Blockchain technologies have been touted as the next disruptor that will reinvent banking and save financial institutions (FIs) significant sums of money. To the layperson, blockchain technologies represent opportunities for fortunes to be made and limitless problems to be solved through its seemingly magical technology. For banks, the blockchain allure is all too appealing: save significant sums of money in transaction and operational costs.
Unfortunately, the promise of blockchain being able to deliver this value is not realistic, and when examined critically, one can see that many of the blockchain applications created for FIs are often overhyped solutions in search of a problem.
A SOLUTION IN SEARCH OF A PROBLEM
To understand why blockchain is merely a solution in search of a problem, it’s helpful to examine what it solves and how it does this. Blockchain is a database that seeks to solve issues concerning validating, confirming, and recording transactions between two or more parties. The database is shared among participants that must follow rules to ensure trust. Blockchain technology ensures the rules are followed and trust is maintained by—in theory—guaranteeing atomicity and authenticating transactions.
Atomicity is crucial for making sure transactions occur correctly. For example, a bank’s software may implement a transfer from account A to account B as a withdrawal from account A followed by a deposit to account B. If the first action happens, then the second had better happen as well. Blockchain technology solves this issue by building what is essentially a chain of transactions that can be replayed and verified. Each transaction can be considered a link in the chain, with each link supporting the next transaction in the series (hence the name blockchain). All blockchain technologies implement some form of cryptography to authenticate the counterparties, and once a transaction is confirmed, it becomes an irreversible part of the chain.
Ultimately, blockchain is intended to provide trust where trust cannot be ensured. This feature is important if you do not know your counterparty or if participants in the system are not acting truthfully (e.g., forging transactions, double spending, etc.).
Fortunately, FIs transacting business with each other in the United States are well regulated and these features of blockchain are largely unnecessary. The irony is that this zero-trust feature is not needed in an industry where BSA/AML, KYC, and Counterparty Risk are a large part of the operating environment—not unless one plans to run afoul with the regulators. As for issues with atomicity, these can be solved in a less complicated and direct way using a centralized clearinghouse. After all, if the industry is willing to agree upon a single blockchain standard, then why can’t FIs agree on using a jointly sponsored digital clearinghouse?
BLOCKCHAIN IS EXPENSIVE
Most staunch blockchain supporters would advocate that the decentralized nature of the technology is its principal advantage. They would argue that by decentralizing, federating, or whatever other distribution schema they espouse, the cost of maintaining a global ledger can be shared by all. I would agree; however, most blockchain implementations today have incorporated some form of digital currency as a means for their developers to monetize their technology and ensure the integrity of transactions.
Early financial transaction cryptocurrency platforms promised to provide a universal ledger that FIs could use to record transactions. The idea was to streamline communication and make transactions cheaper. These transactions, however, have proven to be prone to price volatility, as changes in the underlying “value” of the currency can make them much more expensive than traditional means.
What does this mean? The FI has zero control over the cost of transactions. Even more troubling is that by using a blockchain platform, institutions are effectively relinquishing their price control to an entity that can arbitrarily add more coins into circulation and enrich the founding owners, while reducing shareholder value for the company.
BLOCKCHAIN IS INEFFICIENT
This last point is complicated, so I will keep it concise and simple. Blockchain technologies are typically inefficient. Bitcoin, a household name, can take anywhere between 10 to 60 minutes to process a transaction. The reason for this is that they rely on proof-of-work or other similar authentication schemas that require a form of cryptographic mining (heavy computation work).
This manifests many inefficiencies; the time to record transactions is incredibly long, and the power requirements to support these networks can be environmentally deleterious.
Banks are accustomed to long timeframes for clearinghouses to record transactions. At best, these technologies may only marginally improve timing, and at worst, they may take longer and result in harm to our environment.
Additionally, blockchain requires an investment in hardware since each participant must maintain some chunk of the chain. As such, while the database is distributed, a financial institution will still need to subsidize its use through its infrastructure. At this writing, the Bitcoin blockchain is approximately 400GB in size and averages 250,000 daily transactions. Contrast that with the NASDAQ averaging 3-5 billion daily transactions and one can start to see fundamental issues with how these technologies will scale. Can you imagine having to maintain a copy of all transactions made on the NASDAQ into perpetuity?
There is no doubt that blockchain is a revolutionary technology that has found many good uses outside of typical banking. Creating digital assets allows for easier movements of wealth and can provide some with economic freedom without being tied to a central bank.
I do not want to deride the innovators in this field; however, I want to share caution and wisdom. This technology can be completely replaced with financial institutions forming a consortium to promote interbank standards and a jointly owned clearinghouse. Not only will FIs benefit by coming together and working for joint standards, but also, no one party will be unfairly enriched by simply being the progenitor of a cryptocurrency.
Former large bank balance sheet manager turned entrepreneur. CEO of Quantalytix, an enterprise lending and bank management solution.