Disruptive Technologies: Rising to the blockchain challenge
Jeff Conway says financial instutitions that ignore the potential benefits of blockchain and other disruptive technologies will be left behind
New technologies have the potential to take the agent-free model even further into industry. For the financial services sector, such technological advances present the opportunity to overhaul existing models, speed up processes and streamline costs.
Nearly any market participant will acknowledge that blockchain is going to have an impact on financial services in some form. The extent to which blockchain disrupts existing processes in financial services is the core debate. Some say a complete disintermediation of middle and back office processes is under way, while others contend the impact of this emerging technology will be less forceful.
While 70% of this noise around blockchain is probably hype, the remaining 30% looks set to make a significant impact.
It is one of the more compelling vehicles of technological disruption because, simply put, it could create a single source of truth for transactions, with far-reaching consequences. Because of its distributed-ledger model and use of cryptography, it has the potential to create a reporting system that is not only more efficient than existing options, but also more transparent and secure.
More industry processes will likely move towards blockchain models in the coming years. When we polled 100 institutional investors in January we found 57% expected blockchain to be widely adopted in their industry in the coming five years. Despite this, investors are unprepared – only 7% have initiatives under way on blockchain, while 64% say they need more time to understand it better.
Early implementations are likely to be on a limited scale or in greenfield areas where legacy challenges and standardisation requirements are less of a factor. If we can make blockchain the internet of financial services, we will all benefit – particularly if it allows for real-time settlement across different geographies and currencies.
It will have a significant impact, starting with inefficient areas that are manual, require a lot of stakeholders to engage, align and sign-off, and have intermediaries that create a single point of failure and add cost to the system. The areas likely to be affected first will be those like bank loans, liquidity management (collateral management, securities borrowing), derivatives, and broader settlement area.
Blockchain could ultimately become a standard for financial transactions and real-time settlements, increasing transparency and efficiency in a highly fragmented industry – a fantastic prospect and one that heralds exciting, new opportunities. However, as some analysts suggest, it also has the potential to drastically reduce demand for many custodians – one of our core businesses representing $29trn (€26trn) in assets.
However, there will still need to be on and off ramps to the blockchain, meaning a digital custodian will be needed to enable this tokenisation, and creation and maintenance of smart contracts. Also, for a system based on encryption, there may be a need for secure maintenance of personal encrypted keys. All these are new components in the value chain. A trusted adviser could play such roles. However, the need to evolve to meet the challenge must be recognised.
If blockchain can be made the internet of financial services, we all benefit, particularly if it allows for real-time settlement across different geographies and currencies.
Settlement has always been marred by inefficiencies and a high scope for errors. Some say that real-time settlement finality will call time on the central securities depositories (CSDs). This is over-simplifying things, however. Blockchain could certainly help automate some components of the settlement process, such as reconciliation and corporate actions, but CSDs are likely to play an integral role in any blockchain environment. CSDs have been instrumental in establishing industry-wide standards and monitoring the behaviour of market players. They – as well as custodians – will likely retain a ‘policing’ or governance role in a blockchain framework.
Asset managers have also taken an interest in blockchain. The technology could have a material impact on internal functionalities such as asset managers’ push towards automation and straight-through processing. Reporting transactional and risk data to regulators could be carried out on a blockchain, in what could threaten a lucrative business line for service providers. However, the problem of legacy systems may still remain, and asset managers will still want to leverage the expertise of their service providers to help them report to multiple regulatory agencies in a blockchain environment.
A total disintermediation by blockchain of financial institutions is unlikely. There are flaws with the technology which cannot be ignored. Nearly every single large financial institution is exploring blockchain or conducting some sort of gap analysis. Numerous firms are creating their own private blockchains, which is contrary to the ideal of a public, shared blockchain. While internal blockchains can help companies manage internal inefficiencies and streamline various practices, it does make it harder to create a unified, publicly shared ledger, subject to harmonised standards and regulations. This is evidenced by research which found 55% of asset managers said blockchain would be used privately, while just 13% expected it to be public.
There are several ways for banks to experiment with blockchain, including: internally as part of core software development; selectively partnering with vendors and other partners to conduct private trials; and as part of a handful of consortia. In an example of the latter, 42 banks have started working with the consortium R3, which is targeting a goal of standardised and shared ledger technologies; and in Europe we are also a member of the Post Trade Distributed Ledger Group (PTDLG), which aims to research and identify opportunities and associated benefits of blockchain technologies.
The move towards a blockchain environment will be littered with obstacles. Most financial services institutions are mindful that regulation could be a challenge, with several government agencies expressing scepticism and alluding to possible systemic risks that could arise through the adoption of the technology. One issue is that blockchain must show it can withstand a concerted cyber attack. Its cryptography does provide an element of security but it is unlikely to be infallible against all cyber threats.
The industry is still far from realising the full impact of blockchain and other emerging technologies. Financial institutions, however, cannot count on business as usual with such disruptive technologies on the horizon. One recent report went as far to say that blockchain could become part of the mainstream and in use within the next five to 10 years. Those that do not embrace such change risk being left behind.
Jeff Conway is chief executive officer, EMEA, at State Street