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Distributed ledger technology – where’s the value?

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Julio Faura is global head of R&D at Banco Santander. In this article, he explores where blockchain technology’s value lies.

Blockchain – or more broadly, distributed ledger technology – has the potential to “produce change at the more revolutionary end of the spectrum”.

This is according to Mark Walport – chief scientific adviser to the UK Government – who authored an official report on behalf of the UK Government on the technology at the beginning of this year.

This level of attention from a national governing body is testament to the massive potential for the technology across a number of vertical industries – with the financial services sector pioneering the way.

Walport’s report echoes a number of points made in our Fintech 2.0 paper, published in June of last year by Santander InnoVentures (our own $100m FinTech venture capital arm investing in innovative startups) in partnership with Oliver Wyman and Anthemis.

The paper explores the approach of a distributed ledger system (see Fig.1), looking in depth at applications for distributed ledger technology across financial services.

It identifies roughly 20 use cases in areas such as cross-border international payments and post-trade securities settlement. It then goes on to estimate the collective cost-saving potential of the technology for banks’ infrastructures as billions of dollars per annum.

Fig,1 – Centralised and Distributed Ledger Approaches. Source: Oliver Wyman

 Distributed Ledger

Delivering on the promise

While the noise around distributed ledger grew significantly in 2015 – with the establishment of multiple innovation labs and pilot projects – this year has got to be about starting to deliver on its potential and using the technology to deliver practical solutions that operate in the real world of financial services.

However, there are still a number of challenges facing widespread commercial adoption of the technology, and industry leaders including both specialized startups and banks are collaborating intensely to find solutions around them.

One such challenge revolves around the process of exchanging and representing value on a distributed ledger system.

We’ve seen a similar problem emerge regarding the adoption of bitcoin – the lack of liquidity surrounding the cryptocurrency has been a serious impediment to its success (along with overall governance and identity management issues), particularly when it comes to corporate finance.

The challenge for distributed ledger technology moving forward is to find an effective way to represent (fiat) value in the system, so that cryptographic transactions or tokens traded can be exchanged against fiat currency (currency that a government has declared to be legal tender, but that isn’t backed by a physical commodity).

So what can the industry do in order to make this a reality, and to leverage the benefits associated with cryptocurrencies and distributed ledger technology generally?

This is where industry-wide collaboration is key. Banks and other financial institutions must work together to establish mechanisms to issue and redeem existing assets, such as shares, bonds and currencies, onto distributed ledgers.

Further collaboration is then required to create definitions around legal value of these assets, while guaranteeing enforceability should any issues arise.

One of the most attractive features of distributed ledgers is the removal of intermediaries, creating both significant cost savings and removing a major source of friction in financial processes.

This friction is further amplified by the lack of liquidity surrounding the creation and exchange of value. If the financial services industry can come together, collectively pooling resources and expertise to establish a method of streamlining the rails on which we operate, and agreeing a common way for exchanging value that they all sign up to, then we’ll begin to see the creation of liquidity in the system, allowing momentum to build.

We see no reason as to why industry-wide collaboration isn’t achievable. Santander is an active advocate of such collaboration, as highlighted by our involvement in the R3 blockchain consortium.

Another viable alternative would be the introduction of a pseudo central banker to act as a governing entity.

Sources of value

If these collaborative value exchange mechanisms become a reality, we anticipate two major sources of value to arise from such a system: significant cost saving opportunities with an improved service for existing businesses, and new smart-contract based financial instruments and payments services.

We anticipate the potential bank infrastructure cost savings to be in the order of billions of dollars per annum. Where these potential savings and revenues accrue will differ by institution, but primary savings areas include cross-border remittances, securities registration and maintenance, and simplification and efficiency improvements in processing transactions.

Distributed ledgers also hold the potential to enable and support ‘smart contracts’, as they implement advanced computer protocols that allow computer programs to do the same thing legal contracts do.

These programs can securely (cryptographically) verify contractual conditions, which can then trigger the release of payments and the transfer of other types of value – all done automatically, without the need for lawyers to interpret the true meaning of the contract or for courts to make arbitrary decisions.

Smart contracts have a number of possible uses across financial services, starting from already existing derivatives contracts and other financial instruments, particularly in the post-trade space where they can be used, for example, to automate clearing upon trade completion.

But they can also be used to create new transaction types, ranging from options markets that today do not exist, to the provision of digital and physical services (governed by IoT devices) with payment functionality deeply embedded with the service itself.

Commercial banks, central banks, stock exchanges and even major technology providers are all exploring the potential of distributed ledger technology and its uses.

Innovative companies in the space, such as Ripple (an InnoVentures portfolio company), are also developing new ways to exchange data and assets enabled by the technology.

If banks and other financial institutions can work together, in consensus, to solve the liquidity issues in the value exchange process, and in creating the new standards for smart contract legal enforceability, it is only a matter of time before distributed ledgers become a trusted alternative for managing large volumes of transactions.

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