We speak to Banking Technology on why blockchain won’t fix payments

We share our insight with Bank­ing Tech­no­logy Magazine about the mis­con­cep­tion with block­chain in the industry sur­round­ing the belief that it is a solu­tion to mak­ing faster and securer pay­ments. There are some issues around the block­chain that explain why, in its present form, it isn’t an ideal replace­ment.


For example, the Bank of Canada, the country’s cent­ral bank, has dis­covered that block­chain is not presently an option for under­pin­ning pay­ments.

A July 2017 art­icle by Out-Law quotes the Bank of Canada: “Under­pin­ning whole­sale pay­ment sys­tems with dis­trib­uted ledger tech­no­logy (DLT) would intro­duce greater costs and risks for insti­tu­tions than those which apply under exist­ing whole­sale pay­ment sys­tems.”

The art­icle con­tin­ues: “A study car­ried out by the Bank of Canada, into the feas­ib­il­ity of using DLT to cre­ate new dis­trib­uted whole­sale pay­ment sys­tems, iden­ti­fied poten­tial for DLT-based whole­sale pay­ment sys­tems to deliver bene­fits if they could be linked in to other fin­an­cial mar­ket infra­struc­ture.”

Such bene­fits may be obtained by integ­rat­ing other assets on the same ledger as pay­ments – which could greatly sim­plify col­lat­eral pledging and asset sales – reap­ing eco­nom­ies of scope and redu­cing costs to par­ti­cipants by integ­rat­ing back-office sys­tems,” the Bank of Canada repor­ted in response to its study find­ings.

Block­chain imma­tur­ity

A Septem­ber 2017 art­icle by Reu­ters, com­ments that DLT/blockchain won’t con­sequently be able to power the world’s biggest pay­ments sys­tems, though both the European Cent­ral Bank (ECB) and the Bank of Japan (BOJ) were quoted to state that “it has the poten­tial to improve sys­tem resi­li­ence”.

The real­ity of block­chain sup­ports the find­ings of the US Fed­eral Reserve and the Bank of Canada. In one speech on DLT, the Fed says there are con­cerns about smart con­tracts:

Although the idea of auto­mat­ing cer­tain aspects of con­tracts is not new, and banks do some of this today, the poten­tial intro­duc­tion of smart con­tracts does raise sev­eral issues for con­sid­er­a­tion. For example, what is the legal status of a smart con­tract, which is writ­ten in code? Would con­sumers and busi­nesses rely on smart con­tracts to per­form cer­tain ser­vices tra­di­tion­ally done by their banks or other inter­me­di­ar­ies? Could the wide­spread auto­mated inter­ac­tion of mul­tiple coun­ter­parties lead to any unwanted dynam­ics for fin­an­cial mar­kets? These and other con­sid­er­a­tions will be import­ant factors in determ­in­ing the extent of the applic­a­tion of smart con­tracts.”

The prob­lem, accord­ing to CEO of Kalypton, Lars Dav­ies, is that many people are try­ing to sep­ar­ate Bit­coin from block­chain. Bit­coin is often per­ceived as being bad, while Block­chain is per­ceived as good.

Bit­coin and block­chain are intrins­ic­ally linked, they are sym­bi­otic,” says Dav­ies. “People assume that it is a valid solu­tion, but there is very little ana­lysis. What prob­lem does it solve? They are often spoken about in sep­ar­ate ways and there is an assump­tion that block­chain is use­ful.”

Rather than being use­ful, “it’s a self-feeding frenzy, which eco­nom­ists refer to as an inform­a­tion cas­cade”, he says. “As so much has been writ­ten about block­chain, surely it must be a solu­tion? But what is it a solu­tion to? There is far too much hype about block­chain, and next to no real ana­lysis about what it can actu­ally solve.”

R3 and Ripple

Look at the dis­pute between R3 and Ripple. Here we have two com­pan­ies that aspire to provide an enter­prise grade solu­tion to fin­an­cial ser­vices infra­struc­ture but that means burn­ing through cash like crazy try­ing to make block­chain work.”

Dav­ies adds: “If it weren’t for the vast amounts of sup­posed gains from crypto­cur­rency spec­u­la­tion, the block­chain prob­ably wouldn’t sur­vive. The heart of the dis­pute is that Ripple is try­ing to stop R3 from profit­ing from options ‘worth’ $1 bil­lion it holds on Ripple’s in-house cur­rency XRP. This is a clas­sic ‘mis­dir­ect’ trick. Noth­ing up our sleeves.”

So why do people believe that block­chain is good and Bit­coin is bad? Indeed, why do people sup­port block­chain and think that it will work? Dav­ies believes this is because every­body says block­chain is good, and so they don’t ques­tion or ana­lyse it appro­pri­ately to ensure that it is the right solu­tion for pay­ments. In essence, people believe what they want to believe – even in an industry such as bank­ing and fin­an­cial ser­vices, where due dili­gence and reg­u­lat­ory com­pli­ance are cru­cial.

It’s sim­ilar to what some­times hap­pens when there are mul­tiple wit­nesses to an incid­ent. For example, each wit­ness assumes that some­body else has repor­ted the incid­ent and so they don’t call the police,” Dav­ies explains. He adds that the same band­wagon applies to block­chain. “There’s so much noise around block­chain that people jump on it, assum­ing that someone must have val­id­ated the tech­no­logy. The inform­a­tion cas­cade becomes the con­ven­tional mode of thought.”

Irra­tional hype

In his opin­ion, the hype around block­chain is irra­tional. “Nobody has ana­lysed what it can or can’t do, but people have ration­al­ised util­ising it as being safety in num­bers”, he says. The reas­on­ing behind his thoughts are foun­ded on a cita­tion of eco­nom­ist John Maynard Keynes, who once said: “Worldly wis­dom teaches that it is bet­ter for repu­ta­tion to fail con­ven­tion­ally than to suc­ceed uncon­ven­tion­ally.” So, by being part of the block­chain hype, if it fails you’ve failed con­ven­tion­ally and so your job is safe.

Dav­ies elab­or­ates: “A sim­ilar thing happened with the CDS mar­ket, and that hap­pens with every bubble. Cent­ral banks are now say­ing that block­chain is not the solu­tion, but so much cash is being burnt sup­port­ing it because to say oth­er­wise is to be uncon­ven­tional. In the minds of the par­ti­cipants, so long as they attach them­selves to the con­ven­tion they can­not be fired if they are wrong; every­one else is doing the same thing.”

He adds that the dis­pute between R3 and Ripple is insig­ni­fic­ant: If two com­pan­ies are quib­bling over options about an asset that has no intrinsic value, then leave them to it. Bit­coin and cyber-currencies are no more than pro­gram­ming code. Bit­coin has no value except what someone is will­ing to ascribe to it. Bitcoin’s nom­inal value is zero. It has no col­lat­eral behind it, and no intrinsic value. At least you could plant a tulip bulb and have a reas­on­able chance of grow­ing a tulip.”

Gold Stand­ard

He then explains that bit­coin books offer sup­port for the crypto­cur­rency by cit­ing the Gold Stand­ard without under­stand­ing how it works. “The Gold Stand­ard meas­ured cur­ren­cies against a defined weight of gold. Gold has a value, and every­body agreed that it was the com­mod­ity to use. That’s because gold, or some other com­mod­ity, has value as a com­mod­ity you can ascribe value to it.”

Com­pared to crypto­cur­ren­cies like Bit­coin, fiat cur­ren­cies such as the dol­lar, pound ster­ling, and the euro “have a value ascribed to them based partly on how well the eco­nomy behind the cur­rency is per­form­ing, and the record of the gov­ern­ment”, Dav­ies com­ments. Today, the fiat cur­ren­cies are no longer pegged against gold. He says this is because the Gold Stand­ard became hard to man­age.

Dur­ing times of war the UK gov­ern­ment sus­pen­ded the Gold Stand­ard because that allowed it to deflate the pound and to intro­duce infla­tion to pay down its debt. This is why gov­ern­ments like infla­tion, which is a res­ult of policy and little else”, he says, sug­gest­ing that this leads to a debate about mon­et­ary policy.

He elab­or­ates on the reason this arises: “Liber­tari­ans believe that crypto­cur­ren­cies pre­vent gov­ern­ments from inter­fer­ing with the value of the cur­rency. The idea was that the cur­rency should be free of gov­ern­ment con­trol. This is a mis­read­ing of why gov­ern­ments con­trol cur­rency. Gov­ern­ments are best posi­tioned to pro­tect the value of cur­rency by pre­vent­ing coun­ter­feit­ing and by mak­ing sure that sup­ply doesn’t grow out of con­trol.”

The sup­ply of money has to grow to allow an eco­nomy to grow, but bit­coin has a lim­ited, finite sup­ply”, he explains before adding: “When the sup­ply of money grows, the eco­nomy grows. It is true that if you have a fiat cur­rency, then there can a tempta­tion to print cur­rency. This can decim­ate the value of your cur­rency. It depends on how the gov­ern­ment or cent­ral bank man­ages mon­et­ary sup­ply. Gov­ern­ments can choose to have a hard fiat cur­rency; it all comes down to how the gov­ern­ment and its cent­ral bank chooses to man­age that cur­rency.”

Mar­ket fluc­tu­ations

In Dav­ies’ view, the fluc­tu­ations in the mar­ket show that crypto­cur­ren­cies aren’t suit­able for pay­ments sys­tems. “They don’t have the sta­bil­ity; they are not a means of exchange”, he believes. So, to gain value from any crypto­cur­rency, there is a need to cash in imme­di­ately. Unlike the pound, for example, which is a means of exchange, crypto­cur­ren­cies won’t hold their value. In con­trast he sug­gests that “£100 today will still be worth £100 tomor­row.”

Bit­coin does not have this fea­ture, and that’s one of the reas­ons why the courts are say­ing that bit­coin is not money because it is not a means of exchange, and that’s why even the Bit­coin Found­a­tion itself used this argu­ment in its recent let­ter to the US Sen­ate Judi­ciary Com­mit­tee.” Dav­ies elab­or­ates: “There is no under­stand­ing of what money really is and what its func­tion is. There are, quite simply, too many issues in the design of bit­coin and other crypto­cur­ren­cies that can­not be solved.”

Secur­ity ques­tions

There are ques­tions about the secur­ity of crypto­cur­ren­cies. The mis­con­cep­tion is that block­chain and sub­sequently crypto­cur­ren­cies are fun­da­ment­ally secure when they aren’t. As pro­gram­ming code forms their basis, they can be hacked. They are there­fore inher­ently insec­ure. So, can they be developed to make them secure and free from hack­ers? Accord­ing to Dav­ies, they can’t.

He gives his reas­ons why: “The very nature of DLT means it can’t be made more secure. It’s design assump­tions pre­vent you from chan­ging the way it oper­ates. If you do, it breaks. Ideally, it’s pro­grammed to have as many nodes as pos­sible with the assump­tion that the more nodes you have, the more secure the block­chain or dis­trib­uted ledger will be. But invest­ig­at­ors and oth­ers can fol­low it. If you look at GDPR, pseudo-anonymity is not by itself suf­fi­cient.”

In con­trast to the many pun­dits pro­mot­ing block­chain and crypto­cur­ren­cies, Dav­ies finds that cent­ral banks under­stand what money is. So why are there some reports that they are embra­cing block­chain and crypto­cur­ren­cies? “They were com­pelled to ana­lyse DLTs such as block­chain, but found that it can’t be used for pay­ment sys­tems”, claims Dav­ies.

Some argue that you might be able to use it across bor­ders if you fol­low the exist­ing method of hav­ing mul­tiple parties within the trans­ac­tional pro­cess; this would lengthen the time it would take to pro­cess a trans­ac­tion to get around the fact that DLTs simply can­not pro­cess trans­ac­tions in real-time”, he explains.

The prob­lem is that he finds that even this use case doesn’t stand up to scru­tiny. “A digital pay­ments sys­tem, even one that man­aged cross-border and cross-currency pay­ments, would avoid the need for such inter­me­di­ate steps if it was designed prop­erly, and so settle in near real-time: This is some­thing that DLTs can­not sup­port”, he com­ments.

Mono­lithic archi­tec­tures

In his exper­i­ence, “Block­chain and mono­lithic archi­tec­tures do not scale well and this is the reason cent­ral banks are abandon­ing it. You just can’t scale DLT and block­chains. Another issue is caus­al­ity; DLT and block­chain can’t prove caus­al­ity. For pay­ments, you need caus­al­ity. So, they are unsuited for pay­ments.”

Dav­ies then points out that one of the prob­lems is that authen­tic­a­tion takes place after the event. This means that block­chain can only show what was sub­mit­ted to the sys­tem.

Authen­tic­a­tion issues

One of the design assump­tions is that you can trust both parties to issue a true record of the trans­ac­tion, but there is no guar­an­tee that record is a true record of the trans­ac­tion”, he com­ments. Crypto­cur­rency miners must do the proof of work, which is used to limit the num­ber of forks that can occur when miners try to cre­ate a block. “But that does not prove the truth of the records them­selves. The proof of work is simply that, it proves that they per­formed a cal­cu­la­tion or solved a prob­lem, noth­ing more,” he says.

Each miner will select trans­ac­tions form the pool wait­ing to be added to the block­chain (they won’t neces­sar­ily all choose the same trans­ac­tions – more on this later). The miners then each solve the proof of work prob­lem and the first to do so will have a block and add that block to the block chain. The other miners will then stop attempt­ing to gen­er­ate a block, and add any trans­ac­tions not in the suc­cess­ful block back to the pool (this is one of the reas­ons why the block­chain can­not show caus­al­ity).

If two or more miners solve the proof of work then each will add their block to the block­chain, and the block­chain will fork (the num­ber of forks will depend on the num­ber of sim­ul­tan­eous blocks; usu­ally no more than two but there can be more).”

The pro­cess then requires the miners to gen­er­ate new blocks as before, and then they add them to their forks. This is then repeated until one fork becomes longer than the oth­ers.

This longer block­chain becomes the block­chain, and the other forks are dis­carded (any trans­ac­tions that were pro­cessed in these forks that are not in the accep­ted block­chain are added back to the pool of unpro­cessed trans­ac­tions)”, he explains.

The key issue is that all the proof of work shows that the miners have exer­ted their effort to solve the prob­lem, but it fails to prove that the trans­ac­tions are valid. “That lat­ter issue comes down to the assump­tion that the parties will sub­mit a true record of the trans­ac­tions,” Dav­ies says. “If a trans­ac­tion is recor­ded in a block more than five or six from the top of the block­chain, then users can regard that trans­ac­tion as irre­voc­able, as it is very unlikely to be dis­carded later; forks rarely last for more than two or three blocks. How­ever, that still does not prove the truth of the record.”

Not for pay­ments

He there­fore argues: “Bit­coin and block­chain were never designed to fix pay­ments. They simply will not work in any mean­ing­ful way. The secur­ity of block­chain depends on hav­ing mul­tiple ledgers. Block­chain can only man­age seven to 14 trans­ac­tions per second. The assump­tion is that if you make it harder to change the blocks but increas­ing the num­ber of cop­ies of the block­chain or ledger, it becomes harder to hack. How­ever, there are fewer and fewer miners, as the cost of min­ing a block con­tin­ues to increase, mean­ing that this assump­tion has become a secur­ity flaw.

If you want to increase this through­put, and you can do so, then you have to sac­ri­fice other aspects of the design and so accept that you will have less secur­ity, less dis­tri­bu­tion, etc. You can get a high through­put with two or three nodes or ledgers, but then why bother? You no longer have the pre­sumed secur­ity of present­ing mul­tiple nodes that an attacker would need to com­prom­ise.

How­ever, even that secur­ity model is sus­pect as vari­ous secur­ity research­ers have shown. Oth­ers assume that you can do away with the proof of work and use a con­sensus pro­tocol to syn­chron­ise ledgers. That is not a solu­tion as the per­form­ance starts to degrade as you increase the num­ber of nodes.”

Reg­u­lat­ory com­pli­ance means that banks need to com­ply with know your cus­tomer (KYC) reg­u­la­tions. To achieve this, they need to have access and to include all the con­tex­tual inform­a­tion in the record of a trans­fer or a pay­ment. The trouble is, as Dav­ies argues, block­chain can’t store all the required inform­a­tion because the block­chain is not designed to do so. It is a log and not a data­base.

So, with regards to GDPR as an example, if you have con­sumers involved with the trans­ac­tions, Dav­ies believes there may be a need to “expunge the record of the false trans­ac­tion, but you can’t do this with block­chain without break­ing the audit trail. This is why block­chain is com­pletely unsuited.”

He con­cludes that the hype around block­chain is about fear of not being part of the con­ven­tion. This pur­suit could be dis­astrous. Both bit­coin and block­chain there­fore deserve more scru­tiny – par­tic­u­larly with regards to pay­ments.

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