Have you noticed how questionable outcomes and challenges are always listed in small sections at the end of a praising white paper for any sort of IT endeavor? It certainly is the case with distributed ledger technology – the risks/challenges/complications are rarely as important to pro-blockchain teams as much as exciting opportunities. In fact, blockchain is believed to be able to change the world and there is hardly any industry that will remain untouched by the miracle.
There has been said plenty of amazing applications, trials/projects, financial and non-financial use cases. This time, let’s look at the potential cost at which blockchain may indeed save the world (as Jaan Tallinn, Skype Co-founder, believes) and become an answer to life, the universe and everything.
Despite a commonplace agreement on substantial benefits for the financial services industry brought with distributed ledger technology adoption across segments, there are certain fair concerns shared by professionals with the World Federation of Exchanges (WFE) in the recent report, in particular. Members of the Federations have expressed concerns regarding regulatory and legal barriers, lack of technical skills, vested interests in the preservation of the existing system, and uncertainty about the technology itself.
Here are some of the risks mentioned by the members of WFE:
- The immaturity of the solution (e.g. how to ensure cyber-security protection across distributed nodes, the ability of the technology to scale, lack of an IT governance framework).
- Uncertainty about the application of the technology to existing processes (e.g. how to handle events of theft/fraud, how to ensure that transfers that happen outside the blockchain are reflected on the blockchain).
- Having a potential to disintermediate current trusted parties; distributed ledger technology may reduce regulatory protection for users of the market.
- In relation to clearing and settlement specifically, DLT adoption might require fewer intermediaries than is currently the case but the need for trusted parties would remain.
- As some of the use-cases required proof of identity and/or verification of possession of the assets, they could see the emergence of trusted third parties who would perform this verification function. While DLT can act as pure technology replacement, the capabilities inherent in the technology also mean that it has the potential to disrupt existing business models.
Moreover, Morgan Stanley extends the list of challenges related to DLT adoption with its research project published in April, listing the following issues requiring attention:
- DLT needs to interface with other parts of the tech food chain seamlessly, enabling faster setup time, training time and fixing time. It must deliver on the promise of efficiency and be easy enough for all parties to understand and leverage.
- The matter of security. "Further research would also be required to devise a system which could utilize distributed ledger technology without compromising a central bank's ability to control its currency and secure the system against systemic attack." – Bank of England, Open Bank Research Agenda, February 25, 2015.
- Not one bank we have met wishes a disaggregated, open-source model for identity. Banks and policymakers need close control for KYC and AML issues. Finding a single digital identity passport authorizer will be key.
- Regulation is also critical in driving to a fully dematerialized environment for securities trading. Complex physical certificates need to be digitized to fully benefit from the speed and fraud control offered by a fully digitized system.
- Many of the issues raised by banks and market infrastructure are not technology but process and governance related. For example, who would be in charge of maintaining and managing the blockchain? Who admits new participants to the blockchain (with the corresponding duty to run KYC/AML checks) in a permissioned system? Who validates any given transaction and who determines who sees which transactions?
- Managing network effects to maintain scalability. Scalability has limits, including across network bandwidth, storage and even processing power. In some implementations of blockchain scalability challenges have already become evident, or at least well anticipated. For blockchain to move forward, it needs to offer a more efficient, scalable solution over current infrastructure.
- Disparate incentives of companies in the financial value chain. "Many financial institutions are experimenting in private with a technology that uses consensus protocols to provide transparency. This mirrors the history of financial innovation beyond the few points in time where an industry mandate or regulation forced the industry to cooperate. The current path will result in a new jumbled, disconnected maze of distributed ledger silos. The industry should seize the emergence of this technology as an opportunity to assess how to modernize and significantly lower risk and cost." – DTCC White Paper, Embracing Disruption – Tapping the Potential of Distributed Ledgers to Improve The Post Trade Landscape, January 2016
- Banks will need to share infrastructure build out costs equitably if new systems are to be truly interoperable industry utilities. This is potentially subject to organizational disputes as users assess how much to invest (which can enable free or freer riders), or customize (which degrades interoperability/speed) and by which measure to allocate costs among participants (by revenues? Market share?).