You may have heard of bitcoin and even own some form of digital cryptocurrency or bitcoin Exchange-traded Fund (ETF). Cryptocurrency is shaking up the financial world by making it possible for parties to exchange money without the need for intermediaries like banks and exchanges. However, you may not be as familiar with blockchain, the technology that underlies cryptocurrencies and is increasingly being used in ways that range from trading, lending, payments, contract management, and inventory management in supply chain.
Foundational blockchain concepts such as cryptography, data timestamp, token, immutability, distributed public ledger and peer-to-peer networks were well documented by academic researchers in the 1980’s and 1990’s. It was not until 2008 when a blockchain-based bitcoin network and first bitcoins were created that the financial services industry (FSI) first witnessed its impact. The publication of a paper on bitcoin and an open source blockchain initiative undertook by Satoshi Nakamoto (Pseudonym), who is often considered the inventor of blockchain technology caught the attention of many; realizing the value that blockchain could bring to decentralized finance.
A blockchain is a distributed network that functions as a digital ledger enabling the secure transfer of digital assets without an intermediary. Blockchain facilitates the digital flow of information and exchange of units of value. The technology is based on decentralized and public networks that operate in a peer-to-peer fashion. A record of transaction gets distributed, validated, and maintained by a network of computers. Instead of a single central authority such as a bank, records are supervised by a large community. No individual person has control over the network, and no one can go back and manipulate the data due to blockchain’s distributed nature and confirmed guarantees by the peers.
Blockchain technology has seen its early success in digital cryptocurrency. The technology has many other promising use cases and continues to see adoption throughout many industries but has gained especially strong traction in FSI because of its irrefutable security and ability to provide a complete solution to digital assets. Blockchain technology can not only be used for transactions, but it can be considered as a registry for other physical and increasingly digital assets such as stocks, bonds, derivatives, and non-fungible tokens (NFTs) just to name a few. Anything from bitcoin to payment to digital art can be tokenized, stored, and exchanged on a distributed blockchain network.
Security Issuance, Trading and Settlements
In the past few years, financial services companies have explored many blockchain use cases in security insurance, trading, digital payments, tokenized assets, compliance, and beyond. In a highly regulated industry, a mindset shift towards blockchain technology is driving new business models, products, and revenue streams. In particular, the largest banks have shown a strong willingness to adopt the new technologies. This has resulted in active exploration and early adoption that is transforming some traditional business functions, legacy processes, and outdated operations.
Security Issuance
Companies can raise capital by selling equity or debt either publicly or privately. The issuance and trading of securities is often heavily regulated. In the U.S., the Security & Exchange Commission (SEC) oversees capital markets and security insurance. The current issuance process is based on the creation, distribution, and management of physical documents such as stock certificates and bond notes. The process remains manual, paper intensive, less transparent and costly due to involvement of many intermediaries and different systems used to facilitate the security issuance.
Blockchain technology can support the direct issuance of digital securities by placing them on a distributed ledger, allowing direct dealings among the issuer, investment banker, lead manager, syndicate members, and regulators. Physical stock certificates can be eliminated and replaced with digital ones that offer greater transaction efficiency by being on a distributed ledger on a blockchain network.
In 2015, the SEC approved a plan from online retailer Overstock.com to issue part of company stock via the Internet, signaling a significant shift in the way financial securities will be distributed and traded [1]. Overstock.com then made history by offering digital dividends in the spring of 2020. The dividend transaction took place via Computershare, and a copy of the digital token was created on the blockchain to accommodate future capital markets digitization initiatives.
Security Trading
On a blockchain enabled technology platform, trades occur directly between two investors instead of through brokers, clearinghouses, and other intermediaries. These trades settle almost instantly, rather than the typical 2–3-day cycle. The platform is open, transparent, cost effective, and operates 24 hours/day.
The current markets; however, are not built for that kind of trading. Several blockchain initiatives are underway to create digitized markets. London-based Blockchain.com, funded in 2011, began as a “wallet” service provider and now has the infrastructure needed to offer trading, custody, clearing and settlement services to retail and institutional clients trading cryptocurrencies. The company plans to list traditional assets on its exchange next year. Similarly, Coinbase, a U.S.-regulated and public-traded cryptocurrency exchange, has similar plans.
Blockchain technology offers a big opportunity for traditional banks and online brokers. A large portion of a bank’s operating costs are associated with back-office functions. By making investments in blockchain technology in-house or forming strategic partnerships with FinTech’s like Coinbase, Gemini or Binance, banks gain access to the latest technologies, expand their service offerings in a horizontal integration, and can reinvest savings through operational efficiency gains. In 2019, J.P. Morgan became the first global bank to design a network to facilitate instantaneous payments using blockchain technology - enabling 24/7, business-to-business money movement. The bank has since rebranded its blockchain business under Onyx to pioneer the way that money and assets are moving around the world.
Post-trade Settlement
When investors buy stocks, they use a broker, who holds the client’s assets at a custody bank. The trade is processed by an exchange. A clearinghouse, such as the Depository Trust & Clearing Corp (DTCC) in the U.S., is the holder of every publicly issued stock. Financial intermediaries maintain their own set of records and spend a lot of time reconciling different record books today. On a blockchain platform, transactions would get recorded on an open ledger on a network, of which every financial intermediary maintains an identical copy with transactions visible to all. The process of clearing, settling, and reconciling is automated. A transaction goes from an initiation to its settlement in minutes.
Today, the DTCC is running a pilot program using blockchain technology to trade private equity shares. New York-based Paxos, a crypto services firm, is running a pilot program for a blockchain-based settlement service for stocks. The pilot participants include Wall Street firms like Credit Suisse, Société Générale and Instinet. Outside of the U.S., the Swiss National Bank and the Bank for International Settlements are operating Project Helvetia, looking at the feasibility of integrating digitized trading within a central bank’s monetary infrastructure.
Accelerate Blockchain Investments to Drive Value
As blockchain technology evolves and transforms modern finance, it is disrupting existing players and eco-systems. It has and continues to create winners and losers by removing intermediaries and disrupting revenue streams.
However, despite the FS industries early adoption of blockchain technology, the market is still nascent and a clear recipe for success has not yet emerged. Many blockchain technology use cases and early adoption by FinTech’s or established players have only touched some areas of the market ecosystem. Experimentation of blockchain solutions without an assessment of the value at stake or the feasibility of capturing it means that many companies may not see a return on their investments [2].
Blockchain technologies near-term value is to drive operational efficiencies and cost reduction, focusing on addressing pain points with specific use cases like the ones outlined above. Value cannot be realized by the blockchain hype alone without follow-through investments to integrate blockchain technology solutions with corresponding changes to organizational processes and an enabling team. Long-term value for adopting blockchain technologies can be best realized by building out an eco-system through combination of making targeted investments in-house and forming strategic partnerships with promising FinTech’s in an horizonal integration model that is increasingly adopted by some traditional players.
About Monticello
Monticello Consulting Group is a management consulting firm supporting the financial services industry through deep knowledge and expertise in digital transformation, change management, and financial services advisory. Our understanding of the competitive forces reshaping business models in capital markets and digital banking are proven enablers that help our clients drive innovative change programs to be more competitive and gain market share in new and existing businesses.
Sources:
[1] Vigna, Paul (2021, April 8). GAMESTOP AND BITCOIN RENEWED A PUSHTO DIGITIZE THE STOCK MARKET. Wall Street Journal. https://www.wsj.com/articles/gamestop-and-bitcoin-renewed-a-push-to-digitize-the-stock-market-11617886852
[2] McKinsey Insights (2018, June). Blockchain beyond the hype: What is the strategic business value? https://www.mckinsey.com/business-functions/mckinsey-digital/our-insights/blockchain-beyond-the-hype-what-is-the-strategic-business-value
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