Inside the tech that could "change the face of modern finance"
To say bitcoin attracted hype when it debuted in 2009 would be an understatement. Dropped into the world by an enigmatic founder under the pseudonym Satoshi Nakamoto, the online currency was billed as revolutionary to the way we exchange money, an essential organizing principle to modern life.
Flash forward to 2016, and bitcoin is not yet the currency of choice for the average consumer or business owner in developed or emerging markets. While true believers still think bitcoin points the way to the future, the online currency has endured several setbacks over the past few years: bitcoin exchanges have been linked to fraud schemes; governments, banks and regulators have called foul; and the currency has been tied to major drug and money-laundering schemes. Meanwhile, the jury is still out on who really created bitcoin, with self-professed founder Craig Steven Wright the latest to capture the world's attention.
If, seven years in, bitcoin hasn't quite broken into the mainstream, does it still matter? Well, a closer look shows that the online currency has already shaken up the financial sector in profound ways -- just perhaps not in the ways originally predicted. And we may have only seen the tip of the iceberg so far.
What is bitcoin, again?
In 2009, a mysterious "white paper" outlining the concept of bitcoin appeared on the Internet and the bitcoin marketplace was born. Bitcoin turned the financial world upside down by proving that cash could exist on the Internet, and move seamlessly between parties, outside the framework of banks and regulators. For many, the currency presented an exciting alternative to the current, cumbersome system of exchanging money.
Why cumbersome? Even with online payment systems like Venmo or PayPal -- billed as the 2.0 of financial transactions -- every exchange takes time. These systems essentially act as proxies, signaling Bank A to send assets to Bank B, while both banks maintain centralized ledgers to keep track of their assets. In total, this exchange can take several business days. Cue the "transfer pending" message on your phone.
Digital currencies, on the other hand, are assets in themselves. Send a bitcoin to someone across the world, and that exchange of value is instantaneous. No bank transfers required. No capital left in limbo for days.
How does this work? Bitcoin exchanges are powered by a unique technology called the blockchain. You may not have heard of it, but the blockchain may turn out to be a bigger breakthrough than bitcoin itself.
What is the blockchain?
The blockchain is a high-tech distributed ledger that allows payment systems to work without intermediaries like banks.
The technology is a breakthrough. By eliminating the middle step of financial transactions -- i.e. the step in which banks, which maintain their own ledgers, communicate with each other -- the blockchain significantly improves the cost and speed of transactions large and small. Plus, by bringing all exchanges under one shared, entirely transparent ledger, the blockchain eliminates the mistakes and delays that are inevitable when different ledgers talk to each other.
Like the moving assembly line invented by Henry Ford in 1913, the blockchain has the potential to turn our current system, in which banks reign supreme over transactions, upside down. The Economist calls the technology "downright brilliant."
You don't have to believe in the bitcoin to see the potential in the technology that makes it possible, David Wessel said. A 30-year veteran of the Wall Street Journal, Wessel is now director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution.
"Blockchain technology is a little bit like the Internet before we had the browser. It's hard for ordinary people like us to understand its potential because the potential is all in the future," Wessel said.
Wall Street wants in on the blockchain, too
Right now, players both inside and outside the financial establishment are anxious to figure out how best to leverage the blockchain. This leaves Wall Street playing defense and offense at the same time.
"If you're a big bank and you like this technology, you don't like the idea of some upstart company stealing your business," Wessel said.
The author of the first widely read academic paper on bitcoin in 2011, Reuben Grinberg has been closely watching digital currency evolve for years. Now an associate at Davis Polk, Grinberg advises large banks and start-up clients on blockchain technology. His firm recently decided to double down on their blockchain counsel due to high demand from clients, he said.
"Our clients are putting a lot more thought and time and money into thinking about how blockchain could affect their businesses," he said.
Adam Ludwin, CEO of the blockchain company Chain, is another player trying to help the financial services sector understand and use this technology. In April, Ludwin's company -- whose goal is to "digitize the world's financial assets," from cash to securities to gift cards to loyalty points -- convened a secret summit of more than 100 financial executives in New York City to brainstorm and experiment with the blockchain. Attendees included representatives from heavy hitters like the Nasdaq, Visa, State Street, Fidelity, Citigroup, First Data and Fiserv. This week, Chain released the fruits of that meeting: an open-source blockchain protocol that these companies are now deploying to power blockchain projects of their own.
The executives at Chain's April meeting all had one thing in common, according to Ludwin: all of them understood blockchain's potential.
"These are people who've been in the trenches, building for months. We discussed: what partnerships do we need to form? How do we go about bringing this to market? What are the regulatory and compliance considerations to do this the right way? What are the business model choices and tradeoffs to be considered? It's more the 'how' as opposed to the 'why'?" Ludwin said.
Ludwin points out that banking is overdue for the digital revolution that has rocked and reshaped most other industries. Online banking might exist today, but it's hardly an innovation on the original form, he said.
"When you go to your online bank, it's more like a digital version of your bank's branch. That's akin to, say, just buying a CD on Amazon. Where we're going is Spotify: a totally different medium," Ludwin said. "We're working on a big reset button on the entire financial services value chain."
Ludwin isn't the only one working on this reset button.
Last fall, nine banks interested in blockchain technology came together in a new consortium called "R3CEV." Less than a year later, that consortium now consists of 45 banks, including HSBC, ING, Wells Fargo, South Korea's Hana Financial and Japan's SBI Holdings. A member of the R3 consortium, the Spanish bank BBVA Compass has been vocal for years about promoting the blockchain's potential. In a report last year, the bank's economists wrote: "The key question is not how, but when the disruption will become far-reaching. Blockchain technology could reshape the financial industry well beyond the payments system; it has the potential to change the face of modern finance."
The industry saw a major milestone last January, when the Nasdaq successfully used the blockchain to complete and record a private securities transaction, a first in finance.
Nasdaq's chief information officer Brad Peterson spearheaded that transaction. For him, the blockchain is a huge improvement over the old system of record-keeping -- which was paper-based and prone to errors -- for stocks. The blockchain "forces integrity," Peterson said, by recording all changes in sequential blocks so no party can back-date anything. By design, everyone is forced to follow the rules and companies get pristine records of their stocks, he said.
The best analogy for this sequential system? For Peterson, it's Baskin Robbins, where you enter, grab a numbered ticket, and wait your turn in line.
"The blockchain is the grown-up version of Baskin Robbins," he said.
What's at stake?
A lot is at stake in the blockchain arms race, namely who holds power in financial services. Worried about losing ground, some bank executives could lean on regulators to stifle the blockchain experimentation taking place outside the industry, Wessel warned.
"The hard job of the regulators and supervisors is to encourage innovation and efficiency and avoid locking into place the dinosaurs -- without undermining consumer protection and creating another financial crisis," he said.
The blockchain's full potential is yet unknown. At this point, banks simply cannot afford to ignore this technology, Wessel said.
"Most recognize it has the potential to be something big," he said. "Having seen other industries that have ignored technological innovations, they're looking at it."
Still, finance executives are in early stages of a long game.
"They're in the second inning at the most," Wessel said.
Can we trust the blockchain?
A database that's widely shared and validated by all users, the blockchain is a new animal in finance. It's decentralized, meaning that users collectively agree to each change in the ledger and collectively police each transaction to make sure two parties can't claim the same money. That same decentralization also makes the blockchain exponentially harder -- some say near impossible -- to tamper with.
"In the blockchain world, the trust is in the community," Wessel said.
For now, the blockchain is closely associated with bitcoin, which comes with some baggage. Public perception of bitcoin took a particular dip in 2014, when high-profile bitcoin supporter Charlie Shrem was charged for an elaborate money laundering scheme related to Silk Road, a drug market that accepted only hard-t0-trace bitcoins. The scandal seemed to validate critics who said bitcoin was the currency of choice for criminals.
But the financial industry has started to see that bitcoin and the technology underneath it -- the blockchain -- are different beasts. Think of the blockchain as the marijuana of the financial world. Yes, there's some lingering stigma. But there's also enormous opportunity for innovation and profit. As with marijuana, waves of respected entrepreneurs have rushed in to build the industry framework for the blockchain -- conscious that if they don't, others will reach the gold rush before they do.
"There's a lot of money to be made if you're the guy who comes up with the standard," Wessel said.
As they brace themselves for industry-wide disruption, finance executives are being careful to make strategic partnerships with each other.
"You have to worry that these consortiums get together and all of the sudden it's a cartel. You have to assume that our friends in the government are keeping an eye on this," Wessel said.
Are they? At Davis Polk, Ginsberg said government regulators are, at least at the moment, "cautiously optimistic" toward the blockchain.
"It's a wait-and-see approach," he said. "I would not characterize the regulators as pushing back or holding back development and progress."
Sizing up the "new pie"
Even if it disrupts the financial sector in the short term, the blockchain could have significant positive impact in the long run. For one, it might lower the cost of financial transactions. By reducing the odds of costly lags and errors, the blockchain could create significant savings -- which banks could then use as profit while lowering customer fees.
"We envision a world where the software transformation of financial services will lead to greater financial inclusion -- that financial services products will be cheaper, more secure and reach far more people," Ludwin said.
The blockchain also has exciting implications beyond finance. In BBVA Compass' 2015 report, bank economists noted that efforts are underway to use the blockchain for all kinds of purposes, including "improving audits, registering property, creating digital identities and generating more secure voting systems."
"People are excited because we've all struggled with record-keeping problems in our lives, and wondered why those systems are so outdated," Peterson said. He predicts the blockchain could, for example, help governments collect and maintain robust population data, with all citizens entered into a ledger at birth -- eliminating the need for a costly Census every ten years.
"You could just do a query to know how old people are, where they are, when to tax them," he said.
While bitcoin still grabs headlines, when it comes to the future of cryptocurrency, we might be missing the more interesting story.
"All the noise about bitcoin has crowded out discussion of the new technology," Wessel said.
In six months, Chain plans to host its second blockchain summit, this one significantly bigger than the first, in San Francisco. Meanwhile, every day Ludwin braces himself for the industry shake-up he views is inevitable.
"There will be winners and losers," he said. "The financial industry will probably get smaller. But the winners will have an outsized share of the new pie."