December 6, 2015
Introduced in 2008, bitcoin won the hearts of innovators with no effort. The greatest gift from bitcoin to FinTech was blockchain technology that got the market crazy, racing to apply a new and exciting technology. Back office operations are no exception and blockchain found its way there to disrupt the market.
Firm58—a company that helps capital market firms become more efficient by leveraging the back office for post-trade process improvements—allows to lower staffing requirements, enables better compliance and simplifies processes for fees and commissions. Extensive expertise in back office process improvement in combination with growing market interest in blockchain technology in a variety of applications allowed Firm58 to provide valuable insights into blockchain’s back office application. A recently published white paper from Firm58 provides extensive analysis of the main issues capital market firms will be facing in the race to adopt blockchain.
As Firm58 explains, blockchain technology functions as a decentralized public ledger and verification system, most notable for its foundational role behind bitcoin and other cryptocurrencies. It is a worldwide ledger system for a digitized asset—initially limited to bitcoin. However, technological advancement allowed blockchain to extend the range of use cases in financial markets along with other opportunities. The world’s most powerful financial institutions turned to blockchain looking for opportunities to apply in operations. Some of the biggest banks such as UBS, JPMorgan Chase and Barclays are working together to create industry-wide blockchain standards.
Blockchain has been a hot topic for a while now in a number of conversations at conferences and on the Web. The technology owes its success to the open nature, speed and simplicity. Firm58 brings an analogy of the Internet, explaining that the attempts to centralize authority (or otherwise segment access to the blockchain) threaten to block its potential. Blockchain certainly has benefits to bring into each application case. In a market where trades are recorded on the blockchain, traditional clearing, settlement and reconciliation activities become almost instantaneous. Therefore, blockchain will shake up the industry’s roles, as Firm58 believes. At the very least, settlements would be immediate, reconciliation redundant, and traders’ funds would no longer be tied up for as long as three days.
However, even in this case, broker-dealers would remain relevant, particularly for their role in securing loans and executing trades. Moreover, new types of digitized assets may require attention from broker-dealers, expanding their role in a blockchain-enabled industry. It is unlikely that venues will be eliminated, as functions like dispute arbitration, matchmaking and trade execution would remain uniquely human activities.
However, the company believes that despite the promising opportunities, neither blockchain nor capital markets are ready for each other. There is a variety of technological and logistical obstacles to overcome before blockchain can become a system of record, settlement and clearing for any existing asset class. Firm58 explains some of the barriers to overcome.
Although financial institutions are actively developing their ways to adopt blockchain technology with their own standards, at some point, fragmented work will require unification and standardization. With more and more entities developing proprietary blockchain implementations, unification seems to become an issue in the nearest future.
When the common standard is reached and created, capital markets firms will have to invest in software and supporting systems. Such a significant investment requires a financial justification. If prior companies could pass the costs onto clients, elimination of clearing, settlement and reconciliation costs will leave firms alone in covering software expenses. The incentive for firms to invest in software will get stronger once the ability to instantly settle and avoid unnecessary back office costs and delays becomes a true competitive advantage. Firm58 predicts extinction to firms not embracing blockchain. The reasons why some market participants may be cautious and slow in blockchain adoption lies in the industry’s cultural habits and risk aversion, as Firm58 suggests.
The company believes that blockchain adoption will happen gradually starting with in-house experimentation and emergence of niche blockchain-based digital assets before gaining widespread asset coverage. Internal discovery and research are great ways to start the transition until the time the market adopts the technology massively.
Blockchain is not only a technology to improve operations but also a new concept and way of thinking. Traditionally, industries rely on systems based around trusted authorities. Blockchain is coming to shift it towards digitally distributed verification. Power will no longer be relevant as blockchain is decentralizing it. However, there is a price to pay—difficulties in arbitrating disputes. Ultimately, technological or legal means will be shaped to allow transaction reversion in case of a trade error.
Therefore, the questions of security and compliance remain unsolved. Elaborating on the security issue, Firm58 brings an example of public records, which are only as secure as the software used to write to the blockchain. Public access and visibility into transactional data bring up privacy concerns. The fine line between ensuring trade information and data integrity is under the risk of being crossed. It is always a matter of time when curious, savvy hackers will find loopholes to get to confidential information. Therefore, until a balance is found, blockchain will not be able to eliminate the need for private recordkeeping or compliance technology, nor would it negate firms’ investments in monitoring and surveillance tools.
The final issue brought up by Firm58 are the scalability barriers as blockchain is missing that capability within the financial market. Now, growth of transactions leads to a necessity to expand the storage space. In a very short time, with rapidly growing transaction volumes the whole block bloat, as Firm58 calls it, may become simply unmanageable. Before the mass implementation, the solution for scalability has to be created.
Moreover, the speed will become another issue. At the early stage, with a limited number of transactions, the speed is an amazing advantage. However, the scale will lead to slower processing capabilities. In addition, the seven concurrent transactions that blockchain is now capable of handling needs to be extended drastically to be of use.
Light at the end of the tunnel
Even though blockchain promises efficiency and speed to the capital markets industry, the massive adoption is still years away, as Firm58 believes.
With the variety of barriers for large-scale adoption, including psychological, cultural and technological, there is a significant shift yet to happen for blockchain to have a chance for massive implementation. At this point, the edge can be reached with as little effort as research and familiarity with the technology as the market is still in the experimentation phase. Scalability, standardization and concerns around decentralized security and arbitration will remain relevant in the near future. Although standardization is an important problem to solve in the future, companies still need to focus on discovering the use case relevant to their business models.
Firm58 sees blockchain’s progress as an evolution rather than revolution. Blockchain’s potential is just at the beginning of its realization at a range from more modest adaptations (NASDAQ Private Market) to nontraditional uses (Everledger’s diamond certification).