Off the Chain: The Blockchain Battle

It was a scene witnessed in Midtown Manhattan and in many towns across the US on October 21. Someone graciously parked a silver DeLorean on the street, doors flipped open, in honor of the date’s central role in the Back to the Future films. Crowds formed. Selfies rapidly ensued, and the famous cars presumably returned to their rightful place—dimly lit garages—soon enough.

A car-cum-time-machine is certainly more Hollywood than proven physics; indeed, it’s fair to wonder how the movie’s writers couldn’t have predicted us all staring down at our phones instead. But that is the attraction of technology: It allows us to dream a little bit.

If there is one such dream making the rounds this year in financial services, it is blockchain. It’s just exciting enough with a misunderstood relationship to sexy-yet-scary bitcoin (BTC); just useful enough, with purported applications for authentication, settlement and custody; just open enough to invite a myriad of different techies and investors to the table; and yet just vague enough so that it can be marketed to the industry without a 100 percent idea of exactly what it is, or why it’s better than what we currently have going.

Naturally, questions remain.

In some ways, blockchain is a victim of its own hype. Whereas in January, a CIO’s mere mention of the technology would send fingers searching Google, we finish 2015 with blockchain raising serious and often colorful debate, and also a ton of venture capital. What’s clear is that it is no longer enough to simply call the thing revolutionary, though. Most everyone, including many blockchain proponents, want it put through its paces. And some—primarily experts in the bitcoin world who know it best—wonder if this is all more a straw-man or fodder for a LinkedIn discussion group than a solution to real capital markets problems.

“You’re never going to mitigate risk to zero. But the goal is to apply this to reduce risk where you can. For now, go from point A to B. Over 10 to 20 years, 50 percent is still a huge improvement.” Bobby Cho, itBit

Waters sought to bring form to this debate by rounding up opinions from a pair of recent conferences—one hosted by Buy-Side Technology, the other by sibling magazine Risk—along with views from sources intimately familiar with blockchain.

If nothing else, in the words of one observer, “it’s here, and it’s real.” The better question is: to what end?

Varied Landscape
The view from the blockchain precipice is a vertiginous one.

Where to even start? In one area there is the sell side, with investment banks acting both alone and in partnership with a number of incubators. In another there are bigger projects driving standards and collaboration around the issue, like R3CEV—now a partner of 22 major banks—and the Wall Street Blockchain Alliance. In a third, we have the startups, some of them beginning to align with banks as Wave recently did with Barclays, and others backed by brand-name personalities like Duncan Niederauer (Symbiont) and Blythe Masters (Digital Asset Holdings, or DAH). And a fourth sphere involves firms whose focus is actually on bitcoin, but with natural blockchain expertise, ranging from itBit and Circle Financial, a consumer on-ramp builder, to BTC derivatives trading venues like LedgerX.

Unsurprisingly, they all have very different motivations for blockchains—distributed, or shared, ledgers that act as append-only databases—and the many millions in research dollars now being spent on them. 

Beyond retail payment processing, the banks see a potential silver bullet for cripplingly inefficient post-trade processes. The startups see tremendous business opportunity; some bitcoin firms see an opening to commoditize their own technical knowledge.

With hundreds of ledgers already out there countable as “blockchains,” regular news now drops about stepwise achievements whether around scalability—a billion payments processed in under a day—or a successful issuance. This has prompted some grandiose thinking, and not without reason.

“Some banks will have 40 different systems speaking with the Depository Trust & Clearing Corp. (DTCC). Many are archaic and some of them are still written in Cobol, so every bank, whether in the US, Europe or Asia has a dedicated team looking at this,” says Bobby Cho, itBit’s director of trading. “It’s a race to reduce costs, and looking at it concretely, many have created their own blockchains internally now to test the system, and see what it does. They’re not taking the word of someone else anymore.” 

Cho points to fixed income as illustration of a big-time, long-term target, noting that it takes seconds to effectuate a trade, but three days to settle. “A lot of that has to do with hypothecation and knowing where securities actually are at a given time. A blockchain model can create a transparent system to do that, helping regulators and counterparties alike.”

Bespoke Focus
Many current blockchain applications, for now, are focusing on more bespoke transactions involving either small groups of institutions with minimal secondary trading, or on certain asset classes that don’t yet have a delivery-versus-payment (DVP) mechanism.

ItBit, for instance, is focused on developing a blockchain-based DVP for spot gold trading. Symbiont, meanwhile, is working with a number of banks on loan syndicates, explains Robby Dermody, the company’s co-founder.

“You’re encapsulating all the logic of an instrument—issuance, underwriters, coupon, market allocation—into code. One bank we’re working with on syndicated loans has 17 different ledgers running right now, and they’re just a servicer. An agent will have twice that, with 50 people just working on faxes to process that work,” he says. “Blockchain collapses it down to a single ledger, fusing the process together more tightly and with instructions coded into smart contacts. It means big changes from an operational standpoint, where tech becomes much more integral. We see it as a continued advancement of financial technology, getting in sync with what the internet already did for media, music and other industries.”

A Common Tale
These “permissioned” models make some observers begin to twitch, however. The challenge still remains in defining the use-cases and their contour, according to Houman Shadab, a New York-based lawyer and professor who advises several blockchain startups. 

“Blockchain, as it was originally designed, is completely open and everyone can look in,” Shadab says. “When you start thinking about disrupting the markets—how many of these ledgers should be widely or publicly available, which of them shouldn’t be, and what modifications are required for ‘private’ distributed ledgers?—then things get complicated.”

Indeed, some of the movement’s fiercest skeptics, like LedgerX CEO and Goldman Sachs alum Paul Chou, see the issue coming down to understanding bitcoin’s engineering history, rather than willfully leaving it behind.

In fact, it creates a surprisingly common tale: the old guard versus the intransigent newcomers … except in this case, “old” reaches only as far back as 2009, with bitcoin’s founding.

“Bitcoin solved a long-standing fundamental computer science problem, the classic Byzantine Generals’ dilemma, with a combination of technologies to allow coordination between un-trusted parties,” Chou tells Waters. “The use-case for blockchain has always been an open-access ledger that anyone can use and no one controls. People are taking pieces of this new blockchain protocol and are trying to use it for an application that does not need open access; a controlled network of trusted parties does not need technology that was specifically designed for open access. Trusted ledger databases built in SQL work extremely well already, and hashing (taking a digital fingerprint of data to ensure it isn’t tampered with) has been around for decades. There is nothing wrong with permissioned systems where participants are known—but you certainly don’t need anything like blockchain for those systems.”

A specific logical progression is being lost in the blockchain shuffle, he explains. The open quality of bitcoin required not only cryptographic innovation but also “proof of work.” Proof-of-work calculations, as expended by BTC miners, sustain and secure the system; blockchain, therefore, was designed with integrity in mind, and, using proof of work, to make mutability of the data infeasible. But without this impetus, the protection falls away.

“It is very easy to mutate a private chain that has no proof-of-work invested,” says Chou. “That’s my biggest disagreement. In theory, anything is mutable; it’s just a question of difficulty.”

Practical Limits
Some blockchain proponents might see a BTC-centric argument as purist, but access permeates the discussion in ways that, many say, represent traditional challenges for any market infrastructure refresh, as well. Even blockchains' proponents acknowledge this.

For example, Jonathan Levin, whose Chainalysis firm is representing the creditors of failed BTC exchange Mt. Gox, points to age-old problems of who gets to play and how.

“If it’s completely decentralized, in those situations there are no political costs in terms of who can and can’t participate on a ledger,” he says. “Getting into a permissioned system you introduce those costs, and we’ve always seen this problem before: Look at LCH.Clearnet only recently admitting Citadel Securities to directly clear swaps for the first time. Who sets the rules in how these shared ledgers work? It’s always a risk, or at least a potential cost.”

Second, there’s getting the regulators up to speed. Many in the space insist they’re keen to see regulators condone the use of blockchain, much the same as BTC. But significant work remains in simply fleshing out the technology’s limits in front of authorities, especially given that most blockchain work has, so far, been done in private.

In a telling exchange at the Risk event, one regulator posed the question to Tim Swanson, R3’s director of market research, as to whether blockchain would be good for recordkeeping obligations around algorithms and intellectual property. “What is blockchain good for? Most of all, prevention of fraudulent double-spending. There are better areas for storing data, itself,” Swanson said. “Some entities might be looking at it for that purpose, but no formal body has sanctioned using it in that way yet.”

Chou sees a third problem. Philosophical differences aside, blockchains are simply no panacea. In terms of facing capital markets intricacies, especially around the negotiated and oft-hastily implemented deals that can represent billions of dollars required in a pinch, he says they’re really like any ledger—good, but only to a point.

“I understand the risks in overhauling critical infrastructure,” he says, citing his past experience with production code at an investment bank. “If you’re a tech executive with lots of IT issues and hear about this amazing computer science breakthrough from respected guys like Marc Andreessen, it’s natural to see if that breakthrough can be used. But when I have friends say ‘settlement is just too slow and blockchain will solve that,’ it becomes clear they’ve never had experience analyzing a complex rights offering, exotic stock splits or a special dividend,” he says. “Blockchain doesn’t solve that type of complexity; it’s just inherent to the nature of securities in general.”

Messing with a Good Thing?
Just where blockchain ends up—or doesn’t—is probably best left for 2018 or 2020. After all, financial firms and venture capital have a long history of jumping on the next great thing, only to rubbish it when either their tack or the timing proves wrong. They’ve also been known to raise projects from the dead. 

Just look at bitcoin. As R3’s Swanson puts it, most bitcoin startups don’t talk about their progress today because, following a nosedive in the currency’s value, “they’re doing miserably.” A similar level of cloak-and-dagger can be expected for the ledger’s application in the short term. Not every venture will pay off.

Keeping that in mind, indications are that banks and providers alike will hedge: pick and choose pilot applications, adopt a startup here and there, create yet more industry groups and evangelize in generalities. This should produce some incremental gains, sources say.

“You’re never going to mitigate risk to zero,” itBit’s Cho says. “But the goal is to apply this to reduce risk where you can. For now, go from point A to B. Over 10 to 20 years, 50 percent is still a huge improvement.”

Meanwhile, those who knew blockchain earliest keep their argument simple: remember what got us here. As Joshua Lim, another Goldman alum and head of treasury at Circle Financial, says, “the biggest positive around this technology is still the ability for anyone to innovate.”

Chou puts it in a bigger perspective. “Projects that are trying to repurpose an open technology for use in a closed environment will never yield the benefits of what the technology was designed for. Facebook versus private social network Ning, AOL’s ‘walled garden’ during the early days of the internet, and BlackBerry not opening up its platform for third-party applications are all good examples. If it’s just about recording transactions in privately shared ledgers, that’s all possible today with technology already in the market. What you’re really looking for is a Mark Zuckerberg for finance, hiding out in the middle of nowhere. For the first time in history, developers can write innovative applications that move value around without permission from a bank. A new digital asset class, with global open access underneath attracting talented entrepreneurs, is far more transformative.”

Can blockchain be institutionalized, while still retaining that kind of potential? Something will have to give. 

Salient Points

• Myriad different blockchain startups and bank-backed consortia has sprung up in the past year as financial services attempts to repurpose the distributed ledgers for settlement and other capital markets uses.
• Not all industry experts agree, however, on the suitability of blockchain for these problems—particularly for permissioned groups with known participants. Among the skeptics, those with deep background knowledge of bitcoin have proven most vocal.
• Practical challenges also await blockchain’s adoption, including issues of inclusion and exclusion, getting the regulators appropriately involved, and matching the operational complexity of the bespoke deals and niche asset classes for which it is most likely useful.
• The current tack should lead to continued incremental gains for blockchain’s deployment in the coming year; however, its wider adoption or appeal for larger implementations remains a matter of fierce debate.