Blockchain: the future of finance

November 2019  |  EXPERT BRIEFING  |  BANKING & FINANCE

financierworldwide.com

Have you experienced a security breach in a personal account or had reason to question the cost of a banking transaction? Blockchain addresses these basic shortcomings in the internet while achieving additional material advances. This explains why pundits maintain blockchain will have a greater impact on finance than the internet has had on media. While the internet changed how we communicate, blockchain will fundamentally alter how business is done.

This transformation reflects blockchain’s cost efficiencies from digitalising data and the security achieved by cryptography. These benefits are of particular significance to banking, finance and capital markets. To appreciate this potential, consider what blockchain (also referred to as ‘distributed ledger technology’ or DLT) does, its current applications and what lies ahead.

Myth vs. reality

Blockchain’s utility is proven. Its technical foundations date from the early 1990s. However, popularised with the publication in 2008 of a seminal paper addressing ‘peer-to-peer’ (P2P) cash clearing or ‘bitcoin’, DLT is frequently confused with its high-profile application. The stock market quotes for Bitcoin and other ‘cryptocurrencies’ is viewed as a barometer of investor interest. This misperception between blockchain and Bitcoin belies its disruptive potential.

To clarify the point, DLT is an advanced computer architecture built on a series of entries called ‘ledgers’ or ‘blocks’ containing data and directions in a digital format. These blocks are linked in a ‘chain’ (thus a ‘blockchain’), providing a historic transaction log. These major attributes distinguish DLT from the prevailing analogue and open access internet on which business now depends and in design explain its broad-ranging impact. First, digitalisation and decentralised processing save cost and time, enable complex computation, eliminate traditional central authorities such as banks, and provide transparency through P2P exchanges, as well as access to all historic records. Second, cryptographic protocols are relied upon for every transaction, ensuring the security and integrity of databases and entries. Furthermore, the distributed database can be open to the public or controlled (permissioned) and provision made to update or amend entries.

Reflecting these advantages, DLT is expanding to eclipse such current applications as cash settlement, to include a range of more complex and higher value transactions. The continued decline in the cost of computing and data storage, coupled with technical advances, will accelerate this dynamic.

First wave

The first wave of applications in finance and banking is being driven by easily achievable gains in actively traded assets. These include greater security of data, ease of verification of clients required by Know Your Customer (KYC) and anti-money laundering (AML) regulations, heightened processing speeds and facilitation of recordkeeping. The common denominator of an existing, liquid market in the underlying financial asset supports trading. Propelled by cost savings achieved by digitalisation and decentralised processing, the first wave of blockchain applications in FinTech have focused on transaction processing and settlement routines.

These initiatives are generally sponsored by commercial banks and include the clearing and settlement of trades, such as credit default swaps, payment systems and digital currencies, as well as trade finance, including bills of lading and letters of credit, customer verification and syndicated loan settlement. While the DLT systems and programmes to handle higher transaction volumes are proven, the pace of adoption depends on the rate of change in business processes, regulatory compliance, as well as establishing a level of collaboration to achieve a critical mass of participants, or a so called ‘ecosystem’.

There are numerous examples of these initial applications. MasterCard incorporated a blockchain payment system providing vendors real time, lower cost settlements on cross-border transactions. Representing a consortium of more than 40 of the world’s largest banks, fintech firm R3 launched a payment system built on DLT platform Corda, to expedite intra-bank transfers. Real-time cross-border payment blockchain network RippleNet is supported by a broad base of financial institutions. Swift is another banking consortium formed to reconcile international accounts, optimising system liquidity. And a JPMorgan network – the Interbank Information Network – is designed to expedite compliance and compile data required to confirm payment.

A more ambitious application of blockchain is as a source of start-up or initial equity capital. Referred to as initial coin offerings (ICOs) and modelled after initial public offerings (IPOs), these fundraisings are being scrutinised by the Securities and Exchange Commission (SEC). As transactions are restructured to comply with securities laws, the volume of such offerings – subsequently referred to as security token offerings (STOs) – and the range of applications is increasing. While Wall Street’s brokerage community may be dismissive, the implications of these capital raising ventures is profound.

Coming democratisation

Recent examples of blockchain’s impact on financial markets go well beyond these initial applications or P2P lending or crowdfunding. The range of new, creative endeavours portend a bright future for blockchain. In contrast to the first wave, these emerging initiatives are designed to address less liquid assets and increasingly complex transactions. Resulting impacts will likely be more broadly disruptive and offer substantially greater returns.

By way of illustration, St. Regis Aspen, a Colorado resort, is a partnership formed with a crowdfunding site, Indiegogo, that in lieu of a traditional IPO completed a private placement via DLT financing real estate. This sale of ‘tokens’ – fractional interests in the underlying property – raised $18m, compliant with securities laws. Another innovative application, Ceres, is the digitalisation of oil and gas royalties and mineral reserves. This type of private placement is designed to bring together buyers and sellers to establish a market in complex assets and capitalise on the growing interest in alternative investments secured by high yielding structured financing. The implications of these two initiatives is significant for incumbent markets in public and private placements as well as securitisations.

Capitalising on the previous designation by regulators of Bitcoin as a digital currency, a more disruptive application to global banking is Libra, Facebook’s proposed digital currency. Tied to a basket of currencies of which the US dollar represents 50 percent, Libra is designed to be a tradeable currency, with a ready market based on the unmet needs of a majority of the world’s population living in countries with restrictive exchange regulation. To the extent Facebook’s initiative succeeds, global monetary policy, currency markets and fiscal practice may fundamentally change. Moreover, the growing availability of digital currency represented by Libra will have a multiplier effect by facilitating investment in and increasing the liquidity of all digital assets.

What’s the takeaway?

Such game changing blockchain applications based on proven technology are considered highly likely. But the timing of adoption is by nature always speculative. Resistance to change increases exponentially with novelty. Blockchain technology’s broad ranging impacts are, at the very least, novel. Progress, therefore, will be driven by and rewarded based on initiative. What is certain regarding DLT applications in business generally, and finance and banking in particular, is the critical value of strategies anticipating coming changes and plans to capitalise on the opportunities represented.

Anders J. Maxwell is a partner and managing director at PJ Solomon Co. He can be contacted on +1 (212) 508 1683 or by email: amaxwell@pjsolomon.com.

BY

Anders J. Maxwell

PJ Solomon Co.