In the last 12 months, the buzz around blockchain has exploded. Press coverage has skyrocketed, venture capital is pouring into blockchain startups and nearly every major financial institution is dedicating resources to figuring out how it can take advantage of this new technology.
One big reason for the excitement is that blockchain offers a new approach to sharing data that could radically change the way transactions are processed and value is transferred from one party to another. Even though large-scale commercial use is still far off in the future, many people believe that blockchain has the potential to be as disruptive as the Internet wave of the 1990s, unleashing massive changes in the structure of the financial system. Venture capital firms are buying into this vision, betting hundreds of millions of dollars that somewhere among the exploding number of startups are the future giants of finance.
"We think of blockchain database technology as a financial network technology with network effects."
Ian Lee
Citi Ventures
Meanwhile, the existing financial institutions are scrambling to assimilate this technology and use it to improve the way they do business. In the area of capital markets, for example, banks envision blockchain leading to dramatically lower costs and greater efficiencies by improving how transactions are processed, creating the foundation for a new generation of "smart contracts," and eliminating many of the functions now managed by clearinghouse and other infrastructure providers. For that reason, many leading banks are rapidly building up their expertise on blockchain, searching for potential applications, and making their own investments in promising startups.
One prominent example of this surge of interest and activity came in early May, when more than 1,500 people gathered in New York for a conference called Consensus 2016. The speakers included not only a crowd of blockchain evangelists but also a long list of blue chip companies that have jumped on the bandwagon. Executives from Barclays, Citi, CME Group, Deutsche Bank and Nasdaq talked about how their institutions are investigating this new technology and developing specific applications in such areas as derivatives trading. The conference also showed that many blockchain companies are eager to join forces with financial institutions in collaboration rather than disruption.
Reducing Friction
The event's organizer, a news organization called CoinDesk, is emblematic of the new ecosystem emerging around blockchain. CoinDesk was founded in 2013 and aims to be the leading source of news about alternative currencies such as bitcoin and Ethereum, as well as the blockchain technology that makes these currencies possible. In 2015 it launched its first major event in New York in partnership with Citi Ventures, the technology investment arm of Citigroup. The conference attracted more than 600 people at the intersection between finance and blockchain and served as a springboard for this year's event.
In January, CoinDesk was bought by Digital Currency Group, an investment fund and startup incubator founded in October by Barry Silbert, an entrepreneur who sold his previous company to Nasdaq. Despite being less than one year old, DCG has attracted funding from several large venture capital funds and financial institutions, including Bain Capital Ventures, CME Ventures, MasterCard, New York Life and Western Union. DCG also has persuaded several high-profile individuals to join its board of directors, including Lawrence Summers, the former U.S. Treasury Secretary, and Glenn Hutchins, the co-founder of Silver Lake Partners, a private equity firm known for its prowess in technology investing.
Both Summers and Hutchins spoke at Consensus 2016 about the tremendous potential for this new technology. Summers commented that blockchain not only could reduce the costs embedded in transaction processing and other financial processes, but also pave the way for new types of companies and services.
"When you reduce friction, the experience is that you make possible previously impossible imaginations and combinations, and you get benefits that you couldn't have seen at first before reducing the frictions," Summers said. "Even six years ago, the kind of efficiency about conserving on space and structures that Airbnb has made possible, or the kind of advantages in transportation efficiency from Uber, I don't think those were imaginable. I think the gains will be of a qualitatively similar sort. This is why I think this is something that is potentially hugely exciting."
Hutchins stressed the disruptive power of the new technology and compared the current crop of startup companies to the internet companies that he invested in 20 years ago. He agreed that blockchain has potential value as "enterprise technology" that reduces costs, but said he sees a much bigger opportunity in the ability of the bitcoin protocol to change the way people exchange value. This protocol, which he described as allowing people "to move value around the world at the speed of light at almost no cost," has the potential to fundamentally transform the entire finance sector, he said.
"Look at where the capital is going. Investors have put money into a parallel financial services ecosystem where you have companies that are wallets, exchanges, financial service companies, miners, as well as universal companies in the middle. The capital is voting and the entrepreneurs are working to build much more than just the ledger or just the blockchain."
Hutchins' comments on investment flows were backed up by Garrick Hileman, an academic at Cambridge University who is an expert on alternative currencies. Hileman estimated that more than $1 billion has been invested by venture capital firms in startup companies focused on bitcoin, blockchain and similar technologies. He also estimated that currently there are four times as many startups in this space than there were one year ago.
Finding Partners
Finance differs from other industries that have been disrupted in one crucial respect, however. Both Hutchins and Summers emphasized that finance is heavily regulated and cautioned that efforts to deploy this technology will not succeed without the support of central banks and other governmental authorities. In fact, Hutchins urged the attendees to "embrace regulation" and recognize that they will have to work within existing legal and regulatory frameworks.
This theme of having to work within existing frameworks came up frequently during the conference, as various blockchain companies talked about their efforts to partner with financial institutions. While some companies are working on disruptive alternatives, particularly in the area of payments, many others want financial institutions as strategic partners that can provide domain expertise and regulatory recognition.
Chris Church, a former banking industry executive who is now chief business development officer at Digital Asset Holdings, noted that 20 years ago, there was a debate about whether the internet would be the death of the banking industry's "brick and mortar" network of branches. In the end,that did not happen, and today every bank has an online presence. The same thing will happen this time around, he predicted, in no small part because of regulation.
"Regulators have spent a lot of time since 2008 trying to take risk out of the system," he said. "My belief is that regulation is going to preserve the institutions. Will their processes be transformed and changed? Absolutely."
Sandra Ro, group digitalization lead at CME Group, made a similar comment about the potential for blockchain to transform existing processes, but predicted that the technology may ultimately make certain businesses obsolete. "Never have I seen a better opportunity for new players to come into the market and take pieces of lots of pies in banking, trading and financial services," she said. "I think the scenario we are going to see is the incumbents who manage to adapt the quickest will get bigger. The ones who don't will end up like Blockbuster."
Ro added that blockchain is one of several new technologies that are transforming financial services at a time when existing institutions are weighed down by the legacy of the 2008 financial crisis.
"Who will become the Amazon of banking or financial services? I see the confluence of mobile tech, with the advent of bitcoin, crypto and digital assets, all coming together in a fashion at a time when confidence in the finance sector and the cost structure of financial services sector is suboptimal. To me this is a perfect storm."
So how are the big institutions responding to the challenge? Jeremy Wilson, a vice chairman at Barclays, provided a perspective on how his organization is responding. First, the executives at the top of the bank had to recognize that they were likely to be "the last people to really understand the details of the technology," he said. Instead, the expertise is more likely to be located lower down in the hierarchy. Banks also have to recognize that there is a "certain level of rigidity" at big banks because banking is so heavily regulated, he said.
"I think the scenario we are going to see is the incumbents who manage to adapt the quickest will get bigger. The ones who don't will end up like Blockbuster."
Sandra Ro
CME Group
To address this challenge, Barclays brought together people from diverse areas of the bank and created a "distributed ledger council" that spanned many different silos within the bank, Wilson said. Equally important was the bank's effort to educate regulators such as the Bank of England through the formation of a think tank in London. The think tank publishes policy papers and fosters dialogue with regulators and other interested parties with the goal of promoting better understanding of the opportunities and challenges presented by blockchain. Wilson commented that "a major educational exercise" is needed so that all the stakeholders in the financial system can understand the benefits as well as the risks of this new technology, and encourage innovation rather than stifle it.
Ian Lee, a director at Citi Ventures, offered a very different perspective on how his institution is approaching the new technology. Lee is based in Silicon Valley and works with the bank's network of technology laboratories and its venture investing team. Lee stressed that the technology is still very nascent and probably will evolve considerably before widespread adoption. Lee also runs an "acceleration fund" that provides seeding funding for experimentation in its lab network. Lee explained that Citi started started to research bitcoin in early 2014 to understand how that technology might potentially impact its customers. That evolved from technology research into "a deeper understanding of the opportunities and risks and things that have to be resolved," he said.
Three Findings
Lee distilled Citi's findings into three areas: desirability, feasibility and commerciality. On desirability, he commented that it is difficult to identify precisely where the technology can provide a "10x improvement" over existing solutions. Second, on feasibility, he stressed that "the true learnings" on key issues such as security, scalability, privacy and digital identity can only be discovered by trying to solve specific problems and "learning by doing," through experimentation by the bank's own developers and engineers on various use cases. As for commerciality, he commented that partnering will be essential. "We think of blockchain database technology as a financial network technology with network effects," he said. To achieve the benefits of this technology "requires other people to participate in that network," which in turn requires building the "minimum viable ecosystem" with the right alliances and incentives.
One example of this partnership strategy is Citi's relationship with Chain, a blockchain startup based in San Francisco. Citi has invested in Chain, participating in a $30 million round of funding finalized in September 2015, and has been working closely with Chain this year on a standard protocol for blockchain networks called Chain Open Standard 1.
Creating Standards
Chain released this protocol on May 2, timed to coincide with the conference, and said it is designed specifically to address the needs of the financial services industry. Its key features include the ability to achieve "transaction finality" in less than a second, a privacy solution that limits access to relevant counterparties rather than all parties on the network, and a "metadata layer" designed to meet anti-money laundering and know-your-customer requirements. Several other large financial institutions also were involved in developing this protocol, including Fidelity, Nasdaq, State Street and Visa.
The regulatory dimension goes beyond just meeting requirements, however. Several speakers at Consensus pointed out that blockchain could provide regulators with far more transparency into financial markets. That would be accomplished moving data about transactions and assets into a distributed ledger, and making that ledger accessible to regulators.
That point was echoed by Chris Giancarlo, one of the three officials that make up the Commodity Futures Trading Commission. Speaking at the conference, Giancarlo commented that blockchain could lead to the "digitization" of the relationship between regulators and the regulated, and pointed out that improvements in information flow would help regulators identify potential risks to financial stability much more effectively.
"With the potential of blockchain database technology, we could see real ledgers in real-time across markets and across asset classes," Giancarlo said. "That would be a tremendous step forward. That would be information that we didn't have before. In the event of a future crisis, regulators would be able to be more precise and more calibrated in their response to crisis conditions."
