What could blockchain mean for your business and operating model?

Onslaught of new terminology

Although there is currently no official taxonomy for Distributed Ledger Technologies (DLT), it is safe to say the term blockchain commonly refers to a distributed database structure that can only be updated by appending a new set (or block) of valid transactions to the log of previous ones.

At its most basic, blockchain is a protocol for digital value exchange, solving the problem of double spending, inherent in the transfer of any digital asset, while at the same time removing the need for a centralized authority of trust – a party that would record and verify transactions.

The initial incarnation of blockchain technology has its roots in the implementation of the digital currency bitcoin. However, it has gradually come to also refer to the various other technologies that have been inspired by blockchain but developed in order to address some of its inherent deficiencies for the needs of institutional financial markets. Some of these technologies are essentially a different implementation of a distributed ledger and consequently share only a few common properties with the original implementation. Furthermore, the term is used in connection with some more advanced and only loosely related concepts such as smart contracts, whereby business rules implied by a financial contract are embedded (encoded) in a programming language and executed with the transaction.

Why is it important to financial markets?

By potentially providing a common and ubiquitous ledger, blockchain supporters believe it could reduce the friction created in financial networks when different intermediaries use different technology infrastructures. In theory, the distributed nature of blockchain could also reduce or remove the need for intermediaries to validate financial transactions.

By potentially providing a common and ubiquitous ledger, blockchain supporters believe it could reduce the friction created in financial networks when different intermediaries use different technology infrastructures. Igor Gramatikovski, Product Manager for Trade Processing, SimCorp

The prospect of streamlining infrastructure and even removing redundant intermediaries from the process creates the opportunity to generate significant efficiency gains. This of course, excites a financial industry still struggling to come to terms with the post-crisis financial framework and its associated systemic costs. And while financial intermediaries such as investment banks are enticed by the tantalizing promises of the technology, others such as exchanges and trading facilities, clearing houses, central securities depositories and payment processors are concerned they would be significantly disintermediated and disrupted, some to the point of complete obsolescence.

So, although for various reasons, both investment banks and financial intermediaries have entered the investment frenzy, competing and often partnering with a plethora of new FinTech startups.

One type of financial markets institutions have however, been conspicuous by their absence. Asset managers, while playing a key role in capital market infrastructures, are amongst the last of the financial giants to enter the blockchain race. The main reasons for this is that they are perceived to be much further down the disruptive line of attack, and their ‘wait-and-see’ posture also reflects their much lower appetite for risk.

Potential disruption scenarios

Under the most optimistic scenario, DLT would become the primary means of issuing, trading and settling financial assets. The new infrastructure would allow buy-side firms and end users to not only trade and settle on their own, but also create their own products in the form of smart contracts.

Under the most optimistic scenario, DLT would become the primary means of issuing, trading and settling financial assets. Igor Gramatikovski, Product Manager for Trade Processing, SimCorp

Effectively, all financial assets would move to a pervasive and persistent, distributed and reliable transaction cloud. This Blockchain Book of Records would provide a record of all transactions, and hence ownership, for any product. Leading vendors and utility providers who depend on the current centralized market infrastructure where different financial institutions maintain their own records, which then require reconciliation with counterparties, also stand to lose their primary value proposition. A new set of vendors with a very different product offering will dominate this changing environment.

This scenario, as promising as it may sound, remains very unlikely in the short-to-medium term. Not least because current market practices are enshrined in various financial industry laws and regulatory requirements, which have been developed over many years in order to provide investor protection, financial system stability, reliability and certainty. Untangling the existing regulation and obtaining clarification of the critical legal, operational, and governance issues would entail huge risk, massive cross-jurisdictional effort and would likely take decades.

An alternative route?

On the other hand, a slightly less disruptive scenario envisages a significant level of adoption of DLT only for the issuance, trading and post-trade processing (including settlement) of illiquid products that currently exhibit a low level of automation. One variation of this scenario is the emergence of new (or the issuance of existing) financial contracts, most likely complex OTC derivatives, in the form of smart contracts. Smart contracts would contain the economic terms of the trade encoded in a programming language, and the distributed peer-to-peer network of nodes would automatically perform the associated calculations and execute the exchange of cash flows.

Under most variants of this scenario, the introduction of blockchain technology in the existing mix of multiple layers of orchestrated interactions, reconciliations and workflows, while perhaps solving a particular and isolated efficiency problem, would only add to the complexity and fragmentation of the landscape. Therefore, the value proposition of existing technology vendors such as Investment Management System (IMS) providers would not be diminished; on the contrary, it would require them to provide integration and simplification of access to this new technology in addition to their existing offering.

Significant challenges remain

As any innovation undergoing its peak of the hype cycle, the development of DLT has not been immune to groupthink and intellectual capture. It is therefore important to realize that despite the daily announcements of new developments, new partnerships, and new consortia, as well as a steady stream of news on improvements in the technology, there are few, if any, production-ready enterprise-worthy system based on blockchain technology for capital markets.

…there are few, if any, production-ready enterprise-worthy system based on blockchain technology for capital markets.Igor Gramatikovski, Product Manager for Trade Processing, SimCorp

Currently all established financial markets players engage in a technology evaluation process by setting up technical sandbox “proof of concepts” with an agile approach. This means testing actual technology concepts in a near-reality technical environment, failing fast and working around a hypothesis-based approach. One of the aims of this research is to simulate the lifecycle of a financial instrument in a smart contract executed over a distributed ledger and demonstrate the specific technology or operations. Another objective is the analysis of how to integrate this new technology seamlessly with the existing infrastructure.

There remain some significant and genuine issues, however. One of the most important is around the danger that a lack of standards could impede interoperability. With all the major capital markets players and utilities looking at this technology and most doing their own thing and filing patents, interoperability could become a real problem. Clearly, if everyone has a different ledger technology, then we would be back to the world of fragmented systems in a business network – creating exactly the friction that blockchain is expected to reduce or eliminate.

There also remain some significant technology challenges around confidentiality, scalability, performance and functionality. It is these technology challenges that receive the most attention in the ‘learn-and-explore’ approach taken by the myriad of players in the arena.

The most important considerations

Some of the characteristic features of DLTs can be found in earlier database technologies that have been developed since the 1990s, e.g. in the field of master-master replication. These technologies allow a number of parties to update records in a common database, with conflicts being resolved by some form of consensus algorithm. It is probably not too far-fetched to say that the most recent announcements from the major fintech companies operating in this space imply that they have made a significant departure from the ‘traditional’ bitcoin Blockchain.

…before embarking on any significant development and innovation, it is important to answer the question – what particular technology addresses your specific business case?Igor Gramatikovski, Product Manager for Trade Processing, SimCorp

Instead, currently they are promoting numerous proprietary ‘walled garden’ platforms utilizing the above-mentioned distributed database technologies under the ‘blockhain’ banner. So before embarking on any significant development and innovation, it is important to answer the question – what particular technology addresses your specific business case? Immediately, the question that follows is whether a distributed database or even a traditional blockchain offer some properties that a traditional centralized database does not. Finally, although not very often publicly addressed, is the importance of making a cost-benefit analysis: will the cost-saving justify the investment outlay required in order to replace the industry-wide legacy infrastructure?