Last year saw the blockchain hype cycle reach its peak, and its disruptive influence on the global financial services industry continues to be the subject of much debate. But after a year of talking, how far has the industry progressed in turning potential into reality?

When contemplating the possibilities that distributed ledger technology (DLT), commonly called blockchain, opens up for the financial services industry, it is easy to get swept up in the enthusiasm. Once decoupled from its origins underpinning the virtual currency, Bitcoin, blockchain moved from the domain of cryptogeeks to winning the hearts and minds of mainstream bankers.

By creating a single, immutable and secure digitalised version of the truth for each transaction, banks could strip out inefficiencies in traditionally paper-laden, manual processes, effectively making them leaner, better and more efficient – at a time when the industry as a whole could use a boost. According to Santander InnoVentures’ mid-2015 ‘Fintech 2.0 Paper’: “DLT could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15bn and $20bn per annum by 2022.”

In addition, it promotes a complete rethink of the old ways of doing business, according to Edward Budd, chief digital officer, global transaction banking, of Deutsche Bank, because it fundamentally questions every process up and down the value chain. “Of particular interest is the concept of digitalising an asset from the beginning of its lifecycle,” he says. “Blockchain is exciting for the industry in terms of how we can change, not just the cost structure, but the efficiency and timeliness of what we do.”

Christophe Chazot, group head of innovation at HSBC, calls the concept “fantastic”, but qualifies that by adding, “in theory, on paper”. Despite more than a year of frenzied discussions at industry conferences, a real-life application of DLT outside of a laboratory set-up has yet to be seen at scale in the financial services.

Collective effort

David Rutter, CEO of blockchain consortium R3 CEV, among others, believes that 2016 is going to the year the industry moves from talk into action. “The financial services industry has gone from a period of youthful enthusiasm, which was unrealistic about the possibilities of blockchain, to a more mature understanding,” he says. “The big banks are now firm believers that [DLT] will absolutely make an impact on cost and capital over a realistic timeframe.”

Although estimating that a major infrastructure change will take more time – “measured in years, not months” – he predicts commercial product rollouts in financial services will start to happen within the next year.

The R3 consortium, launched in September, has made great strides in advancing the industry’s collective understanding of DLT. At the beginning of March, 40 of its member banks completed a trial of five cloud-based emerging blockchains on three cloud platforms. The banks connected to R3-managed private DLTs built by Chain, Eris Industries, Ethereum, IBM and Intel.

The main aim of ‘Project Genesis’ was to evaluate the strengths and weaknesses of each technology. The banks ran smart contracts programmed to issue and trade commercial paper in a time-boxed fashion. Microsoft Azure, IBM Bluemix and Amazon AWS provided cloud computing resources to host the distributed ledgers.

Next the consortium plans to experiment in areas that will have a commercial impact, according to Mr Rutter, choosing a few products from more than 40 suggestions made by R3 members. He adds that a significant level of work is going on in the trade finance arena, which is a popular use case among members.

The early runners

Blockchain firm Digital Asset Holdings (DAH), which is focused on the post-trade space, is also gathering momentum. Launched in 2014, the firm has raised more than $60m in funding from investors such as Goldman Sachs, DTCC and Deutsche Börse Group, as well as technology giant IBM. In January, DAH won a contract with ASX, also an investor, to use blockchain to speed up settlement in Australia’s stock market.

Owen Jelf, global managing director for capital markets at Accenture, explains why the consultancy is working closely with DAH. “We believe this technology will become mainstream, particularly in the post-trade area, therefore we want to be able to advise our clients," he says. "The other investors are the likes of JPMorgan and Citi – investment banks that see potential to better automate and improve reconciliation, as well as save money, become more lean and efficient.”

Likewise Ripple, a cryptocurrency-based payments system developer, is another firm with a number of industry players grouped around it. It recently launched a joint venture with Japanese financial services company SBI Holdings to install Ripple’s enterprise solutions for cross-border payments at banks across Asia. The Royal Bank of Canada is reportedly working with Ripple on a new proof of concept for distributed ledger-based remittances.

The Linux Foundation recently joined the fray and is establishing itself as the standards setter. The non-profit, open-source organisation launched the Hyperledger Project in mid-December and counts the great and good among its 30 members, including many of the same players involved in the other projects. For example, DAH contributed the Hyperledger brand, while R3 provided a new financial transaction architectural framework. In February, IBM donated 44,000 lines of blockchain code.

While acknowledging the network effect required to truly realise the value of DLT, Ajit Tripathi, director of PwC’s sophisticated risk and compliance analytics practice, warns of the difficulty in developing standards by committee. “R3 and Linux believe that everyone needs to be involved at the start for standards to form, but most de facto standards weren’t set by consortium," he says. "Instead they were created by developing something that is dramatically more efficient or provided a much better user experience, and then everyone hopped onto the standard. This is like a party – you need some people in the room but not everyone.”

Solo projects

Some of PwC’s clients are conducting experiments with DLT that they fully intend to commercialise on their own, hopefully towards the end of this year, according to Mr Tripathi. “There is a competitive dimension to this,” he adds.

Leda Glyptis, director at Sapient Global Markets, agrees. “Developing in isolation is understandable with new technology and emergent infrastructure, for it isn’t clear yet where the utility ends and business value begins. But at the same time, the fundamental driver of any use case is the power of the distributed ledger. So if banks aren’t doing experimentation in a distributed manner then they aren’t testing the thing that is most important,” she says.

Many banks are doing both. For example, while being a member of R3, Deutsche Bank has independently experimented with smart contracts relating to corporate bonds and ran two different blockchain rails with two partners and a multifunctional team in Deutsche Bank’s Innovation Labs over the course of 2015. That led to a number of conclusions on the capabilities of the blockchain technology on the back of the issuance, the coupon payment, redemption and transfer of value – in a self-executing way. “It does pretty much what it says on the tin,” says Mr Budd.

The bank did not go on to test the scale and configuration from a technology perspective, something Mr Budd believes can only be achieved collaboratively in forums and consortia. He says: “We were left with questions around the legal and regulatory finality, which we can only test by putting these use cases into a real-world example. These aspects will be needed to move this into production. It remains a key unknown which impacts an element of the timeframe for adoption.”

Seeking alternatives

HSBC, also a member of R3, has been working with clients to explore smart contracts in the open-account and documentary trade space, and developing use cases around how blockchain could enhance or provide an alternative to trade instruments, such as letters of credit or bank payment obligation.

The bank’s global head of product, global trade and receivables finance, Vivek Ramachandran, likens these use cases in trade finance to a “3D printer printing another 3D printer” moment. “A world where you have a distributed ledger, which automatically matches buyers and sellers and records transactions at a global level, is a much more efficient world than today,” he says. “By definition the concept of the distributed ledger should take away the need for an instrument to introduce trust – effectively it creates a system that is almost self-policing.”

Mr Ramachandran stresses that the experiments are still at the proof of concept stage with fundamental challenges still to overcome, “not least how the distributed ledger would work in practice”.

Challenges to adoption

Moving out of the design phase and into the industrial-strength products needed may be slow in coming but that is to be expected, according to Mr Chazot at HSBC. He explains that the blockchain built for Bitcoin, with the purpose of conducting transactions between people who don’t trust each other, is not applicable to the financial services industry as it is now.

However, the technology is evolving and different solutions will be invented as more researchers, start-ups, larger technology companies and banks invest time and money in the area. “First we need to design the right technology and then it will make an impact,” says Mr Chazot.

But the balance between the anonymity enshrined in Bitcoin, on the one hand, and the level of authentication needed for know your customer and anti-money laundering compliance, on the other, is a serious issue and one that fintech start-ups are eager to find solutions for.

For example, Cambridge Blockchain, which recently won the Santander InnoVentures Distributed Ledger Challenge, claims to offer both strong identity and privacy in a blockchain system. “It’s not about sharing your full identity with everyone on the system, but sharing certain attributes of your identity with specific counterparts that need to know that information,” says CEO Matthew Commons.

He believes that the identity management piece is what is needed to get blockchain technology out of the lab and into production environments. “A lot of the banks are recognising this,” he says. “It is top of mind and an important issue that resonated with judges in the Santander Challenge.” Cambridge Blockchain expects to launch its first commercial blockchain-based identity solution in the second half of 2016.

Regulatory certainty

In addition, as Mr Budd signals, more regulatory certainty is needed for greater DLT adoption. Mr Jelf at Accenture says: “Regulators will need to get comfortable, particularly when major asset classes start to migrate to blockchain. Before that happens, they will have to sign off that they understand the technology.”

But it is a chicken-and-egg situation. Many regulators, such as the Financial Conduct Authority and European Securities and Markets Authority, are actively monitoring developments but essentially waiting for a use case to emerge.

“Regulators recognise that there are potentially very broad applications and many benefits that can be gained from DLT, but they also see risks,” says Imogen Garner, financial regulatory partner at global law firm Norton Rose Fulbright. “So there is a desire to address those perceived risks, but to do it in a way that doesn’t put a barrier up to innovation is not a small ask.”

Ms Garner warns that fragmentation and a lack of consistency in the responses from regulators across the globe presents an additional challenge.

Catalyst for change

Mr Budd firmly puts DLT in the transformation bucket. “It is game changing from a business model perspective. But it is transformative rather than disruptive – existing roles and players won’t be fully disintermediated, given the regulated nature of some of the roles played in the value chain,” he says.

However, while there are many good use cases for blockchain, there are other innovative technologies out there. “That’s not to say that blockchain doesn’t solve an underlying need – it certainly does – but it isn’t the only transformative topic in the digital space,” says Mr Budd.

PwC’s Europe, the Middle East and Africa leader for fintech and UK blockchain, Steve Davies, agrees that not all problems are equally solved by blockchain, but says that blockchain represents a catalyst. “For example, if the industry started with a blank sheet of paper to create a new trade settlement process, it wouldn’t recreate the way it works today. Maybe the solution doesn’t involve blockchain at all, but blockchain has encouraged the leap to a solution that starts to cut through some of the infrastructure issues,” he says.

Ms Glyptis at Sapient Global Markets is more interested in how DLT can be used to generate new value. She points to Stellar, a non-profit, open-source financial network with an overlay of financial inclusion and banking the unbanked. The start-up is using DLT in the creation of liquidity concepts outside traditional financial instruments. For example, Stellar is looking at ways to “collateralise the goat”, she explains, in developing countries where farm animals play a similar role as money, in that they act as a store of value.

“Stellar isn’t trying to replace something with something slicker, but is moving into areas where no value was being created or energy spent, and it is creating new value,” says Ms Glyptis. “New doors are opening beyond just better, faster rails – but DLT is also about better, faster rails.”

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