BLOCKCHAIN: AN INTEGRATION WITH YESTERDAY’S FINANCIAL INDUSTRY
Views From Banyak Group
By Oleg Biletsky, 28 June 2017
Blockchain has found its seat at the table in today’s financial industry. It’s not a question or a perception, it’s a discussed topic over coffee, at conferences, and in the boardroom. Less than two years ago in one of its equity research reports from December 2015, Goldman Sachs stated that “blockchain technology could disrupt everything.” The Economist reported the same year that blockchain could radically transform “how our economy works.” Major IT corporations such as IBM and Microsoft began making long-term commitments to further develop blockchain technology and integrate it into our daily life. Blockchain has been predicted to change the world the way we know it, but what exactly makes it so revolutionary?
What Is Blockchain And How Does It Work?
At its core, blockchain is a decentralized database of various records, first developed to serve as a supporting system for Bitcoin, a digital currency designed for peer-to-peer trading without the use of an intermediary. Records used in blockchain are called “blocks,” and they are linked with other blocks in the system using a “hash” function, which is a mathematical encryption that creates a unique string of characters that are woven together into new “hashes.” If someone were to attempt to modify those records, they would have to tamper with all the other timestamped and previously shared blocks in the database to do so, as the result would lead to a mismatch that would continue through all future blocks. This keeps the records in the database secure and makes blockchain a trustworthy source of information. The figure below offers a different way of interpreting blockchain’s security, where the miner represents a hacker attempting to modify a past transaction in the structure of all the blocks, while a new block (block 91) is added to the system:
Bitcoin utilizes the Bitcoin blockchain, a subset of the entire blockchain network that maintains records of all transactions involving the cryptocurrency. Setting up a Bitcoin wallet is as easy as downloading an app on your phone, so anyone can use the cryptocurrency. The following graphic illustrates how an individual can utilize Bitcoin:
And Bitcoin is just one of many digital currencies that use the technology. Ether, another blockchain-based, distributed currency, serves as the form of payment in the Ethereum blockchain, a different subclass of the blockchain system that allows developers to build and utilize decentralized applications. Bitcoin, for instance, is a decentralized application intended for peer-to-peer electronic cash transactions, while Ethereum can be used to decentralize any type of centralized service, such as the lending process. Using blockchain, an individual may lend or borrow money in seconds instead of funneling requests through a bank or another intermediary that simply take longer. This technology could eliminate various fee generating services offered by banks of all sizes, and incorporating a proven blockchain technology could create more efficient markets, especially in relation to trading and exchanging assets, as it involves multiple banks and clearing houses.
Blockchain in the Financial Industry
In his 2015 letter to shareholders, Jamie Dimon, the CEO of JPMorgan Chase, claimed that “there are hundreds of startups with a lot of brain and money working on various alternatives to traditional banking.” He stated that they “can make loans in minutes, which might take banks weeks.” These fintech startups such as Ethereum, the company that designed the Ethereum blockchain, are using blockchain to develop faster and safer methods of buying, selling and lending. Jamie Dimon went on in his letter to say that “we are going to work hard to make our services as seamless and competitive as theirs. And we are also completely comfortable with partnering where it makes sense.” Financial institutions such as J.P. Morgan have already started working with startups, as a 2016 SEI report claimed that 42 banks have joined fintech startups to develop blockchain technology for industry use, utilizing blockchain to record financial transactions with much greater security and cost efficiency. A 2017 report by Accenture claims that blockchain could save banks $8 billion to $12 billion annually and cut their operational costs by 30% per year on average. The figure below illustrates a list of different financial corporations by date of investment in blockchain:
Along with banks, private equity firms are turning toward blockchain for its potential to greatly decrease costs, errors and delays, while increasing security. In February of this year, Northern Trust Corp. and IBM announced the launch of the world’s first ever functioning private equity blockchain. This specific blockchain was custom built for the Swiss asset management fund, Unigestion, and it was designed to maintain records of all the transactions involving the fund. By providing a secure and easily accessible ledger of fund’s transactions, the private equity blockchain significantly cuts the private equity firm’s expenses. Similar blockchain applications will likely be applied to hedge funds and other asset management firms in order to decrease their costs, raise security of their transactions and address the high fees issue for their clients.
The popularity of blockchain has been increasing drastically in the financial and tech sector over the years. Banks such as Goldman Sachs, J.P. Morgan and Bank of America are investing in and collaborating with tech startups to further develop different parts of blockchain to leverage towards their own business model. J.P. Morgan and Goldman Sachs, for instance, recently invested a combined $20 million in Axoni, a capital markets blockchain startup. Various banks have also patented some of the most promising applications of blockchain. Goldman Sachs, for example, published a blockchain patent “Systems and Methods for Updating a Distributed Ledger Based on Partial Validations of Transactions” in September 2016 for foreign exchange trading. UBS and Santander had also partnered with a blockchain company, Ripple, whose cryptocurrency reached a value of over $26 billion in May 2017, second only to Bitcoin ($41 billion). As some predicted banks to lose market share to fintech startups with their attractive alternatives to traditional banking, big banks did what most entities with financial resources have done – partnered and/or acquired these technologies and integrated them into their own business models.
Going forward, we will see an even greater investment in and use of blockchain. Banks will continue to develop blockchain technologies toward their own business process, while investment management firms such as private equity funds, hedge funds, and asset managers will look at blockchain to lower their expenses, increase security of their transactions, and help lower fees for clients. Although blockchain offers many inviting opportunities for finance, it may take a while for financial institutions to start profiting from this technology. According to Veronica Lange, the head of innovation at UBS, blockchain is at least a decade away from transforming the financial industry. Speaking during a panel discussion at the Innovative Finance Global Summit on April 10, 2017, Lange stated that “some people have the expectation about a very fast materialization of benefit,” but the real profits of blockchain “will require a much more solid and robust market fabric to deploy on.” Even though there is a lot of buzz surrounding the potential benefits of blockchain, the true value of this technology will only become apparent after years of development. As blockchain becomes increasingly integrated into the financial process, we will be able to conclude more about its impact and see whether it leads to the type of profits anticipated by banks and other financial institutions. For now, we will focus on its possibilities and speculate on the outcomes of blockchain’s integration with yesterday’s financial industry.
Oleg Biletsky is a Summer Associate from New York University to Banyak Group's Managing Principal, Alexander Gannes, a specialist in executive search, consulting, and advisory services to the investment management industry.