The financial crash of 2008 demonstrated (to some) that large financial institutions need to be closely watched and strictly regulated. The meltdown, some believe, also demonstrated the need for an alternative to complex, abuse-prone financial instruments held by few, and understood by even fewer.
Many believe that new tool could be the blockchain, with the new currency, Bitcoin, based on it. Could they put an end to the volatility and opacity of the financial sector? Today, cryptocurrencies are on everyone’s lips, with blockchain – a distributed peer-to-peer database – growing in its shadow, promising radical change.
This could be the first time that a change in global finance comes from outside central banks, stock exchanges, and politicians.
The blockchain paradox
I have written previously about how blockchain can influence financial operations. Its working principle makes it ideal for a wide range of transactions. Blockchain transactions are always encoded, protected with a private key that’s impossible to counterfeit. There are no middlemen, as transactions are conducted directly between parties as in any other peer-to-peer system. There is no need for a central organization to establish standards or issue certificates.
Blockchain forms the core of all known cryptocurrencies, offering support for instant money transfers, payment systems, and smart contracts. As such, it is poised to take a substantial piece of the pie away from banks, financial oversight institutions, and other intermediaries. Unsurprisingly, financial institutions, threatened by a design that keeps intermediaries and regulators out of the loop, are not eager to give up their privileged and profitable positions. For example, JPMorgan Chase CEO, Jamie Dimon, last year famously called Bitcoin “a fraud.” This year, he says he’s “not interested that much in the subject at all.”
For someone who’s “not interested,” he sure talks about it a lot.
Blockchain: Threat or menace?
Governments, however, are interested, issuing multiple statements about how they intend to handle cryptocurrencies. The European Securities and Markets Authorities (ESMA), the guardian of the security of Europe’s financial markets, has called the cryptocurrency market a dangerous place. The European Banking Authority (EBA) would like to prohibit banks from holding, selling or trading cryptocurrencies. Of course, this weighs heavily on cryptocurrency exchange rates and causes a lot of anxiety for the currency’s holders. But as cryptocurrencies raise a growing number of concerns, the blockchain technology is being more favorably regarded.
According to the World Economic Forum, by 2025, a majority of financial executives expect 10% of global GDP to be stored on the blockchain. The consultancy Aite Group projects that the financial industry will invest US$800 million in blockchain implementation in 2018 and 2019. The world’s largest financial institutions are now testing the application of blockchain for swaps, which are highly complex financial transactions. The Australian Stock Exchange (ASX) wants to use it for clearing transactions. The possibilities inherent in blockchain are also being explored by Nasdaq.
So, if financial institutions consider blockchain a threat, why are they investing in it?
Reducing fraud and costs
Blockchain relies on a distributed network of computers owned by multiple users. A distributed network of this kind is highly secure. In the blockchain, there’s no central storage (that can be hacked) or intermediaries. In a traditional system, intermediaries are responsible for a large proportion of cases of fraud and less serious irregularities. After all, there are a lot of them and they often operate in obscurity. Their absence greatly reduces the risks involved in all kinds of transactions between customers and organizations. Blockchain architecture also allows banks to cut their operating expenses. They can generate massive savings in the clearing of transactions among them. According to Autonomous Research, blockchain may reduce transaction clearing costs by nearly a third, or US$16 billion per annum.
Blockchain makes a universal tool that automatically delivers on contractual and transaction terms as soon as specified conditions are met. In the blockchain ecosystem, applications ensure that specific tasks are only performed once the complete set of relevant conditions have been satisfied. Briefly put, the process relies on the IF – THEN – WHEN command. An algorithm is conditionally prompted to conduct a transaction. Any two users who neither know nor see each other, but who nevertheless wish to conclude a mutual contract securely, may choose the smart contract option. Their transactions will be concluded as soon as and only if both parties apply unique codes, i.e., a private and a public key.
This mechanism eliminates errors, ambiguities, and manipulation from contracts concluded by users. Smart contracts save time and increase trust among users while removing such parties such as lawyers and notaries public from the picture. Little room remains for the type of manipulation that requires lawyers to sort out or adjudicate.
In its overview of the possibilities generated by the new technology for the financial industry, McKinsey Global Institute notes that some of the solutions proposed for this new tool may be difficult for the financial sector to accept. In Beyond the Hype. Blockchains in Capital Markets, the Institute points out a characteristic which the advocates of the blockchain technology see as vital: the irreversibility of transactions once they have been made. According to the report, this feature may spell major trouble for banks. Appeal mechanisms are important to many customers. The report also suggests that Bitcoin is not an unmitigated good. Blockchain confirmation times are slow (10 minutes) to allow the synchronization of the network, which runs counter to the financial system’s need for speed, and it requires an enormous amount of computing power, clogging up the financial system’s networks. Indeed, Bitcoin, hyped as an ideal product, may not shine all that brightly when considering its practicality as a currency.
An alternative i.e. the mainstream
Despite these reservations, I still believe we are setting out on a very interesting journey. And there is no turning back. Perhaps we are witnessing a repeat of the history of Linux, an operating system conceived as an alternative to commercial products which itself grew to become a part of many commercial projects. The same may apply to the blockchain. After heated debates, it is most likely to become a standard solution for large companies, banks, and even governments.
In fact, I think that change is imminent.
Fortune, Robert Hackett, No, JPMorgan Chase CEO Jamie Dimon Has Not Changed His Stance on Bitcoin, link, 2018.
MarketWatch, Aaaron Hankin, Beware these cryptocurrency dangers, say European regulators. Don’t invest money you can’t afford to lose, regulators say, link, 2018.
McKinsey Global Institute, Kevin Buehler, Daniele Chiarella, Helmut Heidegger, Matthieu Lemerle, Akash Lal, Jared Moon, Beyond the hype: Blockchains in capital markets, link, 2018.