Banks takeover the blockchain

By:
Peter Lee
Published on:

Everything you thought you knew about blockchain is wrong. Rather than wait for the blockchain to re-engineer banking, the banks are going to re-engineer the blockchain. It will not be public, it will be private. And across the shared ledger there will not be that much sharing. In an atmosphere somewhere between excitement and paranoia, banks are trying to turn an existential threat into a competitive advantage.

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If 2015 was the year of peak hype around the blockchain, when banks first woke up to its potentially transformative power, then 2016 is the year of busy experimentation with shared-ledger technology and testing of commercial applications that might eventually come into use in 2017 and, more likely, 2018.

The blockchain is an extraordinary breakthrough in computer science that holds out the prospect of market participants owning shared databases of financial transactions, with new entries confirmed by consensus and protected by encryption, and containing immutable golden stores of agreed data and time-stamped transaction history. It holds out the prospect of a new approach to payments, transfer of securities and other assets, identity verification and regulatory reporting that could entirely reconfigure finance.

The global financial system has rested for centuries on interlocking networks of trusted third parties that handle their customers’ money and financial assets for them: banks to manage cash accounts and transfer payments; central banks to back these commercial banks and hold reserves to manage temporary imbalances between them; custodians and clearing counterparties to do the same for equities, bonds and derivatives. 

The development of the blockchain as the rails on which to move bitcoin, a revolutionary new censorship-resistant cryptocurrency, suggests that, rather than trusting third parties to intermediate payments for them, banks’ customers might be able to transact themselves directly with each other on a digital network that is itself trustworthy, even if some of the participants on it might not be.

This presents commercial banks, custodians, depositories and even central banks with a clear threat of eventual disintermediation. Remove the need for trusted third parties and what are banks for?

But it also carries a promise of greater efficiency and reduced cost. Participants in the financial system have always each managed their own separate ledgers, databases of asset ownership and transactions that they each control, that only they can modify and that are password protected. Each bank runs many thousands of them. 

For the banks, public blockchains are not relevant for the next 10 to 15 years at least 
 - Gideon Greenspan, MultiChain

The blockchain holds out the prospect of mutualizing cost through shared databases, secured by encryption that might at the very least remove the hefty annual expense of data duplication, data gaps and of reconciling inconsistencies between separate databases. 

This does not sound anywhere near as exciting as transforming the global payments mechanism, unless you happen to be an investor in bank stock or a bank executive.

If it does nothing else, just by making digital ledgers more efficient, the blockchain could reduce operating costs for the global banking industry substantially, cutting banks’ infrastructure costs attributable just to cross-border payments, securities trading and regulatory compliance by between $15 billion to $20 billion a year, according to one estimate from Santander. That is before billions more in potential savings on collateral management.

Others suggest the annual savings could be tens of billions of dollars more than that because there are indirect expenses and opportunity costs too. The database discrepancies inherent in the current financial architecture in turn require maintenance of costly capital and cash collateral cushions to protect against market breakdowns from disputed trades. If that capital could be freed up and churned more rapidly, banks would boost their returns on equity.

With those returns now so low, banks can hardly sniff at this. Charley Cooper, managing director at R3 CEV, which manages a consortium of 45 of the world’s largest banks working on shared ledger technology, says: "Banks in the consortium funding experimentation at a cost in the single-digit millions of dollars each could each secure operational savings measured in the hundreds of millions of dollars a year each, perhaps higher for the biggest banks. Commercializing shared-ledger technology could be the best investment these banks ever make."

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Blythe Masters,
Digital Asset Holdings

Earlier this year Blythe Masters, the former JPMorgan banker who heads Digital Asset Holdings, spelled out at the Morgan Stanley financial services conference how blockchain is the ultimate example of what was once anathema to banks but which many are now desperate to implement – shared infrastructure. It can bring improved security through encryption, real-time regulatory reporting, but most important it can cut costs. 

"And we’re not talking five, 10 or 15% cuts in costs; we’re talking 30%, 40%, 50%," according to Masters. "There’s only one way to do that and that is to share a mutualized common infrastructure that previously was kept separately and run independently by every market participant."

The blockchain arrived last year like some mysterious millennial cult. It held out to a global banking system already beset by the cost of regulation, weak core profitability and threats from fintech disrupters the ultimate existential threat of systemic disintermediation. 

But it also held out the hope of new gains if the banks embraced it. Adding to the mystery, no one in the established banking industry really understood it. What have we learned in the last six months as banks have begun testing use cases?

Gideon Greenspan, chief executive of MultiChain, a provider to banks of a distributed database for multi-asset financial transactions within a private peer-to-peer network, notes: "To begin with, the first idea that we and many others started with, appears to be wrong. This idea, inspired by bitcoin directly, was that private blockchains or shared ledgers could be used to directly settle high volumes of payment and exchange transactions in the finance sector, using on-chain tokens to represent cash, stocks, bonds and more."