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The technology behind bitcoin is transforming clearing houses’ centralized settlement process.
By Basab Banerjee, CTO and Director of IT, Dubai Gold and Commodities Exchange
Blockchain. It’s the current buzzword, and not just in financial circles. Indeed, blockchain technology may prove to be a revolutionary way to speed up and verify many currently manual processes, as quickly as it takes to press a button on a keyboard.
A Blockchain Primer
Before we examine its potential, let’s do a quick review of blockchain and how it works. Distributed ledger technology, commonly known as blockchain, is a file verification network in which every transaction and individual piece of data is verified multiple times by a network of computers. It has the potential to both speed the completion of transactions and make them more secure.
Blockchain technology underlies such virtual currencies as bitcoin. In fact, although the term blockchain tends to be used generically, there are over 700 different blockchains in existence. Those other than the original blockchain that enables bitcoin are technically known as “alternatives to blockchain,” or an alt-chain. Each crypto-currency has its own chain; two of the better known ones are Etherium and Litecoin.
The reason blockchain is so powerful is that a number of nodes—computers in the network—are constantly verifying a transaction chain and creating an immutable record that can’t be changed. Through the use of cryptographic technology, the record, or ledger, of transactions ledger is encrypted so that only authorized parties in the network are allowed to access or alter it. Changes don’t need a central authority or any intermediary to authenticate them; instead, a unique algorithm-generated token is created and assigned to every change. These tokens are grouped into blocks and are validated by the computers on the network. Each block has a timestamp and a link to the previous block. Everyone’s copy of the blockchain is kept in sync, and cryptography ensures that users can only edit the parts of the blockchain for which they have a private key and permission to do so.
Today, blockchain technology is not limited to virtual currencies. Many centralized processes can potentially be replaced with blockchain technology. One such area is the post-trade settlement process, where the new technology could enable the instant updating of ledgers in a synchronized and authenticated manner. This would create a real-time or near real-time clearing and settlement system that would bring it in line with the speed of trading.
Cutting Out the Middleman
As it speeds up processes, Blockchain’s decentralized control on authentication and security also promises to reduce risks for businesses. These include risks involved in verifying the identity of parties to a transaction, as required by so-called KYC, or Know Your Customer, regulations.
For instance, market exchanges like ours typically depend on a clearing house to oversee the clearing and settlement of trades. Clearing houses sit in the middle of a transaction between buyer and seller, guaranteeing that both parties meet their obligations. The clearing house holds what is called margin, a cash advance to be used is if one side of the transaction fails to fulfill its obligations during the settlement process.
To mitigate risk, the clearing house ensures that margins are paid in a timely manner—usually on a day to day basis, but in times of high volatility, sometimes several times a day. Clearing houses offer this service by levying a small fee on each transaction.
As barriers to trading are reduced and technology improves, international borders become less relevant and transactions occur at greater speed. In this environment, regulators are pushing clearing houses to strengthen their security infrastructure.
Blockchain adds a new dimension to this process by bypassing the conventional clearing house stage. Instead, an ecosystem of what may be hundreds of enabling computers, or nodes, register trusted transactions directly between the buyer and the seller. The nodes in the network are able to independently verify transactions, and an automated consensus can authenticate and register a trade.
Introducing Smart Contracts
Because the financial services industry is highly regulated, it is a challenge to make a contract interoperable among different systems while complying with mandated legal frameworks. Smart contracts enabled by blockchain technology have the potential to improve efficiency by reducing the delay in such regulatory processes as documentation, KYC, and anti-money laundering.
In our industry we are seeing the implementation of private blockchains to improve transaction efficiency. For example, something called an electronic vault receipt platform enables businesses to access lines of credit against their inventories, by pledging these inventories to member banks or even the clearing houses. Solutions like this can make the post-trade process more efficient by acting as a central registry of ownership of goods and validating delivery obligations for transactions.
Numerous trading and commodity exchanges are actively exploring way of implementing blockchain technology to both speed up processes and offer an added layer of security.
For example, the Australian Stock Exchange is working to adopt blockchain technology as a replacement for its Clearing House Electronic Sub-register System (CHESS). It recently tested a prototype and plan to invest AUS$50m ($38.5m) in the project by the end of 2017, with the ultimate aim of making a transaction and settlement occur simultaneously.
In another context, CME Group and Britain's Royal Mint have started testing a blockchain-based platform for gold trading. The new platform will enable the trading of "Royal Mint Gold," or RMG, a new digital token issued by the Royal Mint. Each RMG will represent a digital record of ownership to 1 gram of physical gold stored in the Royal Mint's vault.
Building an Ecosystem
Clearly, these are initial, incremental steps. Implementing and standardizing blockchain technology will cost billions of dollars.
The adoption process will be slow and the technology will remain confined to subsets of financial market and for specific uses, at least for now. The majority of the organizations experimenting with blockchain technology are restricting it to internal use or to proof-of-concept trials for the time being. Such disconnected solution silos can’t demonstrate the full potential impact of Blockchain.
We are probably ten or maybe fifteen years away from a global distributed ledger that is beyond the control of any organization or industry. Still, these early adopters are spreading awareness globally among investors, banks, regulators, and other market participants.
As they inspire more organizations to adopt blockchain, they’ll be helping to create an ecosystem in which market participants across borders work together to create a permanent record of digital events. Ultimately, there will be a single and indisputable version of truth concerning financial transactions, one created by mass collaboration that will re-invent and simplify the entire financial world, as well as many industries beyond it.
The views and opinions expressed in this article are solely those of the author and not necessarily the views of DGCX Group, its management, its subsidiaries, its affiliates, or its other professionals.