The blockchain in finance: Hype springs eternal

By the Economist

NORMALLY, it is Simon Taylor’s job to persuade sceptical colleagues at Barclays that rapid technological change will disrupt the bank’s business.

So it comes as something of a surprise to have to dampen the excitement about the blockchain. “It’s quite silly. I get ten invitations to speak at a conference every day,” he says. “The technology will have real impact, but it will take time.”

The blockchain is the technology underpinning bitcoin, a digital currency with a chequered history. It is an example of a “distributed ledger”: in essence, a database that is maintained not by a single actor, such as a bank, but collaboratively by a number of participants. Their respective computers regularly agree on how to update the database using a “consensus mechanism”, after which the modifications they have settled on are rendered unchangeable with the help of complex cryptography. Once information has been immortalised in this way, it can be used as proof of ownership. The blockchain can also serve as the underpinning for “smart contracts”—programs that automatically execute the promises embedded in a bond, for instance.

It is easy to see why bankers get excited about distributed ledgers. Instead of having to keep track of their assets in separate databases, as financial firms do now, they can share just one. Trades can be settled almost instantly, without the need for lots of intermediaries. As a result, less capital is tied up during a transaction, reducing risk. Such ledgers also make it easier to comply with anti-money-laundering and other regulations, since they provide a record of all past transactions (which is why regulators are so keen on them—see article).

Besides, embracing the technology allows big banks to appear innovative. For the most breathless evangelists, it holds out the prospect of liberation from all the dross that has accumulated in the financial system, from incompatible IT systems to expensive intermediaries. “For many, the blockchain is the Messiah,” says Gideon Greenspan, the founder of Coin Sciences, a blockchain startup based in Israel.

Yet the path to the promised land won’t be an easy one. One stumbling block is what geeks call “scalability”: today’s distributed ledgers cannot handle huge numbers of transactions. Another is confidentiality: encryption techniques that allow distributed ledgers to work while keeping trading patterns, say, private are only now being developed.

Such technical hurdles can be overcome only with a high degree of co-operation between all involved. But this is not a given in the highly competitive world of finance. Some efforts are already under way. More than 40 banks now have a stake in R3 CEV, a startup meant to come up with shared standards. Similarly, firms including IBM and Digital Asset Holdings have started the Open Ledger Project to develop open-source blockchain software.

The Open Ledger Project may have trouble combining the bits of code its members contribute. Such problems will slow adoption, notes Tolga Oguz of McKinsey, a consultancy. Moreover, most projects are still “proofs of concept”. Only a few services have gone live. A dozen banks are using a firm called Ripple to process international payments cheaply. In August, an online retailer, announced a “smart-contract” platform, as did Symbiont, another startup. In January NASDAQ, a stock-exchange operator, launched Linq, a service that allows companies to issue debt and securities. It also plans to initiate a blockchain-based e-voting service for shareholders in firms listed on its exchange in Estonia.

Then there are more specialised services. Everledger uses a blockchain to protect diamonds by sticking data about a stone’s attributes on it, providing proof of its identity should it be stolen. Wave, another blockchain startup, encodes documents used in global supply chains, reducing the risk of disputes and forgeries.

More applications will pop up this year and next. Prime targets will be self-contained markets with complex products, many participants and convoluted procedures. One example is syndicated loans, which can involve dozens of lenders and which can take as long as a month to negotiate. Symbiont recently teamed up with Ipreo, another fintech firm, to automate such loans using smart contracts. Another tempting target is trade finance, which still requires lots of paperwork to travel around the globe along with the goods being sold.

Widespread use of the blockchain is still five to ten years off, predicts Angus Scott of Euroclear, which settles securities transactions. What is more, he says, disruptive fintech startups are unlikely to lead the charge. In markets where the success of a technology depends on its adoption by many counterparties, as is often the case in finance, incumbents have an advantage. The Australian Securities Exchange in January set an example when it enlisted Digital Asset Holdings to develop a blockchain-based system for settling trades.

Given the attenuated timetable and daunting obstacles, there is a risk that banks will lose interest and pursue less glamorous technologies instead. BNY Mellon, an American bank, recently decided not to go ahead with a project that would have used the blockchain to simplify international payments, because it could not persuade enough banks to participate. It would have taken “a significant effort” to make it work, according to Tony Brady of BNY Mellon.

Yet it would be wrong to conclude that the blockchain is no more than a fad. It is merely moving through the same hype cycle as other next-big-things have done before it: inflated expectations are followed by disillusionment before a technology eventually finds its place. Although it will take a while for distributed ledgers to rule the world, they are an idea, to paraphrase Victor Hugo, that will be hard to resist.

The article first appeared in the Economist