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Wall Street Loves the Blockchain

While Wall Street is cautious on Bitcoin, it has gone all in on blockchain. But real-world implementation of distributed ledgers in the financial system, mostly in experimental fashion, has been underwhelming.

While Wall Street is cautious on Bitcoin, it has gone all in on blockchain. But real-world implementation of distributed ledgers in the financial system, mostly in experimental fashion, has been underwhelming.

In late May, Bitcoin turned in two of its most volatile weeks in its short existence, trading as high as $2,791 before briefly dipping back below $2,000. Volatility isn’t necessarily indicative of a bubble, but in Bitcoin’s case the primary source of volatility is that the asset remains largely a retail investor phenomenon. There are few professional market makers who can facilitate risk transference during extreme movements like the ones we’ve seen over the past couple weeks.

While Wall Street is cautious on Bitcoin, however, it has gone all in on the technology underpinning the digital currency: the blockchain. The theory goes that while a mathematical currency is an interesting development in the history of finance, the underlying technology is potentially transformative for the financial markets. My favorite Fed Bank President and Gen-Xer, Neel Kashkari, expressed a variation on this sentiment earlier this month:

“I would say I think conventional wisdom now is that blockchain and the underlying technology is probably more interesting and has more potential than maybe bitcoin does by itself.”

Why is there so much enthusiasm for blockchains on Wall Street? Financial systems are old. Really old. Most of the systems that comprise Wall Street’s plumbing were first built back in the 1960s/70s and have been patched together with duct tape and glue ever since. These systems cost billions of dollars to operate annually and only get more expensive to maintain every year. But the technology no longer meets the needs of modern-day trading. You can buy stock on the NASDAQ in tens of microseconds, but it will take three whole days for the shares to actually change hands and be delivered to your account. Corporate bonds will soon take only two days. Treasuries are a modern-day marvel, with a one-day settlement cycle.

And none of these systems are based on open standards or are even interoperable with each other. A huge number of buy-side trades are booked and allocated through spreadsheets that are shared via email and FTP. The communication protocols between banks and clearing houses are a mess of proprietary application programming interfaces (“APIs”). Each firm must maintain its own books and records. There often isn’t a way to resolve a discrepancy in a position or a trade without the manual confirmation of the parties involved. Single points of failure like exchanges and central clearing houses can take down the entire system or introduce unnecessary tolls. Worse still, firms like Bloomberg use their monopoly to limit access to their trade booking services.

Blockchain (and distributed ledger, which are not the same but I’ll use interchangeably for simplicity) proponents argue that the technology offers a panacea to these problems through the use of its shared database-like functionality:

“Information held on a blockchain exists as a shared — and continually reconciled — database. This is a way of using the network that has obvious benefits. The blockchain database isn’t stored in any single location, meaning the records it keeps are truly public and easily verifiable. No centralized version of this information exists for a hacker to corrupt. Hosted by millions of computers simultaneously, its data is accessible to anyone on the internet.”

Another way to think of a distributed ledger is as a shared Google Doc. Everyone can make changes locally that are continuously synched with all other viewers of the document. On the surface, this looks like a promising solution to the problems I described above: (1) All participants must speak the same language for the system to work, so there’s no need for proprietary protocols and there can’t be any gatekeepers; (2) there can’t be single points of failure because everyone on the network keeps a continuously reconciled copy of the ledger; and (3) since the records are public and verifiable, there’s a clear paper trail to resolve discrepancies between counterparties.

When Expectations Don’t Meet Reality

Real-world implementation of distributed ledgers in the financial system, mostly in experimental fashion, has been underwhelming. It’s been difficult to match the ideals (and fundamental benefits) of the blockchain with the everyday reality of what participants in financial markets expect. Carolyn Wilkens, Senior Deputy Governor of the Bank of Canada, wrote about the central bank’s failed year-long experiment with deploying R3’s distributed ledger technology (“DLT”) to replace Canada’s aging payments system. They were never quite able to solve the need for anonymity in transactions:

“One is the need for privacy around transactions in wholesale payments systems. This is incompatible with some versions of decentralized digital ledgers – which operate under an assumption that everything is publicly observable at a certain level […] While we were able to address this privacy constraint in our second phase, the fix made the system susceptible to the risk of a single point of failure – something present in current systems but that was supposed to disappear with distributed ledgers.”

By definition, there are no anonymous transactions in a distributed ledger! Transactions must be observable by all so that each participant can reconcile its copy of the database. This is completely contrary to how most markets work. The buyer and seller of a bond might know who each other are, but no one else is privy to that information. To preserve anonymity, you need a neutral party to facilitate the transaction. This is typically implemented with a single central counterparty or a few trusted peers that can disguise the origin of transactions. This creates single points of failure and eliminates a lot of the benefits of a distributed ledger.

Another issue that Ms. Wilkens found was that the performance of the ledger was inadequate for a country-wide system:

“Another hurdle was scalability, which is still an issue in some versions of DLT. While other versions can achieve greater transaction rates by moving away from a fully decentralized framework, this can reduce resiliency and lessen some of the expected potential cost savings.”

In a distributed ledger, you are continuously reconciling the entire system’s transactions. When I buy fish in Vancouver and you buy beer in Toronto, these transactions are appended to the same global log, and everyone must process the transaction together. This isn’t how the current financial system works. I don’t care where you got the $10 in your Citibank account when you buy groceries from my bodega; only that Citibank ensures that you have it. Requiring everyone to sync their transactions creates a lot of bottlenecks in the system and has been one of the biggest headaches for scaling the bitcoin network. The bitcoin network can only process “seven transactions per second at most” and you often need to wait hours (and pay extortionist fees) for the transaction to go through. A single bitcoin transaction takes thousands of times more energy than a single credit card swipe. The VISA network, and most American financial networks, are built for scale:

“Visa says its payment system processes 2,000 transactions per second on average and can handle up to 56,000 transactions per second if needed.”

Finally, there is a huge one-time cost of transitioning to an entirely new system. For the Fedwire Funds Service, there are 7,500 firms that process trillions of dollars of transactions every day. You can’t make a move to a brand-new system, no matter the benefits, without a long transition time and billions of dollars of new software development (with very expensive, blockchain-savvy developers). We’ve been talking about two-day settlement of US Equities for more than 10 years, and the SEC only recently approved it.

This is one of the reasons why Chain and NASDAQ’s implementation of a market for private securities was smart. Private securities transactions are basically just paper now, and there is almost no technology in place to service customers. Literally, any system is an improvement! Chain can learn a lot of lessons with the implementation and gain the trust of participants before tackling a larger market.

Most of these issues are solvable in one form or another, but we’re still in the first inning. Blockchain startups are going to need to spend a lot more time in the weeds solving real-world problems in finance before distributed ledgers take over the back office.

“At the end of the day, interbank systems must be safe, secure, efficient and resilient, and they must meet all international standards. DLT-based platforms are just not there yet.”

In the meantime, I’ll buy equity in your blockchain company with my newly minted Greco-coins.

This article is adapted from Jim Greco’s newsletter. You can subscribe here and follow Jim on Twitter @jgreco.

Jim Greco is a Startup Founder, US Rates Trader, Low-Latency Software Developer, Rates Market Structure expert, and the founder of Direct Match.


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