Last year, the CEO of JP Morgan, Jamie Dimon, was quick to dismiss bitcoin, telling onlookers at the Fortune Global Forum that investors and cryptocurrency campaigners were wasting their time. “No government will ever support a virtual currency that goes around borders and doesn’t have the same controls”, he said. “It’s not going to happen.” His sentiments will no doubt bolster the resolve of bitcoin advocates. Many of whom appear to closely embody Winston Churchill’s definition of a fanatic: people who are unable to change their mind and unwilling to change the subject.
Ever since Satoshi Nakamoto unveiled the cryptocurrency to the world shortly after the advent of the 2008 financial crisis, bitcoiners have harped on about the potential for the technology to destroy the fraudulent and amoral banking system. But, despite all its strengths, of which there are many, the digital currency faces numerous challenges that prevent it from being the killer of financial capitalism that its supporters desperately want it to be.
Banks spend a lot of money on things like trade credit, with big parts of that process done manually. It is very paper driven and uses up a lot of time and resources
The digital currency currently lacks the capacity to subvert the power of the established system, and the international banking community still treats it with a high degree of contempt for continuing to try to do so. But even so, the technology that underpins bitcoin has begun garnering interest from all corners of the sector, as its potential to improve, rather than undermine, is slowly realised.
Over the years, countless TV game shows have created variations of the prisoner’s dilemma – an example of game theory – to provide entertainment by testing players’ capacity to trust one another. In the final round of the game show Friend or Foe?, contestants played a simple game to decide how the winnings were split. If the players chose to trust one another and cooperate (friend), then they walked away with an equal share. If one chose to take the money and run and the other opts to split the pot, the greedy player takes home the lot (foe).
If they both try to dupe each other, however, then they each leave with nothing. The moral of the story is that in life, as in finance, trust is everything. Building it takes a lot of time, while destroying it takes seconds. But, thanks to the emergence of blockchain technology and smart contracts, it could be possible to remove this crucial component from the equation altogether.
“Since the advent of smart contracts and blockchain technology (see Fig. 1), it is the first time really that we no longer need that element”, explained Marshall Long, CTO at Final Hash, a leading crypto-consulting company. “If you were to reorganise the financial sector so that no trust is required, and things just happen the way you expect without having to put your trust in a third party, a lot of cool things can blossom out of that.”
Put simply, smart contracts are computer programs that can be encoded to execute a transaction once specific conditions are met. Banks spend a lot of money on things like trade credit, with big parts of that process done manually. In fact, it is actually very paper driven and uses up a lot of time and resources – much more so than it would if the process were carried out using an automated system that used smart contracts and blockchain technology.
For example, imagine shipping containers with GPS chips automatically checking in once they arrive at their destination, triggering a smart contract that then makes payment, with the transaction being automatically logged on a blockchain. Not only would this free up billions in capital and be much faster than the paper process, it would do so with zero marginal cost.
It is worth mentioning that the engineering behind smart contract technology is still in its infancy and, therefore, is not yet ready to be rolled out for widespread use in banks and other financial institutions. Nevertheless, due to the automated nature of settlement that it offers, combined with the levels of transparency provided when paired with blockchain technology, it has the potential to radically reduce overheads and even increase the overall stability of the financial sector, particularly with regard to reducing counter-party risk.
“A big part of the problem with Lehman Brothers in 2008 came from counterparty risk and the fact that settlement could not be counted on”, explained Garrick Hileman, Economic Historian at the London School of Economics and University of Cambridge, who is best known for his research on financial and monetary innovation.
“If you take the trust element out of the equation and things are run using smart contracts and settlement is more or less guaranteed because the collateral has been posted rather than withheld, then it could help prevent another Lehman situation occurring in the future.”
Because this technology has the power to cut costs, improve back office functions and generally increase overall efficiency, everybody from the Bank of England to the NASDAQ stock exchange has invested money to develop it. For the time being at least, many of these institutions remain very tight-lipped about their plans. The driver of all this secrecy, at least according to Long, is the complexity of the technology and the fact that many of these large institutions are not entirely sure what they actually want this incredible tool to do.
The whole thing is rather reminiscent of when big data was the talk of the town a few years ago. Everybody in business would bang on and on about how “we’re using big data”, but when asked what they were using it for, many companies would have trouble answering. Another thing that leads to financial institutions keeping quiet about their involvement with the technology comes down to their sheer size.
The high levels of investment that are being ploughed into developing it show that the sector has begun to wise up to the power and potential of the blockchain
“They are such huge entities that everybody ends up doing their own thing and nobody keeps tabs on people, because they are such massive organisations”, noted Long. “They don’t really know what they are doing right now. There are also so many potential uses for this technology that trying to nail one down is proving extremely difficult.”
It will be a few more years before the financial services sector starts to leverage this technology and its full impact is felt. Having said that, the high levels of investment that are being ploughed into developing it show that the sector has begun to wise up to the power and potential of the blockchain – something that is great news for an industry that has been criticised heavily for its sluggish adoption of modern tech.
“It has been impressive to see how quickly major firms have pivoted away from dismissing this technology to really embracing it”, said Hileman. “2015 was very much the year of the blockchain for financial services. They clearly see the disruptive potential of the technology and are keeping their cards close to their chest regarding how they want to play it.”
Private versus public
When financial institutions finally unveil what they have been busily working on over the last few years, the thing that will ultimately determine the direction the technology will take comes down to whether or not these organisations opt for a public or private blockchain.
The bitcoin blockchain, for example, is what you’d call a public blockchain: it is a public ledger that anyone who has bitcoin can gain access to in order to record transactions on it. It is an open and fully transparent database.
A private (permission) blockchain system like the one that the tech company R3CEV is currently developing, with the help of a consortium of 42 banks from all over the world, is one where not everyone will have access to the ledger – it is restricted.
Back in January of this year, R3CEV carried out a test involving 11 of its members (Barclays, BMO Financial Group, Credit Suisse, Commonwealth Bank of Australia, HSBC, Natixis, Royal Bank of Scotland, TD Bank, UBS, UniCredit and Wells Fargo) on a distributed ledger based on the public Ethereum network, but interestingly it was hosted using a private network provided by the Microsoft Azure platform, the public cloud platform offering ‘blockchain as a service’ (BaaS).
“The transition from vision and hypothesis to application and execution signifies the next major step towards using this technology to transform how institutions interact, report and trade with each other in financial markets”, said David Rutter, CEO of R3, in a statement. “This is a very exciting development, both for R3 and our member banks, as well as the global financial services industry as a whole.”
The test was designed to allow members to explore the potential of blockchain technology and give them the opportunity to execute financial transactions instantaneously across the global private network. It also provided the banks the ability to simulate exchanging value, represented by tokenised assets on blockchain, without the need for a centralised third party being involved.
“The new R3 globally accessible lab environment is enabling both R3 and member banks to collaborate technically on experiments related to shared ledger and smart contracts technology”, said Richard Herbert, CIO at HSBC. “As demonstrated by the first project that is already up and running, this lab platform will aid faster experimentation, provide technical agility and aid learning greatly.”
It is unclear at this stage whether or not the private blockchain will become the final choice for the banking industry. One thing is clear, however, and that is that banks are going to cherry pick certain aspects, while discarding the more revolutionary features of the technology.
“If you have a lot of private, permission-based blockchains that aren’t really communicating with each other, you may end up limiting the power of the technology”, explained Hileman. “A much more exciting possibility of blockchain could be something resembling the internet, where you have a large common set of protocols that work seamlessly together. Private blockchains might be just the interim solution for something that is more universal.”
In fact, Hileman uses the internet as analogy for how the technology may develop within the financial sphere over time. He recalls how in the 1990s, when the internet was taking off, the business world was obsessed with intranets. Private, local, more limited networks inside companies became the focus. In the end, it was the internet, a set of protocols that allowed information to freely be exchanged across the globe, that won out.
It is still too early to know the precise direction that banking and the financial services sector will take. These institutions may find, however, that in order to unlock the full potential of the technology, they will have to endure an unwelcome shift to greater transparency.