According to Romain Rouphaël (E09) and Côme Jean Jarry, co-founders of Belem, blockchain technology is about to shake up the financial services infrastructure.
We’re seeing the advent of the first real projects to apply the blockchain technology. UBS, Deutsche Bank, Bank of New York Mellon, Banco Santander and the broker ICAP have announced their decision to team up and demonstrate the viability of the technology to central banks and regulators – and its contribution to the post-trade sector.
But what exactly is a blockchain? We’ll start by looking at the origins of blockchain to understand how it works, and at how the financial world has reacted to its emergence. Then we’ll review an actual case of how it was used to clear/settle securities.
Origins of the blockchain
From pre-coinage currency to cashless money, an instrument of financial transaction relies on trust, which it grants its users as a unit of account, a means of exchange and a store of value. The trust is based on a principle of guarantee embodied by a centralized institution (states or banks, or local bodies for local complementary currencies).
Starting with the introduction of checks and the creation of payment cards, the dematerialization of currency has been accelerated over the last twenty-five years by the development of electronic transactions. This has paved the way for non-conventional currencies – independent from traditional centralized authorities – otherwise known as digital currencies.
Digital currencies are different from traditional currencies – coins, bank notes and their dematerialized versions – as they are based on an encryption protocol. Each digital currency unit is a unique number chain that users can send online during transactions.
The first attempts at digital currencies were a failure as they faced the daunting task of how to secure the currency. It’s easy to copy a chain of numbers – in the case of currency, spent over and over again – effectively making it worthless.
In 1990 David Chaum, DigiCash electronic currency designer, tried to solve the problem by creating a single central register that records each user's transactions, thus ensuring that each currency unit can’t be found in two places at once. The register guarantees the integrity of currencies and transactions.
However, the solution offered by DigiCash has its limits as it is vulnerable to the same uncertainties as any central register (e.g. databases for bank transactions, credit card transactions, ownership titles, identity cards, driver licenses, etc.): there is no guarantee that the content of the register is incorruptible and infallible. The system can actually modify the database, exclude transactions it doesn't approve, or even lose recorded data.
In October 2008 Satoshi Nakamoto (whose real identity is still unknown today), published a whitepaper called Bitcoin: A Peer-to-Peer Electronic Cash System, proposing a new form of digital currency. Bitcoin addresses the flaws through a new protocol, blockchain, offering a decentralized verification system.
Bitcoin relies not on a central authority but on a "peer-to-peer" relationship, in other words an IT network whose participants have moved away from a central server.
At the heart of Bitcoin
Bitcoin is a currency that gradually introduces units into the system. Unlike classic currencies, it is not issued by a central authority and the total quantity of units issued is set in advance, and capped at 21 million. Around 15.25 million Bitcoins have been issued so far, and the last Bitcoin is set to be produced in 2140.
Bitcoins are stored on Bitcoin addresses. Their key is a unique chain of letters and numbers that can be stored on a computer, smartphone, or even a piece of paper.
Once a user sends a Bitcoin as payment, the transaction is stored in a memory. The transactions are then grouped in blocks, each block representing the equivalent of 10 minutes of Bitcoin transactions.
All participants in the network offer their computing power to check the blocks and confirm them in their system. This process is called 'mining'. The participants, who are competing against each other, are paid based on their participation in the calculation, receiving a percentage of the new Bitcoins issued by the system.
The system that groups all the blocks is what we call a blockchain. The blocks are ranked chronologically, and each block includes a digital signature ('hash') from the preceding block, which determines how they are arranged and makes sure a new block can only enter the chain where the preceding one ends.
Those who have installed the Bitcoin software update a copy of the blockchain, i.e. a copy of the record of all the transactions made since the start of Bitcoin. To make sure the system works properly, the blockchains are continuously monitored by the computers of the people who installed the software. At any moment the system knows exactly how many Bitcoins each user has in their wallet: they cannot be copied or spent several times over.
How blockchain works
For the first time, ownership can be transferred without being duplicated, and without going through a central register.
Bitcoin can be purchased, sold and exchanged against real currencies (USD, EUR, etc.) on an exchange market.
Bitcoin price trends since its creation
Satoshi Nakamoto created the Bitcoin protocol to be peer-to-peer, encrypted, and quasi anonymous, which makes it very difficult to link a Bitcoin transaction to the physical person who made it. It’s known as pseudonymous: the Bitcoin blockchain records all transactions, but not their originators.
Today, the Bitcoin blockchain is the largest anonymous, public decentralized database: it's an open access peer-to-peer network in which participants can access the entire register, freely make transactions and participate in their validation.
Many people today think we can apply what’s been done for currency - moving from a centralized operation to a decentralized organization – to other areas.
The financial sector and the blockchain "revolution"
The blockchain, both as a storage technology and a transparent, secure information transmission technology - operating without a central review body - could significantly change the centralized structure of current financial services.
A large majority of financial securities (shares, bonds, financial derivatives, etc.) exist today purely electronically and are managed centrally through trusted third parties, incurring considerable operating costs. Transaction management could be streamlined by adopting blockchain technology to manage the lives of these securities.
By allowing all stakeholders of an operation to validate its characteristics in a shared system before the operation is carried out, we can speed up the transaction, reduce tax liabilities for operational risks, and provide undeniable proof in the event of conflict. We can also follow all transactions in real time, or offer the regulator a full view of ongoing operations.
These advantages provide opportunities for applying blockchain technology to certain market sectors – fragmented markets, where the same information is recorded redundantly in different systems, with long transaction delays that represent a major expense for banks. Examples include the post-trade sector, international payments, the finance trade, the fight against money laundering, the syndicated loan market or even the repo market.
One person in particular has done much to "evangelize" blockchain in the financial world: Blythe Masters. Highly intelligent, she is one of the most successful bankers in JP Morgan and famous for pioneering CDS (Credit Default Swaps) - a real paradigm change for the banking world.
In March 2015 she became CEO of Digital Asset, a start-up that applies blockchain technology to the post-trade chain. The post-trade chain refers to the life of a security once it has been purchased by a counterpart and sold to another. It represents an annual cost for banks of between 65 to 80 billion dollars.
Blythe Masters charismatically promotes blockchain using the following message: forget Bitcoin and its volatility – focus instead on its underlying technology. Thanks to her, banks could drastically reduce their costs by 30 to 50% on post-trade and see a sustainable increase in the performance of their equity capital.
The idea soon took off, and Digital Asset raised 60 million dollars in one round including the biggest names in finance: Goldman Sachs, Citi, BNPP, the Chicago Mercantile Exchange Ventures, American depository DTCC, consulting firm Accenture and IBM.
The entire financial industry now sees the future of financial services in the blockchain.
Financial industry players, however, who operate in a highly regulated context, are not necessarily convinced by the idea of using a public blockchain like the one used by Bitcoin. They are much more inclined to use private blockchain structures ("permissioned blockchain" or "Distributed Ledger Technology").
There are different kinds of private blockchains, but we can define them in comparison to the public blockchain concept: access can be restricted and the consensus approaches different, or information from the register and the validation of transactions are accessible only to qualified members – thus losing a key characteristic of the public blockchain: decentralization. The analogy often used is that the private blockchain is to its public counterpart what the intranet is to the Internet.
To study the potential of the technology, and in addition to their own efforts, major financial services players have often met in consortia.
Examples are the R3 consortium, which brings together the 40 largest banks in the world, or the Hyperledger Project, led by the Linux foundation, which aims to create a common standard for different sectors of the economy. Or in France, the LabChain initiative led by the CDC where BNPP, the Société Générale, Crédit Agricole, AXA, Allianz, and IBM meet alongside start-ups to work on ways to apply the technology.
Before assuming massive adoption of the blockchain – which would fulfill its promise to revolutionize the structure of financial services - let's take a look the obstacles.
First of all, there’s the essential question of regulations governing the technology’s use, particularly on sensitive subjects such as those related to customer awareness. Interestingly, France is a pioneer in this area: the recent Macron Law grants the issuance and logging of interest-bearing notes ("Minibons") in a blockchain. And parliament authorized the government to legislate by ordinance on these issues.
In addition, for a blockchain to become an industry standard the market players have to share the infrastructures. This will inevitably lead to questions on regulation, particularly on cost distribution and decision-making power.
Then there’s the issue of the blockchain's capacity to support millions of transactions. It’s worth keeping an eye on Lightning Network’s solution allowing many hundreds of millions of transactions per second to be validated without affecting the blockchain's decentralization.
Also, migrating current systems towards a blockchain-type architecture will likely be a challenging task.
Despite these issues, major players in the financial world have embarked on a multitude of projects so as not to miss out on the blockchain revolution - and stay on top of the financial game.
To better understand what the technology can offer, let’s take a look at how blockchain was actually applied to a segment of the post-trade chain.
A Case Study: application to securities clearing and settlement
When a company issues a security to obtain financing, a Central Securities Depository (CSD) is in charge of recording all the securities that make up the issue, and checking that the total amount of the issue is equal to the sum of assets held by its participants, primarily financial institutions.
The financial institutions that have an open account with CSDs are:
- banks acting on their own behalf, or
- custodian account holders, having opened a custody account in their books on behalf of the final owners.
Custodian account-holders will, among other assignments, record the transactions made by their clients, inform the owners of events affecting their securities, and manage the taxation of financial products received by clients.
The purchase or sale of securities is notified by a simple book entry between participants and the Central Securities Depository.
A simplified diagram for purchase/sale of shares in an organized market
The order giver, for example an asset manager, sends a purchase/sale order to a negotiating trading member who submits it to the market. The market carries out the order and returns the operation to the negotiator who then informs the order giver. The order giver then instructs his custodian account-holder to deal with the clearing/settlement of the transaction with the negotiator.
The market also sends confirmation that the order has been completed to the clearinghouse, which acts as a central counterparty; the order giver who purchases the securities and the market member he uses do not know the order giver who sells the securities, nor the market member who sent the sale order.
The clearinghouse clears the operations performed by value code, date, and member (negotiators can neither access the clearinghouse nor sub-contract).
We then enter the clearing-settlement process:
- between the clearinghouse and its members,
- between the members of the clearinghouse and the custodian account-holders or UCITS depositories.
The clearing/settlement date between financial intermediaries generally falls within 2 business days after the order has been completed.
The system, which works effectively today, has its limits:
- operational risks: each transaction involves multiple players, who record transaction details in their own systems and can introduce errors and result through their manual intervention,
- clearing/settlement risks (e.g. late detection of a seller's default, for example a capital market),
- change management (e.g. processes, systems) is long and costly.
The blockchain technology could change the way market transactions are processed, allowing operators to manage them from end to end – from making the order to clearing/settlement and without any break in continuity.
We can imagine a blockchain whose hubs bring together order givers, stockbrokers, the market, custodian account-holders, the Central Securities Depository, etc. The details of each transaction could be shared and confirmed directly by all the players involved through a smart contract. This would considerably reduce operational and clearing/settlement risks.
We could even consider a blockchain that would directly link the buyers and sellers of a market, without an intermediary, whose operating rules (applicable to all) would be coded in the system.
Some people even imagine we could see the settlement happening in real time, as soon as the order is executed, without the clearinghouse having to intervene; it would be settled directly between the respective custodian account-holders of the buyers and sellers. It still raises the issue of proportions regarding the number of instructions injected in the clearing/settlement systems, or if one of the counterparties defaults (e.g. suspended securities).
However, many obstacles remain before we are likely to see the advent of a decentralized clearing-settlement system. First of all, we need a legal framework that allows it to exist. As with any industry standard, such a system would need to be adopted by the majority of stakeholders, and moving current systems towards a blockchain system remains a challenge. It’s also questionable as to whether a blockchain infrastructure can absorb millions of daily transactions.
In January 2016 the largest Australian stock exchange, the Australian Stock Exchange (ASX) announced it would work with the Digital Asset start-up on replacing its clearance and CHESS shares clearing-settlement system with a private blockchain.
ASX estimates cost reductions of between 2.5 and 3.2 billion euros for final users (including participants, stock markets, custodian account-holders and financial data providers). The cost reduction will come from both the decrease in back office and compliance costs and the reduction of risks (including the capital allocated to it) thanks to shorter clearance/settlement times.
Applying blockchain technology to finance offers huge opportunities: secure recording of the ownership of financial securities, improved reporting and monitoring through greater transparency and information sharing, faster processing of clearing-settlement operations, and the reduction of counterparty risk.
If questions remain, a flexible regulatory framework is essential to accompany this emerging ecosystem. The initiative of Emmanuel Macron (former French Minister of the Economy, Finance and Industry) to create a range of expression outside the regulatory framework for FinTech (a French-style regulatory sandbox) seems to make sense.
We are now at the PoC (Proof of Concept) stage. Large groups pay to see by investing in start-ups and meeting in consortia. We’re waiting to see how niche applications relevant to the financial industry will be applied in the next two years. Establishing an industry standard should allow the widespread adoption of blockchain technology within three to five years.
We also predict that new ways to use it will emerge with the birth - and consolidation - of the blockchain ecosystem.
First published on Belem’s blog
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