Below is the latest KBRA research report on blockchain, the enabling technology behind the bitcoin payments system. After spending several months talking to participants and organizations focused on this new approach to transferring value between individuals, we find no viable commercial business model in sight. There are however, swarms of hungry consultants, aging derivatives mavens and private equity firms seeking to profit from the hype surrounding bitcoin and the blockchain technology.
Think of bitcoin as a game akin to Monopoly, where the means of exchange, assets and counterparties are all known. Trouble is, there is as yet no tangible business case that proves the utility of this scheme to investors much less financial institutions. This fact has not prevented investors and banks from throwing a great deal of time and money at efforts to monetize the blockchain design. But the elegance and simplicity of blockchain as illustrated in the bitcoin experience may also be the most daunting obstacle to broader adoption of peer-to-peer payments. The full report with footnotes is awailable on www.kbra.com.
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Kroll Bond Rating Agency
February 22, 2016
In November 2008, someone writing under the name Satoshi Nakamoto – it is believed to be pseudonym – posted a research paper on an obscure cryptography listserve describing the design for a new digital currency called bitcoin. Bitcoin was the latest in a series of new crypto currencies going back to the 1980s. But unlike prior attempts, the bitcoin architecture experienced strong retail adoption.
The bitcoin market is a closed system for sending and receiving payments using individually numbered “bitcoins” as the means of exchange. The value of bitcoins expressed in traditional currencies fluctuates significantly with short-term supply and demand: thus, the ersatz currency may not yet qualify as a store of value. The total number of bitcoins available to the participants in the closed system grows at a predetermined rate and will reach a maximum of 21 million in 2140.
The enabling logic behind the bitcoin system is known as the “blockchain,” a distributed network of users that allows the participants in the system to collectively validate each transaction. Think of the blockchain as the combination of cryptography and the peer-to-peer networking behind the Internet. Just as paper receipts allow a company accountant to create an official record of many employees’ transactions, the blockchain serves as a common reference that validates the master record of bitcoin transactions and distributes that record to each participant. When bitcoins change hands, each transaction is added to this single ledger or “blockchain” maintained collectively by and for all of the participants.
Transactions are broadcast to the entire network, and users employ computers to decode and validate each transaction using cryptographic techniques. Bitcoin users who validate transactions are known as “miners.” The bitcoin market participants who focus on mining employ considerable resources to validate transactions and are incentivized to be the first to decode the algorithms because they earn a bounty, currently 50 bitcoins. The considerable computational power required to decrypt these transactions also provides a natural defense against hacking or fraud, since the blockchain adds a new transaction every ten minutes.
Harvey (2016) argues that:
“Cryptography is about communication in the presence of an adversary. Cryptofinance is the efficient exchange of ownership, the verification of ownership, as well as the ability to algorithmically design conditional contracts, all with security, privacy, and minimal trust without using centralized institutions.”
The bitcoin currency has received mixed reviews as a replacement for established currencies. Most recently, bitcoin has been under a cloud because of concerns about its use by terrorist and criminal organizations. However, a number of people and organizations have focused on the distributed blockchain technology separate from bitcoin as a potential means of clearing payments and even securities transactions more efficiently than current centralized systems. A number of financial institutions and private investors have devoted significant time and financial resources to looking at ways to monetize the blockchain technology.
Advantages of Blockchain
Looking at the blockchain technology in isolation, there are a number of potential benefits to users. The blockchain is a distributed database where no third party is required to validate or settle transactions. The peer-to-peer network maintains an identical, time-stamped record of every transaction, which is stored in a semi-public, semi-private manner. The ultimate beneficial owner (UBO) is able to transfer values to other members of the network directly, without utilizing traditional banks, brokerage firms and the clearing system. The table below illustrates the current clearing system vs. a theoretical blockchain transaction.
Current Payments System
? Banks, Visa, Mastercard, are centralized and for-profit businesses which treat payments as confidential.
? Financial Institutions (FI) exercise monopoly control over payments system. All transactions originate with FIs and settle through clearinghouse, which sets basic rules.
? Clearinghouse and members know/validate all transactions and counterparties (CPs).
? Choice of currency for transactions.
? Institutional system facilitates trades via use of “street name” for all transactions, not in name of UBO.
? All trades settled “net” of other clearing balances to reduce “float” and credit costs. ? Bitcoin, other electronic currencies operate on distributed peer?to?peer networks and create a common, public ownership ledger.
Hypothetical BlockChain Settlement
? No role for FIs or clearinghouse. All trades settled bilaterally and directly via members of the network.
? Members of blockchain validate ownership of assets after exchange.
? Identity of the UBO may not be transparent.
? The agreed means of exchange is subject to the rules of the blockchain, allowing for infinite extensibility.
? All assets are carried in the name of the UBO.
? No netting of transactions and, in theory, no float or intraday credit exposure.
Of note, bitcoin and the enabling blockchain technology explicitly and necessarily exclude governments and FIs from the closed, peer-to-peer system. Indeed, blockchain represents a very direct challenge to the governmental monopoly on money and payments that has existed in the U.S. since the Civil War and was institutionalized with the creation of the Federal Reserve System in 1913. Strangely, this fact has not prevented banks and other FIs from spending enormous amounts of time and money studying how to “exploit” blockchain technology.
While there are a number of potential advantages to investors in using blockchain technology to effect financial transactions, actually changing the existing payments system is not a trivial challenge. First and foremost, the FIs which control the payments system have significant market power and political influence that is likely to work against change. More significant than the commercial and political interests behind the present day payments system, however, are the attributes of the blockchain system itself.
In a closed system such as bitcoin, the blockchain system for exchanging these tokens works reasonably well. The members of the network are known to all of the other members and the means of exchange – bitcoins – are limited in number and have unique IDs, preventing “double spending.” Adding additional types of exchange mediums – currencies – and the ability to deliver other types of assets, such as securities, via blockchain would seem to be imminently possible, but would also add considerable complexity and cost to the network.
It is unclear, based on what we know today, whether the blockchain system, if expanded to accommodate multiple currencies and asset types, would have lower cost than the existing centralized clearing system controlled by FIs. Part of the challenge facing proponents of change is that many of the costs in the present day clearing system are not explicit and are embedded in the operations of the participants. It seems clear that blockchain has the potential to greatly reduce the cost of payments related to fraud and other types of unauthorized payments, such as payments made by minors. The real question seems to be whether more complex types of networks can develop that would provide the functionality and seeming efficiency of the blockchain and avoid some of the direct and indirect costs of the current payments and clearing system.
Risk in the Payments System
Following the 2008 financial crisis, the financial industry increased focus on reducing risk, achieving greater transparency, and improving efficiency in order to establish a safer market environment. Specifically, both the EU and now the U.S. are attempting to move from three-day settlement for most financial transactions to two days or “T+2.” Advocates of the blockchain technology claim that the blockchain would allow for same-day settlement of financial transactions or perhaps even multiple sales and settlements of a given asset in the same day. As yet, however, there is no empirical evidence to support such claims.
The fact that the blockchain scheme allows for the payment of a bounty to successful bitcoin miners who validate transactions illustrates that there is a cost involved in processing these exchanges. By no coincidence, a combination of cost and risk considerations are driving the global financial community to embrace T+2 clearing for securities transactions. Can the advocates of broader use of blockchain, at least beyond the very simple example of payments provided by bitcoin, construct a logic that will support the costs of validating cash and securities transactions? For example, would a hypothetical, blockchain-based shared clearing network include a tax on participants to bear the cost?
It is no coincidence, KBRA believes, that the emergence of bitcoin and the blockchain are coming at a time of global financial turmoil and, at the same time, greatly heightened focus on risk by regulators. Most policy makers are familiar with the issues involving consumer use of payments systems, but the largely opaque world of institutional payments and settlements is also experiencing significant change. The cost pressures that are pushing the major financial markets to embrace T+2 as a minimum standard for securities settlement are also generating questions about the credit exposures in clearing and thus the attendant capital costs. FIs are now being required to measure and hold additional capital against liquidity and CP risks. The Depository Trust & Clearing Corp (DTCC), for example, has been compelled to increase capital as a result of its three clearing-agency subsidiaries being designated Systemically Important Financial Market Utilities.
The post trade service provider DTCC currently requires participants in its affiliated networks to post USD $22 billion in deposits to backstop payment flows. Would blockchain eliminate the need for such performance balances? How would these payment flows move in a blockchain environment? We do not as yet have answers to these questions. However, DTCC, to its credit, has challenged the financial industry to adopt the blockchain technology. In a white paper, DTCC observed that although blockchain technology has potential and presents “a generational opportunity to reimagine the financial industry infrastructure,” it is still “immature, unproven, has inherent scale limitations in its current form and lacks underlying infrastructure to cleanly integrate it into the existing financial market environment.”
KBRA has heard similar views expressed by a number of operations professionals who we contacted in the preparation of this report. All of the time and energy being expended by FIs to “leverage” the concept seems to be defensive in nature since, as yet, there seems no way to include FIs in the blockchain template. Or as Wired Magazine opined: “There’s no guarantee that the DTCC will take the blockchain idea to its logical extreme. After all, a truly distributed blockchain-based stock settlement system could eliminate the need for DTCC."
While a number of FIs and investors believe that blockchain will evolve into a more efficient medium for transferring value or ownership of assets, in fact the elegance and simplicity of blockchain as illustrated in the bitcoin experience may also be the most daunting obstacle to broader adoption. Like a face-to-face cash transaction between two people, the bitcoin system functions because the payment mechanism and the means of exchange are transparent and trusted, even if the participants are opaque. The cryptographic system behind blockchain has functioned reasonably well in terms of protecting the integrity of transactions from theft and fraud, but the lack of a sovereign sponsor behind the system probably dooms such distributed schemes to a secondary role in the marketplace.
Trust and credibility are ultimately the most important indicia of a currency’s acceptance, two qualities traditionally associated with government-sponsored, collective currency schemes. With the creation of the Fed a century ago, the U.S. transitioned from a largely private payments system to a government-sponsored scheme, in part because the economic stresses, periodic market panics and related political pressures of that era drove Congress to embrace a centralized and collective system. Even the House of Morgan could not withstand the financial demands of the currency markets in the years before WWI.
It may be that the blockchain could have utility, for example, in enabling complex financial transactions for a limited number of participants, but KBRA does not believe based upon what we see today that the blockchain is likely to supplant existing centralized payments and/or settlements systems any time soon. Ultimately the blockchain was created to replicate an exchange of cash between two individuals, not to enable global payments or securities transactions. And as noted above, the operational design of the peer-to-peer blockchain template makes no allowance for banks, other FIs or the DTCC.
“Nakamoto introduced the bitcoin blockchain as a solution to a specific engineering problem: to move money online in the same way cash is transacted in person without a trusted third party,” writes Saifedean Ammous of the Lebanese American University. “The blockchain was the solution to the electronic cash problem… It did not need investment, venture capital, conferences, or advertisement…. There are many simple technologies banks need to optimize and to improve to enhance their products. Instead, they are seduced by the siren song of futuristic buzzwords and searching for a problem to solve with a blockchain. But they won't find anything.”