Game Changer

Blockchains = game changer.

Imagine with me, as you read this post.

I predict people will use blockchain technology to regain control of our online identities and the security of our personal data. Companies will use it to speed up cash conversion cycles and optimize supply chains—and to solidify the security of critical IT infrastructure. Blockchain technology will automate large swathes of the roles played today by lawyers, auditors, accountants, and professionals who handle operations, claims administration and regulatory reporting. The financial sector will be fundamentally different—better, faster, cheaper and safer. And—here’s what the nerdy lawyer in me finds most exciting—it will restore property rights to the rightful owners of stocks & bonds, bank deposits, and real property.

Blockchain technology is a game-changer. It will be implemented slowly at first, and then very fast.

1. What Is Blockchain Technology?

A blockchain is a new form of database technology. It allows a network of computers to share a list of database records, each of which refers to previous items on the list so that the database becomes “immutable” (i.e., once the network agrees to add a record to the list, it cannot be changed). The network uses a pre-defined method for its computers to reach consensus about the latest version of the database, so that its users do not need to reconcile their own versions. Portions of the data will probably be encrypted.

So, a blockchain is really just a new form of database that’s more secure, resilient, efficient, and auditable than traditional databases. All users see the same data at the same time.

Smart contracts are self-executing agreements, whose terms and conditions automatically execute on a blockchain when certain triggers are met. They could automate simple functions that today involve multiple steps, people and parties. I think of smart contracts as “if/then” actions that computers take when a condition is met. Consider, for example, a bond that has a coupon payment due on June 30th. On June 30th, a smart contract would simply self-execute: if today is June 30 and if the bond issuer has money in its bank account and if authorizations are in place, then send the coupon payment to each bondholder’s bank account. The process would be much faster and involve fewer people, fewer mistakes, less time and lower cost than today’s system.

Delaware’s governor just announced it is building the technical and legal infrastructure for companies incorporated in Delaware to use smart contracts for various corporate actions. Someday, lawyers will draft code instead of prose!

2. Where Is Blockchain Technology Being Applied?

Bitcoin was the first application of blockchain technology. Dozens of next-generation projects are underway—such as building a ledger for all parties in a financial market to share (e.g., for syndicated loans, stock loan, repo, private securities); a new way to record the ownership and transfers of physical property such as real estate, fine art and precious stones; a new way to permission digital rights; and a new way for local farms to manage shares of community-supported agriculture (CSA) cooperatives. This list barely scratches the surface of the transformation already underway!

And, most importantly, multiple central banks are studying the technology as a possible upgrade to payment systems (examples: England, China and others are studying, and Barbados has already started a project, with the full backing of its government).

3. Un-Hackable?? Corporate Boards, Take Note of This

Blockchains are distributed systems, which means they are radically different—and harder to hack—than the centralized “hub and spoke” architecture used by nearly all enterprise IT systems today. In standard IT architecture companies spend fortunes to build supposedly impenetrable perimeters around their data, which is generally not encrypted and is maintained in centralized data centers. This means if a bad actor breaches the security perimeter, its access is probably widespread. Because perimeters have proven easier to breach than they should be, almost daily we read about major data breaches. The SEC is putting pressure on the boards of publicly-traded companies to escalate IT security to board-level oversight.

Blockchains are a completely different IT security model. On a blockchain, data is decentralized, may be encrypted and often hides in plain sight. Today, most data is centralized, unencrypted and stored behind a possibly-penetrable perimeter.

Hackers have tried and completely failed to break the Bitcoin blockchain—thus far. Yes, hackers have broken companies built on top of the Bitcoin blockchain (such as the highly public Mt. Gox failure in 2014), but they have not broken the Bitcoin blockchain itself. Seven years since its inception, Bitcoin’s blockchain stands as testament to the superior IT security of distributed systems.

4. How Can Companies Benefit from Blockchains?

For companies, blockchains could:

• Speed up cash conversion cycles. Imagine this: at the very moment a manufactured widget comes off the production line, it’s registered to the company’s blockchain and a smart contract simultaneously sends an invoice to its customer—shaving time off the company’s DSO (days sales outstanding). If the standard payment date is T+60, the manufacturer could actually receive the cash on day 60 instead of day 61 or 62 because payment systems could operate on blockchains to offer real-time settlement of payments anywhere in the world.
• Free up working capital. Faster payment cycles would not only speed up cash conversion cycles, but they would reduce the amount of cash that banks require companies to keep on deposit. For large companies this isn’t an issue, but for non-investment grade and small companies it very much is an issue—and that trapped cash is expensive capital for the company. Faster payment cycles could free billions of trapped cash for other uses.
• Improve visibility into cash, inventory, supply chains. Corporate treasurers could have perfect visibility into the company’s cash 24/7/365, instead of today’s opacity stemming from the multiple hops among multiple parties that moving cash internationally entails—even for intra-company transfers! Same is true for inventory and supply chains, which could operate among key customers and suppliers to improve efficiency.
• Simplify securities issuance and investor communications. Blockchains could substantially reduce the friction costs of issuing securities and syndicated loans, as the function of multiple parties in the process (e.g., trustees, transfer agents, administrative agents, custodians, exchanges and broker/dealers) could be fully automated or consolidated away.
• Boost visibility into who owns securities. Publicly-traded companies would benefit from access to a truly up-to-date registry of securities owners. This would enable tracking whether a hostile or activist investor is building a position in the company, and would prevent errors in corporate actions such as voting, stock splits and payment of dividends and coupons on outstanding securities. Private companies would benefit from automated management of capitalization tables, which could facilitate secondary market liquidity in private securities.

5. How Can People Benefit from Blockchains?

You don’t own what you think you own, technically speaking. Blockchains could fix this.

Blockchains would permit you to own a direct property right in your assets—your home, your bank account, and the stocks and bonds in your brokerage account.

Here’s why. Ponder whether you truly own your home when your ownership is subject to proper recording of your deed by your local registrar (where mistakes and fraud can happen), and subject to liens (aside from your mortgage, your local government could attach a lien for unpaid property taxes without your consent. Mistakes and fraud can happen here, too). The registrar, not you, has the final say. The same is true for your car. If property ownership were recorded on a blockchain, you—not a third party—would have control over your property rights.

As for your bank, when you deposit money into your bank account you no longer own it. You’ve lent it to your bank, which means the bank owes you an I.O.U. You no longer own a property right in your money, but instead own a contractual right to be paid back by your bank (or by the FDIC, if your bank fails). Legally, your bank can lend your money to your neighbor, hoping you don’t show up to withdraw your money before your neighbor pays it back. In the timeless words of “It’s a Wonderful Life’s” George Bailey, “You’re thinking of this place all wrong, as if I had money back in the safe…The money is not here…your money is in Joe’s house…and the Kennedy house…”

The securities industry has a similar legal structure. Probably what you own in your brokerage account is not actual securities, but instead a type of I.O.U. called a “ securities entitlement ”(unless you possess the paper certificates). The legal owner of an estimated 99% of publicly-traded securities in the U.S. is a company called Cede & Co., which is a nominee of the Depository Trust Company (DTC).

Huh? Here’s how it works, using standard language from an actual SEC filing for a bond offering (called a prospectus): “Neither we [the issuer], the trustee under the indenture nor any paying agent have any direct responsibility or liability for the payment of principal or interest on the notes to owners of beneficial interests in the notes.”

Really? The issuer of a bond doesn’t owe anything to the person who buys the bond? Keep reading.

The prospectus further explains, “Under the book-entry format, the trustee will pay interest or principal payments to Cede & Co., as nominee of the DTC. DTC will forward the payment to the direct participants, who will then forward the payment to the indirect participants or to you as the beneficial owner. You may experience some delay in receiving your payments under this system.” In other words, the issuer’s obligation is not to pay the bondholder, but instead to pay Cede & Co., which is then obligated to forward the payments to the DTC’s various participants (such as broker/dealers), which are then obligated to forward the payments to you.

This complex-web-of-a-market-structure evolved for historical reasons, and it works well most of the time. But it introduces unnecessary risk. And it’s expensive and slow.

For these reasons, it’s no accident that most of the early investments into blockchain technology are in the securities industry—where blockchains could restore actual ownership of securities to people who think they already own them, while also addressing the risk, cost and delay problems.

Henry Ford once said, “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” His remark is as relevant today as it was in 1937, but blockchains finally could render it a relic of history.

Blockchains, indeed, are a game changer!