"How blockchain takes us back to medieval times"

[Brendan Burgess]

I had assumed that there was universal approval of the blockchain but I heard Izabella Kaminska of the FT on BBC Radio 4 yesterday dismissing Blockchain as hype. I don't know her, but Tim Harford, also of the FT, was largely in agreement with her although he did say when he wants to understand anything about blockchain or bitcoin, he asks her. Tim Harford is one of the best writers and commentators.

I couldn't find one of her FT articles which summarises her views and most of them seem to be about the financial services sector.

https://ftalphaville.ft.com/2019/06/14/1560516935000/How-blockchain-takes-us-back-to-medieval-times/

This article is a about the clearing system.

But the point made by Harford was very good. One of the supposed advantages of Blockchain is that there is no one supervising it. But most of us like people supervising stuff. If we have a problem with an airbnb we expect airbnb to sort it out for us. If money goes missing from the current banking system, we expect AIB or BoI to sort it out for us and if they don't, we have ways to complain.

 

[Leo]

One of the supposed advantages of Blockchain is that there is no one supervising it.

I think part of the logic of the crypto community is that everyone bar governments and central banks are trustworthy. The community themselves would oversee it so there would be no need for any retrospective corrective action to recover stolen or misplaced assets.

 

[Andrew365]

I think part of the logic of the crypto community is that everyone bar governments and central banks are trustworthy. The community themselves would oversee it so there would be no need for any retrospective corrective action to recover stolen or misplaced assets.

This has little to do with Cryptocurrency. Cryptocurrency is an application of Blockchain technology. Financial Institutions would operate a private Blockchain.

Brendan,

Blockchain is very much a pilot program in financial institutions at the minute, but anecdotally you should have experience of how fragile and convoluted banking systems are, for example, look at the recent outage at Bank Of Ireland. I have direct professional experience of the clearing system, but it can be simplified into a common problem. Any process with a lot of touch points there is an increased operational risk. In the current systems there are always issues, and a lot of controls have been built with people employed to run the controls to ensure the books balance. The industry has already evolved and there are no 'central' clearing houses that act as the middle man.

The reason Blockchain gets hype is because there is potential to streamline the process and reduce the staff required to run the current process.

There is a definite Hype around Blockchain, but at the end of the day it is just a new database, it may be better than others it may not. Much like how paper ledgers were replaced by software like excel, Blockchain is just another evolution of technology which can help solve a problem that exists.

 

[Brendan Burgess]

There is a definite Hype around Blockchain, but at the end of the day it is just a new database, it may be better than others it may not.

Hi Andrew

That is very interesting because that was exactly what they said on the radio programme, except that they described it as just another spreadsheet.

And they argued, that most of us would prefer a government or a bank to be in control of that spreadsheet.

Brendan

 

[Andrew365]

Hi Andrew

That is very interesting because that was exactly what they said on the radio programme, except that they described it as just another spreadsheet.

And they argued, that most of us would prefer a government or a bank to be in control of that spreadsheet.

Brendan

let's take the example of Clearing. In todays Financial ecosystem the banks run this process not the government, the databases exist on the Banks hardware on their own property. The financial regulators 'govern' the banks and the clearing system has evolved since the crisis to move to a centrally cleared (CCP) model for a lot of the standard product suite. However, the government still depend on the bank to send them information so they can see what is going on. Therefore, Blockchain is not purposing a new process, it is making an existing process more efficient.

Now imagine this is all recorded on spreadsheet, Bank A has a spreadsheet and Bank B has a spreadsheet, both need to be reconciled on a daily basis to make sure they are correct (very costly administrative process). Then on a monthly basis the regulator may get an excel report showing the reconciliation is complete.

What blockchain proposes is to remove the need for entities to store their own database, everything will be on a central distributed ledger, so members have access to all transactions (the truth). This would remove the need for all the reconciliations and operational burden (cost savings). Theoretically, you can make the regulator a member removing the need to send them monthly reports (further cost savings).

The Blockchain technology proposes an eloquent solution to the above problem, but I am sure it can be solved by other technologies as well. There is a hype around Blockchain, and I have been an active member in the community. Professionally, I see Blockchain solutions proposed all the time, when they don't actually need a blockchain solution. However, this is no different to a few years ago when we all needed 'Big Data' solutions.

Blockchain should be critiqued like any other piece of technology and the term Blockchain was really coined to legitimize it and separate it from the controversial Bitcoin. Currently Blockchain is quite divisive, more so than any other new technology I have observed in the last 15 years.

 

[Brendan Burgess]

Andrew

That is a fantastic and clear explanation. Thank you


Brendan

 

[Leo]

This has little to do with Cryptocurrency. Cryptocurrency is an application of Blockchain technology. Financial Institutions would operate a private Blockchain.

I was just talking about the crypto application though and specifically in relation to the lack of central regulation. So not a reflection on blockchain as a whole.

 

[Andrew365]

This is why the Facebook Libra coin is a fantastic idea, the use of a Blockchain technology could radically improve a clunky expensive payment system.

Note, I am currently writing a research article that I hope to get published in the next 12 months. The topic is on a Central Bank Digital currency. I will share if successful.

 

[tecate]

When is there ever a new technology without a hype cycle? Blockchain is no different than AI or IoT or any new promising technology in that respect. The technology is already being used in the wild so there are use cases established. Izabella Kaminska - in the article you linked to Brendan - criticises use of the tech for a clearing and settlement use case. Since that article, Credit Suisse, Societe General and others have proceeded with the use of blockchain to clear and settle trades. I don't know a whole lot about the intricacies of that process. However, it seems that blockchain tech is being used to facilitate same day settlement - which would reduce risk (Lehman Bros collapse as an example). Same day settlement means reduced capital requirements. Furthermore, blockchain in this instance would reduce record keeping.

The use of any new system is likely to come with trade offs. The trade off in this instance seems to be some need for pre-funding. It's not something I fully understand - maybe Credit Suisse/Societe General and Paxos have found a way forward that overcomes this. If not, perhaps this isn't a use case for blockchain. Not to worry - there are plenty. When it comes to tackling the SWIFT system, making payments more efficient using blockchain and crypto tackles the issue of having to pre-fund in the conventional system (via nostro accounts).

But the point made by Harford was very good. One of the supposed advantages of Blockchain is that there is no one supervising it. But most of us like people supervising stuff. If we have a problem with an airbnb we expect airbnb to sort it out for us. If money goes missing from the current banking system, we expect AIB or BoI to sort it out for us and if they don't, we have ways to complain

Isn't it a case of product-market fit and design? There have been cases of people using blockchain where there was no need or it didn't add value. That doesn't mean it doesn't have a use case (clearly it does as it's already been applied commercially in some instances).

As regards Airbnb, I've been a fan of the disruption of the sharing economy. However, centralisation is an issue. All of these guys are taking the guts of 20% each and every time. The disrupters need to be disrupted. There are several blockchain based projects opened for sharing economy use cases but it's going to be really tough to shift the likes of airbnb, uber, etc. And circling back to your point, there will be trade offs along the way.

 

[Andrew365]

Quoting Neil Postman "Every new technology has positives and negatives, but often the negatives are not considered.

I don't know a whole lot about the intricacies of that process. However, it seems that blockchain tech is being used to facilitate same day settlement - which would reduce risk (Lehman Bros collapse as an example). Same day settlement means reduced capital requirements. Furthermore, blockchain in this instance would reduce record keeping.

That is a big statement, and for me I couldn't say that Blockchain reduces the risk of collapse. The financial crisis cannot be tied to one single issue, subsequently regulation has evolved, and we now have central clearing parties. Settlement Risk is very hard to model because it happens rarely, it is essentially gap risk i.e. a trade matures and I am owed money but the time in the time it takes the counterparty to pay me they default. This is related to clearing but a different process, and I believe is only an issue for clients that are now through a central counterparty. I assume how Blockchain would be used is that the ownership of the collateral is centrally held and doesn't physically transfer, thus in the event of a default you can claim the collateral. Do you have a link to the reduction of capital requirements (there are so many requirements these days).

Note with Central Clearing Parties and Blockchain doesn't actually reduce the risk, it just moves the risk around.

Anecdotally, I worked in that Lehman Brothers building featured in the Big Short.

 

[EmmDee]

let's take the example of Clearing. In todays Financial ecosystem the banks run this process not the government, the databases exist on the Banks hardware on their own property. The financial regulators 'govern' the banks and the clearing system has evolved since the crisis to move to a centrally cleared (CCP) model for a lot of the standard product suite. However, the government still depend on the bank to send them information so they can see what is going on. Therefore, Blockchain is not purposing a new process, it is making an existing process more efficient.

Now imagine this is all recorded on spreadsheet, Bank A has a spreadsheet and Bank B has a spreadsheet, both need to be reconciled on a daily basis to make sure they are correct (very costly administrative process). Then on a monthly basis the regulator may get an excel report showing the reconciliation is complete.

What blockchain proposes is to remove the need for entities to store their own database, everything will be on a central distributed ledger, so members have access to all transactions (the truth). This would remove the need for all the reconciliations and operational burden (cost savings). Theoretically, you can make the regulator a member removing the need to send them monthly reports (further cost savings).

The Blockchain technology proposes an eloquent solution to the above problem, but I am sure it can be solved by other technologies as well. There is a hype around Blockchain, and I have been an active member in the community. Professionally, I see Blockchain solutions proposed all the time, when they don't actually need a blockchain solution. However, this is no different to a few years ago when we all needed 'Big Data' solutions.

Blockchain should be critiqued like any other piece of technology and the term Blockchain was really coined to legitimize it and separate it from the controversial Bitcoin. Currently Blockchain is quite divisive, more so than any other new technology I have observed in the last 15 years.

I'd add one other nuance to the above - the banks are also looking at Blockchain as a way of simplifying non-standard contracts. So the example above is what happens for "contracts" around standardised commodities (i.e. cash, shares, futures etc). But if you look at transactions involving non-standardised assets (such as trade finance, bank loans, insurance) where each contract has its own terms and conditions, it is very difficult to have central clearing for a secondary market. So trading activity in areas such as trade finance is completely one-to-one and paper based. The hope is that blockchain technology could also be used to manage the specifics of these markets

 

[tecate]

That is a big statement, and for me I couldn't say that Blockchain reduces the risk of collapse.

I didn't express this very well. I guess I meant that it reduces the amount of capital that needs to be held to counter potential risk (such as a Lehman bros. scenario) - not that it has any bearing on the occurrence or otherwise of a collapse.

 

[Andrew365]

I'd add one other nuance to the above - the banks are also looking at Blockchain as a way of simplifying non-standard contracts. So the example above is what happens for "contracts" around standardised commodities (i.e. cash, shares, futures etc). But if you look at transactions involving non-standardised assets (such as trade finance, bank loans, insurance) where each contract has its own terms and conditions, it is very difficult to have central clearing for a secondary market. So trading activity in areas such as trade finance is completely one-to-one and paper based. The hope is that blockchain technology could also be used to manage the specifics of these markets

Yes, 100% agree, Trade Finance in particular. Surprisingly each Asset Class has varying levels of technology sophistication.

A central Clearing Party can be thought of as performing the same function as a Blockchain, without using Blockchain.

 

[Andrew365]

I didn't express this very well. I guess I meant that it reduces the amount of capital that needs to be held to counter potential risk (such as a Lehman bros. scenario) - not that it has any bearing on the occurrence or otherwise of a collapse.

What is your source for that? I have not come across an instance of Technology allowing less Capital to be held.

 

[tecate]

What is your source for that? I have not come across an instance of Technology allowing less Capital to be held.

As in same day settlement versus settlement over a couple of days - less capital tied up (as in duration of time capital is tied up rather than actual amount).

 

[EmmDee]

As in same day settlement versus settlement over a couple of days - less capital tied up.

Settlement period has very little to no effect on Bank capital requirements. Bear in mind settlement cycles don't mean your cash is tied up for the cycle. It only moves on settlement date irrespective of settlement cycle

 

[Andrew365]

As in same day settlement versus settlement over a couple of days - less capital tied up (as in duration of time capital is tied up rather than actual amount).

The better word to use here is 'Collateral'. Ass EmmDee pointed out, the capital of a Bank is a separate pool of assets that are not impacted by day to day trading.

There are also different settlement times for different products and different types of settlement.