Bitcoin’s blockchain has the potential to be a game-changer for the financial services sector. The massively distributed, online ledger at the heart of Bitcoin’s settlement system does not rely on a centrally managed database or group of databases to manage complex trade flows between bitcoin’s buyers and sellers. Instead, it relies on a massive decentralized global network of computers to simultaneously deliver quick settlement, tamper-free security and an environment where no party necessarily needs trust the other — or any middlemen.
The blockchain’s increasing presence in the clearing and settlement of financial instruments has taken center stage during the past 18 months. Clearing and settlement activity costs the financial industry a whopping $50 billion each year, according to consulting firm Oliver Wyman. Tack on the slow creep of the traditional settlement cycle and structural inefficiencies inherent in the financial sector, and you’ll find an industry ripe for disruption.
In fact, it’s already underway. As Modern Trader wrote in “The many facets of bitcoin” (November 2015), 2016 is a pivotal year for bitcoin and the blockchain. Focus shifted from the idea that we would buy Starbucks coffee with bitcoin (a utopian vision at the time), to the very real application of the blockchain to the systems that underpin global financial and trading ecosystems.
The perception of the blockchain also has changed among financial professionals and institutional investors. Today, the view has shifted from the belief that bitcoin and the blockchain are inseparable to explorations on how a blockchain-like structure can be used without involvement from bitcoin at all. Indeed, even the core requirement that any blockchain-based system needs to be both open and massively distributed — which was considered near-gospel by most in this community just one year ago — has been questioned in the context of developing real-world clearing and settlement applications based on blockchain technology.
The real world has driven the shift in another way. Bitcoin and the blockchain originally were designed to operate largely outside legal and financial circles. Much of bitcoin’s bad press can be traced partially to these characteristics. But for highly regulated companies in the banking, brokerage, trading and asset management industries, such elements make it a non-starter.
As regulatory agencies around the world seriously began studying the bitcoin ecosystem in late 2014 and started bringing participants under anti-money laundering and know-your-customer requirements, the community began exploring ways to take the best of the underlying blockchain technology and design ways it could operate within the constructs of the modern global financial system. Like it or not, this requires adherence to mundane yet mandatory rules and regulations and counterparty, customer due diligence and transaction reporting requirements.
The potential savings and efficiencies offered from blockchain technology in the back office have generated significant interest from institutions and spurred an army of new startups. Meanwhile, blockchain has raised fundamental questions about the future of transaction clearance and settlement.
Indeed, one of the initial realizations from the shift has been that for all its elegance and technical innovation, the bitcoin blockchain itself turns out to not always be that well-suited to large-scale financial industry applications. Blocks typically are “sealed,” or processed, in around 10 minutes on the bitcoin blockchain, which sounds rapid in a world of T+3 equity settlement, but is an eternity in other financial applications.
Naturally, some firms that started in bitcoin trading are now pivoting to capitalization of the core promise of a distributed ledger-based system. Ultimately, financial institutions now spending billions of dollars each year in clearing costs are not truly concerned about how bitcoin and the blockchain function; it simply matters that the system works and improves on bitcoin’s technology.
One company, itBit, began its operations as a bitcoin exchange. But as interest in the blockchain began to skyrocket, and financial institutions began exploring its usage, the company used its deep knowledge of how the blockchain works to create a settlement system called Bankchain.
The Bankchain is a private consensus-based ledger system for financial institutions. In contrast to the open, massively decentralized blockchain used by bitcoin, Bankchain is a private, semi-closed system that trusted participants operate to clear, track and settle trades in near-real time, for little cost and within regulatory parameters. Although it does not use the original blockchain, its rules and efficiencies are blockchain-based.
Should itBit get its way and lead the clearing and settlement industry into the 21st century, the technology it uses has the capacity to change the plumbing of the global transaction universe.
Origins of a bitcoin exchange
itBit CEO Chad Cascarilla graduated from Notre Dame in 1999 and cut his teeth in financial services at Bank of America and Goldman Sachs. He learned the financial sector’s administrative pitfalls, and would go on to co-found hedge fund sponsor Cedar Hill Capital Partners before launching an early stage growth fund dedicated to bitcoin/digital currency-related startups. In 2012, itBit was born.
“When I first came across bitcoin a little more than five years ago, it was trading for a nickel,” he says. “No one knew whether or not it would succeed.”
Bitcoin’s rise has been two-fold. First, significant excitement surrounds bitcoin and how it may alter the future of currency and digital money. But for early adopters like Cascarilla, the breakthrough realization was that the technology could be used to move financial assets quickly, cheaply and accurately.
“It was the underlying technology that interested us; the concept of a payment system, a transaction system or a clearing and settlement system. We were very intrigued by what that could look like. This was the first time you really had a truly distributed database system. Our view has been to take advantage of a distributed database, which is why we want the ability to offer real world access through them.”
Coming from the financial world and seeing where the industry was headed, Cascarilla realized he needed to become a regulated entity if he wanted to attract financial institutions to his concept. itBit was the first firm in its space to receive a license from the New York State Department of Financial Services (NYDFS) allowing the firm to create the itBit Trust Company (ITC). The qualification as a trust company and regulated custodian was a tremendous coup for the company and offers it many regulatory — i.e., competitive — advantages in New York. Chief among them is that users of Bankchain are able to shift assets to one another across the platform without having to rely on regulated, centralized actors who facilitate fee-based transactions.
“We were the first firm in the space to receive approval, in May 2015,” he says. “We started working on the idea in the fall of 2013. At the time, we had the early insights into how we thought it would evolve.” The firm also is seeking membership with the Federal Reserve, DTCC and National Settlement Service.
Challenges to the blockchain
Bankchain is built on proprietary itBit protocols derived from, but not reliant on, blockchain technology. Unlike the bitcoin blockchain, which is open to anyone and relies on a complex mix of cryptography, math and incentives to create a token (bitcoin) that simultaneously clears and settles transactions, itBit’s Bankchain uses a set of proprietary tokens within a closed system populated by verified actors to do the same thing.
“Our whole goal in creating the trust [was] to be able to move real world assets in a way that is not really doable in the bitcoin blockchain,” Cascarilla says. “That’s where we started creating our own product.”
Currently, the public ledger of bitcoin is distributed across millions of computers around the globe. Each bitcoin transaction is recorded with little to no cost, and each receives the digital equivalent of a notary stamp. By using the blockchain to authenticate transactions across networks, a traceable history exists and offers ironclad proof of ownership. There is no central repository of all this data, i.e. a single point of failure that has become susceptible to hackers and other bad actors.
“Bitcoin was a major innovation in database development due to it being completely distributed,” Cascarilla says. “No single individual or company is running the database, and this openness eliminates many of the risks and costs associated with it.”
On private blockchains like Bankchain, only a selected group of users gains access to the decentralized platform. They’re pre-vetted and identifiable, getting around major compliance concerns. Given that the system is closed, companies are able to build trust as they operate.
However, this doesn’t guarantee total transparency, something that would be an anathema to most financial firms. Transactions are approved by system participants who are trusted by the very fact they’re in the group in the first place. Still, the approver’s identity is shielded.
Bitcoin versus the blockchain
“With bitcoin, there are three things that you optimize for,” Cascarilla says, “Openness, security and functionality. Bitcoin is open 24 hours per day, 7 days a week to anybody with the software, and it is very secure, so the first two are satisfied. In fact, the bitcoin system itself has never been hacked. Companies have been hacked and people have lost passwords, which is what happened with Mount Gox and similar events, but the core system has never been compromised.”
“The third element is functionality, and bitcoin is not that functional. It was done deliberately, that you only get two of the three. It’s very hard to get all three at scale,” he adds.
ItBit realized how bitcoin was limited by its lack of functionality, at least in the context of large-scale financial industry applications. Part of this issue stems from the way new activity on the bitcoin blockchain originates. Bitcoin rewards individuals, called miners, with new bitcoins when they mathematically solve complex strings of characters created by pieces of information contained in a group of transactions (a “block” and the origin of the name). When solved, this math verifies that all the transactions in the group are valid, and they are added to a long chain of previously sealed blocks, each connected by a small bit of data that identifies the block and its position in the chain. When transactions have been completed, they cannot be altered.
The financial incentive of earning new bitcoins is a central part of the goal to shift the understanding of “trust” on networks. Instead of relying on a centralized clearing house to process a transaction, a decentralized system allows anyone to verify a transaction and receive rewards for their effort. Individuals on either end of a transaction know nothing about the person verifying the deal, and vice versa. However, Cascarilla (and many others) argues that this system has structural limitations because of the need to own the crypto-currency and the fact that the more people that join the network, the harder the math becomes, and the more processing power that is required to solve a block.
In addition, the rewards provided to miners decline at preset intervals as the size of the blockchain increases, which ultimately will reduce the incentive to process transactions. Meanwhile, the ongoing debate about the maximum size of a block (currently capped at 1 MB) threatens to divide the
bitcoin community into camps of purists who say the sanctity of the original system is at stake, and users who argue bitcoin can never scale unless larger block sizes are enabled.
In short, it’s complicated. Elegant, groundbreaking and revolutionary, but complicated.
In the case of private chains like itBit’s Bankchain and a number of similar efforts underway, including Blythe Masters’ Digital Asset Holdings and the R3 consortium that just concluded a 42-bank commercial paper trial using blockchain technology, incentives are not based on monetary rewards but on the cost savings associated with faster processing speeds and reduced red tape.
“There’s a cost advantage, and there’s technically a speed advantage,” adds Cascarilla. “But the trust company element of itBit hooks us into the current financial architecture where people can do some very unique things and solve some interesting problems.”
A fact not often openly discussed in the bitcoin/blockchain world, however, is the veritable army of brokers, intermediaries and other middlemen with real vested interests in maintaining the status quo. Plus, according to R3 architecture consultant Ian Grigg, implementing true real-time settlement could impact liquidity.
Governance remains a hurdle. Raw technology to clear trades nearly instantaneously has existed for years, but has been stymied by regulations. “How do you bring [it] into the real world?” Grigg asked in a March 9, 2016 interview with International Business Times. “Look at cash, for example. We know how to do cash, and have known how to do it for a long time. The difficulties are all in the governance and politics and the business arrangements that already exist.” It’s when a company is able to marry a regulated entity with a blockchain-based solution that the magic will come, insiders say – and itBit’s status as a regulated trust company could be an example of such a marriage.
“It’s important to discuss how you create distributed consensus,” adds Cascarilla. “You can do that in a private world and a public world. In the public world, the best way we’ve found to create distributed consensus is through “proof of work”, like solving a bitcoin block. That is what makes bitcoin’s process similar to gold; gold is the work of people too, since you mine it. And bitcoin is people work. It’s hard to have a public asset unless you have proof of work everyone can agree upon. That proof of work is what creates the distributed consensus.”
A private network offers unique advantages in that it reduces the need for proof of work to reach that same consensus. “If you do a private network, you don’t to rely on proof of work to create consensus,” he adds. “It’s a private network. You know who everyone is. You can sign legal agreements among everyone involved that lay out the rules, and create a variety of ways to establish trust among the known participants. This allows you to reach a much speedier consensus not based on work, but on the fact [that] you are in the system.”
Deflecting criticism of private chains offered by those who believe the bitcoin blockchain is the purest form of distributed consensus. Cascarilla notes that within a system like Bankchain participants control their own data, there is still no central point of failure and auditability is customizable. Ultimately, the core difference is control, something critical to financial institutions with fiduciary concerns.
In contrast to bitcoin’s blockchain, which is strained by increasing transactions and the 1MB block size limit, itBit’s system accelerates as it grows. “Our system increases speed up to 10,000 to 15,000 users,” Cascarilla said. “That’s quite a lot for a closed system. At some point, you’re not really any more secure at the zillionth user, so the closed system can reap all the benefits of distributed consensus without the baggage of the full bitcoin blockchain.”
Other Uses of Bankchain
To start, itBit is aiming Bankchain at the post-trade gold and precious metals marketplace in London. The gold market is big and important but not too enormous to prevent concept testing. Plus, it is a bilateral clearing market, with no delivery vs. payment (DVP) settlement system. That means a distributed mechanism fits neatly into the existing structure.
“The number of transactions are defined and quantifiable, and are easily handled through the current system,” Cascarilla says. “The optimization for speed doesn’t need to be overwhelming yet — it is not like we’re handling U.S. equity trades.
“But cash moves eight to 10 hours after the trade, and actual settlement takes quite a long time — two to four days in most cases,” he continues. “This market gives us a chance to look at how our technology can be used across multiple aspects of the whole trade lifecycle, including collateral management, delivery, unregistered securities, cross border payments and so on.”
Reception has been warm. “In each one of our use cases, we’ve received a lot of buy in from the market, either from partners who we will launch the solution with or participants who want to use the new solution,” he says. “We’re really able to give somebody true delivery vs. payment, since I’m able to move cash and the asset at the exact same moment. There’s really no market or asset class where DVP truly happens today, except maybe for cash and direct purchases, like packs of gum. We’re able to make settlement times for financial assets be nearly instantaneous.”
The world is an enormous place
Tech enthusiasts foresee a day when the blockchain provides banks and other organizations with novel ways to digitize a whole range of transactions. Markets such as title insurance could be fundamentally improved. “The world is an enormous place,” says Cascarilla. “This technology will eventually apply to anything that requires a large amount of data to be stored and retrievable around a very particular event: Copyrights, equity or debt trades, patents, mortgage securitizations, asset sales and more.”
Cascarilla is optimistic that tools like Bankchain have the capacity to alter the multi-billion-dollar clearing industry. But it certainly will take time, he says.
“Proof-of-concept tests have already begun,” he says. “If we’re talking about initial rollout of some of these products, in certain use cases we’ll see it this year. It’s moving fast.” But fundamentally altering the structural framework of the global financial industry will take some time. Aside from the vested interests of middlemen, anyone who has ever worked inside a large global financial institution knows that inertia is a very powerful force when it comes to wide-scale changes and back office technology upgrades.
Cascarilla explains that many problems experienced post-trade would be solved if banks upgraded to the latest version of centralized database software they’re already running. Still, that is a high hurdle. “No one wants to just rip out the systems,” he says, explaining the costs.
Instead, he foresees an incremental adoption of distributed ledger systems, driven by the reluctance of larger institutions to take drastic steps. He thinks interest will be in solutions that can fit into existing legacy systems like a new glove, yet still save money, integrate seamlessly and provide added advantages of distributed ledgers. Institutions may have digitized around the edges of financial data, but they have yet to reimagine how to interact with such data in the same way the internet forced us to reimagine global communications.
Change is hard
“If you are talking about fundamentally altering the structure of certain markets, we’re [still] a few years away,” adds Cascarilla. “Most financial services are still operating in an Internet 1.0-type of world. I don’t think you’ll see big alterations to the equity market structure for a while, and when it comes to banks replacing their internal system in favor of private distributed databases, you’re at least five years away from really seeing a true transformation.”
Still, that’s lightning fast in the world of back-office tech upgrades, especially for technology as nascent as blockchain. Few could have imagined Facebook, Google and the full impact of the mobile revolution on so many aspects of our lives in, say, 1995. “If we end up getting a dent in the system within five years, that’s actually pretty quick for the finance world,” Cascarilla says. And sales cycles for new systems on Wall Street being what they are, that might be fine.
For now, itBit and other companies working on private distributed ledger systems in finance are content that institutional interest is rising, a welcome change from a few years ago when very few on Wall Street took bitcoin and the blockchain seriously. This year, itBit’s tech team is implementing ACH deposits and real-time streaming market data, and announced in February that it is expanding services in London, the Middle East and Africa. Earlier this year, the company hired Jason Nabi from Societe Generale, who has more than 20 years in securities services and post-trade operations; just one example of a successful trading infrastructure executive joining a blockchain company.
Since inception in 2012, itBit has received more than $32 million in funding from investors like Blockchain Capital and The Digital Currency Group. And Cascarilla admits we’re in the early innings of what could be a very long game. But if he’s right, itBit and other blockchain-focused firms could be in the starting gate of the largest technology upgrade Wall Street has seen since the invention of the transistor.
Modern Trader Features Editor Garrett Baldwin contributed to this article.