18 June 2016, Bachir El Nakib (CAMS) Senior Consultant Compliance Alert LLC
Blockchain, Distributed Ledgers or DLTs, were a specialised technological subject as recently as two years ago, now the terms are arguably the 'hottest topic' in global financial services. It typifies the disruptive potential of Fintech innovation, but the technology may also offer existing players an invaluable opportunity to transform.
These wide-ranging predictions mean that blockchain is a source of uncertainty for many asset managers. Unpredictability over the evolution of the technology, its tangible applications, its commercial viability and its potential risks and rewards may be encouraging some firms to ignore the issue altogether.
In this paper we aim, as far as possible, to bring the often theoretical debate over blockchain into the practical arena, we will use the generic term Blockchain to describe the plethora of distributed ledger technologies taking shape and instead of making definitive predictions, we consider what we see as six crucial areas of uncertainty. Our conclusions can be roughly summarised as follows:
Blockchain is a unique combination of protocols and technologies, evolving rapidly along divergent paths. It potentially has the transformative ability to provide a 'data backbone' for many financial applications
Financial firms seeking to monetise blockchain need to think carefully about development, usage, ownership and control. Creativity and innovation will be key to realising commercial opportunities
Identifying optimal use cases is vital, but challenging given blockchain's rapid evolution. To maximise objectivity, firms need to seek out internal and external views while keeping their wider goals in mind
A range of players are using a variety of routes to invest in blockchain, all of which require flexibility and co-operation. Looking ahead, non-financial investors may become increasingly important
Blockchain could help asset managers and others to revolutionise their operating models and client services. Industry-wide transformation is very possible, especially in developing markets such as Asia
Practicality poses a real obstacle to scaling blockchain; there could be cultural, financial, regulatory and reputational hurdles too. But in the long term, the opportunities should outweigh the challenges
We believe that blockchain's unique combination of capabilities will have a genuinely revolutionary impact on financial markets. One way or another, the result ing changes could directly affect asset managers and their operating models. Change may well be gradual, but it will not be something that any financial institution can ignore.
That does not mean that today's institutions will be swept away by a blockchain-powered entrants.
Asset managers and other financial institutions have a hugely valuable opportunity to leverage this new and distinctive technology for their clients' and their own benefits. This may not happen overnight, but the breakneck pace of blockchain development shows that firms need to consult with external partners, consider the potential implications of blockchain and formulate a strategy that plays to their strengths.
Introduction: International Expansion: a digital revolution
Blockchain technology, sometimes referred to as distributed ledger technology, is not new1. But, like many digital technologies, it is experiencing a huge surge in interest. And although it has potential applications across a wide range of industries, it is in financial services that blockchain fever is at its peak.
Blockchain itself can be described by logical mathematical and computing concepts. In contrast, the prospect of blockchain adoption by financial firms is provoking some remarkably emotional responses, both inside and outside the industry.
Cheerleaders for blockchain see it as a potent 'super-disruptor' that will upend today's financial world and make huge swathes of the current industry redundant. In contrast, many financial firms have not yet given much consideration to why and how blockchain may impact their business models. This is particularly true of asset managers, many of which are already committed to a range of essential technology projects and have limited scope for further investment.
We believe it is far too soon to make precise predictions about the financial potential of blockchain. Instead, as in the previous three papers in our International Expansion series2, we consider six key areas of debate about the future of blockchain within financial services. The scope for industry- wide applications means that we take a broader perspective than usual in this paper. Even so, asset management remains our primary focus.
This paper is not intended to be an introduction to blockchain. In the Appendix we suggest some further reading for those seeking 'Blockchain 101'. Our aim is to highlight as many facets of the blockchain debate as possible, and to help asset managers and other readers reach their own conclusions about its impact on their businesses.
Cian Burke: Global Head of Securities Services, HSBC
Key Areas of Debate: How is blockchain evolving?
Blockchain, described by the Economist as 'The Trust Machine'3, has come a long way since 2008 when someone using the pseudonym Satoshi Nakamoto proposed using one as the platform for Bitcoin4.
Weak customer demand, regulatory risks and operational limitations have made conventional banks and financial firms wary of Bitcoin. However, the last 18-24 months have seen attitudes to Bitcoin and blockchain diverge dramatically. Financial institutions are realising that blockchain itself represents a powerful combination of financial and technological innovation.
Blockchain is often described with pithy phrases such as "the internet for money", "a peer-to-peer financial network" or "a market without intermediaries". These elegant descriptions can be misleading, because they imply that blockchain is a single technology. In fact blockchain combines several technologies to create a distributed, consensus driven database with four key technical features. It is the combination of these features – rather than any of the individual elements – that is novel.
Distribution Blockchain does not rely on a single centralised record. It is a shared ledger, visible to every node or participant.
Security The use of public key cryptography makes it possible for blockchain data to be public, yet secure.
Immutability The process by which data is added to blockchains prevents subsequent tampering or amendment.
Trust A consensus mechanism means that blockchain data is a trusted, mutually agreed record.
This combination of features means that the mechanics of blockchain can appear complex to the uninitiated. For instance, the Bitcoin blockchain is often described in terms of its structural features - such as tokens, nodes, hash values, rewards or keys - or in terms of the steps by which a new block is added to the chain, such as hashing, mining, validation or encryption. (Readers interested in 'how blockchain works' should refer to the Appendix.)
Fortunately, we believe there are good reasons why most non-specialists need not worry too much about the mechanics of blockchain.
First, the idea that blockchain is a solution in itself is misleading. True, many blockchain providers are developing specific applications, but for most financial institutions it may be more helpful to think of blockchain as providing a 'data backbone' or information layer onto which developers can build tailored applications. This explains why blockchains already perform such a wide variety of functions. These include payments (such as Ripple), registers of ownership (such as CoinSpark) and the ability to execute rules-based transactions using 'smart contracts' (such as Ethereum).
Second, the open source nature of blockchain makes it highly adaptable. Applications are diverging rapidly as developers modify one or more elements of previous versions - a process known as 'forking'. Variations on the core concept are multiplying fast at the hands of Fintechs, financial institutions and other organisations. These differences can have a significant impact on how blockchains function. For example:
Blockchains do not have to use cryptocurrency units as tokens. Other data can be 'tokenised', or token-free blockchains (often called distributed ledgers) can be set up
Blockchains operated by vetted or 'permissioned' users can use more flexible or less stringent cryptography, especially when restricted to internal use
Permissioned blockchains do not necessarily require a Bitcoin- style 'proof of work'. Instead the authority to create blocks can be delegated to chosen 'nodes' or users
Commercial blockchains can be given a legal residence, enabling property rights to be enforced – unlike the Bitcoin blockchain
In other words, understanding what blockchain does is much more important than understanding how it works. For financial institutions, we see its most important "outcome characteristics" as being:
Single version of the truth. Blockchain provides a tamper- proof, mutually agreed record that is visible to all participants, without the bottlenecks of centralised networks
Resilience. Distribution, cryptography and consensus mean that blockchains can be secure against infrastructure failure, cyber attack and data corruption
Reliability. Immutability and the consensus mechanism mean that blockchain data can be trusted by all users
It is these characteristics, not the technology itself, which gives blockchain so many compelling financial applications. Blockchain's potential for disintermediation dominates current debate, but this is only one way it could challenge the existing financial order. The strengths of blockchain – trust, security, reliability, accuracy – are all areas where financial institutions have been on the defensive over the past decade.
So for banks and other intermediaries, blockchain offers a chance to reclaim their central position in the financial infrastructure. At the same time, blockchain gives non-financial challengers a chance to circumvent barriers to entry and attack incumbents. It is no wonder that blockchain investment is expanding rapidly, albeit from a low base. In the sections that follow we explore how, where and by whom this investment is likely to be made, and what its impact will be on financial firms and the industry as a whole.
Blockchain is increasingly viewed independently of Bitcoin and other cryptocurrencies
It is better to see blockchain as a combination of protocols and technologies than a singular innovation
Blockchain might function as a 'data backbone' and a foundation for a wide variety of financial applications
Blockchain development is moving in many different directions. Most banks are more interested in token-free blockchains, also known as distributed ledgers
The unique capabilities of blockchain make it a potent challenge – or a valuable opportunity – for the established financial industry. Either way, it is likely to be transformative
Can Financial Firms make money from Blockchain?
Blockchain spending by financial incumbents, challengers and new entrants has recently been predicted to reach USD400m or USD500m per annum over the next three to four years - even if current spending is only a fraction of this sum.
But will investors receive a return on this investment? For many blockchain start-ups and their venture capital backers, the hope is for an acquisition or secondary investment by a banking or technology giant. For established financial firms, the calculation is more complicated. Most already face a range of financial, technological and regulatory pressures and can ill afford to make loss-making investments. Many are also unused to developing commercial applications from open- source technology.
It follows that financial institutions need to think carefully about how they will generate a return on their blockchain investments. We see several potential 'routes to value' and believe that it is vital for financial firms to apply a commercial mind set to blockchain investments from day one.
One obvious approach is to use blockchain internally. Intra-group blockchains could have a range of benefits for large financial groups, which often struggle to achieve consistent reporting across entities, geographies and activities. Blockchain offers a way to achieve the 'single view' that managers and regulators crave without cumbersome centralised oversight, and might make it easy to add or remove 'nodes' as the organisation expands or contracts. Intra-group networks for value transfer could also generate capital efficiencies by reducing the need for inter-company accounting transfers. Clients could benefit from these gains via lower prices and faster, more reliable services.
An alternative approach is to provide ancillary services to blockchain users, such as digital wallets. But a bolder strategy is for financial firms to provide blockchain applications to clients. This could be achieved by giving paying clients access to proprietary blockchains, or by delivering applications through mutually owned blockchains. We believe the last option, with the founding institution acting as moderator rather than owner, may be more attractive in the long term. It will share costs and risks and, as new users join, allow for increasing economies of scale over time.
Finally, a truly collective approach to blockchain investment is to develop industry-wide blockchains, either via member-owned collective vehicles, or by consortia grouped around a single blockchain specialist. This approach is illustrated by the consortium of more than 40 banks, including HSBC, that blockchain specialist R3 has built in the hope of developing standardised industry protocols. In theory, collective networks offer the greatest scope for cost and risk sharing, the exchange of ideas and the rapid scaling-up of applications.
It is striking that all of these approaches – including purely internal applications – will require a significant degree of co-operation. Financial firms will need to work with Fintechs, and many are already investing in specialised developers (see page 12). But collaboration with clients and competitors will also be important.
On the upside, the need for co- operation is a positive development for a sector that has rarely prioritised shared investment. Arguably, blockchain is providing a long overdue stimulus for industry-wide co-operation on technology.
On the downside, co-operation with suppliers, clients and peers will be a challenge for financial firms traditionally reluctant to share intellectual property. Consortia will face particular challenges, such as the need for arbitration, the difficulty of agreeing interoperability protocols, competition and intellectual property rights law considerations, and the requirement to accommodate the 'lowest common denominator' in terms of existing technology. Without a concerted effort to bring scale and liquidity to their chosen solutions, consortia may be at risk of drifting or splintering.
All this suggests that financial institutions will need to demonstrate the creativity and flexibility of venture capitalists if they are to make money from blockchain investments. Traditional approaches to ownership and management may not be appropriate, especially if private, shared and public blockchains connect or interlock in future. If so, blockchain implementation could throw up some new and unique challenges - a theme we return to on page 10.
As an open source, peer-to- peer technology, many financial institutions may find it hard to monetise blockchain
There are a number of potential 'routes to value'. Careful thought about the development, control and ownership of blockchains will be vital to success
Financial firms need to think creatively about ownership structures and retain as much strategic flexibility as possible
Collaborative approaches could deliver greater benefits at lower risk, but may also be harder to manage and bring to fruition
Pan-industry consortia could be particularly productive, but current expectations may be too high. Discipline and direction will be needed to keep goals aligned and maintain compatibility
Are the right use cases being identified?
As yet, there is no consensus over the optimal financial use cases for blockchain. This is understandable, given the novelty of the technology and financial institutions' uncertainty over how to harness its potential. The sheer range of benefits that blockchain could create – including the ability to reduce operating costs, accelerate transactions and settlement, strengthen risk management, enhance reporting and release collateral – are another reason for uncertainty. Firms are unsure whether to use blockchain offensively or defensively, internally or externally, for efficiency or for growth, or for 'all of the above'.
So is the financial industry identifying use-cases in the right way? In our view, firms seeking to identify potential blockchain applications need to ask themselves some key questions:
What are the benefits for clients? The potential for blockchains to help investors and their agents – such as asset managers – will only be fulfilled if client benefits are a central goal of development and if value is passed on to clients and investors wherever possible
Are the right voices being heard? Technology and strategy specialists tend to dominate debate over potential blockchain use cases. Are the voices of compliance, finance, risk management and relationship management experts also being heard?
Are we balancing credibility and creativity? Many blockchain developers are aiming to build on institutions' existing capabilities or to address existing weaknesses. That makes sense but greater potential may lie in more creative combinations, such as blockchains that integrate the supply of goods or services with the means to finance or pay for them.
Is blockchain the best approach? Blockchain can provide the data backbone for a wide spectrum of applications. But it is not the solution to every problem. Does the desire to 'do something with blockchain' mean that alternative approaches are being overlooked?
Are we keeping an eye on the wider picture? Firms need to consider what impact blockchain may have on their organisations (see page 14). Have the wider implications for business models been assessed?
With these questions in mind, we think the most compelling use-cases identified so far are those that eliminate redundant duplication. Too many financial market processes are currently replicated, checked and rechecked across multiple organisations, each using a number of systems and databases. As the following examples illustrate, there are many potential approaches to realising those benefits:
Service-focused use cases, such as building closer relationships between asset managers and asset servicers. A blockchain could provide a single all-purpose connection, filling existing 'air gaps' and providing a seamless, combined book of record. That would have a range of benefits in areas such as portfolio management, investor reporting, regulatory compliance, custody and settlement
Product-focused use cases, such as streamlining a specific document-heavy OTC market. Syndicated lending markets, where manual processes such as email and fax are still widespread, are an ideal example. Shared ledgers could facilitate straight through processing, leapfrogging existing market infrastructure. That would shorten lending cycles, allow easy tracking of assets and liabilities and release large amounts of collateral and capital
Issuer-focused use cases, such as a blockchain that records the issuance and redemption of mutual fund shares. This could be operated by the issuing asset manager, or by a service provider – effectively replacing its transfer agency service. Fund distributors could interact directly with the blockchain to facilitate transactions and changes of ownership
Use cases that tokenise non- financial data, such as developing an industry-wide Know Your Customer (KYC) blockchain. This would cryptographically store customer details for quick and easy identification. The potential benefits to investors are obvious, and a KYC blockchain would allow financial institutions to co-operate in an area where there is little realistic prospect of competition
These are just four of many possible use cases. They give an idea of the potential range of applications, and show how certain uses are better suited to certain users. Every institution will have its own ideas of which use cases are most compelling for themselves and their clients, and success will not only depend on the merits of each application but also on the extent of its adoption.
Finally, the most valuable financial applications may only become apparent once blockchains are already operating at scale. After all, when internet hype peaked in the late 1990s no-one had imagined the potential of applications such as Uber, Instagram or Airbnb. We suspect that the most compelling financial use cases for blockchain are yet to be identified.
Identifying valuable use cases could be crucial to making a success of blockchain in the financial industry, but at present ideas for applications are multiplying faster than they can be tested
While this 'scattergun' approach is understandable, we think that some firms might benefit from a more careful focus
If they want to develop use cases that can create value in the real world, firms need to ensure they are looking at blockchain 'in the round' and listening to a full range of voices
For now, we see use cases that reduce duplication and manual processes as offering the greatest scope not only to increase efficiency, but also to create value for clients and investors
Even so, the merits of every use case will depend on the identity of users and user groups
We believe that it may be some years before the most important long-term applications of blockchain in financial services are identified, let alone implemented
Who is investing in blockchain, and how will this develop?
Banks and broker-dealers are currently the leading financial investors in blockchain, with many building a wide portfolio of projects. Exchanges, clearing houses, payments specialists and consulting firms are also making a variety of investments. At present, the most important investment avenues include:
In-house development: A number of banks and exchanges are experimenting internally with blockchains, setting up innovation labs, filing for patents and trialling applications
Start-up incubation: A few banks have set up incubators to support and co-operate with Fintech start-ups
Partnering with specialists: Some banks, exchanges and consultancies are partnering with specialist providers to develop blockchains for internal or external use
Investing in established Fintechs: Banks, exchanges and payment specialists are making equity investments in Fintechs, giving themselves and opportunity to build expertise and gain insight into emerging trends
Investing in collaborative groups: We have already mentioned the consortium of banks – including HSBC - assembled by US blockchain specialist R3. HSBC is also involved with the Post- Trade Distributed Ledger Working Group, a cross-industry forum exploring the use of blockchain in securities clearing, settlement and reporting. We believe discussions about forming similar groups are taking place in other sectors of the financial industry. What about the future? Despite the number of investments being made, the amounts involved so far represent a tiny fraction of financial institutions' technology budgets. It remains to be seen whether this speculative level of investment will develop into something more transformative. We expect several factors to determine the scale and direction of future blockchain investment, including:
The evolution of scalable use- cases (The 'Push'). Few financial firms have a culture that supports creative, sustained technology R&D. Many also face intense pressure to control costs. Unless practical, scalable use cases for blockchain emerge within the next 12-18 months we would not be surprised to see a cooling of some banks' investment and incubation efforts
Demand from users – especially asset managers (The 'Pull'). Understandably, given their limited budgets and existing technological priorities such as digital distribution and big data, few asset managers are currently contemplating blockchain investment. And yet blockchain could have far-reaching long term effects on asset managers' business models. Developers need to engage with clients and investors to gauge their appetite for blockchain solutions
The actions of other financial firms. Not all banks and brokers have joined the first wave of blockchain adoption. Monitoring developments from the side lines might be a sensible strategy for some, but it is not without risks. Firms' decisions to become 'fast followers' or remain 'wait-and- seers' will shape the investment landscape
The actions of non-financial investors. Non-financial industries are focusing on blockchain too. Telecoms companies including Qualcomm and Orange have invested in Fintechs and Microsoft is partnering with Consensys, an Ethereum specialist. IBM is also reported to have developed a proof-of-concept that uses blockchain to build a distributed 'internet of things'5. Financial firms will not have a monopoly on blockchain investment and development
Investment in blockchain substitutes. Blockchain will not be the ideal foundation for every financial application. Some uses currently under consideration may lend themselves – on cost or suitability grounds – to other distributed database protocols
In summary, we expect the complex landscape of blockchain investment to continue to evolve rapidly. The identity and goals of investors will shift.
The voices of investors, customers, regulators and other stakeholders will gain in strength. And the importance of collaboration - in one form or another – could drive investment in unexpected directions.
In the long term, we also expect blockchain investment to have an indirect influence on other financial technology. In future, we may see blockchain as having played a key role in kick-starting a wider trend towards more creative and co-operative technology investment across the financial industry.
Financial investment in blockchain is at an early stage. Banks and brokers are leading the charge, but a number of other intermediaries are making a range of offensive and defensive investments
Current investments span a variety of internal projects, equity investments, partnerships and consortia – underlining the value of flexibility as the technology evolves
We expect blockchain investment to continue to evolve rapidly – and unpredictably – over the next few years
The drivers of investment will change as technology evolves, financial outcomes become more predictable and new actors join the investment landscape
By stimulating industry co-operation and a renewed focus on client and investor needs, blockchain may also have an impact on other investments in financial technology
How will blockchain impact the financial industry?
Having debated several aspects of blockchain evolution, we now consider what impact blockchain itself may have on the evolution of financial firms. Or to put it more positively, how can individual organisations optimise the impact of blockchain on their own businesses? We expect three factors to be particularly important.
The first is current capabilities. Individual firms' starting positions will have a huge effect on their ability to extract value from blockchain. This is partly about the sectors and markets firms operate in, and partly about the specifics of technology, business models, profitability, capital and competitive positioning.
The second factor is a considered blockchain strategy. Blockchain will provide financial institutions with threats as well as opportunities. Not all will wish to be aggressive; in some cases, the rush to invest in blockchain may reflect a defensive motive rather than genuine enthusiasm. Decisions about blockchain use cases and investment will be far more likely to create value if they are based on a considered, flexible strategy.
The third factor is organisational culture. As already discussed, we believe that creativity and imagination will be vital to developing the best use-cases for blockchain. We also expect co-operation and collaboration between organisations to be crucial to commercial success. Financial institutions will require a flexible culture, the right talent and the willingness to work with start-ups, technology partners and even competitors. Strong leadership from senior executives will also be vital to success.
Whatever steps individual firms take, blockchain will inevitably affect different financial sectors in particular ways. So far, blockchain appears to have comparatively few direct applications for asset managers. Even so, we believe that blockchain enabled changes – such as a new model of integrated enterprise-wide outsourcing – could eventually have a huge impact on asset managers' operating models. Blockchains might not only transform asset managers' post-trade activities. In the front office they could affect client on- boarding and trade capture, as well as providing a 'golden source' of portfolio management data.
Although some asset managers are currently taking a fairly passive approach to blockchain, we believe that many firms are already giving active thought to the technology. We expect to see most wealth and asset managers take a growing interest in their service providers' investment plans. It follows that banks, brokers and other blockchain investors should make a positive effort to engage with their asset management clients about potential use cases.
There is not space here to explore the potential impact of blockchain on every financial sector. However, we offer some quick thoughts as follows:
Corporate and investment banking. Blockchain could reduce duplication and risk in many core activities including payments and OTC trading. Even a modest reduction in post-trade costs would be highly valuable. A recent report estimated that blockchain has the potential to reduce banks' annual infrastructure spending by a total of USD15-20bn from 20226. Faster settlement would also create huge scope for collateral savings
Custody and asset servicing. Although we think the disruptive potential of blockchain for this sector is sometimes exaggerated, there is no question that blockchain could drastically reduce the need for manual, labour intensive processes. As well as helping asset servicers to achieve a step-change in efficiency, it should also enable them to develop a range of new value-added services
Exchanges and clearing houses. Blockchain could revolutionise clearing houses' ability to provide brokers and custodians with an authoritative, mutually agreed record of transactions and ownership. It is harder to see how blockchain applications might strengthen liquidity or price discovery, but some form of consolidated tape would be valuable to market participants and regulators alike
Insurers. Insurers could see several aspects of their business reshaped by blockchain. A single claims management blockchain would bring huge reductions in duplication and fraud. Shared ledgers might also boost the clarity and efficiency of multi-party markets for re- insurance and specialised risks
Other service providers. The evolution of large scale blockchains will require auditors, lawyers and other advisors to adapt their own businesses to a new era of time stamped, verified data
With such a range of possibilities, it is easy to see why some observers expect blockchain to revolutionise or even replace some of the financial industry's core functions. Set against this, the industry has a proven ability to adapt new technology to its advantage – albeit sometimes slowly. The need for widespread adoption could also give incumbents an advantage. Blockchain could potentially represent a threat to a minority of organisations in specific financial sectors. But we expect most financial firms to survive the rise of blockchain, and predict that many will thrive on the new capabilities it brings.
Crucially, we also expect the impact of blockchain to vary across different geographies. What is 'disruptive' in one market may be 'transformational' elsewhere. In particular, we wonder whether the greatest impact of blockchain may not be felt in Europe and North America, where financial infrastructures are at their most complicated, but in Asia where technology is less mature. In markets such as these, blockchain may allow technology to jump straight to a more efficient future. An obvious analogy comes from Africa, where the use of mobile payment applications has grown hugely in recent years, circumventing the need for more traditional banking infrastructure.
The long term effects of blockchain on financial institutions could be surprising. As with any disruptive technology, many factors will be beyond individual firms' control
A flexible blockchain strategy that considers client needs, current strengths or weaknesses and external factors will help to optimise responses, but will be hard to formulate
Despite its disruptive potential, we expect most financial firms to successfully adopt - and adapt - blockchain
Successful implementation could enable many financial institutions – especially intermediaries and central counterparties – to offer new services and reap efficiency gains
Asset managers may currently see little need to invest in blockchain, but they should be aware of its potential impact on front, middle and back office activities
The greatest transformative potential for blockchain may lie in regions like Asia, where financial technology is less mature and rapid improvements are easier to achieve
What comes next?
Some observers have suggested that we are currently in a 'blockchain bubble' – a time when expectations for the technology are outstripping its real world capabilities. It is certainly true that the ability of blockchain to support core functions across a range of products, markets and jurisdictions remains largely unproven. However, the recent history of digitisation in financial services shows that technological development often brings about greater and faster changes than initially anticipated.
So what will the next few years bring? In our final area of debate we aim to highlight some major unanswered questions about the ability of blockchain to take on a lasting, central role in the financial industry.
In the short to medium term, operational practicality represents the greatest question mark over blockchain adoption. There is a huge difference between today's specialised applications and the kind of large-scale use cases we explored in page 10. Bridging that gap will mean overcoming many practical obstacles, some as yet unforeseen. Some hurdles may arise from the technology itself – such as the growing size of chains, the computing power they require, or the challenge of re-creating a corrupted blockchain. But we expect practical questions of implementation and integration to pose the greatest challenges, for instance:
Enabling automated interaction between blockchains, firms' existing platforms and external data sources such as SWIFT. This could emerge as an important area of competitive advantage
Ensuring that weaknesses in the security or reliability of other platforms do not undermine the value or integrity of blockchain data
Co-ordinating with other technology investments in areas such as big data, digital distribution and regulatory compliance
Controlling costs over the lengthy periods during which blockchain applications will need to operate alongside existing technology
Retaining the ability to make ex- post improvements in areas such as analytics or reporting
Even if blockchain development continues to accelerate, we expect the resulting transformation of financial technology to be much less rapid. Change is more likely to be gradual than dramatic. Financial firms will find making the quantum leap to mainstream implementation far harder than setting up trials and testing new applications.
A Supportive Ecosystem
As a distributed technology, blockchain is very different from the centralised platforms most financial companies are familiar with. If blockchains are to enjoy long term success, technological change will need to be accompanied by a number of less tangible adaptations.
Within an individual organisation, a supportive 'ecosystem' will include effective monitoring, reporting and oversight as well as 'softer' elements such as leadership, training and culture (see page 14). Support from external stakeholders will also be important, especially for bilateral or multi-party applications. That implies that individual firms' ability to harness blockchain will depend – at least in part – on the actions of others.
Financing and 'Investibility'
So far, financial institutions have invested comparatively small sums in blockchain. But many firms will soon need to take tougher decisions, weighing blockchain investment against other discretionary spending. The unique features of blockchain, and speculative cost and income projections, make this problematic.
The need to justify investment decisions to senior managers, co-investors and capital providers suggests that a new set of criteria may be needed to judge blockchain investments. These would need to apply tailored evidence-based standards, while also allowing for qualitative judgement in areas such as regulation. As blockchain evolves, these criteria themselves may need to be reviewed to ensure they remain relevant.
Regulation and Compliance
Regulatory authorities in many markets are currently taking a pragmatic attitude to financial blockchain applications. True, blockchain has yet to have a material impact on most regulated activities. But supervisors, frustrated by the limitations of many firms' existing reporting, have been quick to grasp the potential benefits for monitoring areas like payment network reliability and financial stability.
As a result, regulators are going out of their way to demonstrate openness to blockchain applications. The UK's FCA has invited Fintechs to test new applications in a 'sandbox' and several Asian regulators have signalled their openness to innovation.
The key question is whether this benevolence will continue. However supportive regulators may wish to be, compliance is bound to become a growing hurdle as blockchains expand. Many proposed use cases could fall foul of existing requirements, such as legal restrictions on the use of customer data, the single custodian requirements of UCITS and AIFMD, the central clearing requirements of EMIR, or MiFID II's rules on trading venues. And any high profile 'failure' of a blockchain would surely lead to more sceptical regulatory attitudes.
Reputation and Trust
The ability of blockchain to 'create trust' between users is one of its greatest attractions. But trust is a slippery concept and we suspect that reputational issues could have unpredictable effects. As applications diverge, some blockchains will engender more trust than others. In particular, the importance of access controls and 'permissioning' mean that the burden of trust for many commercial blockchains will fall back onto sponsoring financial institutions.
This has several potential implications. One is that investor trust in blockchains may not, in the long term, be as high as currently imagined. Another is that a failed implementation by one financial institution might damage the reputation of all blockchains. Conflicts of interest between the users of mutually-managed blockchains could also have damaging effects.
Financial institutions will begin bringing small-scale applications to market within the next 12-18 months. Large scale blockchains may take several years to emerge
The kind of wholesale re- engineering of financial markets predicted by some blockchain advocates is likely to take much longer – perhaps 5-10 years - to come about
As blockchain technology develops there will be unforeseen bumps in the road, failures and setbacks to overcome
In the short to medium term, sheer practicality looks likely to present the greatest challenges as operational obstacles come into greater focus
Other potential complications could arise from cultural issues, financing hurdles, regulation, or reputational risks
For every challenge that arises there will be an opportunity for individual firms and their partners to help clients and investors move forwards
In this paper we have tried to bring the often theoretical debate over blockchain, consciously simplifying the nature and evolution of distributed ledgers and the concepts of cyptography, hashed data and proof of work, and focus onthe real world context of those that own, manage, trade, administer and safeguard financial assets.
Blockchain's ability to provide reassurance and certainty on a shared, decentralised basis carries huge significance for financial institutions - and their would-be challengers. We may not believe that blockchain will entirely 'replace' any aspect of financial services, but we do expect it to reshape or even revolutionise business models in many sectors of the industry.
Asset management provides a good illustration. Blockchains currently have few direct implications for portfolio management, but could dramatically change the operating models that support that core activity. That in turn could help many asset managers to achieve their own goals in areas such as efficiency, compliance, data management and client reporting.
In the short term, today's stratospheric expectations for blockchain will cool slightly as developers encounter a range of practical, economic, cultural and regulatory hurdles. External factors such as the actions of technology companies and changing economic prospects could also 'disrupt the disruptor' and throw blockchain development off-track.
However, we do not believe that asset managers or any other financial firms can afford to ignore blockchain. In our view, every firm needs to make an informed choice between action and inaction. That means developing a conscious and informed blockchain strategy in consultation with internal and external stakeholders. This will need to be reappraised regularly as blockchain technology evolves.
In our view, blockchain provides the financial industry with some of the greatest strategic opportunities it has had since the financial crisis. Blockchain has the potential to catalyse industry co-operation; to accelerate the evolution of Asian capital markets; to revolutionise financial technology; to rebuild trust in financial services; and above all, to create new sources of value for clients and investors. It is up to individual firms to realise those benefits and optimise the impact of blockchain on their own business models.
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1 N.B. In this paper we use the term 'blockchain' to refer to the technology, rather than any specific entity or application 2 Accessing Asia – UCITS or not?, How will platforms change the game? & A Digital Revolution. Copies available on request 3 Economist, 31.10.15 4Bitcoin: A Peer-to-Peer Electronic Cash System, 2008 6 Santander, Oliver Wyman, Anthemis,15.06