In my first piece titled âbitcoin and the blockchainâ, I highlighted the significance of the recent rise in the price of bitcoin. As a currency, bitcoin is intriguing. As a technology, itâs downright compelling. You can doubt whether bitcoin will take over the world of finance, but it certainly has a role to play.
The first piece in the series described the importance of the engine behind bitcoin, known as the blockchain. This is a database that was designed to transact. Thatâs different to a traditional database that was designed to store information. The bitcoin database design is faster, more secure, and more transparent. If you missed that, have a look at Friday’s issue of Capital and Conflict.
The elegance of blockchain technology makes it possible (and not difficult) to exchange assets other than bitcoin. These assets would include fiat money, shares, gold, bonds or pretty much anything you to trade. However, in order to become a disruptive technology for financial transactions, the blockchain must shift from being decentralised to centralised; let me explain.
Bitcoin operates on a public blockchain. You can download a copy onto your computer and explore the data. You would need to have advanced computing skills in order to do it. But you could do it. For users, bitcoin is little more complex than trading shares online.
No staff
Thatâs another aspect of bitcoinâs appeal; the network has no staff whatsoever. Adam Smith would love it. Itâs a mechanism for exchange operated by the âinvisible handâ. The miners that increase the supply of bitcoins support the network and are motivated by profit. Since this model has no central authority, it is said to be decentralised.
A private blockchain would restrict access to authorised participants. Iâll show you why in a moment. But in a private blockchain, there may be several copies for backup purposes. But the mining function (network administration) would be carried out by a central authority without competition or reward. There would be little or no public access to the blockchain. The creator and owner would have a âvisible handâ and be in total control of the network. This is a centralised model.
Why is a centralised model necessary for the use of private blockchains? The private and centralised concept enables a financial market to embrace the advantages of the blockchain system, but without giving up control. It becomes a secure network where data can be quickly and efficiently exchanged between parties.
Bitcoin uses the blockchain technology to create money that can be used for secure transactions. Those transactions, like all transactions, are between two parties. But bitcoin is playing a role in a public market. The fact that the blockchain canât be controlled guarantees the money supply canât be manipulated.
Business benefit
If youâre going to use the same blockchain technology for other transactions, though, you may want more control of it. One of the pioneers in this field is Digital Asset Holdings. The company was set up to develop and promote blockchain technology. Naturally, they donât call it that, due to the link to bitcoin. Instead say they âdevelop technology that aids efficiency, transparency, compliance and settlement speed using cryptographic, distributed ledgers.â
In other words, they turn the blockchain into a business benefit for the private firm. A âcryptographic, distributed ledgerâ is the respectable way of describing a blockchain. The advantage of this jargon is that the banks, who are petrified of having any link to bitcoin, can embrace this brave new world with a clear conscience.
The CEO of Digital Asset Holdings is Blythe Masters, who had a successful career at JP Morgan as the head of commodities. She is widely accredited for inventing the âcredit default swapâ; a form of insurance for bonds. This enabled bondholders to âhedgeâ their credit risk should an issuer fail. For this and other achievements, Masters is on the Wall Street âAâ list.
Credit default swaps are priced in real time and allow the free market to express a view on a bond issuerâs credit worthiness. For example, it would cost 0.2% per year to insure a US Treasury against default whereas a Greek government bond costs over 10%. These numbers are a way for the free market to express the credit score for a company or a sovereign government.
World taking notice
When Masters took to the stage in March this year and embraced blockchains, the world took notice. If she says this is the ânext big thingâ in financial technology, itâs worth listening. Publically, sheâs no fan of bitcoin (she would have to say that) and has successfully shifted the attention to blockchains.
She describes the advantages of the blockchain over traditional trading systems as being quicker and cheaper, with lower error rates. The result is less risk. For the bank, thatâs a material benefit.
It means the bank has a lower capital requirement to facilitate trading activities. That frees up capital for more productive purposes (like lending). Finally, given the complex cryptography involved, the system is less vulnerable to cyber-attack.
Thatâs quite a list.
Seamless transactions
Masters describes how in a traditional transaction, both parties have separate systems that must be reconciled after the trade. If, instead, the two parties agreed to share the same record-keeping system from the outset, the transaction would be seamless. The blockchain eradicates the need for post trade reconciliation and settlement.
When a financial transaction occurs, the two parties agree a price and swap an asset for cash. In the background, many tasks have to take place and the trade is not formally complete until it âsettlesâ. That means both parties must sign off to the effect that one has the correct asset and the other has the correct amount of cash.
This all takes place across multiple computer systems. Thereâs the buyer, the seller, the banks, custodians, brokers and the exchange. These systems must all be in agreement before settlement can take place. Unfortunately in the real world, they sometimes donât, and this is why âback officeâ functions in the financial services industry can be so costly.
Itâs also why Santander, Barclays and UBS took an early lead in researching blockchains. If you can remove the âfrictionâ in the settlement process, you can remove some of the cost and a lot of the time (time is money!)Those three banks set up incubators and made investments into start-ups in order to learn more about this brave new world.
The excitement has since spread. All the major banks are now involved. They are trying to create common standards. This is vital. The system can only reach its full potential if they are able to share the same dataset.
Custody and settlement
During my time in fund management, the costs of complying with regulation rose even as most other costs fell. For example, share-dealing commissions fell from 0.5% to less than 0.1% for institutional investors. Better still was the cost of index funds. I can still remember the Virgin FTSE 100 index fund that charged 1.5% annual management fees in the late 1990s. Today, you can achieve that same goal for just 0.08% with Vanguard.
Despite falling costs in many areas of financial services, one that remains stubbornly high is custody and settlement. The systems have improved a great deal, but there are still armies of people working behind the scenes in the industry.
They ensure trades are settled and reconciled, and given there are hundreds of millions of financial transactions each day, itâs a gargantuan task. Marc Andresson, founder of tech venture capital firm Andreessen Horowitz said last year:Â “We have a chance to rebuild the system. Financial transactions are just numbers; itâs just information. You shouldnât need 100,000 people and prime Manhattan real estate and giant data centers full of mainframe computers from the 1970s to give you the ability to do an online payment.”
Heâs absolutely right. The financial system has woken up to this inevitability. The next decade will see massive changes to the way in which financial transactions are done. Technology and automated systems will replace people.
Post 2008, new regulation has curtailed the many of the banksâ activities. They have been forced out of lucrative areas and been forced to hold more capital. In order to restore profitability, they must ruthlessly slash costs, and by embracing the blockchain, they will do just that.
Embrace of blockchain
More than anything, this drive to increase margins is the driving force behind the embrace of the blockchain. Again, Adam Smith would understand it perfectly well. Labour-saving devices enhance productivity. Technology drives the division of labour and productivity. Productivity growth is the simplest way to increase wealth.
Itâs hard to know how many middle and back office jobs will be lost. It will be in the millions. Technological progress has found a better way of doing things. Itâs a recurring theme.
The industrial revolution replaced the agrarian world. Now, the information technology revolution is replacing the industrial world, and even those engaged in âindustrial levelâ finance. Bankers are the new farmers and steel workers. Like anyone who has a job replaced by a machine, theyâll have to take steps to prepare themselves.
The banks believe they will win for two reasons. First, because consumers of their services (settlement) will get a better product at a lower price. Second, blockhain technology allows the bank to produce the same services at a much lower cost. This raises an interesting point.
How long will it be before central banks and governments embrace the blockchain? Once the Bank of England floats the pound onto a blockchain you may never need a bank again. Technology will replace the bank as the middle man in the creation of money and its storage. That would be a real revolution.
In the next piece, weâll explore the future for electronic bearer certificates. Bearer did you say? Yes, weâre all going back to the future.
Category: Investing in Bitcoin