Blockchain – Where Hype Meets Potential Magic: Opinion

Blockchain, the technology behind Bitcoin and other digital currencies, isn’t quite as novel or omnipotent as many have advertised it to be. That doesn’t mean, however, that it can’t do wonders in the world of finance.

The World Economic Forum recently published a report on how blockchain will reshape financial services — that is, how to apply 1970s technology (more on this later) to problems that have existed since the 1980s. It covers everything from global payments to insurance claims to proxy voting to contingent convertible bonds — is there anything in the financial industry that isn’t broken? Were you guys seriously not planning to do anything about it until a blockchain came along?

The 130-page report reminds me of those old Coca-Cola ads that promised to cure everything from headaches to exhaustion. The ads worked because nobody really knew what was in a Coke bottle. Similarly, the term “blockchain” has been so misappropriated that no one knows what it means anymore.

The technological innovation of a blockchain is that it combines cryptographic signatures with a fault-tolerant distributed database. This combination allows multiple parties to enter information — say, about money transfers or securities trades — securely and with certainty that every other participant has that same information.

Distributed databases and cryptographic signatures have both been around since the 1970s. For decades, the two fields of computer science had little cause for interaction, as they existed to solve very different problems. The technologies finally became conjoined when people wanted to create a registry of asset ownership without relying on a governing body to approve that ownership.

Why are financial institutions so excited about a shared registry of asset ownership? While the WEF report contains a lot of ridiculous applications, this is a legitimate one:

Clearing and settlement of trades — that is, making sure the cash and assets involved in the deals actually get to their new owners — is difficult because records are distributed across thousands of different institutions, each of which maintains its own accounts in its own unique format. Multiple players must somehow come to agreement on who owns what and who owes what to whom — a reconciliation process that requires a lot of time, money and human involvement.

A blockchain is essentially a shared ledger, to which each player contributes and of which each maintains an identical copy. The cryptographic process of entering and verifying new information automatically reconciles all the copies. As a result, everyone always knows who owns what. There’s no need to go back and check everyone’s records against one another.

R3 is a consortium of big financial institutions that got together to work on ways blockchain technology can be used in markets. They soon discovered that they don’t really want a blockchain at all: No big bank wants to share its ledger, because having more information than the other guy is an important competitive advantage.

The consortium’s solution is a sort of distributed ledger in which everyone maintains their own private records, just as they do now. They then selectively share information on a need-to-know basis, such as when engaging in transactions — again, just as they do now. A third-party “uniqueness” service ensures that no one is lying.

What’s new is that each transaction comes with attached code (a “smart contract”) containing standardized rules about how to decide whether it is valid. The parties download and independently run the code to verify the transaction. This is cheaper and faster than traditional reconciliation, because it eliminates the need for a bunch of back-office employees at each separate institution to reconcile transactions using their own unique sets of rules and data fields.

Brilliant. Why didn’t they think of this sooner? The explanation can be found in R3’s recent white paper:

What makes this vision possible today is that the recent popular interest in distributed ledger and blockchain systems has created an environment in which such a vision can be openly discussed and that a collaborative alliance through which multiple financial institutions can act together has been formed.

In other words, the only thing previously stopping the standardization of reconciliation processes was the unwillingness of financial institutions to collaborate. Financial institutions spend $65-80 billion on back office reconciliation every year. The employees working in back offices probably offered lots of excellent reasons why their roles couldn’t simply be standardized away.

Many regional banks don’t have access to a global clearing network. They rely on bigger correspondent banks for clearing and settlement. When these smaller banks threatened to use a blockchain as a channel to global financial inclusion, the world’s biggest financial institutions formed a collaborative alliance to defend their territory.

Standardization of rules and data fields is a good idea that could save billions of dollars in back-office reconciliation costs. Maybe one of the biggest effects of all the blockchain hype will be getting a bunch of security-conscious egoists to come to an agreement that benefits them all. That would truly be magical.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.