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Unblocking financial services

Although the emergence of a number of 'virtual currencies' a few years ago generated a lot of interest and attention, the key innovation underpinning this new asset class, the blockchain, went relatively under the radar. However, a number of financial institutions have seen the broader potential in block technology to revolutionise the way in which transactions in financial assets can be processed, settled and recorded.

March 2016

The key features of a distributed ledger are worth repeating to put in context their potential to innovate in financial services:

  • transactions are recorded on a shared database that keeps track of who owns a particular asset;
  • the authority to execute transactions on the blockchain is conferred via public and private based key technology;
  • transactions are reviewed and verified by participants in the blockchain solving cryptographic problems in near real time; and
  • upon peer verification, the blockchain is updated automatically with the latest transaction history.

The financial services industry has a number of features suggesting that blockchain is well placed to renew business models but which also present challenges. These include:

  • the significant role of intermediaries in executing and processing transactions and maintaining records of ownership;
  • the importance of accurate and secure transaction data;
  • the importance of accurate and secure records and reconciliations; and
  • the burden on firms to comply with high regulatory standards.

In particular, blockchain, or distributed ledger technology, has the potential to streamline transactions by removing the layering of intermediary ledger and verification activities required to process a transaction and replacing these with a single peer reviewed ledger backed by a robust transaction methodology (i.e. cryptography). Cryptography also enhances efficiency by delivering automated updates to the shared ledger without the need for manual processing.

On the other hand, any workable solution for financial services must appreciate the pre-eminence of accuracy, security and regulatory scrutiny requirements. New models will require significant initial outlay and regulators will likely expect someone to have oversight and responsibility for the integrity of the model (i.e. using a permissioned rather than a pure distributed model, as used for some virtual currencies).

So which areas are ripe for disruption and innovation from distributed ledger technology?

Securities

Currently, transactions in securities go through the relatively costly and time consuming clearing and settlement process. In simple terms, an intermediary is interposed between buyer and seller to collect the security and consideration from both sides of the transaction (clearing) before delivering the respective parts of the transaction to the relevant parties (settlement). Following settlement, the change in ownership of the security is then recorded through tiers of private ledgers from the central securities depositories (CDS) down through custodians and sub-custodians.

Unblocking financial services

The drawbacks to the traditional model are easy to state: interposing intermediaries into the process naturally increases transaction costs and time while also placing a degree of risk at the hands of the intermediary. For this reason, firms are developing models of distributed ledgers to collapse the traditional clearing and settlement processes and to substantially reduce the cost of securities registration, custody and verification.

There are other benefits too: the transparency of a distributed ledger is not only a beneficial tool against financial crime, but can also provide useful business intelligence for firms and enable regulatory authorities to identify concentrations of risk and effect micro and macro prudential oversight. Importantly, any model that reduces costs has an important knock on for financial inclusion.

While it is easy to be enthusiastic about the potential of blockchain, there are benefits of the traditional model that will remain challenging for nascent systems. How will new systems address the settlement risk? While fraud and cyber risks are reduced, they are not eliminated; so how does a system protect itself against attempts to defraud the distributed ledger? Who has oversight and 'ownership' of the system if things go wrong?

Payments

Payments in traditional fiat currencies continue to operate on the basis of a centralised tiered payment system (that is, a system comprising banks, clearing banks and a central bank for settling payments between institutions). Accordingly, whereas a virtual currency transaction is processed directly as a transaction between payer and payee (with a nominal fee to the blockchain participants that process the transaction), a traditional payment requires financial institutions to settle and update their ledgers through each tier in the payment system up to the central bank, again, all adding cost and time.

An interesting issue will be whether distributed ledgers can be used for payments in fiat currencies or electronic money (which, unlike virtual currencies, is redeemable against an issuer). The benefits for payment users could be significant in terms of reduced transaction costs, quicker settlement, easier cross border payments and reducing the concentration of risk that occurs in a centralised system (notwithstanding that a dominant distribution ledger could pose its own significant operational risk).

Current technology within firms, payments systems and financial services infrastructure, are challenged and appear to need significant levels of investment, in any event, being suggestive of an opportunity and rationale for the development of concurrent, if not replacement, functionality to be built around blockchain. The City has a history of developing new, additional ways to find real growth and flush money around the real economy.

Given the rise of virtual currencies, the use of the distributed ledger in payments has a precedent. However, virtual currencies have not been embraced conceptually by the establishment, with the European Banking Authority (from July 2014) actively discouraging European banks, payments firms or e-money institutions from buying, selling or holding virtual currencies and identifying manifold risks with them.

Financial crime

This is another area where blockchain or distributed ledgers could have a real impact. Currently, anti-money laundering checks, systems and controls (AML) are a significant burden and cost for financial services businesses but also in other sectors such as professional services or estate agents, particularly for on-boarding new customers and suspicious transaction monitoring. Furthermore, while reliance on another firm's prior 'Know Your Customer' (KYC) information is permitted by existing regulations, it is burdensome (e.g. requiring written permission from the other firm), untypical and not without risks.

Unblocking financial services

Distributed ledger principles could be applied as a means for firms and individuals to share relevant KYC information, speed up customer on-boarding and provide a peer sourced and more accurate measure of AML risk. Whilst increased anonymity and transaction speed are hazards of the blockchain, it is worth considering how blockchain transactions themselves can enhance AML oversight for firms and regulators alike by revealing an entire transactional history of the asset. Some vendors are already in the business of providing speciality AML analysis on this data.

Taking a broadly permissive approach, following clear statements in the EBA opinion, the UK's Treasury intends to bring digital currencies exchanges within the scope of AML regulation in the UK, aiming to support innovation and prevent criminal use. Indicating its wishes to foster a supportive environment for the development of legitimate businesses in this sector, while creating a hostile environment for illegal activity, the Treasury is proceeding somewhat positively, albeit with caution.

In his speech at the FCA’s "UK FinTech: Regulating for innovation" event (22 February 2016), Christopher Woolard explained the FCA's hopes for blockchain within the AML/KYC context and as part of its RegTech initiative. The FCA's stance will become clearer as applications develop but, as the FCA is engaged in discussions with government and industry, we can assume it is loosely in favour of blockchain technology. The FCA is clear, however, that its ultimate goal will be that the benefits offered can be realised in the interest of UK consumers.

Don't block modernisation

It's clear that there are many uses for blockchain, often positive for business and socially useful. While it will never stymie invention, the absence of clear regulatory direction or ownership of this space is potentially detrimental. Regulatory certainty would bring welcome stakeholder confidence and buy-in.

It would be helpful for a coherent regulatory approach to emerge globally. IOSCO plans to investigate the use of blockchain technology, which is good news for securities, at least. Any regulation needs to be bold, imaginative and innovative in itself, squaring up to risk drivers. This could embrace governance standards, client money and assets protections, capital requirements and controls for the integrity of the scheme (e.g. protocol and transaction ledgers). Just because it is a little bit difficult does not mean we should not go there.

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Unblocking financial services
Chris Ratcliffe

Chris Ratcliffe  


 


Chris considers the potential of blockchain technology in the financial services sector.

"Any regulation needs to be bold, imaginative and innovative in itself, squaring up to risk drivers... Just because it is a little bit difficult does not mean we should not go there."