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Cryptocurrencies, Blockchains and the Future of Financial Services

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First presented at an AFA panel on January 4, 2016 in San Francisco: http://www.afajof.org/details/page/8357781/2016-Meeting-Program.html

Notes and references for the slides: http://www.ofnumbers.com/2016/01/06/afa-presentation-cryptocurrencies-blockchains-and-the-future-of-financial-services/

Copyright 2016 R3CEV, All Rights Reserved.

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Cryptocurrencies, Blockchains and the Future of Financial Services

  1. 1. Private & Confidential AFA Panel 2016 Cryptocurrencies, Blockchains and the Future of Financial Services
  2. 2. R3: AFA Panel The hype surrounding blockchains has recently “jumped the shark”
  3. 3. R3: AFA Panel The topic is now broad enough that it has something for multiple academic interest groups
  4. 4. R3: AFA Panel Financial researchers may find the non- cryptocurrency side to be of interest – In what ways can cryptographically-secured transactions utilizing shared ledgers change how the middle and back offices operate? – If bilateral transactions can now take place atomically, without a third party, what impact could this have on traditional reconciliation processes? – What advantages and disadvantages would faster clearing and settling provide in the – for example – OTC derivatives marketplace? – Real time confirmations to improve intraday capital allocation per trade? – Real time settlement in controlled rollout to reduce messaging costs for delivery? – Lower cost of asset liability management through improved commercial paper and repo?
  5. 5. R3: AFA Panel Economists may find some untapped research into the cryptocurrency angle – [Note: today nearly all cryptocurrencies are effectively public goods] – The long-term sustainability of public goods such as Bitcoin and Ethereum (e.g., a public blockchain largely relies on seigniorage subsidies) – Coordination/collective action problems of development, governance and “upgrades” – The preponderance of users to simply “hoard” (or “hodl”) the native currency instead of utilizing it as a daily medium-of-exchange • (e.g., once ‘long-chains’ and arbitrage are accounted for, relatively low on- chain velocity)
  6. 6. R3: AFA Panel Trade-offs when designing systems - If Satoshi Nakamoto had wanted to build shared ledgers for financial institutions, it would not look at all like Bitcoin does today - Many design characteristics that are needed in certain environments and unneeded in others - For instance, if all participants on a network are known and trusted due to legal contracts and cryptographic signatures, then there are different security parameters to design around (e.g., POW is unneeded)
  7. 7. R3: AFA Panel Trade-offs cont’d - For public blockchains: while gaining censorship-resistance through global energy-based “scratch-off-puzzles,” in the case of Bitcoin, one trade-off comes in the form of probabilistic settlement - That is to say, given an economic incentive, no on-chain settlement on a public blockchain is 100% final due to potential block reorganization attacks
  8. 8. R3: AFA Panel Probabilistic settlement finality: not helpful “Directive 98/26/EC is the Settlement Finality Directive that seeks to minimise systemic risk by ensuring that any payment deemed final according to the system rules is indeed final and irreversible, even in the event of insolvency proceedings. If this definitive finality were not the case, the insolvency of one participant could undo transactions deemed settled and open up a host of credit and liquidity issues for the other participants in the payment system. This translates into systemic risk and undermines confidence in all the payments processed by the system. Thus, by ensuring definitive settlement, the concept of finality fosters trust in the system and reduces systemic risk. This makes it one of the most important concepts in payments. As a result, it is a concept applied to all clearing and settlement systems, including for instance settlement and high-value payment system Target2 and bulk SEPA clearing system STEP2.”
  9. 9. R3: AFA Panel Regulated financial industry has spent past 20 years trying to create definitive settlement finality - The trend over the past two decades through legislation such as Dodd-Frank and EMIR has been around the goal of reducing and removing risks and increasing stability in the clearing and settlement process - By trying to (re)add probabilistic finality back into the process, cryptocurrency-based distributed ledgers may be a non-starter for adoption and regular use by regulated financial institutions – The issue is further compounded in the cryptocurrency ecosystem in that validators (colloquially referred to as “miners”) in the event there is a problem do not have end-user license agreement (EULA), terms of service (TOS) or service-level agreement (SLA) for guarantees • Yet if a SLA is created, then you now have trusted parties using an untrusted network, creating a “permissioned-on-permissonless” situation; might as well use a “permissioned network” in that case
  10. 10. R3: AFA Panel Changing directions
  11. 11. R3: AFA Panel Evolving marketplace / divergence - Based on public announcements, external investment in cryptocurrency-specific startups showed a marked decrease in 2H 2015 with almost nothing ($~4 million) raised in Q4 2015 - Instead, venture funding has for the time being moved towards non- cryptocurrency distributed ledger startups focused on building tools and applications for financial institutions
  12. 12. R3: AFA Panel
  13. 13. R3: AFA Panel
  14. 14. R3: AFA Panel R3 is a commercial fintech company - Designing a shared ledger fabric that is built for purpose and customized for regulated financial institutions - In looking at the existing landscape the past two years, none of the available off-the-shelf technology met both the functional and non- functional requirements - For instance, a lot of the existing tech is based on forks of cryptocurrencies which again, were designed for specific environments that regulated financial institutions do not operate in
  15. 15. R3: AFA Panel Open research questions for the new side of the industry - When designing new financial infrastructure, how to manage the trade-offs of scalability and privacy (e.g., confidentiality of transactions)? Is there a “silver bullet?” - How much does “in-sourcing” of the reconciliation process actually save overall? (e.g. how many bps can be saved?) - When does definitive settlement finality occur on a shared ledger? - How to build a shared ledger system in which governance is still not fully centralized from nuts to bolts?
  16. 16. R3: AFA Panel Fedcoin / State-issued digital currency Fedcoin by JP Koning (2014) Fedcoin: On the Desirability of a Government Cryptocurrency by David Andolfatto (2015) A Central Bank “cryptocurrency”? An interesting idea, but maybe not for the reason we think by Richard Brown (2015) Which Fedcoin? by Robert Sams (2015) Fedcoin—how banks can survive blockchains by Robin Winkler (2015) *Centrally Banked Cryptocurrencies by George Danezis and Sarah Meiklejohn (2015)
  17. 17. R3: AFA Panel Across the street
  18. 18. R3: AFA Panel Questions or comments? tim@r3cev.com

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