Demystifying Blockchain: A Potential Catalyst For New Age Financial Markets

December 30 last year was a red letter day for people in the business of financial technologies. As much as most of us were preparing to usher in the new year with pomp and celebrations, it was a day that marked the dawn of a new era and a 'seminal moment' as Bob Greifeld, CEO of Nasdaq, put it when the stock exchange successfully recorded a private securities transaction i.e. issuance of securities to an investor by a company - the first of its kind using its Blockchain technology platform - NASDAQ Linq.

Six weeks hence, NASDAQ was in the news again for introducing an e-voting service by leveraging Blockchain, thereby allowing shareholders of companies listed on Nasdaq's Tallinn Stock Exchange, Estonia's only regulated securities market, to vote in shareholder meetings.

Close on the heels of NASDAQ, there was news from Down Under with Australia's biggest stock exchange - ASX, developing a private blockchain as a post-trade solution for the Australian equity market.

Heralding Next Wave of Innovation
All these are developments that are suggestive of a new wave of impending innovation that is taking root and getting set to change the way financial markets operate. So far, the prevalence of High Frequency Trading (HFT) and Algorithmic Trading (AT) has been the only major instance of innovation in this sector. However, this is only on the trade execution front. There has been a paucity of innovation in the post trade counterparty clearing/settlement processes.

Fintech companies would now be sensing a great opportunity is this space for deploying blockchain. The objective would be to re-engineer these processes instead of building a new version based on legacy processes in order to deliver benefits in terms of cost, speed, security and efficiency to all the market participants concerned.

The objective of this article is to clear the ambiguity about blockchain technology and highlight how it could play a transformative role across global markets.

Understanding Blockchain
Many of you would associate blockchain with the fad of the century - crypto currencies in general and bitcoin in specific. Besides being the technology that underpins the functioning of bitcoin, what we need to understand is that blockchain is a shared, secured and public ledger system not under the control of any single user, but adopts a consensus process wherein multiple users independently verify ledger changes. All in all, it is a sequential transaction database that is crowd managed with every transaction is bunched into a block (transaction file verified by data miners), validated with timestamps and stored using strong cryptography.

USP Of Security And Decentralization
Every new block added to the blockchain database, contains a key (cryptographic hash) of the previous block, which makes it tamper-resistant. This is because changing any particular transaction in the blockchain database would change the hash of the block being tampered with, which would cascade to all the subsequent blocks added in the blockchain. The database is thus resilient to attacks, as any attacker will need to have control on more than 51% of the computing power of the network to tamper with the transactional data.

Blockchain technology thrives on the theme of decentralization. A Goldman Sachs report authored by Robert D. Boroujerdi has indicated how blockchain technologies have the potential to challenge the profit pool of middle-men and also making centralized institutions obsolete yielding benefits of lower costs and reduction of counterparty risk by providing instant feedback.

Relevance To Functioning Of Financial Segments
A more lucid understanding of this concept can be explained in the process of transfer of ownership title of an asset; be it shares, bonds, mutual funds or even property, works of art, diamonds etc. The originator of the executed transaction (say a stock exchange) can initiate the clearing and settlement via a blockchain powered platform and provide a digital proof of the transfer of money for the shares without the mediation of a third party (say a bank for the money or a depository for the shares).

Let's now understand the application to different segments of the financial markets

Remittances: The World Bank's Migration and Remittances Factbook 2016 has observed that the total remittance flows to India are expected to touch a staggering $72.2 billion in 2015, making it the highest recipient worldwide. Globally, remittances are estimated to exceed $600 billion in 2015. Of this, developing countries are expected to receive a lion's share estimated at $441 billion. Facilitating these remittances are money transfer intermediaries who charge a fixed commission irrespective of the size of the transaction. Blockchain protocol would not just make these remittances cheaper but also enable 75% of the world's un/under banked to avail the benefits of transacting in an increasingly digital world.

Payments: Blockchain technology presents the potential for making payments / micropayments to third parties without the intermediation of banks.

Insurance: Blockchain transforms the way people manage identities and personal information and this will change the way insurers review risk and price the premiums. Blockchain applications in insurance are likely to start with digital identity systems and management of personal data. Smart contracts (where the outcome is pre-determined or event based) can help end users self administer their insurance policies.

Banking: With blockchain, banks will be well protected from mortgage frauds and document counterfeiting since record of transactions and title to the mortgaged property can always be checked. The Reserve Bank of India (RBI) in its financial stability report released in December 2015 extolled the potential of blockchain technology to transform the functioning of the back offices of banks, increase the speed and cost efficiency in payment systems and trade finance. To this effect, nine of the world's most renowned banks are collaborating to create a 'private blockchain' and building an industry-wide platform for standardizing the use of Blockchain.

Trading and Stock Lending and Borrowing (SLB): While high overheads and delays in validating various blocks before the transaction may not make blockchain protocol useful in live trading processes as yet, it may change as and when blockchain technology gets more mature, scalable and faster in the next few years. Execution of Smart contracts (much like that discussed in insurance) generated via smart algorithms (e.g. Buy Brent Crude when Price of Gold increases) could be the future application of such technology. Blockchain would play a key role in Stock Lending and Borrowing (SLB) which is a $954 billion market in the US and a shallow Rs. 322 cr. market in India wherein the ownership title of the collateral in the form of shares/ bonds needs to be verified to avert credit and counter party risks while lending. This can also be applied to 'Peer to Peer lending'.

While a lot of regulatory skepticism does exist on the future of crypto currencies like the bitcoin, the future of the technology powering it is sure to find greater acceptance across multiple sectors. Regulatory authorities would see Blockchain complementing their efforts of making processes more efficient while risk intermediation will continue to be provided by traditional banks.

The jury is out. This tidal wave of a fintech innovation is sure to turn into a tsunami. Brace yourselves for it.