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From Bitcoin to Back Office 2.0 – A Quick Intro to Block Chain Technology

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By Pete Harris, Principal, Lighthouse Partners

“Nothing much more than a fancy kind of database,” is how Blythe Masters described block chains, a technology that underpins the bitcoin crypto currency, but which has applications as diverse as proving ownership of intellectual property to acting as the processing glue between devices in the Internet of Things.

Masters, who was once a senior executive at JPMorgan Chase – where among other achievements she created credit default swaps – was being interviewed at a recent Bloomberg conference and is well placed to position block chain technology and its promise for Wall Street: she’s the CEO of New York City-based Digital Asset Holdings (DAH), a startup that is developing securities processing applications on top of it.

To expand a little on Masters’ characterisation of block chains, the database technology might be considered ‘fancy’ for a few reasons:

  • Block chains consist of a time-ordered record (or ledger) of transactions, grouped into data structures called blocks, and secured from unauthorised modification using cryptographic hashes.
  • Every transaction processing node in a block chain network contains the full record of transactions, so it is highly fault tolerant and resistant to attempts to crash it. This architecture also gives rise to the phrase shared distributed ledger, which is a generally accepted alternative term for a block chain.
  • New blocks are added to the chain according to a process of rules known as a consensus algorithm that allows all nodes to trust that the block and the transactions within it have been verified as complete.
  • At a base level, all transactions – from the very first to the most recent – can be viewed by any node on the network, which makes it transparent and auditable.

As mentioned earlier, bitcoin is perhaps the best known proof-of-concept of how to apply block chain technology. Bitcoin is an implementation of a so-called permission-less block chain, running a consensus algorithm (called proof of work) where any transaction processing node on the network can create a new block of transactions that other nodes will trust to be accurate.

While proof of work consensus is very powerful in the sense that it allows secure and direct transactions between parties that are unknown to one another (such as money transfers from person A to person B with no trusted intermediary, like Western Union), a drawback of it is that using current computing technology, the network is not that fast or scalable – able to process just a few transactions per second. It just wouldn’t work for many financial markets applications.

The shortcomings of the bitcoin block chain have not deterred interest from Wall Street players who see the peer-to-peer technology as potentially a way to rationalise and simplify legacy back office post-trade transaction and payments processing, cutting out costly intermediaries that also add delays to the process. The bottom line is that compared to the status quo, it could mean a better, faster, cheaper way to clear and settle trades, and that in turn means better use of capital, lower total cost of ownership of back office systems and less operational and systemic risk.

Indeed, one estimate that has been touted by London-based SETL, which like DAH is looking to implement block chain based back office systems, suggests that financial markets firms spend between $65 billion and $80 billion annually on trade processing. Clearly there is a great opportunity for cost reduction.

DAH and SETL are among more than a dozen startups (currently) that are tackling financial trade processing, most focusing initially on OTC and illiquid markets or ones where there is little automation. For the most part, these startups are developing systems known as permissioned block chains that feature a different consensus algorithm to bitcoin more suited to the more ordered and regulated nature of the financial markets. As a result, these permissioned block chains offer far higher performance than the bitcoin block chain – SETL for example reckons its version can process 1 billion transactions per day – with more in the way of access controls, audit trails and security.

It’s not just startups working on block chains for securities processing. Quite a number of market participants – including the likes of BNY Mellon, Citi, State Street and UBS – have set up internal labs to investigate the technology. And in another development, the Nasdaq OMX exchange group is working on a block chain-based system to automate securities processing in its marketplace for private (pre IPO) companies.

As well as working independently, a number of banks – 30 so far – have joined a consortium effort led by consulting firm R3 to work on an industry-wide initiative to build what it has termed a ‘Global Fabric for Finance’. It’s the kind of initiative that could one day replace utilities like DTCC and SWIFT, assuming the bank members can agree on a design that is capable of being built.

Outside of R3, other multi-firm block chain initiatives are kicking off, including the Wall Street Blockchain Alliance and a FIX Trading Community working group. Right now, the focus of many participants and consortia is on education and experimentation, but limited pilots and proof-of-concepts should follow before too long.

The next article in this short series will explore market participant, consortium and startup initiatives in greater detail. Watch out for it soon after the calendar rolls over – 2016 is set to be a key year for block chain developments and the birth of back office 2.0 approaches.

Want to know more about financial markets applications of block chain technology? Then attend The Block Chain Conference taking place on February 10, 2016 in San Francisco. Register today for the early bird date at http://www.theblockchainconference.com and use the promo code ATEAMVIP for a further discount.

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