Blockchain: wisdom of crowds begins in blind competition

Blockchain, the technology underlying bitcoin, is coming to a back office, and clearing house, and bank, and front office near you. Instead of one authority keeping records, everyone will. That’s the idea, anyway, of a wave of start-ups rushing to build workable applications. How will clarity emerge from this ferment, and just how will it change the business of capital markets? Jon Hay reports.

  • By Jon Hay
  • 06 Jan 2016
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Have you ever wondered why, when you pay for something with a debit card, your bank can verify and accept the transaction in seconds — yet the money doesn’t actually leave your account for a couple of days?

Or why you can trade shares or bonds instantly — sometimes in microseconds — but settlement will not happen till days later?

Instant global communication has been possible since the days of the telegraph — and in highly sophisticated ways, for decades. If trading messages can be sent, money can move.

Yet the clearing and settlement systems we are using to move money and assets around seem to belong in the 1970s. 

It is easy to see why. The gain to be had from updating them has never been great enough to justify the enormous effort of reform. There have always been more important things to do.

But a technology has come along now that is grabbing the attention of financial leaders, and inspiring them to grand predictions about how all the plumbing of the system is going to be transformed.

Blockchain — the highly complex form of communication between computers that underlies cryptocurrencies like bitcoin — was the most hyped financial buzzword of 2015, with everyone from Jamie Dimon to bearded tech hipsters lauding its potential.

Bitcoin itself had enjoyed the glow of celebrity between its invention in 2008 and 2014. The shine came off a little then, when Mt Gox, the Tokyo-based exchange that was handling 70% of bitcoin transactions at the time, went bankrupt, saying it had mislaid about 850,000 bitcoins worth $470m, mainly belonging to customers.

A new world

Bitcoin continues, but most respectable financial people have ceased to enthuse about it, transferring their excitement to the blockchain. Real aficionados prefer even duller names: distributed ledgers, or shared databases.

NDBut there is nothing dull about what they say it can bring about — “the internet of value,” according to Nilesh Dusane, head of global sales at Ripple, a technology company in Palo Alto.

“If you go back 30 years, when the internet was just getting started, what did the internet enable?” Dusane asks. “It was the exchange of information in a faster, better, cheaper way. We went from a centralised model to a decentralised one. With the internet you don’t need a publishing house to distribute information, anybody can create content.”

In a similar way, blockchain could enable many parties — perhaps everyone — to exchange money or assets, without going through a central intermediary.

The idea is that a reliable record of transactions can be maintained, not in one place, but across a whole global network. This is done using sophisticated cryptography. Encrypted transactions are broadcast to the network, gathered into ‘blocks’ and then, through cryptographic computations, ‘verified’ by the members of the network, accepted as valid and republished to the network.

The goal is to have a near-simultaneously updated record of transactions, identical copies of which are held at many places, which cannot be falsified or altered.

So utopian is this claim that a little scepticism is in order. And at least some blockchain experts do admit that the new systems they hope to build may not be infallible.

Nevertheless, they still believe a vast improvement in the efficiency of financial networks could achieved within a few years.

Rhomaios Ram, global head of product management in transaction banking at Deutsche Bank in London, says commercial implementations will start appearing in the next year or two, and that in 10 years blockchains will be pervasive.

Bees round the honey pot

The excitement is intense. Thirty of the world’s largest banks have joined R3 CEV, a company developing applications for financial markets. All believe the technology could be valuable — or are afraid of missing out. 

But many other companies and groups are working on myriad solutions. 

“There are at least a dozen bitcoin companies that have pivoted over the last year to do blockchain,” says Tim Swanson, director of market research at R3 in San Francisco.

Techies are waking up to the fact that most people are not looking for a means to make untraceable payments. What they might find valuable are other features of blockchains.

“It’s got a huge potential, though perhaps not as big as people are thinking,” says Ian Bentinck, partner, capital markets at Capco, a financial services consultancy in London. “There are three aspects of blockchain as a technology. One is that something is immutable — you can’t falsify a record on the technological level. It’s decentralised, so no one party is responsible for all the costs and management. Lastly — it’s an encryption technology, and that provides authentication.”

Disruptive?

Part of the desire for blockchain is that banks, desperate to cut costs, see an opportunity to wring savings out of their back offices.

But one of the most intriguing debates is whether blockchains are simply a way to make existing processes more efficient, or whether they will shake up the financial universe — the Uberisation of banks and money.

“The potential for operating efficiencies is quite impressive,” says an official at a European bank in New York involved with the R3 initiative. “Most of it is on post-trade processing. But those developments will start to change basic market structures. This is something we need to understand. We don’t know yet, it’s still very early and there is a lot of hype.”

Charley Cooper, managing director of business development and marketing at R3 in New York, goes further. “This technology could be as impactful in financial services as the internet was to media and entertainment,” he says. 

That could make it painfully upsetting to incumbents. If money and assets can be moved around a network safely by virtue of the network itself, will anyone need banks?

“That is the thing banks are worried about,” says Bentinck — “that things get set up in a way that disintermediates them.” No wonder banks want to control how blockchain is introduced.

Asked whether blockchain will change the landscape, Ram says: “That is to be seen case by case. In the short term, we will see commercial examples of blockchain technology that have a narrow scope. But the technology certainly has the potential to erase the whiteboard and force the market to fundamentally rethink parts of the current value chain.”

TS

Pushed for examples of businesses that could become obsolete, bankers insist that banks will be alright because they provide liquidity. They point instead to intermediaries like the Depository Trust and Clearing Corp — though futures exchanges should remain because derivatives are term transactions that require collateralising.

Regulators and politicians, however, are unlikely to suddenly relax their grip on the money system, so any radical decentralisation is probably a topic for the next decade, rather than this, if it ever happens. Much closer is the question of how this technology starts to be used.

While blockchain enthusiasts are convinced of blockchain’s power, they also admit many of the gains it promises are achievable with conventional technology — if systems were reformed.

Most clearing arrangements involve a central counterparty — the central bank for domestic payments, correspondent banks internationally and clearing houses for securities.

But since all electronic messages are near-enough instantaneous, there is no reason why that means clearing has to be slow.

From this point of view, blockchain may appear more important as a cultural force than a technical breakthrough. It is forcing financial firms to think about new ways to do things — something they could have done without blockchain, but were not motivated enough to do.

Getting on with it

The blockchain dream is of whole industries operating on one seamless platform — but that is a way off. The first applications will be systems that can start working without wide agreement. 

Among the furthest advanced is Ripple, which is focused on international payments. Dusane says this is “the only use case that banks are willing to pay for”.

Ripple bypasses the correspondent banks. “Through distributed ledger technology you don’t need a third party to confirm transactions,” says Dusane. “In Ripple we use consensus. We don’t have the mining process that exists in bitcoin.”

Distributed ledgers require computers on the network, or nodes, to verify transactions cryptographically. Bitcoin was deliberately designed to require 10 minutes of code-breaking labour by bitcoin ‘miners’ between the release of each block, to make it costly to pervert the system with fake nodes.

Ripple’s verification process is much faster. If 80% of the nodes recognise a transaction as genuine, the ledger gets updated.

Some banks already offer the system to their own employees, who want to send money internationally. In early 2016, Dusane says banks will start using it for payments between banks.

Banks testing Ripple internally have found two kinds of benefit. “One is the payment processing costs can go down anywhere from 15% to 25%,” Dusane says. “The second thing is they can offer a much better experience to customers.”

What customers really want is to know exactly how long their payment is going to take and what it will cost, to track it in transit, to be notified when it arrives, and to send extra information with the money, such as what invoices it is settling. All this is denied with conventional payments, but possible with Ripple, Dusane claims. Increased speed — perhaps five seconds between two Ripple-using banks — comes as a bonus.

Dusane is convinced that “the first use case for getting to the internet of value is cross-border payment and settlements.”

Go for the complex

However, there are widely differing views about that. Ram says the payments space “is today already highly efficient, safe, and costs are low, and we therefore don’t see a clear case for the market to invest to move to a blockchain-based solution right now.”

He sees a much more immediate promise of efficiency in securities markets, where blockchains could offer a real time overview of collateral positions or shorten settlement cycles. 

“To me, the potential of blockchain is more in those complex processing chains or products that blockchain technology can streamline and simplify,” Ram says.

Knots of blockchain innovators are striving to put it to work in different ways. R3 is studying two use cases, which are believed to involve core fixed income capital markets. 

Another company, Itbit, has a system called Bankchain, which tokenises the electronic receipts that denote ownership of gold bullion. These can be moved swiftly around the world for trading or use as collateral.

RR

Symbiont, which has Duncan Niederauer, former head of the New York Stock Exchange, on its board, is focusing on the issuing and trading of securities, and has encrypted some of the holdings of its own shares by its owners and published them on the bitcoin blockchain.

New York-based Digital Asset Holding is working particularly on speeding up syndicated loan settlement; digitising US Treasury repo business, enabling greater netting of positions; and improving securities settlement systems so regulators can see where assets are and connect them with their beneficial owners.

Deutsche Bank has been creating ‘smart bonds’. The prospectus is encoded in a blockchain, and the bond can then be issued, traded and repaid on the system without any need for third party clearing or settlement during its entire lifecycle, pre- and post-trade.

Deutsche has tested the technology on theoretical corporate bond issues. “We are very pleased with the results,” Ram says. “So the question no longer is whether blockchain could be applicable, but we are moving to the next phase, which is to assess acceptance in the market and tackle hurdles on the legal or regulatory side.”

No panacea

That is clearly an essential step. R3 has had “preliminary” conversations with regulators, Cooper says.

Most are convinced regulators will not stop robust solutions that make sense to the financial industry — though that does not mean blockchain is going to solve all the industry’s regulatory problems, either. “I don’t see how regulators are ever going to see it gives some special integrity benefit,” says Bentinck. “It doesn’t manage market risk or counterparty risk, so any market where the regulator wants trading to go through a central counterparty, it will still want that.”

The claim of perfect security is made by all blockchain promoters. Can its authentication be broken? “Yes,” says Bentinck, “in the way that anybody can lose a key. When the bitcoin exchanges have gone down, it’s been because people have been naive and not stored the keys well. Outside normal security lapses, you are authenticated.”

So the passwords can be lost — rather like with ordinary systems.

More to the point, inviolable encryption may be a hollow victory. Of all the huge losses and fines suffered by banks in recent years, how many have been caused by miscreants hacking into their computers? 

The vast majority of problems are caused by the errors or sins of genuine bank employees. Blockchain is not going to cure those ills — though it might make it easier afterwards to unpick what happened.

Where are the boundaries?

Some believe blockchains have inherent limitations. “There are some significant constraints around the technology,” says Bentinck. One potential obstacle concerns the block-like nature of blockchain itself. It is a sequence of transactions in a strict order — two cannot happen at once. Each one needs to build upon the encryption of the last, and attach to it. This could constrain the technology’s ability to cope with very fast, high volume markets.

However, SETL, another ambitious blockchain company with big hitters on its board — in this case Sir David Walker, ex-Bank of England and Barclays — has processed 5,000 transactions a second in tests, according to Capco, and is expected to reach 100,000 in a real working environment.

Systems like this have left the bitcoin blockchain, with its 10 minute bursts of code-solving, far behind.

But they still rely on many computers doing the same work at the same time, and recording the same information many times. This may prove more robust than simpler, conventional systems, but has an inherent inefficiency.

Whether blockchain systems can be scaled to cope with the highest volume markets, such as equities, exchange-traded derivatives or banking payments, remains to be seen.

To do this, they have abandoned another aspect of bitcoin: its open network. Anyone can use bitcoin, and anyone with the right knowledge and kit can be a miner.

On that openness rests bitcoin’s claim to perfect security, since only by controlling a majority of the nodes in the network could anyone rewrite the transaction record.

“As soon as the network is private, it is not decentralised, and someone can control it,” says Bentinck. “As soon as you start to impose a limited size of network, you are starting to introduce some concept of a regulator. Financial markets are comfortable with that, but do you lose some of the immutable nature of the information?”

In practice, however, the open bitcoin network has suffered failures — and financial players are not going to go for open networks, but closed ‘permissioned’ ones, where you need to be an approved member of the club to participate.

Swanson at R3 has written detailed papers arguing that permissioned systems are likely to work better than open ones for mainstream financial purposes, and that they are faster and cheaper to maintain.

However, Deutsche Bank’s smart bond application is designed to work in a system where no trust is required between players.

The sharing economy

Another issue that remains wide open is intellectual property.

In any new industry, some elements evolve as common standards. Electric plugs and sockets are of a standard size; the internet runs on public protocols such as TCP/IP and FTP.

In the financial world, there are networks such as the Swift payments system, or the FIX protocol, used globally for encoding electronic trading messages. FIX is open source — anyone can design applications using it, and the industry manages it collectively.

Should there be a basic, open source blockchain system?

Swanson says that of over 30 start-ups he knows, working on distributed ledgers, “many are open to creating some kind of open standard, and hoping to open-source parts of that too, if there is a nascent community trying to build that. There are some companies that are trying to do it in a completely vertically integrated way and don’t want to play with others.”

He adds that R3 is not a standards body, but that “to build what we would like we will need to have a common standard”.

It may take a small group of leading blockchain players to have the imagination to open up their system to all comers.

Blockchain

Come together

Whether this happens may hinge on how technologists deal with another issue: should there be one blockchain system or many?

One of the problems blockchains could alleviate is the plethora of different systems used by financial players. At every connection between them, there is friction. Amalgamating it all would save billions.

But to gain the maximum benefit, the whole industry would have to use a single system, at least for each asset class. 

And to super-size the advantage, the definition of ‘asset class’ should be broad. It would be good to have all corporate bonds on one system — but if government bonds were on it, too, how much better still? And repos, and why not fixed income derivatives? Or all securities?

Goldman Sachs, which prides itself on its single, firm-wide risk monitoring system, is now building a single internal ledger out of its hundreds of databases.

At the moment, the rapid development of different blockchain systems by many companies is tending towards diversity, rather than homogeneity.

For now, that is good, but eventually, order will have to emerge from the chaos — certainly if blockchains are truly going to make things easier for regulators.

“I think it’s going to be very hard to have one platform,” says the banker in New York. “What you may have is something on top of your blockchain that combines views. Some kind of integration layer that would be a combined view of that asset class across the multiple blockchains. I don’t know that that really works so well, but you will be hard pressed to get all the market participants to coalesce around one blockchain.”

Something that could help was announced recently by Ripple: an interledger protocol for payments, enabling different ledgers to inter-connect. This is an open source, neutral protocol that enables service providers to flourish in competition.

It is too early yet to know whether it will be widely accepted. Two things are certain, however. In even six months, the implementation of distributed ledgers will have moved on enormously from where it is now. 

And as the New York banker puts it: “Wherever we think things are going to go today, it will be different.”

  • By Jon Hay
  • 06 Jan 2016

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 13 Mar 2017
1 JPMorgan 94,925.33 384 8.39%
2 Citi 87,531.58 331 7.74%
3 Bank of America Merrill Lynch 84,341.49 288 7.46%
4 Barclays 75,288.19 241 6.66%
5 Goldman Sachs 68,504.71 208 6.06%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 14 Mar 2017
1 Bank of America Merrill Lynch 10,650.87 23 11.13%
2 Deutsche Bank 8,169.49 17 8.53%
3 HSBC 6,243.46 23 6.52%
4 Citi 4,355.35 13 4.55%
5 SG Corporate & Investment Banking 4,273.37 17 4.46%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 28 Mar 2017
1 JPMorgan 6,305.34 22 10.84%
2 Deutsche Bank 4,468.97 23 7.68%
3 UBS 4,270.64 20 7.34%
4 Citi 3,833.33 28 6.59%
5 Goldman Sachs 3,788.75 20 6.51%