Blockchain's Disruption of Banking Has Already Begun

Bitcoin’s history is a fascinating story unparalleled in the worlds of tech and finance for its colorful characters, mystery and intrigue.

Banks are urged to get in the blockchain game and gain experience quickly by developing a set of projects and proof of concept tests. They should also be willing to fail quickly, understand the range of possibilities and place strategic bets.

Given bitcoin's backdrop, it’s astonishing to witness the speed with which blockchain has matured. Spending by financial institutions is expected to exceed one billion dollars in 2017, according to Magister Advisors, making blockchain among the fastest development software markets of all time. How did that happen?

Bitcoin was pioneered in the early 1990’s by a group of mathematically gifted anarchists and libertarians known as the “Cypherpunks.”

Concerned about the government’s ability to manipulate so-called “fiat” currencies, the Cypherpunks visualized a better future – one with decentralized currency, backed by cryptography that is transparent, ownerless and open source. They experimented with cryptographic currencies, but continued to fail, running up against two key problems. Each experiment with cryptographic currencies had a central authority comprising a vulnerable single point of failure and suspect for ability to manipulate currency. Each time they were challenged to prevent “double spend” since it is very difficult to ensure the owner of the money didn’t try to spend it more than once.

Enter Satoshi Nakamoto, who published the Bitcoin white paper in 2008. This surprisingly short, elegantly written eight-page paper ingeniously solved the double-spend problem with a distributed ledger that prevents anyone, even with enormous computing power, from high-jacking the network. Adding to the intrigue – nobody knows who Satoshi Nakamoto is! He remains to this day a shadowy anonymous figure, who completely dropped out of sight in 2010. Once he (or she, or they) surfaces, he will be an extremely wealthy individual, possessing bitcoins worth in excess of four hundred million dollars.

Even if we’re skeptical about bitcoin, it’s important to understand the protocol because the resulting financial innovations are either based on bitcoin’s blockchain itself, or a modified copy of the open source code. Bitcoins are entries in a ledger, analogous to “rai stones” on the Pacific Island of Yap. Starting in 1000 AD, the islanders used four-ton limestone disks as money. Being so large, the money was impossible to move, so ownership was tracked through an oral tradition and everyone knew who owned each rai stone.

The Bitcoin protocol works the same way – it’s a public ledger recording ownership of each bitcoin. This ledger is shared among all the network nodes who race to check each block of transactions using a computationally intensive algorithm solving for a random number with the right number of leading zeros, known as a “nonce.” The winning node, the first to verify and approve the block, is paid with twenty-five newly minted bitcoins. When “consensus” is reached – more than half the other nodes agree with the verification – the block of transactions is entered onto the blockchain ledger.

William Mougayar predicts that crypto-economy will evolve in three waves. Wave one consists of various currencies. Currently there are more than 700 currencies recorded at the “Map of Coins” website. Wave two leverages smart contracts that self-execute based on an external trigger. Wave three, self-autonomous corporations, can be imagined as an autonomous self-driving car that manages its own car service.

Large banks around the world have announced experiments and tests around blockchain, bitcoin and permissioned ledgers, fearing the peril of ignoring the technology. Clayton Christensen dubbed this the “Innovator’s Dilemma” - disruptive technologies that are initially overlooked by market leaders because they do not seem to meet customer needs. However, because the disruption meets a new need, usually because it is smaller, portable or less expensive, the technology rapidly improves and ultimately, and somewhat unexpectedly, like cell phones or Wikipedia, supplants the incumbent – land lines and encyclopedias.

How will blockchain technology disrupt financial services? Here are three pertinent predictions.

“Permissioned” networks use blockchain to streamline clearing and settlement of securities and payments. Permissioned networks are a “walled garden” of trusted participants who communicate transactions in a straight-through manner over the blockchain. Use of trusted nodes eliminates the overhead of mining. Over time, this will disrupt centralized network middlemen.

Fast and nearly free international money transfer for individuals and corporations. We conducted an experiment sending one dollar in bitcoin around the world from New York to Mumbai to San Francisco and back to New York. Within ninety minutes we received ninety seven cents back in New York. Traditional international wire transfers would have cost upwards of one hundred dollars in fees and taken close to two weeks to transact.

Smart self-executing contracts to streamline execution and eliminate manual processing and human error. Prime examples are mortgage or insurance contracts, or asset registry. Once ownership or agreement is recorded on the blockchain, it is an immutable and public record with no need for a central authority. Programming the terms of the agreement eliminates subjectivity and provides enforcement – an unbreakable contract.

Deb Baxley is principal for cards and payments at Capgemini Financial Services.