Blockchain Technology -- The Hype and the Hope

TECHNOLOGY HAS THE POTENTIAL TO TRANSFORM BUSINESS TRANSACTIONS

By Shane Randolph, Opportune LLP, Houston By Jim McBride, QSTAR LLC, Houston

IMAGINE A CRUDE OIL producer selling its production directly to a refiner without any intermediaries and never knowing who the buyer is. Imagine the most common method of executing commodity derivative agreements is without a bank, exchange, or broker. Imagine a power plant purchasing natural gas without engaging a wholesale gas marketing company. The power plant simply purchases directly from the natural gas producer, but they never know from whom or where it is coming. Imagine the non-existence of wholesale and retail commodity marketing companies.

Imagine a power producer selling power directly to a consumer without an independent system operator, retail marketer, or utility. Imagine a midstream company managing multiple interstate pipeline interests without teams of schedulers. All of the scheduling is handled by a highly streamlined, ultra-efficient system where transactions are recorded on a single, trusted ledger that is shared with all parties to the transaction and which provides real time information and contingencies.

All of these transactions would be recorded as soon as the product changes hands. All of these transactions would be governed by self-enforcing smart contracts providing certainty of funding with automatic payment upon the collection of the appropriate sequence of approvals. No need for intermediaries. No need for Letters of Credit. No delays while documentation is physically transferred and reviewed by multiple parties.

Such is the hope of the rapidly developing and much talked about blockchain technology – a technology which The Economist has referred to as “The Truth Machine.” Blockchain holds the promise to eliminate the need for intermediaries; eliminate both accidental and malicious discrepancies; eliminate or significantly reduce fraud; provide immediately audited settlements; and significantly reduce the complexity and costs in conducting many routine business transactions.

Over the last 20 years, technology and the internet have radically transformed how businesses interface with their clients, employees, and other businesses. It has brought unprecedented efficiency gains and new business opportunities. Yet, despite these advancements, middle and back office functions have generally remained antiquated and slow, requiring significant human intervention. In most producer to consumer commodity lifecycles, much of the activities are essentially middle and back office functions that consolidate and organize. Within the next five to10 years, blockchain technology has the potential through disintermediation to fundamentally change middle and back office functions and generally the way business is done.

Because of the potentially disruptive impact on the financial system and businesses, all the world’s major financial institutions, most central banks, and numerous large technology companies are actively investigating and researching the potential of blockchain technology. In addition, venture capital firms are now making significant investments in startup companies focused on developing blockchain applications.

Blockchain technology, sometimes referred to as a decentralized ledger, is the backbone technology for cryptocurrencies such as Bitcoin. While Bitcoin has had a seedy history, the underlying technology, blockchain, is what has the most potential to change the way we live. Similar to the internet, groundbreaking technology is rarely limited to its original purpose.

Subsequent generations of thinkers and risk-takers tend to repurpose inventions like the internet and blockchain for the betterment of all. For example, e-commerce and social media were likely not the primary objectives when the US Department of Defense funded the development of the internet.

The core of blockchain technology is a combination of the distributed, immutable ledger and cryptology that creates trust in a transaction. One expert, Joichi Ito of MIT Media Lab, offers the observation that “the blockchain is to trust as the internet is to information.” Trust is the cornerstone of business transactions. Transactions that have a low amount of trust are inefficient, take more time, generally require intermediaries, and are more costly, as there is a concern over performance.

When transactions are executed and settled on a distributed ledger, counterparties don’t need to have an established relationship to create trust. Each participant in the transaction trusts the blockchain itself, and they don’t need to directly trust each other. This opens new avenues of customers for businesses operating on blockchains.

At a basic level, blockchain is a peer-to-peer network of computers called “nodes” that come together to create a decentralized, distributed digital transaction ledger. Through a series of steps, the transaction records on the nodes become blocks that are added to a chain. The chain has established protocols that cannot be circumvented or altered. The transaction record includes sender and receiver pseudonyms, date and time, asset type, and the quantity of the asset. This means that no one entity has control over the transactions the chain catalogues.

Access is also widespread which means that coordination of a fraudulent alteration in the chain would be virtually impossible to achieve, especially without detection. The transparency between parties and immutability of record provide the “trust” that would otherwise be ensured by intermediaries, such as banks and exchanges. However, it is done with fewer human steps that slow the process, increase costs, and increase the likelihood of clerical error. Some tasks that can take days, weeks, or months to complete, such as overseas wire transfers and loan underwriting, could potentially have same-day expediency using blockchain.

Blockchain technology will have a vast number of applications, both public and private. One of the most appealing applications will be the development of blockchain-based smart contracts. The automated, computable smart transactions are the root of what is possible with blockchain. These smart contracts can be digitally signed, computable, and self-executing. In this scenario, much of a contract could be automated with the aid of a software agent, or virtual third party.

The rules programmed into these smart contracts would allow contractual obligations to be executed only when specific actions have taken place. Again, by reducing the amount of human input needed, the process is expedited and there are fewer fees. This has tremendous potential for power, natural gas, crude, and refined product industries as independent third parties can transact without the need of intermediaries, clearinghouses, or exchanges.

There are some very exciting early ventures into blockchain and cryptocurrency development. Experts consider its development to be at about the level of the internet in the mid-1990s, but its continued development is advancing exponentially faster. Companies like OpenBazaar, Ethereum, and Microsoft Azure have provided blockchain development and applications. Nasdaq Linq is on the frontier of providing for the transfer of shares of privately held companies using a blockchain-based digital ledger.

Nearly 40 members ranging from CME Group to UBS have joined forces to form the Post-Trade Distributed Ledger (PTDL), which focuses on streamlining post-trade processing using distributed ledger technologies. Large banking, investment, payment, and technology companies are getting involved in the movement with total research investments in the hundreds of millions of dollars.

With all the possibilities, obstacles remain for blockchain transactions to become mainstream. The significant computing power required for networks is getting attention from environmental groups concerned about a large carbon footprint. Blockchain markets will also have to develop policies, procedures, and controls for compliance with financial crime regulations, such Anti-Money Laundering rules and Know Your Customer procedures. In addition, since transactions can largely be anonymous, significant tax issues could arise from the global nature of these transaction marketplaces.

Due to the exponential development rate and underlying potential, this is not a technology that a company will want to ignore. The number of big banks and other institutions conducting extensive research and development provides evidence that the mainstream adoption of blockchain technology is only a matter of time. Having contingencies planned for different levels of development and adoption will be vital for the success of financial and other institutions.

ABOUT THE AUTHORS Shane Randolph is a managing director at Opportune, overseeing risk management, derivatives, stock-based compensation, and complex securities service offerings. Jim McBride is executive vice president at QStar LLC.