What is blockchain technology and why does the FS industry care so much?
Blockchain technology has been the talk of the financial services industry throughout 2016, and rightly so. Through our discussions with banks and industry leaders, and at industry events such as SIBOS, we can see that the potential of the technology is clear, justifying the excitement and fervour.
Unsurprisingly, the ‘Gartner Hype Cycle for Emerging Technologies’ places blockchain technology at the top of the ‘Peak of Inflated Expectations’, confirming that this is one of the most hotly anticipated technologies not just in FS, but across the world today.
Over the next few months we will publish a series of blogs to discuss the impact of blockchain / distributed ledger technology (DLT)* on FS, to help separate the hype and inflated expectations from the reality of what can be achieved with this nascent technology.
Despite the industry’s enthusiasm to engage in the topic there is still a broad spectrum of understanding between those ‘who get it’ and those who are relative newcomers. For the newcomers, their understanding isn’t helped by the frequent optimistic claims that blockchain technology will solve everything from KYC inefficiencies to vastly improving cross-border payments, with billions of dollars of savings in the process. Listening to this for the first time, it can be difficult not to think of it as a panacea that will quickly deliver untold benefits to the world’s financial system.
In reality, it’s far more complicated; blockchain is a relatively new technology that has shown a lot of promise but has a raft of barriers to overcome, ranging from technology challenges, to legal and regulatory hurdles, to ensuring that the required network effects can be captured.
Blockchain Technology explained
If you’re unfamiliar with the intricacies of blockchain technology (broadly synonymous with distributed ledger technology), here’s a little bit of background to start orienting yourself:
- Blocks + Chains = Blockchain – the word ‘blockchain’ relates to the way – in typical blockchain implementations – transactions are grouped together (in ‘blocks’) before being published to the network for validation and approval. Once validated and approved, the block is then ‘chained’ to the previous block using cryptographic hashing. This method provides blockchain technology with one of its strongest features; the immutability of its transactions
- It’s like a database, albeit a new type of database – that is, a database which can be directly shared, in a write sense, by a group of non-trusting parties, without requiring a central administrator. This differs considerably from traditional databases where a single entity typically controls read and write access. Hence the technology enables mutually untrusting parties to come into consensus about the nature of a set of shared facts securely, and without the need for an intermediary
- Disintermediation vs. Privacy – a corollary of the above is that if you want to allow multiple parties to collectively maintain shared records without a third party in the middle, privacy will (almost certainly) be compromised
- Public vs. Private, and Permissioned vs. Unpermissioned – All blockchain-based systems can be thought of as either public or private (with respect to how data is shared), and permissioned or unpermissioned (with respect to who can access the network). For example, Bitcoin is a public and unpermissioned network; every piece of its data is replicated and visible to all participants on the network, and anyone can join the network (using a pseudonym). R3’s Corda, on the other hand – a system being built specifically for financial services – is likely to be a private, permissioned network where the actors are known and data is only shared with those who need to see it
- Smart Contracts (and shared business logic) – will allow the on-going management of this data, and they have the potential to automatically and independently enforce contracts in a legally binding manner (there will be more on this in a future blog)
And finally – blockchain technology is broader than just Bitcoin! Although Bitcoin was the genesis for the interest in blockchain technology.
Why does the FS industry care?
In short, it’s the possibility that DLT could be an answer to the confluence of stubbornly static cost bases, and increasingly complex IT landscapes. DLT offers banks an opportunity to simultaneously tackle these two areas, however, collaboration will be key; without this, the touted benefits will not be achieved. In the main, the cost savings and reduction of complexity can be realised through the mutualisation of duplicative and non-differentiating processes across multiple entities. For example, a large portion of banks’ costs relate to the on-going management of contractual positions with their customers and counterparties, whether these are retail deposits or complex derivative products. The potential to securely share and manage data and business logic without the need for a third party is driving a large amount of investment in areas ranging from the post-trade lifecycle, to KYC and AML processes, to cross-border payments.
The potential benefits for DLT technology have been well documented, and include:
- Increased trust – “I know what I see is what you see”
- Mutualisation of non-differentiating infrastructure and processes
- Reduced risk and reconciliation – through shared data and business logic
- Regulatory compliance – increased transparency could simplify areas such as regulatory reporting
Despite this, DLT is not a panacea, and there are clear challenges to overcome before these benefits can be realised. These range from protecting privacy, to ensuring interoperability of systems, to making a shared business case stack up. Our next blog will cover these key challenges in more detail – stay tuned for more!
* Whilst there are differences between them, for simplicity we’ll use the two terms interchangeably throughout this series. DLT applies to the more generic technology that is at the base of blockchain technology (a blockchain is a specialised version of DLT). DLT doesn’t necessarily require ‘blocks’ or ‘chains’, however, it does imply the shared management/transfer of records and value without the need for a third party. For blockchain technology, both of these are typically true.