4/21/2017 Blockchains and Banks Design Matters Medium

David Galbraith Follow

Architect: buildings once, now web applications. http://davidgalbraith.org
Sep 30, 2015 9 min read

Blockchains andBanks
As we worked with Eris Industries in the Anthemis Foundry, we came
across the conundrum concerning blockchains: Bitcoin bundled together
various existing technologies in a unique fashion to create something
genuinely new an almost unhackable, replicated database with no
master server, via updates which are based on quickly veriable eort
rather than permission. Blockchains (permissioned chains) remove the
genuinely new bit, but they are the current focus of activity in the
Financial Services sector. Why?

[ tl;dr: Bitcoin created an awareness of a mechanism that could

conceivably disrupt both banks and existing banking infrastructure
providers via a nancial network without either middle men or
trusted entities. This created the incentive for strategic investment to
look into blockchain applications. These replace banking
infrastructure providers with software that doesnt need to be run by
a separate entity (e.g. SWIFT), and lower internal costs but still keep
the requirement for trusted entities (banks themselves).

What blockchains achieve could have been done before, albeit in a

less elegant way, but there wasnt the alignment of incentives to
produce the applications that will create a de facto reality.

Even without the advantages of the Bitcoin approach, this will

stimulate the creation of Internet era banking infrastructure. With
them, we could see the web of money and, more generally, any kind
of contract. ]

. . .

Decentralized Systems
If I have a digital copy of a song, I can duplicate it millions of times
for almost zero cost. I cant do that with a physical product like vinyl,
Id have to stamp a lot of plastic.

This is how le sharing threatened to disrupt the music industry, and

how Napster was born the last time there was buzz around

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decentralized systems in 2001. This was the period that produced

Skype and JXTA and BitTorrent and when OReilly created the Peer-
to-Peer conference that morphed into Web 2.0.

The last time there was a buzz around decentralized systems, in 2001. The OReilly Peer-to-Peer conference,
that morphed into Web2.0.

15 years later there is renewed buzz around decentralized systems, but

this time it is not about duplicating information but preventing it
being duplicated.

. . .

Duplicates of a UniqueVersion
When people duplicated a song on Napster, each version of that song
was actually identical. Ironically, if you could make it so that the le
could not be changed without permission or costly eort, you could
create a system where the identical copies meant there was only one
version of a song, but duplicates of that identical version that everyone
could listen to. That single version of a song could equally be a le
that said who (or what address) was associated with an account
balance. Everyone could listen to that account balance, but nobody
could alter it, thus creating a unique version of the truth, widely
duplicated. This would be a shared account balance database a
shared ledger.

This kind of system would not work for creating a Music Industry
version of Napster, because reading the database listening to the
song is where the value is (nb. a modied version could). But for
contractual exchange of value (i.e. buying and selling) and more

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generally agreement of any contract, where the value is where the le

says it is (e.g. someone else has $5000) not in the act of reading it, it
works. And a system like this works well for a lot of banking.

Why blockchains work for ledgers. The value contained in the music embed at the top is extracted by reading
the le (listening to the song), which is why the music industry didnt want you to copy song les. On the other
hand, reading the account balance below it doesnt have value, it says where the value is so you dont mind if
the le is copied you mind if it isaltered.

If you create a network where every user uses the same database, you
can prevent people from copying or changing data within that
network, without permission. If you tie the update of that data to
nding the unique way to lock it up and that requires doing
something physically costly like doing millions of calculations that
inevitably cost money in electricity spend then you have inextricably
linked the digital world back to the physical one and you prevent
anyone from changing the data with or without permission unless
they are prepared to spend that money.

This means the data can represent money, much like a piece of paper
can. But because the data is in a network it can move around
geographically, much more easily that a physical piece of paper.

Ironically, by using a similar technology that allowed people to

remove scarcity for things like music by copying les, Bitcoin solved
the problem of making digital things scarce by preventing people
changing their contents.

Blockchains take much of this approach and apply it to more general

use cases that dont necessarily involve the creation of currency. This
is a necessary component of the Bitcoin model, to reward and
incentivise the untrusted people who update the database and so

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blockchains require trusted entities as nodes, even if the network itself

doesnt require a separate trusted third party to run it.

. . .

Bankings Not Becoming Digital, it Became Digital Too

Early, PreWeb.
By using blockchain technology to replace banking infrastructure the
banking industry is not suddenly becoming digital, it has been for
decades. But it became so too early, before the web, therefore much of
its back end infrastructure is based on a less networked world. The
system runs in batches, stopping and starting, and databases are not
linked together suciently. Banking infrastructure is less like an
Internet platform with a packaged end user service that combines
data and communication of that data, than a telecoms one which is
merely concerned with connecting the data (the pipes not the whole
end user application).

A more modern, Internet era banking system would consist of

realtime transactions settling on synced, duplicated ledgers. This
could have been achieved years ago, in the days of Napster, but like
many regulated industries, the ecosystem had self-congured so there
wasnt the incentive to innovate. Blockchains have created the market
awareness and incentives to innovate as much as the technological
means.

. . .

Virtual (Software Only) Consortia

Current banking databases are disparate and therefore require
reconciliation between each other, something which doesnt happen in
the realtime manner we have become accustomed to with the advent
of the web. The network connections between these databases, the
rails, are separate and run by 3rd parties and many of the rails that
banking systems operate on are actually standardised networks
operated by middle men, created as a consortia operations by the
banks themselves.

Its the existence of these consortia that has prevented banking

systems from evolving, because there was no incentive for a
single bank to create a better system outside of the consortia.
They would be in control of a non-interoperable standard that

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nobody used. All transactions happen between multiple parties,

that is their nature, so some form of synchronized system and
innovation which is simultaneously adopted by multiple parties is
required.

To replace legacy systems with Internet era ones, there are other
models than that of multiple entities tied together by mutually owned
consortia: (a) the winner-takes-all platform monopoly model that
works in many industries and created Googles, Facebooks and Ubers
and (b) the utility one, where the entire banking service, not just the
rails becomes a utility much like roads.

(a) will not happen because regulatory requirements mean that even
if there are global Financial Service brands, these sit on dierent local
systems that are tied to local jurisdictions. There are certain Internet
platforms that stubbornly remain regional, one of these is real estate
listings, another is banking. There will be no Facebook of banking.

(b) could happen, where there is no Facebook of banking but both

enterprise and consumer Internet platforms from social media to SaaS
based accounting own corporate and retail customers. i.e. there will
be no Facebook of banking but Facebook etc. could own the banks
customers. Precisely because this would be an undesirable outcome
for the banks, it will naturally drive movement towards a new version
of the consortium model.

This updated model can be done much more eciently with

blockchains, which could replace 3rd party consortium entities with
software alone. By removing a middle man from doing this, the
constraint (that the consortium cannot threaten the banks) that
ringfences the consortia from not encroaching outside of their
designated territories disappears and would allow blockchain based
systems software to full their potential to innovate and do more than
existing cooperatives like SWIFT can.

As a side note, the Napster or Bitcoin style model of truly

decentralized systems with no entity in overall control of any portion
will probably not happen in Financial Services unless there is a
fundamental shift in how societies work, triggered by them.

Who knows, maybe this could happen, but not in the short term. The
reasons for this are that decentralized systems cant be governed by
anyone, so they end up being either compromised or outlawed and
secondly, they decentralize revenue. Its dicult (not impossible) to

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imagine a decentralized Facebook usurping them because Facebook

centralizes revenue and therefore may be able to compete more
eectively. Both of these reasons are why the last wave of
decentralization faded.

In summary, the multiple entities tied together by software only

consortia model will be where banking innovation for back end
processes and infrastructure happens, and blockchain technology will
certainly be the initial focus.

. . .

How Blockchain Innovation could PlayOut

How might the Blockchain based virtual consortia (consortia that are
purely in software) model evolve?

Until today, banking innovation through Internet startups, Fintech,

has been concerned one of three things:
1. better interfaces to existing technology through fancy APIs (e.g.
Stripe).
2. better design, simplicity, brand and positioning (e.g. Transferwise).
3. regulatory arbitrage (new kinds of marketplaces with dierent rules
e.g. LendingClub)

All of this has happened against a backdrop of unusually low Interest

rates which have subdued existing revenue streams and created an
opportunity for startups (e.g. an unregulated pre-paid credit card
startup, oering accounts with no interest and with a mobile phone
interface looks and feels much like a real banks current account when
Interest rates are low).

None of the three types of Fintech innovation have tackled the

underlying technology, because until now, nothing has threatened the
consortia businesses to untangle the connections that bind everything
together. And because these consortia take fees which are less than
their members do, you can only disentangle these systems if there is a
simultaneous threat to both the consortia and their members.

Bitcoin does theoretically threaten both it gets rid of trusted

middlemen and trusted parties and counterparties altogether with a
new kind of software architecture for transactions, comprised of
existing technologies put together in a truly novel way.

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What Bitcoin does is provide a perceived threat to both the consortia

model and the banks, and in doing has stimulated banks to break
rank and abstract the blockchain architecture from Bitcoin to innovate
on the back end technology.

Blockchain interest within banks hasnt been driven by panic, but by

intellectual curiosity, and the ability to authorise R&D expense to look
into strategically threatening technology. This money will create
applications and the applications will be useful. The crack has been
opened for a feedback loop of innovation that delivers results that in
turn justies the expense of new innovation.

Internet era banking technology has found its ecosystem t in the

form of blockchains.

A New Kind ofDatabase

Ironically it may not matter if blockchains do anything new that
couldnt have been achieved with relational databases, when they are
stripped of the principal innovation that Bitcoin oered (no
requirement for trusted entities). If enough code is written and
enough people use it banking rails will provide realtime execution of
any type of nancial contract, anywhere and blockchain systems will
evolve into the most elegant systems to do that. Given that their
attributes are what is needed for the job and that conguring existing
systems to achieve what is needed is complex and messy, blockchains
will become the most elegant de facto solution even if they were not,
a priori.

With blockchains added to the mix, the database universe could be:
(1) full-text search systems for fast retrieval, slow updating, and low
accuracy (useful for search engines, social networks and document
systems). (2) relational and object databases, used for complex
structured data and balanced retrieval and update speeds (useful for
business processes and general purpose applications). (3) blockchain
systems, useful for highly accurate transactions between multiple
parties with structured data that is simple enough (as most nancial
contracts are) that it wont change too much over time (new elds
added etc.) these systems are possibly slower and the data much less
compact.

. . .

A New Kind ofWeb

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But the outcome may be more than this. Public chains, with their
genuine innovation could play a role in making the promise of the
blockchain not being a new database, but a new protocol or network
built on that protocol. This would create not just a web of money, like
Bitcoin has, but the web of money and would possibly go beyond that,
even, to create a universal transactional web for any kind of contract.

Nobody knows how this will play out, whether there will be lots of
private chains, like disconnected Intranets, or there will be one web,
one public chain to rule them all. In the interim, what is more likely is
that the separate strands of public and private chains will later join up
if the backbone evolves. The slower, but more secure Bitcoin style
public chain could become the backbone for an Internet of
transactions, where private chains among groups of corporations
checkpoint against that chain at periodic intervals.

If this results in the web of transactions its a very big deal.

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