Blockchain is the technology behind the phenomenon that is bitcoin – and it may end up changing how the finance industry operates forever. From payment processing that bypasses the banking system to cryptocurrencies launched by central banks, its impact could be significant. However, this technological disruption is unlikely to happen overnight, as regulators will want to keep tight reins on the global financial system – but what could we have in store?
A blockchain enables any type of encrypted data – from electronic money to medical records – to be shared between members of a closed network. Blockchain protects the data from fraud and updates all the members concerned. It is what is known as distributed ledger technology (DLT), allowing a network of computers to agree at regular intervals on the true state of a ledger’s position. Copies are shared between all participants and a process is established by which users agree on changes to the ledger. Since anyone can check any proposed transaction against the ledger, this means there is no need for a central authority.
Proponents of the technology argue that it will ultimately reduce the need for much of the financial intermediation that provides lucrative earnings for many businesses in the City, as it essentially removes the need for middle men.
As a result, financial services firms are actively exploring how they can use blockchain to save costs and remove the existential threat it poses.
For example, Nasdaq is investigating the possibility of creating distributed ledgers for private company share registers. The Australian Stock Exchange is testing whether blockchain could be used to replace its existing clearing and settlement systems.
A consortium of 70 of the world’s largest financial institutions has also formed R3 to develop a platform called Corda that settles transactions faster and at lower costs using DLT technology. R3 includes major banks such as HSBC, Barclays, UBS and Bank of America.
However, the development of closed blockchains to which only these companies have access may be ultimately thwarted by competition and regulation may not allow it. Because, ultimately, regulation in this area is highly likely.
Interestingly, central banks, including the Bank of England, are exploring the merits of a digital central bank currency. Earlier this week, Axel Weber, UBS chairman, and past president of Germany’s Bundesbank, argued that central banks should be open to creating digital versions of the currencies. “Whilst the official sector very often looks at the risks of these new means of payment, the private sector tends to look at the opportunities they offer,” Mr Weber said. He urged central banks to consider any benefits they could bring.
The Bank of England could create digital-only pounds and then sponsor software to allow individuals and firms to have their own digital wallets and use DLT to transfer money to others. This would have a number of advantages. It could reduce the “too big to fail” problem, in which the BoE has to support large UK banks because of their importance to the UK payments system, because money transmission is undertaken outside these institutions. A properly-designed digital-only currency could also facilitate tax collection and the prevention of money laundering and terrorist financing.
Importantly, a crypto-pound could help with monetary policy because it would allow the Bank to set negative interest rates if it believed they were appropriate to boost a moribund economy.
Currently, the existence of notes and coins makes this problematic. If a currency was completely digital it would no longer be possible for depositors to avoid negative interest rates by hoarding cash under their mattress. However, there are downsides too. Digital currencies are likely to take deposits away from commercial banks and curtail their lending activities – which may have a major impact on economic growth.
Disruption from technological innovation has devastated traditional business models in many industries such as retail, publishing and media, while the financial sector has been relatively unscathed. But things are now likely to change.
In banking, DLT could be used for general payments, with peer-to-peer payment platforms hitting money transmission services and card payments operations, putting pressure on profitability. If a digital central bank currency is launched that actually pays interest, the deposit taking business of banks will also be negatively affected. It is even possible that technology companies could process payments free of charge, undercutting the incumbents because they seek to profit from the data involved in the transaction. DLT could be extensively used to save costs in settlement and clearing.
Of course, the technology is still in its infancy and we are unlikely to see anything like a central bank digital currency in wide use for some years – if at all. But blockchain has now emerged from the shadow of bitcoin and offers a wide range of exciting possibilities ahead.
It offers a powerful tool to improve efficiencies in financial services by speeding up settlement, reducing risk and costs. However, its adoption is likely to be a slow process, with the pace of change slowed by regulatory investigations and increasing legislation given the enormity of thechange.
The risks are currently quite hard to assess and since the technology could become so transformative, centrals banks are likely to proceed cautiously to say the least.
Garry White is chief investment commentator at Wealth Manager Charles Stanley
