TechVision Research recently held a webinar on the state of blockchain titled “Banking on Blockchain”. One of the attendees asked a couple of intriguing questions prior to the session that I answered in an email reply. I thought the answers would benefit others interested in the subject as well so I published this blog as well.

Question 1: Why should this be important to the banks, I thought it would be more important to the card companies, and the switching companies that enable transactions. What are the advantages over what they do now? What are the pitfalls?

Banks focus on transaction efficiency and regulatory compliance.  Transaction efficiency is directly related to liquidity. Funds, as represented by financial transactions, are unable to be reinvested until outstanding transactions are settled and booked.  When a transaction leaves a “system” whether it is within a company or between companies, it triggers several overhead steps including separate database update, audit logging, error correction, and reconciliation. By leveraging blockchain (more precisely distributed ledger technology) systems can all reference and write to a “shared common version of the truth”.  This has the potential to eliminate those overhead steps and increase the velocity of transaction processing and hence, increase funds flow.

Distributed ledger technology has another attribute that banks can leverage for their compliance efforts. That attribute is “immutability.” A transaction is immutable in that it cannot be modified once it is written to the blockchain. That means banks no longer have to keep redundant audit trails of transactions; the transaction ledger is the audit trail. Regulators and auditors have the capability to review transaction flows and controls directly within the ledger which promises to increase transparency and accountability.

As far as pitfalls, there are a few.

First is the immutability of the ledger.  Software updates the ledger and software is created by humans.  Until humans are perfect, there will be errors in coding and logic that can make the immutability of the ledger a liability.  The problems with the Ethereum DAO highlight the dangers of assuming the code is perfect.

Second is that the right form of governance is required for the ledger to work properly.  Humans need to decide what rules the code will enforce and striking the right balance of independence and fairness is a challenge, especially when competing interests are involved.

Third, distributed ledgers are designed to be accessible to all participants.  This creates a tension between what is public and what should remain private.  It’s not the same thing as creating a bilateral relationship to share information in confidence. If it is put on the ledger, everyone can see it.

Finally, the technology itself is new.  Even if it is proven to be better, all of the rules of acceptance, contracts, laws, and regulations are built around the old technology.  These will need to be changed before the technology is truly accepted.

Question 2: Can the blockchain be divorced successfully from the open Bitcoin? What will be the likely predominant model?

Blockchain itself is system built to solve a particular problem, the bitcoin double spend problem.  The protocol and governance built within the system supports that original premise.  Folks have experimented with it to solve other problems by shifting the content of the blocks and creating “side-chains” to capture different kinds of transactions.  Add to that the 80 or so different distributed ledger companies that are solving different problems including some big players like IBM and Microsoft and one can see that the bitcoin blockchain isn’t the only way to solve issues around transparency and accountability.

Since the blockchain/distributed ledger technology will be used to solve problems within a community (whether that is a consortium of international banks using it for settlements, a government using it to help citizens gain access to services, or simply departments within a single enterprise looking for a single source of truth) the model that best solves the problem for the community is the best choice.  The right combination of resiliency, governance, privacy, and performance will guide the decision.  In the end, the bitcoin blockchain may not be the optimum solution because the technology is only part of the system.  The design of the incentives that maintain trust and the governance that ensures fairness are every bit as important as the code itself.

We have produced several research reports on blockchain.  Excerpts for these and our other research can be found here.