Finance and the Blockchain: A Primer

“Only 1% of 3,138 chief information officers at companies surveyed by Gartner last year said they had ‘any kind of blockchain adoption’….” The Wall Street Journal, May 7, 2018.

Blockchain is all the rage. We are constantly bombarded by reports of how it will change the world. While it may alter many aspects of our lives, our suspicion is that they will be in areas that we experience only indirectly. That is, blockchain technology mostly will change the implementation of invisible processes—what businesses think of as their back-office functions.

In this post, we briefly describe blockchain technology, the problem it is designed to solve and the impact it might have on finance.

The blockchain is a record-keeping mechanism. In that sense, it is simply a 21st century version of the recording systems that have been around since people started chiseling marks on cave walls. Over the millennia we have moved from ledgers that are carved into clay to ones that are digital.

To be more specific, consider the problem of tracking the ownership of a share of equity in a particular company. Imagine that there is a sequential list of all owners of that share, with the name of each former owner crossed out. The last one at the bottom of the list is the current owner. The key question is the following: who has the right to cross out that last name and to write in a new one?

Put another way, the challenge we face is to create a tamper-proof and universally accepted way of recording things like ownership of assets, obligations of one person to provide a product or service to another, levels of inventories, personal identities, and the like. The world runs on records of who we are, what we own, and what we are obliged to do. Having a secure and trusted mechanism for accessing and changing those records is essential if our economic lives are to function smoothly.

Before proceeding further, it is worth pausing to make a point about the details of blockchain technology. While it is critical that someone create and implement high-quality security mechanisms, most people will care little about the details. For example, we all care that our information is safe when we provide our credit card numbers to make a purchase on-line. However, few know the details of the encryption technology that secures the transaction. Similarly, our interest in blockchain technology is in the services it delivers, not the details of how or why. In the same way that automobile engines are for mechanics and engineers, hash functions, nonces and the like are for computer scientists and mathematicians. What we require is that the system be reliable and that it cannot be hijacked by people with ill intent.

Returning to the question at hand, in thinking about the challenge of maintaining records—a ledger—it is useful to consider differences along two dimensions: what is the structure of the database in which the records are stored, and how do we establish that any changes are legitimate. Along the first dimension—call it ledger structure and ownership—the database and its ownership can be either centralized or distributed. And, on the second dimension—access rights—we can have a limited-access system in which either a restricted number of people (or entities) have permission to make the alterations, or we can arrange an open and public (also called “permissionless”) mechanism whereby anyone can participate. In either case, once someone makes a legitimate modification, all versions are immediately updated automatically, guaranteeing agreement on the current state. (We assume that the security system in place allows control of who can see what.)

This two-by-two classification system leads to four possibilities that help us to distinguish among various ledger frameworks. To understand this taxonomy, the following two tables regarding the ledger structure and access rights provide a set of nonfinancial and financial examples. (For a more detailed discussion with examples, see Haeringer and Halaburda and Dwyer.) It is worth going through each of the four cases separately.

Ledger structure and ownership, and access rights: nonfinancial examples

 *Potential implementations.

*Potential implementations.

Ledger structure and ownership, and access rights: financial examples

 Note: CFPB is the Consumer Financial Protection Bureau.

Note: CFPB is the Consumer Financial Protection Bureau.

The upper left cell of each table is the case of a centralized database with limited, proprietary access rights. This portion of the taxonomy pretty much captures the ledger practices of human civilization until now. That is, there is one central ledger that contains the authoritative record of ownership or obligations and can only be changed by the organization maintaining it. Those authorized by this entity not only have the sole right to make changes, but may also control who can view the entries. While there may be copies, there is only one definitive version. Examples of this are easy to find: hospital records and records of securities ownership are just two.

Turning to the top right cell, this is the case of an open-access, but centralized recording system that allows anyone to write and read. Since there is little or no security, this mechanism is of fairly limited use. Nevertheless, examples exist. In the nonfinancial realm, these include the customer rating systems employed by Amazon, eBay, TripAdvisor and the like. It also is the mechanism that Wikipedia uses for creating and updating entries. Given the security concerns, financial examples are more difficult to find. We can think of one instance of wide use: the Consumer Complaint Database of the Consumer Financial Protection Bureau (CFPB).

The bottom row covers the range of distributed (or decentralized) databases. The distinction here is that there are now many copies of the ledger, and they all have equal standing. Furthermore, anyone who has one can change it, so long as they follow an agreed set of rules. Put another way, participants directly interact with each other. And, as with the centralized systems, there can be two cases: proprietary with limited access, and open and permissionless.

Blockchain technology is designed to implement distributed systems. It does this by providing automatic mechanisms that create trust, ensure there are no conflicting changes, and prevent malicious actors from making unauthorized or improper changes. It has the potential to record transactions between two parties, maintaining an agreed sequence, without reliance on costly third-party verification.

To prevent people from arbitrarily attacking the system, violating trust and making illegitimate modifications, the ability to alter the ledger is based on a scarce resource. In the closed, permissioned model, the scarce resource is identity―only specific people or institutions with particular attributes are authorized to make modifications. The idea of an open, permissionless system is to make identity irrelevant—anyone can join, leave, and re-join as often as desired. In this second case, the scarce resource that allows one to alter the ledger can be something like computational power or a stake (possibly financial) that you have in the system.

In the open system, participants are allowed to make changes so long as they follow the rules. Importantly, the rules must be designed to prevent someone from capturing the system. The original Bitcoin protocol, where the scarce resource is computational power, made the system immune from takeover so long as no one controls more than half of the computing power. But, as has been pointed out repeatedly, Bitcoin is incredibly resource intensive. Electricity cost alone exceeds $3 billion per year. In economic terms, this is a pure deadweight loss. In environmental terms, it is a disaster.

As the opening citation indicates, both financial and nonfinancial uses of the blockchain remain limited, with the obvious exceptions of Bitcoin and other cryptocurrencies. In the first table, we have listed two possible nonfinancial applications―supply chain inventory management and property title records―but so far as we know, neither of these has yet been implemented on a broad scale.

Where is this all heading? Without a further theoretical breakthrough, open distributed systems appear both costly to implement and slow. Estimates for the Bitcoin protocol, for example, are that speeds cannot exceed seven transactions per second. In contrast, there may be some promise in distributed systems that are proprietary. We suspect that most of the CIOs working on such projects have this kind of architecture in mind, perhaps in the hopes of creating a profitable monopoly. Unfortunately, a monopolist would be unlikely to lower transactions costs in the way that the advocates of open distributed systems hope. In the world of finance, one proprietary example is CLSNet, a bilateral payment netting solution that lowers transactions costs using distributed ledger technology. It is owned and operated by CLS, a leader in foreign exchange settlement, and is just getting under way.

Conceivably, a blockchain system could securely track the ownership of every financial instrument and exposure in the global economy. While this is a very tall order, it would be truly revolutionary. Money laundering and terrorist finance would be much easier to police. Authorities could monitor position concentrations and systemic risk. And, financial market participants could overcome information asymmetries, improving risk pricing and capital allocation.

This sounds great, but we are still a long way off. For example, before we can map the entirety of the financial system, we need to be able to identify both entities and instruments. We have written about the virtues of the Global Legal Entity Identifier (LEI) and the importance of universal adoption. But a complete mapping also would require global financial instrument identifiers (FII). While the LEI process is now well advanced, as far as we know, no one has plans to implement FIIs.

Suppose, for a moment that LEIs and FIIs were all in place and that everything was recorded on a proprietary distributed ledger that the public can view (perhaps for a fee). This would mean that everyone’s balance sheet will be public. Put differently, anyone will be able to see everyone else’s complete set of financial exposures. They could also ascertain your counterparty’s exposures, so they will be able to map even your indirect exposures.

From the point of view of law enforcement, financial regulators, and risk managers, such a system could be a dream. However, in a democratic society, we would be astonished if any financial institution (let alone investors) would willingly supply the information needed to make this feasible. It would be a world without privacy. Even if a much less invasive version were to become possible, it would be deeply ironic if the blockchain, a technology initially championed by libertarians disenchanted by government and fiat money, ended up by narrowing the range of individual freedoms.

Before we conclude, we should mention the problem of scalability. Before blockchain technology can alter key aspects of the financial system, there will have to be a breakthrough in speed. Today, the fastest proprietary blockchain systems can handle no more than several thousand transactions per second. In practice, the speed is likely far slower, unless there are only a small number of geographically proximate nodes in the network. To put this into perspective, at its peak, DTCC processes 25,000 equity transactions per second. (This is roughly the level of VISA’s payments processing capacity.)  In a recent report, DTCC points out that any new technology would have to have a maximum capacity of 2 to 3 times this peak―that is, it would have to be able to handle at least 50,000 equity transactions per second. Considering that computer scientists have been working on this problem for the better part of the past half century, boosting blockchain capacity (in a low-cost, environmentally acceptable way) remains a major challenge.

All that said, we really have little idea where this will all lead. Nearly a decade since the appearance of the paper that launched Bitcoin, we have more than one thousand crypto-clones. But where are the broader applications of the blockchain technology? As CLSNet suggests, we expect that it will find increased use in the clearing, payments and settlement system. Perhaps it also will be applied across a range of other activities, such as recording property titles or managing the supply chain both within and across firms or for a variety of accounting and audit functions. Such applications would likely focus on cases with limited numbers of transactions and where speed is less important. But, for now, it looks like the proprietary, rather than the open-access, mechanisms are in the ascendance.

We’ll be waiting for the thousands of CIOs to let us know.

Acknowledgments: We thank Morten Bech, Ethan Cecchetti and Hanna Halaburda for helping us understand the blockchain technology and its applications.