Blockchain in the Finance Industry — New Technology to Solve Old Problems

By Alex Libertas

2008 Financial Crisis

In 2008 the world bore witness to what many top economists believed to be the worst financial crisis since the great depression. The initial cause of this collapse originated in the subprime mortgage market in the US and was further exacerbated by excessive risk-taking by banks such as Lehman Brothers. In order to prevent a potential collapse of the world financial system, massive bailouts of financial institutions were employed.

The following years proved to be a difficult challenge, particularly in the US, due to the housing market. People suffered evictions, foreclosures and an exorbitant amount of job losses. On top of this, key businesses failed and consumer wealth declined by trillions of US dollars. In 2009 it was reported on BBC News that £815bn was knocked off the wealth of households which amounted to an average of nearly £31,000 for every household in the UK. The effects are still felt to this day as in 2017 it was reported on Business Insider that “average incomes in Britain would be 20% higher now than they were…..instead, they are only about 5% higher.”

After these catastrophic financial events it comes as no surprise that two-thirds of Britons still do not trust banks and think they did not face severe enough penalties for their part in the financial crisis(source).

The Birth of Bitcoin

On 1st of November 2008 an unknown individual(s) called Satoshi Nakamoto released the technical paper for Bitcoin — a peer to peer electronic cash system that wouldn’t need a 3rd party intervention from a financial institution.

This system was designed to be completely decentralised meaning that users would not need to put their trust in in a centralised authority i.e a central bank.

Satoshi himself expressed his dissatisfaction with the central banking system as he stated “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”

To further cement Satoshi’s view, an article dated 3rd January 2009 was embedded into the Genesis Block on the very first Bitcoin transaction:

The news article embedded into the Genesis Block

Blockchain in the Finance Industry

Fast forward eleven years later and one Bitcoin is currently valued at $3,600.

Although banks have been largely resistant to Bitcoin, they are very interested in the underlying Blockchain technology and the impact it could have on the financial industry. Perhaps the most evident up until this week has been Barclays as in 2018 they filed for Blockchain patents.

However the entire landscape of Cryptocurrency has now been forever altered as JP Morgan are the first movers in creating their own “Stablecoin” digital currency. Some economists have gone as far to say that central bank digital currencies will ultimately destroy Bitcoin.

In Conversation with David Belle

I sat down with David Belle, a trader of 8 years who has worked in sell side and as a broker, to discuss the impact of Blockchain technology in the financial industry.

Do you think that Blockchain can be for information what the Internet was for media?

If you think about what the crux of what the Blockchain can do it’s to liberalise information. The Internet provided platforms like YouTube where you access whatever content you want to learn or browse whether it be informative or educational. With Blockchain we have a decentralised technology that can be applied to banking and finance.

What are the key areas of the finance industry that can be improved by Blockchain technology?

Security

In banks there are multiple different layers — front office, middle office and back office. These are all still centralised in terms of where the information is stored and because of this there are so many potential issues that can arise.

Information can go missing when reporting through the various different layers. This information is stored on private networks with impeccable security but there is still a chance that these servers could be hacked or perhaps a disgruntled employee could steal this information on an USB and take this to another employer. With Blockchain technology, every time this information is accessed then it would be recorded so there is a safety aspect in place here. The immutable nature of Blockchain technology also means that this information cannot be edited which would be greatly beneficial to the banks.

Accessibility

Occasionally information will need to be accessed immediately. Banks use multiple layers of software, databases and programmes to access this information and because of this the IT departments can be reluctant to want to upgrade these legacy systems. In my eyes this is a serious issue and if you could have a decentralised system using Blockchain technology, being accessible by any system in the bank, you could have a much more efficient process in place.

Ultimately changing to this technology would provide efficiency gains within these banks which are highly sought after. Whether you could measure this monetarily is another question, but in the long term you would be able to see a positive change.

Auditing

Auditing is a long and costly process in the banking industry. Most accountants and compliance people are there to protect the business so they can decide which information can be kept and which information can be changed in order to best suit the narrative of the bank.

With Blockchain technology this information is immutable. Therefore the regulators can look through all of these records and see exactly what has occured. So a useful timeline of events has been recorded. So what would do this for bank behaviour? It would probably force banks to be more ethical, transparent and honest due to this liberalisation of information.

Going back to the financial crisis of 2008, people didn’t know what the risk was on the books. Whereas for example if you’re making a CDO (Collateralized Debt Obligation) and you can track and see exactly what mortgages are made up in this one product then you could grade this quite adequately without information being obfuscated.

Working in Silos

Another problem with banks is that you have to go down to the root of what their issues are and this is that they work in silos. If you’re a trader at one desk at a bank then you only care about your desk, whereas the whole bank cares about their overall risk. When you’re working in a siloed system like this then one desk doesn’t care about what the next is doing.

This issue here comes back to commercial banks owning the investment banks. So if you have products that are being traded on one floor and then the counter product being traded on another floor then the risk is muddled through inefficiency.

Again with Blockchain technology, this information can be liberalised across different desks and you can actually see what other desks are doing decreasing the overall risk for the bank. There are issues then with the regulator with chinese walls however this an inherent issue anyway within the industry.

How do you think Blockchain technology will progress over the next few years in the finance industry?

Banks work in an oligopoly and part of an oligopoly is game theory, more specifically the prisoner’s dilemma. Prisoner’s dilemma is essentially a “standard example of a game analyzed in game theory that shows why two completely rational individuals might not cooperate, even if it appears that it is in their best interests to do so”

Prisoner’s Dilemma

So if we try to imagine this in the banking system — if one bank decides to progress with Blockchain technology and has some efficiency gains then the others will be forced to. So it’s all about the first mover advantage in this industry.

Let’s take the example of the mortgage backed securities product. The Solomon Brother’s started this product in 1979 and all other banks quickly followed suit as they knew there was money to be made by securitising the mortgage market. So it’s all to do with the first mover phenomenon.

I believe what the banks are doing is waiting for the next down turn to happen. In 2008 a lot of the unproductive firms were cleared out which gave rise to new ideas and new tech firms. We are starting to top out again, so when this starts affecting the banks in the next few years or so this can pave the way for Blockchain technology to be implemented to improve efficiencies all across the board.

Additionally I think we may also see a public Blockchain implemented across a number of banks for OTC trades. Nothing is recorded on an exchange so everything is recorded pre and post trade and this includes FX derivatives (excluding futures and options) and Interest Rate Swaps. These trades are still made over the telephone or via an e-broker so both parties just have to trust and agree on the conditions. Blockchain should become really important in this space as there are so many regulations put in place by Mifid II (the European regulation) in terms of trade transparency. So far no one has bridged the gap as far as a specific database is concerned so this is an obvious use case for Blockchain technology.

Do you have any last comments?

No one really wants regulation but everyone wants institutions to operate in the Crypto market. In my opinion they will never operate in the ICO market. Until people accept that there needs to be regulation on this product whether it’s Bitcoin, Ethereum etc..then they won’t see stable growth with less volatility. However this will have to come after Blockchain is used prevalently in society. The base of BTC is based on Blockchain so once the banks start incorporating the Blockchain side for information, then they will become more used to the idea of using Crypto and wanting to deal in it.

I thank David for his time.

David has over 8 years of trading experience and runs a weekly newsletter with over 200 subscribers called Macrodesiac. He provides regular macroeconomic updates designed for traders of all skill levels.

If you sign up with this link only, you can get a 5 day free trial.

Final Thoughts

Although we have seen fierce resistance from banks and economists about the use and applications of Bitcoin, there is a strong belief that Blockchain technology can be used in the finance industry to solve numerous issues like we have discussed today. This is evident in the fact that JP Morgan have just released their first Stablecoin Cryptocurrency and the multiple news articles of banks’ research and development arms testing with their own private Blockchains.

Whilst Bitcoin is yet to replace the current banking system, it is possible that the underlying technology can be used to fix a number of old legacy issues including those that contributed to the 2008 financial crash. If Blockchain technology is applied correctly in the auditing process, as we discussed, then it forces them to be more transparent and honest for the regulators in their dealings. This can ultimately have a trickle down effect to the general public and at least ease some of the pain caused by this irresponsible and avoidable crisis to which ordinary people are still suffering to this day.

A bittersweet victory for Satoshi and his vision.

Thank you for reading.

Alex Libertas

www.thedailychain.com

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