The View

Could someone please explain to me how blockchain works in the real world?

PUBLISHED : Thursday, 05 May, 2016, 3:54pm
UPDATED : Thursday, 05 May, 2016, 4:23pm

When a new invention is promised, it is either an absolute breakthrough or absolutely overrated. The investors are either in the early stages of a miracle or the late stages of an investment bubble chasing a mirage.

Blockchain promises salvation for the financial sector in the form of major back office cost savings across a whole range of activities. It’s supposed to be a miracle in the making that could restore profitability to banks. Now if only someone could clearly explain to me how it works in the real world rather than on a presentation deck.

Today’s post-financial-crisis infrastructure and process has required that everything from opening a bank deposit to trading securities carries substantial costs for identity checking, transaction authenticating, reliably and accurately transacting, and securely storing records. These activities seek to resolve problems of trust, fraud, and error.

Substantial amounts of capital and collateral are also locked within the entire financial system. They act as a buffer against the failure of trust and confidence in undesirable outcomes. Today, the costly structure of managing financial risk makes the economics of small-sized transactions expensive, unaffordable and inaccessible – especially to low-income members of the society.

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Blockchain is a revolutionary concept. It is supposed to solve all the challenges of trust, asymmetry of information and the unscalable economics of small transactions by obviating cumbersome risk infrastructure and central intermediaries.

Bankers roughly estimate that it costs about 20,000 and up to 60 days to perform due diligence, process and clear all the approvals to get an institution or high net worth person on board as a client for a bank. These costs include wages of an expanding corps of managers in compliance, risk consultants and services like private investigators.

Today banking customers in Hong Kong complain how difficult it is to open a bank account. Many self-evident and frustrating questions are being asked such as, “Why do you need a bank account?”

Reforms following the global financial crisis weren’t supposed to make banking more arduous for the average citizen. But stringent rules have reduced financial inclusion for many in developing countries. These include migrant workers whose families depend on them being able to send home about US$300 to US$500 a month through forex agents.

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Bankers worry that automation has not yet made a serious improvement in meeting all the regulatory requirements. System consultants are making a fortune designing and maintaining compliance platforms. They say their bank clients are far away from unifying their operations to gain efficiencies.

Making blockchain work has proven to be more complicated and it is stuck in an early stage. Banks and their fintech consortiums are only beginning to develop a plan to start prototyping blockchain. They are struggling with how to manage innovation and inventive focus.

Historically, banks have been slow to adopt new technologies. No one wants to be the first one to assume first-mover risks. ATM machines are still run on Windows. And the mere suggestion of even migrating to a more stable system like Linux scares their technology managers. Far better to stick to system you know than risk downtime, customer complaints and losing your job over a troubled platform migration.

Unlike other technology enterprises, a typical financial tech startup comprising system designers and coders cannot possibly understand the entire step-by-step process of how a loan is made by a bank. So an institution’s expertise is needed for process knowledge.

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Bankers can only describe the process of making a loan, but remain bewildered and clueless about how blockchain works. Blockchain is actually a concept, not an implementation or a single technology. Eventually regulators need to approve the entire implementation.

One of the biggest problems is security. Anonymous trading of anonymous value is supposed to occur with no need for authentication. Therefore, switching costs will be high in terms of costs, operational and technology risk.

While everybody in banks says they are ready to make a change, the fact is that mainframe computers are still being used. Banks can’t even operate outside their firewall so it is inconceivable how they will radically change their operations. Institutional resistance from exchanges and existing technology service providers could prove insurmountable.

Technologists and bankers must bridge a wide gap. It was only a few years ago that banks and regulators derided bitcoin, the father of the blockchain ledger platform. Now they are rushing to incorporate it into their entire business.

Peter Guy is a financial writer and former international banker