Digital Technology Bears Down on Old Finance Models
Forget digital currency. The real revolution for finance may be in what’s under the hood: a digital distributed ledger called blockchain.
What started as a controversial digital currency – bitcoin – has over the last two years morphed into a broad technology that experts say could revolutionize finance.
Bitcoin – which emerged in 2009 – became controversial because it supposedly provided a way to anonymously buy and sell goods, including illicit ones. Skepticism increased when the FBI arrested Ross William Ulbricht and shut down his black market site, Silk Road, which traded in bitcoin. Ulbricht was convicted of money laundering, computer hacking and conspiracy to traffic narcotics last year and is currently serving a life sentence.
Meanwhile, behind the scenes, technology and finance companies have been examining the technologies that underlay bitcoin, especially something called blockchain.
“A more rational discussion . . . is starting to emerge, as market participants gain a better understanding of the technology, figure out how best to adapt it for financial markets and identify the use cases where it can be most disruptive,” Richard Johnson, vice president of market structure and technology at consultancy Greenwich Associates, writes in a recent report.
Blockchain is a digital distributed ledger, which is a database of transactions that is shared among participants and protected from hacking by cryptography. Bill Fearnley Jr., research director of compliance, fraud and risk analytics at market research company IDC Financial Insights, likens a blockchain ledger to a safe deposit box in the cloud. When Party A sells something to Party B, the transaction is permanently recorded in the ledger. If the transaction is changed, then that change is permanently recorded as a subsequent entry in the ledger, without overwriting the previous record. Security features ensure that only authorized parties can make changes, and any changes made are immediately known to all parties of the chain.
“It’s about version control,” Fearnley says. “All these transactions are strung together.” Blockchains can be used to keep track of any digital assets, including currency, transactions and contracts.
Excitement over blockchain’s potential has generated huge investments by established technology companies, large banks and venture capitalists who have funded hundreds of startups. Greenwich Associates estimates that more than $1 billion will be spent on blockchain initiatives by startups, banks and established tech companies like IBM and Microsoft, in 2016 alone. Venture capital investments have surpassed $440 million.
A Digital Paper Trail
And that could be just the tip of the iceberg. In a spring 2016 survey by Greenwich Associates of companies involved in blockchain, 80 percent said they thought the technology would have a meaningful impact in at least one area of the capital markets within two years.
Experts point to several benefits of using blockchain in financial transactions, such as stock or derivatives trades, including:
- It creates an indelible record of transactions.
- Because it’s a shared ledger that fosters transparency, there is a single version of the truth, eliminating replication and errors.
- Settlements can happen not only virtually, but virtually instantaneously, significantly reducing the cost of capital. “In effect, the trade is the settlement,” says the Greenwich Associates report. “There is no separate post-trade settlement process.”
- Used in tandem with complementary digital technologies, such as smart contracts (a software program that literally executes the terms of a contract using computer code), the entire financial services industry could be streamlined and made more efficient.
Of course, all these advantages dramatically reduce, even perhaps eliminate, jobs performed by large financial institutions. If asset transfers and transactions can be securely conducted and recorded between parties, who needs a trusted third party to serve as intermediary or counterparty?
“You should be taking (blockchain) technology as seriously
as you should have been taking the development of
the internet in the early 1990s.”
Blythe Masters, founder, Digital Asset Holdings
As experts pointed out the possibility for disruption, there seemed to be some panic by traditional finance houses. Some tech-savvy executives even left large banks to found their own startups. Among the highest profile was Blythe Masters, a former executive at J.P. Morgan, who launched Digital Asset Holdings in 2015.
“You should be taking this technology as seriously as you should have been taking the development of the internet in the early 1990s,” Masters told an audience of investors last year.
Potential for Disruption
That warning was heeded. Investors in Masters’ company include banks such as J.P. Morgan and Goldman Sachs, tech companies such as IBM and venture capital firms. As of February 2016, investors had poured some $60 million into the startup. In fact, large banks have invested in many startups, as well as banding together in consortia to develop their own blockchain technology. Over 50 global banks formed a group called R3 that announced in April it was developing a distributed ledger platform for financial services called Corda. There are also groups led by the tech industry. The Linux Foundation in December 2015 launched the Hyperledger Project, in which companies are cooperating to develop software and infrastructure for open-source blockchain development. The project’s goal is to develop enterprise-grade distributed ledger applications, said Brian Behlendorf, its executive director.
Another effort is Ethereum, a crowdfunded project run by a Swiss nonprofit, which is combining blockchain with so-called smart contracts that execute the terms of a contract using computer code. The group got a black eye in June, however, when a hacker was able to rob more than $60 million from The DAO, a fund that was set up to demonstrate the use of Ethereum’s technology. (Experts say that the flaw was in the smart contract, not the blockchain. See below sidebar.)
Many groups are moving this year to launch pilots and proof of concepts, according to Johnson. For example, NASDAQ and a company called Chain just completed a private shares transaction. Retailer Overstock.com, which formed a blockchain subsidiary, has already used the technology to issue private bonds and has received permission from the U.S. Securities and Exchange Commission to sell public shares using this method.
Even state governments are getting into the act. In May, Delaware’s governor announced an initiative to “embrace the emerging blockchain and smart contract technology industry.”
A $60-Million Loophole in a Digital Contract
The public may be spooked about blockchain technology after reading how hackers stole some $60 million from the DAO, which stands for Decentralized Autonomous Organization and was designed to show how blockchain and smart contracts work.
But technologists point out that the problem was actually with the smart contract, not the blockchain. A smart contract is “a computer program that can verify or enforce the terms of a business transaction,” according to the Greenwich Associates report. It complements blockchain technology. The report explains by using an example:
“If a corporate bond is digitized on a distributed ledger, when a coupon payment is due, the smart contract could calculate the payment amount, referencing an external data source such as LIBOR, and trigger the payment of the coupon from borrower to lender.”
The DAO thieves exploited a vulnerability in the computer code of the smart contract, enabling them to drain money out of DAO and into their own account, Johnson says, adding: “It’s absolutely a wake-up call as to the potential risk around smart contracts.”
It’s also an indication that it’s still early days of these technologies. There are no established rules or procedures for writing software to implement contracts, notes Behlendorf. “There is no precedent in computer science for building smart contracts,” he says. “And this is not just a new system, it’s an entirely new category of system.” In the case of DAO, no safeguards were built into the contract to enable the parties to cancel it if something went wrong. Indeed, according to press reports, the hacker taunted DAO as he was in the act of stealing “ether” – its version of digital currency.
“I have carefully examined the code of The DAO and decided to participate after finding the feature where splitting is rewarded with additional ether,” the hacker reportedly explained. “I have made use of this feature and have rightfully claimed 3,641,694 ether, and would like to thank the DAO for this reward.”
So far, regulators seem willing to give the nascent technology room to develop. In fact, blockchain’s ability to create a secure, immutable record creates opportunities for the watchdogs, notes Fearnley. “The regulators think this is a great idea,” he said. “It’ll help them aggregate and analyze information to find bad actors.”