Understanding Blockchain Use Cases

Man Controlling Trade

“Man Controlling Trade,” by Michael Lantz, 1942. Photo: Jeff Kubina

It’s been a big year for distributed ledgers, often branded “the blockchain” by the media and making the cover of both the Economist and Bloomberg Markets while Oxford added its definition to their dictionary. 2015 has been the year of the blockchain.

Financial institutions have gotten the hint. In the last two months alone, 13 financial services firms made their first investment in one of these startups and over $1 billion has been invested in blockchain technology, according to CNN.

“For the banks it offers the opportunity to revamp existing banking systems and speed up settlements as long as transactions comply with tough money laundering and ‘know your customer’ regulations,” Philip Gomm, the head of banking and payments at Capgemini Australia, told AB+F.

In all, the industry could save $20 billion a year by leveraging distributed financial technology, says Santander Bank, which is an investor in Ripple.

With all this industry attention on blockchain’s potential, one might draw the conclusion that every asset under the sun will soon be traded and transferred on a distributed database. This is evidenced by the spectrum of financial services firms investing in the technology, from insurance companies to investment banks to exchanges.

But while financial institutions are eager to jump on the blockchain bandwagon in an effort to signal their commitment to innovation, not every use case necessarily makes sense. That’s because, by definition, a distributed system will never be as efficient as a centralized one.

That’s also why, generally speaking, blockchains have the greatest chance of success in areas where the world has not already agreed to a central counterparty for clearing and settlement.

Cross-border payments is a great example (while also being the fundamental transaction the underpins the world economy). In part due to political and sovereignty concerns between nations, the world has not been able to agree to a centralized agent for the settlement of cross-border payments. If there were a centralized agent in this situation, the actual mechanics wouldn’t be that crazy to figure out. If all the nations of the world agreed, even Paypal could conceivably handle it.

Of course, geopolitical realities prevent such global cooperation under the current climate. Russia, understandably, wouldn’t want to give the U.S. sovereignty over systemic payments infrastructure. In other words, the neutrality that the blockchain provides is the killer app that facilitates more efficient cross-border payments.

Naturally, other kinds of assets operate very differently from payments. In the case of securities, market participants have already agreed to an operator for settlement infrastructure in the U.S.—the Depository Trust & Clearing Corporation (DTCC). DTCC subsidiaries handle the settlement of Treasuries, equities, corporate bonds, municipal bonds and agency mortgage backed securities among other types of assets. [Editor’s note: Former DTCC CEO Don Donahue is a Ripple advisor.]

Given that an operational system to clear and settle securities is already in place, changing post-trade processes comes at an enormous cost to both the industry and to regulators. If that’s the case, does moving to a blockchain system actually make sense? Similar to our design goals for Ripple and supporting faster payments, a common pain point talked about in the context of securities is that U.S. equities take three days to settle, or T+3. Blockchains, on the other hand, can adjust ownership in real time.

So can’t we get to real time by switching equity settlement to a blockchain?

Unfortunately, it’s a bit of a red herring to assume that the central counterparty is the main holdup here. While we don’t intimately understand the internal systems of DTCC, there’s no logical reason that a centralized database can’t adjust in real-time. If anything, it should be easier to speed up a centralized system than a distributed one.

To take an example from the payments world, about a dozen countries have already upgraded their national payment systems to real time, still retaining the legacy central bank operator as the central clearing agent. In such cases, a centralized architecture was not the impediment to getting to T+0.

There is a great 2012 paper from Boston Consulting Group called “Cost benefit analysis of shortening the settlement cycle,” which was commissioned by the DTCC. From the paper:

Moving to a T+2 environment [for equities] would require approximately $550 Million (M) in incremental investments, whereas upgrading systems and processes across the market to support T+1 would require nearly $1.8B. Although these values are large in aggregate, the required investments are small on a per-firm basis. For example, large institutional broker-dealers would need to invest, on average, $4.5M for T+2 and about $20M for T+1, driven by various degrees of systems/platform enhancements and end-to-end testing and analysis. Similarly, large retail broker dealers would need to invest, on average, $4M for T+2 and $15M for T+1 for a comparable set of changes.

All of which seems reasonable. What about moving from T+1 to real-time?

“T+0 was ruled out as infeasible for the industry to accomplish at this time, given the exceptional changes required to achieve it and weak support across the industry.” [Granted this was in 2012.]

As it happens, a substantial roadblock exists in getting the information from the trader’s desktop, matching the trade and then delivering it to the settlement database—as opposed to the difficulty of simply managing a central ledger in real time. So if the design goal is real-time, it’s not clear that the solution has to be a blockchain. Moreover, a blockchain might not be the cheapest way to accomplish that goal.

Phil Rapoport contributed to this report.