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Blockchain Technology

A Morning Exploration of Blockchain Technology in Financial Services

Recent Edelman seminar provides answers but, more importantly, inspires smart questions.

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Late last week, we held a breakfast seminar to discuss blockchain technology, as well as its implications for financial services and, more specifically, financial communicators. The seminar welcomed several representatives from the Chicago-area financial services community.

The questions from the attendees generally focused on three core themes.

Public and Permissioned Approaches

Discussion of blockchain technology nearly always starts with bitcoin, but rarely ends there. Many of the questions had to do with the fundamental differences between a public blockchain (like bitcoin and Ethereum, where anyone can write/read the data) and the private, permissioned approach that banks generally prefer (where public access is either dialed down or simply not made available).

This expansion and adaptation of a handy comparison chart best outlines these differences and tradeoffs.

Public Permissioned
Read/Write Open Either/both closed
Security Compensate for untrusted environment (e.g. Proof-of-Work/Proof-of-Stake) Identified and pre-approved participants
Speed Slower Faster
Energy use At least in the case of bitcoin, perhaps excessive Likely more conventional
Identity Anonymous/Pseudonymous Known identities
Asset Native (e.g., Bitcoin, Ether) Any asset
Financed Mostly volunteer efforts, sweat equity, foundation-based and open-source contributions A combination of private money and contributed effort
Source: Chain and Chris Skinner’s blog, via CoinDesk, with some additions by Edelman based on the Nov. 17 seminar. Note that some features may vary.

 

Given that financial institutions are rapidly trying to embrace a technology that was initially developed to disintermediate them, it’s natural to ask what such institutions are trying to replace with a permissioned blockchain approach. (In an ongoing debate on the matter, blockchain absolutists maintain that a permissioned blockchain is really little better than a more conventional approach). The answer lies in examining the days-long process required by many transactions (even in this modern age), ranging from stock trades to letters of credit. Instead of reconciling many disparate ledgers, the advantages of working from one shared ledger are immense. Santander thinks blockchain technology will save banks $20 billion per year by 2022.

Trust in Systems vs Institutions

The attendees wrestled with the notion of trust in institutional brands (e.g., banks, payment providers) versus trust in systems, especially when (at least in the case of bitcoin) the original author is unknown.

The answer lies in the openness of the system. Bitcoin’s code is open for the world to see, as is Ethereum’s code. During Money 20/20, the R3 consortium of blockchain-exploring banks open-sourced its “Corda” technology. Days later, blockchain technology provider Chain made a similar move. The Hyperledger Project runs under the aegis of the Linux Foundation which, as the non-profit association behind the very successful Linux operating system, knows a thing or two about open source and trust.

Granted, this openness holds the risk that an attacker may see something in the code that its authors could have missed. The heist of TheDAO, for example, required identifying and exploiting a loophole in the smart contract that allowed the improper transfer of millions of ether (the Ethereum cryptocurrency). Dramatic? Sure but, then again, mundane elements of print-and-paper-based contracts often have similar results. Also, in an open source world, the errors are usually fixed very quickly once identified. Further, while the TheDAO could be seen by cynics as the Ethereum Project’s “too big to fail” moment that required a Faustian bargain to address, the community nevertheless arrived at the solution via consensus. On the other hand, during the financial system’s too-big-to-fail moment of 2008, consensus was hardly the default remedy considered by banks and governments.

There was also some concern regarding the backing of cryptocurrencies like bitcoin versus, say, the dollar, which enjoys the full faith and credit of the most powerful economy in the world. Most of this backing, I argue, comes from the network effect: the more people see something as a currency and are willing to accept it as payment, the greater the demand for that currency and the more valuable it becomes. One can say that faith in the code and its rules—such as a predictable money supply based on a strict mechanical rule—gives bitcoin its own backing. Call it Metcalfe’s Law made quantifiable via the economic measure of market capitalization rather than its original expression of the value of a network—the much fuzzier idea of taking the square of the number of the network’s participants.

Collusion and Fraud

The attendees had significant interest in the notion of collusion and fraud. In the case of bitcoin, people wondered about the possibility of events like a so-called “51 percent attack,” whereby a group of the “miners” that secure the bitcoin blockchain in return for new bitcoin could corrupt it by monopolizing the share of computing power and making invalid results appear valid. While this is an ongoing concern — almost 55 percent of bitcoin’s mining capacity is currently held by four mining pools as of this writing — it is tough to imagine that people would invest vast capital in computer hardware and electricity only to engage in an activity that devalues the currency. In fact, we’ve already seen that miners will leave overweight pools for smaller ones to mitigate this uncertainty and prevent a crash in value.

In the case of a permissioned blockchain, alleviating stakeholders’ suspicion of potential collusion comes down to those parties’ perceived motivations to collude and whether those stakeholders are satisfied with that blockchain’s terms of consensus. Again, here as in elsewhere, an open source approach is vital.

Finally, we discussed challenges that arise when blockchain technology — or any technology, really — interfaces with the so-called “real world,” such as it is. A blockchain doesn’t deliver an objective “truth” so much as a single, immutable version of a shared truth. That is, it still requires the input of human beings, flawed creatures that we are. Ultimately, trust in a shared system’s publicly viewable rules and its underlying code will inevitably win over the need to trust any one or several of that system’s participants.

Even with those caveats, the potential for blockchain technology in financial services and elsewhere is both immense and inspiring. We will continue following these developments — and learning alongside everyone else — with great interest.

Phil Gomes is a senior vice president in the Chicago office.

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