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Blockchain: An Informal Investigation of Strategic Competition for Profit Pools

If You Can't Beat Them, Join Them

First of all, a confession is due. After weeks of fretting over the futility of predicting the future of technology, I have now formally joined the high minded sport of predicting blockchain's future. That's what this blog is about, may the reader be forewarned.

W Edward Deming once said - Without data, you're just another person with an opinion. Well, he was right as usual. That said, these days, I see tons of power points full of graphs and charts and numbers from blockchain experts, who then draw conclusions from their own data that stand in direct contradiction to the data they've just presented.

So I am not going to throw a lot of data at you. I will just unashamedly lay out my (strictly) personal opinions, based on my personal experience, in my own style and English, without hiding behind any sort of selective data or interpretation.

Post Trade, Post Blockchain

I have spent much of Q4 talking to senior banking executives about payments and post trade services on blockchain and most believe mass adoption is at least five years away. I think they are right. Left to banks and large financial intermediaries, blockchain will take a long time to be adopted in most financial markets.

Here is why:

Banking May Be Ripe for Disruption but Banks are NOT Ripe for Innovation

Pre-2008, banking was a joyful and creative industry, similar to high tech today. These were the days when Blythe Masters, who now runs one of the most promising Blockchain ventures (Digital Asset Holdings), was credited rather than blamed for selling Credit Derivatives to the industry. Those were the days when as a mere SecDb minion at Goldman Sachs, I could just push code into Production and mostly live to see the consequences.

Alas, no more. Now a steering committee, an operating committee and a bugfix prioritization committee (you couldn't make this stuff up) decides on every line of code.

Banks are Betting on Technology, but not their own IT

Banking IT is now riddled with paperwork, reporting and remediation projects that run forever and produce little positive enterprise value or customer benefit. Indeed, the compliance officer has taken over, and not just in the compliance function. Even inside IT, there are multiple compliance functions such as data governance, information securitiy, IT resilience, various forms of COO, RTB, change control, internal audit; and well, tons and tons of program management and PMO.

In 2009, developers who actually know the business content of what they are working on, sit squarely inside End User Computing Functions using cutting edge data science tools such as MS Excel and MS Access. In the meantime, IT spends years and millions faithfully replicating what's in multitudes of 'requirements documents', which are frequently wrong, and immediately invalidated by a well-meaning update from any of the numerous regulators.

For innovation, this is compliance by a thousand cuts. I can only wonder if Amazon or Google would be what they are today if five types of compliance teams each ran seven types of workshops before the product shipped.

Budgets Are Drowing In Compliance

Let's be clear. Almost every bank on the street has a MIFID, BCBS, Volcker or Conduct program budget that’s individually 10 to 50 times bigger than the bank's TOTAL blockchain or innovation budget. In my estimate, the size of VC investment banks have made in blockchain technology in 2015 is at least fifty times bigger than their combined technology innovation budget. 

To make it even more interesting, a large chunk of this meagre ‘innovation’ budget has just gone into membership of one or more consortia, which leaves little for the internal IT organizations to deliver any innovation of value. If you are a blockchain developer inside a bank, generally the best you can do is exchange tokens, upload signed documents, write a hello world smart contract, write a nice blog and impress your peers and colleagues with all that you might know about this hot topic.

Even Bankers Know They Won't Be The Ones

What this 50x ratio of banks’ VC investment to innovation budget tells us is that the banks know themselves know that

  1. Blockchain will disrupt one or more markets over time
  2. Such disruption is rather unlikely to come from the banks themselves.

The Clayton Christensen Playbook

To be fair, that's how Clayton Christensen defined disruption. A disruptive technology starts as a cool piece of kit that does one thing very well for some dude with little cash, but noone with real money wants to buy it. Over time, the disruptor saves enough cash and builds enough scale to start selling to the rich dude with real money and voila, in what appears like no time, the kid's taken over the big market.   

No One Likes to Self-Disrupt

In fact, if I read professor Christensen right (the fifth time), the incumbent has little incentive to disrupt. There are managers inside each large organisation whose very comofrtable livelihoods depend on status quo, who have been successful in a familar environment and have all the reasons to keep things going, and rather few to change them.

Generally, in mature industries (which banking has alas become), innovation is that naughty baby that you wanna mollify with a pacifier, or maybe stifle with a pillow. Unfortunately, you can't do so because there's this money minded banker, working with this nerdy programmer, who's lost his job last year, joined a startup and now he's coming for yours.

Blockchain is All About Incentives

There is yet another, bigger force at play, and it's Game Theory. Incentives in short.

Assume banking is one big global oligopoly of utilities which have nicely divided up the global market in each asset class. Now each bank that sees this shiny new toy called blockchain is caught in a bind. On one hand, there is this sweet opportunity to innovate, which if successful, will lead to market dominance. On the other, it involves a truckload of work, rewiring your organisation, operations infrastructure, technology, culture, people, skills…

…and yes, did I mention that you might fail?

Yes, on the other hand, is this fear of missing out - someone else might run with the opportunity and and take your piece of the pie.

Indeed, Ms. Masters, the quintessential banker if there ever was one says, FEAR AND GREED WILL DRIVE BANKS to adopt blockchain.

Logic Is Grossly Overrated

Let me drill down a little. Not each bank has the same incentives. Investment banks would like nothing more than if they could stop paying CSDs, custodians and all manner of other intermediaries that today take a cut for providing trusted data through reconciliation. As a client of a bank, I'd like nothing more than watching a piece of my little pension disappear into these data reconciliation based profit pools. 

Yet, if you are a bank CEO, you're stuck. You probably run a great trading operation and a growing wealth management arm, but then maybe you also run a custodian shop, a CSD, a reporting service and maybe even hold some kind of an equity stake in an exchange and a clearinghouse. 

Which one of these chicks in the nest are you gonna feed and which one of these chicks are you gonna let wither away?

If you were a bird, you'd have done it already.

Be absolutely certain in your mind that in any conglomerate, the capital allocation exercise I have just described is NOT a logical exercise conducted by a strategy consultant on a spreadsheet. It's an intensely political one, often driven by WHO rather than WHAT. Indeed, economic theory has shown that capital allocation outcomes can be unpredictable inside a conglomerate, and in ways that defy all logic, nine boxes or portfolio allocation (apologies to my colleagues at McKinsey and BCG).

Innovation By A Gigantic Committee AKA the Interplanetary Council of Star Wars

Before banking technology happened to me, I spent three years at a telecommunications firm called Bell Communications Research, now known as Telcordia. One of the things Telcordia made a lot of money from was writing, selling and implementing standards.

I have written about the various types of standards in a previous blog and I will not waste (too much of) your time on standards here. Only a little. Standards are needed because they allow participants to conduct business inside a network, and they allow these networks to interoperate.

However, anyone who thinks standards arise by a nice bunch of businessmen in suits discussing architecture over coffee and cookies has not followed the history of Telecom, does not use Google or Facebook and probably not written much Java code either. 

Standards Alright, But for What Exactly?

Standards negotiation process started in telecommunications markets well after someone had already built a really useful piece of kit people were paying for and these pieces of kit needed to interoperate. On Planet blockchain, this would be a future akin to itBit's BankChain running a gold market in the US and DAH's HyperLedger already running a syndicated loans market in Europe. 

What's happening in planet blockchain is a little premature. Two significant standards bodies exist today. There's R3 with four dozen banks in a parliament sized building, working on the grand unification platform, and then there's Post Trade Digitial Ledger (PTDL) group with a more focused bunch working on specific problems in specific markets. Both of these are full of incredibly smart guys, but then no one in financial markets is NOT smart. I just think too many smart people in the same room ain't no good thing. There's almost this diminishing marginal returns to incremental smartness thing that happens... and I've seen this sad kind of magic from inside a bank for a full 11 years.

Standards Can Arise Without Consensus

All this while, focused startups with code ready to go with DVP, integration with payments platforms, deep knowledge of the microstructure of their markets and equally deep pools of focused venture capital are going for the kill. This bunch is already hiring driven bankers, compliance people, operations people and consultants for less and they have everything to play for. Further, these ventures have the EXACT same incentives as the banking shareholders - which are efficiency, profits and untold wealth. As a banker, I'd not bet any which way but I will buy options on all while these are still cheap.

Nothing boring about David, or Goliath

Will standards arise de-facto, or de-jure? If I knew, I'd invest my mortgage in the winner, but I don't. I know that someone is gonna win and it ain't everybody.

Form Follows Function

We've been through this with James Champy's re-engineering the corporation. Every discussion of innovation in financial services starts with Banks as a fact of life. All commentaries assume that there will always be banks in their current form. That's far from destiny. The bank holding companies of today are certainly different from the banks before the Glass Steagall act was repealed and the banks of tomorrow will be different too. At the end of the day, form follows function. 

Beware of the Bitcoin Crowd, That's Where the Real Disruption Still Is

When I look at who's really building stuff that can really create a vastly more efficient internet of value, it's probably not the big banks or the consorita or superconsortia. It's still the open source bitcoin and ethereum bunch working on weird futuristic things like sidechains, smart contracts, DAOs et al. The last thing I'd want to do as a government is stifle that bunch, the bunch that might make the whole system multiple orders of magnitude more efficient by fixing the internet, no less. Maybe FIXING the INTERNET is a 10, 20, 30 year project but maybe not... that's the whole point of the internet. It's faster than you think and it goes and does unexpected things everywhere.

If I Were A Regulator

Actually, I'd see Blockchain as a timely gift from Silicon Valley. I'd be a little fed up with the current banking system and looking for alternatives to reshape the industry. Before 2007, I'd have believed that the math wizards and programmers at banks know what they are doing and I, with my law and liberal arts degree should let them do it.

Since 2008, I have probably not even received a log of transactions, risk, P&L or from a bank that's accurate and on time... which'd make me question what all these smart PhDs and MBAs have been doing all these years! 

And yes, I am probably tired of making new colorful covers for the sick engine of the economy, which I don't have the tools or the budget to enforce, which do little to reduce systemic risk of the car blowing up, and maybe I want a new engine alright. Maybe this overcomplicated system of brokers, custodians, csds, exchanges and clearinghouses with all its infinitely many reconciliations and reports is simply not going to work because....

RECONCILIATION itself is the problem and that's what Blockchain is About

Maybe I want a live copy of what's going on by the microsecond so that I can figure out what's really going on and what's about to fall apart.

Alright, Get to The Point Mate!

So here we go with them bullet points alright:

1. Some markets will definitely migrate to blockchain based settlement.

2. Not all markets will migrate to blockchain at the same time. Some will migrate before EOY 2017 and some never will.

3. The time of transition to blockchain will be market specific with an early start and a long tail.

3. Low Volume, High Friction Markets Will Migrate to Blockchain First.

4. In the current regulatory environment, it's difficult for a big bank to be the source or driver of innovation in blockchain. 

5. Any regulator that wants the system to heal itself must back blockchain with all the force they can muster.

6. My bet for disruption is still on open source blockchains, particularly Bitcoin, Eris and Ethereum. Everything else is probably a simplifcation, customization or standardization.




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