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VikalPa • VolUMe 44 • iSSUe 1 • JanUaRY-MaRch 2019 1

Blockchain in Finance

Jayanth Rama Varma

P E R S P E C T I V E S

KEY WORDS

Blockchain

Distributed Ledger

DLT

Crypto Currency

includes research articles that focus on the analysis and resolution of managerial and

academic issues based on analytical and empirical or

case research

B lockchain—the decentralized replicated ledger technology that underlies Bitcoin and other cryptocurrencies—provides a potentially attractive alterna- tive way to organize modern finance. Currently, the financial system depends

on a number of centralized trusted intermediaries: central counter parties (CCPs) guarantee trades in exchanges; central securities depositories (CSDs) provide secu- rities settlement; the Society for Worldwide Interbank Financial Telecommunication (SWIFT) intermediates global transfer of money; CLS Bank handles the settlement of foreign exchange transactions, a handful of banks dominate correspondent banking, and an even smaller number provide custodial services to large invest- ment institutions. Until a decade ago, it was commonly assumed that the finan- cial strength and sound management of these central hubs ensured that they were extremely unlikely to fail. More importantly, it was assumed that they were too big to fail (TBTF), so that the government would step in and bail them out if they did fail. The Global Financial Crisis of 2007–2008 shattered these assumptions as many large banks in the most advanced economies of the world either failed or were very reluc- tantly bailed out. The Eurozone Crisis of 2010–2012 stoked the fear that even rich country sovereigns could potentially default on their obligations. Finally, repeated instances of hacking of the computers of large financial institutions is another factor that has destroyed trust. When trust in the central hubs of finance is being increas- ingly questioned, decentralized systems like the blockchain that reduce the need for such trust become attractive.

It is no coincidence that Bitcoin was launched shortly after the failure of Lehman that marked the peak of the global financial crisis. Over the subsequent decade, cryptocurrencies have grown rapidly: as of early November 2018, Bitcoin alone had a market cap exceeding that of India’s most valuable listed company (and Bitcoin was only around half the value of all cryptocurrencies). However, even a

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2 Blockchain in Finance

decade after the launch of Bitcoin, we have seen only a few pilot applications of blockchains to other parts of finance. This is because cryptocurrencies (while being extremely challenging technologically) encoun- tered very few legal/commercial barriers, and could therefore make quick progress after Bitcoin solved the engineering problem. The blockchain has many other potential finance applications—mainstream payment and settlement, securities issuance, clearing and settle- ment, derivatives and other financial instruments, trade repositories, credit bureaus, corporate governance, and many others. Blockchain applications in many of these domains are already technologically feasible, and the challenges are primarily legal, regulatory, institutional, and commercial. It could take many years to overcome these legal/commercial barriers, and mainstream financial intermediaries could use this time window to rebuild their lost trust quickly enough to stave off the blockchain challenge. However, whether they are successful in rebuilding the trust, or why will they be disrupted by the new technology remains to be seen.

BENEFITS OF THE BLOCKCHAIN

The blockchain is a decentralized, replicated, tamper resistant (immutable), append-only ledger of trans- actions (see Box 1A for a brief description of the technology, and Box 1B for blockchain software and implementation issues).

Box 1A. What Is the Blockchain?

Instead of relying on a central trusted institution to maintain the authoritative record, the blockchain allows all interested parties to maintain their own copy of the ledger that is therefore decentralized and replicated. Cryptographic integrity checks are used to ensure that nobody is able to corrupt or tamper with their copy of the ledger. This is needed because unlike a paper ledger where any overwriting or alteration would be quite visible, digital records can be edited without leaving any visible trails.

The blockchain ensures integrity by chaining blocks of transactions together in such a way that altering any block breaks the link with the next block. It is impossible to

change one block without changing the next block, which in turn forces a change in the next and so on till the very last block. This ensures that while new blocks can be added at the end, older blocks remain immutable: the ledger is append-only. The chaining of blocks is obviously not physical, but is based on a cryptographic hash.

The hash is a digital fingerprint that uniquely identifies a piece of text. For example, the SHA-1 hash of the Project Gutenberg Full Text of The Complete Works of William Shakespeare (which contains nearly a million words) is 6799e461c8177d88b6e0c782242642d3450c8b34.

If we edit the file and add a space at the beginning of line 5,000, the hash changes to 5d960169ea490568abf 4ec69c127ae12d57cedc2.

If instead, the first occurrence of ‘The’ in the file is changed to ‘the’, the hash changes to 65a835f4845395c929d5076029c a818f614a4119.

It is evident that even tiny changes in a large file cause major changes in the hash, making it suitable for use as a digital fingerprint.

The mathematical properties of hashes that make it a good digital fingerprint are discussed in standard cryptography text books like Handbook of Applied Cryptography (Menezes, van Oorschot, & Vanstone [1996]). The most important properties are that (a) it is computationally infeasible to find two distinct texts that have the same hash, and (b) that given a specific hash-value, it is computationally infeasible to find a text with that hash.

The blockchain is a set of blocks that have been chained together with cryptgraphic hashes. Each block (except the first) contains the hash of the previous block. If a crook alters an old block, say block 1000, the blockchain would fail the integrity check because the hash of block 1000 would no longer match the hash stored in the next block (block 1001). So the crook has to alter block 1001 so that the hash of the previous block stored there matches the hash of the altered block 1000. But this changes the hash of block 1001, and so the crook has to correct the hash stored in block 1002. This process goes on until the last block is reached. If all participants in the blockchain keep track of the last block,

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they are indirectly guarding the integrity of the entire chain even if it has grown to millions and billions of blocks.

While cryptgraphic integrity checks protect older blocks from being altered, every blockchain needs rules (‘consensus mechanisms’) that govern how new blocks are added at the end. There are two main categories of blockchains— permissioned and permissionless—that differ in terms of their consensus mechanisms. Cryptocurrencies use permissionless chains that are open to the whole world, and in which there are no privileged participants with special rights. Participants in these chains are also typically anonymous (or more precisely, pseudonymous). Managing consensus in these chains is a very difficult technical challenge because no kind of majority rules can be implemented in an environment where there is no list of voters and where it is hard to prevent impersonation. Nakamoto used the idea of proof-of-work to solve this problem:

The proof-of-work also solves the problem of determining representation in majority decision-making. If the majority were based on one-IP-address-one-vote, it could be subverted by anyone able to allocate many IPs. Proof-of- work is essentially one-CPU-one-vote. (See Nakamoto [2008] for further details of how this works)

Most applications of the blockchain in mainstream finance use a permissioned blockchain. First of all, only the participants in the system are able to even read the data in the blockchain. Second, not all of these participants might have the privilege of adding new transactions to the chain. Third the identity of participants is typically verifiable. It is quite straightforward to implement consensus mechanisms based on majority votes in these chains because the voters are identifiable: usually a majority or super-majority of privileged participants is required for every new transaction.

For readers who want to understand blockchains in greater detail, Chokshi, Dixon, Nazarov, Walden, and Yahya (2018) provide a comprehensive list of resources and reading material organized into various categories.

Box1B. Blockchain Software and Implementation

Almost all of the software used in blockchain applications is open source and is actively maintained and developed. However, most of these are designed to run on the Linux operating systems, and the preferred way to run this

software on Windows machines is to use virtual machines or Docker containers that provide a Linux environment in which they can run. This is not a constraint for business applications because financial service companies already run a large number of Linux machines for other applications.

For permissioned blockchain applications, the most common software platforms are Hyperledger Fabric, an open source collaborative effort by a consortium of large technology companies and banks, and R3 Corda, an open source platform with a commercial version (Corda Enterprise).

While permissionless blockchains have found it challenging to achieve high throughput because of the inherent limitations of proof-of-work, the permissioned systems have no difficulties on this score. Depository Trust & Clearing Corporation (2018) report that during their tests, distributed ledgers were able to ‘perform at levels necessary to process an entire trading day’s volume at peak rates, which equates to 115,000,000 daily trades, or 6,300 trades per second for five continuous hours’ (see also GFT Technologies, 2018).

From an application point of view, the blockchain provides the following features: First, decentralization and replication means that a full audit trail is available to all participants. Moreover, the inbuilt cryptographic integrity checks ensure that this audit trail is verified by all of them. The result is a significantly lower need for trust in central hubs.

Second, the blockchain is partition resistant: if a few nodes fail or are disconnected from the network, the rest of the nodes can continue to function because they all have a copy of all the data. In traditional finance, on the other hand, if the central trusted institution is temporarily down for any reason, the whole system grinds to a halt. For example, on 20 October 2014, the real time gross settlement system (RTGS) of the United Kingdom experienced an outage of approximately nine hours (Deloitte, 2014). Though all banks and other entities were functioning, high-value payments could not happen during this period. In its subsequent consul- tation on building a new RTGS for the UK, the central bank described the advantages of using a distributed ledger: “the chief potential benefit when applied to core settlement in an RTGS system is resilience” (Bank of England, 2016).

4 Blockchain in Finance

The third benefit of the blockchain is Byzantine fault tolerance. While partition resistance deals with nodes that cease to function, Byzantine fault tolerance deals with nodes that malfunction and function maliciously. This has come to prominence with the rise of hacking and cyber-attacks. While criminal gangs might be content to steal money, terrorist group and nation state adversaries might seek to inflict catastrophic damage by corrupting or destroying data. The blockchain provides strong defence against this attack because of (a) replication of the data across large number of nodes running on completely different computer networks and (b) cryptographic integrity checks.

Fourth, the blockchain provides an excellent foundation for smart contracts—contracts embedded in computer code instead of legal language. By automating contract negotiation and enforcement, smart contracts reduce transaction costs and make small value transactions economically viable. Smart contracts can achieve efficiency gains by automating one or more of the key contractual phases of search, negotiation, commitment, performance, and adjudication (see Box 2).

Box 2. Smart Contracts

Nick Szabo coined the term smart contract two decades ago when the internet was still in its infancy.

Smart contracts combine protocols with user interfaces to formalize and secure relationships over computer networks.…These protocols, running on public networks such as the Internet, both challenge and enable us to formalize and secure new kinds of relationships in this new environment, just as contract law, business forms, and accounting controls have long formalized and secured business relationships in the paper-based world.…The contractual phases of search, negotiation, commitment, performance, and adjudication constitute the realm of smart contracts. (Szabo, 1997)

It is possible to have smart contracts without the blockchain, just as it is possible to have computer databases without the blockchain. The problem in both cases is that of trust. Two parties may use the blockchain because neither is willing to trust the other to record the data faithfully. Similarly, neither may be willing to let the smart contract software run on the other’s computer. This is where the blockchain helps: it is not only a shared database, but also a shared computer. As Szabo puts it,

A block chain computer is a virtual computer, a computer in the cloud, shared across many traditional computers and protected by cryptography and consensus technology.…A block-chain computer, in sharp contrast to a web server, is shared across many such traditional computers controlled by dozens to thousands of people. By its very design each computer checks each other’s work, and thus a block chain computer reliably and securely executes our instructions…. (Szabo, 2014)

A contract is a meeting of minds that was traditionally reduced to long written documents in legal language. However, many financial contracts are so complex that they are better described by computer code than in natural/ legal language. In fact, many years ago, the US Securities and Exchange Commission proposed to require that the terms of most Asset Backed Securities be disclosed in the form of computer code in the Python programming language (Securities and Exchange Commission, 2010) so that investors could understand them better.

Smart contracts can also facilitate the search and negotiation phase of contracts. Many financial transactions are today automated, but they depend on a trusted third party to accomplish the automation. Stock trading is today done largely by algorithms that decide to buy or sell based on price signals and other publicly available information. A momentum or trend following algorithm might send a buy order to the stock exchange, while another contrarian algorithm might send a sell order. The stock exchange’s order matching software might match these orders based on highly complex rules (e.g., the orders might have price limits and might be partially hidden as well). A stock trade can thus happen without any human intervention at all. But this works only because of the stock exchange that stands in the middle between the two algorithms. Smart contracts running on a blockchain can achieve something similar in over the counter (OTC) markets where there is no exchange in the middle.

Smart contracts can also automate the performance of contracts. In derivative contracts, for example, both the final settlement and the daily mark to market are governed by well-defined rules. With smart contracts, these transactions can be fully automated. If there is no need for human intervention, then the costs of these transactions comes down, and it is feasible to have OTC contracts of much smaller ticket sizes. The International Swaps and Derivatives Association (ISDA), which governs most OTC derivatives, has carried out a great deal of work on smart contracts.

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In a recent consultation paper (International Swaps and Derivatives Association [ISDA], 2018), ISDA states:

Smart contracts could help revolutionize the derivatives market by creating much-needed efficiencies that would benefit the entire industry. But transforming smart contracts from an exciting concept to practical use will present a number of challenges.… For smart derivatives contracts to fulfill their potential, it is important they are developed in a way that is compatible and consistent with the technological, commercial, regulatory and legal standards applicable to both derivatives contracts and smart contracts. This will require knowledge and experience from different disciplines and domains. Expertise in the technology used, the commercial context of its use, the regulation that applies to it and the law that supports its effectiveness, are all critical.

LEGAL/COMMERCIAL CHALLENGES

As mentioned earlier, non-cryptocurrency applica- tions of the blockchain have to overcome some major legal/commercial barriers. First, unlike cryptocurren- cies that exist only on the blockchain, in most other applications, assets that exist in the real world (dollars, rupees, securities, real estate) have to be represented by entries in the blockchain. Cryptocurrencies do not need any off-chain (real world) jurisprudence at all; they are able to go beyond the pragmatic idea that code is law to the more radical notion that only code is law. When we try to move real world finance to the blockchain, code and law have to co-exist. Some real world law has to recognize code as law at least to some limited extent so that transactions on the blockchain can effect change of ownership in the real world. Today’s mainstream financial institutions operate under similar legal protec- tion going back to the 19th century. For example, in the United Kingdom, the Bankers’ Books Evidence Act of 1879 provided, “Subject to the provisions of this Act, a copy of any entry in a banker’s book shall in all legal proceedings be received as prima facie evidence of such entry, and of the matters, transactions, and accounts therein recorded.” A similar law was passed in India a decade later. Some law of this kind will be needed to give legal sanctity to the blockchain for assets other than cryptocurrencies.

Second, most blockchain applications in finance will need to ensure regulatory compliance on day one. Regulators are not often clear in their regulatory stance on the new technology, and obtaining their clearance

is not always easy. By contrast, for a long time, crypto- currencies could operate outside the regulatory frame- work entirely. In recent years, this has begun to change as many cryptocurrency exchanges have become licensed money changers, and as traditional exchanges, securities brokers, and asset managers have begun to offer cryptocurrency related products. For example, in the United States, Cboe Futures Exchange launched Bitcoin futures in December 2017 after obtaining requi- site regulatory approvals.

Third, many blockchain applications in finance have to ensure commercial viability in the face of compe- tition from incumbent players who are not only rich and powerful, but also well entrenched in the current legal and regulatory framework. Cryptocurrencies, on the other hand, were (in the initial years) dominated by ideologically motivated computer professionals (‘geeks’) and anarchists who were not too constrained by commercial considerations. By staying outside the regulatory framework, they also avoided direct confron- tation with incumbents defending their monopoly/ oligopoly. Only after establishing themselves outside the formal system, did cryptocurrencies become more mainstream and start attracting speculators seeking quick returns.

For the blockchain to succeed in mainstream finance, these critical hurdles will have to be overcome. The blockchain ventures that we have seen so far have been driven by either (a) venture capitalists funding poten- tial disruptors in the hope of large rewards if they succeed or (b) the incumbents themselves launching pilot projects to protect themselves from being disrupted. It remains to be seen whether these projects will achieve sufficient scale and traction to challenge today’s entrenched business models.

POTENTIAL APPLICATIONS

Since the blockchain is basically a technology for recording transactions, it can potentially be applied to most parts of finance. However, the following sections describe applications that are most promising because the current system is not working well enough, or because blockchain pilots have been successful.

Fiat Money on the Blockchain

Finance is essentially about money, and much of the financial system can run more easily on the blockchain

6 Blockchain in Finance

if fiat money (dollars, euros, and rupees) could be transacted directly on the chain. There are many ways of doing this, and it is reasonable to assume that one or more of these mechanisms would achieve sufficient liquidity and scale in the near future (see Box 3).

Box 3. Tokenization of Fiat Money

There are three main ways in which ordinary fiat money (dollars or rupees) can be converted into tokens that live on a blockchain. First, the central bank itself could issue digital money that lives on a blockchain. Many central banks around the world have been thinking about this, and have discussed the matter in their reports and documents, but none looks likely to take the plunge soon. The Bank for International Settlements put it very tactfully: “the issuance of a [Central bank digital currency] requires careful consideration” (Bank for International Settlements, 2018). Some market participants have been exploring the idea of a temporary fiat money token that would be redeemed and destroyed at the end of each day. The idea is that, for example, a group of large European banks deposit a few billion euros each with the European Central Bank (ECB) before the markets open, and the ECB issues euro-coins of equal value on the blockchain. During the day, the banks can make euro payments to each other on the blockchain using these euro-coins. At the end of the day’s trading, the banks surrender their euro-coins to the ECB that redeems them for euros. There may be less resistance to this idea, but even this will be a bit of a leap into the unknown for the central banks of the world.

Second, a large trusted institution could issue cryptocoins fully convertible into fiat money with its promise backed by a 100 per cent reserve of fiat money. The challenge is to find a way for this institution to make money out of this activity. When central banks issue money, they earn seigniorage revenues because their money issuance does not have to be backed by non-income earning assets. Essentially, the central bank pays no interest on the money that it issues, and is able to invest the proceeds in government bonds that do earn interest. If the issuer of fiat money tokens has to back the issuance with 100 per cent reserves of highly liquid safe assets, the return earned on these reserves might be limited. If the institution is subject to banking regulations, it might be required to maintain

capital based on a leverage ratio. Until the issuance reaches a sufficiently large scale (possibly billions of dollars), it might not earn enough to cover its operational costs and the return on its own capital. There is a coin called Tether that claims to be backed 100 per cent with US dollars, but there are questions about the trustworthiness of the issuer (Griffin & Shams, 2018). In February 2019, one of the largest banks in the world announced that it had created and tested a digital coin representing the US dollar but its usage is restricted to the bank’s large institutional clients (Morgan, 2019).

Third, decentralized smart contracts can be used to create a token that is pegged to a fiat currency. The Dai Stablecoin (MakerDAO, n.d.) is pegged to the US dollar (1 Dai = 1 US dollar) through a smart collateralized debt contract. Anybody can create new Dai coins by locking up sufficient value of a cryptocurrency (ether) in a collateral contract. For example, a person deposits $200 worth of ether into a smart contract and issues 100 Dai (worth $100). At this point, the contract is 200 per cent collateralized (the locked up ether is worth 200% of the coins issued). The problem is that as the value of the ether fluctuates, this excess collateralization (the liquidation ratio) will also change. If ether drops by more than 50 per cent, the Dai will no longer be backed by adequate ether. To prevent this, the system specifies a minimum degree of excess collateralizion. Suppose the liquidation ratio is 150 per cent, and there is drop of more than 25 per cent in the value of ether. The value of the ether in the collateral contract will now be less than the liquidation ratio, and the system sells the ether for US dollars and uses the proceeds to buy back the 100 Dai that were issued. After deducting a liquidation penalty, the remaining collateral is returned to the original creator. In a decentralized system, the question is who will perform the liquidation, and the answer is that the sale of ether and the buyback of Dai will both be done by smart contracts. Any person can initiate the process of liquidation and earn a small reward for doing this. It is expected that people will set up smart contracts to monitor all the Dai collateral contracts in real time and trigger liquidation as needed. Of course, the creator of the contract can also choose to top up the collateral to avoid the liquidation penalty. The risk to the Dai-Dollar peg is that ether falls so sharply and quickly that in the time between initiation and completion of the liquidation, the value of the collateral drops below

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the required 100 dollars. This risk can be reduced by high liquidation ratios. The Dai Stablecoin is backed by further lines of defence designed to minimize the risk of the peg being broken. Details are available in the Dai Stablecoin whitepaper (MakerDAO, n.d.). Again, the issue is whether the economics will work well enough to motivate adequate creation of Dai, particularly when the MakerDAO platform on which the system runs wants to appropriate significant seigniorage income for itself. The creator can sell the Dai for dollars and earn interest on these dollars, but her ether becomes a dead asset locked up in a collateral account. Locking up ether might not matter much when credit and money markets in ether are undeveloped and there is no opportunity cost of locking up ether. As and when cryptocurrency money markets develop, the economics could become challenging. There is, however, the view that cryptocurrencies with hard issuance caps might be structurally deflationary and might therefore exhibit zero or even negative interest rates. Meanwhile fiat currency inflation and interest rates are rising from their post crisis lows, and this improves the economics of fiat currency tokens by increasing the seigniorage income.

Micropayments and Micro Financial Services

Second level networks running on top of existing cryptocurrencies are making it feasible to make very low-value payments. For example, on the Lightning Network (see Box 4), median fees of one Satoshi (less than 0.01 US cents) are being reported. If these low fees can be sustained as the network scales, it would be possible for the first time to make micropayments of 1 US cent or less between complete strangers in near real time. For example, a web search may show you a snippet of an article from a newspaper that you have not even heard of and offer to display the entire article on …