• Why Banks are Really Investing in Blockchain
  • In prospect: A Complete Reset of The Financial System over next few years

It’s easy to see why the financial establishment ignored Bitcoin when it was first introduced. Coded by an unknown hacker, and germinating in the underworld of cryptographers and criminal interests, it was difficult to see how it could reinvent financial services.

Larry Summers, for example, said it would have no “geo-economic impact whatever”.

In the last year, the financial establishment has delved deep into this world, rushing to experiment with systems that make use of the blockchain technology that underpins Bitcoin.

Blockchains are seen as a means for big banks to transfer and store digitised assets such as bonds, shares, and payments in a frictionless way, radically reducing the need for fee and commission taking ‘trusted’ intermediaries, potentially heralding a new open source financial system.

A recent survey of 200 banks by IBM revealed that 65% of them expect to have blockchain systems in place by 2019.

Is this a case of turkeys voting for Christmas?

After all, if blockchain removes the need for third parties, hundreds of thousands of banking jobs could go as the financial system resets.

The real reason banks are adopting blockchain

The rush to domesticate blockchain says a lot about the potential of this technology.

Blockchain may help the big banks save billions, wiping out thousands of jobs, but it may also provide the basis for a reinvention of the entire financial system as based on math, code and encryption.

Today Larry Summers says that those who underestimate the coming impact of blockchain innovations are ”on the wrong side of history” like those who ”thought the internet and digital photography were gimmicks.”

And Wall Street seems to learned the lesson that Silicon Valley has taught every other industry: embrace the biggest threat or you will be colonised.

The thing is, as I’ll explain today, it is by no means obvious that big financial institutions will create the dominant platforms for this technology. And there are deep implications for investors as a result.

Why Blockchain is so important

The blockchain is a breakthrough in computer science that builds on forty years of research into cryptography. It is a constantly updated, publicly available ledger of verified transactions which is protected with powerful encryption tools.

The system works like a distributed network — see the diagram below — as transactions are added in blocks to the chain, all the information in the record is permanent and each of the computers keeps a copy of the record to ensure this. If you wanted to hack the system, you would have to hack every computer on the network.

This basic system could be far more secure and transparent than traditional financial networks and allows for continuity and trust without validation by a third party. And it is made possible by the storage ability that we have available to us. With cost per terabyte in free fall, we are making use of storage to create an inviolable record of transactions, ownership, digital identity and trust among parties with no prior relationship.

Allowing for a number of limitations — I’ll return to those shortly — the idea is that Blockchain will do for storage, what the PC did for computation and the internet did for communication.

The question then is: who will be in control? I make seven predictions.

1. Banks will lead the way

For banks, 2016 has been a year of tests, trials and proof of concept. By this time next year, some 15% of them could be running blockchain systems, according to research by IBM.

So far banks are favouring closed internal ledgers where individuals are giving permission to access the network. The sticking point is confidentiality. Blockchains require every participant in a network to see every transaction in order to verify and apply them to their copy of the ledger. Given the nature of regulations and interbank competition, many banks are preferring to launch internal ledgers that don’t strictly apply full transparency and peer-to-peer settlement.

There are several immediate payoffs for banks.

Case in point: Blythe Masters previously JP Morgan’s youngest ever general manager and inventor of what turned out to be the toxic credit default swap derivative, who is now at the helm of blockchain start-up Digital Assets.

Her base case is that blockchain technology can digitise and automate ‘back office’ stock market reconciliation and settlements and streamline them: saving billions in costs in the process.

This can allow banks to have a lower capital requirement to facilitate trading and it frees up capital for more productive processes (like lending). The complex cryptography also makes these systems less vulnerable to cyber attack.

So while there is a really tremendous amount of hype building around blockchain, it is easy to see why banks will continue to develop these networks.

2. Forget fintech, it’s “regtech”

The really big pay off for banks, according to David Birch of Consult Hyperion, could be regulation.

For most financial services, the place where costs are out of control and growing without limit is in compliance.

And with an open, public, fully transparent ledger, banks would be able to solve this problem — causing banks to focus less on internal ledgers and more on radical transparency.

“I detect the emergence of “regtech” as a distinct from “fintech” as a paradigm and organising principle,” says Birch. “The idea that there might be new categories of technology (and actually I think that the shared ledger might be one of them because of its potential for a new kind of transparency and a regulatory win-win) where the impact is to reduce the cost of complying with regulation rather than to reduce the cost of delivering a functional service”.

That alone could have create a seismic change in culture among banks.

3. Radical disruption as 20% of economy is reinvented

Of course, banks are not the only ones experimenting with these systems.

Careful research based on US Commerce Department statistics by Gil Luria at Wedbush Securities estimates that over 20% of US GDP is based on ‘trust’ industries that perform middlemen tasks that blockchains can and will increasingly digitise and automate.

What we are witnessing is a perfect storm of collapsed trust in the security of networks and in the integrity and competence of bankers, brokers, lawyers and real estate agents has opened the way to the codification of money, markets and trust itself.

No wonder VCs, private equity, Wall Street are suddenly investing heavily in blockchain.

4. You need to watch Ethereum

It is by no means clear however that banks will be able to create the dominant blockchain.

These institutions are adapting 20th century cultures to a radically open source technology — one that is far better suited to younger digital natives who are steeped in engineering, encryption and have extremely open minds about what comes next.

The most promising developments at the moment are happening on Ethereum — a relatively new platform with its own blockchain and currency (called ether) and a protocol that supports not just payments but programmable transactions — “smart contracts” that are executed in code rather than law.

Setting aside the currency part of this offering for a second, what the developers behind Ethereum have created is the first decentralized ‘world computer.’

Businesses can use this decentralized computer to referee all kinds of global transactions without the need for a third party or centralized authority as arbiter.

It’s creator Vitalik Buterin, an emaciated encryption genius with the flat tone of a voice synthesiser, has helped create a fast growing but very, very fragile ecosystem of applications.

The most notable was the DAO — a decentralised autonomous company that operated as a VC, attracting $130m in funding, before it was defrauded and collapsed.

Ethereum continues to attract thousands of tech engineers and open source developers — and it’s here, or on platforms like this that we are witnessing a new financial system gestating.

These include new means of investing: With Digix, you can convert your Ether immediately into gold tokens that are cryptographically linked to and backed by the Singaporean gold vault. At any time (even in the case of a Digix bankruptcy) a person can redeem their tokens for physical gold. No brokers, no banks, no fractional reserve, near-zero fees, immediate, and secure.

There are also fascinating new economies gestating: slock.it are targeting the multi-billion dollar market for IoT devices, by allowing any asset (bike, apartment, car, etc) to be digitally locked or unlocked and turned into income by renting it out over the platform.

New means of transacting, employing, renting — Bitcoin is only the first of many instances of digital currencies that signal a rush away from traditional finance.

So a central conflict over the next few years will be between the permissioned blockchains controlled by banks and coalitions of intermediaries and the far more radical programs that will give users direct access to open source protocols.

There are deep political problems on platforms such as Ethereum to resolve, with many divisions opening up with each new fork and change in strategies for the community. It’s a mess to be honest. But these networks are being built for a fragile, densely networked, complex, real-time world chronically short of ‘trust’ whether in the terms of weak network and institutional resistance to cyber attack and cascading error, or in the honesty and competence of those running financial institutions, and the ability of regulators to house train and monitor them.

5. A spike in energy demand

In order for blockchain to go fully mainstream, there are also serious scalability problems that need to be resolved.

Currently, Bitcoin can handle 3 to 5 transactions per second and Ethereum 15 to 25. But the interbank Visa system handles 2,500.

Then there is energy. The methods for encrypting bitcoin for example require a network of individuals who can “mine” new coins by computing complex problems. This requires a huge amount of server power. Bitcoin mining already consumes as much electricity as a US city of 280,000, and by one estimate as it will be as much as Denmark by 2020.

And larger block size and new ledgers would intensify economies of scale, driving consolidation and making the validation system more vulnerable to collusion. Already, 58% of the hashpower on Blockchain is held by four Chinese mining pools.

There is a large contest for political organisation ahead.

6. War between Tech Titans and Banks

Blockchain may well hit the giant corporations such as Google and Facebook over the mid-term, as these companies have built proprietary systems and networks on top of the existing open Web code and protocols to become the most powerful intermediaries and network gate-keepers.

In fact, this may be a means for financial institutions to make up ground on the big internet platforms, having fallen well behind in the development of computing power, user bases and artificial intelligence.

7. A total reset of the financial system

My base case: Bitcoin/blockchain came out of left field eight years ago to stunned confusion. Within another eight years it may well have become the basis for a radical reinvention of the entire financial system as math, code and encryption are developed to work in vast new trust networks: a new trustworthy iteration of the web.

It’s potentially as big as the emergence of the web itself. But that potential is also complicated by the political tensions: between banks and tech giants, between banks and the Nerd Nation, between traditional finance and radical transparency across global networks.

The implications of this economic warfare are quite staggering.

If you consider that debt-based money allows for the payment of interest and taxation, creating a flow of wealth from end users of money and those who create it (banks and monetary authorities).

And when you consider that the economics of the 20th century was predicated on increasing debt as a means of driving growth.

And if you consider that Blockchain, bitcoins and their ilk have no basis in debt or direct interest payments to central authorities, then we are set for a deep change in the financial system over the next few years.

Drop me a message here if you have any queries or questions: michael@signumintel.co.uk

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