Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Daily Archives: April 2, 2019

Blockchain in Finance

I have a perspectives piece in the current issue of Vikalpa about Blockchain in Finance. I have been teaching an elective course on the Blockchain for over three years now, and my approach has been to treat both mainstream finance and crypto finance with equal dollops of scepticism, cynicism and openness. That is what I do in this piece as well:

Blockchain – the decentralized replicated ledger technology that underlies Bitcoin and other cryptocurrencies – provides a potentially attractive alternative way to organize modern finance. Currently, the financial system depends on a number of centralized trusted intermediaries: central counter parties (CCPs) guarantee trades in exchanges; central securities depositories (CSDs) provide securities settlement; the Society for Worldwide Interbank Financial Telecommunication (SWIFT) intermediates global transfer of money; CLS Bank handles the settlement of foreign exchange transactions, a handful of banks dominate correspondent banking, and an even smaller number provide custodial services to large investment institutions. Until a decade ago, it was commonly assumed that the financial strength and sound management of these central hubs ensured that they were extremely unlikely to fail. More importantly, it was assumed that they were too big to fail (TBTF), so that the government would step in and bail them out if they did fail. The Global Financial Crisis of 2007–2008 shattered these assumptions as many large banks in the most advanced economies of the world either failed or were very reluctantly bailed out. The Eurozone Crisis of 2010–2012 stoked the fear that even rich country sovereigns could potentially default on their obligations. Finally, repeated instances of hacking of the computers of large financial institutions is another factor that has destroyed trust. When trust in the central hubs of finance is being increasingly questioned, decentralized systems like the blockchain that reduce the need for such trust become attractive.

However, even a decade after the launch of Bitcoin, we have seen only a few pilot applications of blockchains to other parts of finance. This is because cryptocurrencies (while being extremely challenging technologically) encountered very few legal/commercial barriers, and could therefore make quick progress after Bitcoin solved the engineering problem. The blockchain has many other potential finance applications – mainstream payment and settlement, securities issuance, clearing and settlement, derivatives and other financial instruments, trade repositories, credit bureaus, corporate governance, and many others. Blockchain applications in many of these domains are already technologically feasible, and the challenges are primarily legal, regulatory, institutional, and commercial. It could take many years to overcome these legal/commercial barriers, and mainstream financial intermediaries could use this time window to rebuild their lost trust quickly enough to stave off the blockchain challenge. However, whether they are successful in rebuilding the trust, or whether they will be disrupted by the new technology remains to be seen.

Blockchain is still an evolving and therefore immature technology; it is hard to predict how successful it would be outside its only proven use domain of cryptocurrencies. History teaches us that radically new technologies take many decades to realize their full potential. Thus it is perfectly possible that blockchain would prove revolutionary in the years to come despite its patchy success so far. What is certain is that businesses should be looking at this technology and understanding it because its underlying ideas are powerful and likely to be influential.