Don’t Believe the Distributed Ledger Hype

Payments Leader

Posted on April 28, 2016

blockchain

Is Blockchain Becoming Technology’s Snake Oil?

A year is a long time in fintech; in that time, blockchain technology has gone from the badlands of Bitcoin to the boardrooms of the world’s leading financial institutions. We certainly haven’t reached ‘peak-blockchain’ yet as investors and banks continue to pour billions of dollars into fintechs working with the technology. But many banking executives are struggling to filter out the noise and focus on reality.

Blockchain and distributed ledger technology advocates are certainly not guilty of underplaying the hype with widespread predictions of nothing short of a total overhaul of the global financial infrastructure. The end is nigh (allegedly) for centralized message systems, custodial banks and clearing houses. In their place, participants can use blockchain-powered distributed ledgers to manage all interactions with automated settlement and reconciliation, all delivered in real time and with no risk of fraud! Bold claims, indeed.

Irrespective of the hype, blockchain has strong potential to make transaction processing more efficient, improve regulatory control and eliminate unnecessary intermediaries. But claims that banks will become redundant are premature to say the least.

Where the Dream Hits Reality

Traditional financial institutions are interested in distributed ledger technology (DLT) because they fear and covet its advantages. Virtual currencies can grease the skids of all sorts of transactions, transparent and immutable record keeping can eliminate fraud, non-hierarchical consensus systems enable near-real-time settlement. Cryptography enables participants to operate with security and anonymity at will within a large distributed environment, and smart contracts enable frictionless automated transactions and payments.  While the peer-to-peer nature of the distributed ledger is foundational to many of these key benefits, it is also an area of concern for traditional financial institutions and regulators. Peer-to-peer distributed ledgers allow complete transparency, with every participant able to see every event in near-real-time, and for all time. Mitigating concerns around confidentiality and participation are non-trivial. While automated consensus is a game changer for faster settlement, it’s no match for the simplicity and processing power of traditional centralized databases with trusted administrator control.

This does not imply blockchain is dead on arrival. While many stakeholders in traditional FIs and governmental organizations are skeptical – or even hostile – to Bitcoin and other emerging cryptocurrencies, few have such negative views of the underlying concept and technology of the blockchain.  Anonymity and unrestricted participation may be poor fits for banks.  Those characteristics of the Bitcoin blockchain are solvable with new derivative distributed ledger solutions. The most enlightened institutions are actively solutioning new iterations of the blockchain that solve for the requirements of traditional financial markets.

But will the touted benefits of the blockchain really add up for banks?

The Devil is in the Integration

A new technology or new platform will only be widely accepted if it can integrate into established systems. Anyone who believes that the great preponderance of massive trading, core, and payments processing systems and platforms can be swapped out for blockchain is in for a rude awakening.  Even without replacing major systems, the value of the integration of established financial technology into blockchain environments is not a simple and straightforward business case.  An entire industry is popping up around the build of integration layers to interface with existing systems and supporting infrastructure. Supporting workflows must be created for exception processing or any pre-processing logic for matching, allocating, clearing, settlement, etc. Regulatory compliance and security is relatively uncharted for employing blockchain technology to take over elements of the global financial infrastructure.  The question is, once we solve for all of these issues and use cases, will the resulting distributed ledger provide enough of an improvement to have been worth the investment?

Perhaps it will. Blockchain carries significant advantages in situations where a number of disparate networks need to communicate and transact, but there is no obvious trust between the networks or a central authority. The corresponding banking market may feel the pinch here as blockchains have the potential to take-out the middleman (and the associated high costs and delays) through the use of distributed ledgers to connect numerous payment networks into a single global system.

Decentralized inefficiency

While centralized databases may be more vulnerable to attack, decentralized ledgers are inherently less efficient as shared computing among a community of trusted (or untrusted) parties requires complex synchronization and coordination adding to transaction processing time. Network bandwidth as well as data storage will become an issue as all the decentralized nodes replace high powered centralized processing cores to perform computations and store ledger data.

Regulatory Bottlenecks?

Regulatory issues surrounding data storage and reporting come in as many flavors as the countries in which banks operate. As every transaction must be distributed to each remote node, the laws protecting the data privacy of individuals or corporations restrict data storage beyond the national borders. There is talk of ‘partitioned’ ledgers to bypass the problem, but given that blockchain technology has been developed without much regulatory oversight, it is still unclear how adopters of the technology will handle international transactions and data flow.

Steady as She Goes

Without doubt, mature and integrated distributed ledger technology will improve many existing financial systems and contribute to significant cost savings. However DLT will not solve every problem and  we should keep in mind that there are many alternative ways to lower costs and risk by standardizing industry workflows as well as expanding cloud technologies internationally – all using the current infrastructure.

 

Blockchain is undoubtedly a major shift opportunity in how we approach financial problems. We are at the point where there is an opportunity to create an industry-wide initiative to develop the appropriate architecture and infrastructure building blocks that support focused and collaborative projects to assist the technology mature.  This process will be slow and deliberate with improvements and change manifesting incrementally over time.

 

Banks spend hundreds of billions of dollars on IT operations and blockchain aims to reduce some of that spend and also reduce the fees banks currently have to pay for post-transaction servicing. Despite its current lack of maturity and the fog of over-optimism, blockchains and distributed ledger technology will certainly help to reduce some of the inefficiency in the financial services industry.

 

Increasingly, reports are suggesting that it will be another four to five years before we see truly big developments in key financial markets, and a decade before blockchain is deployed industry-wide. But we can expect many niche markets to rollout blockchain within 18 months. This last point is critical to the acceptance of blockchain; to ensure continued investment, it is important that practical uses of the technology, in controlled non-critical processes, begin to be launched. For the longer term it is vital that the offerings coming to market are robust, but more importantly, some long-term investment in time and resources is needed by a large number of leading market players to agree common and open standards before implementation can begin.

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Payments Leader

Payments Leader from FIS provides insights on credit, loyalty, fraud and emerging payments strategies through blog posts from our industry experienced authors.