As blockchain technology becomes more widely used, some researchers are recognizing that cooperation and collaboration among all stakeholders, including government, is critical to enable the technology to deliver the efficiencies it promises.
A report [PDF] from the C.D. Howe Institute by Thorsten Koeppl and Jeremy Kronick, “Blockchain Technology – What’s in Store for Canada’s Economy and Financial Markets?” identifies challenges facing policymakers and regulators.
Koeppl is an associate professor and RBC Fellow at Queen’s University while Kronick is a senior policy analyst at the C.D. Howe Institute.
It is not clear how the technology’s benefits will be realized in a way that ensures they are delivered to the economy as a whole, the authors noted at the outset of the 28-page report. The three major challenges for policymakers and regulators are:
1. Design a principle-based regulation system that provides high safety standards, legal certainty and a stable environment for transactions.
2. Ensure that the technology leads to end-user cost efficiencies rather than only a redistribution of profits among intermediaries.
3. Identify areas where government involvement is helpful, such as the role of facilitator for a public or private or public distributed ledger, or as a direct central node that applies the technology but retains a monopoly in managing the ledger entries.
Safety And Accuracy
Because public ledgers have traditionally been run by neutral third parties, the key challenge has been how to ensure that a public ledger is safe and accurate. A blockchain can be used to solve this problem. Based on cryptography and a peer-to-peer network, the technology creates an online ledger that, once distributed among network participants, can verify transactions without needing a trusted third party.
While regulation should not stifle experimentation, it can be beneficial for creating a legal framework and putting standards into place that offer stability and safety.
Policymakers must ensure that blockchains do not reshuffle rents at the expense of users, but really create cost efficiencies. One way to do this is to engage in public-private partnerships to create systems that are stable, solve start-up problems associated with network externalities, and support competition by ensuring access to blockchain-based systems.
The technology can improve existing systems, but applications in areas of critical infrastructure will often require direct government involvement.
Policymakers will have to decide to what degree small private networks can provide services based on blockchains and how governments should engage with these networks. Examples include the Bank of Canada’s Project Jasper exploring an interbank settlement engine along with several foreign government projects to streamline online identities.
Blockchains’ Cost Duplication
One concern is that many costs in a distributed ledger are often duplicated. A major flaw in bitcoin, the first application of a blockchain, is that it duplicates the costs of updating the ledger. When network nodes compete for the right of updating the ledger, resources are wasted, which is not always the case when a neutral third party handles the task.
Other costs arise when a proof-of-work protocol is used, since confirmations take some time to be produced.
But over the last few years, these costs have been partially alleviated. Verification and confirmation times have been reduced by alternative applications while maintaining the proof-of-work protocol. Second, alternative protocols have been introduced that avoid the duplication of effort.
Deploying central nodes to update and maintain the ledger combines existing infrastructure with distributed technology. Blockchain protocols can enable a cost-efficient processing of transactions that is often not possible with existing payments infrastructures.
An important challenge is how a blockchain evolves dynamically over time. Potential participants have to coordinate on its design and who will be granted access. As a distributed system, a consensus is needed among a critical number of participants to make changes or adjustments.
There is no guarantee a ledger will continue to be distributed. When some participants gain enough power within a network, they can determine how it is run and updated. This creates a public system where only a few members retain all the power or reverts back to a centralized one where one node acts like a third party administering the ledger.
A restricted blockchain with a limited number having direct access to the chain can alleviate many of these concerns. One can imagine hybrid forms of a distributed ledger in which access is tiered among participants. The core of the network would be in charge of the ledger’s design.
Payment Sector Lessons
The payments sector is an area where blockchain technology has already been deployed.
Cryptocurrencies are being used for retail transactions since the costs can be much smaller than traditional payment systems. Examples include using bitcoin for person-to-person international money transfers and the Ripple Transaction Protocol, which enables banks to move money across borders without needing correspondent financial institutions.
Such developments have already created turbulence in the financial sector. Intermediaries are being pressured to make retail and cross-border payments easier, safer and less costly. Settlement and communication platforms such as Western Union, SWIFT, Visa and MasterCard face the risk of becoming obsolete once cryptocurrencies for cross-border payments become more common.
What has kept blockchain technology from being more broadly adopted for payments, in addition to security concerns, are limits on transaction throughput, a high confirmation latency and variability of confirmation times with high transaction volumes.
Startup enterprises are working on resolving these issues.
It is less clear how blockchain technology can benefit the large-value wholesale payments sector. This is because payments cannot be real-time with immediate finality and zero risk for the counterparties.
One reason is the period of time between processing the transaction and confirming its finality. Second, with blockchain technology, forks can occur. Previously confirmed transactions may no longer be valid. In state-of-the-art, large-value payment systems, a third party like a central bank guarantees immediacy and finality of payments.
Permission-based consensus ledgers offer an alternative to a traditional blockchain. A small network of nodes maintains the ledger so that faster consensus protocols can reduce latency and allow greater scalability. Settlement finality in such a system is more achievable since the central nodes are known and inconsistencies can be resolved faster.
Blockchains can revolutionize corporate governance. Governance traditionally takes place in the form of annual shareholder voting, often via proxies. Maintaining a distributed ledger makes it possible to have votes more often with direct shareholder participation.
Corporate decisions can be pre-programmed and automatically executed via a voting scheme. A blockchain implementation would give users tokens to transmit to specific addresses by a deadline to cast a vote on an issue.
Attempts are also under way to use distributed ledgers to allow the exchange of financial securities. Cryptographic keys can be used as a messaging system to sign trade agreements within a ledger for transactions later confirmed by central nodes.
In addition to trading of financial instruments, the technology holds promise for achieving real-time processing of financial transactions. The post-trading requirements of settling and clearing transactions often involve cumbersome procedures. Using smart contracts for trading, traders could calculate exposures and margin calls right up to the automatic transfer of cash and securities in a delivery-versus-payment mechanism.
Recently, blockchain solutions have been tested to link several ledgers that keep information on asset, collateral and cash positions of market participants. In the U.S., the Depository Trust & Clearance Corporation in partnership with Digital Asset has demonstrated the potential for settling and clearing repurchase agreements via a distributed ledger.
Safety And Accessibility
The biggest concern is that a ledger is safe and accessible. Users must be able to rely on the accuracy of the information in the distributed ledger to be able to use it reliably to engage in transactions. A similar critical aspect is that users can easily and cheaply access the information when necessary.
Over time, standards will have to be developed to protect consumers from unsafe implementations. This requires a continuous dialogue among developers, regulators and users in creating applications. It also needs a certain degree of monitoring to ensure cybersecurity and stability protocols are followed.
Coordination issues and network considerations raise the question of whether distributed ledgers can be developed in a decentralized fashion for critical infrastructure.
Applications are also likely to be driven by new or existing businesses. Hence, it is reasonable to expect that future blockchain applications will rarely be fully public networks where every user has unrestricted access. Consequently, private networks that retain the distributed nature of the ledger, but restrict the right to modify update it, are thus the most likely outcome.
Image from Shutterstock.