Finance & Accounting Jan 3, 2018
How Blockchain Could Radically Alter Global Finance
The technology underlying cryptocurrencies like Bitcoin is already starting to make its mark.
Since its creation in 2008 by the mysterious Satoshi Nakamoto, Bitcoin has fascinated the technical world and bedeviled law enforcement. The digital cryptocurrency gained notoriety for fueling Silk Road, a marketplace famous for selling illicit drugs, but subsequently won commercial acceptance from outlets like Expedia and Overstock.com. More recently, Bitcoin has been the object of much attention for its wild price gyrations and the introduction of Bitcoin futures.
While Bitcoin and competing cryptocurrencies have captured headlines, many industry experts believe the underlying technology that makes Bitcoin possible —known as “blockchain”—could have a profound influence on the future of global finance.
In its most basic form, a blockchain is a computer file that serves as a digital ledger, recording transactions and acting as an authoritative record of past transactions. Importantly, the blockchain is encrypted. Thus, it can be copied and shared widely. As transactions occur, it can be securely updated to reflect the latest transactions. The Bitcoin blockchain, for example, is maintained by computers around the world competing to process the latest transactions. Bitcoin’s blockchain works like a public Google Doc in the sense that everyone who wishes can view updates as they occur – except that there is no Google (in other words, no central administrator) involved in Bitcoin, as the network is fully decentralized.
Because a blockchain does not rely on a central authority to approve transactions, proponents believe it offers a faster and more transparent way to record and track the movement of assets. Ironically, the fact that copies of a blockchain can be distributed across numerous computers potentially makes it more secure against cyberattacks than a single master copy of transactions.
Given its attributes, blockchain could radically alter a global financial system that remains surprisingly slow, asynchronous, and error-prone, says Bob McDonald, a professor of finance at the Kellogg School.
“There are many inefficiencies in the way banks and other financial institutions work. The inefficiencies have to do with recording and retrieving information and accessing definitive records of transactions among banks, or between banks and customers, or between companies and shareholders,” he says. “Much of the plumbing in the financial system is devoted to having a common, authoritative, up-to-date database of who owns what and who has what obligations to whom. That’s what blockchain can provide.”
Instantaneous, In-Sync, and Transparent
In McDonald’s view, the curious case of Dole Foods illustrates the cumbersome nature of the financial system.
In 2013, investors sued David Murdock, chairman and CEO of the Dole Food Company, for allegedly devaluing the company’s stock before taking it private. Two years later, after a court in Delaware ruled against Murdock, he agreed to compensate shareholders an additional $2.74 per share.
And then things got weird. There were 36 million Dole shares outstanding. However, investors filed payment claims for 49 million shares. How could this have happened?
According to Bloomberg, some of the discrepancy was caused by unsettled trades and short-selling.
Let’s say you owned Dole Foods and you had an account at a firm like Schwab. In this scenario, your Schwab shares are actually held in “street name,” meaning that Schwab records you as a shareholder, but Dole Foods does not know you are a shareholder. Schwab’s total shareholdings of Dole are recorded by the ledger at Depository Trust Corporation (DTC)—but the DTC does not know that you are a shareholder either.
If you bought or sold a share, the transaction at that time would have taken three days to complete; during this period, the trade had not yet “settled.”
To complicate things still further, Schwab could have loaned your shares to someone wishing to short-sell Dole stock, in which case there would actually be no Dole shares in your account, just an obligation by someone else to return them eventually and in the meantime make payments due you as a shareholder.
Against this backdrop, investors may have thought they had shares of Dole, but those shares could have been included in transactions that had not yet settled or loaned out by Schwab.
In the above situations, investors should have actually been paid by other investors, not by Dole. In theory, the brokers who facilitated these unsettled transactions and short sales were responsible for distributing the $2.74 to the correct parties. But in practice, two years later, there was confusion. The judge ordered the brokerage firms to sort it out and determine who should make and receive the payments.
In McDonald’s view, the case is emblematic of the complexities and limitations of financial infrastructure that allows securities to change hands in a matter of seconds, yet where transactions can take days to settle, and investors are left largely in the dark about what they actually own.
Blockchain technology could solve this problem by processing all transactions without any delay, and keeping all accounting systems in sync.
“Currently, there’s a gap between the time you buy a share and the time you’re actually labeled as the beneficial owner of the share,” McDonald says. “The transaction takes multiple days to clear. But with blockchain technology, it would happen quickly, and the process would be transparent. Schwab can still lend out customer shares, but the process would be more open and explicit than it currently is.”
Efficient and Less Expensive
Another major benefit of blockchain technology—perhaps the one that is most likely to lead to its wide adoption—is that it could drastically reduce expenses.
Payments are an obvious application. “There are trillions of dollars of trapped working capital on the balance sheets of Corporate America,” says Caitlin Long, president of the smart contracts company Symbiont. “A large corporation will have about 2,000 bank accounts around the world, and they’re trapping cash in all of them. If you think about this from an economic point of view, that is the ultimate dead-weight loss in an economy. If we can speed up the payment infrastructure among central banks, that will free up a tremendous amount of working capital around the economy.”
A less obvious arena for blockchain is the syndicated-loans market.
“There’s a tremendous amount of paperwork that hasn’t been digitized yet,” says Long, speaking at the FinTech and the Future of Finance conference at the Kellogg School earlier this year. “This is a market notorious for sending faxes back and forth.” If the process were automated, she says, not only would it speed up the process of selling loans—it would also save companies a lot of money.
“In the U.S., we’re used to institutions being trustworthy, but that’s not the case in every country. There’s reason to believe that by providing an authoritative, distributed record of transactions, blockchain could help reduce corruption.” — Bob McDonald
Automating the administrative side of private equity would also cut costs.
“Blockchain would automate about 30 percent of the work we do for fund administration,” says Peter Cherecwich, an EVP at Northern Trust, who also spoke at the conference. “That’s a 30 percent increase in profitability. Of course, we won’t be able to take all that profit. So we will reduce the fees for the general partner, and now the general partner reduces fees on the limited-partner side. For every player along the chain, revenues go down but profits go up. That’s progress from my perspective.”
This would not be the first attempt to streamline transaction processing within financial services. In the late 1990s, there was an industry effort called the Global Straight Through Processing Association—which hoped to reduce the delays involved in clearing securities transactions—but the effort died after lukewarm commitment from investment managers and shareholders.
For Cherecwich, the lesson is clear: change requires buy-in from lots of stakeholders. For blockchain technology to be successful, the entire ecosystem has to benefit. “If you only have one part of the ecosystem benefit, it’s going to fail,” he says.
As a final example of how blockchain might streamline operations, Symbiont, Vanguard, and the stock market data provider Center for Research in Security Prices (CRSP) have recently collaborated to use blockchain to distribute real-time information about index composition, for example, of the S&P 500 index. Updating this information has been surprisingly labor-intensive for such a critical component of the investment industry, but blockchain has the potential to radically improve the speed, accuracy, and efficiency of the updating process.
Secure and Incorruptible
Blockchain’s advocates claim that because it is considered the most secure way to store and share transaction data, the technology might someday become the new global standard.
Indeed, a number of central banks have expressed interest in distributive ledgers. And those who seek more transparency in government contracts, campaign donations, and the offshore accounts of the global elite view blockchain as a powerful asset.
“Open-source cryptography has been a huge success,” McDonald says, “and that’s what is at the heart of Blockchain.”
The greatest opportunity might be found in the developing world. Just as the cellphone industry “leapfrogged” older versions of telecommunications infrastructure, some financial industry leaders hope blockchain technology can create a more efficient, more accessible, and less corrupt financial services industry.
“The technology was designed to make it unnecessary to trust institutions,” McDonald says. “In the U.S., we’re used to institutions being trustworthy, but that’s not the case in every country. There’s reason to believe that by providing an authoritative, distributed record of transactions, blockchain could help reduce corruption.”
Theoretically, at least, blockchain could also make life easier for regulators—since all transactions would be logged automatically on a single digital ledger—while also ensuring the sovereignty of national regulations. To preserve data confidentiality, regulators might not have access to the entire blockchain (access being granted by IP address), but they might be able to access a relevant portion of it at all times.
Yet despite the technology’s potential to bypass global corruption and fraud, it will still need a legal infrastructure if it is going to be widely adopted.
For McDonald, how this will play out is still an open question—he compares it to the Internet, a new technology that was monetized and regulated in ways that few could predict before the age of Google.
“We enforce contracts and property rights with the law,” he says. “In cases where there are commercial disputes, the government has to have rules around Blockchain-encoded transactions. And that puts the government right in the center of it.”
For more information about blockchain and its potential implications, McDonald recommends the following resources:
ARTICLE: “How the Bitcoin Protocol Actually Works” by Michael Nielsen
VIDEO: “Thinking Through Law and Code, Again” by Larry Lessig
ARTICLE: “Sydney Blockchain Workshop: Lawrence Lessig On the Law and the Net” by George Michaelson