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Evolution Or Revolution? Distributed Ledger Technologies in Financial Services

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Evolution Or Revolution? Distributed Ledger Technologies in Financial Services Evolution or revolution? Distributed ledger technologies in financial services Anil Savio Kavuri1 and Alistair Milne2 (There are two versions of this paper: a short summary report of 16 pages plus references; the full research report of 121 pages plus references.) 1 Loughborough University and Australian National University. [email protected] 2 Loughborough University. [email protected] Evolution or revolution? Distributed ledger technologies in financial services Contents of full report 1 Introduction to the full report ............................................................................................... 2 2 Distributed ledgers: basic concepts and supporting technologies. ...................................... 5 2.1 Definitions ....................................................................................................................... 5 2.2 The component technologies used in distributed ledgers ............................................. 7 2.3 How the technologies are combined: the database ‘stack’ ........................................... 8 3 Applications of distributed ledgers in financial services ..................................................... 11 3.1 Fourteen areas of application....................................................................................... 11 3.2 Seven case studies ........................................................................................................ 38 4 Distributed ledgers: the adoption decision ......................................................................... 55 4.1 The benefits of distributed ledger technologies .......................................................... 55 4.2 Costs and benefits of adoption..................................................................................... 59 4.3 Radical versus limited adoption ................................................................................... 60 4.4 Distributed ledgers: not necessary to delivering all their perceived benefits ............. 63 4.5 Shared multiparty versus single party governance ...................................................... 65 4.6 The challenges of data management. .......................................................................... 67 5 Distributed ledgers and public policy .................................................................................. 71 5.1 The legal and regulatory treatment of crypto assets ................................................... 71 5.2 Encouraging adoption ................................................................................................... 72 5.3 Radical reform? ............................................................................................................. 73 6 Conclusions .......................................................................................................................... 76 Appendix 1: Announced distributed ledger initiatives in banking and capital markets ............. 78 Appendix 2: the legal and regulatory treatment of ‘crypto assets’. ......................................... 114 A. What are crypto assets? ............................................................................................. 114 B. Legal and regulatory classification of crypto assets ................................................... 117 C. Other regulatory concerns ......................................................................................... 119 References ................................................................................................................................. 123 1 1 Introduction to the full report Over the past five years there has been a lot of discussion of cryptocurrencies and their supporting ‘blockchain’ or ‘distributed ledger’ technologies.1 While the opportunities of ‘crypto’ as an asset class have attracted most media attention, for many practitioners and policy makers it is the technologies that are of greatest interest. Over one hundred announced projects have invested hundreds of millions of dollars applying distributed ledger/ blockchain in mainstream financial services.2 A handful of projects are reaching commercial scale. This report examines the adoption of distributed ledgers in financial services, both what has taken place to date and prospects for the future.3 Are distributed ledgers, as some suggest, a radically disruptive technology that will transform banking, insurance, capital markets and asset management?4 Or are they supporting tools, to be gradually deployed in a range of applications but without fundamentally changing the industry? Our investigation is both conceptual and empirical. We discuss the distinguishing features of distributed ledgers. This has required grappling with considerable terminological confusion. Practitioners and technologists use the terms distributed ledger, distributed ledger technologies (or DLT) and blockchain in different ways, sometimes with no precise meaning at all and on other occasions consciously departing from the ways in which these terms are used and understood by others. We provide definitions of these key terms correspond to their most common usages, but also note where usage varies. Do these definitions matter? Proponents of the application of distributed ledgers in financial services may argue that accurate definition matter less than practical application. This though masks an important practical issue, one that helps explain why there is so much confusion about distributed ledgers. There is no single distributed ledger technology, rather distributed ledgers are a ‘pick and mix’ solution using modern cryptographic security tools to address an old challenge of sharing business and operational data. Each distributed ledger is a combination of technologies tailored to the requirements for sharing data in a particular business situation. One distributed ledger solution can be very different from another. There is often little commonality between them. To make sense of this complexity, our analysis is founded on a detailed review of what is going on in practice, looking at: the many ‘blockchain’ start-ups; the work of the various distributed ledger consortia (R3, Distributed Assets, the Ethereum Enterprise Alliance and the participants in Hyperledger). We look at the application of distributed ledgers in fourteen different areas of financial services; and in a little more detail at seven case studies of more developed implementations of distributed ledgers. Our emphasis throughout is on the business and operational applications of distributed ledgers, not technical implementation. We think our analysis is long enough, without paying unnecessary attention to technical details, for example to the supporting cryptography, to the 1 Google Trends reveals a thirty-fold increase in searches for the terms “blockchain” and “distributed ledger” from January 2015 to Dec 2017, falling back a little since as the cryptocurrency prices fell from their end-2017 peaks. 2 Documented in Appendix 1. This count excludes cryptocurrency and crypto asset projects. 3 There is so much activity of this kind that we have not been able to cover all current developments, for example Facebook’s Libra project, announced in June of 2019, is not covered in this report. 4 Our focus is on financial services. There are also many applications in both non-financial industries and public administration, e.g. health records, supply chain transparency, see (Government Office for Science 2016). 2 establishment of ‘consensus’ across the multiple distributed copies of a distributed ledger or the fashionable references to ‘tokenisation’ of financial transactions (a shorthand for automation of operational processes through digital record keeping). For decision makers this is the appropriate focus: balancing the benefits of using a distributed ledger for data sharing and on the associated costs, both the one-off costs of system change and the ongoing costs of ledger governance, without getting diverted into excessive detail of the supporting technology. We do examine in detail the adoption decision: when is a distributed ledger solution business relevant? what must be taken into consideration when making the decision to adopt? We find that adoption of distributed ledger technologies is appropriate when existing arrangements for sharing of data are insufficient and the additional costs of governance and replacing legacy arrangement to support a shared arrangement are justified. We also argue that adoption of distributed ledgers is not something to be left solely to the initiative of market participants. Adoption requires co-ordination and overcoming vested interests which in turn can justify promoting adoption through regulatory initiative or other public policy intervention. Distributed ledgers may support radical improvement in the organization and structure of financial services, but in our view more radical change is only going to take place through public policy leadership. Our paper is organised as follows. Section 2 discusses the key features of distributed ledgers and what distinguishes them from other forms of databases. We offer definitions distinguishing distributed ledgers from distributed ledger technologies. Distributed ledgers are permanent, tamper-proof, sequences of data records with (i) multiple operators storing copies of the ledger and independently adding data records; and (ii) multiple users reading and proposing new data records. Their key distinguishing feature is having multiple
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