Nasdaq Signals Confidence in Bitcoin, Not Just the Blockchain

Critics often pay Bitcoin a backhanded compliment by calling it the Napster of finance. The underlying technology may change how business is done, they say, but the system itself isn't long for this world.

Now the Nasdaq stock exchange is challenging that conventional wisdom by not only testing Bitcoin's much-vaunted blockchain technology, but doing so on the Bitcoin network.

Last week Nasdaq announced plans to use Bitcoin's blockchain – a real-time public ledger of transactions – with the exchange's private markets platform, designated for firms preparing for initial public offerings. Users will be able to issue and transfer securities on the blockchain via the Open Assets protocol, which uses specific units of bitcoin as tokens to represent ownership of equity shares or other assets. These tokens are referred to as "colored coins." If all goes well, Nasdaq may expand its use of blockchain technology to other businesses, including its central counterparty clearinghouses and central security depositories, according to a person familiar with the company's thinking.

The shift to the blockchain represents a leap into the digital age for Nasdaq. Most stock exchanges use an outdated record-keeping system that relies on paper certificates. Bitcoin's distributed ledger will improve the auditability of Nasdaq's records and allow officials to keep better track of ownership of assets as they change hands, according to the person familiar with the decision.

Nasdaq is far from the only big-name firm to proclaim interest in using distributed-ledger technology to facilitate speedier, cheaper and more auditable transactions. But financial firms have typically dismissed Bitcoin itself as too risky for mainstream use.

Cryptocurrency researcher Tim Swanson explained this hesitancy in a report earlier this year, writing that banks were unlikely to adopt Bitcoin's "permissionless ledger" because the anonymity of blockchain users would make it hard to hold anyone accountable in instances of fraud or other transactions gone awry.

But now the financial industry has a "brand-name firm experimenting for real" with the Bitcoin blockchain, as Richard Gendal Brown, IBM UK's executive architect for innovation in banking and financial markets, wrote in a blog post last week. Nasdaq's move lends credence to the idea of using "the inherent security and open-access of the Bitcoin system to 'carry' representations of real-world assets," Brown wrote. "Dismissing [Bitcoin] entirely could be a big mistake."

In fact, Bitcoin's status as the most popular blockchain around may have made it the most logical choice for Nasdaq, according to some experts in the digital currency community.

"Some advantages of using Bitcoin include that it has been tested fairly well and there is a dedicated community of developers supporting it, so the technological risk may be lower and deployment may move faster than some alternatives," Susan Athey, a senior fellow at Stanford University's Institute for Economics Policy Research and an advisor to digital currency firm Ripple Labs, wrote in an email.

A number of factors may have informed Nasdaq's decision to experiment with the Bitcoin blockchain, according to experts in the digital currency community.

"The advantage of the main chain is that it's very secure" because of Bitcoin's decentralized structure, said Flavien Charlon, who helped develop the Open Assets protocol. Miners, who record transactions into the ledger, must demonstrate "proof of work" by using computing power to solve a difficult math problem in order to collect their bounty. The fact that there is no single point of failure for validating transactions makes the blockchain difficult to compromise. "It's really expensive to attack the main network, and it's also very auditable because it's completely public."

While some financial institutions have expressed concerns about the dangers of using a public blockchain like Bitcoin’s, "there are ways to make it more of a semi-closed loop," Charlon said. Bitcoin's protocol is designed to be flexible, which means that "Nasdaq could prevent transactions they don't want to happen" by using a multisignature feature that requires several different private keys to independently approve a transaction. (Think of the scene in "WarGames" where two people must turn separate keys to launch a missile.)

Charlon, who is also the founder of Coinprism, a wallet service for storing colored coins, argues that treating bitcoins as representations of assets helps to safeguard mainstream financial institutions. Since bitcoins serve as tokens under the protocol rather than as a currency, companies that use the option are largely protected from the price volatility associated with money untethered to a central bank or government. Under a colored coin system, small fractions of bitcoin can be designated to represent much larger values. Users need to purchase some amount of bitcoins in order to move them, but bitcoins are divisible to eight decimal places. With the bitcoin exchange rate around $230 today, an issuer could purchase a thousandth of one for less than 25 cents and subdivide it into smaller pieces for distribution to investors.

Some industry insiders cautioned that Nasdaq's move should not be taken as a sign that the entire stock exchange—and other financial firms—will shift to the Bitcoin blockchain.

The securities industry needs a ledger that the legal system will treat as an authoritative account of the ownership of assets, Robert Sams, founder and chief executive of Clearmatics, wrote in a blog post Monday. A "permissionless" ledger that anyone can use anonymously wouldn't hold up in court, according to Sams, whose company offers its own distributed-ledger technology system for clearing and settling over-the-counter derivatives.

"The law will not treat a ledger record as authoritative if everyone knows that the current longest chain contains blocks generated by an anonymous attacker who replaced a bit of history that was chronologically prior," he wrote.

Using the Bitcoin blockchain on a broad scale poses additional challenges, according to Preston Byrne, co-founder and chief operating officer of Eris Industries, which offers its own blockchain platform targeted at mainstream companies.

"For the process of developing a full-on, blockchain-based exchange that can satisfy commercial requirements and [sanctions] requirements, you wouldn’t want to use Bitcoin because you can’t get the controls you need," said Byrne.

The issue lies in the fact that Bitcoin is designed to resist interference, according to Byrne. This is useful for warding off hackers but makes it difficult to reverse transactions. If Nasdaq needed to rescind a fraudulent sale or otherwise intervene with the Bitcoin blockchain, it could run into a problem, he speculated. The stock exchange might also have difficulty configuring the blockchain to prevent the transfer of shares to countries like Iran and Syria that are sanctioned by the Office of Foreign Assets Control, according to Byrne.

Regardless of these challenges, it's clear that big-name firms are starting to get serious about putting blockchains into action. The online retailer Overstock.com, for example, announced in an April filing with the Securities and Exchange Commission that it was considering issuing up to $500 million in "digital securities" using distributed ledger technology.

Smaller financial institutions are also testing the waters. Cross River Bank in Teaneck, N.J., and CBW Bank in Weir, Kan., last year became the first banks to use Ripple Labs' distributed ledger to facilitate cross-border transactions.

Not to be left out, the New York Stock Exchange announced the launch of a bitcoin pricing index Tuesday that will use data from transactions on the Bitcoin exchange Coinbase. The NYSE participated in Coinbase's $75 million funding round earlier this year.

Such moves suggest that the fast-clearing transactions and precise records offered by blockchain technology will become a new standard in the financial industry, according to industry insiders.

"In the future, we should expect that the settlement of asset transfers (including fiat currency as well as securities) should be roughly instantaneous and there should be an auditable digital trail," Athey wrote in an email. This change would "reduce the need for companies and financial institutions to tie up capital while assets are in transit."

As one of the first big companies to make use of the blockchain, Nasdaq could help this future come about a little faster.

Nasdaq's move "shows a natural progression toward a greater understanding of the financial community around the power of the blockchain," said Peter Shiau, chief operating officer of Bitcoin security technology provider CryptoCorp. He also suggested that there's plenty of room in the world for both permissioned ledgers that use legal entities to authorize transactions and Bitcoin's "permissionless" blockchain.

"I can envision a world in which the public Bitcoin blockchain is going to have a fundamental role to play in how financial services are delivered," Shiau said, "and we'll also have a bunch of private blockchains that different institutions can use with each other."