Big changes beyond Bitcoin

Blockchain technology will quickly spread in the financial sector

Blythe Masters

CEO of Digital Asset Holdings

In 2015 , the technology known as “blockchain” went from being a novelty to being mainstream. A clear distinction was drawn between cryptocurrencies like Bitcoin and the technology that underpins them (now known as “distributed ledger technology”). Today, almost every major financial institution is exploring the technology. Once hailed as a huge disruptor, the technology has become a powerful enabler for major financial institutions. In 2016 , the first commercial tools will begin to roll out.

What do such tools look like? Despite the hype and high-profile crimes and accidents associated with cryptocurrencies, distributed ledgers are simply a clever new form of database technology. They were born out of the internet , open source protocols, advances in computer power, and cryptography. They are shared, replicated, decentralized databases of transactions.

Transactions submitted to this database are added to all previous transactions and remain part of an immutable ledger. No one has the ability to unilaterally edit or modify the history of the ledger, and no single entity acts as an administrator. These ledgers are constantly replicated and synchronized. Resilience is enhanced by eliminating central points of failure: if one location is attacked or fails, other locations can maintain the integrity of the ledger. Security and privacy are achieved through sophisticated credential checking technology, and data is protected through encryption.

The simple upshot of all this is that distributed ledgers give independent entities the opportunity to rely on the same, shared, secure source of information. The entities that need to know about a financial transaction include not only the buyer, seller, and their brokers, but also custodians, registrars, settlement and clearing organizations, central depositories, and, importantly, regulators . Costs are greatly reduced because there is one master record instead of each stakeholder having to keep their own records. This reduces duplicate records, eliminates the need for reconciliation, minimizes errors, and helps speed up the settlement process. In turn, faster settlement means less risk in the financial system and lower capital requirements.

In contrast, traditional financial infrastructure is based on a centralized, unencrypted hub-and-spoke database architecture. This architecture is costly, inefficient, and vulnerable to operational failures and cyberattacks. Differences within and between individual databases create inconsistent transaction data that requires costly reconciliation. As a result, a large portion of financial institutions’ operating expenses is spent on generating, communicating, and reconciling large amounts of data. All of this creates opacity and delays, making it more difficult for regulators to stay up to date.

Technology is evolving rapidly. The original Bitcoin blockchain, designed to allow two parties who do not know each other to make irreversible payments on a public network, has some features that are problematic for regulated financial institutions. This has led to the emergence of alternative technologies known as private or permissioned blockchains, although there is a heated debate about whether this deviates from the original intention and spirit of blockchain design. By only allowing known and permissioned parties to participate, privacy, transparency, and total processing capacity are improved (all important features in regulated capital markets).

But why is clever database design suddenly popular? After all, traditional financial infrastructure has not been modernized in decades. The answer lies in average return on equity. Data from Autonomous Research shows that in 2014 , the average return on equity of major banks around the world was 10.8 %, down from 11.1 % in 2013 and 15.8 % in 2004. As a result, banks' returns are close to or below their cost of funds, which is obviously unsustainable.

This reflects a challenging revenue environment, with bank costs rising and leverage falling as a result of post-crisis reforms. This means that the immediate priority for banks is to find ways to overhaul their cost base and reduce their need for capital, while also addressing new regulatory requirements for greater transparency. This is why distributed ledger technology has received so much attention.

chain reaction

Distributed ledger technology has the potential to solve pressing business realities. Rather than looking for problems, the technology solves them. In other words, the time for distributed ledger technology has arrived.

In 2016 , we will see the first limited adoption of distributed ledger technologies in wholesale financial markets, based on private permissioned blockchains, and over the next five to ten years we will see them develop, improve, standardize, and proliferate until they eventually become the new normal.