Arjun Jayaram, Founder & CEO, Baton Systems
It has been no secret that banks are thoroughly testing blockchain applications and some have even begun to apply the technology to key business ventures. However, while most would agree that innovation is pivotal to global banking’s evolution, the last few years of “blockchain fever” have been clouded with minimal results.
Most of the high visibility initiatives including the ones with large central banks and exchanges have fallen short. Firms are spending ample time to get a deep understanding of the problems and scale needed in payments and reconciliation for capital markets. Experimentation with blockchains is being conducted and it’s fair to say that blockchain technology is providing inspiration. However, while not all solutions are built on the existing blockchain codebase, there is a way to leverage distributed ledger technology to solve some of these problems.
Financial institutions have been burdened with four factors that have acted as, for lack of a better term, a blockade, in the race to solve the blockchain - participation, privacy, scale and interoperability. Until these issues are addressed, banks will need to find alternative solutions for efficient and high-speed payments between counterparties.
Many experiments on the blockchain, including some prominent ones, are unlikely to move beyond a proof-of-concept stage because it lacks these core tenets. Let us look at why this is important for any solution that will meet the needs of capital markets.
Participation: Blockchain solutions today are akin to a closed-loop network. You can only do business with members in that loop; so unless your counterparty is on the same blockchain, it is very hard to conduct business with them.
Privacy: This is where the blockchain in bitcoin was truly a breakthrough, where anonymous entities could transact and the data was tamper resistant. However, what worked for the bitcoin blockchain does not work for capital markets. Pseudo anonymity works when you have millions of nodes; not when you have twenty nodes.
Scale: The bitcoin blockchain scales very well with the number of participant nodes. But it never boasted fast transaction commits. Capital markets need infrastructure that can handle a billion events a day. This is where the enterprise blockchains fall really short, and an area where many companies are researching and contributing to increase transaction scale.
Interoperability: Any new technology that does not interoperate with existing legacy systems is going to find it very hard to survive. ISO20022, FIXML and others are standards that have continued to gain adoption. It is important for blockchain developers to consider this as well.
Blockchains – whether public or private (“permissioned”) networks – require a critical mass of participants to be effective. If only a few institutions participate in a blockchain network, transacting with non-network institutions will require maintaining two systems and harmonizing their datasets, which causes a heightened level of fragmentation. This, in turn, also increases the level of operational risk. Despite anonymity of the actual parties when on the blockchain, financial firms require confidentiality in the amounts, timing and other details - such as the currency type - of transactions for the protection of their own business dealings and their competitive strategies.
While the initial concept of blockchains may sound enticing to some, there are very few banking and finance executives that would be comfortable allowing their post-trade settlement functions to be divulged over a decentralized platform that hosts takeout ordering services or experiencing tumultuous governance. Not to mention that even the most mature blockchains, which are almost all public networks, require a radical overhaul to banks’ internal standards for data privacy and sharing - additional processes that require abundant time and money.
These privacy and information security concerns have challenged regulators to plot a multi-year course for a technology that at its core relies on active disruption, innovation and experimentation. Regulators’ plodding, methodical course often draws the ire of frustrated start-ups and institutions that want to move their technology out of the lab and into a live environment. But policy requires shrewd, calculated maneuvering to ensure that when banks do transition their enterprises to a blockchain, investors and stakeholders will not be rashly exposed to these operational hazards.
What’s the immediate solution?
A shared, permissioned ledger that works with the existing rails of financial services is the optimal route while the battle of the blockchains is fought and victors are crowned. It is also unlikely that there will be only one blockchain that will win these battles. It is likely that we will see variants of blockchain for different purposes, which is another reason why standards and interoperability are important.
In the meanwhile, without the luxury of the expansive balance sheets and stores of operational resources of days gone by, institutions can’t afford to wait for the prophetic revolution to post-trade processing.
There has been a lot of discussion around digital assets and how they are going to revolutionise and speed up payments. By digging a little deeper, you’ll find that this hypothesis is a fallacy. Most assets today in a bank or a central security depository (like the DTCC) are already digital. Settlement at the Fed is also digital, and the dollar is mostly digital. The problem or slowness in payments has not been due to the lack of digitized assets. Rather it is because of the orchestration across heterogeneous systems over which to move those digital assets.
Seamlessly recording the movement of money and assets, from issuance to settlement, isn’t a pipedream that is years away from now. In fact, it’s already here.