Distributed ledger technology – popularly known as blockchain – has the potential to become a massively disruptive force in financial services. By enabling ‘smart contracts' with automated post-trade processing, for example, the technology could eliminate the need for clearing houses.
Big banks and exchanges are paying attention. "On the blockchain front, [the second quarter of 2016] saw a number of banks and financial institutions globally begin focusing on proof-of-concept initiatives, moving from initial ideas to actual pilot-testing of solutions," said a report on fintech investment published last month by KPMG and CB Insights, a New York-based research firm.
Blockchain startups are exploring a wide variety of potential applications. As usual, many of their ideas will fail, while some might enjoy exponential growth and, ultimately, turn ubiquitous. To draw a parallel with the early days of the internet, it's hard to tell at this stage which firms will be Amazon or Google and which will be Pets.com.
So what will be the killer app of blockchain in financial services? I may be biased, but I would take a close look at the firms seeking to apply distributed ledger technology to energy and commodities markets.
The blockchain concept may be a natural fit for the tracking of physical commodities along the supply chain, where transfers in ownership are often still recorded on paper and fraud remains a persistent risk, as illustrated by the Qingdao port scandal in China in 2014. If title transfers were recorded electronically though a shared ledger, and verifiable by any participant along the supply chain, that could help build trust between physical market players and, ultimately, yield greater efficiencies.
If you can use blockchain to improve the traceability and fungibility of physical commodities, it would be a very important step towards the further financialisation of commodities
Jean-Marc Bonnefous, Tellurian Capital
"If you can use blockchain to improve the traceability and fungibility of physical commodities, it would be a very important step towards the further financialisation of commodities," says Jean-Marc Bonnefous, managing partner at Tellurian Capital, a London-based commodity hedge fund.
"Today only the front end of commodities trading has been financialised, in the form of electronic trading," explains Bonnefous, whose firm is also an investor in Clearmatics, a London-based blockchain startup. "What hasn't been fully financialised yet is the infrastructure. In many places it is still pretty antiquated – in the metals business, for example."
Another exciting application of blockchain is in the distributed generation of renewable energy. As more households and businesses mount solar arrays on their rooftops, turning themselves into mini-power plants that supply energy to the grid instead of just buying it from their local utilities, it becomes more challenging to track payments. Blockchain-based software, combined with ‘smart metres' that track the flow of electricity in and out of each home or business connected to the grid, offers a solution. It sounds far-fetched, but a pilot project along these lines is already up and running in New York City, allowing homeowners to pay for the purchase of green energy from their neighbours.
Over-the-counter commodity derivatives are another potential sweet spot for blockchain. Banks such as Barclays have explored the use of smart contracts for interest rate and equity derivatives. They might consider trying them out in OTC commodity derivatives, which are largely not yet subject to regulatory central clearing mandates. The lack of potential resistance from clearing houses, as well as the smaller size of the markets overall, might make it easier to roll out smart contracts in OTC commodities than in other asset classes.
Some might question whether commodities – the oldest asset class around – will really be the sector where blockchain takes off. I would advise such sceptics to look at a little company called Ice. When it started out in the 1990s, it was a minor US electricity exchange. But thanks to a strategy of ruthless technological innovation and disintermediation, Atlanta-based Ice is now a global giant that owns, among other things, the mighty New York Stock Exchange.
It is impossible to say whether any small fintech firms today, tinkering with blockchain applications in commodities, will be the next Ice – but ignore them at your peril.