Blockchain and the Financial Markets Ecosystem

The enthusiastic cyber gossip around “Blockchain” continues unabated and, in some cases, uninformed. There have been some notable exceptions. As reported in the Global Custodian news pages (27th July), Chi-X are using the technology for a planned speed up of member settlements.

 

The enthusiastic cyber gossip around “Blockchain” continues unabated and, in some cases, uninformed. There have been some notable exceptions. As reported in the Global Custodian news pages (27th July), Chi-X are using the technology for a planned speed up of member settlements. This ties in with the conclusions from two excellent recent research papers, published by SWIFT and the Bank of England respectively. These are well worth reading as they put the developments into perspective.

The SWIFT sponsored paper, “Bitcoin- the Miner’s Dilemma”, is the more technical but has clear messages about the need for private pools in the high value payments or securities arena to assure the validity of holdings. This paper clarifies the operational weaknesses of the Blockchain process in an open environment. The recent arrest of the Mt GOX CEO, following the loss of around 7% of the global Bitcoins in issuance, as a result of apparent failings at that company, highlights the risks inherent in the current open architecture environment.

The Bank of England paper, “Innovations in payment technologies and the emergence of digital currencies”, is far less technical and excellent reading for anyone looking to get a grip on this new technology. We must remember that it has the ability, and is likely to, replace our current approach to record keeping with potentially dramatic impacts on players with embedded old technologies.

The Chi-X initiative could be one of many and could well be a building block adopted by infrastructure that leads to this change. The challenge is that each pool could be infrastructure specific and efficiency would demand a development that straddles infrastructures from at least execution through to settlement. The market has found it hard to adopt new technologies and maintain common technical standards. Historically, it has preferred to use IT architecture and technical standards as competitive differentiators and barriers to exit. Although Blockchain uses standard cryptographic techniques, there remain many areas of potential differentiation between platforms and processes.

Bitcoin, the original user of the technology, was also developed to avoid central controls. That sullied its name as a start-up, given its association with drug trafficking following the “Silk Road” dark web case. Governments, Central Banks and Regulators will not allow such lack of transparency in the payments or the securities field. And they are right to do this. However, especially with transaction reporting, there are vehicles to accommodate their need for data. The question is whether they would be comfortable with a distributed ledger based platform rather than the current centralised ones. The Chi-X and similar planned initiatives appear to allow for this need as they are really a hybrid using the technology among their members and thus a limited purpose distributed ledger. However, if I am correct and their initiative should constitute a part of a wider process, the controllability issue resurrects itself. We need to avoid the redundant costs of any duplicative environments, with a distributed database for transactions and a more centralised one for control purposes.

One of the concerns of the Blockchain technology was that it accommodated a simple value for value exchange. Essentially it was used to move bitcoin from one person to another. Securities and payment markets have other needs. First they are not just principal to principal markets but also reflect underlying client activity. Second, they often incorporate conditionality as in a delivery versus payment securities instruction. Third, they demand information on the status of the transaction. And finally, they require confidentiality around many of the transactions. It appears that the Blockchain technology could accommodate the inclusion of conditions, but it is less clear how information on status or a requirement for privacy could be met. After all, currently in Blockchain all participants have sight of all accounts and all their history; and that is incompatible with many user core needs and, often, laws of individual countries.

There is a need in payment and settlement systems for three core attributes. These are credit, liquidity and operational integrity. They can all be overcome within Blockchain although the cost and structure is still unclear. As an example, in Blockchain there is a risk, if one loses ones private key, with, as an example, one’s hard drive becoming corrupt, that one’s digital currency is lost. That requires a new thinking around contingency within the structure to eliminate a flaw of the nascent environment rather than being a roadblock to future development.

A future Blockchain technological landscape will be different from Bitcoin and the emotional umbilical cord between the two should be cut. Blockchain is a new technology. Bitcoin is one of its first users. Payment and securities settlement systems were slow movers after the advent of basic automated technologies. They will be slow movers in this development. But, as I pointed out in an earlier blog, the slow movers will come around much faster than in the last century. And, although financial institutions will continue to be needed for credit and liquidity intermediation, their stranglehold on process may well be coming under attack.

And finally I would note the welcome initiative from SWIFT to sponsor public research into the use of Blockchain in the securities ecosystem. Such research is an imperative if the industry as a whole is to move to a common understanding and reach a common and economically sensible solution.

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