Intermediation and blockchain

Blockchain is a buzzword in financial technology and there is a lot of hype around it. But what’s behind the hype and what will blockchain technology mean to investment managers? A lot of different answers and conflicting arguments from stakeholders can make it difficult to get an overview. In this Q&A, two experts shed light on the topic and give their views on how blockchain will impact the investment management industry.

Journal: Will blockchain “change everything” or is it a solution chasing a problem?

Ben Keeler: It’s probably reasonable to say blockchain-enabled solutions are more hype than reality today, but I believe it’s worth investing in R&D. Broad adoption isn’t imminent but blockchain has the potential to reduce cost, provide scale, and support the next generation of investment management. Some get caught up in pushing the disruptive potential of the technology, but we see blockchain as a foundational technology that will require time, failure, and exploration.

Personally, I find it difficult to imagine every investment management operation around the globe still managing basic, common operational processes in say, 2030.  Look at mandatory corporate actions. Asset managers are responsible for processing the same activity, repetitively, and reconciling their records with counterparties to whom they pay significant fees for other recordkeeping services. Blockchain-enabled solutions provide an opportunity to change those dynamics.

Igor Gramatikovski: The reason that blockchain is making waves is that in its design, people have seen the potential to change the very way economies are organized by eliminating centralized third parties or authorities of trust. I believe, the reason so many industry players are excited about blockchain is not the technology—as ingenious as it is in the context of a censorship-resistant medium of value exchange outside the existing financial system. Rather, I think the interest stems from its ability to change the current economic setup in a way that transforms existing dominant relationships of power. However, after several years of experimentation and proliferating proof-of-concepts, production use of the technology remains elusive.

Journal: What common misconceptions are you seeing?

Ben Keeler: The first misconception is that all blockchain-related development will mirror the development of bitcoin or other digital currencies.  While our industry can learn a lot from others, financial services firms are looking at blockchain technology in a very different way. We share investment in common platforms (such as Ethereum or Hyperledger) but our industry is embarking on a focused and unique path just like healthcare, food production, real estate, and others are. In general, financial services-related activity is focused on three distinct places: 1) digital currency like bitcoin, 2) payments (the process you currently follow when you use your debit card) and 3) distributed, secure networks tasked with transacting and maintaining accurate digital records. Our industry’s focus is on the third, R&D-focused scenario.

The second misconception is that everyone wants to create “one chain to rule them all.” This is completely false. No one actor is going to create this new distributed environment and no one has the stick to force change of that scale. Interoperability between these networks or environments is already a big area of development because growth will be incremental.  We don’t use one internet. No one is developing “one blockchain.”

Igor Gramatikovski: There are many misconceptions around blockchain and distributed ledger technologies (DLT), which reflects the fact that as an emerging trend it is not very well understood. Holistically, we need to consider technology (both computer science and database, data structures, and algorithm design), game theory, cryptography, and most importantly finance, as well as the fact that the experience with experimentation is limited.

One such misconception is that the blockchain of the cryptocurrency bitcoin is the same or very similar to the numerous ‘blockchain-inspired’ technologies currently explored out there. Hence, a lot of people ascribe the same properties (and benefits) that apply to bitcoin to any DLT. While the bitcoin system has proven to be quite resilient and successful in the implementation of a decentralized, censorship-resistant and, pseudo-anonymous cryptocurrency, many of its original design features undermine its suitability for financial markets use cases. For example, (i) all transactions are visible to everyone, which may violate banking laws and disclose confidential competitors’ information; (ii) POW as a decentralized-consensus mechanism is very costly in terms of computational processing power, time, and energy;  in other words, it’s typically an overkill in trusted environments; and (iii) the system is open to anyone who would like to join and participants are anonymous, which violates KYC (know your customer) and AML (anti-money laundering) requirements.

To address these issues, financial technology companies have been developing alternatives to the bitcoin blockchain. With different design aims and solutions, giving rise to different technical specifications and properties, each DLT needs to be analyzed on its own merits.

Journal: Do you see blockchain as a source for significant disintermediation for the buy side?

Ben Keeler: No, while distributed ledger technology (DLT) does support low friction peer-to-peer transactions, but we don’t think predicting a seismic shift in buy-side players is realistic. Providers, utilities, and consortiums are pushing the agenda and making investments today - and that’s good - but those parties aren’t going to disintermediate themselves. On the other side of the coin, buy-side investment managers simply aren’t going to invest, cooperate, and drive long-term change via blockchain without the support of service providers, existing clearinghouses, and regulators. That said, we don’t believe that having partners driving the agenda means that the buy side is absolved of their own R&D and resource spend - anything but. In the case of DLT, it will need to be done with partners. 

Igor Gramatikovski: Perhaps one of the areas where blockchain has the potential to help the financial services industry is in the disintermediation of the sell side, by enabling peer-to-peer trading and eliminating the need for capital intermediaries. However, the debates about whether CLOB (Central Limit Order Book) offers a better alternative to the traditional Request-For-Quote (RFQ) approach, DMA, and other forms of direct client-to-client trading, have long preceded the emergence of this new technology.  What we should really ask ourselves is whether we have so far lacked the appropriate technology, or have the hurdles in achieving market efficiency been more of regulatory nature or even due to the lack of appetite for any infrastructure investments? At any rate, this is an area that does require a lot of active involvement, research, and investment by the buy side, as well as cross-firm cooperation, which is unfortunately not something that we are currently seeing.

Journal: It can be hard to cut through all the hype and buzzwords. What is relevant to an investment manager?

Ben Keeler: Well, I always answer that by making sure to point out where not to spend time and energy first. Retail payments, digital currency, and non-industry proof-of-concepts are all interesting, but rarely immediately relevant for investment managers (outside of increasing investment in digital currency as an asset class). Today, no buy-side applications are “open” and in production. These are segregated “walled gardens” transacting only with trusted, incented partners.

What is relevant? Well, blockchain is a valuable tool when a business process or activity has three characteristics: 1) It requires significant reconciliation, 2) relies on agreed-upon calculations and 3) benefits from a shared understanding of statefulness. With that criteria in mind, middle and back office opportunities like settlement, accounting, and associated reconciliation would be targets.  Also important: no major buy-side-focused technology firms are actively pushing a model that includes leverage of blockchain today.  

Igor Gramatikovski: Cost are always important and relevant to Investment Managers. This is something that is currently very often omitted from any Blockchain-inspired discussions. This is certainly obvious when looking at the numerous analyses, which focus on the current cost of a particular banking process and entice their readers with the prospect of replacing these costs in full. Of course, this makes the dangerous assumption that DLTs come for free, neglecting the costs of R&D, agreeing standards, implementation and adoption across the enterprise and beyond, in the wider user community. In the case of the bitcoin blockchain, for instance, the costs of running a blockchain network: the costs of electricity and data storage, as well as network bandwidth, are very often neglected or omitted.

Journal: What is a compelling use case that you believe the market isn’t talking about right now? 

Ben Keeler: I dream about what impact blockchain and DLT would have on regulatory reporting.  Can you imagine giving regulators secure and timely access to holdings and activity? Think of the impact that would have on operation and technology teams. No more fire drill aggregation efforts and significant savings for invasive, reactive integration work required for most new regulatory-driven efforts. 

Journal: What does the market look like now? If the technology is immature, why the huge investment from others in the financial services industry?

Ben Keeler: The market seems to be shaping up as a combination of larger institutions looking at incremental improvements and startups building solutions for clients, hoping that they make the right bet on the underlying platform (Corda, Ethereum, Hyperledger, etc.) before the cash runs out.

Outside of a significant change, the path forward will be driven by cost-cutting efforts for banks. There was an air of defense from banks at first but they appear to be consistent in their R&D push as they become more familiar with how the technology could potentially reduce cost for them and their clients.  Same could be said for smart contract enabled derivatives transactions. Buy-side activity is still driven by top 20-40 AUM managers that can use future-focused tech labs to drive research and development.

Journal: What is the biggest challenge to blockchain that few are talking about?

Igor Gramatikovski: First of all, we must acknowledge that there is no formal taxonomy nor standards in DLT. Furthermore, the process for how governance works in blockchain is also unclear to many. Whether we acknowledge it or not, DLTs face the same governance issues as conventional third-party enforcers. You can use technologies to potentially enhance the processes of governance (e.g. transparency, online deliberation, e-voting), but you can’t engineer away governance as such. If you still rely on a board of directors or similar body to make it work, how much has the economic setup really changed? For instance, R3 is a firm that develops blockchain technology for use in the financial services industry. It has enrolled a consortium of banks to guide the effort, and its documents talk about the “mandate” it has from its “member banks”. Its governance model thus sounds a lot like the beginnings of something like SWIFT. This leads me to ask the provocative question: how revolutionary blockchain-based technologies really are? And if they do not hold the potential to transform economic setup as originally imagined, shouldn’t we continue the debate about their future purely from the efficiency angle as yet another communication protocol, on par with ISO20022, FIX, FpML, etc.?

Journal: Any other thoughts to share with asset managers interested in blockchain exploration?

Ben Keeler: We always say that changing legacy technology requires more than a new piece of software; it requires changes to legacy thought processes and actions. We think, it is imperative that asset managers embrace that same spirit when it comes to working with blockchain, RPA, AI, etc., even in the face of daunting day-to-day responsibilities. These efforts require exploration and collaboration, not something that buy-side technology and operations are known for. To do something truly different, the buy side is going to need to get off the sidelines a bit and accept that to reduce overall support costs, they likely need to invest more in developing the next generation investment platform. Without a concerted effort, they are largely falling into legacy behavior: waiting for a provider or vendor to invest and do something on their behalf and then being discouraged when it wasn’t truly different than their current state.

Igor Gramatikovski: The old pearls of wisdom applicable to “retail value investing” continue to hold. Namely, “do not invest in something that you don’t fully understand”, which by itself does not advise the buy-side firms to continue to stand by the side. “Follow the smart money” – with DLTs being one of the most funded emerging technologies in last decade, you ignore them at your peril – but also, do not neglect the old-fashioned cost-benefit analysis: ask yourself whether the cost-saving will justify the investment outlay required in order to replace the industry-wide legacy infrastructure? And finally, learn from industry experience, but never forget that “past performance is not an indicator of future success”!

About the interviewees

Ben Keeler is a Managing Director with over 20 years of experience in investment management and consulting. In his role, Ben leads partnerships with investment managers and supports the advisory needs of Citisoft’s global client base. Ben strives to help C-level executives make informed decisions on technology and operations direction.  Ben is a recognized industry leader on topics including technology strategy, operating models, investment operations outsourcing, data management and front office technology. His extensive delivery experience allows him to offer pragmatic solutions and counsel to the industry’s leaders.

Igor Gramatikovski is responsible for SimCorp’s Securities Processing solution and strategy as part of its IBOR offering. Prior to joining SimCorp, Igor worked as an Investor Market Manager at Citibank’s Securities and Fund Services. He joined Citi from Markit, where he held Business Development positions for the Credit Data and Portfolio Valuations service, and was responsible for the Alliance Program in EMEA. He started his career at Thomson Reuters, where he was a Fixed Income Real-Time Content Product Manager for 6 years.