal bonds, government bonds, and asset-backed securities. The lending business has spawned a number of ancillary industries that perf
orm credit checks, credit scores, and credit ratings. For the individual, it’s a credit score. For an institution, it’s a credit rating—from investment grade to junk. On the blockchain, anyone will be able to issue, trade, and settle traditional debt instruments directly, thereby reducing friction and risk by increasing speed and transparency. Consumers will be able to access loans from peers. This is particularly significant for the world’s unbanked and for entrepreneurs everywhere.
5. Exchanging Value: Daily, markets globally facilitate the exchange of trillions of dollars of financial assets. Trading is the buying and selling of assets and financial instruments for the purpose of investing, speculating, hedging, and arbitraging and includes the posttrade life cycle of clearing, settling, and storing value. Blockchain cuts settlement times on all transactions from days and weeks to minutes and seconds. This speed and efficiency creates opportunities for unbanked and underbanked people to participate in wealth creation.
6. Funding and Investing: Investing in an asset, company, or new enterprise gives an individual the opportunity to earn a return, in the form of capital appreciation, dividends, interest, rents, or some combination. The industry makes markets: matching investors with entrepreneurs and business owners at every stage of growth—from angels to IPOs and beyond. Raising money normally requires intermediaries—investment bankers, venture capitalists, and lawyers to name a few. The blockchain automates many of these functions, enables new models for peer-to-peer financing, and could also make recording dividends and paying coupons more efficient, transparent, and secure.
7. Insuring Value and Managing Risk: Risk management, of which insurance is a subset, is intended to protect individuals and companies from uncertain loss or catastrophe. More broadly, risk management in financial markets has spawned myriad derivative products and other financial instruments meant to hedge against unpredictable or uncontrollable events. At last count the notional value of all outstanding over-the-counter derivatives is $600 trillion. Blockchain supports decentralized models for insurance, making the use of derivatives for risk management far more transparent. Using reputational systems based on a person’s social and economic capital, their actions, and other reputational attributes, insurers will have a much clearer picture of the actuarial risk and can make more informed decisions.
8. Accounting for Value: Accounting is the measurement, processing, and communication of financial information about economic entities. It is a multibillion-dollar industry controlled by four massive audit firms—Deloitte Touche Tohmatsu, PricewaterhouseCoopers, Ernst & Young, and KPMG. Traditional accounting practices will not survive the velocity and complexity of modern finance. New accounting methods using blockchain’s distributed ledger will make audit and financial reporting transparent and occur in real time. It will also dramatically improve the capacity for regulators and other stakeholders to scrutinize financial actions within a corporation.
FROM STOCK EXCHANGES TO BLOCK EXCHANGES
“Wall Street has woken up in a big way,”17 said Austin Hill of Blockstream. He was speaking of the financial industry’s deep interest in blockchain technologies. Consider Blythe Masters, one of the most powerful people on Wall Street. She built JPMorgan’s derivatives and commodities desk into a global juggernaut and pioneered the derivatives market. After a brief pseudoretirement, she joined a New York–based start-up, Digital Asset Holdings, as CEO. The decision surprised many. She understood that the
THE GOLDEN EIGHT
Blockchain Transformations of Financial Services
FUNCTION
BLOCKCHAIN IMPACT
STAKEHOLDER
1. Authenticating Identity and Value
Verifiable and robust identities, cryptographically secured
Rating agencies, consumer data analytics, marketing, retail banking, wholesale banking, payment card networks, regulators
2. Moving Value—make a payment, transfer money, and purchase goods and services
Transfer of value in very large and very small increments without intermediary will dramatically reduce cost and speed of payments
Retail banking, wholesale banking, payment card networks, money transfer services, telecommunications, regulators
3. Storing Value—currencies, commodities, and financial assets are stores of value. Safety deposit box, a savings account, or a checking account. Money market funds or Treasury bills
Payment mechanism combined with a reliable and safe store of value reduces need for typical financial services; bank savings and checking accounts will become obsolete
Retail banking, brokerages, investment banking, asset management, telecommunications, regulators
4. Lending Value—credit card debt, mortgages, corporate bonds, municipal bonds, government bonds, asset-backed securities, and other forms of credit
Debt can be issued, traded, and settled on the blockchain; increases efficiency, reduces friction, improves systemic risk. Consumers can use reputation to access loans from peers; significant for the world’s unbanked and for entrepreneurs
Wholesale, commercial, and retail banking, public finance (i.e., government finance), microlending, crowdfunding, regulators, credit rating agencies, credit score software companies
5. Exchanging Value—speculating, hedging, and arbitraging. Matching orders, clearing trades, collateral management and valuation, settlement and custody
Blockchain takes settlement times on all transactions from days and weeks to minutes and seconds. This speed and efficiency also creates opportunities for unbanked and underbanked to participate in wealth creation
Investment, wholesale banking, foreign exchange traders, hedge funds, pension funds, retail brokerage, clearinghouses, stock, futures, commodities exchanges; commodities brokerages, central banks, regulators
6. Funding and Investing in an Asset, Company, Start-up—capital appreciation, dividends, interest, rents, or some combination
New models for peer-to-peer financing, recording of corporate actions such as dividends paid automatically through smart contracts. Titles registry to automate claims to rental income and other forms of yield
Investment banking, venture capital, legal, audit, property management, stock exchanges, crowdfunding, regulators
7. Insuring Value and Managing Risk—protect assets, homes, lives, health, business property, and business practices, derivative products
Using reputational systems, insurers will better estimate actuarial risk, creating decentralized markets for insurance. More transparent derivatives
Insurance, risk management, wholesale banking, brokerage, clearinghouses, regulators
8. Accounting for Value—new corporate governance
Distributed ledger will make audit and financial reporting real time, responsive, and transparent, will dramatically improve capacity of regulators to scrutinize financial actions within a corporation
Audit, asset management, shareholder watchdogs, regulators
blockchain would transform her business as the Internet transformed other industries: “I would take it about as seriously as you should have taken the concept of the Internet in the 1990s. It’s a big deal and it is going to change the way our financial world operates.”18
Masters had dismissed many of the early tales of bitcoin, exploited by drug dealers, harnessed by gamblers, and hailed by libertarians as creating a new world order. That changed in late 2014. Masters told us, “I had an ‘aha moment’ where I began to appreciate the potential implications of the technology for the world that I knew well. Whilst the cryptocurrency application of the distributed ledgers technology was interesting and had implications for payments, the underlying database technology itself had far broader implications.”19 According to Masters, blockchain could reduce inefficiencies and costs “by allowing multiple parties to rely on the same information rather than duplicating and replicating it and having to reconcile it.” As a mechanism for shared, decentralized, replicated transaction records, blockchain is the “golden source,” she says
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“Bear in mind that financial services infrastructures have not evolved in decades. The front end has evolved but not the back end,” says Masters. “It’s been an arms race in technology investment oriented toward speeding up transaction execution so that, nowadays, competitive advantages are measured in fractions of nanoseconds. The irony is that the posttrade infrastructure hasn’t really evolved at all.” It still takes “days and in some cases weeks of delay to do the posttrade processing that goes into actually settling financial transactions and keeping record of them.”21
Masters is not alone in her enthusiasm for blockchain technology. NASDAQ CEO Bob Greifeld said, “I am a big believer in the ability of blockchain technology to effect fundamental change in the infrastructure of the financial service industry.”22 Greifeld is integrating blockchain’s distributed ledger technology into NASDAQ’s private markets platform through a platform called NASDAQ Linq. Exchanges are centralized marketplaces for securities and they are also ripe for disruption. On January 1, 2016, NASDAQ Linq completed its first trade on blockchain. According to Blockstream’s Hill, one of the largest asset managers in the world “has more people dedicated to its blockchain innovation group than we have in our entire company.” Hill’s company has raised over $75 million and employs more than twenty people. “These guys are serious about making sure that they understand how they can use the technology to change how they do business.”23 The NYSE, Goldman Sachs, Santander, Deloitte, RBC, Barclays, UBS, and virtually every major financial firm globally have taken a similar serious interest. In 2015, Wall Street’s opinion of blockchain technology became universally positive: in one study, 94 percent of respondents said blockchain could play an important role in finance.24