Fraud and the jitters

by Jean-Pierre Brungs for Unsplash
by Jean-Pierre Brungs for Unsplash

All is far from well in the Chinese bond market. And the implications for blockchain technology are deep.

December was not a good month for bond traders. As if the deep slump in bond prices after the US Fed raised rates wasn’t enough, the market was also shaken by two major incidents of fraud.

In one case, the forgery involved papers in which a bank guaranteed a bond that subsequently defaulted. The bank said “not my problem” and refused to honor that guarantee.

In another case, it emerged that two rogue employees of a trading house called Sealand Securities had used a forged company seal to purchase, on behalf of other financial institutions, over 16 billion RMB (almost $2.4bn) worth of bonds. You read that right, “billion”. The bond prices fell, and someone had to make up the loss. Sealand said “not my problem”, the blame lay with the perpetrators, and why not, also with the correspondent financial institutions who “should have checked”.

In the end, Sealand agreed to honour the bond contracts, but the fright did not help market jitters. At least 29 bonds defaulted in 2016, up from 7 the year before. Over 117 billion RMB of sales were canceled or postponed in December, almost four times the amount in November. A government bond index fell 1.7% in December, the steepest monthly decline since October 2013. And with interest rates heading higher and economic difficulties ahead as leverage is reigned in and global trade becomes more, um, complicated, it looks like defaults will continue to increase in 2017.

Tighter regulation and controls could help to calm fears that fraud is making the system more vulnerable. Local media has reported that the government is contemplating the creation of a regulatory body just to focus on systemic risks.

Or, financial institutions could step up their investigations of blockchain technology applications.

On the blockchain, transactions cannot be tampered with, and fraudulent use of signing keys is instantly visible to network participants. An unalterable ledger of events would make accountability more transparent, authorizations can be more tightly controlled, and the falsification of ownership documents ceases to be an issue.

In other words, with financial settlement supported by blockchain technology, fraud would be much more complicated. The incentive would not just be for corporations. With enhanced transparency, government officials would be under greater pressure to clamp down on irregularities, especially given President Xi Jinping’s anti-corruption drive.

China’s financial institutions, tech enterprises, universities and startup community are active in blockchain innovation. The central bank recently announced that it was testing a blockchain-backed digital currency, with a view to using the platform for bank bill transactions.

The government, perhaps aware of the need for speed, is encouraging blockchain research and adoption. In October, the Ministry of Industry and Information released a white paper that explored blockchain applications, particularly in finance, and encouraged businesses to be more active in global experimentation. The same month, the government hosted a forum aimed at fostering cooperation in blockchain development.

Given the obvious need for a lasting solution, we can expect these efforts to intensify over the next few months. But will it be fast enough?

While blockchain-based solutions could restore confidence in the integrity of the bond market and open up channels of financing to a broader range of businesses, it is unlikely that any would be ready for the market in the short term.

The situation is verging on urgent, though, as a rapid build-up of leverage has made firms increasingly vulnerable to an economic downturn or even to a change in market sentiment. A looming trade war with the US, or even military conflict in the South China Seas, could be enough to trigger a string of defaults, which are likely to uncover even more fraud and misappropriated leverage.

The damage could be harsh, in an environment that would already be suffering from economic and geopolitical factors.

Blockchain and settlements: why?

I used to work, many years ago, as a broker of Canadian equities in London (don’t judge, it was the ‘80s). It was so long ago that I confess that I don’t remember much about the process, other than that we would write down our clients’ orders on bits of paper, and hand them in at the end of the day to the head of the desk. From there they would get passed on to the settlements department, which had its own floor, it was so large. Several days of stock price and currency movements later, the settlement would go through. I never thought to question the efficiency, I just assumed that that’s what it took to get ownership transferred.

When I started studying the blockchain, I assumed that aha!, here was a way to save billions in tied up money, simply by reducing the settlement time to seconds rather than days. I assumed that the blockchain’s transparency and immutability would make the cumbersome checking of ownership and payments unnecessary. Matching, verifying and netting would be reduced to code. So it needn’t take several days, right?

As with most financial concepts, it’s not that simple.

by Josh Pepper for Unsplash - trading settlements
by Josh Pepper for Unsplash

To see why, let’s start with a simple example. You and I are together in a café. I have a share certificate in my hand, and you want to buy it. You hand me the cash, I hand you the certificate, and we have instant settlement.

But wait a minute: how do you know that that share certificate is not fake? How do I know that the cash is not fake? My doubts are easier to resolve than yours (I just happen to have a fake bill detector in my pocket). How are you going to check that the certificate was not forged or copied? That’s going to take you a while. We no longer have instant settlement.

Back in the day when share certificates were bearer items (pieces of paper that belonged to whoever held them, much like the €20 in your pocket), checking authenticity could have been enough for the transaction. But now you need to know for sure that I have the right to sell that certificate, because if not, once I’ve disappeared with the cash, you could find that the rightful owner appears and wants the sale declared null and void. How do you do that?

And while you’re doing all your checking, I could decide to change the price. Markets move, after all. How do you prevent that from happening?

The settlement is getting more complicated, right? Now let’s throw in the delicacies of electronic payment, and electronic transfer. To the same doubts about authenticity, we can now add doubts about settlement. Even if we’re satisfied that we are who we say we are, and that we have the right to send the digital certificate/payment, I’m not going to transfer ownership until you send the money, and you’re not going to send the money until I transfer ownership. Who can help us with that?

And, since it’s unlikely that I hold my digital certificates, I have to route all instructions through my certificate custodian. And, how did you and I find each other in the first place? Suddenly a lot of other parties are getting involved, and each is going to want to verify and check that everyone is who they say they are.

So, a lot of verification is going on. And it’s that verification that takes the time.

In theory, the blockchain can help us with verification, in that if something is stored on the blockchain, it’s fact. But is it? Let’s presume that I, personally, don’t have the power to publish my share ownership on the blockchain. My custodian would have to do that. (Why he would do that is an interesting dilemma, since once he has published all his clients’ shares to the blockchain, he is out of a job.)

And how do we know that my custodian will publish the correct information? That my share holdings are 100% intact (nothing has been siphoned off), verifiable, and in a universally accepted format? Who decides what that format is? Would that not be a very, gasp, centralized decision? For a technology that rests on decentralization?

Let’s assume that we figure out a way for my custodian to blockchain all of my holdings and manage to keep his job. So, he transfers the digital ownership of the shares I want to sell to my broker, who is in contact with your broker. Why is my broker going to trust your broker to make the payment on your behalf? It’s easy enough if they know each other or have done business before. But what if you are in Azerbaijan and I am in Iceland? (And let’s not even go into how long it would take a payment to get from Azerbaijan to Iceland…). Right now regulation makes this all work relatively smoothly. And regulation insists on verification and re-verification of the facts and identities. It’s very unlikely that just putting it on the blockchain would be “good enough” for the regulators.

And we shouldn’t want it to be. Efficiency is great, yes. But when it comes to large sums of money, reliability is more important. And when you think of all of the verification that needs to happen for a trade to take place, settlement of two or three days doesn’t sound like that much, after all.

It is possible that the financial sector could come up with a way to encode verification, identity and transactions. But to do it going back far enough for it to be useful would entail a colossal cost. And to do it in a uniform manner in a fiercely fragmented business would require almost magical management skills.

But that’s not to say that blockchain settlement is not a good idea. Some asset classes take longer to settle than others. So, it’s quite possible that we’ll end up seeing separate settlement practices for separate types of deals, and some of those may well use the blockchain. I can especially see blockchain-style settlement being used for future asset classes that haven’t even been invented yet. Building a new settlement system from scratch would be an excellent opportunity for the blockchain to show its power. Converting current systems? Not so much.

And while decentralized trading sounds efficient and, well, democratic, we need to take a look at the steadying role a centralized control can play. Imagine what could have happened in September 2001, and again in the 2008 crash, withoutSEC interference. And the need to reverse a trade, either because of error or because of contractual conditions, is a relatively common occurrence, and something that the blockchain is not set up to allow.

The “blockchain as a new settlement system” dream is appealing. But as with much of the information and talk surrounding this powerful technology, it is largely hype. An improvement on the current system would benefit liquidity and profits, and make the sector more resilient to shocks. And the blockchain does have a role to play in making payments and data transfer more efficient. But it would be a mistake to assume that technology alone is the barrier to an instant settlement system. There is much to explore, though, and much to learn, and things can always be improved, indeed should be if the solution is practical. The sector and the blockchain will find ways of working together if we can move away from sweeping proclamations and towards practical applications that can help today.

Goodbye blockchain, hello ledger

We’ve seen how many bitcoin companies have pivoted away from the digital currency to become blockchain companies. Now, here comes the next pivot: the term “blockchain” is being replaced.

With what? With “distributed ledger”. Not nearly as sexy. But much more accurate, and by that I mean “less confusing”.

We have the bitcoin blockchain. In fact, many insist that the bitcoin blockchain is the only blockchain (“There can be only one”). That is open to fierce debate, and I am in the camp of the many-blockchained universe. I know very smart people who insist that without bitcoin (or other cryptocurrency – and many argue that bitcoin is the only cryptocurrency) as an incentive, the blockchain won’t work. That’s true, if you are operating a blockchain in which the participants don’t know each other. You need a financial incentive to keep it “honest” and to prevent identity-based attempts to control the majority.

But I also know very smart people who insist that blockchains can function well in situations that do not require that level of validation work. If you don’t need the same high level of decentralization and permissionless participation (ie., anyone can join), you don’t need the same incentives. These would be private blockchains, in which the range of participants is limited to a sector or field in which everyone knows each other. While you may not trust everyone in the group, you know who they are and can verify their identity. What you need is a way to allow modifications to the database and the chain of information, while keeping the process transparent.

I’m not going to go into the technical side any more than I already have, at least not today – it’s long-winded and convoluted (and actually only interesting to total geeks like me). To appreciate the trend and the hype, it’s only necessary to grasp the difference between public blockchains such as bitcoin, in which everything is open, transparent and decentralized, and private blockchains, in which participation is limited but which still offers significant business process improvements.

Both systems operate on the same principals, but have slightly different mechanisms. Both technically are “blockchains”. Yet they serve different purposes and have different markets, and calling them both blockchains is generating a lot of confusion. And confusion is not good for new systems struggling to grasp a new concept and explain it to its markets. So, we need to find another name for private blockchains. The obvious choice is “distributed ledger”.  Boring, perhaps. But that’s marketing’s problem. And I’m not sure that the financial sector should sound exciting.

I’m obviously not the only one. Big blockchain players are starting to distance themselves from the “blockchain” label. Some are substituting with “distributed ledger”. Others are not using either. This trend is fascinating to watch, and is just getting started. And in the process, it will bring on a greater clarity of purpose and communication, and foster even more innovation in a sector that really needs it.

Let’s take a look at some of the big names in the blockchain space:

blockchain digital asset holdings

Digital Asset Holdings is arguably one of the biggest. Created as a bridge between the digital currency sector and stuffy Wall Street, it boasts an impressive roster of directors from the financial sector, and deep pockets for blockchain startup acquisitions. Even though its mission is to advance blockchain technology, nowhere on its home page does it mention the word “blockchain”. Nor does the word appear on the explanation of the technology, although “distributed ledger” does.  They do refer to blockchains when talking about their recent acquisitions. But their technology apparently is blockchain-free. Now they call it “Business Logic Engines”. While it’s true that they’re not just focussing on distributed ledgers, it is striking that blockchains are so conspicuously absent from the sales text.

“Our platform can commit transactions to private or public distributed ledgers or traditional databases depending on the requirements of the use case.”

R3CEV has been making headlines recently with its initiative to get big banks to experiment with the blockchain technology. While the press still insists on calling it that, R3CEV has no mention of the blockchain on its home page, not until you get down to the list of press articles about them. They do refer to distributed ledgers, but only once.

Abra, a remittance company that uses the blockchain to send money around the world, has no mention of the blockchain on its home page.  Nor on the “How It Works” page.  If you persist, you can find a well-hidden reference to “modern blockchain technology” on the FAQ section when you click on “What is the technology behind Abra?”.

MoneyCircles is a P2P lending system built on the blockchain, that does not mention blockchain on their home page at all.  When you go to “How it works”, you find it:

“We allow people to create and operate their own credit unions on the Blockchain, which provide savings and lending services to their members without all the usual associated costs and restrictions.”

blockchain safeshare

Safeshare Insurance, which provides insurance for the marketplace economy (sometimes mistakenly called the “sharing economy”) over the blockchain, does not mention blockchains or even ledgers anywhere on their website (that I’ve been able to find, anyway).

BuyCo, which uses the blockchain to make it easier for businesses to get together to buy things, doesn’t mention blockchain anywhere on their home page.

The list goes on…

There’s a whole lot more going on here than a simple re-branding. We’re looking at a clarification, and a step back from the hype. The press will continue to label these companies as “blockchain” players for some time, though. It sounds a lot more interesting than “distributed ledger”, and the press needs a bit of hype to get the clicks. Yet the experimentation on both sides of the bitcoin/not-bitcoin blockchain divide, whatever the system is called, will lead to a greater understanding of the potential, the business models and the economic impact. And we all will get a clearer idea of what the future will look like, with blockchains, distributed ledgers, or whatever the next transformation will be called. Not boring at all.

 

The magic of the blockchain is that it’s not what you think it is

So, it’s intensifying. From dismissing bitcoin to grudgingly admitting that the blockchain might be interesting, to tiptoeing around more in-depth research, banks now seem to be rushing to experiment with or even outright buy the technology. Let’s take a look at why, and why we won’t see much change in how banks work any time soon.

blockchain - by Joanna Kosinska for Unsplash
by Joanna Kosinska for Unsplash

A large part of the banks vs bitcoin debate revolves around the nature of the blockchain. Bitcoin’s blockchain is decentralized (no-one controls it), permissionless (anyone can use it) and public (all transactions are there for anyone to see). Does that sound like something a bank would be interested in? Something that no-one controls and anyone can use? Something that openly publishes transactions? Not any bank that I know of, anyway.

But surely a bank could adapt it for internal use? Yes, but why would they want to do that? The blockchain works more slowly than a database, and is more expensive to run. If what they want is an efficient way to transmit value internally, a database is much more useful.

What if they want the “permanence” of the blockchain record of transactions? What if they need to know that each transaction, once included, is very difficult to modify, increasingly so the farther back in time it goes? The blockchain is more secure than a database, true, since if a historical transaction is modified, every single subsequent transaction block also needs to be modified. But what if the blockchain is controlled by one entity? What’s to stop it from changing whatever it wants? The system is secure because it is public. A private blockchain is not so secure.

So, why are banks looking at it? In part because of the hype. Blockchain talk is almost everywhere, and if others in your sector are looking into it, you don’t want to be left behind.

And there is value in the notion of a private chain. For a single entity, the expense of the blockchain doesn’t make much sense. But for a group working together, the transparency, security and automation could lower costs and increase efficiency. A supply chain could use a blockchain-like system to pass documents from one stage to the next, for example. The participants would be all entities involved in the process, that don’t necessarily trust one another, and that want the transparency and group verification that the blockchain can offer. Or, a group of banks could create a private chain through which they could enact certain transactions, such as the hand-over of loans, or the exchange of securities. Developer R3CEV recently trialled a chain-based transaction with the participation of a consortium of 11 banks. And the blockchain’s use in securities settlement is potentially fraught with legal barriers, but if they can be worked out, the gain in efficiency and liquidity will be huge.

So, as with most hyped-up innovations, the blockchain is unlikely to be the explosively disruptive force that the media makes it out to be. Its use in private situations is limited. The sector is buzzing with activity, though, as very bright minds research and experiment, for small startups and for large institutions. The results will no doubt produce even more innovation and use cases, some of which will surprise us all. The internet today is used in ways the original developers never imagined. But its impact is unquestionable. We could well see the blockchain acquire the same status: part builder, part destroyer and part transformative magician.

Bitcoins and banks and patents

Banks’ growing interest in Bitcoin is not news. Yesterday I came across a new twist: banks filing bitcoin-related patents. This development makes sense, given the increased activity in Bitcoin research. It looks like the banks, far from being terrified of the potential disruption, are jumping on board and seriously thinking about how this new method of value transmission can improve their operations and their service. By starting to file patents, they seem to be moving – however slowly – from research to actual implementation.

lightbulbs
image via Death to the Stock Photo

Just last week the US patent office published a filing by Bank of America for a patent called “System and Method for Wire Transfers Using Cryptocurrency”. The idea is a simple exchange: client 1 exchanges dollars (for example) into bitcoins (for example), which are then transferred to client 2, who changes them back into its local currency. This way client 1 avoids hefty currency transfer fees, and client 2 receives the funds sooner (10 minutes or less, depending on the cryptocurrency, versus several days). In addition, client 1’s information is kept more secure, and stays with the originator (Bank of America), who obviously has complied with the Know-Your-Client/Anti-Money-Laundering laws.

The twist here is that Bank of America’s algorithm will decide whether a cryptocurrency is appropriate (there are cases in which it will be simpler to use traditional channels), and if so, which one.

Other financial services companies have tried the patents game: Western Union was granted a patent in 2014 for an alternative currency exchange. While it didn’t explicitly mention cryptocurrencies, it did refer to tokens and virtual “coins” in use at the time of filing in 2009. In 2014 Mastercard filed a patent for a “global shopping cart” that supports a variety of payment methods, including bitcoin. And Amazon, which seems to be on its way to becoming a financial services company, has been awarded a bitcoin-related patent for cloud computing payments.

Bank of America is the first “bank” to file a patent that would allow it to offer more flexible and lower-cost services to its clients. It certainly won’t be the last, and in the typical game of catch-up, we’ll probably see more activity in bitcoin-related patents filed by established institutions over the coming months. Barclays, UBS, Citi, Santander, ING and many other big banks have all acknowledged bitcoin “labs” dedicated to exploring and improving on the blockchain technology. Citi has so far said that the results of its experiments with Citicoin (a bitcoin-like in-house virtual currency) will be open source, which means that they have no intention of patenting, so that other brains can build on its work. But patents are a logical extension of private research, and an understandable way of getting some sort of return on the lab investment, as well as of stopping others from patenting “obvious” and/or proprietary technology.

A flurry of patent filings, which we’re likely to see over the coming months, is a good sign that case uses are being polished. Let’s hope that the patent office is sensible in which ones to grant. And let’s hope that patent filings are rapidly followed by implementation.