In a recent white paper, a trend analyst and a portfolio manager at Robeco put their heads together to look at the value of blockchains, or more formally of “distributed ledger technology,” in the financial world. Jeroen van Oerle (the analyst) and Patrick Iemmens (the manager) contend that there is both real value and some faddishness at work, or in other words that DLT is “hyped but here to stay.”
They cover the basics well: As they explain, a DL is a database that keeps track of ownership of a specific asset. It may keep track of diamonds, land, shares of stock, etc. But that is simply to say that it is a “ledger.” What is also key is that it is distributed. As Oerle and Iemmens write, “every participant can keep a copy of the ledger which is updated automatically when new transactions occur.”
The best known example is Bitcoin and its blockchain. Every bitcoin transaction is processed and recorded so that every such transaction ever made can be traced, and will continue to be traceable until the reverberations of the last trumpets of doom themselves die away.
Hashing is an essential feature of DLT. These Robeco authors define hashing as “the process of running a computer algorithm over content in order to create an alphanumeric character that cannot be back-computed into the original content.”
Talkin’ Bout My Generation
There have been three generations in the application of this technology. Blockchain 1.0 consisted of Bitcoin and its imitators, currencies and applications related to cash such as payments and remittance. Blockchain 2.0 expanded to include a wide range of other financial implications, including stock or bond transactions and mortgages, This, the Robeco authors say, “is where most attention goes to at the moment.” But the newest expansion, Blockchain 3.0, has taken in the internet of things, medical data banks, community supercomputing, etc.
A vital fact about the second and especially the third generations is that they have brought the technology into a synergistic relationship with “smart contracts.” Smart contracts are autonomous and self-sufficient contracts, that do not need to be monitored by humans. For example, a smart contract could cause the engine of a leased automobile to stop working if the lessee failed to make payments. Such a contract would save the auto leasing company the expense of hiring or contracting with traditional “repo men.” Yes, marginal auto lenders may well resent the “smartness” that works to their disadvantage. But the creation of such contracts would make the auto lending industry a good deal more efficient and, other things being equal, should expand that margin considerably.
The auto-lending example is not in the Oerle/Iemmens paper, but it may help make their point vivid. They say that smart contracts “open up a whole new range of opportunities” for blockchain technology.
Banks are more advanced
Oerle and Iemmens argue that banks are at present more advanced in their development of DL technology than are other players in the financial sectors, in particular insurance companies or asset managers.
A consortium of banks called R3CEV is working to test blockchain applications for their world, and to establish standards, helping the industry serve the needs of its counterparties and stay in the good graces of national regulators. The Robeco authors say that they “see opportunities for banks in the areas of trade, (international) payments, regulatory compliance (KYC/AML) and structured investment products.”
Asset Managers and Disintermediation
Although matters aren’t as far along in the asset management world as in banking, Oerle and Iemmens see opportunities in the former as well. Not insofar as concerns securities in publicly listed issuers, where blockchain only offers a solution for which there is no problem, the system works efficiently and quickly as is. But in regard to the post trade process, and trading in interests in private company, there is work to be done. DLT, especially combined with smart contracts, will enable a large efficiency gain in those areas.
Will anybody get disintermediated in the process? For example, will the role of the custodian disappear? Oerle and Iemmens see that role transforming itself. The custodians will survive as validators of off-chain transactions that come onto the chain and vice versa. Their traditional role as record keepers will, though, surely fade out.