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Up Front

The Hutchins Center Explains: How blockchain could change the financial system, part 2

Peter Olson and David Wessel

Bitcoin and its underlying technology, blockchain, have the potential to challenge the dominance of the big players in payment systems and significantly reduce the cost of financial transactions and the speed with which they are completed. In part 1, we explained the basics of Bitcoin and the blockchain and how they could change the financial system. Here, we delve deeper into a discussion of the tensions within the industry, and between the industry and regulators, as gleaned from a recent roundtable convened by the Hutchins Center on Fiscal and Monetary Policy. (To see videos of the two parts of the discussion, click here and here.)

Q: What’s causing conflict in the Bitcoin/blockchain community?

A: A big issue is whether the cryptocurrency itself is needed to harness the technology’s information transmission and accounting features (the “rails” and the “ledger”). Here’s why some argue it’s necessary: The blockchain is a perpetually updated record of transactions independently saved by users across the internet, kept pure because users are paid a small amount of Bitcoin to encode other people’s transactions in the chain. If Bitcoin as a cryptocurrency did not exist—the argument goes—there would be no incentive to devote one’s computer-processing power to maintaining the blockchain. 

Broadly speaking, many in this pro-cryptocurrency group tend to have anti-establishment, libertarian leanings. They like privacy and gold, and they’re distrustful of large banks and monetary policymakers. They like the fact that transactions on the Blockchain are anonymous, and many of them look forward to a future where no governing authority controls the money supply. They see themselves as the scrappy start-ups taking on the big guys.

This camp is well represented by Barry Silbert, founder and CEO of Digital Currency Group, a company that invests in and builds Bitcoin-related companies “to accelerate the development of a better financial system.” Silbert is quick to expound how Bitcoin is like digital gold, but better: “It is finite, scarce, highly divisible, and can’t be counterfeited. It’s fungible, which is why people seem to love gold, but the big difference between Bitcoin and gold is, at least in my opinion, Bitcoin actually has usefulness. You can buy a car, you can buy a house, and you can buy a cup of coffee with Bitcoin—hard to do with gold.”

Q: Without the cryptocurrency component, what’s left?

A: Some see the cryptocurrency idea as more like fool’s gold than gold, and are interested in exploiting the rail and ledger technologies to facilitate transferring money or information on a closed network, rather than one open to anyone with a smart phone or a personal computer. For example, R3CEV, a blockchain consortium which counts more than 40 of the world’s largest banks as its members, thinks this could make transactions between banks much less costly than under the current system. Brad Peterson, CIO of Nasdaq—which is implementing elements of the blockchain rail and ledger protocols into some of its systems for tracing stocks—admitted that such applications are “not as exciting as what Barry [Silbert]’s vision is,” but, in the eyes of many in this group, could still be transformative, and are much more likely to be approved by wary regulators.

Q: Are these two visions all that different? 

A: Jerry Brito, executive director of Coin Center, a cryptocurrency research and advocacy center, thinks that just using these new technologies to improve the transfer of payments inside a network with a limited number of authorized participants takes away most of its power: “The innovation of something like bitcoin and blockchain is not just a more efficient way to settle maybe a little bit faster, it’s really the fact that, for the first time, you can have these networks in a way that are permissionless the way the internet is permissionless, and permissionless just means that anybody can get a laptop, download some software, and join the network and begin to innovate on it.” Those who disagree tend to take the pragmatic view that a widely-used, global and anonymous system is incompatible with enforcement of know-your-customer, anti-money-laundering laws.

Q: How would you describe the constituencies of these two camps, and who will come out on top?

A: In some ways, this is a fight between the financial establishment (e.g., the big banks with which R3CEV partners) and the upstarts (such as Digital Currency Group). Brito thinks the history of the internet provides a clue as to which approach will prove more consequential: “One of the biggest competitors to the internet was the X25 standard which was developed by the international telecommunications union of the UN and it was a very complex, robust—it was kind of like the Betamax of internet working standards but the VHS internet blew it away because it was permissionless, right? It was not a consortium of global telecom companies which is what X25 was.” Borrowing the terminology of Harvard Business School’s Clay Christensen, Brito calls the permissioned blockchain a “sustaining innovation,” and the permissionless technology a truly “disruptive technology.”

R3CEV’s Managing Director, Charley Cooper, counters that the internet story isn’t applicable because finance is a much more highly regulated sphere: “Wall Street operates in one of the most highly regulated industries in the world and there are amazing technology companies that are building really cool stuff that is totally irrelevant to what the financial services markets are doing.  If you don’t understand Wall Street and you don’t understand the regulated nature of it, your technology is useless, it’s become an academic exercise.”

Q: How do these factions interact with regulators, and what are the roadblocks?

A: These camps do agree on at least one thing—that regulation needs to be “better.” Not surprisingly, opinions vary on what “better” means. In answering a question about the problems his cryptocurrency-related companies face, Silbert said: “I’m going to give you my top three:  Banking, banking, banking.  We have investments in 60 companies.  These companies have raised an aggregate 70 percent of the venture capital money that has been invested into this space—excluding the miners—backed by the best investors in the world, run by ethical, well-intentioned entrepreneurs. They can’t get bank accounts. And the result of that is we are starting to see innovation happening in the UK, in Singapore, in Germany, in places where the government has taken a much more supportive, accommodative, approach to this industry.”

Silbert also offered a warning to regulators, saying that the innovators aren’t likely to wait for regulators before moving: “I hope regulators appreciate that the industry entrepreneurs are not going to sit back and wait for those decisions to get made, and I think hopefully everybody can appreciate that we and they are—we are doing our best and we’re trying to be helpful, we’re trying to engage, but the expectation cannot be we are going to wait for clarity.”

R3CEV’s Cooper says that his firm is willing and eager to work with regulators, but there’s no one person to talk to: “In the U.S. it’s incredibly difficult because it’s unlike many other countries where the regulators fall under a single umbrella. So if you want to go see the [Financial Conduct Authority] in England, for instance, and the Bank of England, they can both be at the meeting.” When asked what regulatory barriers he faces, he continued on this point: “The first one is I don’t even know who to call.  Do I call Treasury, the Fed, the OCC, the CFPB, the SEC… It’s almost like the universe is so big we don’t know where to start, and one thing that would be again useful—and I recognize that this is Pollyannish—is I think the regulatory community would do well to ask itself a process question as to how it, as a whole, to the extent possible, would like to approach this.”

Q: What are industry’s proposed solutions to these problems?

A: Some want regulators to think of Bitcoin from broad first principles. Ryan Zagone of Ripple, which facilitates cross-border bank payments using distributed ledger technology, thinks that’s how the government handled—admirably—the internet in the mid-1990s: “We sat around similar tables back in 1997 and asked the same question about the internet.  And while we didn’t know how to regulate it then, we did come forth globally with a set of pillars that we use even today on how to regulate e-commerce.  And that was that regulation should be simple, clear, consistent, coordinated, and have security and consumer protections. And that was proposed by Bill Clinton at the time, presented to the U.N.  It was adopted there and it was adopted in Europe under the Bonn Declaration.” 

Others advocate a case-by-case approach that varies based on how Bitcoin technologies end up being used. For example, Perianne Boring, founder and president of the Chamber of Digital Commerce, which aims “to promote the acceptance and use of digital assets and related technologies,” suggested Bitcoin be regulated this way. “[O]ur motto at the chamber is regulate by function. Look at exactly what the entity is doing and have very narrow parameters on how you look at that because over time this technology is going to go in many different directions.”

Q: What do the regulators say?

A: Some have expressed concern about expecting too much, too soon. Sayee Srinivasan of the Commodity Futures Trading Commission made this suggestion to entrepreneurs: “[M]y advice to individuals would be take the path of least resistance [meaning, use cases where legality isn’t a question] because if you are going to be waiting for regulators to change things, it just takes a lot of time because writing rules is a very, very difficult, challenging, risky, painful process and that’s not in our DNA to go and quickly change rules….”

The entrepreneurs argue that the regulators aren’t clear, but some regulators feel the same way about the entrepreneurs. When he was at the Federal Reserve as a senior staffer, Jeffrey Stehm, now of Promontory Financial, said that entrepreneurs would “come in with a broad concept and then they’d want you to opine on it and give it the papal blessing and out the door you would go.” Most regulators “don’t wake up in the morning and want to be resisters to new things and don’t want to be resisters to technology, but on the other hand they have a mandate from the governments, whether it’s state or federal, to do certain things.”

Q: So what’s going to happen?

A: How these regulatory interactions will play out is an open question, and will likely depend on whether the Bitcoin community is able to present a united front, or whether the two broad camps each push for their own approaches: the “big-picture, we’re moving whether you like it or not” mindset, the more measured “try to work within the existing framework” one—or something else entirely. It will also depend on the response from other vested interests who don’t want their current business models overthrown (for example, credit card companies), and whether—as many in the Bitcoin space fear—those entities will use their lobbying power to throw up regulatory roadblocks. Michael Barr, advisor to Ripple and law professor at the University of Michigan, is worried that premature regulation, even if well intended, could entrench those interests further, or at the very least stop innovation from changing the system as we know it—“locking in the dinosaurs,” as he calls it. Bitcoin’s success in moving  from sideshow to center stage over the next few years will prove particularly important in determining whether it disrupts business-as-usual or simply fizzles.

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