Blockchain comes to the financial services industry

The banking community met Bitcoin with an air of hostility when the digital currency first made headlines a few years ago. Since then, sceptics have come around to the fact that Bitcoin’s underlying technology, blockchain, could revolutionise financial services. Alex Batlin, head of UBS’ new innovation lab, spoke to The New Economy about why the bank has partnered with technology companies to explore the benefits of blockchain.

How does blockchain technology work?
The easiest way to think of it is as a way of distributing decentralised data. So if you think about what banks do today, they have private ledgers for accounts, using their own proprietary software to check the business logic of any messages passed along. That task is undertaken, on average, once a day.

What blockchain – essentially the technology under the rug of virtual currency – does is speed that whole process up immensely. So first of all you have a common fabric, because you have the same software, and this allows you to effectively reconcile ledgers and synchronise them. Instead of doing this once a day you’re doing it – in the case of Bitcoin – once every 10 minutes, and new technologies could make the process faster still.

Instead of doing this once a day you’re doing it once every 10 minutes

On top of that, it’s much more than just a distributed database, because, unlike today’s world where we send what are called ‘dumb messages’, we can now send ‘smart messages’, where you embed the business logic needed to validate the transaction. So it’s almost like a distributed application where I can send a message out not only containing the details of who you want the money paid to and how much, but also the conditions under which it should be paid.

The final really interesting part of blockchain is that, just because you send a message – as it so often is with kids – recipients can ignore the instructions they’re given. Someone might choose, for instance, to accept and confirm an invalid transaction, such as double spending. In order to prevent this from happening, you, rather than resorting to a central authority, ask everyone to participate in the network and effectively re-run the same checks. Everyone votes on the result and as long as 51 percent of the voters – so to speak – are honest then it can eliminate malicious intentions.

The problem with that model, because there’s no single person voting on the issue, is that it’s really easy for someone with a fast computer to issue lots of votes. To prevent that activity, there’s a concept in the community known as the proof of work concept, and the idea is that, if you don’t have a registration-to-vote mechanism or central authority, then you effectively pay to vote. Voters will be asked to solve a complex mathematical problem, which on average takes 10 minutes, so you need enough computing power and enough electricity to have a chance of winning this lottery.

There’s no central monetary control because it’s a peer-to-peer network, meaning that, if one participant drops out, then another will make up the crowd. This means that there’s no central point of failure, and it’s actually a pretty robust system.

What benefits can blockchain bring to the banking sector?
We’ve got a number of high-level benefits that we talk about. First is that we’ve now got a new model of trust, away from central utilities and on to this distributed ledger world. Another is that it’s close to real time clearance and settlement, so our clients get much faster access to their operating assets, and reduced settlement risk and reduced cost of mitigating that risk – resulting in cheaper transfers.

Banks could potentially move towards a cheaper infrastructure by adopting this common fabric where business and regulatory logic is processed by all network participants. This gives us the opportunity to move towards shared business logic and a shared platform. Some of the intermediaries we have today could potentially move towards providing those facilities on blockchain and at lower price points, which again means greater operating efficiencies.

At the same time, we could potentially look at the effect on regulation, and the ability to monitor transactions in real-time means that we can move to reporting as a by-product of doing business, and reduce a lot of the costs associated with regulatory compliance.

The other thing for banks is that we reduce operational risks where they’re no longer relying on a single solution or single utility, so there is no single point of failure.

What about the challenges?
It’s extremely nascent technology. The development tools are really fresh and there’s very little expertise in the market. What’s more, the technology only supports a limited number of transactions and voting takes time compared to centralised systems.

You also have issues with finality, because if somebody were to take over 51 percent of the network they could in theory rewrite the ledger. Now, you can mitigate that, but ultimately it’s part of the network. However, regulators could detect what appears to be a malicious attack on the network, and, if you incorporate the right circuit breakers into this new network, you could control it.

Can you tell us about UBS’ innovation lab and the work you’re doing there?
We’ve been engaged with fintech innovation for a long time. We’ve built up a lot of experience and hopefully respect in this ecosystem, so we decided that we wanted to take our agenda further.

With Level 39 we saw an opportunity to be a part of the system and send a clear message that we want to collaborate with fintech companies. We knew that it had to be a cross-market initiative, and it felt right to position what is an inherent cross-market technology in an environment that promotes collaboration. So that’s Level 39.

We hope this will promote financial inclusion, because of the reduced costs associated with the blockchain. We’re doing a bunch of experiments; a lot of internal experiments, and some experiments we talk about publicly when we believe it helps the industry to move forwards in the right direction.

One thing that has resulted from what we’ve been doing is that we’re very much encouraging firms to take a strategic view towards the architecture based on blockchain. By that I don’t mean it takes years and years. Some technologists today, for instance, are really good at working on specific solutions that support one asset class. However, certain technologies allow you to model near enough any type of asset, and those are more interesting to us because we can potentially put many assets on the same chain. The added cost of putting these assets on the same platform is insignificant compared to the months of work it takes to create a dedicated solution for each. This way there’s so much more scope and this stops us going into a technology cul-de-sac, so we really would encourage folks to take this approach. This technology could be a game changer, so let’s try and get it right.

Why have banks decided to partner, rather than compete, with tech start-ups?
First of all, we’re doing just that. We’re partnering with fintech companies, and the reason we do that is that I think startups have the right kind of mentality.

For us, as a large bank, we cannot take the same risks that a startup can, because if we get it wrong then the impact on our clients is significant. Startups can take greater risks, but at the same time they often hit scaling issues once they get to a certain point in their product maturity. This is where we can help as well. I think them having the ability to take risks and us having the skill to take them to the next stage is a good mix. For the foreseeable future I can see this relationship working really well.