In 2015 “blockchain” technology evolved from a novel backwater to a mainstream matter. A clear distinction has been drawn between bitcoin and other cryptocurrencies, on one side, and the technology that underpins them (now known as “distributed-ledger technology”). Today, virtually every large financial institution is exploring it. What was hailed as a great disruptive force for incumbents has evolved into an even greater enabler for them. In 2016 the first commercial implementations will start to be rolled out.
So what is it? Once you strip away the hype and the high-profile crimes and accidents associated with cryptocurrencies, distributed ledgers are nothing more than a clever new form of database technology. They are born of advances in the internet, open-source protocols, computing power and the science of cryptography. They are shared, replicated, decentralised transactional databases.
A transaction committed to the database is added to all those that came before it, and it persists for life as part of the immutable ledger. No one has the unilateral power to edit or revise the ledger’s history and no single entity acts as the administrator. These ledgers are continuously replicated and synchronised. Resilience is enhanced by elimination of central points of failure: if one location suffers an attack or breakdown, others are able to maintain the integrity of the ledger. Security and privacy are achieved by sophisticated credential-checking techniques, and data are protected through encryption.
The simple consequence of all this is that distributed ledgers create the opportunity for independent entities to rely on the same, shared, secure source of information. Entities with a need to know about a financial transaction include not just the buyer and seller and their brokers, but custodians, registrars, settlement and clearing agencies, central depositories and, importantly, regulators. Costs are cut dramatically, because instead of every interested party keeping their own record, one prime record can do the job. This reduces duplicative record-keeping, eliminates the need for reconciliation, minimises error rates and facilitates faster settlement. In turn, faster settlement means less risk in the financial system and lower capital requirements.
By contrast, legacy financial infrastructure is based on centralised, unencrypted hub-and-spoke database architecture. It is expensive, inefficient and vulnerable to both operational failure and cyber-attack. Differences within and across separate databases create inconsistent transaction data that require costly reconciliation. So financial institutions spend a lot of their operational outlays on the generation, communication and reconciliation of vast quantities of data. All this creates opacity and delay, and makes it harder for regulators to keep abreast of what’s going on.
The technology is evolving fast. The original bitcoin blockchain, designed to permit irreversible payments between parties unknown to each other in a public network, has certain features that are problematic for regulated financial institutions. Amid furious debate about whether this obviates the original purpose and genius of the design, alternatives—known as private or permissioned blockchains—have been developed. These improve upon privacy, transparency and throughput capacity (important features in regulated capital markets) by limiting participation to known and approved parties.
Why, though, should clever database design suddenly catch on? After all, traditional financial infrastructure has not been modernised in decades. The answer lies in a ratio. The average return on equity for major banks around the world was 10.8% in 2014. This was down from 11.1% in 2013 and 15.8% in 2004, according to data from Autonomous Research. As a result, banks’ rates of return are unsustainably near or below their cost of capital.
This reflects a challenging revenue environment, rising costs and reduced leverage(a good thing) as a result of post-crisis reforms. It means that it has become imperative for banks to find ways to restructure their cost base radically, and to reduce their need for capital, while simultaneously responding to the new regulatory requirements for greater transparency. This is why distributed-ledger technology is attracting so much attention.
It is a technology that has the potential to address pressing commercial realities. Rather than being a technology looking for a problem, it is one that can solve real problems. In other words, a technology whose time has come.
In 2016 we will see the first, limited applications of distributed-ledger technology to wholesale financial markets, based on private permissioned blockchains. And over the subsequent five to ten years we will see these evolve, improve, standardise and proliferate, until eventually they become the new norm.