Can Blockchain Become the Infrastructure of Financial Services?

“Banking’s back end is a mess,” Forbes says. The Harvard Business Review puts it this way: “It’s antiquated, a kludge of industrial technologies and paper-based processes dressed up in a digital wrapper.” But evangelists for blockchain technology believe that may all be about to change.

If it proves out, blockchain software—most visibly used to create bitcoin—can be a secure, easily-audited, nearly frictionless ledger. “It sets up a series of permanent, transparent checks and balances that in theory eliminate the possibility of fraud and the need for pesky third parties that charge a fee to clear transactions,” notes Forbes. “That is the best of both worlds for an industry besieged with cyber criminals and transaction costs that swell with every new financial regulation.”

Blockchain-based tools could eliminate billions in fees annually. On the order of $16 billion to $20 billion, according to studies cited in the Harvard Business Review, which goes on to observe that streamlining the infrastructure of finance might not be the endpoint. “By reducing transaction costs among all participants in the economy, blockchain supports models of peer-to-peer mass collaboration that could make many of our existing organizational forms redundant.”

While blockchain’s revamping of civilization may be a ways off, the fintech firm Digital Asset is already creating distributed ledger platforms for its clients. Yale Insights talked with CEO Blythe Masters about the technology’s potential to bring innovation to the regulated financial institutions that provide the infrastructure of the financial system.

Q: What’s wrong with the way that financial institutions have traditionally shared their data?

If you imagine a process such as, for example, the settlement of securities in a post-trading environment, there are many entities involved: the buyer and seller, a broker on each side, a custodian on each side, a clearinghouse if one is involved, the settlement bank that provides the payment or account services, and a central securities depository that tracks the ultimate records of ownership. Today, all of those entities keep their own records using their own databases. Those databases use their own perimeter security, and the information typically is unencrypted. There are expenses associated with maintaining independent records as well as with coordination, validation, and verification of transaction information.

In any situation where you have multiple independent entities depending on the same information but where that information is held separately, fragmented, and often in different formats, the process required to reconcile and reach agreement on that information—in order to allow a transaction or a contract to come to its fruition, even something as simple as a stock transfer from me to you—is inherently inefficient, challenging, and exceedingly expensive. It’s the reason why settlement, for example, takes as long as it does, which is days and for certain asset classes weeks or even months.

Now imagine a system where all relevant parties share a common record of the information. By design it cannot get out of sync. The task becomes much simpler. The records become like conveyor belts running through the center of a manufacturing process where the interested parties interact with the data. Each completes their respective role, but ultimately, they’re all working on one body of work as it progresses through the stages of the transaction or contract cycle. That is, in essence, what blockchain or blockchain-inspired technology allows you to do, in a fashion which, importantly, is secure.

The key is designing a system which enables multiparty processing of a common or shared record while maintaining privacy so that the only information each entity sees is exactly what it has a need and a right to, nothing more, nothing less.

Q: Are the incentives in place to drive innovation and implementation of a new system?

The incentive for improvement is there because these are very costly, time-consuming, and inefficient processes. Banks and others in the financial sector are challenged by the fact that they’re not delivering returns that justifies their long-run cost of capital. They need to improve the economics of their business. They also need to provide a better customer service so that it no longer takes eight days for a dividend to appear in someone’s account.

But only with the advent of blockchain-related technology has the mutualization of these activities become feasible in a way that allows you to be sure of the integrity of the information without giving up your fiduciary responsibility to be able to independently establish that that information is accurate.

Q: Are there reservations within the industry?

There are many barriers to adoption which are, I think, all eroding, gradually or in some cases quickly. The potential for application of blockchain technology in financial services, at least on a wholesale scale, has only been seriously thought about since late 2014. Blockchain technology has been around longer than that, but focused investigation into applying it to regulated financial markets is quite recent.

The impediments include the fact that the systems that this would replace are gigantic, old, and extremely complex. They have to integrate with many other systems, both inside and outside the institutions in question. Progress requires investment, coordination, and cooperation among independent entities, and that is inherently a difficult thing.

There are other questions which relate essentially to getting comfortable with the claims that I’ve made as to the security, privacy, and capacity of this approach. The throughput, the ability to process gigantic volumes of activities, has to be demonstrated. That’s an educational process. There’s a been a tremendous amount of work going on throughout the industry. Startups, the major financial firms, and some of the biggest technology companies in the world—VMware, Intel, Oracle, IBM, Amazon, and Microsoft—are all working in and around this space to develop and test the technology.

Because the theory sounds very simple and very appealing, the practice needs to be very convincing, very resilient, and very secure. You don’t just build enterprise-grade, systemically meaningful infrastructures overnight. It takes time. But the adoption rate is building. Momentum is building.

Given the tremendous amount of capital, both in terms of dollars invested and time and effort coming into this space and the pace of technology evolution today, it’s not surprising that we’re now seeing enormous strides forwards. We were talking about concepts just a few years ago. Now the concepts have been thoroughly proven. We’re working on actually implementing enterprise-grade versions of this technology. The challenge is finding the right use cases where the economics justify the investment. Progress has been remarkable where those have been uncovered.

Q: This space is quickly getting crowded. How does Digital Asset differentiate itself?

Digital Asset is differentiated from many others in the sense that it combines depth of experience in the financial services industry with technology expertise. Familiarity with the existing infrastructure, regulation, players, and reasons why the ecosystem works the way it does, lets us respect the complexity, challenges, and the compliance needs of the businesses. At the same time, we have extraordinary technology talent, including specialists in functional programming, cryptography, and formal proofs for the software engineering end of the business.

Our product is an asset-class-agnostic platform. It enables you to process transactions in clearing and settlement or repo or corporate actions—an array of different activities in different asset classes.

This isn’t a product looking for a problem to solve. We started with customers who had clearly articulated problems and worked with them to build a technology to solve those problems. That has enabled progress that is much harder when you don’t really have a real use case in front of you.

We’re expecting to be the first to deploy a blockchain-based system for a major market infrastructure anywhere in the world. The system won’t be proprietary; it’s licensable by other customers using our platform.

Q: To what degree does there need to be convergence on standard tools to make progress?

There are many different approaches at the moment, and different approaches for different use cases are fine. There are clearly going to be opportunities for standardization, though we’re not going to arrive at a point where you have one blockchain to rule them all. That would be neither desirable nor very likely. If you look at all technology in terms of enterprise platform evolution, you always find that there are common components and elements that remain bespoke, with highly value-added layers.

Q: How do the regulatory framework and the new technology interact?

It is hard to introduce a new technology in a highly regulated financial ecosystem, where you’re operating a systemically consequential market infrastructure. But that body of regulation is well understood. The principles have existed for a long time. And they are black and white. You either build systems to those standards or you fail to do that, in which case your regulated customer will not be able to use it. In this particular area of fintech development, the regulation doesn’t need to change. We need to comply with it in order to enable our customers to operate within it.