Settlement risks with blockchains - Real or perceived?

I recently stumbled upon a pretty detailed account written by R3's Director of Market Research. (Link below). It was an interesting read for a new comer like me to see what R3 is doing and where is the focus of the Banking Community as far as the Block chain and distributed ledger goes. I admit I am quite new to the Block chain game but I do understand Settlements, hence Tim’s article was quite relevant for me and my peers.

Settlement risks involving public blockchains

I can understand for someone who is primarily looking at the situation from the existing banking and financial sector will come from a bias, and I found quite a few such anecdotes in Tim’s article. I’ll try to be as neutral to this as I could be as I feel Banks and incumbent solutions are as much a part of the solution as are the new radically FinTech revolution motivated start-ups.

Investment banking sector has indeed missed quite a few upgrade cycles as far as processes and technology advancement goes that impacted the Banking world in general and Retail banking in particular. The app culture adoption and its impending repercussions for standard IT development cycles have been radicalized by Agile methodologies and where rest of the sectors are adopting this rapid development and excelling on extracting its benefits BFSI Sector was relatively slow to adopt it, though there are good large IT programs running today that can be the poster children for BSFI sector.

As the IT cycles were disrupted by technology advancements, the so called FinTech revolution has spurred the business cycle of the equation as well. Banks only realized late what Silicon valley can do to them apart from generating great IPOs and minting money for Big banks.

Let’s come back to Settlement process, as it somehow still has a strong case of reluctant adoption, due to trust issues embedded in it. Any money transaction erodes trust between counterparties unless that money changes hands and it is in accordance to the agreed contract terms. So stimulating the settlements cycle with any sort of change is always met with a lot of resistance in past and this creates the bread and butter for the regulatory work.

The core of crypto currencies or distributed ledger based solutions will always be looked upon with suspicion by traditional bankers and in turn the clients and they take advices from these (trusted) bankers.

Bitcoin changed the game a bit but its market volatility didn’t help either. People misplace their wariness of currency volatility of Bitcoin with everything related to Bitcoin. Distributed ledger does have its skeletons. Bitcoin could do it successfully because from the onset the block chain model (read distributed ledgers) were starting anew currency transactions from a Nil.

Whereas using a similar distributed ledger (call it any fancy name block chain, open blockchain or public blockchain) for an established and already traded currency is not practical. I am sorry to say this but the adoption of this technology has to start with an execution strategy of certain new products will start on the new block chain and rest would follow through the conversion / migration model.

That said there are serious challenges existing banks would face to convert or migrate existing products on to this new distributed ledgers. Some questions that need definitive answers are:

1. How will the existing settlement risk be transferred to this new model?
2. For bit coin the current mining is getting exceedingly challenging, how will the bulk transactions for an established currency be handled and shared with all. This problem in particular has its following daemons, both technical and functional:

• There are only a few companies / governments in the world who understand this complexity and have the capability to build the nodes to handle it.

• Even if they can build a solution, the complexity and transaction handling capacity will out run any standing infrastructure or computing power within a few months.
• Only a few companies have that much funds to handle that much hardware, then how independent will the voting remain?
• How about the exiting settlement disputes between counterparties, who will settle them and bring those records to this block chain.
• Systemic risk will reduce from a central system being a bottleneck but will be added exponentially if any of the nodes working will go down.

This subject in itself could be a PhD thesis for a budding financial psychology graduate but that discussion can be pushed for a later date.

The opportunities block chain brings to the table are numerous, and so are the challenges. I found Tim’s take for the blockchain purely from the incumbent’s perspective. Though it is a start-up but I will take them as the voice of banks as they achieved the improbable, by bringing 40 Banks together and admit that block chain is real. Opportunity or Threat only time will tell.