The quick rise of virtual currency Bitcoin has posed little threat to the role of banks as overseers of traditional financial transactions.


The technology which underpins it – blockchain – is an entirely different matter.

“This technology has forced us to rethink our entire value chain in a way we had never done before,” Bank of New York Mellon head of EMEA Innovation Centre, Leda Glyptis, said during a SIBOS panel discussion on blockchain.

“Whether the solutions to the new paradigm that will emerge will be on the blockchain is not to be known yet but we're thinking about what it is we [as banks and as financial institutions] are for.”

It represents a fundamental threat which could disintermediate almost every process in financial services.

Defining the blockchain

Most digital payment schemes run on a centralised network model – it requires users to trust the central counterparty which sits between their bank and the bank receiving their funds. Centralised systems are dominated by banks, financial institutions, and payment schemes and protocols such as SWIFT, Visa, and MasterCard.

Decentralised systems, such as the blockchain protocol, have no need for a central counterparty. They instead rely on a single distributed ledger (or database), such as the public ledger of transactions used to track and transfer Bitcoins. The ledger allows monetary value to be transmitted directly between users, secured by cryptographic processes.

The major advantages include transparency, no counterparty risk, lower direct transaction costs, and near real-time settlement. While Bitcoin has become the poster child of decentralised systems, the threat to established financial services is much broader.

Blockchain technology could potentially underpin a global market infrastructure, built on an open protocol, for money and financial assets. Simon Taylor, VP Blockchain R+D at Barclays, said blockchain is best viewed as a reconciliation technology, rather than a payment technology.

“If you asked 10 people in this room what a blockchain is you'll get 10 different answers and I think that's why it's at the peak of the hype cycle… we need to understand it, we need to come to shared agreement of what is it and what are we going to do about it,” he told the conference.


Twenty-five global banks, including the Commonwealth Bank of Australia and National Australia Bank, are now working together through the R3 distributed ledger initiative, which is developing a framework for using blockchain technology in markets.

Early experimentation 

UBS has also set up its own innovation lab which has been working on several blockchain projects, including a trial of ‘smart bonds’ where the financial instruments’ interest payments were made without using a middle or back office, or registry.

“We are in the experimentation phase,” UBS group chief investment officer Oliver Bussmann said at SIBOS. “Like everyone else we are looking at ‘use’ cases.”

He said the smart bond project showed that setting up a new market infrastructure required a “mind-blowing effort” and the entire industry needed to think about ways to simplify those processes. “If we have that agreement on that infrastructure debt at the end it will drive trust, scalability, security – and at that moment I think you will see a tipping point.”

Bussmann worked on the World Economic Forum’s recent Disruptive Innovation in Financial Services project which identified blockchain as the key area that the banks were keen to collaborate on.

However, Preston J Byrne, a co-founder of blockchain software platform enterprise Eris Industries, said there is also a danger that financial institutions will pursue inappropriate uses for blockchain technology, such as clearing.

“Blockchains are transparency engines and do not do privacy well so if you disclose everyone’s exposures to one another you’re giving very sensitive data,” he said at the conference. “So in the short term, business process automation within the enterprise within a bank is going to be where this actually has the most impact.”

Joyce Kim, executive director of not-for-profit organisation Stellar.org, is attempting to build a network for micro-finance and agricultural co-ops using blockchain technology. The network would be interoperable with the banking industry’s SWIFT allowing low-cost financial transfers for up to two billion of the world’s poorest people.

Challenges

While the promise – and threat – posed by blockchain technology loom large, so do the questions marks about its viability.

Unlike central counterparty-dependent traditional systems (which were strengthened in the wake of the global financial crisis), decentralised systems have yet to be tested under high-volume, real-world conditions.

Cryto-currencies such as Bitcoin have also fluctuated significantly in value while the anonymity of accounts and irreversibility of transfers has raised the concern of regulators.

“The real challenge for blockchain in adoption right now is it needs a legitimate on-and-off ramp to the financial services industry to get traction – and it can't get one,” Danny Gilligan, co-founder of Australia’s largest fintech investor, Reinventure Group, said at the recent Citi Australian & New Zealand Investment Conference.

While time will tell whether blockchain proves to be a truly disruptive threat, the banking industry is taking no chances.

“Banking processes in place for 100 years-plus will be massively disrupted,” UBS’s Bussmann said, “and from that perspective, the eco-system driving that collaboration and also defining how markets end up going forward will be very critical.”


 
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