Tempering the blockchain hype
In our previous blog we provided some background as to why blockchain and distributed ledger technologies have generated such excitement in financial services, with multi-billion dollar per annum savings forecast for the industry. We believe there will significant benefits to the industry but there is a need to provide some counterbalance to the current hype, and be clear on the challenges the industry will face in adopting and implementing these technologies.
This blog explores the non-technical challenges that need to be overcome, and outlines how the industry is addressing some of these challenges. Given the progress that has already been made, we believe these challenges will be resolved but they need to be tackled sooner rather than later if DLT is going to be able to deliver the potential benefits.
As with any new technology, it’s inevitable that competing platforms or software implementations will emerge, as discrete islands of innovation spring up in different geographies and areas of the industry. This will be unsustainable and we expect that over time the industry will begin to consolidate on perhaps three or four DLT platforms. DLT depends on network effects to fully realise the benefits, so having three or four competing, un-integrated standards is not desirable. Interoperability is essential to enable those different platforms to integrate, but for that to happen standards are required. This requires the industry to collaborate and cooperate to drive out the optimal approach for all aspects of the technology – with ‘the industry’ not just meaning banks, but also regulators, industry bodies (e.g. ISDA) and financial market infrastructures (FMIs, such as clearing houses). We see open-sourcing of codebases as a key enabler of this cooperation, providing full visibility to everyone of how each platform is built, how they can be integrated, and providing the opportunity for cross-pollination of ideas.
There has been a huge amount of discussion on how DLT will be regulated, most of it missing the key point that regulators don’t regulate technology: they regulate processes, controls, legal constructs and roles. However, regulators will want to understand how DLT is applied to existing processes, or used in new processes, and this could impede the widespread implementation of DLT. The good news is that, in general, regulators have been warm to DLT and are keen to be involved early on in its lifecycle. As a starting point they should validate DLT-enabled processes against existing regulation to see where the shortfalls are in either the technology, or the regulation. The FCA, MAS and HKMA have all set up FinTech sandboxes and RegTech units to proactively engage with FinTech firms and do just this. There will be challenges, but the right people are in the room and working together from the start.
Building on the regulatory challenges, there are also likely to be legal hurdles to overcome. The promise of Smart Contracts on distributed ledgers has many applications in financial services, but there are still open questions about the legal enforceability of self-executing Smart Contracts. There is a gulf between Smart Contracts with code that just represents part of a legal prose document, and fully automated Smart Contracts where “the code is the contract” (google “The DAO Attack” for some great reading on this). In financial services we believe this latter approach is many years away, if it happens at all. However, we do expect to see some degree of legal contract being encapsulated within the code of Smart Contracts and this will need legal input. The industry will also need to determine an approach for how disputes from Smart Contracts, or DLT in general, will be resolved – given the cross-jurisdictional nature of many use-cases of DLT (e.g. trade finance, cross-border payments and digital identities), and the complex and nascent technology, it is worth considering whether the existing geopolitically-centric courts are the best dispute resolution fora.
The financial services industry does not have a great record of its participants working well together. As an example, the move to KYC utilities could have driven huge cost savings and efficiencies but the continued existence of multiple competing utilities limits the potential benefits achievable from the network effect. In order for DLT to succeed, the banks, central banks, FMIs and industry bodies all need to collaborate – individual banks doing their own thing are unlikely to succeed. A number of industry consortia such as R3, PTDL and the recently announced JPX-led coalition have emerged, bringing different companies together to solve common problems and prototype potential solutions. This is promising but needs to continue through to the implementation of the technology, rather than firms ‘going it alone’ once the solution is clear.
The industry, and the technology companies developing DLT solutions, are generally settling on the view that DLT networks within financial services will need to be private and permissioned in order to provide the required privacy and regulatory controls. While this brings some benefits, such as knowing the identity of participants on the network, it does raise the question of who controls access to the network and ultimately who governs the network. This role will be fundamental to the operation of the network and could place too much control in the hands of one organisation, which is likely to be frowned upon by regulators. While there are several potential models being explored, the resulting structure will depend on the business models of the companies or consortia providing DLT networks, and the willingness of the market participants, and regulators, to engage with those approaches.
It is worth stressing that we don’t see these challenges as insurmountable and they are already being worked through, but it’s worth having an understanding of these to bring some pragmatism to the blockchain hype that’s typically seen.
As a final thought on this, we currently see the DLT initiatives within banks being run by the Innovation teams. This is to be expected, but the business lines (i.e. those holding the purse strings) need to build their understanding of the technology to understand how it can improve their world. It is only when they are engaged, and are demanding and funding DLT initiatives, that real traction will be possible. However, they will need to prioritise DLT programmes against their existing change portfolios, which in recent years have been dominated by regulatory change programmes, leaving minimal capacity (and budget) for discretionary projects.