17 November 2015
Will blockchain change the financial services industry?
You know what the blockchain is, I’m sure. It is the new kind of database that is going to change everything. Or something like that. It’s a form of decentralised replicated shared ledger. Well, along those lines. It’s an immutable record of all of the transactions that have taken place in a particular market. Generally speaking. And it’s going to disrupt money. Or financial services. Or everything, which is why banks need to be thinking about it. When they’ve worked out what “it” is, of course.
So the blockchain is the future of banking, except that the blockchain does not solve any problem that any bank actually has.
Yes, that’s right. The blockchain does not solve any real bank problem. To understand why I can make this sweeping claim, and to understand why some of the world’s biggest banks have just formed a consortium to explore it despite this — “Blockchain initiative backed by nine large investment banks”, Financial Times (15th September 2015) — you need to step back a little.
The blockchain is just one kind of "shared ledger". A shared ledger is a view of the current state of a community, and all of the transactions that led to that current state. Since it is held by a community, there must be a mechanism for determining which versions are true. This is called a consensus mechanism and it varies according to the type of ledger. So for now, let’s just say that advances in networks and storage mean that it’s become possible for all market participants to be able to store everything and to resolve, in a reasonable time, discrepancies between the different copies.
I have to say, by the way, that I do believe the general claim that the use of shared ledgers is going to change the financial services industry. I think that’s true and I'll come back to why later on. But will the blockchain change the financial services industry? That’s a very different question.
Over the last couple of months the blockchain has been all over newspapers, magazines and web sites. To save you the trouble of having to read too many of these articles let me take you through a typical one. A recent edition of Bloomberg Markets Magazine had a front cover featuring the noted investment banker Blythe Masters over a headline that said that the blockchain will change everything. This is what bank CEOs see. The blockchain will change everything. If you read the article however, you will note that Blythe does not talk about the blockchain (in other words, the public blockchain that is used to implement Bitcoin) but private blockchains. So the headline talks about the blockchain but the article is about a blockchain, and the distinction is far from semantic. What’s more, if you read to the end of that Bloomberg article, you will discover that Blythe’s company (Digital Asset Holdings), as one of its first actions, acquired Hyperledger which is a company that delivers a kind of shared ledger that is not a blockchain.
Time for some clear thinking. Is the shared ledger really a revolutionary new way of doing business? Or is this whole thing just some technology hype that will blow over? And if it isn’t going to blow over, is it really going to replace / devastate / make redundant (* delete where applicable) the existing legacy infrastructure of “the man” (such as SWIFT, VocaLink and Western Union)? And if the shared ledger is going to do so, then will we implement it using private or public ledgers? And if we implement it using public ledgers will we use the kind of blockchain that Bitcoin uses? The key design requirement for that blockchain is uncensorable value transfer in the presence of untrusted market participants, which is a problem that banks do not have (hence why they will not use it).
So why will banks bother at all? Shared ledgers, whether of the Bitcoin blockchain type or not, provide three advantages over conventional centralised database ledgers.
First, they are more robust. If your copy of the ledger vanishes because a cleaner pulled out the plug on your bit of the cloud then you can just copy someone else’s ledger or go to a recent back-up and rely on the fact that the ledgers will synchronise using the consensus mechanism. And each bank can have its own interfaces between its legacy systems and its version of the ledger and it can develop APIs to open up ledger functionality throughout the organisation. And if someone makes a mistake or does something wrong, then they can’t corrupt the shared ledger.
Second, a shared ledger provides for transparency. One of the great problems of the financial system and a major contribution to the last crisis is the lack of transparency in markets. The “ambient accountability” of a ledger shared not only with market participants but also with regulators brings significant benefits beyond cost saving.
Third, and most important, they can be platforms for innovation. There are a great many people, and I am one of them, who think that while the robustness and transparency that might be expected in a shared ledger environment are all very interesting, they are not in themselves revolutionary because they provide a better way of doing things that we already do. The fact that shared ledger technology can be used to share code as well as data is, however, another thing entirely. And here is where I think some of the techno-utopians might be right: the world of "smart contracts" is a different world, a world with a new level of automation, a new way of working in the shared ledger paradigm that will deliver new operational efficiencies, new markets and new institutions.
Does the adoption of shared ledger technology mean that the position of incumbents such as VocaLink is under threat? Well, it would be crazy for the incumbents to ignore such a promising new technology that offers potential benefits not only to them but to all market participants, including the regulators. Therefore it makes sense to take an active role in shaping industry developments, experiments, prototypes and trials. If the benefits of the shared ledger are real then VocaLink is in an excellent position to turn the new technology into a big "win win" for the sector.