The lack of harmonization in the regulatory treatment of Bitcoin has left a bad taste in the mouth of the financial industry, but blockchain – the virtual currency’s distributed-ledger architecture – has only whetted the industry’s appetite.
In the last few months, news reports have focused on the promise of blockchain, and several big names have signed on to the new architecture, which was designed to transfer bitcoins from one person or entity to another. Now, financial firms and technology companies are seeing a path to settle and clear trades in a more efficient way.
But not just yet. “If you believe the general blockchain hype, you would believe that the technology is here, it’s ready, and that the whole industry is either using it or about to use it,” said Rob Palatnick, a managing director and chief technology architect at the Depository Trust & Clearing Corp. (DTCC). “None of that is true. It’s probably a number of years away to use in a significant manner in the industry infrastructure.”
That has not stopped the industry from reading a number of recent blockchain-related contract wins and industry-initiative milestones as proof that the new technology is on the rise. In late January, the financial blockchain consortium R3 CEV announced that Barclays, BMO Financial Group, Credit Suisse, Commonwealth Bank of Australia, HSBC, Royal Bank of Scotland, TD Bank, UBS, UniCredit and Wells Fargo had connected to a private peer-to-peer distributed-ledger network managed by R3 and hosted in Microsoft’s Azure cloud-computing platform.
A day earlier, distributed-ledger platform vendor Digital Asset Holdings announced that it had inked a deal with Australian exchange operator ASX to develop a new post-trade settlement system that will incorporate distributed-ledger technology.
Also in late January, Nasdaq announced that blockchain-developer Chain.com had been its first client to use the exchange operator’s distributed-ledger-based Nasdaq Linq platform to transfer company shares to a private investor.
All of these announcements seem par for the course, according to Richard Johnson, vice president of technology and market structure at industry-analysis firm Greenwich Associates. “I think that 2016 is going to be a year where we have more proofs of concepts where the players are learning a lot more,” he said. “And by 2017, we’ll have some real products out there.”
That said, the industry still has quite a bit of heavy lifting to do before the financial and capital markets can adopt distributed-ledger architecture in any significant way, according to DTCC officials.
In a recent DTCC-published white paper, entitled Embracing Disruption: Tapping the Potential of Distributed Ledgers to Improve the Post-Trade Landscape, the paper’s unnamed authors cite several organizational, technological and regulatory hurdles that the industry will need to clear before using distributed ledgers in production.
For firms to adopt blockchain architecture successfully will require widespread cooperation from everyone who touches post-trade processes: asset managers, broker-dealers, custodians, exchanges and regulators, according to the authors.
Next, any distributed ledger will have to integrate with existing third-party and proprietary systems and databases, such as symbol master databases.
The highest blockchain hurdle, which is completely out of the hands of financial technologists, is addressing the legal and data-privacy regulations for distributing client information across multiple blockchains that are hosted by a variety of companies.
Too Many Cooks
All financial institutions face the same difficult questions when dealing with nascent technologies like distributed ledgers: Which vendor should they select? What technology firms are prepared for a brand-new technology paradigm? As with cloud computing and distributed grid networks when they made their debut last decade, selecting a potential blockchain partner can be a tricky process.
At the end of 2015, AngelList, an online community that matches startups with angel investors, listed approximately 200 blockchain startups seeking investors, and that number is only likely to grow this year and next.
Fortunately, there are several industry-led initiatives that are attempting to develop viable standards for the use of distributed ledgers within the capital markets.
The R3 CEV consortium, which consists of 42 financial institutions from around the globe, is working on a number of projects to prove the viability of distributed ledgers within financial services.
A second initiative, the aptly named Post-Trade Distributed Ledger Working Group, which consists of the CME Group, Euroclear, LCH. Clearnet, London Stock Exchange Group (LSEG), Societe Generale and UBS, has the much narrower mandate of investigating how blockchain architecture could be incorporated into post-trade processing.
“We’re collaborating with companies that seek to securely reduce cost and time of traditional transactions through the use of ledger-based technologies,” said a CME Group spokesperson describing the firm’s participation in the working group.
Probably one of the largest distributed-ledger initiatives is the industry collaboration that the Linux Foundation announced at the end of 2015. This group aims to develop an enterprise-grade, open-source distributed-ledger framework that would free software and hardware developers to create their own industry-specific offerings based on the framework.
At the time of the Linux Foundation’s announcement, Accenture, ANZ Bank, Cisco, CLS, Credits, Deutsche Borse, Digital Asset Holdings, DTCC, Fujitsu Limited, IC3, IBM, Intel, J.P. Morgan, LSEG, Mitsubishi UFJ Financial Group, R3 CEV, State Street, SWIFT, VMware and Wells Fargo had agreed to take part in the project.
For its part, IBM has contributed tens of thousands of lines of code base and the associated intellectual property to the initiative. R3 CEV has contributed the consortium’s financial technology framework, while Digital Asset Holdings provided enterprise-grade code, developer resources and its Hyperledger mark, which the initiative has adopted as the project’s name.
With numerous industry initiatives and an ever-growing list of blockchain-related vendors, the key for successful widespread adoption of distributed ledgers comes down to interoperability across the various blockchain offerings, according to Steven Wager, executive vice president of operations and development at itBit.
“We are very positive on interoperability,” Wager said. “We are a little less positive on an industry-wide ‘one chain to rule them all’ type of construct. But we see the overall push by the industry being very positive.”
A Feast of Opportunities
Distributed-ledger architecture’s standard rules for securities transaction validation and replication, its immutable linkages to transaction history and its ease of auditing make the technology exceedingly attractive for several clearing and settlement processes, according to the authors of the DTCC white paper.
Among the various processes the authors cite are master data management, asset/securities issuances and servicing, asset trade confirmation, trade/contract validation, collateral management and settlement, netting and clearing, and providing recording and matching platforms for complex-asset types that either lack platforms or do not have strong ones.
The architecture also theoretically could eliminate the need for a trusted third party, such as a central counterparty (CCP), from the clearing process since a distributed ledger’s database cannot be altered once a transaction’s details have been committed to it, according to Greenwich Associates’ Johnson.
“The original blockchain was for Bitcoin – it allows you to send bitcoins from one person to another without a bank, Visa or PayPal sitting in the middle of the transaction,” Johnson explained.
Not only could distributed-ledger architecture turn current clearing and settlement systems from a hub-and-spoke model into a flatter peer-to-peer relationship between counterparties, it also could simplify each counterparty’s back-office processes by eliminating the need of replicating the same data between various systems, added DTCC’s Palatnick.
“If everyone looked at a single set of books that contained the undisputed truth and, in turn, used it as their golden copy, it could simplify a lot of processing, remove a lot of risk and potentially some costs from the center of processing,” he said.
One place where the industry might not see firms deploying distributed ledgers initially is in the equities and fixed-clearing space, since the present systems can clear and settle with costs less than a penny per trade, according to the authors of the DTCC white paper.
And these processes will only get more efficient as the industry finishes its migration to a three-day processing window (T+2) from today’s four-day processing window (T+3), which the industry is slated to complete sometime in the second half of 2017, according to Palatnick.
However, itBit has been approach by parties interested in leapfrogging over T+2 to achieve same-day clearing and settlement of trades (T+0), itBit’s Wager said. “It really comes back to the philosophical argument: It is 2016, and how many years has it taken the U.S. to [get to] T+2 while most of the other markets are already there?” he said.
By introducing a T+0 clearing and settlement cycle in the U.S., Wager envisions it leading to greater dual listings while increasing the need for exchange and clearing services.
“I think we need something like that to bring back volumes to the U.S. from a more global basis,” he added.
In the meantime, most early deployments of distributed-ledger architecture have been in asset classes that lack clearing and/or settlement processes or where those processes are exceedingly messy, commonly referred to as “white-space” assets.
Those verticals are really around the introduction of delivery-versus-payment for asset classes in which it doesn’t exist today, according to Wager.
“The mantra to date has been baby steps and getting out proofs of concepts that work,” he added. “Let’s try something first and get people comfortable with it.”
The precious-metals market is one such market in which itBit has been working with participants to deploy the vendor’s Bankchain distributed ledger.
The global gold market, for example, is bifurcated between allocated and non-allocated trades. In allocated trades, which represent approximately 10 percent of all gold trades, the gold is non-fungible. Each bar of bullion has a record of ownership, an associated account number, fineness rating, warehousing location and other data.
Nearly 90 percent of gold trades are non-allocated trades, in which investors purchase an interest in a pool of gold held by a bullion bank, which treats its gold holdings similarly to cash on its balance sheet.
The main difference between the ownership types is how each is treated in case the bullion bank holding the assets becomes insolvent.
“In case of a default, the unallocated gold likely will not be recoverable,” Wager noted. “Whereas allocated gold is a client asset and is off the bank’s balance sheet. In case of an insolvency, it’s protected.”
The vast majority of global allocated and non-allocated gold trades settle through London Precious Metals Clearing Ltd.’s AURUM electronic clearing platform, which is owned and operated jointly by Barclays, HSBC, J.P. Morgan, Scotiabank and UBS.
“What we are trying to bring to market are all of the elements of allocated gold for the safety and protection of unallocated gold,” Wager said, “but let it trade, clear and settle with the same efficiency as today.”
