A cryptocurrency fit for Wall Street

Rand Paul loves to present himself as a political pioneer. This week, however, the Kentucky senator and darling of the Tea Party is carving out new frontiers in finance. Announcing a 2016 presidential bid on Tuesday, he said he would collect donations via bitcoin. That makes him the first US politician to raise funds using the cryptocurrency. The move is likely to be wildly popular with his libertarian supporters, given the Republican party's deep suspicions of fiat currency and the US Federal Reserve.

But there is another bitcoin saga that investors should watch. Behind the scenes Wall Street financiers, too, are embarking on market experiments - not in relation to the retail payments or donations with which bitcoin is normally associated but rather the wholesale financial world. Notably, initiatives are being launched to use bitcoin for back-office financial markets settlements. And, while they are at an early stage, they could become important; not least because they are attracting support from wealthy investors.

To understand what is going on, think for a moment about the six-year-old bitcoin technology. Cryptocurrencies are often described in popular culture, and by Mr Paul's Tea Party followers, as "electronic money". But it is better to visualise them as financial ledgers - a public record book that keeps track of how many units of the currency each user's bitcoin "wallet" contains.

The ledger is mathematically signed in a way that prevents unauthorised doctoring. To own a bitcoin is to possess a secret code that identifies you as the holder of a particular wallet, to whose contents the public ledger (or "blockchain") attests. Trust in the system is created not by a third party (a central bank, say, as with official currencies) but by a type of cryptography. This can make bitcoin a store of value (albeit a lousy one recently; the price has roughly halved in the past 12 months).

But the cryptoledger can also be used to make financial transactions through blockchain technology, which has three notable features. First, in theory a blockchain can execute transactions instantly. Second, blockchains can also perform transactions anonymously. Third, transactions can occur without the need to use third parties, or pay fees to a bank or clearing house. That is because the "cost" of running the bitcoin network is borne by the anonymous owners of servers that connect computer code in exchange for receiving new bitcoins as the system expands (this is known as "mining").

These features make the system attractive for retail-style trades and money transfers, legitimate and illicit. But they could theoretically be useful for financial markets. Bankers often say they are at the cutting edge of innovation, but many of the systems they use are lamentably old-fashioned. It can take days, and significant fees, to settle trades in loans or derivatives. That makes the system ripe for disruption.

And some names are already jumping in. Last month, Blythe Masters, the former JPMorgan banker, unveiled a company called Digital Asset Holdings to develop bitcoin-based settlement systems. Don Wilson, a Chicago markets luminary, and Sunil Hirani, a derivatives and exchanges veteran, are also working with the company. Separately, JPMorgan Chase has applied for a patent for a technology that sounds similar to bitcoin; and patents are pending from other banks and financial groups.

It remains to be seen if these initiatives succeed. One obstacle is that the stance of regulators is unclear. Another is that the bitcoin name carries stigma because the currency has sometimes been used by criminals. Then there is the issue of anonymity. DAH says it wants to provide much-needed transparency for bitcoin. This will be hard in a system organised by anonymous computer scientists - unless DAH itself becomes a third-party intermediary and charges fees, in which case part of the attraction of bitcoin disappears.

Such problems do not deter the enthusiasts; after all, they point out, most financial innovations appear unlikely to take root at first. When people such as Ms Masters developed credit derivatives three decades ago, for example, they seemed truly bizarre.

So perhaps the real lesson for investors is that the focus on "innovation" is changing: in an ultra-low interest rate world, the idea of creating financial products looks less exciting. It is boring back-office technology that is the new innovation frontier. Consider it another consequence of the peculiar post-crisis financial system - or, as Mr Paul's supporters might argue, an era when money is so distorted that normal assumptions are turned upside down.

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