Distributed ledger technology is slowly transforming the world of financial services, aided in many cases by a new generation of rapidly proliferating digital currencies. Fintech companies have emerged to challenge incumbent financial companies in payments and other businesses, but credit card companies, hedge funds and insurers have also woken up to the transformative potential of this technology.
Banks were among the first financial companies to recognise the need to embrace digital currencies, which allow financial institutions to manage cash on distributed ledgers. Unless they learned to exploit these emerging technologies, they risked being left behind by innovative start-ups who would.
But banks were not the only ones. Some argue credit card companies look even better placed to issue digital currencies. They have pre-defined networks, including the issuers, the stores, the suppliers and the consumers. That makes it easier to create an enclosed system within which digital currencies could completely replace the kind commonly used today.
Such a move would be an important landmark in the evolution of money, a journey that some believe will culminate in the eventual demise of cash as we currently know it.
“There are fewer major credit card companies globally [than banks] and they are more widely utilized around the world,” explains Joshua Satten, director in the fintech practice at tech advisory firm Sapient Global Markets. “Issuing their own digital currencies would allow them to offer discounts for staying inside the network and offer new products around B2B supply chain financing.”
Potential for credit card companies
Both Visa and Mastercard have been looking at blockchain technology and the potential it has to transform the world of payments. Both have identified corporate international business-to-business payments as the biggest opportunity. Visa has been developing Visa B2B Connect in partnership with Chain, a blockchain enterprise company, which it believes can offer simple, fast and secure global B2B payments using distributed ledger technology (DLT). Mastercard’s version is called Mastercard Blockchain.
Technology giants like Google, Amazon, Facebook and Apple have also expressed an interest. It may not be long before corporates and fintech firms are launching their own commercialized native coins, a step a number of banks have already taken.
In the future financial institutions may compete not only on the goods and services they provide, but also the currencies used to pay for them.
The prospect conjures visions of a future where financial institutions compete not only on the goods and services they provide, but also the currencies used to pay for them. These digital currencies would coexist and compete with cryptocurrencies like bitcoin, as well as fiat currencies.
This remains some way off. Before digital currencies can gain broad public acceptance they have to be both easy to use and secure, and institutions have yet to prove they can be either at this stage.
Hedge with the edge
Hedge funds have been among the most innovative in their experimentations. Numerai, a San Francisco-based hedge fund, has developed its own cryptographic token called Numeraire, in a bid to develop artificial intelligence. The idea is that data scientists developing AI models stake Numeraire in an auction to quantify their confidence in the models. Those that prove their predictive prowess earn Numeraire, while those that don’t see their digital stakes destroyed.
Numerai also runs these predictive competitions using dollars, but believes Numeraire communicates more information about how highly users rate their own models. In either case the fund takes the best predictions and runs its own machine learning on them, advancing its own AI learning tools, which can ultimately be used to make better investment decisions.
A more traditional approach is being taken by funds like Polychain and Global Advisors, which recognise digital currencies as an emerging asset class and are investing as they would in equities or bonds. Bitcoin remains the obvious choice for many, but other cryptocurrencies are gaining ground. Ethereum – on which Numeraire is based – was launched in 2014 and in March was seeing daily trade volumes of $450m. Its price rocketed to $400 in June, making investors who bought at the start of the year a return of 5001%.
Asset management companies will be looking for digital currency experts to become their new stock pickers. And as the market matures, a range of different strategies is also likely to emerge around this asset class.
Augur has created a forecasting tool that allows users to trade virtual shares – tokens that are essentially a digital currency – based on specific outcomes. Investors earn money when they correctly predict events.
Other funds are taking a different tack. Augur, for example, has created a forecasting tool that allows users to trade virtual shares – tokens that are essentially a digital currency – based on specific outcomes. Investors earn money when they correctly predict events, which will be of interest to managers seeking to identify market trends.
“I think we will start seeing more and more novel coin applications in the finance realm,” says Geoffrey Bradway, vice president of engineering at Numerai.
Other hedge funds, like banks, are focusing on DLT’s potential to streamline settlement and reduce costs and risk, especially through the virtual elimination of counterparty risk. While it remains a prospect for the future right now, as more business is conducted on the ledger, asset management companies could reduce their own back office costs while also paying less out to service providers such as custodians.
Insurers cooperating in DLT pilot
Insurers are also getting in on the action. In October 2016 a group of insurers and reinsurers including Aegon, Allianz, Munich Re, Swiss Re and Zurich launched B3i, an initiative intended to explore how DLT can deliver faster, more convenient and more secure services for clients. While part of the justification is that it could speed up the transmission of cash, which would require tokenisation or the use of digital currencies, equally important to insurers is the exchange of information, streamlining paper work and reconciliations. It should also make it easier to conduct audits.
Participants have agreed to cooperate for the pilot project using anonymised transaction information and anonymised quantitative data. The hope is that the experience will allow them to develop standards and processes for industry-wide use, at which point companies could start creating a new generation of solutions for clients.
That approach probably sums up the whole sector’s general approach to DLT. While there are a lot of different types of projects in development or up and running, there is a distinctly experimental feel to it. Over coming years it will become clearer what works and what doesn’t.
What already seems clear is that the distributed ledger, and the digital currencies that help harness its potential for financial institutions, will have a profound impact on how financial companies deliver their services in coming years.
This article is part of the #cryptocurrencies series. In May 2017 we looked at the potential of digital currencies and distributed ledger technology for central banks. In June, we discussed what’s in it for banks.