The blockchain revolution in banking and trading
The time it takes to settle a trade with blockchain could be slashed from days to a matter of minutes.
A change is coming to financial services that its proponents compare to the introduction of the internet: its effects will be dramatic, but it’s hard to see all its potential yet.
The change is the introduction of blockchain, or distributed ledger, technology, which could have broad impacts across banking and trading for both individuals and institutions.
For private investors, the technology could allow for cheaper share trading and faster settlement. It could also help provide confidence to market participants in times of stress and allow more issuance of stock, particularly from smaller companies.
Blockchain technology is best known for its role underpinning digital currency bitcoin, but its uses are much wider.
The technology allows all participants in a network to agree that each transaction has taken place and to keep a record of all transactions, rather than leaving the record-keeping to a central authority.
Equity trading currently requires a settlement process involving post-trade clearing houses that exchange cash for shares and keep a register of ownership changes. These intermediaries can help give investors confidence that they will get their assets from the unknown party they are trading with.
But the current settlement process is less efficient than an exchange on the distributed ledger could be, according to Judd Bagley, director of communications at Nasdaq-listed Overstock.
The online retailer last year launched two bond offers using the distributed ledger and is working on issuing shares using the technology.
“When that process is moved to that venue (on the blockchain) the whole process takes about 10 minutes and costs about 80-90 per cent less than otherwise,” Mr Bagley told The Australian. “And that’s really because you’re taking so many intermediaries out of the process.”
The Nasdaq was also involved in a transaction where unlisted blockchain developer Chain.com issued its own shares to a private investor using the distributed ledger.
Research into blockchain’s possibilities has been widespread across the financial services industry. Ron Quaranta, chairman of the Wall Street Blockchain Alliance, points to another blockchain pilot program focused on syndicated loans — loans between corporations that are securitised and traded in a “very inefficient” process that involved in the order of 25 million faxes last year.
“I’ve often called 2016 the pilot year and I would suspect as we enter 2017 we’ll start to see these pilots go into production,” says Quaranta, who is also the chief operating officer of Loyyal, a blockchain start-up focused on loyalty and rewards points.
“I have the privilege of speaking to executives at banks and broker dealers. Almost all of them have some proof of concept in the works or have teams focused on how will blockchain change the work of what they do in banking, payments or trading equities.”
A report by the World Economic Forum this month shows the depth of interest from the financial services community. At least 24 countries are currently investing in distributed ledger technology, with venture capital investments passing $US1.4 billion ($1.85bn) in the past three years. Some 80 per cent of banks are tipped to initiate distributed ledger projects by 2017.
The US is host to several start-ups in this space, but interest is global. “It’s likely you’ll see a quicker path to adoption in smaller economies,” says Canada-based Matthew Spoke, founder and chief executive at blockchain start-up Nuco. He compares this to communication technology: “A large part of the African continent skipped over the need for landline telephones and went straight to mobile.”
The ASX has also made well-documented effort in this area, working with New York-based Digital Asset Holdings on a prototype of a distributed ledger clearing and settlement system.
Before the technology could be widely adopted, regulators would need approve its use. The industry is also working on increasing the volume of transactions per second that the technology can handle, which is not yet high enough for public equity markets.
Security is also front of mind. Although the distributed ledger offers a key advantage over centralised record-keeping — one participant can’t tamper with the record of transactions because every participant holds this record — there are still questions about how to prevent theft. High-profile cases such as the theft of about $US72 million worth of bitcoins from a Hong Kong exchange this month raise fears about safety.
Although experts are reluctant to predict a date for its widespread adoption, the introduction of blockchain technology to settle equity trades, or to create and exchange new securities, would have clear implications for private investors. Given the potential to reduce costs, the technology’s advocates expect the fees for buying and selling stock to be dramatically reduced.
The time it takes to settle a trade could also be slashed from days to a matter of minutes. Not only would faster settlement mean investors would have access to their cash more quickly after selling shares, it could also make a difference in times of market stress.
Overstock’s Bagley points out that during the GFC, institutions were hesitant to do business with Lehman Brothers and Bear Stearns because they worried those banks might not be solvent in three days when the trades settled. “It (blockchain technology) would make institutions at least more willing to engage in the kind of liquidity generating trades that are generally considered to be healthy for markets,” he said.
The technology could also allow for alternative securities trading venues where shares in pre-IPO companies could be traded. This could allow investors to take stakes in smaller or earlier stage companies, and to access more investment opportunities.
If and when blockchain technology becomes commonplace, it could reduce current inefficiencies in a way Bagley described in graphic terms at a New York conference this month:
“The simplest solution is to take Wall Street behind the barn and kill it with an axe.”
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