Chris Middleton examines the potential for blockchain in Financial Services, on the back of a glowing analyst report. Common sense and critical thinking are key, he warns.
By underpinning and validating the concept of a distributed ledger, blockchain has often been proposed as a way to minimise fraud, verify transactions, create a secure audit trail, and inject greater transparency into Financial Services.
Meanwhile, decentralised or distributed networks could be a way of side-stepping the problem of monolithic control over financial systems by all-powerful institutions, such as credit reference agencies, from which any errors can fan out across multiple platforms and affect people’s lives.
So say blockchain’s proponents. The context is a traditional financial system that has sometimes abused public trust, with fraud, market rigging, mis-selling, money laundering, and other crimes tainting the reputation of many a big name, in the wake of a global crash caused by high-risk finance.
So alongside FinTech startups, blockchain’s idealistic movers and shakers have good cause to disrupt a system that sometimes appears to serve its own interests, rather than those of its customers. The public is broadly supportive of those aims if it leads to greater insight, speed, trust, self-service, and convenience for them.
Innovation in Financial Services is popular with users and, in some cases, long overdue. The pandemic has seen a doubling of Open Banking uptake, for example, while some level of mobile or digital banking usage is found among a majority of account holders.
Blockchain is part of that overall trend, but is a phenomenon in its own right.
While it is true that, once written into a blockchain, data cannot be unwritten/rewritten without invalidating the chain or highlighting that a record has been tampered with, there are flaws in any argument that says this, in itself, makes it a fix for systems that are open to abuse.
For one thing, replacing simplicity with complexity is rarely a good idea when it comes to technology, however flawed the simpler solution might be. That’s especially true if your goal is creating simplicity.
A related issue could have far-reaching consequences: what if a blockchain’s data relating to an individual is wrong – for example, if a person has been misidentified, given an erroneous credit rating, or wrongly chased for repayment of a debt? The same might apply to transactions that have been wrongly flagged or incorrectly made.
Such problems are commonplace in Financial Services (affecting roughly 20 percent of customers, according to the US Federal Trade Commission), so it is hard to see how an inviolable, persistent, yet incorrect record could be regarded as an advance in such cases, though it might help identify the point at which error entered the system.
In some situations, might blockchain even perpetuate a financial crime, or a case of bad data or mistaken identity – set it in digital stone, as it were, and so ‘legitimise’ it? Some technologists claim the opposite is the case, as we will explore later in this report. They add that blockchain could reduce conventional cybersecurity risks by removing the need for human intermediaries.
There are further problems, however. For example, GDPR mandates a right to be forgotten and for permanent destruction of data. That is difficult to square with the concept of an immutable record. Technical solutions exist to this problem, but involve adding further layers of complexity.
It’s an oversimplification, but generally the data persists but access to it is cut off: not the letter of the law, therefore, but the spirit. That’s problematic to a regulator.
So how did we get here? Blockchain was introduced, in part, as a form of digital hoop-jumping to prevent hyperinflation in Bitcoin, via a digital proof of work. Yet at the time of writing, a single Bitcoin now has a notional value of over $55,000. Just 10 days previously it was worth $10,000 less.
So if any system can be judged against one of the strategies behind it, then blockchain could be said to be a failure. The rollercoaster valuation of Bitcoin since its foundation suggests, at least, that the digital checks and balances built into the system may have been conceptually flawed.
A cynic might observe at this point that a technology that was originally designed to be a brake is now being acclaimed by some innovators as an accelerator.
Other problems related to Bitcoin (a common distraction when discussing blockchain) are discussed in these Diginomica reports by this journalist: one on Bitcoin energy use, and the other on the emerging crypto economy.
Another flaw is that blockchain, like all distributed computing systems (and crypto-mining) is energy intensive: it stands to reason that any consensus-based system in which a ledger is held in multiple locations, with a hash of earlier versions, uses more MIPS than a ledger held in just one.
The environmental impact of that could be considerable, given that a great deal of electricity is still generated from fossil fuels in many countries – notably in Bitcoin gravity-well China, where nearly two-thirds of the coin’s miners are based, according to Cambridge University research.
However, blockchain’s, distributed computing’s, and crypto’s proponents rightly say that cloud platforms and large data centres also use vast amounts of energy, while all computing hardware creates environmental and sustainability challenges.
Yet the evidence shows that, collectively, the Bitcoin network alone uses more energy than Argentina does across all applications of electricity, according to Cambridge researchers.
Despite this, there are blockchain and digital token initiatives that supposedly help people offset and reduce their carbon emissions. These may not be cryptocurrencies, of course, but still demand significant energy consumption.
Distributed systems also have a tendency to offload their energy costs onto participants and, logically, are only as fast as the slowest member/device. After all, the word ‘blockchain’ hardly suggests ‘swift and agile’. Again, it was designed to be a brake.
So, all of these considerations need to be set against the hype that still surrounds the technology, alongside the difficulty of integrating blockchains (and distributed ledgers of every kind) into legacy systems, or interoperating with them.
Common sense is essential in a market of noisy evangelists. Put simply, ledgers record transactions and so ought to be boring, so we should perhaps be wary of any projects that seek to be earth-shatteringly transformative and exciting.
Despite that, CBInsights, the insightful analyst house that specialises in new technologies and their investors, has released a new report suggesting that blockchain could serve the same macroeconomic function as banks: as “critical storehouses and transfer hubs of value”, to use their words.
They single out a number of recent initiatives to back up this evangelism. These include Credit Suisse partnering with New York-based Paxos to use blockchain to settle US stock trades, and JPMorgan Chase releasing its JPM Coin as a way to facilitate transactions between institutional accounts.
“Blockchain has the opportunity to disrupt the $5 trillion-plus banking industry by disintermediating the key services that banks provide, from payments to clearance and settlement systems,” says CBInsights.
“Facilitating payments is highly profitable for banks — cross-border transactions generated $224 billion in payments revenues in 2019. However, blockchain technology offers a secure and cheap way of sending payments that cuts down on the need for verification from third parties and beats processing times for traditional bank transfers.”
Cheap? For whom? Meanwhile, blockchain specialist Ripple has partnered with over 300 customers, including Santander and Western Union, to improve the efficiency of cross-border payments, continues the report.
“R3, another major player working on distributed ledger technology for banks, saw its technology used by Switzerland’s central bank for a pilot to settle large transactions between financial institutions using digital currencies.”
CBInsights also singles out examples in stock trading and hedge funds, such as TØ.com, a subsidiary of Overstock, which wants to enable share transactions online using blockchain.
Chain, which was acquired by Stellar in 2018, helped orchestrate a live blockchain integration that successfully connected the Nasdaq exchange to Citi’s banking infrastructure, notes CBInsights.
More recently, Nasdaq partnered with R3 to build a platform — using R3’s Corda system — that financial institutions can use to create or manage their own digital asset marketplaces.
Meanwhile, Numerai is decentralising hedge funds, backed by the likes of First Round Capital and Union Square Ventures. But does decentralisation really help tackle the transparency problems associated with offshore finance and shadow banking?
Crowdfunding, crypto exchanges, wills and inheritances, accounting, loans, credit, and insurance are further finance-related sectors that could be disrupted by blockchain, according to the report.
Centralised credit reference agencies can be “hostile to consumers”, it adds, with an estimated one in five Americans having a “potentially material error” in their score that negatively impacts their ability to get a loan.
Alternative lending models designed around blockchain could offer a “cheaper, more efficient, and more secure way of making personal loans to a broader pool of consumers”, claim the authors.
“With a cryptographically secure, decentralised registry of historical payments, consumers could apply for loans based on a global credit score.”
It’s a promising idea for tackling what is a real problem for many consumers. A number of companies are working in this space, such as Dharma Labs, which has created a protocol for tokenised debt.
Yet the wider issues with the technology, set out above, remain. In summary, then, blockchain is an intriguing technology that has significant potential in applications where validation, double-checking, and verification are genuinely essential.
But common sense is equally important, and we should never lose sight of the questions that arise whenever hype is louder than detail and tech evangelists promise easy answers.