Practical analysis for investment professionals
02 August 2018

Blockchain: A Progress Report

Much of the fintech world believes that blockchain technology will revolutionize how the financial services industry operates. Of course, some of the current iterations of the technology —bitcoin, among them — are criticized for their slow speed and high energy consumption. These qualities would seem to make the prospect of blockchain shaping the future of finance far from inevitable.

Blockchain supporters, on the other hand, maintain that the technology is still in its infancy, that its shortcoming will be addressed, and that it’s just a matter of time before one of its applications takes hold and has a truly transformative impact. Carl Wegner, who serves as managing director and head of Asia for the blockchain technology developer R3, recently spoke with us about the progress he and his firm have made as well as where he anticipates blockchain heading in both the near and far term.

Larry Cao, CFA: Tell us about R3 and your work in the blockchain area.

Carl Wegner: R3 started out in 2015 as a consortium of 42 institutions. It has now grown to a network of more than 200 financial institutions, regulators, and technology companies, all working together to explore and develop blockchain technology for businesses.

We just completed our funding round last year and more than 40 member banks and technology companies have invested in us. Our board structure is very global with one third of our revenue and investment stream flowing from Asia, one third from Europe, and one third from the USA. It is easy to say that R3 is one of the biggest global blockchain initiatives and we are working on several central bank digital currency projects with regulators in Canada, Singapore, Hong Kong, and Thailand.

We started out doing projects where each would have five to 10 financial institutions working on a specific area to learn about blockchain technology. These areas include insurance, trade finance, payments, digital assets, KYC [know your customer], etc. As we went through the process, we realized that while blockchain has tremendous potential in the unpermissioned world, financial services requires a permissioned blockchain. Hence, we built Corda, a permissioned blockchain platform on which technology providers are building solutions for different areas.

When we do a project, very often half of the people involved are from the technical side and the other half are business people. We have quite a few members leveraging this education to future-proof their IT decisions and investments. It is also valuable for the business people to understand how this new technology is going to change their use of data and how to deal with KYC and customer privacy in the future.

As a global blockchain initiative, we continue to work on educating and working with our partners who are building on our platform while helping central banks and regulators learn about the challenges and opportunities with this new technology.

You listed a number of areas where you see applications being developed. Could you highlight some that are really promising?

Blockchain in trade finance is looking extremely promising. In the last month, we had ING and HSBC talking about a trade finance deal they did with Cargill. They completed a live trade finance transaction using Corda that involved a bulk shipment of soybeans from Argentina, through Geneva’s trading arm of Cargill, to Malaysia, through Cargill’s Singapore subsidiary as the purchaser. A letter of credit was issued using Corda by HSBC to ING.

Conventional exchanges for paper-based documentation related to letters of credit usually take between five to 10 days. This exchange was done in 24 hours.

What was the timeline for these projects?

There are three-month projects dubbed incubator projects, which eventually go into a commercial product and we have several ongoing. Marco Polo recently announced an open account trade finance platform that started out as a pilot. There was also an announcement recently from Guardtime and Ernst & Young about building their pilot for marine insurance based on Corda. We also have a company that is trading physical gold in Canada with the regulator’s approval.

There is quite a lot of stuff going on, however, it takes baby steps to change financial infrastructure. Anything built now has to work with legacy systems for the next couple of years as more and more functionalities are built. Savings in terms of reconciliation and database costs are going to be incredible.

Can you elaborate on blockchain’s cost advantage?

For example, I understand that Deutsche Bank globally has over 14,000 platforms with APIs [application programming interfaces] built among them. It has been estimated that in general, about 15% to 20% of the bank’s costs go to their IT budget. How much of that goes to regulatory reporting? If a regulator had a node on the blockchain along with whomever they are regulating, you would not have to do another regulator report again. The regulators would have a window to see what they are allowed to see in real time. They would be more efficient as well because they would not have to sort through massive amounts of data.

What makes blockchain particularly suitable for such tasks?

Blockchain is a distributed ledger. A blockchain or a distributed ledger is valuable when you have different databases for regulatory, national border, and commercial reasons that cannot be shared. For example, in Taiwan, you would have a health card, which is a chip card. It has your medical history on it. When you go to the doctor and they prescribe you your medicine, you then go to a central counter to take a number to pay for your fee. It will be a fairly inexpensive because you are co-paying only your portion. Then you would wait in line and pick up your medicine when your number comes up on a screen. The reason why you have all these steps is because there are different databases managing this information. If those databases could overlap, then instead of having to put an invoice in for you to make a payment, it will automatically debit your bank account for $6 and take the $34 from the insurance company to be paid directly to the hospital. It is all in one ledger. It would know your phone number. Therefore, it will just SMS you that the medicine is ready when the database from the hospital indicates the medicine is ready for pickup. The AIA insurance company, a member of ours, said that potentially up to 75% of their back-office costs could go away by not having to re-key in data or to have paper-managed information keyed into separate databases.

Does the data need to be replicated to establish trust on blockchain?

Blockchain traditionally offers a type of consensus mechanism where you broadcast information out to the world and no one can lie because you tell everyone what you did. When we built Corda we recognized that this model doesn’t work for financial services because, for one, there is not possible to have HSBC be aware of every transaction that JPMorgan and Citibank does daily. Secondly, if you had a database that included every bank globally, there would be over 11,000 banks sharing data. If every bank had to maintain a database that contained every other bank’s data, it would be immense. That is one of the reasons that traditional broadcasting blockchain does not work for financial services. It would be too expensive to maintain, unwieldy and too slow for high-speed FX transactions, for instance, as 50% of the banks would have to approve every transaction before it was completed.

Corda is actually a system where consensus is done on a peer-to-peer basis, where only members of the transaction get to see it. It is much quicker if you do not have to distribute it out to 11,000-plus financial institution users. It is a permissioned network.

How is data verified on a permissioned network?

With Corda, we have what we call a configurable consensus. In our system, consensus is configurable based on the security needed in the transaction. An intra- branch payment does not need as many parties contacted as for a cross-border FX transaction. Thus, it can be configured to what the entities find acceptable and what the regulators are comfortable with. Since the information is shared in a smaller group, it also moves much faster.

Think about reconciliation. HSBC buys a stock that Citi sells. It takes T+2 because both of them have the data in their database but the custodian bank has to go double-check with each one of them. With a shared database, they would be looking at the same data so there is no need for reconciliation. Whichever party started the transaction is entering their part of the transaction. They do not have to duplicate the information because they are looking at the same thing. The verification of that transaction comes from using the same database. They could use what is called a notary, which is a verification engine. It could be hardware, software, or even a third party like a regulator. You do not have to use a broadcast network to all banks globally for every transaction. There would be at most four to five entities touching each transaction: two banks, a notary group, and a regulator.

Blockchain is often criticized for its speed, energy consumption, and consensus mechanism. Your thoughts?

Public blockchain is one way of verifying data by broadcasting it out to everyone. If you have to broadcast to everyone — say, 50% of the participants — 2,500 of the 5,000 blockchain miners have to verify it. That is going to be too slow for FX transactions. As I mentioned before, the costs for maintaining the same database for the whole global banking system will also be exorbitant. It just does not make sense. Private blockchain is a way of sharing databases for mutualization of costs and speed.

This also seems to resolve the business system issue, but there is always a concern that you need to sign everyone up for trade finance, to, for example, make the system work. It is impossible to have everyone sign up from the beginning. As you expand, the hurdle is high because people use different systems and they have low incentives to switch.

You cannot have a perfect storm with everyone joining at once. A technology decision we made in Corda is to build in interoperability between solutions. If someone builds an open account trade finance application, they might just focus on that. There will be others focusing on FX transaction, KYC, and other components that a bank needs to fully service a trade transaction. Any components built on the Corda platform will be able to interact directly and therefore the value of the sum of the components will bring the extensive benefits to automating trade finance. This will not be able to happen at once, but it’s a process that is already happening on Corda as we see the trade finance ecosystem services growing and more services being added monthly.

Thanks so much for sharing your work with us.

Ru Ng contributed to the compilation of this interview note.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/LuckyStep48

About the Author(s)
Larry Cao, CFA

Larry Cao, CFA, senior director of industry research, CFA Institute, conducts original research with a focus on the investment industry trends and investment expertise. His current research interests include multi-asset strategies and FinTech (including AI, big data, and blockchain). He has led the development of such popular publications as FinTech 2017: China, Asia and Beyond, FinTech 2018: The Asia Pacific Edition, Multi-Asset Strategies: The Future of Investment Management and AI Pioneers in Investment management. He is also a frequent speaker at industry conferences on these topics. During his time in Boston pursuing graduate studies at Harvard and as a visiting scholar at MIT, he also co-authored a research paper with Nobel laureate Franco Modigliani that was published in the Journal of Economic Literature by American Economic Association. Larry has more than 20 years of experience in the investment industry. Prior to joining CFA Institute, Larry worked at HSBC as senior manager for the Asia Pacific region. He started his career at the People’s Bank of China as a USD fixed-income portfolio manager. He also worked for US asset managers Munder Capital Management, managing US and international equity portfolios, and Morningstar/Ibbotson Associates, managing multi-asset investment programs for a global financial institution clientele. Larry has been interviewed by a wide range of business media, such as Bloomberg, CNN, the Financial Times, South China Morning Post and the Wall Street Journal.

2 thoughts on “Blockchain: A Progress Report”

  1. Muhammad Azam says:

    Indeed replication of same data us hassle. With DLT the problem is solved. R3 is also working on clearing and settlement systems backed by blockchain…… As mentioned in a reply, it is not a storm that will wipe out, it will take time like the digital era of 90s, but today the world is far from that point.
    I would urge every finance professional to find out his use case via this tech…..

  2. Jonathan says:

    The thing that is really working sounds more like a protocol for people to digitally sign and share data with each other than a “blockchain”. It sounds like it is called “blockchain” because it is hip.

    It may be a thorny problem because there are high costs for each player in the system to adopt any new protocols and processes, but it doesn’t seem like radically new technology.

    What am I missing?

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