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Fintech’s Biggest Impact May Occur Behind the Scenes

Disruptive technologies are reforming, if not revolutionizing, the retail side of financial services. New innovations, such as payment services Zopa and Venmo, are reshaping the long-standing relationship between banks and their clients and forcing incumbents to rethink operating models and engagement strategies to remain competitive.

Although this dynamic is playing out in the public eye, there is a more far-reaching technology trend occurring behind the scenes that could have a much greater impact on the global capital markets. Fintech providers have begun to focus on transforming the industry’s back office. There is tremendous potential to replace decades-old mainframes and the patchwork of computer systems responsible for processing financial transactions that represent hundreds of billions of dollars each day in the U.S. alone.

Yet these potential disruptions create a unique set of issues and considerations. The primary responsibility of market infrastructure is to protect the stability and integrity of the financial system. Therefore, any change must be viewed in the context of its impact on the global economy and the ability of the industry and regulators to manage and mitigate risk.

Two of the more compelling technologies making headway with financial firms are cloud computing and distributed ledger technology. Both technologies provide ways to modernize key functions and processes, though they must first demonstrate they can ensure seamless execution of transaction processing while also meeting the scalability, integrity and resiliency the existing infrastructure already provides.

Despite the hype surrounding distributed ledgers, or blockchain, the smart money is betting on cloud computing to make inroads among firms in the short term. Although security concerns and regulatory compliance have left many financial institutions hesitant to use the cloud in the past, they have begun to embrace the technology as digital security on the platform has improved. A recent survey by the Cloud Security Alliance reinforces this point, finding that 61 percent of institutions are now developing a cloud strategy. The expectation is that adoption will continue to rise as the industry and regulators grow more knowledgeable and comfortable with the technology. In fact, over the next five years, cloud computing could have the biggest positive impact on the application by and cost base for banks globally.

Cloud computing offers many advantages. Perhaps the most significant is that it allows firms to innovate, test and succeed (or fail) faster and at a lower overall cost. There’s no need to buy, build and maintain expensive servers, storage and security structures when the work can be done in the cloud at a fraction of the cost. In addition, because cloud computing shifts expenses from capital budgets to operational ones, firms can quickly switch gears without having to justify a significant financial investment in hardware and infrastructure. This trend is one worth watching.

Whereas the impact of cloud computing will be more immediate, distributed ledger technology will almost certainly disrupt the back offices of banks. The time frame, however, is less certain. As Microsoft co-founder Bill Gates has remarked, we’re probably overestimating the impact that blockchain will have on the industry in the next two years and underestimating its impact in ten.

Although today’s market infrastructure is reliable and cost effective, there is room for improvement. Distributed ledgers, although not a solution to every problem, offer a once-in-a-generation opportunity to reimagine and modernize the posttrade ecosystem. Wide-scale adoption is a goal for the future, though there are many opportunities in the short term, specifically in targeted areas in which automation is limited or nonexistent.

The U.S. repurchase agreement, or repo, market is a good example. A distributed ledger can reduce the risk that exists throughout the day in this market by eliminating the multiple steps and reconciliations that are now required to clear and settle these transactions, while also giving all parties to the transaction access to the same information simultaneously. Implementing the technology in large, mature markets will require compelling evidence that it represents a significant improvement over existing systems and processes. In some cases, such as calls to replace the clearance and settlement system in the U.S. with a blockchain-based product, the technology would need to advance significantly before this goal can be achieved. The system already settles some trades in real time and can support same-day settlement across the entire U.S. equity marketplace without the need to upgrade or enhance the existing technology.

The most immediate challenge for the industry, however, is forging consensus around a core set of standards and priorities for future distributed ledger solutions. Today most firms are exploring how to leverage this consensus technology individually. An undertaking as significant as redefining the global posttrade ecosystem demands an unprecedented degree of collaboration across stakeholders. It would be a missed opportunity if the many players in this effort are unable to coalesce and, as a result, create a new and disconnected maze of distributed ledger silos based on different standards and with significant reconciliation challenges — essentially, the same issues we have with today’s infrastructure.

The Hyperledger Project, a consortium of financial institutions, technology providers and other stakeholders, is helping to bring all parties to the table to drive adoption of standards. Although herding so many interests is a challenge, it is essential to ensuring that the basic building blocks of future implementations are open source. Gaining consensus on standards and fostering collaboration among all the different players are the most immediate and critical challenge we face.

There’s no doubt that cloud computing and distributed ledgers will transform and modernize the capital markets. Whereas the greatest impact will likely occur behind the scenes in the back offices of financial firms around the world, the results have the potential to be profound and ultimately create a more efficient, safer and cost-effective marketplace for investors.

Michael Bodson is president and CEO of the Depository Trust & Clearing Corp., as well as of the Depository Trust Co., the Fixed Income Clearing Corp. and the National Securities Clearing Corp., the DTCC’s principal operating subsidiaries. He is also No. 14 on Institutional Investor’s 2016 Tech 50 ranking.