Behind the Hype

It appears that blockchain will soon be essential to the economy – including for central banks. Indeed, these institutions show no reticence as they are performing analysis, review and testing. However, it is still a long way from being ready to roll-out, and the question remains of whether to do so at all:

Who wants to be beaten with their own weapons? According to tech oracles, blockchain – an abstract and decentralized database network construct – will turn entire economic sectors upside down. Yet it is being tested by organizational entities that carry the centralist principle in their very name, as central banks discover Distributed Ledger Technology (DLT) for themselves. Across various media, this technology is loudly touted to be a revolution in finance, and even the entire world of business. But one by one. And above all: Handle it with care! What is it exactly? DLT refers to a distributed ledger: A decentralized database that grants participants in a network shared read and write authorization. The Financial Times Lexicon: "The idea is to remove the need for middlemen like banks to vouch for facts, such as a person’s identity or the health of their finances". Potential uses are diverse: "Digital Money is just one. Land registries, identity storage and peer-to-peer stock exchanges are just some of the potential uses of the blockchain".


A useful and counterfeit-proof ledger

Because people like to think in simple pictures, it helps to present blockchain as a ledger: When a data transaction takes place between a sender and a recipient, this is entered as a new item in the ledger. So it’s traditional accounting? Not quite. Instead of being kept in a single drawer, the ledger is distributed on computers worldwide as thousands of copies. When a new item is entered in this ledger, it appears on all the other ledgers and is authenticated by the computers participating in the network. Only then is the entry and transaction valid. In addition, because each line remains unchanged and permanently in the ledger, and needs to be authenticated by hundreds of computers, transactions using blockchain are considered as good as counterfeit-proof.

When Sue gets money from John – and everyone sees

In his now-rather-famous blog post titled “A blockchain explanation your parents could understand”, Jamie Skella, co-founder of Australian blockchain-based coordination and decision-making platform “Horizon State” describes the system as follows: “It’s as if John and Sue had a few hundred mates stand around them and watched John hand Sue the money in question, and they all agreed that he really did hand her the money, as well as other aspects of the transaction, such as it being the right amount.” Many people believe that the fact that John and Sue remain anonymous – unless they would like to be recognized – makes the blockchain principle a revolution both at technical infrastructure level and at business level.

A fantastic technology that demands resources and capacity

With all the hype about blockchain, bitcoin and business models, one can first state that: “DLT is a fantastic innovation, and the idea that underlies it – sharing ownership of the database with the community – is certainly convincing. However, it also requires the community to provide computing capacity and storage space, and it is not as performant as centralized solutions,” comments Florian Gawlas, Technology Director at Giesecke+Devrient Currency Technology. And: “If trusted third parties demand excessive fees for their services, then operating a business on a public DLT platform seems to be the cheaper option In the first place,” Gawlas continues. ”The actual overall costs of operating a DLT platform could be high as well – the annualized estimated global mining costs for bitcoin is around two billion US dollars per year, according to the Bitcoin Energy Consumption Index”.


Critical infrastructures are already relatively fail-safe

High energy consumption by decentralized ledgers has also been discussed repeatedly in recent months: The Bitcoin Energy Consumption Index calculates that transactions and mining takes up 0.2-0.3% of global power consumption. Do central banks really need it?

“Decentralized infrastructures are certainly not essential for a central bank, but distributed infrastructures are,” comments Florian Glaser, Karlsruher Institute of Technology (KIT). “Distribution and redundancy increase fail-safety. This relates both to technical faults and deliberate attacks.”

He added that critical infrastructures are already relatively fail-safe due to decentralization and redundancy – without the need for a blockchain. “The advantages of blockchain result almost exclusively from the theoretical possibility of reducing centralization – but the systems tend to re-centralize in practice,” Glaser continues. “Consider the example of mining activity for the bitcoin cryptocurrency, these days concentrated at a few server locations, which reveals that the individual as an authorized participant has ceased to play a role here.“

In practice, decentralized systems also tend ultimately to recentralize.

 

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Florian Glaser, Karlsruher Institute of Technology (KIT).

Potential for collaboration and reduction

Composure, realistic assessment of potential, and objective consideration – the hype about this technology should be categorized. With data from more than 200 companies, DLT startups, central banks, and public sector institutions from 49 countries, the “Global Blockchain Benchmarking Study” published by the Cambridge Centre for Alternative Finance in autumn 2017 tried to do precisely this. Their first finding: “Central banks are increasingly also researching the area of digital currencies. More than 80% of the 57 central banks surveyed state that they engage with this question,” comments Hamish Thomas, Partner in Financial Services Advisory at EY and co-author of the study. He continues, “Central banks now also certainly see potential in using DLT to reduce transaction, processing and coordination costs, or equipping their infrastructure with collaborative, interoperable systems and platforms.”


From clearing to trade financing

Making up 46% of contributions to the “Global Blockchain Benchmarking Study” central banks are the largest public sector group to participate. More than half of them stated that they are researching DLT-based payment systems for transfers or online banking payments, while 36% identify potential in the use of DLT technologies with respect to compliance with statutory specifications, and 18% for audit trails.

“Central banks are reviewing the possibilities from DLT in clearing, accounting for assets, and even specific applications in trade financing,” the study states. In addition, some central banks participating in the study reported that distributed ledger technologies could contribute to improving financial market infrastructure in general, including collaboration and interoperability between a range of various stakeholders, systems, and platforms.

Market harmonization still insufficient

To put it in a nutshell, it’s still rather hazy. And all forecasts state that that won’t change soon: “There are many initiatives, and so we assume that DLT will continue to gain traction – even if the hype about the technology cools off noticeably,” comments Florian Gawlas, Technology Director at Giesecke + Devrient Currency Technology. As to whether the capacity and functionality of this technology will develop far enough that it is ultimately suitable for practical use in business environments for its central banks, Gawlas comments: “That remains to be seen.”

Florian Glaser from KIT agrees with him, and believes that a clear cost/benefit analysis will be decisive for the use of this technology: “Existing systems are running, paid for, and integrated – the level of resources needed for complete migration, compared to the cost savings, also needs to be assessed when considering a closed, decentralized system.” He adds that, for example, developing a competing T2S system from this would require vast resources. “Not only are requirements higher yet again, but there is also a relative lack of practical experience in using this type of system,” Glaser continues.

As a central bank, we are primarily interested in an efficient technology that is also compatible with regulatory stipulations.

 

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Carl-Ludwig Thiele, Executive Board Member at Deutsche Bundesbank

“With T2S and the integrated, pan-European processing of securities, we have set the initial standard that any new concepts need to reach,” adds Carl-Ludwig Thiele, Member of the Executive Board of Deutsche Bundesbank and currently responsible for cash management, controlling, accounting and organization, and payment and settlement systems. He adds that, although DLT is constantly being refined, “to date, we are not yet seeing sufficient harmonization of applications in the market. The realization of supposed advantages from blockchain technology can only be expected once processes are sufficiently standardized and there is interoperability across different applications.”


Decentralized infrastructures – but with rules and responsibility

What changes would this mean for central banks? Little if any, believes the Bundesbank Executive Board: “The mandate and underlying responsibilities of the central bank are not changed by the use of new technologies. Among other aspects, we ensure stable cash and secure and efficient payment transactions.” So dry, so little hype: “Although decentralized infrastructures certainly can be used, it must involve responsible entities ensuring certain rules are complied with,” Thiele continues.

He adds that participants must be able to prove their identity, and that approval criteria and responsible entities to ensure network stability and security are essential. Or, to sum it up, hype aside: “As a central bank, we are primarily interested in an efficient technology that is also compatible with regulatory stipulations.” Cash, for example, which will retain its significance despite increasing interest in decentralized networks.


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