Whether disruptive or delightfully progressive, blockchain is a force of nature that’s growing fast, and attracting the attention of the powers that be...
Some call it a revolutionary, come to transform financial technology for ever more, some call it a troublesome disruptor, and others tip it merely as a passing fad, bringing interesting theories, but ultimately unable to make the monumental changes that it promises. It is, of course, distributed ledger technology, or, going by its street name, the much-discussed, much-revered and still little-understood blockchain.
For all the excitement and glamour around the technology, which promises real-time totally transparent information sharing, there are still many unknowns.
Questions around security, reliability and scalability raise their heads again and again, and how it will, or can, be regulated is a perpetual question that regulators, law makers and industry participants—big or small—are yet to answer.
Trevor Belstead, partner and head of transaction banking at Delta Capita, notes that with big game-changing ideas, there are always hurdles to overcome, “especially for something as radical as blockchain, which seeks to transform various established business models from trading to settlement”.
For some firms, Belstead says, business models will be turned upside-down, challenging ability to create value in long-standing business and deliver profit to shareholders—the very things they rely on for survival.
Now, banks should really be re-evaluating these business models and architectures, starting to reduce the complexity therein.
He says: “Companies need to effectively address today’s challenges in order for investors to reap the rewards in the future.”
Saket Sharma, chief information officer for treasury services technology at BNY Mellon, notes that, while the technology is promising, blockchain is not a viable solution for financial services just yet.
He says: “Interoperability will be crucial for successful adoption and that poses a challenge today because the technology is still fluid and standards have yet to evolve. Also, risk and regulatory frameworks need to evolve.”
Start-up fintech provider RISE, however, offers blockchain solutions focused on securities safekeeping and settlement. CEO Thorsten Peisl suggests that for blockchain to live up to its hype, the technology has to be re-imagined and re-designed, so that its attributes are matched to the particular needs of the post-trade space.
The RISE solution focuses on decentralised ledger qualities and permissioned transparency, allowing investors complete sight and control of their own assets, but not of the assets of other participants.
Peisl explains: “It enables issuers to have a view but no control into final beneficiaries; financial institutions—ledger operators or validators—to have access to client information; and regulators to have a complete view of the information in their jurisdiction in real-time but no direct control over the assets.”
In this way, he says, “investors can continue to put trust in regulated institutions to provide settlement with better functionality, transparency and risk management”.
However, there are also security concerns remaining. Jeremy Taylor, strategy owner for capital markets at GFT, points out that making sure records are secure and tamper-proof is “paramount”.
“Any security breach would seriously undermine confidence in the whole blockchain approach,” he says, adding: “These challenges must be solved before blockchain is economically viable.”
Better together
Taylor also notes that the very nature of distributed ledger technology poses a challenge. He says: “As it is based in a distributed architecture where consensus is achieved by majority, this makes it difficult reaching a common agreement to use the technology in a public network.”
Although the theory behind crypto currency has been around for about 20 years or more, and digital currencies like bitcoin have been on the scene since as early as 2008, using blockchain itself in mainstream financial services is still a relatively infant idea, but one that is developing extremely quickly. Addressing the “nascent state” of distributed ledger technology, Mark Wetjen, managing director for global public policy at the Depository Trust & Clearing Corporation (DTCC), suggests that a lack of existing industry standards and best-practice standards could be to the technology’s detriment, despite the potential for transformation.
Wetjen says blockchain’s youthful nature “could create an environment where solutions are developed and delivered in silos, creating the same inefficiencies and disjointed framework that exists today”.
Despite industry collaboration through the likes of R3’s blockchain consortium, which has more than 40 participant banks, institutions are running their own tests and experiments. This could eventually lead to distributed ledger silos, creating even more fragmentation in the market, rather than the opposite, and the desired, effect.
“The current state of the technology is immature,” Wetjen says. “It has inherent scale limitations and it lacks the necessary underlying infrastructure to efficiently integrate it into existing financial market infrastructures and processes.”
He adds: “Without consistent standards or an otherwise efficient means of network interoperability, the continued creation of individual, private blockchain solutions could increase the fragmentation that exists across financial market processes today.”
That said, if developed properly in a collaborative manner, blockchain potentially has the power to improve the stability of the financial markets as a whole.
With regards to securities settlement, Peisl argues that blockchain can bolster resilience in the global financial system “by removing certain central points of failure”.
Pointing to past failings in the industry, he suggests: “Some of the losses experienced by investors in recent cases have mainly been a result of the inefficiencies in the process of proving claims to assets which delay insolvency resolution.”
Belstead, however, warns that blockchain technology could potentially threaten financial stability, albeit only if banks fail to address some of the challenges in the market today. According to Belstead, banks must address the way they tackle operational risks and failures, and how they will continue to in the future.
“It is clear that there is a lot of complicated groundwork, planning and adjustment to be done before this particular silver bullet can be fired.”
Regulation games
For better or for worse, blockchain is catching the attention of the regulators. The UK’s Financial Conduct Authority (FCA) has launched its Innovation Hub, a dedicated space for start-ups to test and develop products using blockchain and other innovative solutions, while the European Securities and Markets Authority has called for contribution on how it should approach regulating the new technology, outlining concerns and inviting comments from industry participants on what would help them manage emerging technologies.
Peisl notes: “Global regulators are keen to understand how this technology can be best applied for the benefit of all, and are very open to working with the industry.”
Similarly, Taylor praises the FCA’s efforts—the Innovation Hub is in place to spot and address any regulatory issues that may arise during blockchain testing and development. He notes that regulators should be aware of technology developments in the market and be on hand to provide a framework that supports innovation. In fact, to do so would make life easier for the regulators in the long run, too.
Taylor says: “The technology can simplify processes in banks, and regulators could have much more real-time and transparent information.”
In the same way, regulators can also play a role in the consortium discussions and experiments. As Sharma says: “They are key stakeholders in any potential industry blockchain-based solution.”
He adds: “The regulators play an important role in making sure that the proper rules are being considered as we look at solutions.”
The role of the regulatory authority here, however, is not quite a clear-cut as in other areas of the industry. Belstead suggests that actually, in blockchain, the regulator’s place is as of yet undefined. Financial institutions should address the existing legal and contractual frameworks around their use of the technology before regulators get involved at all, he says, asking: “Where does the trust really reside in these platforms? Who owns a platform and the data?”
“All that is even before considering aspects of security, identity or cost, revenue and return-on-investment models.”
The industry seems to be in a state of limbo, undecided whether regulations should be adapted to work with new technologies, or whether new technologies should be moulded to fit with existing regulation. While Peisl argues that regulatory change is probably not necessary, and that the existing frameworks can be used to introduce distributed ledger systems, he adds that regulators should perhaps embrace the tech, so that “more industry-wide benefits can be achieved”.
Taylor says: “The current fintech regulatory environment is somewhat of a grey area that needs to be addressed. Fintechs that are hoping to use blockchain to provide services to compete with banks will need to comply with current regulations. This is an area under close scrutiny by the regulators.”
He reiterates that blockchain has the potential to completely re-hash the market landscape, leading to the creation of new roles in the system and new types of participants.
“Regulators will need to stay abreast of developments and ensure that investors, and the wider economy, are protected.”
Wetjen, however, suggests that, at least in the institutional, non-retail space that DTCC operates in, regulators are likely to expect blockchain technology users to demonstrate how their solutions fit within the current regulatory framework. The objectives of the regulations remain the same, he says, and so it is likely that the framework as a whole will remain as well.
“Existing frameworks reflect key policy objectives that have been formed over decades of market activity, such as systemic risk mitigation, improving transparency, reducing fraud and manipulation, and investor protection,” he says.
“These objectives are nearly universal and have been effectuated by the current rules. It is very likely that global regulators will want to ensure that these key objectives continue to be realised, regardless of what technology is being used by market participants.”
It is possible, Wetjen says, that current regulation could become “inapplicable”, because of the changes in use of technology, in which case, updates could be on the cards. However, despite this, key policy objectives are likely to remain set in stone.
Help or hindrance?
Wetjen’s view of the regulatory objectives could be considered fairly rigid, therefore making it more difficult for blockchain technologies and solutions to grow, develop and thrive. However, Peisl suggests that the opposite is the case.
“On the contrary,” he says, “regulators are excited about the opportunities DLT could create. The technology’s ability to provide transparency and self-enforcement of regulation in a way that was not possible before is proving particularly interesting.”
Proactive regulation could encourage developments, providing support for start-ups and established institutions alike. Taylor argues, in fact, that actually neither party really poses any particular threat to the other.
He says: “If the distributed ledger technology simplifies the lives of all stakeholders, the regulation and the technology will find their way.”
Sharma even goes a step further, saying that, especially in this business, regulatory considerations can act as a springboard for new innovation. He says: “Regulatory compliance is a critical component of any technology solution in the financial services industry, and always has been.”
“While it may present an additional layer of challenges that other industries don’t face, it’s an important part of our business.”
And this innovation is set to continue. Where blockchain has sprung into the forefront of the industry’s collective agenda, there is no knowing what could be the next topic of debate, the next mind-boggling innovation and the next big thing to get regulators in a tizz.
Although for Belstead, “it is hard to look beyond blockchain”, which may be “the ultimate goal for a common platform”, Sharma looks towards a future of “multiple emerging technologies,” particularly focusing on “the internet of things, machine learning and robotics”.
Peisl and Taylor, however, see blockchain as a stepping stone to a bigger technology future. In the modern world, high quality, scalable and resilient technology is widely available, and relatively affordable. This means new business models are emerging. And fast.
Peisl says: “The new blockchain will transform securities settlement by combining the best of traditional database technology, such as performance and data privacy, with key benefits associated with de-centralised ledgers such as resilience, data integrity, or immutability.”
Considering the emergence of the ‘sharing economy’, ever-improving artificial intelligence and machine learning, and the effects this has on predictive analytics, Taylor suggests: “The concept of distributed ledger is another step towards a wider democratisation of technology.”
He says: “The winners will be those who can leverage this cocktail of new business models and advanced technologies to help our society in evolving and sorting out the challenges and needs we have.”
