Decentralization– Blockchainapplicationsandcasestudies

2016

Overviewofblockchain applications

• Buildingtrustbetweencounterparties• Makingdistributedmarketsmoreeffective• Reducingtransactioncostsinunderwritingtitleinsuranceandotherfinancialtransactions• Streamliningclearingandsettlementofcashsecurities• Improvingefficiencyinanti-moneylaunderingcompliance

Advantagesofblockchain applicationBlockchain hasthefollowingadvantagesoveraconventionalcentralizeddatabase:1. Security:Blockchain relies onencryptiontovalidatetransactionsbyverifyingtheidentitiesofparties involvedinatransaction.

Thisensuresthata“false”transactioncannotbeaddedtotheblockchain withouttheconsentofthepartiesinvolved.Acomplexmathematical calculationknownasa“hash”isperformedeachtimeatransactionisaddedtotheblockchain,whichdependsonthetransactiondata,theidentities oftheparties involvedinthetransaction,andtheresultofprevioustransactions.Thefactthatthecurrentstateoftheblockchain dependsonprevioustransactionsensuresthatamaliciousactorcannotalterpasttransactions.Thisisbecause ifprevioustransactiondataischanged,itwill impactthecurrentvalueofthehashandnotmatchothercopiesoftheledger.

2. Transparency:Byitsverynature,blockchain isadistributeddatabasethatismaintainedandsynchronizedamongmultiplenodes– forexample,bymultiplecounterpartieswhotransactwitheachotherfrequently.Inaddition,transactiondatamustbeconsistentbetweenpartiesinordertobeaddedtotheblockchain inthefirstplace.Thismeansthatbydesign,multiplepartiescanaccessthesamedata(insomecaseslocallywithintheirorganizations)– thussignificantlyincreasing theleveloftransparencyrelative toconventionalsystemsthatmightdependonmultiple“siloed”databasesbehindfirewalls thatarenotvisibleoutsideasingleorganization.

3. Efficiency:Conceptually,maintainingmultiplecopiesofadatabasewithblockchain wouldnotappear tobemoreefficient thanasingle,centralizeddatabase.Butinmostreal-worldexamples(includingseveralofthecasestudiesweexamine incapitalmarkets),multiplepartiesalreadymaintainduplicatedatabasescontaininginformationaboutthesametransactions.Andinmanycases,thedatapertainingtothesametransactionisinconflict– resultingintheneedforcostly,time-consumingreconciliation proceduresbetweenorganizations.Employingadistributeddatabasesystemlikeblockchain acrossorganizationscansubstantiallyreduce theneedformanualreconciliation, thusdrivingconsiderablesavingsacrossorganizations.Inaddition,insomecases(seeourdiscussionofAML)blockchain offersthepotential fororganizationstodevelopcommonor“mutual”capabilities thateliminate theneedforduplicationofthesameeffortamongmultiple organizations.

Overviewofablockchain verificationsystem

Groupsverifytransactionsbyconsensus

Party5hasdifferentdatafortransaction3thantheother5parties,whichwillchangeviatheconsensusalgorithm

CaseStudy:Reducingtransactioncostsinrealestatetitleinsurance• TitleinsuranceisanichebutsizeablemarketintheUS,with$11bninpremiumspaidin2014• Titleinsuranceexistsmainlytoprotectapropertyownerand/ormortgagelender’sfinancialinterestinarealestatetransaction(residentialorcommercial)againstlossfromtitledefects• Titledefectsinclude,butarenotlimitedto,outstandingliens,easements,orotherencumbrancesunaccountedforatthetimeofthetransaction.Importantly,titleinsurancepremiums,ascomparedwithotherinsurancelines,arelargelydeterminedbytheinsurer’sunderwritingcostfactorsasopposedtoactuarialriskofexpectedlosses• Blockchain applicationscouldmeaningfullylowertransactionalriskassociatedwiththeexistingpropertyregistrationsystemintheUS,introducingsignificantcostefficienciesthatwouldbenefittheendconsumer

Titleinsuranceindustryexpense/lossration

Titleinsurersabsorbsubstantialcostsconducting propertytitlesearchestoreducelosses

Breakdownoftitleinsurancecoststructure

Titleinsurers’operatingcoststructuremainlyconsistsofheadcountcosts

Titlesearchprocess

Titlesearchisamanuallyintensiveprocessbecauseabstractorsandcuratorsmustprocessandclearpaper-basedproperty records

Blockchain titlesearchprocess

Estimatedindustryheadcountoperatingexpensescomparedtoblockchain savings

Blockchain applicationscansave$2.3Binheadcountsavingsfortitleinsurance

Estimatedinsurancelegalandclaimsexpensescomparedtoblockchain savings

Blockchain applicationscansaving$550Minlegalandclaimsexpenses

Estimatedindustryoperatingexpensecompositioncomparedtoblockchain savings

Labor-intensiveunderwriting expensescoulddeclinesignificantlyasapercentageofpremiums

CaseStudy:Capitalmarkets– UScashequities• TheUScashequitiesmarketisthelargestandmostactiveequitymarketintheworld,tradinganaverageof7billionshares,or

approximately$277Bofnotionalvalue,perdayin2015• Throughoutthelifecycleofanequitytrade,anumberoffinancial intermediaries arerequired: stockexchanges/tradingvenues

(NASDAQ,NYSE),broker-dealers,custodybanksandtheDepositoryTrustCompany(DTC,asubsidiaryoftheDTCC)• Blockchain couldfurtherstreamline thepost-tradepartofthetradecyclebyeliminating duplicativeconfirmation/affirmation

steps,shrinkingthesettlementcycle,andreducingtradingrisk,whichinturnshouldlowertheindustry’scostandcapitalneedsPlacesforimprovement:• Multipleversionsofthetrade.Whenmultiplepartiesareinvolvedacrossasingle transaction,multiple versionsofthetradecan

berecordedacrossthevarioussystemsthateachpartyuses.Thisintroducesanelementofuncertainty,whichcanrequiremanualinterventionwhenpartiesdisagreeontradedetails

• Thesettlementprocessislong.While stocksintheUStradeinfractionsofseconds,thesettlementprocesstakesthreedays(movingtotwoin2017),whichtiesupcapitalandliquidity

• Accountinformation/instructionsareconstantlychanging.Overtime,accountinformationandsettlementinstructionschange(newaccountsareopenedorclosed,accountnumberschange,custodianschange,etc.)resulting instaleinformation(particularlyforstandardsettlementinstructions)requiring increasedcommunicationandmanualintervention

• Operationalrisk.Firmsencounterextraoperational riskinconnectionwithtradesettlements thatcouldbeeliminated withpre-tradechecksviablockchain technology

IllustrationofUScashequitiestrade

Globalequityoperatingmodel

Blockchain save$9BinUScashequitiestrading

ListofselectBitcoinblockchain technologycompanies

Listofselectnon-Bitcoinblockchaintechnologycompanies

Conclusions

Futurechallenges:• Criticalmassofcounterpartyinformation.Criticalmassofinformationisneededinorderfordatatobecommerciallyreliable.Forexample,incaseswherethereisascarcityofvalidatedcounterpartyinformation(e.g.,validatedonlybyasinglesource),weexpectbankswouldstillneedtoruntheirownKYCchecksand/ortransactionsurveillancetoindependentlycorroborateclientinformation.

• Regulatoryreform.Regulatoryreformthatsupportsblockchain-basedapplicationswillbeneededbeforefinancialinstitutionsareabletoembracethetechnology.Whileblockchain willlikelynotremovebanks’AMLliability,blockchain-baseddistributedledgerswillneedtobelegitimizedbygoverningbodies(i.e.,fiatcurrency)inorderforbankstocomfortablyrelyonthemasasourceofcounterpartyinformation.

• Infrastructuredevelopment.Thedevelopmentofblockchain-basedinfrastructurethatoperatesinconjunctionwithexistingindustrystandardsisneededforcommercialadoption.Forexample,wenotethatwiretransferinformation(e.g.,ABAroutingnumbers)willneedtobetiedtoablockchain indextoimprovethesecurityofmoneymovementtransactions.Assuch,webelieveconsiderableinvestmentisneededtoimplementrequisiteinfrastructure.