Note: This is a prologue to my next post “Demystifying Bitcoin/Blockchain: How it Actually Works.” I will also be exploring the brilliance and short-comings of Bitcoin/Blockchain, from the perspective of someone who did not understand it three months ago. Special thanks to Andreas Antonopoulos,Pascal Bouvier, Vitalik Buterin, and Simon Taylor, whom I have not met but whose intellectual generosity has accelerated and deepened my understanding of the subject.
The post could also be found on Linkedin Pulse.
Overview of Bitcoin/Blockchain – Where it All Began:
Invented in 2008, Bitcoin is not just a currency or a payment system. Andreas Antonopoulos, author of “Mastering Bitcoin: Unlocking Digital Cryptocurrency,” provided a well articulated definition:
It is “a network-centric protocol and platform for recording [and transferring] ownership and trust on a peer-to-peer basis.”
Blockchain is quite topical recently given hyped up interests by financial institutions; it was also featured on the October 31st cover of The Economist. However, Blockchain by itself is just a boring ledger distributed or replicated among all the participants in a P2P network, it is only with the protocol/incentives (in purely mathematical forms) integrated into the Bitcoin system that Blockchain becomes a powerful trust machine. One cannot understand Blockchain and its full potential without understanding how Bitcoin system as a whole works – Blockchain is Bitcoin.
That said, the unique features of the Blockchain are that every transaction is linked to a specific previous transaction, and every Block of transactions is linked to the previous Block, creating a completely traceable digital chain of ownership. Jumping back to a higher level, the core features (not bugs) of the Bitcoin system are:
- Completely open and decentralized – there are no third party intermediaries such as a central bank, a payment network, or clearing and settlement providers
- Completely permission-less and borderless – anyone can participate in the Bitcoin system with equal rights, without pre-screening, and no country or entity owning the platform
- Un-censorable or uncontrollable – e.g. know-your-customer (KYC) is not possible or necessary
Key concepts worth further discussion include:
- Keys and Bitcoin Addresses
- Transaction structure
- Block structure
- Emergent Consensus
How is Blockchain being used today (in the financial world)?
Broadly speaking, there are three forms of Blockchains emerging today with varying degree of maturity, philosophically and architecturally:
- Public Blockchain – the prime example is the Bitcoin Blockchain, which is completely decentralized and permission-less. This is also the most mature application of Blockchain that exists today.
- Consortium Blockchain – as of November 2015, 25 banks including JPMorganChase, HSBC, BofA, and Citi have signed up to join the R3 Bockchain consortium to explore how it could be used in inter-banking transactions, potentially to increase speed of execution and trade settlement in markets including syndicated loans and repurchase agreements. Discussions are still at very early stage. How will it work and will it work remains outstanding, but the banks have plenty brainpower and will figure out eventually, albeit slowly maybe.
- Private Blockchain – in October 2015, Nasdaq formally unveiled its private blockchain product Nasdaq Linq. This marks the first time an established financial services firm demonstrated how security trading could be based on the Blockchain technology. Nasdaq Linq is used to trade shares in private companies and is part of Nasdaq Private Market.
Will the evolution of Blockchain technology influence how individual securities are traded?
Bitcoin purists denounce the concept of consortium or private Blockchain as a mere shared database and a far cry from the fully decentralized ideal. On the other hand, financial institutions regard, at least from a PR and legal standpoint, Bitcoin and Public Blockchain as “bad,” given the former’s association with drugs and money laundering. Pragmatically, the answer may lie in the proverbial “it depends,” same goes for the question around clearing and settlement.
Conceptually Blockchain technology certainly has the potential to disintermediate clearing houses and exchanges, or any trusted third party intermediaries. Practically, it is just not that straight forward and simple. Pascal Bouvier from Route 66 Ventures shared a penetrating insight around this issue in his blog post “Distributed Ledgers Part II: Clearing, Settlements & Legal frameworks“:
“No one will dispute that the technology supporting clearing and settlements in the financial services industry is antiquated. Few if any will argue the international legal framework that rules the clearing and settlement of securities is not working. The legal regime ruling the securities markets globally is fairly well harmonized and is the way that it is for good reasons. Therein lies the complexity of applying crypto solutions to clearing and settlements: how to replace the thing that needs replacing (the technology) whilst working within the thing that isn’t broken (the legal regime).”
The Bitcoin implementation of the Blockchain and its protocol certainly would not fit and work with the current legal regime. How will the protocol be re-designed for the Consortium and Private Blockchain represents one level of complexity. The second degree complexity is that securities trading is significantly more complex than cash transactions due to the heterogeneous properties and behavior of different instruments. There will not be a one-size fits all solution. What this implies is that there may be many parallel Blockchains, and will they and can they be harmonized remain the task for the many smart people on the street.
That said, I remain optimistic and analytical (not judgmental). “Stay hungry, stay foolish.”
Next post coming soon.