Blockchain is a disruptive technology platform that uses cryptography and a distributed messaging protocol to create a shared ledger between trading counterparties to execute simple transfer of asset ownership or more complex transactions using ‘smart contracts’. The data on the ledger is pervasive and persistent and creates a reliable ‘transaction cloud’ as that transaction data cannot be lost or corrupted by any of the participants
There are many possible applications of blockchain technology in investment banking. Suggested use cases in testing mode include KYC/AML data sharing, trade surveillance, regulatory reporting, collateral management, trading, settlement and clearing. This transformation has the potential to make trading processes far more efficient, improve regulatory control and eliminate unnecessary intermediaries.
What is blockchain in the investment banking context?
Blockchain is a disruptive technology that uses a distributed messaging protocol to create a shared ledger between trading counterparties to validate transactions. The data on the ledger is pervasive and persistent and creates a reliable ‘transaction cloud’ so that transaction data cannot be lost or can only be technically corrupted by any of the participants at very high costs.
What is different about blockchain compared to other technologies?
Blockchain technology has a fundamentally different set up than traditional technologies in the capital markets environment. It was designed to allow participants to trust the blockchain network itself via a consensus mechanism, which means there is no traditional governance assumed as the maintenance of the ledger is performed by a network of communicating nodes running dedicated software.
The cryptographic distributed ledger is replicated amongst the participants in a peer-to-peer network which does not rely on a third party and leaves a cryptographically auditable trail. The blockchain concept removes the third party intermediary holding custody on the asset rights as that is managed by ‘smart contracts’ which execute themselves meeting pre-defined conditions.
A distributed ledger shared near real-time between the capital markets participants and validated among separate nodes creates a platform which promises to remedy existing pain points in the current banking landscape, such as:
Supplant major middle- and back-office functions
Introduce unprecedented cohesion to the internal bookkeeping processes
Show a record of consensus with a cryptographic audit trail of transactions
Create near real-time settlement
Strengthen risk management through stronger auditability and counterparty ties
For what can it potentially be used?
There are many possible applications of blockchain technology in investment banking. Suggested use cases in testing mode include KYC/AML data sharing, trade surveillance, regulatory reporting, collateral management, trading, settlement and clearing. Some banks are looking at the technology to explore it internally first within their own middle- and back-office operations.
Blockchain supported distributed ledgers are particularly useful for complex financial assets where there is no clear central authority to regulate, arbitrate, and/or mitigate risk of trade or counterparty failure, hence products benefitting from the technology will be Public & Private Stocks/Bonds, FICC derivatives, Syndicated loans, Corporate Bonds, Factoring, Letters of Credit, and Derivatives Margin/Collaterals.
What are the benefits?
Blockchain technology has the potential to disrupt business models through automation, smart controls and risk and cost reduction. The ability to settle currency, equity and fixed income trades almost instantaneously through permissioned distributed ledgers may create a significant opportunity for banks to drive efficiency, improve regulatory control and eliminate unnecessary intermediaries.
Leveraging blockchain technology within the capital markets industry will be significant if the existing legacy technology, operations and infrastructure landscape within the established capital markets players is considered. The number of applications within and outside the banks will be reduced as the blockchain transaction contains all relevant information for the successful transfer of assets and/or related contracts.
What are the blockchain unknowns?
As the technology is maturing, various concerns will need to be addressed. Here are just some of the questions investment banks will need to ask themselves before diving into blockchain technology:
How can client privacy and security be respected?
What is the cost/benefit of supplanting or introducing this technology with current systems?
How can blockchains scale better with processing speed?
Will counterparties need to be identifiable and linked to a legal entity?
Should access to the blockchain be controlled or open?
Can the ownership of a financial asset that is not crypto currency be transferred using the distributed ledger concept with certainty and finality?
Can this financial asset be legally enshrined in computer code as a smart contract, such that any legal dispute could be decided by how the code of the smart contract executes on a distributed network?
Can a smart contract be programmed to execute the lifecycle events of a financial asset?
How will we establish a legal framework across both smart and traditional contracts?
How is the ledger version controlled?
What is the likely regulatory framework to define the good practice?
What are other associated risks which need to be considered?
Is that the same as Bitcoin?
Blockchain is the underlying Bitcoin technology providing the distributed ledger structure. The Bitcoin blockchain was originally designed to be a decentralized permissionless ledger with anonymous consensus which is primarily and growingly used for virtual currency transfers. The validation of the transactions are happening via a mining mechanism which burns energy as equivalent to ensure the node network stays incorruptible. As of this writing, more third-party solutions for Bitcoin are increasingly permission-based.
Blockchain utilization in capital markets looks beyond the money transfer and tries to address more complex issues. When we talk about the blockchain in capital markets, we do not envisage an energy consuming mining mechanism to validate transactions but rather alternative technical consensus mechanisms. By design, permissioned, distributed ledger systems are more congruent with the existing needs of capital markets participants while also supporting growing regulatory requirements.
Finally, we believe Bitcoin will continue to serve a very valuable purpose and we anticipate a number of new innovations and apps to be built on Bitcoin going forward. However, we also believe that Bitcoin based applications for capital markets will be limited by a number of factors, including the fact that Bitcoin was not built with specific capital markets business needs in mind.
Is Blockchain technology worth considering or is it a passing fad?
The short answer: Blockchains could become the critical backbone of the future capital markets infrastructure addressing significant industry issues, including the reduction counterparty risk minimization, reduction of settlement times, improvement of contractual term performance and increased regulatory reporting transparency.
Banks and venture capitalists have begun investing significantly in blockchain technology. We can envisage various stages of technology adoption, starting from an internal utilization within a bank to an intermediary stage where capital markets participants run private (permissioned) blockchains until regulation or legislation catches up and defines a new industry technology standard.