Ben Jessel is a managing principal at Capco, a global business and technology consultancy dedicated solely to the financial services industry (and FIS company).
In this opinion piece, Jessel discusses how organizations are adapting to blockchain technology, and how advances in the field are creating new competitive pressures for financial markets participants.
Today, financial services companies need to have a ‘winner takes all’ mentality in order to secure a competitive advantage in the marketplace.
Just to stay ahead of the pack, these companies are now investing hundreds of millions of dollars in advanced computer and data hardware in order to shave thousandths of seconds off the time it takes to make a trade.
What complicates matters is the fact that successful blockchain innovation requires a far more collaborative approach than before, so being first to market actually involves being first with an ecosystem primed to function with other financial institutions – a far more complex undertaking.
Many in financial services are talking about this next wave of innovation that promises to deliver a profound change. In particular, blockchain and distributed ledger technology offer the ability for financial institutions to significantly improve their efficiency and reduce prices.
If successful, blockchain will remove the middlemen just like electronic exchanges brought buyers and sellers together. Ultimately, this technology has the potential to fundamentally shift the economics of certain financial markets.
Innovation – through new technology and business models – has the potential to change industries very quickly.
This is especially true in an industry like financial services where there is a great deal of capital at stake, and a small difference of a fraction of a cent in transaction costs can mean the difference between success and failure.
However, innovating is not without its risk. An incorrectly timed entry into the market and the lack of refinement of the product or service can challenge success.
The question remains whether blockchain and distributed ledger tech will have the same profound effect of innovations from the past decade. Is it a case of ‘winner takes all’ for those who are the first to adopt blockchain?
The answer from surveying those in the industry is that, in some cases, it does appear to be so, and in other areas it is less clear.
There are situations for certain institutions where there is benefit in ‘playing offense’ with blockchain and distributed ledger technology. In other areas, particularly concerning financial middlemen, blockchain represents an existential threat so profound that they need to be first to market with a defensive play that redefines their role and keeps them relevant.
Exacerbating this challenge is that proven innovations have typically worked within the framework of the financial services ecosystem – no matter how arcane it may be – rather than rewriting it. But blockchain innovation will require changing the fundamental plumbing of the financial ecosystem.
The easiest path for blockchain adoption involves rewiring markets where there is little infrastructure today, or better still, the creation of new markets that do not exist today by building networks that bridge the gap between those needing access to capital and those with the funds to invest.
In some cases, savings with blockchain are potentially so profound that adopters will want to abandon old trading venues entirely. Markets that rely on a chain of middlemen to connect them are ripe for a first-mover to take advantage and achieve outside returns.
This technique of cutting out the middlemen is the same technique that led to the rise of electronic exchanges in the 1990s. Then, it provided broker dealers with the opportunity to circumvent the slow and costly operation run by floor traders through electronic venues that could provide information on markets and the ability to change in fractions of a second as opposed to minutes.
Tripartite financing is an example of where cutting out the middleman provides a very large opportunity to capture a market through the building of new networks using blockchain technology. Today, an agent bank mediates between those who have capital and those who need it, through packaging up debt and managing the collateral obligations of the borrower.
With blockchain and smart contracts, which in essence replace financial agreements with autonomous computer code, the role of the intermediary packager becomes redundant. This could lead to large savings for a buy-side firm looking to provide access to capital at a lower cost than its competitor.
In some cases, financial middlemen, even with the advent of blockchain, will still have a role because of the complexity of the service they provide.
Here, those that will win in the market will be those that use the technology to achieve efficiency benefits to provide their service at a lower cost than their competitors.
This advantage will become even more acute in asset classes that tie up a significant amount of capital for a long period of time, such as with leveraged lending, which is a market that involves over $174bn of capital in the US alone. Transactions in this domain involve providing lines of credit to clients that are typically in the hundreds of millions of dollars in notional value.
Having capital sitting on the sidelines for buy-side institutions can be very expensive for financial institutions. In this industry, it is common for settlement to take 30 days.
If blockchain were to reduce the settlement time by a week, this would translate into several hundred thousands of dollars in savings on a $100m notional dollar loan facility.
And if barriers to adopting such a network were low, which they tend to be with blockchain, the buy-side will be quick to vote with their feet. Very quickly, millions of dollars could quickly switch from one agent bank to another just by virtue of having a shorter settlement cycle or lower administration costs.
Time for action
In the high stakes game of ‘winner takes all’, financial institutions need to formulate a well-thought-out strategy about how they choose to address blockchain. Those that are middlemen will need to use blockchain to become more efficient than their competition or shift business models so that they add value in transactions.
Those with access to capital or financial products have the opportunity to move to a blockchain-enabled network that provides a frictionless mechanism for their clients to access those products.
Financial institutions now have the tools for ‘winner take all’, the rest is up to them.
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