Blockchain: revolution waiting in the wings

Blockchain. In today’s 21st century digital age it promises to solve the problem of slow and cumbersome ways of regulating and controlling contracts, transactions – and the records of these – between individuals, communities, organizations and even nations. By the 2030s, contracts would be embedded in digital code and stored transparent and shared databases, protected from deletion, editing or revision. Every task, from the simplest to the most complex, would have a digital record and signature which could be identified, validated, stored and shared. And there might be no more need for such Intermediaries as lawyers, brokers or bankers. SimCorp’s experts look at the implications of blockchain for the financial world.

Blockchain is a protocol for implementing a distributed database, which maintains a continuously growing list of data records secured from tampering and revision by using cryptographic functions to achieve decentralized consensus amongst all its participants (nodes). 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.

Igor Gramatikowski

That’s the theory, but how should we imagine this? Igor Gramatikovski, Director of Settlement at SimCorp: “We can imagine Blockchain as a database where all nodes contain replicas of the same information contained in all other nodes. However, that’s the original Blockchain, known as Blockchain 1.0.”

“Today’s implementations have little in common with the original blockchain of 2008-2014, meaning a shift away from blocks, miners, pervasive data across equal nodes, and the possibility of using multiple consensus mechanisms,” Gramatikovski continues. “Instead, today’s distributed ledger technology is a permissioned, distributed and not really a peer-to-peer network. For example, as the New York Times wrote, the US-based Depository Trust & Clearing Corporation (D.T.C.C.) project ‘will not use Bitcoin’s blockchain. Instead it is building something similar to a blockchain, known as a distributed ledger, which multiple financial institutions can update and view at the same time. Unlike Bitcoin’s blockchain, the D.T.C.C. ledger will be open only to invited participants.’ These multiple implementations are essentially distinct proprietary platforms, in the form of ‘walled gardens’, to which investment managers, as key industry participants and asset owners on the buy-side, will undoubtedly soon be invited to participate.”

With a new player in the game, are the rules expected to change as well? Or has blockchain already changed the rules? “It is important to realise that despite the daily announcements of new developments, new partnerships, and new consortia, there is still no single production ready enterprise-worthy system based on blockchain technology,” Gramatikovski says. “Currently all established financial markets players engage in a technology evaluation process by setting up technical sandbox ‘proof of concepts’ (PoC). This means testing technology concepts in a near-reality technical environment and working around a hypothesis-based trial-and-error approach. So, while a lot of PoC exist out there, no rules have been changed yet.”

Which, as with every technical revolution of a global magnitude, begs the question who will set the rules. “A lot of organizations are currently vying to become the standard setters,” Gramatikovski says. “Some, such as the incumbents, those mostly affected by the disruptive line of attack of this technology, such as financial intermediaries of the likes of JP Morgan, Santander, Barclays , Goldman Sachs and all other Investment Banks are patenting their technical developments and platforms. Some others, such as Markit, SWIFT, DTCC, the exchanges,… are working in consortia. Similarly, organizations such as ISITC, ISO, BSI and others are hoping to define a standard – although as far as I can tell, they are not yet making any significant progress. If any progress is made, it is by the Linux Foundation and their Hyperledger project, which opens up several technical platforms (including the one by R3, called Corda) for standardization by the community of participants.”

The last technology revolution that changed the world in a profound way, was the internet, not even two decades ago. Is blockchain to set about a similar revolution? “The parallels between blockchain and TCP/IP , the foundation technology behind the Internet, are clear,” says Gramatikovski. “Just as e-mail (the first use case for TCP/IP) enabled bilateral messaging, blockchain enables bilateral financial transactions. The development and maintenance of blockchain is open, distributed, and shared—just like TCP/IP’s. A team of volunteers around the world maintains the core software. And just like e-mail, bitcoin (the first incarnation of blockchain) first caught on with an enthusiastic but relatively small community.”

Blockchain seems to be on everybody’s mind these days. Does this indicate that the pace of development of blockchain is much faster when compared to that of the internet? Maybe not, says Gramatikovski. “We need to distinguish between the unfortunate hype surrounding the technology and its reality. For instance, we need to remember the .com bubble and its bursting when drawing parallels between the evolution of the Internet and the Blockchain evolution. Most authors of any credibility would argue that Blockchain currently is essentially at the pre-2000 stages of Internet development. Perhaps even pre-late 1990s, when companies such as AOL, Compuserve and similar were trying to utilize TCP/IP in order to effect a private system without much interoperability with other competing systems. The parallel would be of course with the multitude of companies such as R3, Digital Asset Holdings, Ripple, Chain.com, Axoni and many others – who are now marketing what is essentially a proprietary platform in the form of a ‘walled-garden’. It should be noted that most of these companies have of recently made their code base open source; nevertheless, there remains an element of competition between them and very little inter-operability.”

The benefits of blockchain for the financial world could be far-reaching and beneficial at the same time. “By potentially providing a common, ubiquitous distributed ledger technology, blockchain 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 altogether remove the need for intermediaries to validate financial transactions. The prospect of streamlining infrastructure and/or removing redundant intermediaries from the process creates the opportunity to generate significant efficiency gains. Under the most optimistic scenario, distributed ledger technology would become the primary means of issuing, trading and settling financial assets. Most financial intermediaries, such as Sell side firms, exchanges, multi-lateral trading facilities, clearing houses, central securities depositories, payment processors and messaging networks would be significantly disintermediated and disrupted, some to the point of complete obsolescence. 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. 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 centralised 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. SimCorp believes this scenario of total disruption is unlikely to happen, at least in the short-to-medium term, for several reasons – the most significant of which is the regulatory framework that underpins the existing centralised, trusted and guarded model of securities processing today. Moreover, we at SimCorp agree with those other market participants who believe that the achievement of a blockchain –led replacement of the entire existing financial markets infrastructure necessitates standards and interoperability. This will require industry-wide coordination and hence will take significant amount of time.”

“A slightly less disruptive scenario envisages a significant level of adoption of blockchain technology only for the issuance, trading and post-trade processing (including settlement) of illiquid products that currently exhibit a low level of automation. One such example in capital markets is the syndicated loans market, where current settlement is around 20 days due to the number of lifecycle events and manual processes involved. One variation of this scenario is the emergence of new (or the issuance of existing) financial contracts, most likely the most 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.”

“Furthermore, it is possible that blockchain technology is adopted in certain emerging markets that suffer from the lack of established practices or legacy technology. Under most variants of this scenario, the introduction of the 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 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. SimCorp judges this scenario of distributed ledger technology emergence in the financial infrastructure landscape and therefore in the enterprise infrastructure stack very likely in the short-to-medium term. We do not see this as a threat; on the contrary, this scenario would offer several opportunities for a potential response by SimCorp.”

“At this stage, however, it is impossible to predict which variant of this scenario would play out and in which market, as well as which of the dozen or more competing technologies or business models would emerge as successful.”

Governments around the globe, via their Agencies, Debt Management Offices, Treasuries and Central Banks, are of course closely and actively following the development of blockchain technology. The Bank of England's fintech accelerator programme has launched a new community forum for innovation talks and two new proof of concept trials exploring the use of artificial intelligence and distributed ledgers, whereas the Monetary Authority of Singapore announced the successful conclusion of a proof-of-concept project to conduct domestic inter-bank payments using distributed ledger technology (DLT). International securities regulators, too, are stepping up their research into the disruptive potential linked to the development of distributed ledgers, robo-advisors and cybersecurity threats.

The Bank of Canada, on the other hand, said that, following a year-long experiment, the distributed ledger technology is not ready yet to act as the backbone of a wholesale interbank payment system.

In December 2016, the US Federal Reserve released a white paper on the potential impact of distributed-ledger technology on payments clearing and settlement, emphasising that regulators must be convinced of the security of any technology disrupting a system that processes approximately 600 million transactions a day, valued at over $12.6 trillion in the US. The Fed has now put emerging software and technology firms providing blockchain underpinnings for wholesale financial markets on notice that they may be deemed to have taken on a financial intermediary role and will ‘likely need to acquire some type of charter or license to provide services or conduct activities that involve the holding and transferring of assets on behalf of households and businesses’.

But the blockchain/distributed ledger technology is neither cheap to develop or run, nor simple to implement. “Its complexity (such as cryptographic functions used to achieve a decentralised ledger, pervasive data on every node of the network, public-private key cryptography etc) exists in order to ensure that (pseudo-)anonymous parties who do not necessarily trust each other can exchange value without an intermediary (or a custodian, who could otherwise act as a censor). So, in other words, there is no reason to implement it in areas that do not need trust-less exchange of value – simply as a protocol for communication, it is not very efficient nor fast,” Gramatikovski concludes. “It is important to realise that blockchain is not a panacea for all ills of the world and society, whether of a technical nature or not…”

The DTCC is the post-trade services provider for the U.S. market and provides settlement and clearing services for fixed income securities and equities as well as derivatives.
Transmission Control Protocol/Internet Protocol