03 Jun 2015
In Australia, two of the major banks are looking at opportunities with Ripple, a firm that has adapted the Bitcoin distributed ledger model to make it more suitable for institutional banking.
" The more substantive point is because of the open nature of current distributed ledgers and block chains used, such systems are not even private."
Andrew Cornell, Managing Editor
This interest might suggest the financial mainstream is starting to recognise – or fear – these disruptive systems as a genuine threat which need to be co-opted or at least understood.
Yet look behind some of the more widely reported comments and the prevailing view from the mainstream is much less embracing. “Awake and aware” is one phrase used.
But some financial regulators and operators of major payments systems are much more outspoken in their views.
Erkki Liikanen, the governor of the Bank of Finland, at the European Central Bank/Bank of Finland Retail Payment Conference last week, gave a speech outlining five criteria any payment system must satisfy.
“Their criteria are: 1) technical efficiency, 2) accessibility and non-discrimination, 3) efficient and cost-based pricing, 4) operational stability with contingency plans in case of problems, and 5) international compatibility,” Liikanen said, adding “these criteria should not be considered as something that is imposed upon the payment method providers; they are an essential building block of any sound business case within the field of payment services.”
About Bitcoin he was blunt: “Bitcoin is not subject to the most basic principles governing payment systems, starting from the know-your-customer fundamental principle. Continuity of operations and contingency planning are problematic. And fluctuations in the bitcoin value will impose additional costs to people who use bitcoins.”
Meanwhile, Wim Raymaekers, who manages banking and treasury markets worldwide for the payments giant SWIFT wrote in the Journal of Payments Strategy and Systems if Bitcoin and other cryptocurrencies are to truly disrupt conventional systems “and become a dominant alternative, they must provide distinctive incremental value and overcome a number of critical challenges, such as regulatory uncertainty”.
“That is unlikely to happen in the short term, as illustrated by the relatively low and flat number of Bitcoin transactions.”
This debate is a heated one – just scan the online payments and Bitcoin forums to see – and proponents of the new technology will argue regulators and players like SWIFT are simply seeking to preserve the ancien regime of which they are a part.
But even if their motives are not disinterested, cryptocurrencies face some very considerable challenges – which are becoming more apparent as the scrutiny intensifies.
Some are almost existential. While regulators and governments may lament such new currencies allow unsavoury elements to elude regulation, in fact the more substantive point is because of the open nature of current distributed ledger and block chains implementations such as Bitcoin and Ripple, transaction details are not private.
In order for the vast array of computers in the system – the distributed ledger - to validate transactions, all transactions must effectively be public.
“The block chain, which serves as a public record of all transactions, provides a great tool for regulatory (and competitive) scrutiny,” as Raymaekers says. “If a public key can be linked to a business or individual, it is possible to gain visibility on who is sending what to whom, as well as to examine the block chain retrospectively in order to determine how much money is contained in a given Bitcoin wallet.”
The block chain and ledger system also makes a given transaction more complex to validate. Typically initial verification can take around 10 minutes and have the potential to be reversed. Even final verifications are not totally certain and can take up to an hour.
In an online, instantaneous transaction world, that's too long. And that's with relatively low volumes.
Nor are such transactions cheap when the full costs of verification and running the systems which do the verifying – massive banks of specialised computers – are factored in. Typical estimates put the daily cost or running system at between 1 and 2 per cent of daily transaction value.
Meanwhile, the ranks of computers are increasingly owned by a smaller number of large organisations who, if they come to dominate the market, would be theoretically be capable of gaming transactions.
For a fascinating and slightly unnerving look at one of these operations, check out Life inside a secret Chinse Bitcoin mine (Video). The computer arrays which race to solve the mathematical challenges behind verification are known as “miners” because they are rewarded with new Bitcoins – hence their work is “mining” for Bitcoins.
But this taps into another challenge: price stability. Bitcoin is one of the most volatile “currencies” in the world as events spike or flatten demand. Meanwhile, the constant addition of new Bitcoins dilutes value. The US$ price of Bitcoins hit $1147 in 2013 after an exponential rise but has fallen rapidly since and seems to bounce around the $US350 mark – for the moment.
Another, libertarian promise, of cryptocurrencies is liberation from the tyranny of existing banking and payments systems. But at present, this is impossible. Mining aside, it is difficult to earn Bitcoins and there are not enough merchants accepting them.
So value has to be transferred back to the conventional world and loaded onto the cryptocurrency via existing payments systems. Which is a problem because increasingly the institutions in these existing systems must abide by strenuous “know-your-customer” and anti-money laundering provisions.
It is by no means certain banks would not breach these regulations, at least in some jurisdictions, by facilitating transfer of value to a cryptocurrency.
Yet none of these considerable challenges means Bitcoin or particularly the concept of distributed ledgers and block chains are technological cul de sacs. Indeed, at the SWIFT Business Forum in London, Usama Fayyad, chief data officer at Barclays, told a panel discussion he believed block chains would be transformative – but more for how distributed ledgers would allow other applications.
As I argued in this BlueNotes article, disruptive technologies often survive the collapse of pioneer institutions.
Indeed, a growing number of financial institutions – including SWIFT – are investigating how these distributed systems can be used, sometimes in private networks.
As Liikanen says “the key challenge for developers is how to solve the trilemma between usability, costs and security of a payment method. The competitors in this future payment race are likely to come from different directions and their solutions can be very different”.
Currently, existing cryptocurrencies pose challenges for banks and their customers including the ability to meet global compliance requirements (such as Anti Money Laundering, Counter Terrorism-Financing); the privacy of customer data; who actually decides which transactions to accept or reject; the true 'cost' of any system (beyond just transaction fees); and the customer and merchant experience.
Regulators can't yet agree whether to treat Bitcoin as an asset, a currency or a commodity for tax and regulatory purposes.
None of these challenges are insurmountable. As even Raymaekers argued “while Bitcoin may not replace traditional and new payment methods to become a dominant alternative in the short term, banks should look at its underlying technology as a potential generic new way to transfer ownership of value in the longer term.”
This is indeed what banks around the world, including ANZ, are doing.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
03 Jun 2015
31 Mar 2015