Barron’s featured story this week is Beyond Bitcoin: How Blockchain Is Changing Banking. It can be a little complicated but you don’t need to be a tech nerd to get it. The article does a good job explaining how the whole thing works to the average Joe. By now most of us have heard about the Bitcoin mania but have a little understanding on how the whole thing works. Blockchain, the technology behind Bitcoins, is not a fad. It’s the real deal and many industries outside finance, such as medical and insurance are testing.
To simply put it, a blockchain is a digital ledger that is kept and validated simultaneously by a network of computers. Think of a shared Excel document that no one person can change without the agreement of the others. Importantly, it allows deals to be made without the blessing of a “trusted intermediary,” such as a clearinghouse. It has many advantages.
Blockchain will gain wider acceptance soon. Why? Well lots of money can be save. But also it has been proven to be secure, reliable, and operates at a lower cost than traditional mechanism. Why is it more secure? True record is kept by all participants and doesn’t depend on one person but by all participants. There’s not a single point of failure. For example, your notary can make a mistake that wouldn’t normally happen. Executives know they need to understand blockchain, but not everyone is clear yet on how exactly it will help their business. I’m in the same boat. I don’t want to buy or invest in bitcoins, but I understand that blockchain is the way forward.
Here’s a copy of the article:
Beyond Bitcoin: How Blockchain Is Changing Banking
by By Avi Salzman from Barron’s
The hottest investment of the first half of the year wasn’t Amazon.com, Netflix, or even Tesla. In fact, your broker probably isn’t pitching it, and it is barely even recognized by the Securities and Exchange Commission. Yet cryptocurrencies—the most famous of which is Bitcoin—are shooting out the lights.
Investors who bought Bitcoin for $5 or less just five years ago are millionaires today, as its price has soared above $2,500. Unlucky ones have lost small fortunes simply by misplacing a password, much like leaving a suitcase full of cash at the train station. Bitcoin, which has nearly tripled in price this year alone, is blamed for fueling drug sales and for helping hackers wreak havoc on businesses and governments. On some days, its price swings 20% up or down, often on a whim or a rumor. (See related story: “How to Invest in Bitcoin.”
It’s easy to dismiss the digital currency as an outlandish, even dangerous, fad. Don’t.
Even if Bitcoin ultimately falls apart or crashes, its underlying technology—known as “blockchain”—is likely to disrupt financial markets for years to come.
A blockchain is a digital ledger that is kept and validated simultaneously by a network of computers, almost like a shared Excel document that no one person can change without the agreement of the others. Importantly, it allows deals to be made without the blessing of a “trusted intermediary,” such as a clearinghouse.
Companies are already using blockchain technology to send payments and redesign how trades are settled. Financial giants like JPMorgan Chase (ticker: JPM) and Bank of America (BAC) could save billions by standardizing their record-keeping for all sorts of financial processes—at a time when they have come under increasing pressure to raise margins and cut costs. And it shows promise in other areas, from insurance to medical record-keeping to energy trading. Even traditionally conservative financial companies are speaking of the technology in world-changing terms.
“Blockchain technology isn’t just a more efficient way to settle securities,” said Fidelity Investments Chairman and CEO Abby Johnson at a blockchain conference in May. “It will fundamentally change market structures—and maybe even the architecture of the internet itself.” Johnson has a unique viewpoint: She’s even “mined” Bitcoin herself.
BITCOIN IS MORE THAN CASH you can trade over the internet. Unlike traditional currencies, the supply of which is controlled by central banks, new Bitcoins are mined about every 10 minutes by a global network of computers that maintain a constantly updated list of Bitcoin transactions. (The network itself is also called Bitcoin.)
Illustration Jay Zehngebot
Theoretically, anyone can become a Bitcoin miner by hooking their computer into the Bitcoin market, but there’s little chance they’ll win many Bitcoins. The mining business is dominated by Chinese operations that use specialized equipment to quickly complete the complicated mathematical tasks of verifying transactions.
There is no physical token involved—Bitcoin owners get codes, or “keys,” to access their money. The keys that each party enters allow the system to verify the transaction and memorialize it in a block. Only 21 million Bitcoins will ever be created (16.4 million of them have already been mined), so no central authority can devalue the currency.
Bitcoin was not the first idea for a digital, or “crypto,” currency. For at least a decade before it was created, libertarian-minded tech enthusiasts had dreamed of inventing a digital token that would allow them to trade directly with each other and avoid interference from central banks and regulators. Yet early efforts failed to catch on.
In 2008, in the heat of the financial crisis, a programmer or programmers using the name Satoshi Nakamoto shared an idea for a currency called Bitcoin on an online message board. Bitcoin’s key innovation is that it allows people to trade with each other without relying on a trusted intermediary, a strong selling point at a time when a growing number of people distrusted the institutions that were supposed to protect their money.
For some people, finding Bitcoin was a eureka moment. “I felt like I had stumbled across a really big idea that had the potential to be really important, but I also realized it would take years for something like Bitcoin to prove itself worthy of people’s trust,” wrote Gavin Andresen, a very early Bitcoin proponent, in an email to Barron’s. Andresen, a Massachusetts software developer, quickly became one of Bitcoin’s most prominent figures. In 2011, Nakamoto, just before ending public communication, appointed him as Bitcoin’s lead developer.
Bitcoin was beset by controversy and fraud from early on. People who didn’t want to mine Bitcoin by connecting their computers to the Bitcoin network often bought and traded them on exchanges, which were easily corruptible. The largest of them, named Mt. Gox, “lost” 850,000 Bitcoins (some were recovered), worth $450 million at the time and $2.2 billion today, and filed for bankruptcy in 2014.
Criminals quickly realized Bitcoin’s potential, too. A vast Bitcoin-fueled drug-dealing operation called Silk Road briefly thrived, then imploded. Hackers and blackmailers have demanded ransom in it.
All this could have destroyed Bitcoin, particularly if the U.S. government had stepped in to regulate it. But the Bitcoin network itself proved resilient to hacking and other chicanery—and its core users were in it for the long haul. “Most of us expected (and still expect) that Bitcoin would be a long-term project, not a get-rich-quick scheme,” Andresen writes.
IN THE EARLY DAYS, Andresen literally gave away Bitcoins in order to spur interest. Not anymore. One Bitcoin fetched eight cents in 2010. Last week, Bitcoins were trading for $2,550, up 170% since the start of the year. Clearly, investors are speculating on Bitcoin; many view it as an asset that, like gold, has a low correlation to the rest of the economy.
But Bitcoin is also rising because it has gradually gotten more useful and accepted. Stephen Pair, the CEO of Bitcoin payment-processor BitPay, says he was “happy to get five or 10 transactions a day” when he co-founded the company in 2011. “Today, we’re doing around 8,000 per day, on average.” Expedia (EXPE) and Overstock.com (OSTK) accept Bitcoin, and people sometimes use it to buy houses and cars. In general, though, your local grocery clerk or tailor isn’t accepting it, and perhaps never will.
In the U.S., about 0.5% to 0.75% of the adult population—roughly 1.2 million to 1.9 million people—have used Bitcoin, according to Scott Schuh, director of the Consumer Payments Research Center at the Boston Federal Reserve. “We’re not finding that the adoption rate is growing very fast,” he says. Bitcoin has gotten a better reception in some places overseas, where central banks have devalued the local currency. In fact, BitPay pays its employees in Argentina in Bitcoin.
Lately, Bitcoin has been suffering growing pains. Its network is too slow to handle the number of transactions people are attempting to process, forcing users to pay fees if they want their payments to go through. Only five to eight blockchain transactions can be processed per second, while credit-card networks process 10,000 times as many, according to a Goldman Sachs report. Absent a major change to the underlying Bitcoin code, the subject of a fierce debate among adherents, the cryptocurrency will be too illiquid to use for daily purchases, and will mostly be a store of value—a bar of gold instead of a Visa card.
The government, for its part, hasn’t even settled on what Bitcoin is. The Internal Revenue Service considers it an asset; the Commodity Futures Trading Commission says it’s a commodity; and Treasury Department regulators have described it as a “virtual currency.” Fed Chair Janet Yellen has said the agency has no authority to oversee Bitcoin, but has encouraged central bankers to study it. The SEC didn’t respond to Barron’s question about how the new administration will handle cryptocurrencies.
FOR INVESTORS, buying Bitcoin is a major gamble. There are few options beyond purchasing Bitcoins themselves or shares of the Bitcoin Investment Trust (GBTC), an over-the-counter security that tracks the price of Bitcoin (see “How to Invest in Bitcoin”). The SEC rejected an application by Cameron and Tyler Winklevoss, famous for suing Mark Zuckerberg over Facebook, to create a Bitcoin exchange-traded fund—the Winklevoss Bitcoin Trust—though the decision is being reviewed.
Meanwhile, entrepreneurs have come out with other digital coins that mimic Bitcoin’s structure, with some differences. The value of the most popular offshoot, a cryptocurrency called Ethereum, has risen to $300 from about $10 at the start of the year—a 3,000% rise. (Its market value is about $27 billion, versus $42 billion for Bitcoin.) Like Bitcoin, it’s extremely volatile, and even had a “flash crash” last month, when it briefly traded for 10 cents.
Yet Ethereum is much more than a coin. The blockchain network it runs on allows people to embed complicated information, including “smart contracts” that turn contractual terms into computer code and govern how they are executed.
“The sky is the limit in what I can express” with a smart contract, said Grainne McNamara, who runs financial blockchain programs for PwC, at an SEC conference in November. “I can write a check that says, ‘Look, I’d like to fund your Kickstarter, I’d like to give you $5,000, but only if you have raised the $5 million that it’s going to take you to shoot your new indie film. Otherwise, the money reverts back to me.’”
The Ethereum platform is so useful that JPMorgan Chase, Microsoft (MSFT), and dozens of other companies have formed an Enterprise Ethereum Alliance—yes, it sounds like something out of DC Comics—to explore its potential.
THE SUCCESS OF BITCOIN AND ETHEREUM has convinced others to launch their own “initial coin offerings,” some of which have raised tens of millions of dollars on little more than promises. The new coinmakers often say they’ll create a product tied to the coin and give coinholders preferential treatment. But there’s no guarantee a product will ever appear, and it’s starting to resemble a mania—Massachusetts Institute of Technology Professor Christian Catalini warns that we’re headed for a “dot-coin bubble.”
“Given the enthusiasm and the levels and amount of money that have been raised, it’s almost inevitable,” he said in an interview.
BUBBLES? DRUG MARKETPLACES?Malicious hackers? How is it possible that anyone in the traditional banking industry is interested in this stuff?
In the post-Napster, post-Uber world, Wall Street no longer has the option of ignoring technologies whose legality or utility isn’t immediately clear. That doesn’t mean that U.S. banks have started trading Bitcoin. Few, if any, will touch it, in part because they can’t effectively comply with “know your customer” laws.
The financial institution that has seemed most interested in experimenting with Bitcoin is Fidelity, which allows employees to use the currency in its cafeteria and invites guest Bitcoin lecturers to its Bits + Blocks Club. Fidelity Charitable helps clients turn their Bitcoins into tax-advantaged charitable donations.
Fidelity will soon allow people who hold Bitcoin through a company called Coinbase to see their balances in their Fidelity account, although the customers will have to leave the Fidelity site to actually transact in it.
STILL, FEW EXPECT that Bitcoin will find a place in the traditional finance system anytime soon. Instead, entrepreneurs are harnessing the underlying technology to change finance.
By 2014, startups were already designing financial products that used blockchain technology with no direct connection to Bitcoin. Their pitch to bank executives: The new tech could speed up several back-office operations, such as settling trades or making cross-border payments, and make these activities cheaper. And unlike Bitcoin—whose users need no permission to enter the network—blockchains can also be closed to the public, creating a system that users can access only with explicit permission. That makes it secure enough to operate in the tightly regulated world of finance. Also, while Bitcoin transactions can be anonymous, blockchains can be designed to be transparent, so every transaction is easily linked to a person or corporation.
“That was the tipping point,” says Julio Faura, an executive at Banco Santander (SAN) who first became aware of blockchain’s promise in 2014. Faura got his Ph.D. in electrical engineering and designed computer chips before getting his M.B.A. He is now the head of research and development at Santander, leading the bank’s blockchain efforts.
“The rails on top of which the financial system was built—those rails are not broken,” Faura says. “They do work. It’s just that they are old. Our job was to see how this could help build a better financial infrastructure, rather than disrupting the world of finance.”
Santander has been a leader in testing and adopting the new technology. It has partnered with a company called Ripple that allows employees to send cross-border payments, an innovation that cut processing times to hours from days.
Bank of America Merrill Lynch and others are also partnering with Ripple.
While financial trades happen virtually instantaneously, the process to settle them remains slow and cumbersome. It often takes days to actually exchange assets, and financial counterparties tend to use different systems to settle accounts, which can make disputes particularly thorny.
Speeding up transactions and encasing them in a shared blockchain could save financial institutions $15 billion to $35 billion per year, according to Bain & Co. And it could actually make those transactions more secure, because the true record is kept by all participants. “Architecturally, it does not depend on just one, but on a community of people,” says Faura. “There is no single point of failure.”
THE DEPOSITORY TRUST & Clearing Corp., or DTCC, and its precursors have been settling trades since the 1970s, giving brokers a central clearinghouse to exchange securities. The DTCC is now working with IBM (IBM) and two startups named Axoni and R3 to put the $11 trillion credit-default-swap market on a distributed ledger similar to a blockchain. (A distributed ledger is an umbrella term for technologies, including blockchain, where computers certify transactions in a shared record.)
That credit-default-swap ledger should be operational by next year. The DTCC is also redesigning the $3-trillion-a-day U.S. Treasury repo market after completing a successful test with tech firm Digital Asset.
There have also been some experiments in share-trading. Overstock.com announced late last year that it had issued public securities on a blockchain. Nasdaq, too, has created a blockchain to trade shares, although its experiment was in the private market. Under Nasdaq’s system, developed with a company called Chain, private companies transferred shares without having to keep a literal paper trail, as many do today.
The pilot program was successful, says Fredrik Voss, who oversees the blockchain programs at Nasdaq. The exchange is now considering whether to open this option up to more clients. “The tech is there,” he adds in an interview.
Nasdaq’s experiments are not limited to trading shares: The company is also creating an exchange using blockchain that allows advertisers to buy, sell, and trade ad inventory. And it has put together a proxy voting platform in Estonia that lets shareholders vote on the internet, which “successfully demonstrated how a blockchain could be used for something other than transaction settlement.”
Other companies are embarking on similarly ambitious projects.
IBM last week announced that it will work with seven European banks, includingDeutsche Bank (DB), to conduct trade-finance transactions—which now can take weeks and reams of paper—on a blockchain.
Elsewhere, blockchains are being tested to store medical records. The technology has even been employed in esoteric smaller-scale projects, like a solar electricity trading platform in one Brooklyn, N.Y., neighborhood.
VOSS IS OPTIMISTIC that blockchains will gain wider adoption, but he says that financial firms need more guidance from regulators. How will different governments treat cross-border payments made over closed networks? What information needs to be embedded in each trade or contract? What’s the right balance between security and privacy? “The world is full of these legal questions right now,” Voss says. “For people to commit billions to this, we need more guidance.”
More market players need to become involved in blockchain-powered exchanges to make them worthwhile. “This is a technology that’s not about building a faster engine for us,” he adds. “It’s about building a new road. If no one else is using it, there’s no use in having it.”
Banks are also reluctant to commit too many staff members or too much hardware to the projects, knowing that the first movers in blockchain—the ones who create the rails—will absorb most of the initial risk and upfront costs.
Indeed, much of Wall Street remains reticent. Bain surveyed executives at financial firms and found that about 80% expected the technology to be transformative and see their firms using it in some form by 2020. Still, they’re sketchy on where exactly they’ll deploy it at a time when older technologies still work.
One executive in a blockchain consortium with other companies told Bain that “half of the people in the group are looking for a solution; the other half are there uniquely to obstruct progress.”
“If there’s a consortium working on some sort of new cool solution, but that will threaten your existing business, people will try to steer it one way or the other or potentially delay it while they work on their own solution,” Thomas Olsen, a Bain blockchain expert, said in an interview. “There’s some of that going on right now.”
EXECUTIVES KNOW they need to understand blockchain, but not everyone is clear yet on how exactly it will help their business. Payment-processing company WEX surveyed 500 chief financial officers, and nearly two-thirds said they had a strong understanding of the technology. But only six explained how they were actually putting it into practice.
Nonetheless, Olsen expects blockchain to gain wider acceptance soon, spreading in a “piecemeal” fashion, rather than a “big bang” like how Uber changed taxi service.
What’s true of Bitcoin—and really all money—is true of blockchain too: It has value only inasmuch as everyone believes it has value. Then, perhaps, the sky’s the limit.
NICHOLAS JASINSKI contributed reporting to this story.