Blockchain. Bitcoin. Cryptography. Nodes. Distributed ledger. These are just some of the terms that are rapidly moving from the world of computer experts to multinational financial institutions and regulators.
Research indicates there are now 192 start-ups engaged with blockchain for financial services14 and investment in blockchain related enterprises is expected to surpass $1bn in 2015 alone. To understand this direction of travel, we must first remember the primary basis of our current financial system - trust. In a world of digital records, we trust banks, insurance companies, asset managers and other firms with our money, identity and assets. We trust them to maintain books and records to record our holdings securely without the risk of tampering.
In turn, markets rely on centralized ledgers held by custodians and/ or central counterparties as the ‘golden source’ for reconciliations and asset/money ownership. The trillions of transactions that occur daily on a global basis rely on checks and balances within the financial system that fundamentally boil down to a level of trust that centralized ledgers will not catastrophically fail.
In comes blockchain. An astonishingly simple concept that creates either an open (permissionless) or closed (permissioned) distributed ledger that is neither owned nor controlled by a single party, yet requires approval before any transaction is ‘added’ to the blockchain. Transactions are verified within a blockchain through complex cryptography requiring significant computing power, making it effectively impossible to tamper with. Once transactions are approved, they are added as part of the next block in the chain and distributed for everyone to see.
Simply put, a distributed ledger using a blockchain would enable two counterparties, who have no particular confidence in each other, to interact and transact without going through a neutral middleman.
The possibilities of blockchain in financial services are endless - from Know Your Customer and other anti-money laundering information to securities clearing and settlement. Imagine a world of instantaneous settlement, unforgeable identity and a revolution in the back-office and middle-office of banks and other financial services firms. It is the ultimate utopia of creating trust directly between unknown counterparties. In fact, a recent report by Santander indicates that the technology could save banks alone $20bn per annum by 2022. Daniel Alter from itBit also raises in this report how blockchain will help both the industry and regulators through more efficient record keeping.
We are many years away from seeing a wholesale revolution in financial services or from knowing which companies will endure. Regulation will undoubtedly follow innovation as the years progress. However, in a blockchain system without a central authority, mass adoption by users and approval by regulators will not occur until the fundamental questions of security, trust and overarching governance are answered.
The coming years will be interesting to see how regulators keep pace with innovation, and how banks and other investors work in competition and collaboration to realize the potential of blockchain.