Banks look to digital ledgers for speed and transparency

In late October, Wells Fargo and Commonwealth Bank of Australia announced they had tapped new, shared database-related technologies to track a cotton shipment from Texas to Qingdao, China, and facilitate and guarantee payment. It marked the first-ever global trade transaction between two independent banks that combined the technologies, Wells Fargo and Commonwealth Bank claimed.

The technologies are centered on what is called blockchain, a kind of digital ledger that contains cryptographically encoded blocks of data in a chain. One block of data depends on the blocks before it, with information shared between all parties. Also, known as distributed ledger technology, this kind of database sharing or management incorporates so-called smart contracts, which are programmed to generate instructions—such as payment—once conditions are met. They enable various concerned parties to see and swap information almost in real time, information that can be updated instantaneously. They can make and verify transactions on a network without a central authority or clearinghouse and without the need for various intermediaries.

“Existing trade finance processes are ripe for disruption and this proof of concept demonstrates how companies around the world could benefit from these emerging technologies,” said Michael Eidel, executive general manager of Commonwealth Bank’s cash-flow and transaction services, in a statement.

Blockchain technology provides both transparency and speed that is unimaginable with traditional forms of trade finance, such as letters of credit, the standard for guaranteeing payment since the 19th century.

“You’re trading evidence of ownership in a very secure and virtually instantaneously way,” said Gregory Nowak, partner and hedge funds practice leader for the law firm Pepper Hamilton LLP. “The blockchain is the embodiment of the value, and it walks along with the goods, and when the goods are delivered, who has the encryption key puts it in and says ‘pay,’ and the payment automatically happens.”

“You take away all the need for people internally to move that piece of paper from one place to another and ensure payment,” Nowak continued. “You do it electronically. Accounts get credited instantly. Accounts get debited instantly.”

Blockchain is best known as the technology that empowers the digital currency bitcoin. But it has potentially profound implications for a wide variety of industries.

“It has potential in any industry where more transparency concerning information about a transaction can improve efficiency, particularly in transactions involving multiple parties. This technology could enable parties to a transaction to access certain information on the blockchain in real time based on preset triggering events,” said Joseph Guagliardo, the vice-chair of Pepper Hamilton’s technology practice. He referred to solving “the problem of shared facts” such that parties to a transaction can achieve consensus about the current state of the transaction.

Financial services will likely be in the forefront of this development and already are investing substantial sums in this technology, according to research and advisory firm Greenwich Associates. The firm estimates banks will have spent more than $1 billion this year alone on blockchain-related investments.

The consultancy Oliver Wyman in a study earlier this year identified a wide array of potential financial services applications: retail payments, wholesale payments, capital markets and securities servicing, and trade finance and transaction banking.

This is a potentially disruptive technology, with an enormous upside, but major hurdles to overcome as well. Oliver Wyman lists several: “technology, industry coordination, standards and governance, laws, regulation and policy.”

It’s still very early days. “Batting practice,” quipped Guagliardo, when asked what inning we’re in when it comes to blockchain.

Yet, the technology is coming on fast, and financial institutions are working on developing uses and applications. It’s understandable that financial services take the lead, not only because of the transactional nature of a blockchain, but because of its potential to help streamline in financial services expensive and labor-intensive processes.

“We’re at the foundational level,” Guagliardo said. “We could very well see implementation and uses of this technology to support certain operations but it may not to have a flashy, new launch, [instead] maybe much more behind-the-scenes technology.”

Greenwich Associates, for one, predicts a “meaningful impact” within two years and widespread application within five years in financial services. Oliver Wyman agrees that blockchain will gain “wide industry traction” in five years, but mass adoption will take at least 10 years.

One early indication of where banks are headed came in September, when JPMorgan Chase unveiled a blockchain-based trading platform called Quorum. This builds on the existing Ethereum network code and is being developed with such activities as derivatives trading in mind.

Quorum is aimed more at developing a public blockchain, such as bitcoin, where any trader can gain access. This is in contrast to private blockchains, such as the cotton trade, where access is limited to a small group of concerned parties.

Everyone from insurance companies to logistics providers is investigating blockchain technology. Numerous startups are developing the technology and applications, although their ability to monetize the platform, as well as scalability, may prove problematic to potential outside investors, who also are scouring the landscape.

“While private equity firms love the technology, I still think people are keeping their powder dry,” Nowak said. “I don’t think that the revenue model for blockchain as a disruptive technology has been developed yet.”

To understand how a private blockchain can be applied, Guagliardo suggested the example of a simple real estate transaction. You are selling your home and buying another. The buyer of your house is doing the same. There are multiple sales contracts, mortgages and title checks. Several banks or mortgage companies are involved, but each has a different database. They must communicate to each other and confirm that funding is issued and payments are made. All this comes down to a single event, the closing, but necessitates considerable time, pushing reams of paper and involving scores of middlemen.

Now, Guagliardo explained, “imagine in the real estate business if all of those parties who need that information at the same time, mainly closing, could be have access to relevant information in a database upon certain triggering events.” That database also contains the ability to complete the transaction. That’s the beauty of a blockchain.

Blockchain has applicability for private equity. Nowak suggested this example: “Instead of using data rooms, you put the data on the block chain,” he said. When private equity is preparing a portfolio company for sale, all pertinent information is on a blockchain and available to any interested party. “Hey, you want to buy this company, here it is, it’s all on the blockchain,” he said.

The JOBS Act provides opportunities for blockchain as well. A Regulation A+ offering, for example, requires information be made available to perspective investors similar to a 10K. That could be put on a blockchain. Or the blockchain itself could be the vehicle for a kind of initial public offering.

Cybersecurity is, of course, a major concern. Skeptics point to the theft of $55 million this year in a blockchain called DAO, a mammoth crowd-sourced investment fund that uses a digital currency similar to bitcoin. Investigations are ongoing.

However, technology advocates believe private blockchains will prove far more secure.

“An event has to happen and someone with a pre-encrypted key has to authorize the transfer,” Nowak explained.

While the cotton trade may have made history, the comfort level involved may well have been high to begin with. That’s because the buyer and seller were related: Brighann Cotton Marketing Australia and Brighann Cotton (US). That’s not surprising, and the same is likely with financial services.

“We’re seeing that in the banking industry, with the banks working within a controlled group to test the technology,” Guagliardo said. “With this technology, interoperability is important so testing with friends in your network is important.”