Ledgers have been the core of commerce for millennia. They have formed the records and bookkeeping for everything from accounting to land ownership. They started with beads and 5-bar gate tally counting, advanced through parchment to paper books and card indexes to computer databases. The last 50 years or so have seen the move from paper or card to computer databases but the essence of the process has largely remained the same, only faster.
Now with Blockchain we have the possibility that these ledgers can be distributed across all interested parties allowing them to be uniformly, simultaneously and speedily updated. This builds upon sophisticated algorithms and technologies that were originally created for the cryptocurrency known as Bitcoin.
The technology is known as Distributed Ledger Technology (‘DLT’) and is essentially a database with records that can be shared across a network of diverse users, locations and roles. All authorised participants within a network owning an identical copy of the ledger. Changes to the records are updated in all copies potentially in real time.
In December 2016 the French bank BNP Paribas announced that it had for the first time used Blockchain to complete a major wholesale money transaction for two of its major clients.
“Using Blockchain technology, BNP Paribas successfully processed and cleared for Panini Group and Amcor payments in various currencies between BNP Paribas bank accounts located in Germany, the Netherlands and the United Kingdom. The payments were fully processed and cleared in a few minutes, highlighting the real potential of this innovative technology which eliminates delays, unexpected fees and processing errors, paving the way for real time cash management.”
The security and accuracy of the distributed ledger are maintained cryptographically through the use of ‘keys’ and signatures to control who can do what within the shared ledger. Entries can also be updated by one, some or all of the participants, according to rules agreed by the network.
Bitcoin has come to have a mixed reputation in the financial world, its price has been extremely volatile and its association with illegal activities, whether completely fair or not, has been hard to shake off. However, Blockchain, the DLT infrastructure originally created for Bitcoin, appears to be exciting interest amongst financial institutions, Central Banks and Governments most of whom have been extremely reluctant to get involved in Bitcoin.
Blockchain is a relatively new technology for the capital markets industry and because it has often been mentioned in the context of Bitcoin, it is no great surprise that the two things are somehow interwoven in the popular imagination.
While Bitcoin is built on blockchain technology, it is just one type of distributed ledger and other variants might be better options for the industry.
The Internet, as well as a small number of commercial networks outside of it have radically altered front-office functions for investment banks, bringing unprecedented efficiency gains and new business opportunities. Yet, despite the front-office advancements over the past 20 years, middle- and back-office functions remain mostly antiquated, slow, inefficient and insecure. Here, firms are still dealing with overly complex procedures involving multiple counterparties, manual processes and third-party service providers.
Distributed Ledger Technology has the potential to help minimise counterparty risk, reduce settlement times, improve contractual term performance and increase transparency for regulatory reporting.
Contractual payments and asset transfers can be executed without reliance upon third-party intermediaries through the use of “smart contracts”—programmed code that replicates conventional commercial agreements by digitising business transactions between parties and validating them through a blockchain. Practically speaking, this means blockchain-enabled networks have the potential to increase trading efficiency, improve regulatory control and eliminate unnecessary intermediaries.
Summary of potential advantages for Financial Markets
Reduce total cost of ownership. Blockchain records offer a robust and verifiable alternative to traditional proprietary records at a fraction of the cost.
Manage system-of-record sharing. Blockchain technology makes it possible to give various parties (e.g., clients, custodians and regulators) access to their own live copies of a shared system of record.
Clear and settle transactions faster. Blockchain technology can facilitate the transition from overnight batch processing to intra-day clearing and settlement.
Create self-describing electronic transactions. Smart contracts can use blockchain’s programming language to create context-aware transactions for complex arbitration. For example, an options contract or a binary option could pay out automatically according to automatic monitoring of, and response to, data feeds.
Blockchain could ultimately transform the whole area of margin and collateral management through speed transparency and ‘smart contract’ automation.
Anything that improves efficiency and lowers costs in markets will, almost by definition improve liquidity.
One note of caution
Some firms currently extract rent from their roles as ‘gate keepers’ or information intermediaries in the businesses mentioned above. Paying agents, invoice discounters, clearing houses, banks and brokers are all likely to see some of these ‘rent’ streams reduced or even eliminated. In some cases this may well lead to reduced Enterprise Values in the view of the stock market.
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