It is impossible today to open any news source without a headline (or several) about Bitcoin and related matters jumping out at the reader and loudly demanding attention. It is no longer the domain of techno geeks or shady characters trading in illicit goods: now serious bankers get involved in blockchain projects, while coffee shops start accepting Bitcoin and youths mine for coins in their student dorms. Ubiquity of the topic and associated buzzwords has not helped much clarity, there is still confusion and rife misunderstanding. Inherently conservative, private bankers and wealth managers have been hesitant and slower to pursue opportunities in the area. With this article we seek to establish some clarity and hype-unbiased understanding of the trending technologies and artefacts, and their potential for the sector.
The thinking and technology behind it all: substance vs hype
While cryptocurrencies (and Bitcoin in particular) are getting all the fanfare, a humble logical and technical concept in the background is the real enabler and carries most of the potential. The fundamental idea was originally the one of having a consensus dataset shared across space and technical environments, without a single data store or centralised administration. Called ‘shared ledgers’ or ‘distributed ledgers’, the concept has been around for years and has now evolved to a class of technologies, usually referred to as DLT (distributed ledger technology).
One model for implementing distributed ledgers is based on a series of sequentially connected and time-stamped data records (blocks). Known as a blockchain, this model uses specific validation protocols, secure encryption and fault-tolerance mechanisms to enable decentralised consensus, the core attribute of distributed ledgers. Before being applied to financial transactions (see use cases below), the blockchain model is providing tamper-proof and secure recording and sharing of any data resulting from any form of physical or virtual event. It is considered that historically blockchains were first applied for monetary payments without a central authority around 2008-2009 and are at the heart of the cryptocurrency that became Bitcoin.
To sum it up: the most important property of blockchains is the possibility to reach the mentioned consensus – an agreement between all parties about a fact (a ‘truth’) without the need for any intermediary or central authority. So – what can be done with DLT and blockchains?
Use Cases for DLT: only limited by imagination
So far the distributed concept and enabling technology solutions have found most convincing application in payments and financial transaction processing. Part of the interest in cryptocurrencies is also based on the same area pf application. Valid and with huge potential, however, this is by far not the only domain where the decentralisation and security of DLT can create value. Some applications have moved past experiments and pilots and are well into business-as-usual maturity. Others are still ideas to be developed and tested. As the ‘blockchain industry’ (yes, it is already considered an ‘industry’ by many) is moving incredibly fast, any list cannot be exhaustive or even current, but let’s try to look at some of the better known use cases and examples of successful deployments:
Smart contracts: an older idea now made practical with distributed ledgers and blockchains, smart contracts are enabling the unsupervised automated transfer of value upon meeting agreed conditions and validating in a secure way both the delivery and the payment transaction. Also called ‘digital’ or ‘self-executing’ contracts, these autonomous and distributed arrangements also bring consistent accuracy (machine-executed with no human error) and trust (as the critical data is on a shared ledger and securely encrypted). They are expected to find popularity in many sectors from SCM (supply chain management) to Healthcare, Insurance to Logistics, and certainly in the public sector. In most of these areas there are already working solutions and case studies:
- AXA is starting to process travel (flight delay) claims and compensation payments using Ethereum-based smart contracts.
- The DTCC (Depository Trust & Clearing Corp.), an organisation which processes over 345 million securities market transactions worth $1.5 quadrillion (!) is already using multiple DLT and Blockchain solutions in its post-trade clearing and settlement services and derivatives processing.
- The Corporate subsidiary of Barclays bank uses blockchain platform Wave to store and track shipping documents and automate the payment for goods upon arrival.
- HMLR (the UK Land Registry) has a Sign Your Mortgage Deed service for remortgaging homeowners, using a disintermediated digital conveyancing process, coupled with identity assurance from GOV.UK Verify
These early examples are just the start and 2018 is expected to be ‘the year of smart contracts’ globally and across industries.
Authentication: the ability to sustain securely tamper-proof, distributed copies of a single ‘truth’, makes the technology ideal for validating the authenticity of documents and other objects, and – in the same way – for verification of identity. This may be for classical ID purposes (as in current ID documents and systems, but tamper-proof and globally accessible) – but also for secondary and auxiliary proof of identity, e.g. in Health or Education. Further from identifying individuals, distributed authenticity is applied to organisations, objects (documents, digital artefacts, physical goods) and records of events (including, but not limited to transactions, e.g. ownership title or birth certification).
- Microsoft in partnership with Accenture are offering Digital ID, a universal ID method, token and distributed system for the identity of individuals. It is of particular interest where traditional ID documents are hard to validate or even non-existent (migrants, refugees). It can link to national and international registers for residence, property ownership, education, health and more and provide a single source for all ID purposes.
- The Brazilian government is piloting an ID program using the Ethereum blockchain.
- IBM, while implementing SecureKey ID solutions with Canadian banks, are receiving interest from the government (as well as US government agencies) to pilot similar approaches in the area of citizen ID-s.
- The state of Illinois, through the IBI (Illinois Blockchain Initiative), are already providing blockchain-enabled land titles and birth certification.
Value exchange: this is happening at every transaction, whether purely monetary or a payment for a product or service that can be validated in a smart contract. However, a different new level of utility is provided by marketplaces, facilities where multiple transactions are occurring simultaneously between multiple players and supply-demand factors are enabled to have impact on values. Blockchains are used to create new currency-, securities- and commodity-exchanges, or enhance the efficiency and security of existing ones.
- Ing, SocGen, and ABN Amro banks have partnered to create ‘Easy Trade Connect’ for agricultural commodities trading, after piloting earlier the same concept for oil trades. The fully digitised document creation, validation and exchange is reported to reduce the end-to-end time of a trade fivefold.
Data sharing: in situations where multiple entities and stakeholders, with or without formal relationships, need to exchange sensitive data, DLT solutions can provide a secure and decentralised environment where all parties can place and access the relevant information. Shared data doesn’t have to be monetary or financial at all – any type of content can reside and be exchanged on distributed, blockchain-based networks. Examples are supply chain and logistics, content curation, reputation rankings, or – with rapidly growing interest – IoT (internet of things) applications, where one of the most prominent DLT players, IOTA, is already providing a range of services.
The Ecosystem: established and emerging types of players
The DLT world (including cryptocurrencies) originally belonged to a handful of tech outfits with the ability to offer guaranteed and un-administered functionality to a captive user base of individuals and entities who need secure and anonymous payments. Since the DLT space expanded into a myriad of use cases and applications, the technology firms continue to dominate the space, with diverse offerings and new ideas – but an increasing number of other players are emerging and getting established:
Service providers: those may or may not own a unique technology. The providers, who emerge from a technology background, do not sell it in product form, but use it as a platform to offer a value-added service. Others rent or buy technology to enable their propositions. Most services fall in the categories described in the previous section and range from micro-transactions at individual consumer level, to mega-volumes of institutional user clearing and settlements.
Financial institutions: banks are particularly active in the DLT and blockchain space, on their own, in groups (consortia), or in partnerships with technology firms. Retail and commercial banks alike, investment banks and non-banking financial institutions (fund- and asset managers) have started benefiting from efficiency gains in distributed transaction environments. Some are finding improvements in authentication and security, and some – in sharing data with external stakeholder networks (clients, intermediaries and specialist service providers.) The insurance industry is not far behind, with similar objectives and early results. In addition to direct consumption of DLT benefits, many financial institutions are acting as drivers of the development and accelerated adoption of these technologies and services. They invest in their own R&D, fund provider fintechs, and some even engage in setting up public incubator / accelerator facilities to encourage start-ups and broad innovation in the area.
Exchanges and facilitating service providers: originally focused on cryptocurrencies, they have evolved to use DLT to enable trading in any other form of value, from financial instruments to physical goods and beyond. Some include, among the traded items or payment methods, cryptocurrencies – but this is not necessarily universal, as blockchains offer most of the benefits without a dedicated measure of value (‘currency’). There are instances of traditional marketplaces where the technology has been deployed as a new enabler, and also examples of new, previously non-existent exchanges, built around DLT.
Pure-play technology vendors: there are still a class of tech firms who do not offer services on top of their product, just license it as deployed (on premises) or SaaS (cloud) solution. This includes independent ‘dApp’ (distributed app) developers, who expand the ecosystem into endless new ways to use blockchains and keep increasing their utility and value.
Hybrid and comprehensive platforms: some technology-based service providers also offer their own cryptocurrency complete with mining incentive mechanism, storage and validation facilities and transaction channels. The most advanced and comprehensive are ecosystems, catering for all other types of players described herein, and offering a single environment to conduct all mentioned activities. A most notable example is Ethereum, which from a humble start as a scripting language to improve Bitcoin evolved to a blockchain system in its own right, a cryptocurrency (Ether), and to a full-blown operating system and public distributed computing platform with its own VM (virtual machine), scripting and smart contracts. Building blocks on top of this platform offer developers endless opportunities to create apps and services, as well as ready-to-use functions from pegging digital assets (tokens, currencies) to fiat currencies and to gold, through ID and crowdfunding functionality, to services for gaming and charging of electric cars.
Miners: individuals or groups using their computer resources and time to solve blocks of the blockchain, against a reward (typically in crypto-coins). Mining is essential in ensuring supply of cryptocurrencies while also limiting the supply by linking it to a form of investment (of time, effort and computing resources). Early forms of mining were based on a concept and protocol called PoW (proof-of-work), for achieving distributed consensus, based on earlier methods for preventing malicious attacks. PoW is still the method for Bitcoin and widely used elsewhere, but there is a trend towards a PoS (proof-of-stake) algorithm, with Ethereum even planning to transition to a full CBC system (correct-by-construction, a form of PoS) which can eventually make mining obsolete.
It is worth mentioning that mining comes with a variety of challenges and controversies: the extreme rise in cryptocurrencies value has intensified mining activity to excessive energyconsumption, with some sensationalist reports comparing the global Bitcoin electricity use to that of an entire country. It is also a performance bottleneck, causing overall system speeds to slow down and impact transactions and other, non-monetary uses of blockchains (although speeds also depend on the algorithm and Ethereum block time is under 15 seconds, while for Bitcoin it is 10 minutes. One negative side of mining is the malicious exploitation of unsuspecting computers (and other computing devices, like phones) for distributed mining by infecting them with viral code and turning them into mining slaves for the benefit of unscrupulous criminals. Even YouTube adverts were recently implicated in delivering such viral code for hidden mining purposes.
Investors: Due to the hype, these are often seen as cryptocurrency speculators, seeking to gain from price gains of specific coins. Recently some more sophisticated vehicles have emerged, allowing users to spread their investments between several coins (as well as non-crypto assets), while providing a degree of protection against the wild volatility and associated risks. Other investors, however, are more interested in the technology or service provider firms listed above, and invest in them through early-stage VC funding or more mature, market-listed securities. In all cases the investor community makes a significant contribution to the speed of dissemination and adoption of DLT practices, the variety and quality of products and services in the industry, the capital availability and valuations of players – benefiting from high returns on their input.
Central banks, governments and other authorities: even more conservative than private sector financial institutions, they were initially reluctant and even hostile to the idea of distributed and un-administered storage of critical data. However, the rapid adoption in the rest of the economy and the growing evidence of efficiency benefits, changed the minds of many authorities and even central banks. Today they are not only experimenting, but routinely using DLT in parts of their operations and the expectation is this will continue to grow.
One area of uncertainty and concern is the issuing of digital currencies by countries’ central banks: while this has certain merits, having a single/central controller of the value allocation, validation, storing and exchange, goes against fundamental DLT and cryptocurrency principles and may eventually be self-destructive for the idea. For the time being only very few single central banks are experimenting with (or considering) centrally issued digital currencies. More likely to move from trials to business-as-usual are blockchain enabled processes (without a currency) in interbank operations, as well as a variety of non-financial public services. Further to the above mentioned Illinois example (IBI service for land registry), other governments and local authorities are making inroads with DLT like the Public Registry in Tbilisi, Georgia and systems implemented in Russia for secure digital voting in local elections. And the EU is planning a single digital ID for financial purposes under its Horizon 2020 programme, recently funding Norwegian fintech to develop the DLT tools for that.
Cryptocurrencies: currencies, crypto, or none of these?
It is impossible to discuss blockchains without mentioning Bitcoin, Ethereum, or Litecoin (or the mushrooming world of lesser-known value tokens). They emerged as early applications of DLT to address specific needs, and because they performed key functions of money, were easily called ‘currencies’. The ‘crypto’ reflects a true feature (they are encrypted), but currency by definition is more than a payment token (‘medium of exchange’ in textbook definitions). As a measure of value and store of value (other definition characteristics) cryptocurrencies are still not fully meeting functional criteria, because of the ‘value’ keyword, undermined by liquidity and volatility issues.
A combination of scarcity (the mining process) and naturally growing interest in Bitcoin (and other cryptocurrencies) drew attention to their investment potential as an asset – and promptly triggered speculation. This, in turn, exceeded rational scale as typically acceptable for legal tender, securities, commodities and other traditional assets. It will be an understatement to say that late 2017 speculation in Bitcoin ‘went wild’, reaching astronomic heights (and also dramatic falls). This is in contrast with the requirement for a currency to provide a degree of stability (the opposite of volatility) and balanced supply against demand, resulting in high liquidity. By these measures cryptocurrencies are still far from satisfying classic requirements to be called (and used as) a currency.
Quite differentiating from traditional (fiat) currencies is the ICO phenomenon (initial coin offerings). The ease, with which a new virtual digital token can be created and launched has led many businesses to offer their own currencies. These range from the rather logical and legitimate XPR from leading payment services provider Ripple, to consumer marketing initiatives of questionable financial basis like KodakCoin from the eponymous photographic company. Some new ‘coins’ are used to reward behaviours (e.g. customer loyalty), and a most popular recent use is for crowdfunding of start-up businesses or new products. The promise of early investors benefiting from explosive growth (the analogy with Bitcoin) appeals to many, but coming form a mushrooming multitude of issuing organisations does carry even greater uncertainty and risks than the more established cryptocurrencies like Ether, Litecoin, Monero, Zcash and, of course – Bitcoin.
Cryptocurrencies, in our view, have their place in the financial world – in this we are aligned with visionaries and highly credible business leaders like Bill Gates, who declared that “Cryptocurrencies are the future of money…” and is using Ripple technology in his charitable activities. The current cryptocurrencies must undergo a ‘natural selection’ to separate substance from hype, to achieve truly wide acceptance and deliver to the expectations for ubiquity, stability and liquidity that will turn a deserving minority into true future currencies.
What it all means for Wealth Management?
First and foremost, we should never forget that operating institutions are in this business for the profitable outcomes for their shareholders, while protecting and growing the wealth of their clients. To maximise shareholder value, wealth managers seek to grow the revenue streams resulting from providing client value, while reducing the associated costs of performing their services. DLT and blockchains offer opportunities for both:
Operational efficiency: by using blockchains for fully automated payments, in trading transactions, and participating in institutional clearing and settlement schemes that utilise DLT, private banks and wealth management organisations can significantly reduce operating costs while improving the quality and reliability of transactional operations and reducing the risks involved. There are gains from a variety of DLT applications addressing regulatory compliance, from specific reporting types, to niche (but resource-consuming) areas like client onboarding and KYC.
- Ripple, a world leader in blockchain-based payment services, are one example of efficiency gains opportunity for the private wealth sector. Ripple are constantly enhancing their offering and currently also providing liquidity management, asset exchanges, and most recently – XRP, their own cryptocurrency.
- Tradle, on the other hand, are applying the same distributed technology to t he challenges of KYC and providing a most secure and highly validated environment for obtaining critical client information. They position their award-winning platform as a ‘trust provisioning network’ that speeds up capital and risk allocation.
Revenue opportunities resulting from enhanced and diverse client offerings, based on cryptocurrencies or other blockchain artefacts and applications. The obvious use case and the early pioneers were simply facilitating the client access to cryptocurrencies, the purchase transactions, and eventually – the storing and verification of such assets. This is rapidly evolving into a full-service offering that includes conversions to/from Fiat currency, trading services, collateralisation of crypto-assets, AML verifications and more – all in line with suitability, K&E and risk profile requirements. This is expected to grow significantly, but private wealth players vary today from sternly unenthusiastic to daring early adopters.
- Falcon Private Bank is an early example which, at the time of writing already offers a full service across 3 cryptocurrencies (Bitcoin, Ether and Litecoin) – including buying, custody, selling and reporting. The bank also accepts wealth originating from crypto assets that has been converted into a Fiat currency.
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Despite the doubts triggered (not without reason) by the December 2017 extreme market fluctuations in Bitcoin, it is obvious that blockchains and generally shared ledgers / distributed technologies are too useful to be ignored or to be declared a bubble and forgotten. Even cryptocurrencies, with all the volatility, are more likely to stay for the long-term. In the current state of this evolving technology and finance area, the Private Wealth sector can hardly go wrong by embracing, rather than rejecting the trend. Those who find ways to leverage DLT and all associated applications for value creation for their clients and shareholders will be the future leaders in the market. Some of the most reluctant laggards may no longer be with us in the next decade. Like with the risk/reward awareness about cryptocurrencies, the overall move into distributed technologies can be safe and successful with healthy consideration and measured steps forward. Start simple – one trial and one win at a time, and build consistent competitive advantage.