There has been a lot of hyperventilation over the past few months about the “blockchain revolution”. The evangelists believe that this technology, which was originally created to underpin the digital currency Bitcoin, is about to reshape huge swathes of the financial services industry, sweeping aside whole sections of the existing infrastructure and replacing it with faster, cheaper alternatives.
Blockchains are an exciting idea with great potential but the talk has run far ahead of the reality. So what’s all the excitement about?
In essence, a blockchain is an online database that can be accessed by multiple users simultaneously. Every change to the information it contains is verified as true and can be viewed by every user in near-real time, while information recorded in the database cannot be changed retrospectively. A blockchain therefore provides a true and accurate digital record that updates constantly as new information is added.
These databases are often called “distributed ledgers” because they do not sit in a single repository but are spread across the network of computers controlled by their users.
This idea has sparked a lot of interest because a “distributed ledger” that updates in real time is potentially a very powerful tool. It could provide a cheap, trusted means to record the ownership of assets of all kinds and to settle transactions. The finance industry today relies on trusted third parties to act as the intermediaries between the two sides of many different transactions, which adds cost to the process and often slows it down. If those intermediaries could be replaced by a shared database that all parties could access, transactions could be made cheaper and quicker to execute.
But the blockchain that underpins Bitcoin is extremely unlikely to be the version that ends up fulfilling this role. Why?
Content from our partners
The reason is that Bitcoin was created to enable people to make direct digital payments to each other without an intermediary standing between them. It was therefore intended to make banks and financial institutions obsolete – not to help them become more efficient.
The crucial point about Bitcoin is that it uses a so-called “public, permission-less” blockchain. This enables anyone to pay any other user directly in Bitcoin without the payment having to pass via a trusted intermediary. However, to enable users to trust this public, permission-less system, Bitcoin must ensure that no one can defraud another user by spending the same Bitcoin twice. It therefore needs to verify every transaction as it happens and create a permanent, immutable record of every transaction that has ever taken place.
Bitcoin uses the Bitcoin blockchain to achieve this, but the process its creators came up with for verifying and recording each transaction requires a lot of computing power that must be contributed by the people who use the Bitcoin system. This enables Bitcoin to operate without using any financial intermediaries, but it’s expensive (because it uses a lot of electricity) and it’s slow, which means it cannot record large volumes of new transactions in anything like real time.
That’s why we believe that “private, permissioned” blockchains will ultimately prove a much better option for the financial services industry. These will be closed systems accessible only to limited groups of authenticated participants – a consortium of banks or asset managers, for example – who will use private blockchains to record and verify information about assets, such as ownership and the settlement of transactions. A private, permissioned blockchain – or distributed database – would enable direct transactions between participating institutions and make third-party intermediaries obsolete.
This would have a number of important attractions. For a start, it could make certain operations a great deal cheaper than they are today, by removing the cost of using trusted intermediaries. And second, by removing the need for Bitcoin’s cumbersome verification process a private, permissioned blockchain would be much faster and more efficient than the public, permission-less version, making it much better suited to handling large volumes of financial transactions in real time.
The blockchain evangelists are right to argue that distributed databases have great potential to make parts of the financial services industry more efficient. But there’s a long way to go. The likelihood is that, in the words of Bill Gates, we will over-estimate the rate of change on a one-year horizon and underestimate it over the span of a decade. In the end, the blockchain revolution may well prove as radical as its supporters expect. But it may take a while for the world to notice.
