Last May, the blockchain fraternity met in New York City at a conference called Consensus 2016: Making Blockchain Real. Representatives from up and down the technology food chain participated—from the tiniest start-ups to megabanks and other huge corporations. Every possible permutation and combination involving blockchain technology filled the agenda—from finance to law enforcement to the theoretical “Fedcoin.” The infectious enthusiasm peculiar to leading-edge high technology filled the air.
And then Gari Singh, an IBM distinguished engineer, speaking on a panel about blockchain and the internet of things, looked out on the audience and said: “People here have been saying all day that ‘the answer is the blockchain.’ But what’s the question?”
The attendees didn’t pelt Singh with airborne mobile devices—he spoke rhetorically, of course, and he is a leader in his company’s extensive blockchain activities. But asking such a question now about this potentially highly disruptive, fledgling technology is not only necessary, but healthy.
A very different tech
Flashback to February of this year. Five very smart community bankers gather to speak about the future of their business. An interviewer asks them what impact blockchain technology will have on the industry. Four of them have never heard the word. The banker who has at least a working knowledge of the technology more or less shrugs—not going to affect his bank much, he says.
Yet in his 2016 book The Business Blockchain: Promise, Practice, and Application of the Next Internet Technology, technologist William Mougayar writes, provocatively, “Understanding blockchains is tricky. You need to understand their message before you can appreciate their potential. In addition to their technological capabilities, blockchains carry with them philosophical, cultural, and ideological underpinnings that must also be understood.”
That is a pretty heady brew of concepts to imbibe. It’s hard to see the introduction of the EMV card as being a matter for a philosophical discussion. Online banking and mobile banking certainly have had cultural impact, but another Mougayar comment puts blockchain at another level: “If blockchains are a new way to implement trusted transactions without trusted intermediaries, soon we’ll end up with intermediary-less trust. Policy makers who regulated ‘trusted’ institutions like banks will face a dilemma. How can you regulate something that is evaporating?”
Whether that is an exaggeration remains to be seen. Many, many blockchain-oriented pilots, consortia, and other efforts are out there now. You can’t go to a fintech “demo day” without a good many of the speakers referring to the blockchain as part of their plans. Large banks and investment banks are part of the movement through cooperative efforts, such as R3 CEV, a consortium of over 50 large international players. Another is the Linux Hyperledger project. But for all the industry involvement, there are others, in addition to Mougayar, who say that blockchain technology will replace traditional intermediaries.
“Can we build a better mousetrap with blockchain to solve problems of the financial services industry?” asks Ron Mazursky, director of the Strategic Initiatives Group at Jack Henry & Associates. “We think so—and there is a ton of money being thrown at it out there.”
Yet Mazursky says that bankers need to understand—to their relief—that “it’s still very early in the process” for blockchain. He suggests that to a great degree, in spite of all the activity, blockchain is still in the “hype” stage of its cycle overall, though some services, such as Ripple’s cross-border payments service, are well established. He uses real-time payments to illustrate the point. While the Federal Reserve is attempting to administrate a shift to real-time payments, multiple competing systems are already out there.
“If real time is the wild west,” explains Mazursky, “blockchain is still at creation. We have no rules. Frankly, you don’t want to be in the garden with just Adam and Eve.”
Fruit's still on the tree
Don’t take Mazursky as a naysayer, rather, a realist. “There is a good tool here, but it will take time to ramp up,” he says. Those who may think that large banks are co-opting blockchain technology don’t “get” the blockchain, he says. Other than adaptations being tried for internal use, many potential applications of the technology require a community of users to make sense.
“You want a network,” says Mazursky. “It’s not just about you and your customers. I don’t think big banks are going to own it exclusively.”
In fact, there’s a school of thought that it is the consortia that will help open up practical application of blockchain. “A lot of the consortia’s work is standardizing the things that should have been standardized years ago,” says Angus Champion de Crespigny, financial services blockchain and distributed infrastructure strategy leader at Ernst & Young LLP.
Harking back to Singh’s rhetorical question, there’s an interesting response in Mougayar’s book, where he poses the question: “What problem is the blockchain solving?” His response: “It is a good, but self-limiting question, because it assumes that the blockchain can only solve known problems. What if the blockchain could create new opportunities, instead of solving existing problems?”
So understanding more about what’s going on with blockchain appears to be something the well-armed banker should want. We’ve distilled our conference coverage and expert-authored blockchain articles from BankingExchange.com; several recent books; vendor backgrounders; recent testimony in the House Energy and Commerce Committee; and interviews to construct the following Q&A.
Please note that talk about blockchain technology is full of phraseology—fans love the word “ecosystem,” for instance. We’ve tried to minimize such. Also, bear in mind that this is an overview and not intended as a technical discussion.
Q1. Where did blockchain come from?
A. Blockchain technology’s basics don’t belong to anyone, being at its heart a form of open-source software. The concept was born as part of the invention of Bitcoin. Without getting too technical, the author of the founding paper behind it, Satoshi Nakamoto (a pseudonym), had the following in mind:
“Commerce on the internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. . . . What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud. . . . The system is secure as long as honest nodes [computing endpoints] collectively control more CPU power than any cooperating group of attacker nodes.”
According to testimony by the Chamber of Digital Commerce, a blockchain trade organization: “The blockchain is a peer-to-peer digital asset transfer system that is independent of any third party intermediary, including financial institutions and governments. In short, it is open-source software that is available to the public. Anyone and everyone may have access to it and innovate with it.”
That’s the philosophy—that word again—behind blockchain. It will likely evolve, however. Already, there are those who see the value of sovereign virtual currencies. At Consensus 2016, an entire session discussed this, including the (unofficial) idea of a “Fedcoin.”
Q2. What does “blockchain” mean? And how does it work?
A. This will get a little technical, but we’ll keep it simple. Some of the best nuggets come from congressional testimony.
From Paul Snow, chief architect and cofounder of blockchain protocol developer Factom: “Blockchains utilize ‘Hash’ functions to link together blocks of information. A Hash is a way of taking any digital artifact, a document, picture, video, transaction, etc., and producing a short digital fingerprint. A block is a collection of transactions, and can include these fingerprints and other digital data. When a block is added to a blockchain, the hash of the previous block is also included in the new block. That’s the ‘Chain’ part of blockchains. Validating a blockchain includes checking the hashes or the fingerprints, and making sure they match. Any error or change in data would ‘break’ the chain; the hash of the changed block would no longer match the hash in the next block in the chain.”
“Blockchains provide three things: accountability for the data entered, notification of services of new data, and algorithms for ensuring all systems have the same data, i.e., consensus between systems,” continued Snow.
We particularly liked the following explanation from Gennaro “Jerry” Cuomo, an IBM fellow and part of the company’s blockchain practice. Cuomo’s words help explain the blockchain concept of “smart contracts” as well: “Here’s where blockchain fits well—managing a business agreement between two or more companies. They can record the terms of that agreement on a blockchain, knowing it will execute and be enforced autonomously (e.g., ‘If you pay me in under 15 days, then I will give you a discount.’) Nobody is in private control of the ledger and nobody can secretly change the terms of the agreement. It’s like every guest at a B&B writing in the guest book with an indelible Sharpie. So, with blockchain, facts and agreements are recorded certifiably and indelibly, increasing trust, reducing risk, and thus reducing friction in business.” [Emphasis added.]
The blockchain also has been compared to a freight train. Each boxcar, or “block,” contains critical data that may be an asset or that may represent value. What’s in the car can only be seen by those entitled to look, though the train itself can be observed and tracked.
A key element of blockchain technology is that it is intended to function in a decentralized environment. Using the rails of the internet, the intent is that blockchains will function both as processing software and as a mobile kind of database.
Because blockchains typically will be self-validating, transactions thus would not have to go through a central place for settlement in the usual sense.
Q3. I’ve heard the term “distributed ledger” in connection with blockchain technology. Where does that fit?
A. Sometimes, this term and blockchain are used synonymously, but without getting too technical, that is not correct. Mougayar writes: “Technically the blockchain is a back-end database that maintains a distributed ledger that can be inspected openly.” He also states that “The blockchain is also a distributed, public, time-stamped asset ledger that keeps track of every transaction ever processed on its network, allowing a user’s computer to verify the validity of each transaction such that there can never be any double-counting.”
These ledgers can be replicated in order to permit sharing publicly, privately, or semi-privately.
A staff memo of the House Committee on Energy and Commerce adds some helpful insight: “There are several versions of distributed ledgers that may be leveraged by a company working on developing business or consumer applications on top of a blockchain. The main differences between blockchain systems are how many copies of the ledger are created, who controls the copies of the ledger, and how is the authenticity of the ledger verified. The Bitcoin blockchain is a public blockchain because records of the ledger are shared with the entire network without any centralized control over who can enter the network or verify transactions through the [Bitcoin] mining process. Other blockchains may be developed that limit ... a user’s ability to interact with the system, otherwise referred to as permissioned blockchains.”
Q4. The issue of trust seems to come up a great deal in regard to blockchain. What’s behind that?
A. Ultimately, if Earth was peopled by completely honest folks who always paid what they owed and who always abided by their side of every contract, then other than unintentional mistakes or shortfalls, we wouldn’t have to worry about settlement, in the sense of enforcement through an independent authority. We don’t live in that world.
Mougayar sums this up: “All blockchains commonly hold trust as an atomic unit of service. In essence, it is a function and a service that is delivered. But trust does not apply only to transactions. It is extended to data, services, processes, identity, business logic, terms of an agreement, or physical objects.”
Mougayar elaborates that once a business person accepts that the algorithms securing the trust layer of a blockchain work, the “old paradigm of centralized consensus, that is, when one central database used to rule transaction validity,” goes by the boards. In fact, there are multiple forms of blockchain, and a point of debate at Consensus 2016 was whether, in homage to Tolkien’s Lord of the Rings, there would be “one blockchain to rule them all.”
Q5. What does this mean for banks?
A. One school of thought sees banks and their regulators becoming less relevant as blockchain technology becomes less a concept and more a working reality. In our research, that reasoning appears to arise chiefly from the payments world.
In his new book Augmented: Life in the Smart Lane, for example, Brett King, writing about the blockchain, states: “The banking system of 2025 will need to work more like an IP, or peer-to-peer, network than the current centralized banking networks that we have today; and the blockchain is a better, future-proof example of that.”
King predicts that restricting payments to approved channels, such as banks and licensed money transmitters, in the name of trust, will go by the boards. One caveat is that the concept of identification will have to change in such a world. (King sees banks still holding big deposits and savings, but current account funds will, he believes, be held and transferred outside of banking.)
Author Mougayar generally paints banks as behind the times and trying to hold onto a monopoly that is doomed by blockchain. Unless banks grasp innovation, he sees them serving as little more than the on-ramps and off-ramps of the blockchain highway. Mougayar recognizes that some banks have tried to adapt the new technology, but he sees much of this happening within the walls of existing regulation.
Federal regulators have had little specifically to say about blockchain publicly, beyond a speech given in mid-April by Federal Reserve Board Governor Lael Brainard. She made it clear that while the Fed sees some benefits to the blockchain, it intends to be very involved in where this technology goes in the U.S. banking system.
(To diehard blockchainers, this is something like an oxymoron. We’ll see.)
While acknowledging the efforts by bank consortia to develop blockchain applications, Mougayar states that: “Banks will be required to get their hands dirty and learn the new technologies directly. They will also need to get their minds dirty and try ideas even if they risk failing. The more basic experience they acquire early on, the faster they will be able to progress. . . . On the bad news side, some of the blockchain startups will be going after their business, FinTech style. But the good news is that blockchain technology is perfect for streamlining much of banking operations.”
Mougayar offers, as well, that the industry may use the blockchain as an opportunity to completely reinvent itself.
Chamber of Digital Commerce Chair Matthew Roszak, cofounder of blockchain software firm Bloq, stated in congressional testimony:
“On the horizon we are going to combine the Internet of Information with the Internet of Money. These two things compound each other. The internet as we know it is great for collaboration and communication, but deeply flawed when it comes to commerce and privacy. Blockchain technology fixes that, which means loans without banks, contracts without lawyers, and stocks without brokers, executed and recorded over hundreds of servers at all corners of the earth.”
Whether the time is ripe to declare winners or even to take odds is debatable—consider the recent tribulations faced by marketplace lenders. “There’s always a period when everyone gets excited, and then the hard stuff has to happen,” says Jack Henry’s Ron Mazursky. “Blockchain is not a product—it’s a process. ... The products mostly haven’t been figured out yet.”
Mazursky points out that while much has been suggested outside of the payments elements of blockchain, such as aspects of lending, a good deal hasn’t reached any kind of fruition yet.
Testified IBM’s Cuomo: “Most blockchain implementations, and the tools surrounding them, aren’t yet ready for many serious business uses. The concept and architecture are taking form, but some key capabilities and standards are missing or only now emerging.” Indeed, while trust is a major factor in the blockchain, it isn’t airtight, according to even some big backers.
Said Cuomo: “We’re ... taking steps to ensure that participants cannot commit fraud or collude in ways that jeopardize the integrity of the blockchain. Fraud and collusion resistance is achieved by ensuring that every transaction is validated by all the members of the blockchain networks, which might include regulatory and clearinghouse institutions.”
You could be forgiven if “not ready for prime time” comes to mind. And yet another cliché also applies: “It’s later than you think.”
- As Bank Branches Go Digital, How Do They Attract Customers?
- Building A Data-Driven Culture the Right Way: Five Lessons to Build Better Relationships
- Community Bank Consolidation Accelerates: Simmons First National in $277M Double Buy in Tennessee
- How a Digital Dollar Could ‘Reshape the Banking System
- Banks Look to Digitize Customer Onboarding