Digital currency has had little impact on banking and financial services – until now. In 2016 blockchain-type technology, developed by Bitcoin, will start to move into the mainstream as banks strive to cut the cost of doing business, at scale and securely. The technology should also introduce highly scalable new business models and players, according to Annie Turner.
Bitcoin is by far the world’s largest cryptocurrency. It emerged in 2008, when trust in banks was perhaps at its lowest ever, as the subject of a research paper by Satoshi Nakamotom making the case for the world’s first decentralized digital, encrypted currency. The developer has never been identified.
It might be more helpful and accurate to think of Bitcoin as a massive public ledger rather than a currency – and that ledger is, as Blythe Masters, CEO, Digital Asset Holdings, writes, “nothing more than a clever new form of database technology…born of advances in the internet, open-source protocols, computing power and the science of cryptography.”
When someone buys bitcoins, or pays for something with them, they are entered into that public ledger/database and can then send or receive bitcoins. The entry in the ledger is verified by issuing the user with a secret, encrypted private key. To make a transaction, the bitcoin holder just needs to know the public address of whomever they are paying and verify the payment using their own private key.
The remarkable blockchain
The distributed nature of the underpinning database – known generically as distributed-ledger technology– is the real innovation. Every single transaction of bitcoin is recorded in it and every bitcoin holder has an identical copy of the database, which is updated every few minutes in batches – or blocks. Every block includes all the transactions that have taken place since the last update a few minutes earlier, and the blocks form a ‘chain’, hence the name blockchain. The updates are triggered when all computers in the network are sent an automated, complex, random, algorithmic task.
Whichever computer works out the solution sends it to all the others in the network, along with the new block, which is added to the chain. There is no central repository, no single point of failure and so far it has never been compromised. The ‘money’ supply is managed by awarding the computer that solves the task new, ‘mined’ bitcoins (25 at the time of writing, worth around$10,000), which is also an incentive to be part of the network.
Alec Ross, formerly Senior Advisor for Innovation to then Secretary of State Hillary Clinton, explains in his new book, The Industries of the Future, why this is such an important development:
“Because the algorithm is difficult to solve, but easy to check, it serves as a reliable signal for telling the entire network when to update.
“And because the algorithm has a random element, every computer in the network has a chance at solving it, which prevents any lone powerful computer from seizing central control. The slight time buffer introduced by the algorithm also prevents any user from trying to double-spend their bitcoins, since the delay allows the network to snuff out any attempt to use the same funds twice.”
It also makes counterfeiting all but impossible, although no doubt someone somewhere is putting a lot of effort into trying.
If Bitcoin goes bust…
Many established banks and governments are deeply skeptical about Bitcoin – and its recent meltdown, caused by it being unable to handle the rapidly rising number of transactions – has added to their distrust. But as Alistair Fairweather of TechCentral, concluded in an article on March 7, whether Bitcoin survives or not is almost irrelevant because “even if it does die, it leaves behind a legacy that will reshape our entire world” – a conclusion many banks, among others, have reached already.
Distributed-ledger technology’s robust security and audit trail are obviously very attractive, but in the digital age, all sectors are under terrific pressure to decrease the cost of doing business while increasing operational speed. Banking is no exception.
As Masters points out, “Differences within and across separate databases create inconsistent transaction data that require costly reconciliation. So financial institutions spend a lot of their operational outlays on the generation, communication and reconciliation of vast amounts of data. All this creates opacity and delay, and makes it harder for regulators to keep abreast of what is going on.”
Also, the average return on equity for big banks around the world was 10.8 percent in 2014, down from 11.1 percent in 2013, and from 15.8 percent in 2004, according to research from Autonomous Research.
Hence banks’ rates of return are not sustainable; they are too close to or below their cost of capital. They have to find ways, and fast, of slashing their cost base and reducing their need for capital while complying with regulation that demands greater transparency.
Do banks get it?
To these ends, banks are looking at a modified version of distributed-ledger technology to meet their particular needs. Masters says,
“Entities with a need to know about a financial transaction include not just the buyer and seller and their brokers, but custodians, registrars, settlement and clearing agencies, central depositories and, importantly, regulators. Hence private or permission-based blockchains have been developed to improve privacy, transparency and throughput capacity — important to regulated capital markets – by limiting participation to known and approved parties.”
Masters believes that this year will see the first, limited applications of distributed-ledger technology in banking, based on private permissioned blockchains.
She goes so far as to predict that “over the next five to ten years we will see these evolve, improve, standardize and proliferate, until eventually they become the new norm.”
Surely this is missing the point. As TM Forum’s Craig Bachmann says, “Truly being digital is about taking advantage of new models and opportunities, not just replicating digitally what you were doing before.”
Why couldn’t it wipe out all those intermediaries that take a slice of every transaction and add to the cost and complexity for everyone? Shouldn’t we expect the elimination of commission for the sale of stocks and bonds as those deals could be done with the contract embedded ledger, such as proof of ownership of physical assets?
New business models
Pat Patel, Content Director, Money20/20 Europe, observes, “While corporates are trying to figure out how to improve their solutions by rebuilding, on blockchain technology…agile startups launching in this space are seizing the day.”
So while distributed-ledger technology could be very appealing as a mechanism for huge, secure, overseas payments, it has the potential to handle millions or perhaps billions of micropayments too, opening up whole new markets for things that it previously wasn’t economically viable to sell, except as part of a bundle, such as individual pieces of content from a newspaper.
Margins in online retail for things like consumer electronics are typically paper-thin – even the mighty Amazon doesn’t make a money on its retail activities – and out of that margin, online traders are charged 2.5 percent and upwards in payment fees and much more for international transactions.
At the moment, there are four parties involved in credit card transactions, excluding the customer – this is antiquated, expensive and unsustainable.
Then there is the cost of lost business: Todd Lutwak, Partner, Andreessen Horowitz, the venture capitalist company, reckons that fraud-detection mechanisms in today’s payment systems are so poor, particularly for overseas transactions, that billions of dollars of genuine sales are lost annually as a result of declined transactions.
There have even been suggestions that it would provide a solution to spam and all the irritation and costs it brings. Ross writes,
“If it cost 0.0001 bitcoins to send an email, for instance, the effect on the regular user would be negligible. Spamming millions of email addresses…may become economically unfeasible. That might be one of the best arguments for Bitcoin [or more accurately distributed ledger technology]yet.”
The same audit principles and techniques could be applied to streams of data other than those for financial transactions, for example, to assure the integrity of open data and monitor its uses in smart cities.
As TelecomTV’s Ian Scales reported in February 2016, “One of the prime movers behind smart cities in China (China being a big M2M/IoT hotspot) is a consulting firm called iSoftStone, which has been working on smart city strategies around auditing, verification and data storage. It has just teamed up with blockchain specialist Factom to see if the technology can be applied to smart city development.”
Surely the question is how, not if?