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Theme for 2018: Capital markets brace for blockchain breakthrough

By Lewis McLellan
03 Jan 2018

When the shadowy figure known as Satoshi Nakamoto launched bitcoin in 2009, few predicted that the technology underpinning it would, in a few short years, be hailed as an invention as important as the internet. Capital markets are on the front line for disruption, writes Lewis McLellan.

Virtually every industry is experimenting with blockchain technology, but fintech and capital markets will be among the first areas to experience wholesale disruption.

Technology looms ever larger in the concerns of global investment banks. In an increasingly connected world, having the most advanced and well-designed technological solutions is crucial if a bank wishes to stand out. No one can afford to be left behind. 

Blockchain is the latest revolution to set the financial world alight. The technology that underpins bitcoin is shaking off its anarcho-libertarian roots and its history as a dark web currency for buying drugs, and has burst on to the stage of mainstream financial technology. 

Blockchain has gathered such momentum that, irrespective of its actual merits, potential or realised, enough institutions are working on blockchain projects that it seems almost certain to soon be a part of many capital markets bankers’ daily lives.

Mastercard, Visa and American Express are all working on blockchain technology payments systems, looking to take advantage of the distributed system to facilitate free cross-border instant payments; and a bewildering myriad of start-up companies are launching blockchain systems in an effort to disrupt capital markets business. 

Banks are embracing the developments, working with start-ups in an effort both to understand the possibilities of the technology and to steer its development towards a solution that will fit their needs.

At its root, blockchain (or distributed ledger technology), does not involve any great leap in computer science in the way that, say, quantum computing does. It is simply a means of organising information such that it can be verified by a group, rather than by a central organisation. 

Banks are working on a dizzying variety of applications for the technology, from automating payment streams with smart contracts, to streamlining the securities issuance process. 

Simply harmonising the manifold systems used by different banks, and even different departments within banks, could save both time and money. Lee Braine, part of the investment bank chief technology office at Barclays, explains: “A blockchain contains a golden copy of data, which all parties with sufficient privileges can access. That means there’s no need for manual reconciliation of data between parties.”

Braine also points out that a blockchain trading platform could make the process of making disclosures to regulators much easier. “It enables the possibility of a ‘regulator node’, which would see all reportable data and reportable events that take place in the network, allowing a more elegant means of meeting regulatory reporting obligations.”


Too many cooks?

However, given the profusion of systems emerging, a new challenge may appear. Craig Butterworth, Nomura’s head of client eco-system, explains: “One of the key challenges is the absence of any interoperability standards. There are still regulatory uncertainties and, until common standards are established, it will be hard for a single solution to emerge.” Without this, the benefits of blockchain adoption will be difficult to realise.

Post-trade and settlement solutions have been at the heart of many blockchain projects to date. Johann Palychata,head of blockchain for BNP Paribas Securities Services, says: “It’s clearly an important aspect of the business. Everything starts from there. How do I transfer an asset from one person to another?”

The Utility Settlement Coin (USC) is among the most exciting blockchain projects under development. While KfW was able to issue five day commercial paper and replicate the transaction on the blockchain in late 2017, without any means of settling the cash leg of the transaction via a distributed ledger it could not form a model for a replicable mainstream system.

The USC would fix this absence. Rather than an independently valued crypto-asset such as bitcoin, USC would form an on-blockchain proxy for regular fiat money, collateralised by funds deposited at a central bank.

However, broader, more ambitious uses are on their way, according to Palychata. “As the technology matures and evolves, we are discovering uses beyond settlement and record keeping, including actual financing.” 


Loan market’s faster future

The syndicated loan market in particular is the focus of many bank blockchain projects. “We are looking at smart contracts to automate the life cycle of the loans,” says Emmanuel Aidoo, head of the distributed ledger and blockchain effort at Credit Suisse. Credit Suisse is involved in the Synaps project, which aims to reduce loan settlement from T+7 or longer to T+3. “Loans can take a long time to settle because the process is still largely manual. This leaves brokers exposed to market, operational and credit risk between the trade date and the settlement date. Through blockchain, we can potentially reduce the settlement time for syndicated loans, significantly reducing these risks.”

With a blockchain system shared between parties, when payments are made, the system can automatically acknowledge it and update a broker’s position accordingly, freeing up capital on the bank’s balance sheet and potentially increasing the amount of lending it can do. 

With so much hype and notoriety, blockchain has attracted its fair share of detractors. Alongside security concerns and privacy issues, blockchain sceptics believe that the technology cannot be scaled to cope with the colossal flows of transactions in some modern financial markets.

Braine believes these criticisms are valid. “We just have to accept that the architecture is not suitable for high frequency, low latency trading. We look to blockchain and distributed ledger technology to provide other services.”

The lofty libertarian ideals so beloved by blockchain’s early proponents seem destined to be left behind in a storm of enterprise-driven innovation, but perhaps some of the most valuable aspects of its legacy might be retained. The result of the efficiencies blockchain promises capital markets should be to lower the barriers to entry, allowing small businesses to thrive.  


Bitcoin and blockchain: how it works 

 Bitcoin was among the first attempts to make use of decentralising technology to maintain a distributed ledger. Currencies are traditionally guaranteed by central banks. The alternative is to maintain a ledger containing every transaction made in the currency. Each ‘block’ making up bitcoin’s blockchain is like a page of the ledger containing all the data describing the state of the bitcoin universe — i.e. who owns each coin.

Each ‘node’ (computer engaged in verification) in the network competes to discover a hash (sequence of numbers) for the new block which, when run through the SHA256 algorithm, produces a hash function (another sequence of numbers) beginning with a specific number of zeroes. The number of zeroes indicates the difficulty of finding a valid hash function and is adjusted depending on the amount of processing power in the network to ensure that each new block is processed in around 10 minutes.

The node that finds the valid hash function first is rewarded with new bitcoins. This process is known as mining. It ensures that transactions are verified by the consensus of the network. Fraudulent transactions can only become (and remain) part of the blockchain’s record if agreed upon by more than 50% of the processing power in the network. Given that bitcoin’s network is the most powerful in the world, this is an extremely unlikely occurrence. 

The system is far from perfect. As a CEO of a blockchain start-up put it: “Bitcoin spends electricity to buy security.” The process is immensely inefficient, with the hordes of servers at work on verifying the ledger making use of a small country’s electricity every year. Additionally, the network can process only about five to seven or so transactions a second. Since more transactions occur than can be processed in each block, a backlog builds up. Miners charge users transaction fees to process their transactions quickly. 

Bitcoin is not under the control of a board appointed by shareholders. Developers propose alterations to the code but ultimately the power rests with the miners. In the early days of bitcoin, this meant it was under the control of everyday users. However, economies of scale prevailed and the vast majority of mining power now rests with a handful of server farms, most of which are located in China, taking advantage of cheap hydro-electricity. 


The miners decide which changes to the code to adopt. Disagreements do occur, resulting in ‘forks’ — splits in the blockchain which cause the creation of new currencies. Bitcoin Cash is one such currency, spawned from a fork resulting from a disagreement over whether bitcoin’s block size should be enlarged to allow more transactions per second.  


By Lewis McLellan
03 Jan 2018