Rather than being lauded for its elegant mathematical model, bitcoin was, up until fairly recently, in danger of becoming more notorious for its wildly volatile price fluctuations, collapsing exchanges and links to the wild west of the drug and guns trade. Established banks, for the most part, appeared to be steering well clear of the cryptocurrency. See also: what is Blockchain?

Fast forward just a short time, however, and some of the biggest players are now openly discussing their use of bitcoin, or more accurately, its underlying technology - the blockchain.

© iStock/Tim Arbaev
© iStock/Tim Arbaev

From Deutsche Bank to UBS, which opened a blockchain innovation lab in London earlier this year, to Barclays and Santander, the world's largest banks have revealed they are testing the increasingly popular distributed ledger technology. This means striking partnerships with startups, creating proof-of-concepts and even pilot programmes to see how the blockchain can keep them at the forefront of fintech innovation.

So why the change of attitude?

The simple answer appears to be that banks, startups and even the regulators have become more attuned to the potential of the blockchain and distributed ledger systems. For the banks this involves adapting the technology at the heart of bitcoin transactions to their own needs, opening up a number of intriguing possibilities.

"The distributed ledger is very elegant way to solve financial problems," says Julio Faura, head of innovation at Santander.

"It could mean payments that are much faster: today international payments can take days, this could take minutes or even seconds."

"We believe that [distributed ledgers are] a fundamental innovation which can help run finance ledgers and certify transactions in a much more efficient, faster, and more transparent way. That should lead to great opportunities in terms of cost cutting and also simpler and less invasive regulation and supervision."

What is the blockchain?

Blockchain technology has underpinned bitcoin transactions since the technology was first published in a 2008 white paper, by Satoshi Nakamoto, and released as open source software the following year.

The blockchain has since been described as the 'internet of value'. It uses each node - or computer - on a decentralised public network to achieve a 'distributed consensus' of who owns what. It is, to a certain degree, like a crowd-sourced record book that verifies, processes and notes down each value transfer. In the case of bitcoin this allows the network to verify ownership of units of the cryptocurrency following each transaction .

However, some of the properties of the bitcoin blockchain which attracted people to it in the first place - such as the anonymity of those on the network, and the ability to avoid middlemen such as banks - have put it at odds with the traditional financial sector.

Now, though, the underlying principles are being applied to some of the functions performed by banks.

How are banks using the blockchain?

One clear benefit is in international payments, which "remain slow and expensive", according to a report by Santander and Oliver Wyman, which said "significant savings can be made by banks and end-users bypassing existing international payment network".

Modernising archaic payments systems means enabling faster, cheaper and more transparent transactions, not to mention keeping the regulators happy thanks to better transparency.

This has benefits for the customer too, says Frank Schuil, founder of Safello, a startup currently working on a bitcoin-related proof of concept with Barclays.

"What is interesting is that it is enabling people in countries that have no stable currencies, that have no easy access to banking, to now to be part of a global financial system," says Schuil.

"So [for the big banks] it is also part of the customer of tomorrow and how the millennials in the western economy and those in other countries that are hard to reach with existing infrastructure, and how can they tap into that market."

But payments are not the only use case. Startups such as Eris and Ripple claim that public ledgers can be applied to almost any business process, with agreements or contracts between parties recorded on a blockchain.

"We are looking at international payments, then we are actively the potential use cases with the smart contracts - so things like syndicated lending, settlement of different financial instruments," says Faura.

These 'smart contracts' can act as a verification for all types of transactions and value exchanges, with the potential to streamline complex back office processes carried out by banks, potentially saving between $15-20 billion (£10 billion to £13 billion) per annum by 2022, according to the Santander report.

Celent analyst John Dwyer says distributed ledgers will drastically reduce the duplication of effort in part of the finance sector: "The ability to move capital in a very, very frictionless way presents enormous financial benefits to the financial community," he says.

"That is really what they are trying to do: if you transact with somebody in the capital markets then you get immediate settlements, immediate clarification. And also you have huge duplication of huge back office systems.

"So if I am Goldman Sachs and you are Merrill Lynch and we trade with each other, I record it and you record it - there is enormous duplication there. Whereas if you have one central database or ledger which is secure and transparent and you can both see it, then you, theoretically, cut in half or mutualise the cost of recording that transaction."

Who is using blockchain technologies?

The list of banks backing the blockchain appears to be growing every week. Deutsche Bank, for example, revealed last week it was investigating blockchain technology for fiat currency payment and settlement, but also securities issuance and transfer, post trade processing, asset registries, know your customer (KYC) and anti-money laundering registries.

"Every large and even small banks are looking at this technology," says Jerry Norton, head of financial services strategy at CGI, adding that about one bank a week is joining the service provider's blockchain innovation programme.

He explains: "It is not just banks that are looking at it - it is anyone with networks or common central infrastructures, clearing houses; all those sorts of people are interested. It is wherever you are sharing information with many many parties, it has the potential for quite a profound effect."

However, while interest in distributed ledger technologies is growing, most developments are in their infancy.

"We are still at an early stage, like many other banks in the industry. So we we are learning about it, doing proof of concepts, and talking to other potential actors in the industry," says Faura.

"We are studying all of these things, and we are working with potential alternative technologies to see how to solve of these use cases."

How far are banks from deploying blockchain applications?

One of the reasons that banks are not using already blockchain technology in production, publicly at least, is simply that the technology is so new.

"There are a lot questions around what the actual right type of blockchain approach is, and that is why you have seen the emergence of these various other ledgers like Eris and many others," says Celent's Dwyer.

CGI's Norton adds: "The technology is new and it is morphing all over the place, there are loads of companies springing up all over the place and the language is changing. So some people will say 'blockchain' others will say 'decentralised consensus ledger' - there is not a consistent language: this is a marker of the newness.

"That means that nobody has a complete handle on the best of technology - or the most appropriate."

Making the next step from early investigations will also involve regulatory approval. Regulators in the UK have shown some openness to the technology, with the Financial Conduct Authority expressing an interest in "exploring possible benefits from blockchain technology" and "how it might be used elsewhere in financial services".

"The UK government is very pro-fintech and they want to create the right environment to encourage innovation and blockchain is seen as a big part of that," says Celent's Dwyer.

"The Bank of England and other UK regulators have demonstrated that they have looked into blockchain in some detail and they have highlighted the risks around cryptocurrencies like bitcoin, but they are also alive to the potential opportunity of blockchain technology.

"So I don't think they are going to be a handbrake on the development. That doesn’t mean they aren’t going to be a big part of how this all pans out, but they are in a mode of openness and willing to seeing if we can transform our financial services in this way.

Nevertheless, the highly regulated nature of the financial services sector means that getting the go-ahead for wider use of blockchain systems could be tricky.

Santander's Faura believes that it could take some time before the technology reaches more mainstream adoption.

"How far are we from being able to apply this in reality?  I think banks have the will to do it, and the technology is starting to be ready - we are starting to see very good alternative technologies that could be used in production very soon. We will also need to work with regulators to make sure that all of these things are acceptable, and I don’t know how long that will take.

"My personal guess is that we are still months, if not years, away from taking this to the real market."