Understanding bitcoins and blockchain
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I was asked by a senior banker last week what bitcoin and blockchain were. I had been hoping to ask him the same question! If bankers are unaware of the implications of this technology, then ordinary mortals like us must be far behind. The technology is very new and is still underfunded because few understand what it means. According to The Wall Street Journal and research firms familiar with venture capital (VC) funding, only about 2-3% of the total new VC funding of about $20 billion in financial services goes to blockchain.
Blockchain is the formalization—through Internet technology—of a process that most Indians intuitively understand—the promissory note—and its dark side, the hawala system. If I issue a promissory note to pay the bearer a sum of, say, Rs.20,000, then I have no choice but to cough up when the holder of the note demands payment, assuming I want to continue to have a reputation among my business associates and their extended network that I can be trusted. In a hawala transaction, the same process works, except that the promissory note is notional, and may be converted into different currencies while it passes through the hands of individuals—each of whom trust that the other will deliver on the promise to pass on the same Rs.20,000 until it reaches its final recipient. In short, it is a clearing system. The Rs.20,000 (or any other amount initially defined by the first two transacting parties) is the defined ‘block’ and the hands it passes through form the ‘chain’; all these hands recognize that the value of the block is Rs.20,000 and not some different amount, since they have all written down in their account books what each unique block is worth.
Blockchain technology allows for instant recognition of the exact size of the block by all transacting parties in the chain since the block is simultaneously updated on all their databases, and has unique security features that do not allow tampering with the definition of the block. In addition, each block’s movements across the chain have the ability to be verified by all parties in the chain since the block carries with it the digital imprint, or ‘signature’, of wherever it has been. The impact of this is revolutionary. It creates instant trust without having to rely on a series of trustworthy banks to clear cheques or having blind faith in ‘honour among thieves’, i.e. that the various parties transacting in a hawala deal regard their reputation as being more important than reneging on it.
When I was a partner at KPMG in the US, I was deeply involved with the Global Straight Through Processing Association, or GSTPA, a consortium that 90-odd banks had contributed to, and which KPMG partners were seconded into as the key C-level executives. The idea behind the GSTPA was to create a technology ‘middleware’ messaging platform that allowed GSTPA’s member banks to settle transactions among themselves faster than existing clearing and settlement processes could. Hooking up to this messaging platform allowed banks to settle cash transactions immediately (t+0) and securities transactions in a maximum of three days (t+3). This was a vast improvement over prevailing processes that could take 3 to 5 days for cash and over 5 days for securities. Banking consortiums still have such proprietary systems that they use among themselves, and blockchain technology threatens to upend these systems.
So, what then, is bitcoin? It is an attempt by a firm, using blockchain technology, to create a set of shares in a trading entity that had an initial set value and fixed number (much like the face value and number of shares offered in an initial public offering), in the hope that these shares would become the medium of exchange through which people trade goods and services. Since the number of shares is fixed, demand for them goes up over a period of time as more and more people use the shares to settle their transactions; so, the bet is that each bitcoin’s value goes up stratospherically since there will never ever be any more bitcoins issued. This is still legal since it hasn’t yet been regulated by many countries. Sovereign governments don’t like allowing companies to issue their own coin and will eventually regulate such systems, much like Victorian England stopped allowing the East India Company to issue its own coinage in India. That last intervention took a war for Independence in 1857 before the British Crown stepped in. Today’s governments are unlikely to wait for war to break out before they regulate something that affects their ability to issue and guarantee currency.
However, banks are still at threat with blockchain, since more and more firms (using their IT service providers from India and elsewhere) will build systems that can create and exchange ‘blocks’ with one another completely legally, without ever having to use the banks as a financial intermediary. Some telecom firms in places such as India and Kenya are already using their networks to help people settle cash transactions, but these are proprietary and meant largely for poor and underbanked areas with considerable mobile penetration.
There are applications for blockchain outside financial services as well. A ‘block’ could be defined as anything—a unit of services, products, raw materials—the list is endless. In their attempt to evolve into software product firms, Indian IT service providers would be well advised to expend significant energy to produce software products that incorporate blockchain technology for a variety of industries. This ocean is yet uncharted and the ones with the best navigators will win.
Siddharth Pai is a management and technology consultant.