Within the financial services and technology industry, it is hard to go a single day without hearing, speaking, or reading about blockchain and cryptocurrency technology. Whether it's discovering that Goldman Sachs is launching a cryptocurrency trading desk or that Long Island Iced Tea Corp. has changed its name to Long Blockchain Corp. causing an immediate 289% increase in share price, the fervor around blockchain is difficult to avoid. While it is easy to dismiss this technology as a passing fad given its meteoric rise, it is prudent to understand what it enables and how it can be applied within the financial services industry.
Blockchain is a distributed ledger technology (DLT) which aims to facilitate the creation of a single source of truth by enabling many people, or systems, to maintain the same record of transaction. Once consensus is reached on a particular set of transactions through an automated process, one copy of this record is encrypted and deemed immutable. This record is considered a “block” on the blockchain. As with most transactions, in blockchain transactions, there are at least two parties involved, thus there will be at least two records of every transaction and two parties that agree the transaction transpired as recorded. This redundancy will prevent misinformation and disputes. Going even further, “smart contracts” have been introduced to remove any potential for misrepresentation. A smart contract is a digital agreement that is executed in an automated fashion once the terms of the agreement are met. In addition to executing the agreement, a record will automatically be created within all ledgers. The combination of blockchain technology and smart contracts makes record falsification or manipulation an impossibility.
Financial institutions have spent billions of dollars building out internal organizations to verify records and prevent fraud. Similarly, governments across the world have established regulatory structures to ensure financial institutions’ internal controls are adequately mitigating the potential for fraudulent activity. In fact, much of the function of the middle office within investment banks and asset managers is to act as an objective party to ensure all trading activity and transaction details are accurately accounted for and reflect the real trades that occurred. As regulations on monitoring and reporting have become more stringent since the financial crisis, the size of these “control organizations” has grown to meet this demand. Historically, institutions have relied on people such as internal controllers and external auditors to act as independent verifiers. But imagine if the technology was capable of verifying the front-office’s transactions? This is precisely what DLT enables, and if properly deployed at an institution, it could replace the need for independent reconciliation functions.
As an example, let’s consider a standard over-the-counter repo transaction. In today’s world, this transaction requires a trader to book the trade, a product controller to verify the trade, back-office operations to ensure settlement, and potentially compliance to review the terms of the contract. Using DLT, a repo transaction could be handled using a smart contract, eliminating most of these handlers. Once the cash and collateral are in the proper accounts, the record would be created and both counterparties would hold a copy of the transaction. This same transaction would also be added to the record of all transactions maintained by all market participants rendering an independent verifier unnecessary.
Blockchain technology is still very much in its nascent stages and institutions should be cautious to avoid blockchain and crypto-mania. That being said, it is clear that DLT has the potential to revolutionize the industry by reducing costs and decreasing potential for nefarious activity. Banks are currently exploring blockchain with institutions like Goldman Sachs and JPMorgan Chase racing to patent new blockchain technology. The Depository Trust & Clearing Corporation is re-platforming its Trade Information Warehouse, deploying a cloud-based system utilizing DLT. While it will likely take time before blockchain technology can replace traditional financial institutions’ wholesale practices, large securities trading organizations should seek ways to leverage blockchain technology to replace existing infrastructure designed around trust, control and verification/reconciliation. While much about the application of blockchain and DLT remains ahead of us, it is clear that the technology will play a revolutionary part in shaping the future of the financial services industry.
Monticello Consulting Group has managed some of the most transformational technology programs on Wall Street with services that include data management, testing governance, and program office implementation. Our in-depth knowledge uniquely positions us to guide clients in the deployment of the latest financial technologies – including blockchain that can accelerate innovation and reduce risk.
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