Around the world, finance experts are betting that a technology called blockchain can create the one true record of transaction – and cut billions of dollars in costs.
By Beverley Head
Every time you make a transaction this week, you will inevitably use the services of a trusted middleman. A bank confirms you have the amount needed for your cup of coffee, and passes it on to the cafe owner. The state titles office confirms you own your house and transfers title to the young family who won the auction. The auditor checks your company’s books and confirms their veracity so that people can deal with your business confidently.
Removing that trusted middleman would strip time and costs from all sorts of processes.
Now a technology called blockchain – originally developed for the troubled Bitcoin digital currency – is being touted as a way to get the middleman out of the way. Its enthusiasts, moreover, are not starry-eyed digital idealists but hard-headed financial players.
Morgan Stanley, for instance, says blockchain and its shared ledger could strip billions of dollars of costs each year from financial markets, while improving security, speed and market visibility and reducing disputes and fraud.
Australia’s leading banks, the Australian Securities Exchange (ASX) and international law firms – plus a raft of start-ups – are investing in blockchain experiments. Streamlined supply chains are said to offer a “trillion dollar opportunity”, dispensing with paper-based systems in favour of transactions verified by the blockchain, with funds transferred directly between the trading partners.
John O’Connell, chief investment officer of Macquarie Group, argues that at some stage, however, blockchain will significantly impact every digital business. He calls blockchain “a layer of trust on top of the internet … a mathematical chain defining the provenance of what you are looking at”.
Trade in antiques, for example, can rely on blockchain certificates to prove that the item is not a fake. Similarly, if you are paying A$80 for a jar of Manuka honey, the blockchain can confirm you are getting what you paid for.
The single, trusted record is the promise of blockchain, and it’s why there is so much discussion of the nascent technology.
Examples of blockchain’s success, however, remain rare and insights on its actual effects are scarce. This is why so many discussions of the technology appear vague. Analysts suggest it could take up to a decade for the technology to be deployed in streamlined supply chains; it is expected to make its mark sooner in the finance sector, where it could roll out in the next three to seven years.
“Blockchain” is a layer of trust on top of the internet.” John O'Connell, Macquarie Group
CSIRO’s Data61 and the Australian Treasury are midway through a nine-month review of the technology to gauge its long-term impact on industry and government.
Mark Staples, one of the project leads, says experts are still working out how blockchain can be used to achieve goals. He argues that because the potential uses are so broad, “it’s a bit like saying ‘where could databases be used?’”
Potentially, he says, blockchain can be used for any sort of information exchange.
Jonathan Perkinson, a partner in Deloitte’s payment advisory practice, believes blockchain will have an impact but that the disruption of all accounting and finance is a long way off. Macquarie’s O’Connell expects there will be a slow build as organisations test the technology, work toward standards and monitor regulator commentary.
The shared ledger’s single version of truth should, for example, make reconciliation instantaneous. Instead of being a monthly, often manual chore, reconciliation of the blockchain is immediate – and there is no opportunity for error or fraud, because the reconciliation is digital and agreed by all the parties on the blockchain.
Says Staples: “It won’t reduce the broader need for accounting, but there will be a different way to store and share information. This is not just about cyber currency but all sorts of assets and information.”
In their recently published book, Blockchain Revolution, business strategy writers Don and Alex Tapscott note the blockchain’s potential power to make ownership more secure. In most advanced nations, trusted title databases allow the secure transfer of real estate.
In developing nations, however, that is not the case; people can find their farms and homes sold from under them. The blockchain could be deployed to overcome the issue without needing a third-party trusted agency. Examples of how blockchain could be used are now emerging for real estate, farm produce, antiques and art, supply chains, settlement systems and more.
The Tapscotts even posit the emergence of a “World Wide Ledger” that records every transaction along with a time-stamped receipt on a shared ledger.
“The financial reports for a company would become a living ledger – auditable, searchable and verifiable,” they say.
For auditors or regulators, this is a compelling proposition as the raw data can be viewed in real time at any time – rather than at the end of a financial year after a lengthy physical audit.
Blockchain technology could also interact powerfully with what is called the “internet of things”. Sensors in driverless cars, in fridges and in other smart devices could be embedded with smart contracts able to pay a road toll or schedule a service, order groceries and buy electricity, with the whole transaction managed and recorded in a secure blockchain.
In the case of the road toll, the contract is embedded in the sensor in the car, so that instead of a toll operator deducting an amount from an account every time a car travels on the road, the smart contract authorises a direct transfer of value.
Making it real
One of Australia’s highest-profile blockchain projects is being undertaken by the ASX, which in January announced its 5 per cent, A$15 million stake in New York-based fintech firm Digital Asset Holdings. In June, it provided a second A$7.2 million injection.
At present, the ASX needs to hold A$250 million in its default fund. Blockchain-based settlement could do away with that requirement as funds would be transferred much faster.
The ASX and Digital Asset Holdings are working on a blockchain-based distributed ledger for faster post-trade settlement that could cut today’s T+2 (trade date plus two business days) settlement period to near-real time.
CPA Q&A. Access a handpicked selection of resources each month and complete a short monthly assessment to earn CPD hours. Exclusively available to CPA Australia members.
Fear is the key for banks
In the banking world, the Commonwealth Bank of Australia (CBA) was the first of the local majors to show its blockchain hand, revealing last year that it was testing the Ripple solution to make direct bank-to-bank international settlements. These settlements currently rely on correspondent banking systems, which can be slow and inject expense.
Spanish bank Santander has suggested that distributed ledger technology could save the world’s banks as much as US$20 billion a year by 2022, by cutting the cost of cross-border payments, securities trading and regulatory compliance.
Global trading network SWIFT has also recently acknowledged that distributed ledgers that share, agree and validate data could “substantially reduce … the US$40 billion or more of costs in global post-trade processing of securities trades”.
That explains why 50 of the world’s largest financial sector organisations – including CBA, NAB and Westpac – have joined the global R3 consortium, which is developing solutions and finance sector standards for blockchain applications. A fear of disruption is driving this race to experiment among the banks.
Ray Valdes, fellow and vice-president at technology advisory firm Gartner, says: “I’ve been to internal meetings with one of the world’s largest banks, managing US$30 trillion in assets. The CEO said, ‘We need to work with blockchain, because we want to disrupt ourselves before we let someone disrupt us’. That’s the motivator.”
The Australian Securities and Investments Commission has demonstrated how large that disruption looms. It plans to allow Australian fintechs to test new services – including blockchain-based services – without first needing a financial services licence.
The digital deal
The disruptive impact played a role in the release of a blockchain-based smart contract by the Sydney office of international law firm King & Wood Mallesons (KWM). The digital smart contract is a computer program stored on a blockchain that secures, enforces and executes settlements of recorded agreements. The firm says such smart contracts “activate automatically when lifecycle events occur in the contracts”.
These events, it says, include not just payments and deliveries, but other events such as credit or succession events under derivative contracts.
“This already works on centralised financial market infrastructure like clearing houses and trade warehouses, and it could also work on decentralised financial market infrastructure created using blockchain,” adds the firm.
"This is about all sorts of assets and information." Mark Staples, Data61
Partner Scott Farrell explains that the smart contract was in part the firm’s way of responding to a technology that was being touted as a replacement for conventional legal services. Its smart contract is the digital element of a deal that can be augmented with conventional legal services for a particular application.
KWM’s first smart contract supports clients doing deals in the debt capital market, where a key element of the transaction involves computation and clearly defined standards. That is handled automatically by the smart contract, with the shared ledger agreed by the parties up front.
“This allows the parties to reconcile, at the start, what their transaction is,” says Farrell, who expects far fewer disputes to arise as a result.
John O’Connell agrees that the shared ledger will deliver benefits. “With the current system of traditional ledgers, you have lots of redundancies and everyone has to maintain their ledgers,” he says.
“So mistakes are made and eventually you have to true up your books – and there are costs in that.
“With a distributed ledger, you are effectively getting a consensus view. This is the one and true record.”
9 technology trends you need to know about
What is blockchain technology?
When Bitcoin was first introduced seven years ago, it was based on a technology known as blockchain.
The classic accounting ledger records each transaction. Blockchain’s “distributed ledger” does the same thing but with transaction information stored in “blocks” – effectively pieces of computer code. The block is then transmitted to every party involved in a transaction. Network participants verify, clear and store data in this block, and it is then linked to the preceding block, forming a blockchain.
Instead of being kept in one place, as in a normal set of accounts, the record of transactions is stored in many places at once, updated in all of them at the same time and available to everyone involved in the network.
Because every block is linked, the contents can’t be changed without rewriting every single block in the chain – which is considered computationally impossible. That means information can’t be corrupted or changed.
The blockchain record, then, is both transparent and secure.
The most likely brakes on blockchain’s progress will be technical and regulatory. The computer processing overheads associated with Bitcoin are so huge that it can only handle seven transactions a second, compared with Visa’s 56,000. By 2025, faster computing should end this problem.
In the meantime, smaller communities can use different methods to prove the accuracy of the block. Smaller communities are also more likely to create standards and gain regulatory approvals.
Gartner suggests sturdier platforms will replace current blockchain technologies by 2023. By then, blockchain platforms will connect to business software such as ERPs, helping blockchain solutions to spread everywhere.
Beware the Blockwash
Any new technology dragging this much hype in its wake can unseat the unwary. Ray Valdes, a vice-president and fellow at technology analyst Gartner, believes blockchain technology is approaching what Gartner calls “peak hype”, and that it will shortly enter a period of disillusionment as a result.
Valdes and other experts see plenty of evidence of organisations setting up blockchain experiments where there is absolutely no benefit to derive. If a database would do the job just as effectively, the recommendation is to stick with the database, which is tried and tested technology accepted by global regulators. If the use-case is within the walls of the organisation, conventional ledgers can be used.
"The CEO said, 'we need to work with blockchain, because we want to disrupt ourselves before we let someone disrupt us." Ray Valdes, Gartner
Valdes says that this “blockwash” problem often arises because “the CEO reads in an airline mag that blockchain is the next big thing – he calls in the CIO and asks ‘are we doing it?’. When you are the CIO talking to your boss, the only answer allowed is ‘yes, we are doing it’.”
John O’Connell, chief investment officer of Macquarie Group, acknowledges that there is already a degree of scepticism about blockchain because of Bitcoin. The digital currency introduced blockchain technology, but the currency’s reputation has been tarnished by a wildly oscillating exchange rate and the collapse of various exchanges.
Meanwhile, the hack earlier this year on the Decentralised Anonymous Organisation (DAO), a venture capital business built using the Ethereum smart contract platform, also affected views of blockchain.
On their own, such problems won’t prove fatal to blockchain’s long-term prospects. Data61’s Mark Staples notes that this year has seen several attacks on the SWIFT global financial information network, yet people continue to use it.
Valdes is likewise bullish about blockchain’s eventual impact and the emergence of what Gartner describes as the “programmable economy and internet of money.”
To be part of that, says Valdes, organisations are wise to inform themselves about blockchain and distributed ledgers, explore potential use cases and develop blockchain skills before the technology has seen action.
Macquarie Group's John O’Connell will be speaking at CPA Congress 2016.