Much has been written about Bitcoin since its creation in 2008 by Satoshi Nakamoto. Indeed, the high volatility of and scandal after scandal involving this new digital currency have been amply documented in the press. In recent months, however, the price of Bitcoin has stabilised at around 40% of its record high and appears to be rising. One reason for this is the financial sector's interest in the technology underlying Bitcoin, namely the blockchain.
This article first explains blockchains in very simple terms, how they work and how this technology can revolutionise the financial industry. It concludes with a closer look at certain concrete efforts the financial sector has made in this regard.
Blockchains for dummies
A paradigm shift
The blockchain is heralded as the fifth disruptive computing paradigm after mainframes, personal computers, the internet and social networks/mobile phones. Although it has become increasingly difficult to imagine a world without the aforementioned technologies, most of us don't understand how they work. In our daily lives, however, even the least tech savvy amongst us is able to see the clear advantages they bring.
To date, however, blockchains (and similar distributed ledger technologies) have primarily been used by issuers of digital currency. In the absence of other concrete applications, the underlying technology and the advantages of the distributed ledger remain largely a mystery. Therefore, we first explain below the structure behind a blockchain and its advantages.
A decentralised ledger
In short, a blockchain is a digital, publicly available ledger, register or record book. In Bitcoin's case, the blockchain records every transaction made and allows users with proper identification to verify their ownership of Bitcoin at any time. This description, however, is too simplistic. To uncover the blockchain's true potential, it's necessary to dig a little deeper.
The revolutionary and paradigm-shifting nature of the blockchain is due to its decentralised and distributed form, as a result of which it functions independently from a central authority, such as a central bank.
Decentralisation is obtained by saving a copy of the entire block chain on every user's computer, both when joining the network and upon every change of content. As each member has a copy of the ledger and transactions are verified by comparing them with the latest version before validation, malicious intent is virtually eliminated.
Before taking a look at concrete applications, it's helpful to clarify how any type of asset can be recorded on a blockchain. As Bitcoin is a virtual currency, it's represented by a letter and number combination. Obviously, any other type of (tangible) asset can be reduced to a similar combination and recorded and traded on a distributed ledger, thus rendering it "smart". At present, every digital file (containing for example a description of a tangible asset) can be transformed into a sequence of up to 64 numbers and letters.
Likewise, smart contracts are those whose terms are recorded in a computer language and which can thus be automatically executed by a computing system, thereby significantly reducing enforcement and compliance costs.
Initially, blockchains were designed to enable the creation of and trade in Bitcoin. It quickly became clear, however, that distributed ledgers have much more potential.
In a recent report, the World Economic Forum identified "distributed trust" as one of the six megatrends that are shaping society, as "the blockchain replaces the need for third-party institutions to provide trust for financial, contract and voting activities".
The UK Government Office for Science summarises the potential for distributed ledger technology as follows:
"[…] distributed ledger technology provides the framework for government to reduce fraud, corruption, error and the cost of paper-intensive processes. It has the potential to redefine the relationship between government and the citizen in terms of data sharing, transparency and trust. It has similar possibilities for the private sector."
Although the possibilities currently appear endless, the following discussion is limited to how distributed ledger technologies are expected to impact the financial industry.
Oddly enough, R3CEV's chief technology officer compares Bitcoin's innovative character to that of physical cash. Physical cash is indeed unique, as it can be transferred between two people without the involvement or permission of any third parties. Bitcoin and its blockchain have shown how such transfers can be performed electronically. Since every type of asset can be traded using a blockchain, this technology has the potential to virtually eliminate middlemen and enable direct contact between the parties involved in any type of transaction, for example issuers and investors , without the need for traditional intermediaries such as exchanges, brokers, central counterparties (CCPs) or central securities depositories (CSDs).
Permissioned and unpermissioned distributed ledgers
Part of Bitcoin's success is due to the fact that it operates independently of a central authority. This means that private parties, in Bitcoin's case "miners", are required to validate transactions. In exchange for their services, they are rewarded with Bitcoin. Since every transaction must be validated by the entire network, the possibility of individual fraud is excluded. This type of ledger is called an unpermissioned ledger, as opposed to a permissioned ledger, which requires trusted players (such as governments or banks), rather than unknown members of the network, to validate transactions. Therefore, in the case of a permissioned ledger, the system is maintained by a well-defined pool of participants whose membership is not open to the public.
At a recent hearing of the European Parliament's Economic and Monetary Affairs Committee, Primavera De Filippi, a researcher at the National Centre for Scientific Research (CNRS) in Paris, stated that blockchain technology can be regarded as "a type of regulatory technology, enabling laws to be enforced more transparently and more efficiently".
The potential to significantly reduce financial institutions' compliance, infrastructure, logistics and transaction costs has many experimenting with the new technology. SETL, a company whose mission is "to deploy an institutional payment and settlement infrastructure based on blockchain technology", is one such party. It is building a system that will enable market participants to transfer cash and assets directly between themselves, thus facilitating the immediate and final settlement of market transactions.
Since the SETL system is being designed to meet the needs of the finance industry it will use a permissioned distributed ledger rather than an unpermissioned one. In this way, they plan to eliminate the disadvantages related to, for example, Bitcoin's blockchain, such as anonymity, which makes it difficult for financial institutions to meet their anti-money laundering (AML) and know-your-customer (KYC) obligations. In addition, unpermissioned ledgers require some type of virtual currency to reward transaction validators.
R3CEV is another initiative based on blockchain technology. It is currently backed by 42 of the world's largest banks and aims to achieve faster transactions in the areas of trade financing, syndicated loan processing, the settlement and clearing of OTC derivatives, and marketplace lending.
Nasdaq, on the other hand is experimenting in-house. Linq, part of Nasdaq Private Market, is the first platform by a stock exchange, or any financial services firm for that matter, to demonstrate how asset trading can be managed digitally through the use of a blockchain. In Belgium, KBC-broker Bolero indicated that it has started a project to trade unlisted shares and bonds via a blockchain.
A number of public initiatives have also been launched. The Bank of England recently stated that it is undertaking work "to understand the implications of new digital or e-monies and new methods of payments and financial intermediation […]."
According to a report by the Depository Trust & Clearing Corporation (DTCC), the current state of distributed ledger technology still poses some challenges: "it is immature, unproven, has inherent scale limitations in its current form and lacks underlying infrastructure to cleanly integrate it into the existing financial market environment".
It appears, however, that the financial sector is determined to address these challenges and that the development of a permissioned distributed ledger will be the way forward.