Blockchain Babel

The Crypto Craze and the Challenge to Business

Igor Pejic

• Publisher: Kogan Page
• Year: 2019
• Print ISBN: 9780749484163
• eBook ISBN: 9780749484170
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

WINNER: Independent Press Award 2020 - Technology Category

Blockchain is the technology behind bitcoin and other crypto-currencies. According to Santander, it could save financial institutions $15-20bn a year from 2022 onward. Most experts see an unprecedented potential, but many banks, payment processors and credit card companies fret that bitcoin entrepreneurs could cast a pall over their core business. Whatever the position of blockchain, many voices are shouting from different angles, creating a cacophony of confusion including tech-evangelists, anarcho-libertarians and industry experts. But while everybody in IT and banking seems to have an opinion on the blockchain, there is little systematic research, no strategic analysis. Blockchain Babel is the ultimate guide to the most disruptive technology to have entered the finance industry in recent years.

Blockchain Babel looks at blockchain alongside innovation diffusion, competitive dynamics and management strategy. Shortlisted as one of the three best business book proposals by McKinsey and the Financial Times for the Bracken Bower Prize in 2016, this is a must-read for business leaders and aspiring leaders wanting to grasp blockchain and put it into context and understand the practical implications it may have.

CHAPTER ONE

Blockchain, Bitcoin and Distributed Ledgers – Disentangling the Hype

Myth: ‘The blockchain is the second generation of the internet, equal in heft.’

Why stop with banking? The dream of blockchain 2.0

Those who have followed blockchain over recent years will have noticed that it has turned from an unknown, online technology enabling transactions into a panacea for all ills. Once you have a hammer in your hand everything suddenly looks like a nail. Blockchain is the hammer. Eight major categories of blockchain applications have been identified:

• general applications;
• cryptocurrencies;
• financial transactions;
• public records;
• identification;
• attestation;
• physical asset keys; and
• intangible assets. (Swan, 2015)

Each of the above is said to have the potential to revolutionize not only an industry, but often the entire economy. Take the safeguarding of property rights as an example. In many less developed countries property rights are often endangered due to an unchecked ruler, a corrupt judicial system and – here comes the code word for blockchain enthusiast – a malleable property ledger. If you oppose the predominant political system, if a member of the ruling class needs your land to give it to a person of their blood or ethnicity, or a king wants your property to build a highway, you don’t stand a chance. The record is changed and your possession is no longer yours (Tapscott and Tapscott, 2016). This is bitter for the individual, but also for the economy as a whole. It makes it harder to use land or other real estate as collateral, for instance to build a new business, which in turn diminishes investment and impacts employment levels (The Economist, 2015). Also, foreigners will think twice before investing in that country.

Another annoyance the blockchain could remedy is the misuse of intellectual property rights. It will, its proponents tell us, make micropayments possible and feasible. Artists, journalists and movie creators can be paid by cents instead of having their content illegally downloaded. Blockchain could also revolutionize secure digital-identity verification. Voting is a widely described example. Putting identities on the blockchain will make it tamper proof and foster democracy. No longer will governing parties be able to manipulate voting cards or hackers meddle in elections. The immutable ledger also ensures that foreign aid reaches its target (Tapscott and Tapscott, 2016) or that electronic patient records in the health sector are secured (Baxendale, 2016). Governments across the world have realized the potential and are trying to harness it. This is especially true of the D5 Group of Nations (Estonia, the UK, Israel, New Zealand, South Korea), which is striving to implement blockchain-related technologies. Estonia launched services such as e-tax or e-business registers based on distributed ledger technology verification (Walport, 2016).

Not only are these possibilities intriguing, but they are also simplistic. Could a piece of code really prevent an African dictator from usurping a farmer’s land to build a highway? Would users really want to go through the hassle of making a transaction every time they read an article, just to give the author a fraction of a cent? As for voter-ID, how would you ensure the person entering the alphanumeric sequence is really the person whose face is on the ID? This technological determinism assumes that one tool will in itself make the world a better place. There is no doubt that the blockchain is powerful, but how markets act on it will be even more so.

This is where ‘smart contracts’ come in. Everything discussed so far can be subsumed under the term blockchain 1.0. Smart contracts take the blockchain to the next level: blockchain 2.0 (Swan, 2015). An often quoted example is the car that locks its doors if the car’s owner fails to pay the monthly lease. Contractual conditions are encoded into the algorithm and executed automatically instead of having a human judge and executor. The smart contract idea is nothing new, and was first discussed in the 1990s (Szabo, 1997), but it was only after the advent of the blockchain that a possible technological footing emerged. A good example of a blockchain platform that uses smart contracts is Ethereum. Ethereum is a platform built on a powerful blockchain. This platform runs apps that move around value and safeguard ownership. By using smart contracts technology, Ethereum has become one of the top blockchain projects; the company saw its share price skyrocket from US $11.29 on 5 January 2017 to $1,044.54 exactly one year later (Coinmarketcap, 2018). Meanwhile, sensors are making their way into almost every device. Cars and smartphones are bursting with them – and who would have thought five years ago that fridges would be made up of sensors that are connected to the internet and can automatically order food by monitoring stock and diet patterns? We are at the very beginning of the connected-device economy. The research firm Gartner (2015) estimates that the internet of things (IoT) in 2020 will count a staggering 20.8 billion connected devices, up from ‘only’ 6.4 billion in 2016. This exploding number gets harder to manage centrally every day. Even incumbents like IBM acknowledge that a centralized model will not work in the IoT world, claiming that it is ‘time for the cloud to move from the data centre to your doorknob’ (Pureswaran and Brody, 2015). To manage a global system of interconnected smart devices at reasonable costs, a trustless, P2P system is needed. As the blockchain offers decentralized consensus, the authors of the IBM report conclude that blockchain is not only the technology to facilitate the transactions, but also the coordination between the devices.

This explosion of applications has also been boosted by the invention of a new investment vehicle: Initial Coin Offerings (ICOs). ICOs can be used to raise capital for a new crypto coin or token by which early investors purchase coins and hope their value will balloon. It is comparable to a company’s stocks, but you do not receive dividends. Some ICOs can even equip the holder with voting power in the network, because their technical basis privileges nodes with a stake in the particular token.

So with all these exciting new possibilities, why does Blockchain Babel focus on the banking sector? First, even smart contracts rely on the blockchain to serve as the new (micro) payment layer of the economy. Second, the finance industry often paves the way for other sectors in terms of new business models, market dynamics and capital. If the blockchain manages to free tied-up capital, it could trigger a global investment splurge. Third, there seems to be a consensus among blockchain experts that finance will be the central area to be transformed. In its annual survey CoinDesk (Hileman, 2016) interviewed thought leaders and found 77 per cent of them convinced that finance would be the domain most affected by the blockchain, whilst 54 per cent of them felt that identity would see the biggest impact, and a mere 38 per cent thought it would be property titles.

Finance as blockchain’s weather vane

But even when we talk about blockchain and finance, the possibilities seem endless. Cryptocurrencies, transactions and remittances are just the most imminent application possibilities. Financial blockchains fall into one of four groups: retail payments, wholesale payments, capital markets and securities servicing (Wyman and Euroclear, 2016). Retail payments are the best known and most important. Most applications fall in this category, and they underpin the other groups. They comprise parallel currencies, including crypto and traditional currencies, as well as remittances and associated wallets. Wholesale payments include the overhauling of banking networks and cross-border financing. Thanks to the blockchain, money between companies can be moved easily even across states. Blockchain will also impact capital markets and securities servicing, primarily in the settlement of securities and asset documentation. Finally, blockchain can be used in trade finance and transaction banking, including supply chain and receivables finance, as well as commodities trade finance. We’re not talking about scenarios in the distant future here; NASDAQ has already built a blockchain-based solution called NASDAQ Linq that helps companies to represent share ownership digitally (NASDAQ, 2016). So this list shows the wealth of application fields; blockchain is a panacea. Yet the reason I highlight this is not to underline its importance, but to shed light on a central problem that will emerge once loans, bonds, stocks and derivatives join the payments transformation on the blockchain: interoperability. By this I mean that different blockchains will be in use and they should all be compatible. Companies, and financial institutions in particular, will be part of multiple blockchain-based ledgers – a foreign exchange (FX) network, a bond network, a bitcoin network, and so on. This tells us two things. First, the only way to harness the entire potential of the new technology is for a consortium of IT companies and financial institutions to come together and define shared standards. One such effort is already under way, namely the Linux-led Hyperledger Project. Hardware, software platforms and applications need to be in line. Second, no application will be able to lead in isolation in the blockchain world; a decisive selling point for any application will be the ease with which it can be integrated into other systems.

For the blockchain, finance is, and probably always will be, the weather vane, and, as we have just seen, construction sites in financial services abound. So is there really any need to bother with other application fields such as e-voting? The main argument I want to make with this chapter is that those in the finance industry must not see the new technology as an attack or simply an opportunity to trim down the current IT systems. Such a limited view, one that sees the technology simply in terms of delivering cheaper financial services, would overlook a core potential competitive advantage. Banks, credit-card companies and the like are institutions of trust. For centuries people have entrusted them with their most valuable material possessions. With the blockchain they get a tool to use this trust and break into new markets. Many of those markets are highly profitable for small and specialized companies. Bear in mind that the financial dimension of the blockchain underpins many other fields, so a blockchain strategy must not end with monetary transactions. But before we dive into strategy, let’s look at the mechanisms that breathe trust into all these diverse fields.

The second shot at electronic money and why this time it might actually work

Pioneers get the arrows, settlers get the land. That is a truth that so many headline-capturing trailblazers have experienced first-hand. Great visionaries and breakthrough inventors come in all shapes and sizes, but there is one thing they need above all else: the right timing. There is no doubt that Satoshi’s 2008 paper was ground-breaking, yet had it come a decade earlier, no one would have paid any attention to it. As a matter of fact, crypto payments had already been invented by the time Satoshi wrote his paper. In 1983 the cryptographer David Chaum had noticed the insecurity of card payments, especially over the internet. He wrote a paper (1983) describing an early form of encrypted crypto currency that would make internet payments anonymous and safe. He called it electronic cash or e-cash: it was a software the user installed on the PC. Money was stored in that software, but you still needed to have a bank to guarantee the money’s authenticity and ensure it wasn’t spent twice. It did so by a cryptographic signature. In many ways e-cash worked similarly to PayPal: money was withdrawn from a bank account or credit card and a credit note was given to the retailer as a guarantee. In any case the retailer needed to have a bank account to which the e-cash could be converted to ‘real’ money. You can also compare it to a prepaid card, only with an attached virtual wallet where a digital representation of money could be stored. So back in 1983 we had the exchange of fiat money to a digital token that was transferred anonymously, securely and quickly. Sound familiar? Sure, blockchain works with a different verification mechanism, but the benefits offered to the user were pretty much the same.

So why then did DigiCash, Chaum’s company, have to file for chapter 11 bankruptcy in 1998, just two years after he left it? It was not that Chaum was a bad entrepreneur. All the big boys such as Citi or Microsoft sat at the table with him. The maker of Windows at one point even offered to pay him US $180 million to put the program on to every PC. So surely he must have had a bad sales strategy, failed to have convinced crucial partners, or made some other game-changing blunder? None of the above. Deutsche Bank, Credit Suisse and Bank Austria were just some of the banks that partnered with him and actively offered e-cash to its customers. Banks had realized the technology’s potential and they tested it as an additional option for internet payments. Despite these major partnerships the technology did not take off – end customers just were not interested.

David Chaum and his pioneering ideas went a long way, but he was decades too early. He might have been the first, but, sadly for him, his ideas came too soon and he failed to gain the same recognition as Satoshi Nakamoto, or to inspire a host of TechCrunch articles.

Bitcoin has risen despite – and some would say because of – the fact that it was not another layer on top of the current banking structure. But is adding block after block on a distributed ledger really what made bitcoin succeed and e-cash fail? For bitcoin’s first users that might have been the case. The ability to completely bypass the established banking system fits bitcoin’s association with the dark side of the web. But this is not what has turned crypto currencies and the blockchain into hype. The world has changed dramatically since 1983. Back then, purchasing on the internet was only done by the most reckless daredevils. Payments were very much cash dominated, particularly outside of the United States. Today, credit, debit and prepaid cards account for a total yearly transaction volume of US $31.878 trillion (The Nilson Report, 2017b). Online banking is displacing bank branches, and by 2022 bank-branch traffic is expected to decline by 36 per cent (Peachey, 2017). ATMs, laptops and mobile phones are all you need to get the job done. When was the last time you visited a branch of your retail bank? In addition, payment terminals are now ubiquitous. The figure for newly shipped terminals amounted to 54.2 million in 2016, an increase of more than 10 million from the previous year (The Nilson Report, 2017a). PayPal has already become the largest online payment method in the United States and covers over US $354 billion in payment volume globally. It has almost 200 million active user accounts (Statista, 2017). Mobile payment is on the rise: in the years between 2017 and 2022 a rise of 132 per cent is forecast for mobile transactions (Pilcher, 2017). The point is, the average person is used to digital tokens of value. Purchase decisions are sometimes made on the method and ease of payment; a shop that does not offer credit-card payments might be shunned. Studies show that each business not offering card payments misses out on $7,000 in revenue each year (Intuit, 2012).

People have also become more impatient. Have you ever stood in a queue at a cash register, dreaming about kicking the terminal to speed up the processing? Contactless cards have increased our expectations even more, as not having to punch in PIN codes for small transactions makes queues faster. We don’t have to slide a plastic card into a terminal any more, but can just tap it. So contactless has fuelled the rise of many other payment-form factors, whether that is putting your NFC chip (near-field communication) into a piece of plastic, a contactless sticker, or even a plush mascot. We have come a long way from copper and paper, and even plastic. Everyone understands that money is not driven by a truck from one bank to another if you tap your Mastercard at a terminal. The idea of digital ledgers being updated in the background has taken root, as has the idea of cryptography and data security. Computer and internet penetration are at an all-time high: 51.7 per cent of the world’s population have internet access – in Europe it is 80.2 per cent and in the United States it is 88.1 per cent (Internet World Stats, 2017). What’s more important, e-commerce has had an impressive winning streak capturing 8.7 per cent of all retail spending, and is set to see double-digit growth until 2020, if you believe market research experts (eMarketer 2016). Unlike three decades ago, the stage is set for an easy, secure and cheap payment system that spans the globe.

Banks also now have higher incentives; as we noted in the last chapter, slashing credit-card fraud alone would save financial institutions almost US $23 billion a year. That is not all though, as there is an even bigger threat knocking on the banks’ doors: independent fintechs. To understand the magnitude of the threat posed by the fintechs, we need to look at the history of payments in the recent past. As payment processes have evolved, new functionality has been added, and the payments chain has lengthened. For every step in the chain, a new type of actor appeared, selling services for the small step in the payment process. This enabled these actors to gain expertise and scale advantages to carve out extremely profitable niches spanning the globe. These actors were not independents, but bank subsidiaries or partners. In banking this situation is referred to as ‘co-opetition’. Due to the high market concentration, makers of components of the payment value chain competed and cooperated with each other at the same time. Payment instruments only work if customers know they will be able to use their card in every store, or that they will not have to open a bank account with a specific bank to pay their electricity bill. Thus, networks, issuers and acquirers had no choice but to partner with their competitors to build a joint infrastructure. Sometimes this took decades and, due to the complexity and the interdependence of the steps, banks had to find a modus vivendi with each other, while at the same time fightin...

Table of contents

• About the author
• Introduction
• 1 Blockchain, Bitcoin and Distributed Ledgers – Disentangling the Hype
• 2 A Libertarian Fantasy in the Most Regulated of Industries
• 3 The Dreaded Kodak Moment that will Never Happen – Why Banking is Different
• 4 Data Behemoths are Coming
• 5 Hunting for the New Competitive Advantage
• 6 Business-Model Evolution – The arrival of the IT paradigm
• 7 An Unparalleled Promise… for Some
• References
• Index