In a DerivSource Q&A, Dave Birch, director of innovation at Consult Hyperion, explores why Blockchain has become such a hot topic for the financial industry and what benefits use of this technology may realistically deliver for individual banks and the market as a whole. Listen to the podcast.
Q. What is the main difference between Blockchain and Bitcoin?
A. That is a complicated question to answer on a couple of different levels. So, I’ll complicate the question more first, and then hopefully I’ll provide a simple answer.
Bitcoin, the payment system and currency, uses a form of shared ledger technology. In other words all of the participants in the network essentially have a copy of all of the transactions, and we call that a shared ledger. Having a shared ledger is a good thing because if you have bad actors in the network and they attempt to sneakily change some of the transactions, everybody else has a copy of the ledger. So basically if you want to cheat, you’ve got to sneak in and change all of their ledgers as well, that’s quite hard to do – that’s why we like shared ledgers.
Bitcoin uses a form of shared ledger, or a Blockchain. And there are some different kinds of Blockchains, but one kind is called a Proof of Work Blockchain, which is the specific kind that Bitcoin uses and is probably the reason why there is confusion in the marketplace about Blockchain versus Bitcoins.
In short, shared ledgers are a really interesting new category of technology that has a lot of promise for reasons I’ll explain later on.
Q. Why has all of a sudden Blockchain become such a hot topic over the past year?
A. Firstly, I have a sort of sociological theory about the sudden interest in Blockchain. My view is that this all traces back to the recent financial crisis. There had been a variety of experiments with different kinds of new forms of money, new forms of electronic cash and virtual currency, for many years, but I somehow think that the market crash meant that people were more prepared to look at more radical alternatives which maybe they hadn’t been in the past.
And so along comes Bitcoin and of course it has a fabulous creation-myth to go with it, you know, this mysterious guy who was sitting under a tree somewhere and thought it all up. I mean, that’s just a great story. And somehow that got some traction and got going. And then when boring people like me had a look at it, they said: “The currency thing is kind of stupid because first of all it’s not really money. Whatever you want to call Bitcoin, whether you like it or not, it’s not money, it’s a form of digital commodity of some kind. And I think the regulators are, broadly speaking, agreeing about that. But the way that it maintains consensus between all of these different copies is really pretty interesting, so why don’t we take a look at that? I remember going to the first European Bitcoin Conference, which if memory serves was around 2011. I came back and told our clients, “You know I wouldn’t really put too much on Bitcoin, but the shared ledger is something that’s time has come.”
I should say that for my clients, which are banks, Bitcoin doesn’t solve any actual problem that any bank actually has, because the crucial design requirement for Bitcoin was to provide for uncensorable value transfer between untrusted actors, and that’s not the world banks live in. So, if you have a network of people that are trading derivatives, or stocks, or fish, or something, you have a network of people who are known and trusted. The design goals of Bitcoin have got nothing to do with that environment so that’s why it doesn’t really fit in.
But this idea of the shared ledger has a crucial driving narrative behind it, which is why I think even if it’s not articulated in that way, which is why I think it’s gaining traction, and this is all to do with transparency.
One of the most critical problems of the recent crisis particularly true for the complex derivatives market, is that no-one knew what on earth was going on then because there was no transparency, and in particular from a regulatory point of view it was very hard to establish the state of the market.
So the idea of a shared and a replicated ledger, where all the market participants have essentially copies of the same ledger which they’re updating, and then you have a clever consensus-forming protocol to work between them to make sure that the ledgers are updated and maintain a view of the real world, where access to that ledger can also be given to regulators, provides a very interesting new degree of transparency that we haven’t had before, and I have a feeling that, technological reasons aside and issues of cost reduction and simplification particularly in post-trade taken into account, I have a feeling it’s this narrative around transparency which is actually giving the whole thing traction.
Q. What about cost reduction? Are there any studies done on how much that can save the bank or deliver other benefits to financial institutions?
A. We have done studies for a variety of different clients but I’m slightly suspicious of any assertions that a bank could save trillions of dollars a year. There is a consortium of some of the biggest banks in the world coming together now to explore shared ledger technology, but it’s very early days. I’m not traducing them, because they have brilliant people on board but I doubt they could even show you PowerPoint now; it’s still to early for that. So when I see a thing that says ‘the Blockchain could save a billion Dollars a week’, I ignore it. It’s too soon to say any of that.
Having said that, even if use of Blockchain results in no cost saving whatsoever, I think there are probably three factors, which will drive the marketplace in that direction.
One is there are good reasons for thinking that it provides a more robust market infrastructure. So if everybody is working off copies of a shared ledger rather than a single centralised ledger, which could fall over or be cyber attacked, so everybody having a copy provides for a kind of robustness which I think is interesting and very appropriate in certain markets.
Secondly, there are reasons for thinking that it provides for a more open structure for innovation. We’re moving into a world of APIs and apps so the idea that you could have a ledger that was audited by app constantly, rather than once a year than some accountants, that’s quite interesting. I suspect that opens up the possibility of some new products and services sitting on top of the ledger there as well.
I shouldn’t want your readers to think this means an end to privacy in the marketplaces. We’ve taken to calling these ledgers translucent because there are a variety of mathematical techniques, which mean that you can store things on ledgers that can be shared, but the data can remain private. I can look at your ledger and see that you’re solvent, or that you’re not breaking laws, or whatever, without being able to read individual records. I don’t want people to think there’s no privacy in all of this, that’s not true.
But I think there’s plenty of room for innovation there. The idea that people will build new stuff on top of these ledgers is broadly true. And also, because the ledgers are replicated, different banks, different institutions can interface in different ways to their existing legacy infrastructure; I think that provides us some opportunities as well.
And then the third reason why we will move towards Blockchain is the issue of transparency that I was talking about before.
If you read some assertions that shared ledgers are going to lead to new kinds of financial services and new kinds of institutions, I think I would probably believe that. If I see something that says the Blockchain is going to do that, I’m not entirely sure. In fact I think that’s probably not going to happen. And if people say, well Bitcoin is going to cause this, I’m utterly skeptical.
Q. For what type of applications will Blockchain be first used? Will it be liquid or illiquid markets, and why?
A. The idea that you’re going to use it for regulating high frequency trading seems a little unlikely, because the way the technology works at the moment, the way we expect it to work, this isn’t something you’re going to build to replace some trading platforms that are doing a million trades a second, I don’t think it’s that to begin with. I think we need to look in other areas where the technology can be proven; in an area where one of those factors I talked about is important. Again I’d be hard pressed to prove this to you with bar charts and spreadsheets, but I have a feeling it might be the transparency area.
I’m saying ledger, and you’re probably picturing a dusty old book and somebody writing in it with a quill pen, but of course one of the interesting things that’s going on at the moment is that people are storing essentially executable code in these ledgers – this is also where the concept of smart contracts comes from. I can put things on the ledger that are programs that run, as well as just data. And you can imagine an environment where the choices of operations that those programs can perform are defined by markets and regulators so that I actually can’t write a bad contract, it just won’t work, there isn’t the code for it. So the regulators would regulate in a very different way.
At Consult Hyperion, we’ve done some work on this in some other areas and I’ve stolen a term for this from architecture: we call this ‘ambient accountability’. The idea that you simply can’t run software that executes something improper. This is a really interesting area to explore. I believe we might be looking for markets where we need some transparency, where the rules are simple enough that they can be written into programs without too much trouble, where we can experiment with the robustness and the innovation alongside that transparency. I’m not expert enough to say whether these are good enough or not, but people have spoken about certain kinds of OTC derivatives in that space, you know, certain corporate bonds for instance. It’s certainly going to be worth the experiment.
Q. What, as with all new technology, what are the barriers to adopting it? Are the regulators responding well, are they accepting of this new technology?
A. Well, with the obvious caveat that almost everybody involved doesn’t really understand it or know what’s going to happen yet. I don’t know what’s going to happen either – it’s a new area. With that obvious caveat, As a result of transparency aspects to it, I would have thought the regulators would be rather in favour of Blockchain, because that’s the area where small improvements could make quite big changes in overall stability and security. I don’t see this as a negative thing; if I was a regulator I would be very interested in exploring this, of course.
Q. How do you see the solution developing? Will it be industry-led or will the technology be developed by individual banks or vendor providers, or a combination of all three?
A. Speaking from a technological perspective, and I’m not by any means the first person to make this point, what we’re likely to see is a number of shared ledger platforms emerging which are for different industry sectors and then, particular markets or particular products will build shared ledgers on top of those platforms. So I expect to see a number of platforms arise.
If you look at what’s actually happened in the market, in particular the bank consortium that’s building and using R3 to start to look at what the standards and practices might be, I think if they can put together an initial platform that can be used for two or three different kinds of products, I think that’s all we need to do at this stage. So, I do very much see it as a kind of industry sector and platform-oriented thing.
That’s not to say that you couldn’t see individual kinds of shared ledgers emerge to serve very specific niches, but I couldn’t see an industry along the size of the securities industry messing around with those kinds of things, I think they’re probably going to want to agree something on a much bigger scale, which of course means it isn’t going to happen tomorrow.
So we can carry on experimenting with shared ledgers and learning and trying out some different things, but the market isn’t going to change tomorrow.
* Read related blog: “What is a smart contract anyway?“
