Dinesh Venugopal, President – Mphasis Digital and Strategic Customers
Industries that create employment and earning potential for a majority of the population tend to be the most disrupting. For example, at the start of the 20th century, agriculture employed nearly 40% of the population while today it employs less than 2% in the US. Similarly, mining and manufacturing combined employed 35% of the work force in 1950, and while still declining, employs less than 10% now. It is ‘services’ that account for 80% of the workforce today. Yet, this too is seeing disruption - distribution of printed news is becoming obsolete, retail is moving online and soon the world may stop requiring a driver inside every taxi. We know that financial services form a big part of services, but is that too going to change dramatically? Think of the several organizations in the financial services industry that play the role of a middle-man. If you take the pre-electronic trading era, you had many brokers and market makers who performed the role of matching a buyer with a seller (it still happens in certain ill-liquid instruments).
Suppose you wanted to sell a stock but there were no buyers at that point in time, you had to either wait until the buyer turned up or the broker bought it from you and took the risk until the buyer turned up. For this risk and for providing this liquidity to the market, the middle-man, the broker, made a premium. It was a necessary function and he legitimately needed to get paid for it. Take exchanges, the economic role that exchanges provide, is that of price discovery, by bringing all the buyers and sellers to one location. If there were no exchanges, every buyer would have to individually know every seller. The Exchange, did that role instead. It ensured that the participants in the market were whetted and became the trusted middle-man. So practically, all you did as a broker was to sell to an exchange or buy from the exchange.
Similarly there are many roles that middlemen provide. Custodians or Central Depositories are required because you need a trusted party to keep a record of who owns which asset and to ensure that a seller is not mis-representing ownership. Land registries exist for the same reason.
However, a new kid in the block, called Block-chain technology is threatening to disrupt this very role.
How does this work?
Encryption is the key. In 1977, three professors at MIT invented a cryptosystem using a public and a private key that is considered near impossible to break. While the invention has evolved over the years, the basic concepts remain the same. In this system, a user first encodes a message using a private key and then shares a corresponding unique public key with anyone authorized to read the message. The public key not only allows the authorized person to read the message, but also verifies without a doubt as to who the source of the message is. This brings trust, authentication and data protection to information sharing like never before.
Building on top of this, block chain databases use similar encryption techniques for consolidating messages and storing them in an append only method, and then making sure that everyone in the system always has an accurate and up to date version of the data. This makes the data immutable, tamper proof and even more trustworthy, potentially removing the need for custodians and mediators.
What are the challenges in adopting this?
One of the biggest challenges expected in blockchain implementation is the integration with other systems. Every large institute has a plethora of software applications, some built in house some licensed, with custom features added over years of effort. While most licensed applications will have established APIs, in house applications may not. Some might accept real time data while others will work in batch modes. Designing the integration with these applications will require in depth understanding, comprehensive testing and potentially, the cleaning up of interface protocols cluttered over years. Banks, Insurers and other institutes will need help overcome these challenges.
Implementations of blockchain solutions that are replacing incumbent systems will also face the challenge of a phased roll out. Let’s take the example of NASDAQ. At the end of 2015, NASDAQ announced that shares were successfully issued to a private investor using the Linq blockchain technology. While this may work well in the case of a private placement as the entire stock resides within this database, NASDAQ plans to expand to services that cannot be self-contained. Let’s say they put street side trade matching on a blockchain called Linq2. Now think of the first trade on Linq2. As is the case for any other trade on NASDAQ, the time and price of this trade will be reported to FINRA and SEC, along with multiple separate reports to custodians, market data service providers and interested management. What adds an additional layer of complexity is the fact that this trade will happen alongside an average of ten million other trades that will take place outside of Linq2 on the same day. While DTCC is the custodian for the ten million trades, Linq2 should own the data for the one trade. However, who owns the golden source? What happens when there is a conflict? What happens if the two systems report the data differently, will FINRA become unable to investigate the trades? These are some of the issues expected when two systems run simultaneously trying to achieve the same goals. Not only do they have to be in sync, but the ecosystem surrounding them has to be ready to expect changes in behaviour. In an ideal world, the design for the replacement system will be robust enough to abstract that change from the ecosystem, to ensure business continuity.
Why should I relook at my firm and may be retool myself for this disruption?
Strangely, disruption seems to happen in two ways, of which one is by destroying the role of a middleman, as we have just seen. On the other hand, disruption is also seen from new jobs or value creation in the form of network orchestrators, a new type of middleman, like Uber or Airbnb, who have become the middleman in industries that never needed one before, by performing a role that adds economic value by helping a product and its consumers meet. It is technology that is making this possible.