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Blockchain: The Technology and its Impacts on Commodities Trading February 28, 2017 Presented By: David T. McIndoe, Eversheds Sutherland (US) LLP Cheryl I. Aaron, Eversheds Sutherland (US) LLP Kevin K. Batteh, Delta Strategy Group Association of Corporate Counsel www.acc.com 2
Topics What is Blockchain? Key Technology Developments Potential Impact on Commodity Trading Current Regulatory Developments The Next Big Thing? 3
What is Blockchain? 4
Modes of Description The Uses of Technology q Car transportation; sport; project style or status, etc. q Blockchain medium for effecting transactions and creating and maintaining related records The Systems that Make Up the Technology q q Car engine; brakes; electric; cooling, etc. Blockchain computer science; encryption; information technology 5
Blockchain Defined Blockchain is a form of Distributed Ledger Technology ( DLT ) q q A decentralized database On a peer-to-peer network That maintains a ledger of records arranged in data batches called blocks, and In which each server (or node ) must validate transactions in order to reach consensus It may be easier to comprehend Blockchain and DLT by seeing what they do and how they work 6
Blockchain Transactions ú An operation that cannot be further divided and that works or fails as a complete unit, but never partially ú Ex: purchase and sale with delivery vs. payment Hashes Bruce Arena will lead the US MNT to a World Cup victory! Algorithm Fg300fki789 90llk88s29g
Blockchain Merkle Tree Top Hash Hash 0 Hash 1 Hash 0-0 Hash 0-1 Hash 1-0 Hash 1-1 Trxn 1 Trxn 2 Trxn 3 Trxn 4
Blockchain A Public Key is an address on the blockchain (a long, randomly generated string of numbers) A Block Top hash is incorporated into the next block
Before DLT Counterparty trust is paramount for efficient and effective trade execution and settlement. Transaction Events Onboarding Negotiation Execution Confirmation Collateral Exchange Reconciliation Trade Reporting Recordkeeping Amendments Testing Transportation Storage Settlement Payment Hurdles and Risks Inconsistent Terms Fraud Failure to Pay Failure to Provide Collateral Failure to Deliver Insolvency Disputes Testing Errors Performance Errors Disasters
Before DLT Trust is placed in intermediaries to facilitate trade execution and settlement. Intermediary Roles Shifted to Intermediaries Onboarding Negotiation Execution Confirmation Collateral Exchange Reconciliation Trade Reporting Recordkeeping Amendments Testing Transportation Storage Settlement Payment New Hurdles and Risks Related to Intermediary Fraud Mistakes Theft / Conversion Insolvency Disasters Lesser Degree of Care (in practice)
DLT Idealized A Peer-to-Peer Network A Node = Individual Server Each node has an entire copy of the database (with records of all of the transactions) which the node continually updates and reconciles with each other node in the network. The result is a distributed ledger.
DLT Idealized A 1. Digitally signed transaction initiated 2. Transaction sent to miner who verifies transaction 3. Transaction is broadcast to all connected nodes as a block 4. Network accepts transaction if data is valid 5. Principal receives the transaction
DLT Continued Advantages of DLT: ú Weaves together functions of several intermediaries - E.g., collateral management and reporting ú Continual verification and reconciliation - Prevents fraud - Protects and maintains data - Creates a Golden Ledger ú Removes problem of infinite reproducibility ú Can create contracts that have self-execution functionality ú Regulator potentially can pull information in lieu of parties reporting it
DLT Permission A blockchain can be: ú Permissionless and open (e.g., digital currencies); ú Permissioned, run by a trusted intermediary and accessible only to those with the necessary keys; or ú A hybrid of both (built on public DLT infrastructure but with technology for permissioned networks)
Key Technology Developments
Bitcoin Bitcoin is a digital currency or cryptocurrency that uses a public blockchain as its underlying technology ú No intermediation ú No central bank ú Created and held electronically Bitcoin is currently the best known use of blockchain CFTC deemed Bitcoin as a commodity
Smart Contracts A smart contract is: ú A digitally signed, computable agreement using blockchain technology Key attributes of a smart contract: ú Self-executing ú Real-time self-valuations ú Self-reporting ú Automatic margin calculations and payments ú Automatic termination on counterparty default 18
Recent Developments Most active sector in blockchain development: banks and stock exchanges ú 14 out of 30 top banks engaged in blockchain proofs-of-concept Cross-industry consortia and partnerships also playing a large role in blockchain development and standardization ú Hyperledger Project ú R3 ú Project ConsenSys 19
Blockchain: Recent Developments Overstock subsidiary t0.com ú Settlement platform with a goal of settling securities transactions instantly ú Recently approved by the SEC to issue public bonds via blockchain Australian Stock Exchange ú Working with Digital Asset Holdings to completely replace its clearing system with a blockchain alternative DTCC ú Exploring new technology to improve securities settlement and other projects Digital Asset Holdings ú Created a Smart Contract Alternative with privacy optionality
Blockchain: Other Industries Developments Payment Systems ú MasterCard: blockchain-based APIs Music Industry ú Royalty payments; selling music directly to fans Real Estate ú Sweden and Georgia land / property registries Insurance ú Asset micro-insurance for sharing economy Healthcare ú Blockchain-enabled platforms for data storage and verification
Potential Impact on Commodity Trading
Potential Uses of Blockchain In both physical and financial trading, DLT has the potential to perform principally five functions: ú Fraud Protection ú Disintermediation ú Record Retention ú Smart Contracts ú Regulatory Monitoring 23
What Blockchain Will Likely Not Do Perform Negotiation ú Though may lead to further standardization Resolve Disputes Abate Certain Risks ú Performance ú Some credit risks ú Change in law
Disintermediation AMC / KYC Execution Confirmation Collateral / Exchange Reconciliation Trade Reporting Life Cycle Events Settlement
Commodity Trading Qingdao port scandal ú Evidence of the need for reform Wells Fargo / CBA cross-border cotton shipment ú First commodity transaction via blockchain Other potential uses: ú Distributed Smart Grid (houses can generate and sell their own electricity) 26
Supply Chain Management Every participant can input and track materials in real time Single source of shared truth (golden ledger concept) Smart contracts can trigger events that indicate success or failure Trade settlement can occur in seconds 27
Derivatives Trading Blockchain technology may disrupt but not wholly replace the role of central counterparties ( CCPs ) The following CCP roles may be performed by DLT: ú Contract valuation ú Variation margin payment settlement ú Initial margin calculation and custody ú Novation / netting ú Close-out on default DLT may transform and revive the OTC derivatives market by providing a transparent alternative to CCP trading
Current Regulatory Developments
Blockchain Regulation U.S. Currently, federal regulations and enforcement actions relate to bitcoin, not really blockchain CFTC ú CFTC Technology Advisory Committee meeting ú Acting Chairman Giancarlo: regulators should avoid undue restrictions on blockchain innovation ú Bitfinex - $75K settlement for bitcoin exchange for failure to register as an FCM SEC ú DLT Working Group ú FinTech Forum
Blockchain Regulation International EU ú ESMA Discussion Paper ú EU Parliament: voted to take a hands-off approach toward blockchain tech regulation United Kingdom ú FCA Regulatory Sandbox ú Blockchain-based social welfare payments Central banks are exploring blockchain technology ú ú ú ú Monetary Authority of Singapore: testing its own digital currency Reserve Bank of India: encouraged banks to develop applications for digital currencies and DLT Bank of Canada: running experiments on interbank payment systems using DLT Central Bank of Philippines: stated that it is considering how to regulate digital currency exchanges
Potential Regulatory Implications Positive regulatory implications: ú Simplification of data records - Single golden record to which the regulator can be granted access ú Transparency / immutability - All network participants (including regulators) have access to data in real time - Data cannot be altered or deleted - Recordkeeping and reporting are automatic and will not require separate processes - Efficient AML / KYC compliance Negative regulatory implications: ú Uncertain regulatory landscape ú Need to make rules technology-neutral to accommodate blockchain
The Next Big Thing?
Blockchain: What the Future Holds Heard at the SEC FinTech Panel on DLT: ú Adoption on a grand scale coming soon ú Astonishing and new technology ú Compared to other major market disruptions - Charles Schwab (discount broker, 1975) - ebay (garage sales and swap meets, 1995) - PayPal (electronic money transfer, 1998) - Napster (peer-to-peer music file sharing, 1999) World Economic Forum year-long study concluded that: ú DLT will fundamentally alter the way financial institutions do business and ú DLT will become the beating heart of the finance industry
Blockchain: What the Future Holds Potential for failure: will the technology live up to the hype? q q q q q Security concerns (hacking, bugs DAO Attack) Industry participants need assurance about transaction anonymity and privacy Cost savings and efficiency need to make initial investment worthwhile Collaboration and standardization are necessary in order for DLT to be widely adopted Regulatory contradictions or ambiguity could hinder advancement of the technology 35
Questions?
Thank You David T. McIndoe 202.383.0920 davidmcindoe@eversheds-sutherland.com Cheryl I. Aaron 202.383.0917 cherylaaron@eversheds-sutherland.com Kevin K. Batteh 202.547.3035 kbatteh@deltastrat.com 37
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