Blockchain’s Growing Role in Financial Services

By Helen Thompson for SWIFT Institute,

In this article, Thompson examines how financial services firms might benefit from blockchain technology and some pitfalls they need to avoid as they move towards adoption.

Much has been made of the blockchain, the name given to the underlying technology of the digital currency bitcoin, but these systems are not as novel as some believe.

Having built a shared distributed ledger system 20 years ago, professor Michael Mainelli, co-founder and chairman of the commercial think-tank Z/Yen and emeritus professor of commerce at Gresham College, London, can attest that this technology is most definitely not new.

Yet banks, discovering the existence of blockchain through bitcoin, have only recently started to realise the possibilities such technology can provide.

Mainelli contends that two concurrent developments have been occurring.

Firstly, people have been coming to the realisation that there could be a multitude of ledgers responsible for a multitude of purposes, potentially in the several billions, due to the expected growth of the Internet of Things.

Secondly, companies in the financial services industry have begun to grasp the fact that these systems are relatively easy to build, meaning that banks could construct a shared distributed ledger themselves thereby doing away with the role of a trusted third party.

“Banks are on the cusp of change, but sadly what is driving them into this space is fear,” Mainelli pointed out.

Leda Glyptis, newly appointed director at business and technology marketing and consulting company Sapient, based in London, agreed.

“In the past year we have seen the industry move from panic and disbelief to realisation that the technology is real and very powerful,” she said.

Adjustments, however, need to be made to the original bitcoin code in order to make it work for applications in the financial services industry. It is not likely, for example, that banks would share information on a public blockchain. The assumption is rather that they would exist as gated communities.

Glyptis pointed out that while established industry players are now much more comfortable in exploring the possibilities of blockchain, a short-term problem remains in the expense of running parallel infrastructures.

Banks, eager to stay competitive, need to further explore where the line between the technology’s utility (and its associated economies of scale) and its business value might lie.

Standardisation

Industry consortiums are beginning to provide thought leadership on the topic, nevertheless, there will be limitations as to what can be achieved. In order to build a shared ledger, one has to share – which makes for cautious conversations.

Mainelli commented that whilst 30 banks had signed up to a recent, well-publicised cross-industry initiative, they had yet to decide upon any firm use cases.

Glyptis noted that an agreement over a common architecture was “not nothing” and she feels it is right to have API standards driven by practitioners.

She said, however, that whilst standards are important, functionality of the system as a whole should first be determined before the drafting of specifications.

‘Trust spectrum’

Is the blockchain limited to certain types of financial services transactions?

Glyptis explained that we simply do not know all the different variations that a blockchain system could be used for, but warned that it is critical the industry should not cut corners when thinking through what future configurations might be needed.

“We need to minimise technical debt, meaning we need to ensure that our chosen stack is not limited in terms of capabilities,” she said. “Some blockchain companies have gone down the route of designing capabilities to suit functions of today, but I feel that this approach would limit our imagination in terms of what we could eventually do.”

Mainelli explained the best way to approach the issue is by imagining a spectrum of trust with the left-hand side designated as ‘low trust’ and the right-hand side as ‘high trust’.

On the extreme left would sit a structure built on very low trust and open membership – representing bitcoin or Ripple. Other examples at this left-hand end of the spectrum include the open public-facing blockchain system, Ethereum. The project is currently trying to build in smart contracts and faster transaction times, however, this has proven expensive to maintain.

In high-trust environments, on the right end of the spectrum, players have historically gone to a central counterparty or exchange, which typically charge high fees for either membership or associated market data.

With the introduction of blockchain technology, however, no one body would own the data – rather it would be collectively owned, thereby reducing the potentially monopolistic position of a central counterparty.

“So in answer to the question about the types of non-payment transactions that are suited to mutual distributed ledgers, it is most of them within regulated financial services,” said Mainelli. “For almost all non-payment transactions, eg: time-stamping, regulatory reporting, standing data updates, proof-of-identity, or even asset transfer (with payments separate), tokens are not needed.

He added:

“Once you remove the tokens or coins, you realise there are enormous varieties of shared distributed ledgers. Without tokens, some of our ledgers can handle a billion transactions per day.”

A tokenless future

Mainelli believes that the role of shared distributed ledger systems in financial services would be quite different to that provided by a cryptocurrency system.

He outlined the possible options for designing a blockchain system; for example, whether the system should (1) be open for reading or closed, (2) have permissioned or permissionless participants, (3) represent a fully or mildly distributed ledger, or (4) have a wide choice of validation mechanisms.

It is expected that the financial services industry would for the most part decide upon a closed, permissioned system – one that would exist within a regulated market with an identifiable regulator who would determine which players would be allowed to operate within that community.

Once these options were chosen, the idea of producing a proof-of-work validation mechanism – the equivalent of a cryptocoin (eg: a token) – would seem a bit redundant.

Participants would also have further options to consider; for example, the setup of a single party system with the regulator effectively becoming the master node, or the establishment of identity systems and voting mechanisms.

Each shared distributed ledger could be set up with individual specifications, but it is clear that systems without a validation mechanism would be much cheaper to run because they would be based on simpler rules.

“I don’t see why you would want to have this huge overhead if it’s not adding value,” Mainelli said.

Furthermore, the role of a trusted third party would fundamentally change. While, from the outside, the system would appear to be accessed in a similar fashion to that of a central database, the data would actually be retrieved from completely different servers because the system would be technically decentralised.

The central party would therefore lose its control of the functions of storing data (preserve) and prevention of double selling (safeguard), but it would still maintain a role in validating transactions. It would follow that the regulatory role of a third party would remain intact, though the commercial element of selling market data would likely disappear.

“Trusted third parties are having to think about the relative benefits of what they do; validate, safeguard, preserve,” maintained Mainelli. “It is similar to a central phone system moving onto a Skype platform.”

He went on to say: “The weight shifts from providing cable to building a community to chat with.”

This means a certain party would still need to hold responsibility for access to the community and would also need to verify the transactions on the ledger. As a result, identity services rise in importance.

A trusted third party would be able to do this much more cheaply and quickly using a shared distributed ledger system than they have been able to in the past, he said.

Fifty-one percent

One aberration in the structure of the bitcoin blockchain is that, if one player were to gain over 51% of the computing power used to verify transactions, it would then have the ability to add on new, potentially invalid transactions. A disincentive, however, has been built into the system, because it is extremely costly to obtain this amount of computing power.

Yet if the validation mechanism were to be removed as advocated by Professor Mainelli, what would then prevent manipulation of the system?

Mainelli commented that, whilst the technology took away the ability to alter a historic transaction, risks still exist. A trusted third party would still be needed in order to maintain the integrity of the community in terms of preventing false new entries.

Glyptis believes that it would be naive to assume that any system would be impervious to meddling. A blockchain system would be much harder to tamper with because it minimises the amount of time settlements would remain in limbo.

“Once the design of the system would be more or less established, you could then build your security, assumptions, tests and harnesses around it,” she explained. “This process is part of discovery. It is something we have not done in this industry for a very long time.”

Not a blockchain provider

Looking forward, the development of blockchain technologies represents an opportunity for greater efficiency, transparency and democratisation. Reconciliation would become a thing of the past and regulatory transparency would be remarkably improved.

Mainelli is of the opinion that overall the banks would not do too badly from a switchover to blockchain systems, because they could still provide the valuable trusted third party role.

Glyptis foresees the iteration of this maturity in that FinTech start-ups providing niche services to incumbents would no longer define themselves as blockchain providers, rather they would simply be leveraging the best-of-breed distributed ledger technology for functionality.

She speculated that this could prove to be the future tipping point for the large banks – when they realise that most of their technology providers have already moved to a distributed ledger capability, they might as well convert the rest of their systems.

Glyptis concluded:

“We are embarking on this journey because it has captured our imaginations. It is something that can change the way we live and it can actually bring the exchange of value back into the real world [in a way] that we have not had in over a century.”

This article was first published on 10th February by the SWIFT Institute. It is republished here with the author’s permission.