Is blockchain technology about to upend the financial world?


Many people have heard of Bitcoin, a shadowy form of currency that operates outside normal banking channels. It was introduced in October 2008 by a computer scientist under the alias Satoshi Nakamoto, and later released in the form of open-source software in 2009. Over 100,000 merchants now accept Bitcoin for products and services; the total value of circulating Bitcoins is currently about 10 billion U.S. dollars. In May 2016, Craig Steven Wright, an Australian computer scientist, publicly confessed to being Satoshi Nakamoto, although some skeptics still dispute his claim.

Blockchain: the technology behind Bitcoin

A even more interesting development is that blockchain, which the underlying mathematical technology of Bitcoin, is being actively explored for a variety of applications in the financial and business world to take the place of trusted intermediaries such as banks, brokerages, funds and exchanges.

Nowadays, investors who trade loans or derivatives or transfer funds internationally are saddled with tediously complicated and time-consuming back-office processes, which rely on negotiated contracts between buyers and sellers, all mediated by contract specialists and lawyers. Some types of syndicated loan exchanges can take up to 20 days to conclude.

Thus some in the industry, such as former J.P. Morgan investment banker Blythe Masters, are convinced that blockchain technology can be used to streamline many types of financial transactions. A June 2015 report by Santander InnoVenture estimated blockchain-related technologies could save financial institutions USD$20 billion per year in settlement and international fund transfer costs.

The idea of a blockchain is that a series of encrypted transactions are connected in a chain, where each transaction contains a hash of the prior block in the chain, so that it is irrevocably connected to the previous transaction. Security comes from the fact that the blockchain database is replicated in many different sites — there is no “official” copy, and no particular site or user is trusted any more than any other site or user. Two (or more) parties can perform a transaction by posting it to the blockchain. Since the posted block includes a publicly verifiable digital signature of both all parties, any third party can verify that each of the transactees participated in the transaction.

The mathematics behind blockchain is described, with examples, in a separate Math Investor blog.

Current and planned implementations

Among those organizations already offering blockchain services are:

  1. Real Asset in London offers a service for gold owners to record their metal on the blockchain; soon they will be able to trade.
  2. MeXBT in Mexico City proves a Web-based app that permits migrants to send money via blockchain to Mexico and withdraw cash from ATM machines.
  3. Everledger, a London startup, provides a “fingerprint” service for large diamonds, recording a stone’s characteristics on the blockchain all the way from the mine to the final purchaser.
  4. Factom in Austin, Texas is constructing a land title registry in Honduras so that homeowners can defend their property from unlawful seizures.
  5. Earthport, a London startup, and Ripple Labs, a San Francisco startup, have launched an international payments network based on a private blockchain.

Other organizations, both new and existing, are hard at work developing various capabilities. These include:

  1. Digital Asset Holdings, a firm created by Blythe Masters, is developing a distributed ledger to handle the settlement of pooled corporate debt. It is also developing a system to record and settle short-term government bond trades.
  2. Nasdaq is developing a system based on blockchain for trading shares in closely held concerns.
  3. Chain, a San Francisco startup, is offering software tools for developers to build apps to transmit almost anything on a blockchain ledger, even including airline miles and other loyalty points.

Prospects for the future

The financial industry is already reeling from the introduction of new technologies, and those organizations that have been slow to adopt these technologies have, in many cases, been left behind. One example, now about 20 years in the past, is Internet-based security trading for consumers. Another example is low-cost index funds, typically operated by computer programs with almost no overhead so that they can operate with fees as low as 0.05% per year. These funds are now available not only from Vanguard and Blackrock, but also, although in some cases belatedly, from major brokerages. Actively managed funds are, in many cases, reeling from the competition, even though many analysts agree that some actively managed investments, based on fundamentals, are essential for the proper functioning of markets.

Another example of the financial industry being slow to adjust is the hedge fund industry, which is at a loss as to how to manage in their miserable new world, not only competing with low-cost index funds, but also with other hedge funds and similar organizations who have embraced modern quantitative finance methods. Some firms who delayed their move into the quantitative finance arena are now struggling to catch up.

Is history repeating itself with blockchain technology?

A May 2016 Harvard Business Review article described numerous potential applications, both in finance but also in other sectors of the economy. The music industry, for example, could be transformed by “smart contracts,” which permit artists to sell directly to consumers without going through a label. Blockchain-based payment systems may run without banks, credit card companies or other intermediaries. Similarly, blockchain-based schemes could transform the manufacturing world, as intellectual property for almost any product could be more securely protected and appropriate fees exchanged.

In short, it really does appear that blockchain technology is poised to make major inroads into the financial industry. Time will tell who will be the most successful in this brave new world.

[Added 23 Oct 2016: A Bloomberg News article describes an “experiment” by the Commonwealth Bank of Australia, Wells Fargo Bank and Brighann Cotton to process a large shipment of cotton, including payment and transfer of ownership, all through a blockchain-based contract.]

Comments are closed.