Over the past few years, business media and publications have spent an ever increasing amount of time and effort researching, analyzing and publishing information regarding the variety of new technologies that are impacting global financial markets. For example, the innovation known as blockchain technology has garnered interest and investment from global banks, exchanges, trading firms, governmental institutions and more, and continues at an increasing pace. Advocates for this particular technology are working hard to surpass each other in their comparisons of its disruptive potential, with many comparing its innovation and long term impact to the creation of the internet. One recent example went so far as to compare it to Gutenberg’s invention of metal movable-type. Investment in blockchain and digital asset startups seems to support this perspective, to the tune of more than $1.7 billion since 2012 (to say nothing of “initial token offerings” that have raised more than $1.5 billion in 2017 alone, and would justify their own article). Broad fintech technology investment for 2017 so far in fintech companies topped $3.2 billion.
The world of trading has been continually evolving in the midst of this activity, with focus on the growing number and variety of technologies, including blockchain, as well as artificial intelligence, robo-advisors, big data analytics and more. All of these have not only the potential to modernize what many believe are relatively antiquated trading systems and infrastructure, but to also offer up the hope of increased profitability for market participants in the future.
There remains a significant degree of confusion and overall lack of understanding about what blockchain technology does and what it truly represents, so this article will attempt to provide a brief background on the technology and how it functions, as well as touch on the power of smart contracts. More importantly, we will discuss whether and how these capabilities shift existing roles, such as that of lawyers and traders, to blockchain and smart contract programmers, as well as increasingly complex computer systems. Understanding these possibilities will help us understand how the usual roles may become gradually redundant, as global trading may be administered by algorithms and even the client-fund relationship itself may eventually be governed by smart contracts.
What is blockchain?
It makes sense to start with the basics. What is blockchain? Where did it come from and what is it meant to accomplish?
Many industry organizations around the world are working to provide a level of understanding that complements the already existing deep technical aspects of blockchain which, though critical, often confuse non-technical professionals’ perception of this innovation. What is important to understand are the problems that blockchain is designed to solve. Ultimately, blockchain technology requires revisiting how businesses do what they do, and how that might change in the future.
By now, many in financial markets are aware that blockchain as a concept and first application has its origins in digital currency, most notably bitcoin. While this article does not delve into the creation of bitcoin, its anonymous creator (or creators) nor the challenges digital currencies have and continue to face, it is worth understanding it was created.
Essentially, bitcoin was only ever meant to be a payment system that allowed for borderless, instantaneous transactions, conducted anonymously and transparently. It is a testament to the elegance of the underlying technical design that blockchain is being used for far more than originally envisioned.
Blockchain, the underlying technology of digital currencies, is a public, decentralized ledger (or database) that records transactions without requiring any trusted central authority to maintain the ledger. Maintenance of blockchain is performed by a network of nodes, with new transactions broadcast to the network. The network validates every transaction, adding each new transaction to its copy of the ledger and then broadcasting these additions to all other nodes. Once added, a record cannot be modified and it is virtually impossible to falsify records (again, without delving into technicals, the computing power that would be required to illicitly change a block of data would approach the unimaginable). As originally designed, all records can be viewed publicly, allowing anyone to verify the legitimacy of any transaction.
The truth of a transaction is confirmed by what is known as a “consensus mechanism,” which, for the purposes of this article, is simply a method of authenticating and validating a value or transaction on a blockchain without the need to trust or rely on a central authority to do so. Consensus mechanisms are central to the functioning of any blockchain or distributed ledger.
As many in financial markets will acknowledge, fully public, open and decentralized data sharing does not blend well with financial markets. The significance of protecting clients’ personally identifiable information, as well as the series of regulatory mandates such as anti-money laundering and “Know Your Customer” rules, make public blockchains difficult to leverage in financial markets, and other industries. Thus, the research and use of “private blockchains” has become prevalent.
Private blockchains are not fully public, decentralized networks. In these structures, access permissions are controlled and rights to modify or read blockchain are restricted to a few users. Ideally, they are designed to maintain the partial guarantees of authenticity and decentralization that blockchains provide, while complying with the realities of life in financial markets as they exist. Many technologists continue to struggle with this trend, citing that full decentralization is part and parcel of the underlying idea of blockchain. Regardless of perspective, it is worth noting that private blockchains are the primary focus of research and testing for financial institutions and most corporate engagements in this arena.
Fundamentally, blockchain represents a major change in how data is managed and value is transferred or reassigned. Structurally, it greatly reduces opportunities for errors that arise when reconciling complex and disparate information from multiple sources as well as the impact of human error. In the areas of finance and trading, this yields some interesting possibilities, and many trade related organizations are beginning to conduct deep research into blockchain.
So what are smart contracts?
The world gets even more interesting, and confusing, when we define the above noted concept of smart contracts. Smart contracts are computer protocols intended to facilitate, verify, or enforce the negotiation or performance of a contract. The goal for advocates of smart contracts is the ability for a wide variety of contractual obligations to be, in whole or in part, self-executing, self-enforcing, or both. Smart contracts offer the ability to automate the life cycle events of a contract, such as a synthetic financial instrument for example. Coupled with the added security of minimized human intervention and significantly reduced costs, smart contracts provide an ideal complement to the power of blockchain technology. In this context, a smart contract could theoretically work across a blockchain to facilitate business activity and commerce.
Simple, automated buy-sell contracts already exist, and have for some time. As the technology grows, we begin to envision the evolution of smart contracts to accommodate ever more complex interactions. Solutions such as land title registration, digital rights management and even personal identity ownership are all at the forefront of smart contract growth and adoption.
How this affects the world of trading, fund management and beyond
How does this relate to the global world of trading? How do the roles of industry participants evolve? To answer these questions, it is worth thinking through the roles and responsibilities in this realm. Take fund directors, for instance, who possess several statutory obligations. For example, they are required:
- To maintain proper books of account for the fund.
- To comply with anti-money laundering regulations under current law.
- To ensure that the fund is audited on an annual basis.
For each of these obligations, there are either blockchain-based prototypes available or research on such protocols is being conducted.
For instance, in a blockchain world, the maintenance of the books and records of a fund become not only “real-time” but what we in this arena call “immutable” (i.e., unchangeable and fraud proof). What happens when trades are powered by blockchain technology, when counterparties are all part of the same secure register and when the records of trades are not only automatically registered, but also verifiably accurate between counterparties? What happens when auditors themselves are part of blockchain implementations and integral to the consensus verification process that powers a particular blockchain? What happens when the trade and audit are all part of the same process?
One can envision not only the cost savings associated with the minimization or even elimination of reconciliation, but also the possibility of new ways of conducting global trading. Add to this mix the growing power of self-executing, self-correcting smart contracts (to say nothing of the rapidly emerging fields of machine learning and artificial intelligence, subjects worthy of their own article), and the future begins to look more automated, efficient, effective and ultimately profitable.
Indeed, lest the reader believe that this broad futuristic vision is simply theory, rest assured that multiple discussions are happening right now with regulators, attorneys, trading organizations and auditors around the globe to not only educated themselves on the power and benefits of blockchain, but also to learn how to adopt the technology to their particular missions.
No part of this article is meant to imply the elimination of the roles of traders, attorneys, regulators and other parties currently at the core of global trading. But, as has always been true for new innovations, from the advent of double-entry accounting to the birth of the internet, the role of professionals will change and they will have to adapt in order to become valuable participants in a new future.