Five hurdles blockchain faces to revolutionise banking

17 September 2019

By Markos Zachariadis

Twitter founder Jack Dorsey believes Bitcoin will become the internet’s “native currency”, while Tesla CEO Elon Musk has hailed the cryptocurrency’s structure as “quite brilliant”.

That structure is underpinned by blockchain – a tamper-proof system of distributed ledgers that does away with intermediaries on the internet (for a more indepth look into the various definitions of blockchain take a look at our paper).

Blockchain is undoubtedly technologically complex, with many versions of it in existence, but all distributed ledgers share a basic premise which shapes their day-to-day operation and governance: they offer a decentralised infrastructure to maintain the ‘single version of truth’, recording all changes made on the blockchain database since its formation.

It means there is no need for a central authority as all blocks across the network share the same full copy of the database - the shared ledger - and thus no administrator needs to hold a ‘master version’.

Blockchain has been touted as the next step in the internet, a revolutionary technology, which top academics have claimed will “do to the financial system what the internet did to media”.

Experts and blockchain investors predict the technology will do away with the need for banks to act as intermediaries, so that when we buy our groceries online it will be immediately recorded on the distributed ledger, rather than waiting a couple of days for it to register in our account as banks contact each other on a system invented in the 1970s. Blockchain does it instantly.

As Insead Professor and tech author Don Tapscott says: “For the last 40 years we’ve had the internet of information; now, with blockchains, we’re getting the internet of value.”

And just as newspapers took the threat seriously by investing in their own websites banks are experimenting with blockchain. BNP Paribas is using blockchain technology for its currency funds and for order processing, Santander is using it to reduce costs by $20 billion a year, Barclays is trialling it with start-ups and even the Bank of England is looking into using distributed ledgers.

A lot of this experimenting by banks started in 2015 and four years later blockchain removing banks as intermediaries in our payments system still seems a long way off. That’s because there are five basic challenges that the technology has to overcome if it is to be accepted as part of the financial system.

 

1 Governance

Blockchain’s strength is it has no central authority, but this is also a weakness. Who makes the decisions about how the technology works or when it needs updating?

If Microsoft Windows needs an update, Microsoft will decide on that and send out an update, but with no central decision-maker, decisions about updates in the world of blockchain become slow and dysfunctional.

Blockchains are more like a community, there is no systematic way to decide on updates or improvements. Instead they happen through huge debates among the community, with groups forming and arguing over such issues as the length of a block, the number of transactions it should hold and how quickly they should be chained. Often there is no solution to these debates, with no way to organise these communities and make decisions.

Sometimes this can result in a split, such as in 2016 when 3.6 million ether (amounting to roughly $60 million at the time) was stolen on the Ethereum network, so founder Vitalik Buterin agreed to “unwind the theft” by creating a new version of ether. The ‘hard fork’ allowed people to reclaim their funds, but some of the community felt it went against the principles of blockchain and so carried on using the old ether, now known as ethereum classic.

Also using simple majority voting mechanisms to make decisions means issues are vulnerable to lobbyists or particularly active contributors seizing control. While the steeling of 3.46 million also highlights that when things go wrong, who is responsible and adjudicates the rules? These questions are still unanswered.

 

2 Scalability

If blockchain is to be used for payments then this is a big issue. The inability to resolve what became known as the ‘block size debate’ has resulted in multiple hard forks since the launch of Bitcoin in 2009.

There are those who want to keep the blocks small to encourage more participants to mine, but there are others who argue for the need to scale-up, which could mean fewer specialist developers mining larger blocks.

Despite blockchain’s popularity it is still at a very small scale compared to everyday electronic payments. At the moment Bitcoin’s blockchain does 2,000 transactions every 10 minutes, whereas Visa handles more than 65,000 transaction messages every second, and SWIFT (Society for Worldwide Interbank Financial Telecommunications) - the global messaging system used by banks and financial institutions to transfer payments - deals with approximately 24 million messages a day.

The debate of scale needs to be resolved for blockchain to grow big enough to become part of the world’s financial plumbing.

 

3 Standards

This is a big question for blockchain – interoperability. At the moment there are many ways different blockchains organise information, which means transferring from one to another would not be easy.

Blockchain helps move value around the internet, but these transactions only use proprietary formats for the messaging to exchange tokens. There is no agreed universal layout of the transaction information.

In a financial payment a block will hold the person or company’s name, account information, payment, location address and any other relevant factors. But the cryptocurrencies all do this differently, so it would be difficult to move from one currency to another.

They will need to create standards for the information they contain and how it is systematically laid out. People may have Bitcoin, but at the moment you can’t take them to different platforms, like Ripple or Litecoin, and exchange them. Whereas with physical currencies there is a system for that, it is easy to convert dollars into sterling.

Who should create these standards though? There needs to be a body taking the lead on this and a general consensus come to the fore, like the Internet Engineering Task Force (IETF) has done for the internet.

 

4 Liability

Who do people turn to when something goes wrong on the blockchain platform and they lose all their Bitcoin when it crashes?

There is no liability for the platforms at the moment, Bitcoin is essentially a community of volunteers. For instance, in 2017 Canadian digital currency exchange QuadriagaCX announced a computer error led to losses of ether worth $14.7 million.

The ether was trapped in the Ethereum system, but the Ethereum community decided not to take any action in recovering it and so QuadrigaCX had to swallow the loss so no client balances were affected.

Surely, liability will need to be cleared up before the public can trust it if failures occur and for that we need more regulation in the space of crypto and blockchain in general.

 

5 Transparency & identity

Blockchain payments mean all users can see all the transactions, this makes them easy to audit and trace. Users are pseudo-anonymous, in that they are not obliged to identify themselves in any way, but they can still be traced through their alphanumeric address.

It means other users can see the amount of Bitcoins going from one address to another, but no name is linked to that address. Coins are spread across the universe of blockchain and buying one gives the user a key to unlock the movement of them, that is how users track who ‘owns’ the Bitcoin.

SWIFT is a private network infrastructure, considered secure and resilient, allowing access only to users who are fully identified and verified as legal entities in the finance sector. While Ethereum, for instance, is a public network accessible to anyone who cares to download its digital wallet and trust is created by relying on the blockchain protocol which prevents any double-spending of the digital tokens.

Its transparency is its strength, but eventually the lack of a digital identity and identification framework will be problematic for many users and investors as it is a fundamental premise on which the financial system resides.

 

Unless these issues are addressed it is hard to see blockchain achieving “foundational technology” status, which advocates such as Harvard Business School Professors Marco Iansiti and Karim Lakhani’s are predicting.

There are many start-ups, technology companies, and established financial firms working with blockchain and experimenting with the technology, but at the moment, it is looking more like a complement to the system we already have, rather than the internet’s native currency.

Certain projects such as Libra from Facebook – which has received mixed responses – seek to tackle some of the challenges I talked about above, but we’re certainly far from a blockchain-based cryptocurrency dominating the space and becoming the “internet of value”.

Further reading:

Zachariadis, M., Hileman, G. and Scott, S. V. (2019) "Governance and control in distributed ledgers : understanding the challenges facing blockchain technology in financial services", Information and Organization, 29, 2, 105-117.

Scott, S. V., Van Reenen, J. and Zachariadis, M. (2017) "The long-term effect of digital innovation on bank performance : an empirical study of SWIFT adoption in financial services", Research Policy, 46, 5, 984-1004.

 

Markos Zachariadis is Associate Professor of Information Systems and teaches Platform Strategy on the Warwick Diploma in Digital Leadership. He also lectures on Digital Finance, Blockchain and Cryptocurrencies on the MSc Management of Information Systems & Digital Innovation

Follow Markos Zachariadis on Twitter @MarkosZach.

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