It’s hard to believe any new technology could have the impact of the Internet on our lives. It’s dramatically altered life itself – from the ways we purchase clothing and food, listen to music, and watch movies, to how we store large amounts of data and operate businesses. It’s accelerated development of technologies that affect almost every industry and business area. But today, a new database might signal that this kind of seismic change is ready to happen again.
The financial services industry has been particularly affected by the Internet revolution. Financial services leaders now spend much of their time:
- Seeking new solutions and trying to increase transaction speed
- Making sense of large amounts of real-time financial information
- Increasing interconnectivity and significantly reducing costs while complying with legal and regulatory institutions
With the emergence of innovations such as blockchain and distributed ledger technology, industry experts and professionals are hoping that long-anticipated change will finally arrive and align a number of complex financial processes. Just as with the Internet’s arrival 20 years ago, the transformation potential with blockchain is immense.
What is blockchain?
Blockchain is a special kind of database, with copies of it replicated across multiple locations of transactions between two or more parties. These transactions are split into so-called “blocks” and are “chained” together along with other blocks within the database. These blocks are then validated by encryption. To establish legitimacy, the transaction details must contain the involved parties’ unique signatures.
Blockchain allows unacquainted parties to engage in a transaction – exchanging information or money – without a centrally trusted intermediary. As a result, parties avoid the high legal and transaction costs that are usually incurred. Blockchain, at its core, is a distributed store of information that contains transaction copies between two or more parties, which are replicated across multiple locations.
According to London-based technology consultancy firm Magister Advisors, financial institutions will spend over $1 billion on blockchain-related projects next year – making blockchain one of the fastest-growing enterprise software markets of all time.
Application in post-trading
Applying blockchain can reduce back-office expenses and shorten the security settlement window. Consequently, less capital will be tied up in the settlement process, which can be recycled back to the market. This improves liquidity and reduces market risk for transaction parties.
Transaction participants would use a distributed ledger, enabling them to track where documents are in the sequential approval process. This pushes intermediaries such as central securities depositories (CSDs) and custodians to speed up the review process.
According to a recent Goldman Sachs report, total cash-trading compensation expenses equal roughly $4 billion (U.S. equity market, 2015). From that, $1.3 billion, or roughly 33%, is related to back-office clearing and settlement. The main driver of these back-office costs is not the cost of storing redundant data, but the redundancy of processes and manual reconciliation of transaction data. Blockchain can significantly optimize back-office operations through reduced headcount and fewer platforms. The result? Fewer trade errors and elimination of manual reconciliation.
Blockchain vs. T2S
Current TARGET2-Securities (T2S) specifications suggest that CSDs and custodians play an essential role as intermediaries or gateways to the platform in the settlement process. This implies that establishing a single platform with unified standards creates a natural monopoly, with large economies of scale relative to the market size.
More than likely, all European securities will be settled in T2S. Choosing other gateways and platforms will only split liquidity and enhance risk. Furthermore, the problem of increasing regulatory demands and compliance is causing the lack of post-trading efficiency. Unlike T2S, blockchain technology places little importance on intermediaries, because users themselves act as validators in the transaction chain.
The road ahead
Many challenges to full adoption and implementation of this technology still remain. We must consider:
- Blockchain’s transparency could cause confidentiality issues
- The lack of privacy could allow users to assess other users’ liquidity needs, and thereby gain competitive advantage and increase trading costs
Transactions need to be executed confidentially by trusted and reliable third parties who run the permission-less ledger and select validators. The key is to identify, develop, and implement a validation method that allows settlement without sharing details with users who aren’t part of that specific transaction. Solutions using zero-knowledge proofs could potentially prevent exposure of money flows between transaction participants, but such validation methods have not been fully developed.
Finally, market participants such as national central banks, governments, and financial institutions need to reach a consensus on regulation to:
- Achieve full scalability
- Reach significant capital investments
- Develop standards in cross-border settlement
Such a collaboration would exceed all previous political, economic, financial, and technical agreements. However, the unprecedented effort would be worthy of the potential blockchain offers.
To learn more about blockchain, please visit us at Sibos September 26-29 and visit us at www.sap.com/sibos.