From bitcoin to the back office, and beyond!
The technology behind bitcoin is just beginning to be mined for use in a wide array of financial services. But it has limitless potential for use in institutional investing, from interest-rate swaps to settlements and back-office functions, say those who've studied and are actively pursuing its development.
“We see all kinds of ways it could evolve,” said David E. Rutter, New York-based CEO of R3CEV LLC, a cryptofinance firm working with a consortium of 22 banks to study the application of distributed ledger technology — the infrastructure called blockchain that connects all computers that verify and validate all bitcoin transactions — to financial services. “It's early days with this technology. Right now, we're balancing Wall Street knowledge with the knowledge of how blockchain works.”
That's no simple task. According to a report released Sept. 30 by consultant Greenwich Associates, “Distributed Ledgers in Capital Markets: Answering the Big Questions,” 102 financial professionals interviewed for the report said there's a basic understanding of blockchain technology, but that “taking that premise and deploying it broadly within institutional capital markets is a complex undertaking.”
“This means that product managers and strategists are having a field day coming up with new applications for the technology, all while software developers are working day and night in hopes of making those dreams a reality,” the report said.
That's why the consortium, which includes banks such as State Street Corp. (STT), Goldman Sachs Group (GS) Inc., Deutsche Bank AG, Barclays PLC, UBS AG and Royal Bank of Canada, is starting from square one, with all kinds of services on the table for study. Among the early subjects related to institutional investing: trade finance, securities finance, over-the-counter derivatives, interest-rate swaps, fund administration, and back- and middle-office functions.
But, members of the consortium said, there could be other uses that haven't even been thought of yet.
One area of emphasis behind State Street Corp.'s involvement is what impact blockchain technology could have on activities now handled by custodians like itself — State Street had $28.7 trillion in assets under administration as of June 30.
“Now you know why we're so interested in this,” said Hu Liang, senior managing director, head of the emerging technologies center at State Street Corp., . “The technology could save us a lot of money. But we're also doing this for defensive reasons. The technology could have a very direct impact on our business. Some things probably can't be automated, but certainly so much of this can be applied to custody. We want to be ahead on this.”
And though it's too early to say how the technology can work for financial services, sources said it's not too early to take a look at blockchain applications and build on them. Those that don't are taking a risk, said Daniel Connell, managing director, head of market strategy and technology, Greenwich Associates, Stamford, Conn., and co-author of the report. “Does it transform those in the financial services industry or is it disintermediation?” asked Mr. Connell. “It's disintermediation if folks ignore it. It's something that everyone will need to pay attention to.”
What's also in its nascent stage is how asset owners could use or be affected by distributed ledger technology. Mr. Rutter said executives from some large pension funds have been in contact with the consortium about potential involvement in studying applications, although he wouldn't name the funds.
“Large plans especially would have the most to gain from our efforts.” Mr. Rutter said, because they often handle internally some administrative functions that could lend themselves to blockchain applications. “In what we're setting up, we're keenly interested in the buy-side perspective and in what they need. Having asset owners in some involvement with this is important to us.”
Officials and spokesmen at numerous pension funds contacted for this story said it was too early to comment on potential uses of ledger technology, preferring to see what the consortium develops.
“It's a reach right now to say what (asset owners) will see,” said State Street's Mr. Liang, “We do think this will change how back-office and middle-office functions work. How that will change is hard to say right now.”
Mr. Connell agreed, saying, that asset owners “are a step removed from jumping into distributed ledger technology with both feet.”
The immediate attraction of distributed ledger technology is how secure it is vs. traditional network-based technology systems that are prone to hackers, said R3CEV's Mr. Rutter. Blockchain technology is cloud-based, with data held on each individual computer used in the blockchain. “At a high level, new technology pushes cryptographic controls to the data level rather than the network level,” said Mr. Rutter. “Blockchain protects that data on a cloud, and matching data is then confirmed. Validation is made through a trusted cache or through truth-of-work” in which every computer on the blockchain, rather than a central server, validates the value of the data being transferred. “Many people will have ledgers in the same form. It would mean hackers would have to break into all ledgers at the same time to access the data.”
There is some disagreement on the security issue. According to the Greenwich report, “making the distributed ledger network private doesn't necessarily cure all security issues. ... The blockchain is by definition a public network and, as such, cannot be broken into. A private network on the other hand, especially one storing sensitive banking information, will in all likelihood become a hacker target. This threat is something all financial services firms are adept at handling today, but it is important to remember that a private blockchain does not necessarily equal a perfectly safe one.”
Keep a record
Greenwich's Mr. Connell said bitcoin miners — those who use their computers to make calculations to confirm transactions — use their own computers to keep a record of the blockchain. Once a sizable number have done that, the official blockchain is considered verified even though the identity of the miners isn't known. “Miners do this because every time they verify a transaction, they get a unit of bitcoin. That's how they get paid,” Mr. Connell said.
So how would this transfer to financial services? “The issue becomes, if you take bitcoin out, what is the incentive for applying resources to the process?” Mr. Connell said. “What makes the blockchain work are the miners. What if instead of miners you had, let's say, 25 banks involved? What if, instead of being paid in bitcoin, you're paid with efficiency?”
That efficiency is important, said State Street's Mr. Liang. State Street has looked at several ways ledger technology could improve efficiency, Mr. Liang said. “We have our fingers and hands on everything. On the one hand, it's pretty much a clean slate. We're keeping an open mind on how we all can use it. On the other hand, we have to think about how we at State Street will use this. We're focusing on overall disruptive technology as we've seen the evolution and revolution of this technology over the years.”
This article originally appeared in the October 5, 2015 print issue as, "Blockchain set to rock industry with tech magic".