Blockchain: Changes Coming to Wall Street?

New technology can both disrupt and entrench existing large and powerful players in a market. In a previous article, I explained the importance of blockchain technology. A blockchain is a type of database that is distributed to all users without a centrally managed hub and that stores unalterable digital records. It is most commonly known today as the technology underlying bitcoin, keeping records of the cryptocurrency’s ownership and allowing ownership to be transferred.

There are many other possible applications for the technology, and some observers predict that blockchain will be as important an advance for transactions and record keeping as the internet has been for communication and information.

Blockchain technology can empower financial transactions without governments or large corporations acting as intermediaries. However, as this article shows, large financial corporations are developing and deploying their own versions of blockchain technology. As blockchain is adopted, we may see both significantly less use of intermediaries and current financial intermediaries becoming more efficient and even more profitable.

The retail industry’s experience with the internet helps illustrate how new technology can lead to an array of seemingly disparate impacts occurring at once. It was fashionable 20 years ago to predict that the internet would democratize the retail business, enabling a myriad of small firms to exist without brick-and-mortar locations and with consumers reaping the benefits of heightened competition. This prediction was not entirely false: A small seller today can reach customers around the world, creating markets that were not previously possible for niche products. But existing retail giants like Walmart used the new information and communication technology to become even more efficient, placing new pressure on small competitors, especially brick-and-mortar stores. Finally, the internet enabled new retail giants like Amazon, which contributed to the failure of both small and large brick-and-mortar retailers. Trends resulting from major technological changes can cut both ways, disrupting markets but also strengthening existing players.

Public vs. private blockchains
Bitcoin, the best-known current application of blockchain technology, uses a public, or “permissionless” blockchain, meaning anyone can choose to participate in the market, and all participants receive full and equal access to the (encrypted) data. But most of the applications being developed by financial firms discussed here use private, or “permissioned” blockchains, meaning one or more parties get to restrict access. While this makes sense in certain environments—for example, when participants in a market only want to interact with a select few parties -- it might also reduce the technology’s ability to enhance and protect the economic rights of all people equally.

As observers like Chris Horlacher, CEO of Equibit Development Corp., point out, attempts to build blockchains that are not open and decentralized make the technology little more than a more efficient version of the databases and trade ledgers currently in use. However, even changes in efficiency have the potential to dramatically affect the financial industry and economy as a whole. In the examples that follow, we will discuss the implications of private blockchains, which generally enhance the efficiency of a market while leaving the current structure intact; and open, decentralized blockchains, which could radically alter the structure of markets.

Blockchain and big banks
Blythe Masters, former J.P. Morgan executive and current CEO of Digital Asset Holdings, notes the great disparity between the near-instantaneous execution and settlement of trades and the archaic “back end” in which reconciling different parties’ records and actually transferring ownership can take anywhere from three to 20 days. Because of the nature of blockchain technology, where a digital representation of an actual asset can be transferred rather than a copy, the time it takes to settle trades can be reduced from days to minutes. This alleviates a great deal of counterparty or settlement risk, which was shown to be a huge problem during the 2008 financial crisis, when many already-executed trades by Bear Stearns & Co. and Lehman Brothers could not be settled after the collapse of those firms. In addition, transactions using a blockchain can vastly ease the time and effort needed to meet regulatory requirements such as reporting and transparency. Digital Asset Holdings is creating blockchains to take advantage of these efficiency gains, beginning with assets such as syndicated loans and U.S. Treasury repurchase agreements (repos).

A Digital Asset white paper describes its product, the DA Platform, which has the security features found in a blockchain but eliminates the openness: “Participants in the Platform share a single source of truth which provides continuous data integrity, and desired or mandated degree of transparency and the opportunity for rapid innovation.” DA believes that an open blockchain is not workable in markets for more complex assets due to the high dollar amount and volume being traded, and it has regulatory concerns. The DA Platform has an “operator,” which will typically be a “centralized market infrastructure provider that is responsible for processing transactions.” Sound familiar?

The implications of DA’s product are still important. For example, banks currently set aside billions of dollars for settlement risk; blockchain technology could free that money in the economy. The technology could greatly enhance the transparency of banks’ books and operations. Banks work with large customers and need voluminous knowledge of institutional details and current market developments, suggesting a continued role for large financial intermediaries. But the type of product being developed by Digital Asset enhances the efficiency of a market while leaving its centralized structure intact. It will be interesting to see, if this technology takes hold, who will gravitate toward open-blockchain trading platforms and who will still be willing to pay intermediaries large fees.

Blockchain and exchanges
The Nasdaq stock exchange has made significant and highly publicized investments in blockchain technology. Most notably, it uses Linq, a blockchain-based private trading platform for companies not listed on a stock exchange. In addition, Nasdaq has launched a pilot program in Estonia to use blockhain for shareholder-proxy voting.

Linq is another example of using a private blockchain to provide efficiency benefits without decentralization. In fact, Nasdaq says that you don’t need the revolutionary aspects of blockchain that establish trust between peer-to-peer users, because you can always trust Nasdaq: “Since the inception of bitcoin’s blockchain, the notable underpinning of this technology has been trust, since it is not controlled by any single user. However, with Linq being a private distributed ledger (as opposed to bitcoin’s open, public blockchain), Nasdaq is expecting efficiency and transparency to be the foremost virtues of its blockchain technology. According to Voss (Fredrik Voss, Nasdaq vice president of blockchain innovation), ‘When you have a trusted party, and, of course, Nasdaq is a trusted party, then you don’t really need the concept of mining.’” (Mining refers to the decentralized process with which cryptocurrencies like Bitcoin are created.)

It is tempting to dismiss Nasdaq’s proclamations of its own trustworthiness and see its investments in blockchain as an attempt to stay relevant in a world where stock exchanges will no longer be necessary. But exchanges serve purposes beyond being a source of trust in transactions. For example, by enforcing financial and transparency requirements before a company can be listed on its exchange, Nasdaq plays a curatorial role for smaller investors who don’t have the time to research companies. However, if transactions could be decentralized on an open blockchain, this curatorial role could be separated from the exchange itself and could be provided instead by investment advisers or even decentralized communities of investors. If blockchain is widely adopted, intermediaries like stock exchanges may be on shakier ground than big banks.

A guessing game
It is often easy to identify markets ripe for either efficiency gains or restructuring resulting from new technologies like blockchain. But as experience with the internet in the past two decades has shown, actual outcomes are the result of a complex web of entrenched interests, institutional details, technology adoption, management decisions, and many other factors. Furthermore, if blockchain succeeds, there will likely be major applications we have not yet thought of. Predictions help us think through a technology’s applications, but it is critical to remain open to changing ideas as a technology evolves.

Max Gulker

Max Gulker is an economist and writer who joined AIER in 2015. His research often focuses on free markets and technology, including blockchain and cryptocurrencies, the sharing economy, and internet commerce. He is a frequent speaker at industry conferences, especially on blockchain technology. Max’s research and writing also touch on other economic topics, including governance, competition, and small businesses.
 
Max holds a PhD in economics from Stanford University and a BA in economics from the University of Michigan. Prior to AIER, Max spent time in the private sector, consulting with large technology and financial firms on antitrust and other litigation. Follow @maxgAIER.