Most people are familiar with bitcoin as a digital currency. It is believed more than 100,000 companies now accept bitcoin for payment.
Blockchain technology underpins bitcoin transactions in the form of an algorithm that allows bitcoin to be traded without a centralized ledger. The potentially disruptive nature of the technology is that it can also track the exchange of stocks, bonds and other financial securities, and almost anything else of value. Famous venture capital investors like Marc Andreessen compare blockchain technologies to previous tech revolutions like personal computers in 1975 and the Internet in 1993.
Currently, securities are settled using a “closed ledger.” There is a fundamental lack of trust in the process because the buyer wants to know the seller owns the securities and has not transferred them twice. The current securities settlement system requires a three-day cycle, is inefficient and can be systematically unstable if large transactional partners fail. During the financial crisis we learned that the record-keeping infrastructure of the multi-trillion-dollar swaps market was recorded on handwritten tickets faxed nightly to the back offices of market counterparties.
Blockchain technology is based on a distributed “open ledger.” Distributed ledgers use open, decentralized, consensus-based authentication methods unlike the current settlement process. The technology allows parties who do not know one another to work together to facilitate nearly instantaneous settlement, which eliminates costs, errors and systematic risk. According to a commissioner of the Commodity Futures Trading Commission, open ledgers may make possible new “smart” securities and derivatives that can value themselves in real time, automatically calculate and perform margin payments, and even terminate themselves in the event of a counterparty default.
A vast global network of independently owned computers known as “miners” collectively work to prove a ledger’s authenticity and maintain, update and verify the blockchain. According to the technology news website TechCrunch, the blockchain stores information in blocks that record all transactions ever done through the network. It allows validating both the existence of assets to be traded and ownership.
To avoid double spending, the technology requests several nodes to agree on a transaction to process it. A validation is also artificially difficult to achieve: miners leverage computer power to solve complex cryptographic problems (the proof-of-work). Every time a problem is cracked, a block is added to the chain, and all the transactions it includes are thus validated. The updated chain, including the new block, is shared with other nodes and becomes the new reference. New blocks issued are also linked to previous ones, so that it is almost impossible to go back on a transaction. This technology addresses all the issues to validate a transaction, so that processing one doesn’t require a third party anymore: the network replaces institutions.
The Linux Foundation recently announced an industry collaboration effort, which it refers to as the Open Ledger Project, to develop blockchain technology for the financial services industry. The project will develop an enterprise grade, open source distributed ledger framework and free developers to focus on building robust, industry-specific applications, platforms and hardware systems to support business transactions.
Accenture, Digital Asset Holdings, IBM, J.P. Morgan and Wells Fargo are among the companies making early commitments to the project. Many of the founding members are already investing considerable research and development efforts exploring blockchain applications for industry. IBM intends to contribute tens of thousands of lines of its existing code base and its corresponding intellectual property to this open source community. Digital Asset is contributing the Hyperledger mark, which will be used as the project name, as well as enterprise grade code and developer resources.
In many respects, the future has already arrived. The SEC approved Overstock.com’s registration statement to sell securities using blockchain technology. The Nasdaq Private Market, which trades shares in unlisted companies, will deploy blockchain technology in a pilot project this month.
Of course, there are risks and uncertainties associated with widespread implementation of a blockchain settlement process. For example, a truly disruptive system may not be embraced by those trying to protect profit streams. The technology has to prove it is scalable to handle global settlement streams, including sufficient data processing and storage power to solve the complex algorithms necessary to transfer property and maintain ledgers. Global cooperation of financial institutions and regulators is needed in a way that the system remains open and not proprietary. Hacking, confidentiality, money laundering and terrorism must be addressed.
Yes, there are obstacles blockchain settlement technology must overcome. But as the technology develops and an ever-expanding list of blue-chip companies embrace it, there is little doubt that the blockchain settlement process will transform from a disruptive force to an everyday routine.