"Distributed ledgers, or blockchains, have the potential to dramatically reshape the capital markets industry, with significant impact on business models, reductions in risk and savings of cost and capital." So reads Beyond the Hype: Blockchains in Capital Markets, a report just released by McKinsey & Company that focuses on ways the blockchain will contribute to finance.
The bottom line: more black, less red. How soon can this happen?
In the report, McKinsey, a multinational management consulting firm, identifies four steps to the adoption of blockchain technology in capital markets:
- Single-enterprise adoption across legal entities.
- Adoption by a small subset of banks as an upgrade to manual processes.
- Conversion of inter-dealer settlements.
- Large-scale adoption across buyers and sellers in public markets.
Holistic Benefits to Capital Markets
The authors point out the implicit worldwide understanding that the current model, which is dependent on a network of centralized ledgers, is imperfect. While the focus of blockchain technology to date has been on improving how individuals transfer funds, banks can also benefit from overcoming the multi-day transaction times, high costs and operational risks that come from inefficient payment systems.
Streamlined payments are definitely a major benefit, but the authors go beyond that to forecast distributed ledger technology rolling out out across the entire industry, resulting in widespread and significant cost savings. A few examples, beyond the expected clearing and settlement solutions, include:
- Document retention: Using blockchain technology, authorized parties are able to access and verify ownership records.
- Audit trails: Because a blockchain stores everything and is immutable, information and transactions can be traced back to their origins. This will help prevent money laundering, as a blockchain provides a timeline of transactional events.
- Book-entry systems made redundant: Assets that are now backed by physical assets can become completely digitized in a blockchain world. This would alleviate the need for custodians.
Challenges to Implementation
There is no doubt that blockchains present unique opportunities for investment banks and other participants in capital markets. But deployment will not come without its challenges. In the interest of "forewarned is forearmed," the authors offer a clear-eyed picture of the anticipated hurdles, along with some proposed solutions.
Another challenge has to do with margin finance, where trades are often made with assets that are not owned by a participating party. The Bitcoin blockchain specifically identifies who owns an asset, making it impossible for someone to transact without holding an equal value. While there is no current way around this issue, McKinsey reports that some companies are already creating custom ledgers to help resolve the problem.
One potential hindrance is block size. Presently, there is a 1-megabyte limit on block size, that caps how many total transactions can be included in a block. The current limit could interfere with the efficiency of banks that transact in greater quantities than the Bitcoin blockchain can support. A number of blockchain developers are involved now in testing alternative Bitcoin implementations that would increase block size; capital markets participants would be well advised to watch for breaking news on this critical front.
In addition to technological challenges, capital markets blockchains pose bank-specific issues. The first has to do with the actual deployment of the ledger. While a forward-thinking bank could roll out a blockchain-type ledger, it would need to be made compatible with current ledgers from banks that are more antiquated.
Cooperation Is Key
"McKinsey sees great promise in distributed ledger technology, but expects that development will require cooperation among market participants, regulators and technologists," the authors write in their report.
For the immediate future, blockchain solutions will be deployed primarily for niche products. The authors expect that, as more firms start to adopt the technology, rapid uptake and wider use cases will quickly result.
For now, for capital markets participants looking to unlock future profits, knowledge is power.