Blockchain: the disruptive technology that will make financial markets more efficient – Or maybe not
A lot gets published on a daily basis about the seemingly awesome, game-changing possibilities of #blockchain and other distributed ledger technologies (“DLT”) applied to smart contracts, optimising payments systems and other aspects of the financial markets. A growing number of financial entities are seriously investing in it, and we keep reading and hearing that this is the future of financial markets.
The message for financial entities being: get in the game now or risk irrelevance tomorrow.
So what are these distributed ledger technologies all about, and are they all they’re cracked up to be? DLT, in its various flavours, is the #technology behind #Bitcoin and every other #cryptocurrency. The blocks necessary to put together the puzzle to complete a transaction are distributed across a decentralised computer network of users, and DLT’s main selling point is that it’s self-authenticating and very difficult to tamper with.
Around 2016, #banks started to get very excited about DLT because they figured that it could be applied to efficiently and quickly settle payments and securities transactions, and even to develop smart contracts: algorithm-based programmes that use DLT to automatically detect when a party performs its obligations or fails to do so, and trigger payments or penalties accordingly. It’s easy to see why financial entities get so excited about DLT: it can significantly cut down the time required to settle transactions (a process that normally takes two or three days for securities), and automate verification procedures which are currently carried out manually.
Ever since that epiphany, financial entities’ investment in DLT has grown dramatically, whilst the rest of us wait with bated breath in anticipation of a brave new financial world any day now – only that it might not happen just yet.
The fact of the matter is that DLT was developed for the purpose of sustaining cryptocurrencies (and smart contracts, in the case of Ethereum), and it works well in that application. But just because DLT fits the bill for cryptocurrencies, does that mean that it will also do a good job when applied to the financial market infrastructures?
A few days ago, the Dutch Central Bank published a report with its conclusions on a series of blockchain trials conducted over the past three years to assess the actual usefulness of DLT in realistic financial market infrastructures scenarios. These trials are particularly insightful for a number of reasons:
- they were conducted by a central bank, which means that the focus was not on commercial gain but on whether this technology is actually fit for transaction settlement purposes from a systemic point of view;
- they were conducted over a three-year period;
- over which four different DLT prototypes were tested in different scenarios, all of which conveys the idea that this testing exercise was thorough and reliable.
When it comes to financial markets infrastructures, there are strict requirements in terms of authorisation, availability, capacity, costs, efficiency, legal certainty, reliability, scalability, security, sustainability and resilience, and each of them is a deal breaker. Current interbank payment systems, such as Target2 in the Eurosystem, meet all of the above requirements and, in the words of the Dutch Central Bank “are highly efficient, can handle large volumes and offer the legal certainty that a payment is completed.” It follows that any new technology must at the very least tick all boxes, and additionally show distinct advantages, if it is to replace existing systems.
So did DLT live up to the hype? Not quite, it seems. Again, quoting the Dutch Central Bank: “The blockchain solutions we tested proved to be inefficient – in terms of both costs and energy consumption – and unable to handle large numbers of transactions. Furthermore, several consensus algorithms we used will never achieve the full certainty of a transaction, so that it cannot be undone, which the central banks&39; Target2 system offers. Other algorithms are able to withstand parties with malicious intent and have the potential of raising the [financial market infrastructures’] cyber resilience, but they currently fail to meet other [financial market infrastructures] requirements. DLT may well offer enhanced efficiency in payments that involve multiple currencies, however”.
What does this all mean? It means that, though “the blockchain technology underlying bitcoin is interesting and promising, and future algorithms may well offer improved compliance with [financial market infrastructures] requirements” in its current form, DLT does not seem to cut the mustard.
Undeniably, DLT is an exciting technology and, in some form yet to be developed, it might be just the ticket to improve the efficiency of financial settlement systems. Just don’t expect that to happen next week.
[linkedinbadge URL=”https://www.linkedin.com/in/adolfo-pando-molina-5b4a7555″ connections=”off” mode=”icon” liname=”Adolfo Pando-Molina”] Adolfo Pando-Molina is CEO & General Counsel of RegBot®
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