Cooperation and trust: the challenges of integrating Bitcoin into the financial industry

Just as securities clearing was supposed to be like a night at the club with Pete Tong, the DJ and electronic music pioneer who would stand before an audience and effortlessly manipulate a vast slate of music using only an iPad, the back offices of global financial institutions were supposed to allow traders to buy and sell trillions of dollars worth of assets with impeccable precision.

In reality, however, their performance looks more like Rick Wakeman, keyboardist for 1970s progressive rock band Yes, who will be wearing a wizard's robe and waving his sleeves wildly as he pulls strings from 12 incompatible instrument cases.

Coordinating the books of banks around the world requires just as much skill and effort. Deals initially agreed upon over the phone, by email or over lunch must be recorded, summarized and entered into those systems. Sorting out those deals and ensuring that everyone has the same record is a cumbersome task. Electronic confirmation of transactions is useful, especially for standardized products, but in many markets, paper documents still rule the roost.

Not all errors are so eye-popping, but the one involving UBS’s Kweku Adoboli, who lost $2 billion when a pile of unconfirmed trades was found in his desk drawer, was the most spectacular. But there are always “errors” that slip through the cracks, and when they do, they cost money. In the U.S. Treasury market alone, about $50 billion in trades go “wrong” every trading day, costing the equivalent of 3% interest on outstanding debt for a year. Including private-sector markets, the total size of the errors is likely in the hundreds of billions.

In the world of arena rock, the standardization problem has long been solved. You won't see Radiohead's Thom Yorke standing in front of a large number of electronic instruments that look like a telephone exchange, because in 1983, manufacturers of synthesizers and keyboards agreed on a unified standard that allows musicians to connect cables without having to be half-electronics experts.

The finance industry may not have noticed, but the technology that solves the compatibility problem has also been invented. Its name is Bitcoin, but it probably wouldn't object to a new name; secret-key currencies still carry a bit of a whiff of gunpowder, given their past association with anarchists and their use by users of Silk Road, an online marketplace for narcotics. Richard Gendal of IBM says the underlying system should be renamed "shared ledger technology."

The technology’s usefulness to legitimate finance has nothing to do with its alleged ability to make transactions untraceable—a feature that can be easily turned off. Its usefulness has everything to do with the “blockchain”—a public record of transactions that is updated every time one person pays another person a bitcoin. Every bitcoin user can access this shared ledger, and all copies are equally reliable; there is no single authoritative source. Clever cryptographic algorithms make it easy to tell if a copy has been tampered with, so that all copies stay in sync.

This is exactly what securities settlement needs: a way to record every trade, share that record in exactly the same form between parties, and then update it in a standardized, agreed-upon way. It provides an easy way to create settlement systems for new or custom products.

It would also automatically create a comprehensive and agreed-upon record of trades, which would greatly assist risk management and compliance functions. And with such a system in place, it should be easy to ensure that netting opportunities are never missed. If a trader sells some shares of an exchange-traded fund and his colleague buys the same fund, their financial institution does not need to deal with any outside counterparties.

The potential cost savings from this technology go far beyond eliminating opportunities for error: Back-office staff earn six-figure salaries doing little more than manually sorting settlements and confirming trades.

The biggest barrier to adoption of a “shared ledger” is one that has certainly delayed much needed investment in the past. Banks are unlikely to use Bitcoin in its current form, so they will have to agree on the design of a new standard. That means collaboration and mutual trust. Unfortunately, those habits are harder for bankers to develop than for musicians.