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Blockchain: Slow and Steady Wins the Race

As more firms continue coming to market with distributed ledger-based technology solutions, Galen Stops looks at the competitive landscape of this market.

It is perhaps unsurprising, given the amount of hype that has followed distributed ledger technology, that there has been a near avalanche of firms rushing to offer services around the technology.

Some of these firms were initially involved in bitcoin when it first came to the fore and have since pivoted from offering bitcoin-related services or technology to distributed ledger technology, of which blockchain is the most well-known form. Some have been working around this technology for years, while others are coming fresh to market.

With such a variety of firms offering different business models and use cases for distributed ledger technology in what is an increasingly crowded market, there are inevitably going to be some winners and losers.

One of the first questions that springs to mind when considering the firms currently touting distributed ledger solutions is how they plan to monetise their offerings.

“A lot of these firms are working with proof of concepts with some of the larger banks. There’s no revenue and they’re not profitable right now, but there’s lots of potential,” says one research analyst.

Despite all the potential though, there is still a dearth of tangible distributed ledger solutions actually being offered to financial services firms. 

In March, The Depository Trust & Clearing Corporation (DTCC) and Digital Asset Holdings announced that they would be testing distributed ledger technology for repo transactions.That same month Icap announced that it had completed a proof of technology test case using blockchain.

Then in April, Mitsubishi UFJ Financial Group formed a partnership with blockchain infrastrcuture firm Chain to test distirbuted ledger technology in issuance, while seven other financial services firms announced a successful test of blockchain technology for standard North American single name credit default swaps. As the number of partnerships around this technology continues to grow, in the majority of cases they are still only testing this technology rather than applying it.

The lack of end product from some of the firms coming to market could be one reason why venture capital (VC) funding started to dry up in this space towards the back end of last year. Using data on VC investments in bitcoin-related firms, which includes firms offering distributed ledger technology, there was clearly a downward trend in terms of funding in 2015. 

Investment Squeeze

According to CoinDesk, in Q1 2015, $229 million of VC money was pumped into firms offering bitcoin or blockchain technologies, compared to just $26 million in Q4 2015.

“One of the reasons why firms in this space are seeing their evaluations challenged and their funding dry up is because of the dialogue that’s going on at the moment,” says George Samman, an independent bitcoin/blockchain advisor in New York.

“There’s an ongoing dialogue about whether firms are going to be using shared ledgers or the bitcoin blockchain, with some increasingly thinking in simplistic terms that the former is good for financial services firms and the latter is bad for them. So we’re starting to see a glut of solutions being offered in the shared ledger space.

“Then on top of this, the banks all have their own internal pilot programs looking at this type of technology. In some cases, the banks might be working with distributed ledger technology companies on these programs, and in others they might not be paying a cent for this pilot program, so there’s nothing to stop them moving ahead with their own internal projects rather than using the vendors already in the market.”

The uncertainty over what type of distributed ledger technology the financial services industry will ultimately adopt, combined with the growing number of firms offering solutions around it has seemingly left many investors waiting on the sidelines to see how everything shakes out. 

“Are there a lot of companies out there that probably won’t
survive? Sure, I would suggest that somewhere in the region of 80% of the
companies that are in start-up mode right now will not be around in three to
five years, for one reason or another.”

It should be noted though that the slowdown in VC investment in these firms is actually symptomatic of a broader slowdown in technology startup valuations, with Samman highlighting a number of high-profile technology startups that endured a rough end to 2015. Many technology firms suffered down rounds last year, such as Foursquare, which saw its 2013 valuation of $650 million cut in half last year. 

Others suffered valuation compression, such as when Fidelity marked down its valuation of its stakes in Spanchat twice in the last three months of the year. There were also some disappointing IPOs, such as that of Square, which went public at $9 per share in November, well below its predicted range of $11 to $13 per share.

Consolidation Ahead?

According to Samman, this valuation is trickling down into FinTech startups, and ultimately impacting even into funding for bitcoin and blockchain companies. The result, he says, is inevitably consolidation.

“I think that the shared ledger space will probably continue to grow, but that the funding will be less than it has been. There will continue to be new entrants to the market, but these new entrants will need people with real banking expertise, and these people won’t leave high-paid banking jobs for companies that aren’t well funded,” he says.

This year has largely bucked last year’s downward trend, however, with $160 million of VC investment into bitcoin and blockchain companies in Q1. The vast majority of this funding went into just two companies. The Blythe Masters-led Digital Asset Holdings secured $60 million in funding in January, while Blockstream, a firm looking at ways to expand the bitcoin blockchain for commercial use, secured $55 million in series A funding in February. Together, these deals represent 81% of VC money into bitcoin or blockchain related companies in Q1.


“I don’t think that the tightening of venture money in this space reflects a lack of confidence in the overall technology,” says Charley Cooper, managing director at R3CEV. “I think it reflects that investors are getting more savvy and realising that while this technology has a lot of potential, it’s very complicated and therefore they have to be more thoughtful about where they decide to invest their money.

He adds: “I don’t know if this necessarily leads to more consolidation, but what I do think you’ll see is a winnowing of the field in terms of the number of startups that actually find themselves with enough backing to make a go of it.”

Cooper likens the development of blockchain technology, and the funding around it, to the early days of the Internet, but argues that the potential excess of firms coming to market in this space is good for the overall development of the industry.

“Are there a lot of companies out there that probably won’t survive? Sure, I would suggest that somewhere in the region of 80% of the companies that are in start-up mode right now will not be around in three to five years, for one reason or another. Does that mean there’s a glut of these firms right now? Yes. Is that a negative thing? Not at all. I would suggest that it’s precisely this environment – where companies are coming in and offering competing technologies – that demonstrates the value of the underlying technology and helps develop it to a point where it is fit for purpose for mainstream applications,” he says.

Building Consensus

Rather than relying on venture funding, R3’s business model has seen them bring together a consortium of over 40 banks to try and identify different use cases for distributed ledger technology, with plans to open up the consortium to buy side firms in the future.

One advantage of this model, according to Cooper, is that it alleviates some of the pressure to rush a product to market.

“If you’re backed by venture funds and you need to get a product out quickly because you’ve got to prove that you have a revenue model, then the risk you run is that you build something that isn’t fit for purpose, doesn’t meet regulatory requirements or isn’t technologically up to scratch. 

“Speed to market matters, but what matters more to the financial services community is that the product effectively satisfies their needs. With the consortium model we can take our time to evaluate solutions and potential different use cases that we can develop into a commercial product,” he says.

There are, of course, other advantages to the consortium model. The most obvious one being that with so many banks involved in the various projects being undertaken by R3, there is clear buy-in from the industry and it aligns the incentives of all these banks to make these projects successful.

Additionally, another potential benefit of this model is that it keeps the end-users of this technology involved in what the company is developing from the start. This means that the commercial, legal, technological, operational and logistical concerns and requirements of the end-users will be voiced and considered as the product itself is developed.

In terms of long-term monetisation of the business, Cooper says that R3 is very much a technology company, but stresses that the firm is able to take a very flexible approach to how it provides this technology. 

Describing what he calls an “adopt, adapt, build” approach, Cooper explains that R3 is happy to take other existing technologies and apply them to its clients’ needs, take existing technologies and tweak them until they fit clients’ demands or, if there is nothing available close to what its clients need, then it will build new technology from scratch. 

Finally, although distributed ledger technology potentially has a number of useful internal applications for banks, much of the excitement around the technology focuses on the network effect it creates. In other words, the more distributed the ledger is, the more effective it is. Having so many banks involved in such a consortium means that there is a very real possibility of developing a widely distributed ledger across a broad range of the institutional financial services industry.

6u8KhYiY5L7OAlALoZf5Csmigv3EZ0BuSnos5stqBuilding Flexible Architecture 

However, this consortium model is not without its challenges. The most obvious one that springs to mind is that with so many different voices involved in the consortium, it must be difficult to drive consensus. Different banks will have different priorities and ideas for the initial use cases for the technology. 

In contrast, firms operating in a more traditional vendor model can focus specifically on developing one use case to solve a specific need for their potential clients.

Although he acknowledges that the consortium model is not without difficulties, Cooper argues that the benefits outweigh the challenges.

He explains that all the banks are incentivised to work together in order to create a base layer distributed ledger architecture that is flexible enough to be interoperable with other types of distributed ledgers and blockchains in the long-term and in the short-term can be integrated with banks’ existing legacy systems.

“I’m not downplaying the challenges associated with this, because they are significant, but what the consortium model does is drive the participants to infuse the technology with as much flexibility as possible because everyone at the table recognises that they need to be able to plug it into their own systems,” he says.

Cooper says that although the consortium members do have different ideas about which distributed ledger use cases should be developed, they are able to pursue these various use cases simultaneously within the consortium. He says that the members naturally coalesce around the areas that are most important to their business and form working groups within the consortium to develop use cases in these areas. 

For example, he notes that some of the banks are more focused on how distributed ledgers could help make trade finance transactions more efficient, while many of the custodian banks are interested in the development of smart contracts and other banks are looking at improving post-trade workflows.

“Our plan is to see a whole host of use cases over the next 12 to 18 months,” says Cooper. “That doesn’t mean that we will end up developing every one into a commercial product, quite the contrary.

“Most of the work will go into forming the base layer and reference architecture discussion and only those use cases that address the most critical problems that the majority of banks feel is a real pain point will get developed into a commercial product. And this will be the same methodology that we use with the non-banks.”

Different Motivations

Another question for the consortium model is that when so many banks are involved, how many are committed to driving the technology forward and how many are simply cutting a cheque to stay in the loop with regards to distributed ledger developments?

With distributed ledgers being such a “hot topic” in financial services right now, on the one hand it seems likely that there are a number of firms who feel under pressure just to stay involved in any developments and on the other hand, there could be others using such a consortium as a means to feed their own internal projects.

“There are definitely leaders and followers in this space. In some cases it’s just the buck being passed down, someone gets asked by their CTO ‘what are we doing about blockchain?’ and so they go and join an initiative somewhere,” says the CEO of one blockchain startup.

While Cooper agrees that there is a range of motivations driving the firms in the consortium, he argues that these motivations are less important than their participation.

“Yes, there are some firms who are pushing very hard on this technology because they want to be the most innovative in the business and there are others that are involved because they don’t want to be left behind. And you know what? Both motivations are fine with us as long as they take it seriously, and all 42 do take it seriously. Some of the firms are being driven by their technology teams on this, others by their strategic teams and others by their business teams, but that doesn’t matter, they’re all taking it very seriously,” he says.

Another challenge related to this technology is the need to protect certain elements of the bank’s data, while also allowing enough transparency for the distributed ledger to be effective. Although this problem is by no means unique to the consortium model of R3, it is made more acute when companies are coming together to form the base architecture of any distributed ledger.

Indeed, Rob Palatnick, managing director and chief technology architect at DTCC, says that this need to balance transparency with privacy “is an area of particular concern and why ledger security is actively being investigated and researched by many vendors today”.

He adds: “We know that the security standards need discussion, along with a focused validation of the security itself. However, what makes the technology so exciting is that security is built into it. Controlled access management must be considered as this technology matures, and many experts in cryptography are closely evaluating this area.”

Zpy5l6wdsfyx5yvc4NHcHzuvCGS52WVwFYlYUxPqIndustry Disruption

The impact that distributed ledger technology could have for third-party infrastructure and utility providers, such as DTCC, is another as-yet unknown variable in this evolving business landscape.

As the excitement around this technology continues to build, there have been rumblings in the market that the eventual widespread adoption of distributed ledgers within financial services could disintermediate some of these third-party infrastructure and utility service providers. The argument being here that if all these financial firms have a shared network of information between them, then there is less need for a third party to, for example, store and reconcile trade data.

However, these third-party infrastructure providers are not sitting idly by while this technology develops. Many, if not all, of the major infrastructure providers are looking at this technology themselves and argue that it could actually hand them an even more key role in the market going forward.

“The role that we play with distributed ledgers or any new technology is not different from what we do in the traditional model, and that is we act as a connector,” says Jeffrey Maron, a managing director in Markit’s Processing division. 

Maron says that Markit currently has a number of proof of concepts underway, and plays a slightly different role in each of them. Sometimes, they provide the expertise to financial services firms that have been less exposed to distributed ledger technology. In other instances they actually provide the technology sandbox for firms to play in to help firms understand and test this technology.

“So in many cases we’re both the technology provider, as well as a source of information and knowledge for these firms,” he says.

As a neutral third party, these providers already have the connections to and the trust of a wide range of market participants, and thus the argument goes, they could be the natural choice to develop and maintain industry-wide distributed ledgers for utility purposes.

This issue of trust should not be understated. This isn’t just trust of the industry; it is also the trust of the regulators.

“Our unique ownership structure, our regulatory oversight and our role as a market utility focused on mitigating risk and reducing costs for the industry positions us to provide many capabilities to enable this technology,” says Palatnick. “DTCC has 40-plus years of experience building infrastructures that scale to the volume and performance necessary to seamlessly process transactions during market shocks and address industry-wide challenges. 

“DTCC can also provide the necessary and trusted links to existing securities processing capabilities across the entire post-trade lifecycle. Bringing trust, reliability and certainty to this platform will be critical to winning the confidence of underlying clients,” he adds.

A major migration from an established infrastructure provider and towards a new technology like distributed ledgers is a major operational risk, and not one that heavily regulated financial services firms like banks will take lightly. 

Although “disruption” is a phrase that often comes attached to distributive ledger technology, it is unclear as to whether there is really any appetite from the market to disrupt utility functions and jettison the incumbents in this space in favour of a solution utilising this new technology. 

A more likely scenario is that firms like Markit, DTCC, Swift, or even CLS, will themselves adopt this technology in order to provide the same services that they do now in a cheaper, faster and more efficient manner.

“I think it’s important to distinguish between
decentralisation and fragmentation. Because although fragmentation is a
concern, I think what we’re actually seeing is decentralisation, and that’s not
necessarily a bad thing”

Fragmentation Fears

When considering the future of the distributed ledger industry, one concern that has been raised is that the proliferation of firms offering this technology could lead to a fragmented infrastructure landscape. Samman warns that the industry could be headed towards a point where there are numerous different blockchains being operated in financial services, none of which can interact with one another. 

Similarly, in a recent paper looking at distributed ledgers, DTCC highlighted how fragmented the trade reporting landscape has become and warned that uncoordinated attempts to implement distributed ledgers could lead to history repeating itself.

This is why Palatnick argues that industry standardisation is crucial for the successful development of distributed ledger technology.

“One potential solution is to establish an organised working group representing a broad spectrum of market participants, similar to the approach that was used to develop the plan to shorten the US settlement cycle to T+2 and resolve Y2K,” he says. “As evidenced in the past, these types of groups are an effective way to forge consensus.

“There has been greater industry collaboration around blockchain technology in recent months, and this will certainly help future planning, risk considerations and architecture,” he adds. ”The ideal approach would be to build the base layers and standards in the most open, non-commercial, industry governed, regulated and guided space, and then enable vendors, consortia and groups to innovate on those layers in standards.”

One example of this collaboration occurring has been the open source code initiative organised by the Linux Foundation, the Hyperledger Project. This initiative is a collaborative effort created to advance blockchain technology by identifying and addressing features for a cross-industry open standard for distributed ledgers. So far it has secured contributions from a number of major vendors in the space, including Digital Asset Holdings and R3.

Some of the fears about fragmentation might be overblown though, suggests Maron.

“One way to look at this is to say the technology can only work if we have one solution, but that’s not the correct way to view this. People are bringing best of breed ideas to the table and we need to find ways to engage them. There are firms like Ripple that are coming up with technology that enables firms to leverage across different types of chains, then there are ideas about public chains, private chains and side chains, etc. 

“At some point this will all coalesce, but I think it’s important to distinguish between decentralisation and fragmentation. Because although fragmentation is a concern, I think what we’re actually seeing is decentralisation, and that’s not necessarily a bad thing,” he says.

SUHz6bikUxHqXSlozKfsaaGcy8T0PLHdF7fXSMwlCatalyst for Talent

The continued evolution of the fledgling distributed ledger technology industry is looking every bit as intriguing as the development of the technology itself. With so much money and interest being thrown in the direction of this technology, it is no surprise that so many technologists are trying to get into the space, and in the long-term, that is only to the benefit of the industry.

“I’ve invested in FinTech for 15 years, most of which has been super boring and nichey, to be honest,” said Matt Harris, a managing director at Bain Capital Ventures at a blockchain symposium hosted by DTCC in March. “The last five years have been more interesting, but within FinTech, blockchain has been the most interesting of all and what that means is that the best engineers want to talk about blockchain. It is a catalyst for talent and talent is really driving this thing,” 

But once again, with technologists increasingly attracted to working on developing distributed ledger technologies, it is clear that the vendor landscape is becoming more competitive and, sooner or later, the inevitable result of this is consolidation.

“Will there continue to be some additional consolidation? Yes. Are there going to be some firms that fall off? Yes. Will others successfully merge? Yes. Will there be successful joint ventures? I don’t know, but I do believe that folks that bring value to the table will be the ones that get used,” says Maron.

It will not only be the firms that bring value, but also the ones that are able to secure sustainable funding for the next couple of years that survive this consolidation.

“Let’s be real, nothing’s going to happen in a meaningful way for the first part of this year other than getting people to agree how this technology might be able to solve certain business problems, which problems to address, how we can work together, who’s bringing the right value to the table and commercially how this is going to work,” says Maron.

Despite all the excitement around distributed ledgers, it will be some time before the mainstream financial services industry moves from proof of concepts to actual widespread adoption of this technology.

Although the technology underpinning much of the financial services infrastructure may eventually be replaced by distributed ledgers, it is unlikely that there is going to be a major shift away from using third-party providers. As well as representing a major shift and operational upheaval, in many cases these firms are the best placed to offer technology and services around distributed ledgers.

Although distributed ledger technology is very much considered the “sexy” topic in financial services right now, many of its initial applications will probably occur in rather unsexy areas where it can make utility or infrastructure more efficient. 

The technology will inevitably take a significant amount of time to see widespread adoption and in the meantime there will be a natural expansion and contraction of firms selling services around it. And while it might change how some infrastructure and utility firms do business, it is unlikely to change their businesses.

Yet the promise of this technology and it’s long-term future within financial services seems more certain than ever. Expect change, but it will be a slow change.

Galen Stops

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