Written by Tom Owen
Tom Owen is a Consultant and Operations Manager with Aon’s Global Investment Center Operations Team. Tom is based in the U.S., Chicago, IL.
Blockchain, also known as distributed ledger technology (DLT), is an innovative combination of cryptography, distributed ledgers, and consensus. While this technology has gained notoriety due to its role as the ledger underpinning cryptocurrencies such as Bitcoin, it has potential applications elsewhere, including in the financial services industry. Does distributed ledger technology make sense for every business? Certainly not. However, within financial services, there are many processes that still require intensive human direction or interaction, including securities clearing and settlement, securities lending, transition management, client onboarding and recordkeeping, and audit and compliance, among others. Through that lens, it is worth considering where we are today, the merits of the technology, applications in the market, and some of the headwinds to future development.
Where are we?
There are millions of dollars being spent on the development of distributed ledger technology – the $280MM spent in 20161 was double estimates, and that is expected to accelerate in the next several years. Given the current limitations of the technology, coupled with the cost of research and development, the implementation effort is increasingly falling to some of the largest banks, regulatory authorities, and broker dealers/intermediaries. What does that mean for institutional investors?
In the near term, the answer is: not much.
In the future, the answer is: potentially a lot. Thus, it is important to understand the merits of DLT, how it is being viewed by participants in the capital markets, and how their respective interactions can change.
Merits of Blockchain
In 2015, members of the Federal Reserve Board of Washington, DC interviewed industry stakeholders to identify their reasons for implementing DLT. While there were several, those pertaining to payments, settlement and clearing cited the following:
- Reduced complexity (especially in multiparty, cross-border transactions)
- Improved end-to-end processing speed and availability of assets and funds
- Decreased need for reconciliation across multiple recordkeeping infrastructures
- Increased transparency and immutability in transaction recordkeeping
- Improved network resiliency through distributed data management
- Reduced operational and financial risks2
These general concepts can also be applied to other areas of financial services, such as securities clearing and settlement, securities lending, transition management or others. Additionally, blockchain can provide tamper-resistant records, in real-time, reducing the effort spent in the data verification component of audit processes.
Of the institutions most likely to be early adopters, institutional investors interact most often with their intermediaries, including custodians/recordkeepers, broker-dealers, and consultants.
Capital markets cost benchmarking firm, McLagan3, recently produced a white paper on the prospective economic impact of blockchain on custodian banks, predicting that embracing distributed ledger technology could result in an existential crisis for intermediaries. The core of this piece analyzed custodians’ financials over a four year time period (2012-2015), and determined that wherever implementing blockchain led to significant cost savings, they would often be matched or exceeded by revenue losses.4 This is due to custodians deriving a large portion of their revenue from assisting customers through the current inefficiencies of post-trade processing – if blockchain eliminates these inefficiencies, what replaces this revenue stream?
Considering these economic implications, we spoke with some of the largest custodian banks in the institutional market (e.g. J.P. Morgan Chase, BNY Mellon, and Northern Trust) to gain their perspective. While many of them agreed in concept, they also thought that blockchain would open up new lines of business for them. The ensuing conversations also had a commonality, in that they believe the common perception in the mass financial media tends to overestimate the impact of technology in two years and underestimate its impact in five.
J.P. Morgan was one of the first major banks to endorse blockchain technology for its efficiencies (despite Jamie Dimon’s commentary on cryptocurrencies), and is a premier member of the Enterprise Ethereum Alliance (EEA), a cross-industry consortium exploring use for the “Ethereum protocol” (a base layer blockchain code that programs can be built upon). The bank has also built its own Ethereum based protocol called Quorum, and continues to actively develop the application of these systems. BNY Mellon similarly is a member of EEA, and has established a global emerging technology team to consider how best to apply blockchain to its business. Lastly, Northern Trust chose to adopt the Hyperledger protocol (a separate blockchain code base), developed in part by IBM and the Linux Foundation, and is exploring how best to evolve back office functionality, particularly for private equity fund administration processes.5
These firms are all actively engaged in proof-of-concept (PoC) projects, designed primarily around improving back office efficiencies. Let’s take Northern Trust as an example. Currently, private equity fund administration requires several manual touch-points across multiple parties, including the investment manager, the fund administrator, custodians, regulatory authorities, and clients. Using blockchain can reduce the back-and-forth interactions between parties, reduce time spent on these interactions, and reduce fees for regulatory and audit functions. This is an important characteristic of most financial blockchain applications – they do not replace core financial functions, but rather reduce inefficiencies in how those functions occur. Another pertinent example would be IBM Global Financing, the firm’s internal lending division, and their deployment of a cloud-based blockchain solution. By implementing the technology for its distributed database and audit capabilities, they were able to reduce time spent resolving financial disputes by 75%, and increase capital efficiency in disputes by 40%.6
Theory suggests that reducing inefficiencies creates value. However, an important consideration often forgotten in that equation is technology risk. Blockchain is largely unproven in private markets and there are few examples of live enterprise blockchains. They cost a considerable amount to deploy, particularly when it comes to the intellectual capital required. It’s unlikely that we see a distributed ledger clearing and settling stocks and bonds in the same fashion as cryptocurrency transactions in the near future.
What’s more, distributed ledger technology is not a comprehensive solution for many of the inefficiencies in the financial markets.
- They are not effective databases, and should never be thought of as a substitute for one, though the lines tend to blur when discussing an immutable, continuously expanding ledger of information.
- Scalability of distributed ledger technology has been an issue, with public blockchains capable of processing considerably fewer transactions than comparable traditional systems, such as credit card transactions. Providers such as Visa can accommodate up to 65,000 transactions per second across their network, 7 compared to current blockchains which facilitate between 3 and 1500 transactions per second. 8, 9
- Personal identity and data security are opaque and require additional definition. There are undeniable risks in deploying a developing technology as the security of the network has yet to be verified in a live environment. Furthermore, an individual’s right to be forgotten runs counter to the functionality of an immutable ledger, as any individual engaging with a blockchain network will have their actions recorded in perpetuity. This also introduces efficiency issues when considering a network at scale, such as one used to clear transactions in equities, where there may be many unique participants.
- The very same elements that give blockchains their value also create the necessity for established recourse mechanisms. The inability to reverse or nullify transactions after the fact is a key component of distributed ledger functionality, but presents challenges in replicating the capabilities of traditional transactions.10
- Distributed ledger technology presents an interesting catch-22 in that the network is significantly more valuable when it has the ability to interface with other networks, a concept known as network effects. This presents a challenge in that early adopters are not properly incentivized to develop networks, unless there is a guarantee that additional networks will develop simultaneously.
- Interoperability between those separate networks is another hurdle, as currently there are no effective methods of combining two different distributed ledger protocols (e.g. Ethereum and Hyperledger).
Considerable progress has been made developing distributed ledger technology. Several large financial services firms have invested substantial sums of money in developing sophisticated proof-of-concept studies exploring the application of blockchain in modern day financial processes. As the technology matures, there will continue to be significant hurdles towards future development. With all that said, distributed ledger technology still represents one of the most compelling technological innovations in the last decade, particularly when it comes to legacy financial systems. While the residual impact from blockchain applications may not be realized in the near future, it should continue to be on the institutional investor’s radar.
3McLagan is a sister company Aon Hewitt Investment Consulting
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