Banks Claim They’re Building Blockchains. They’re Not

Even after bitcoin gained some name recognition – as nerd money, as a lubricant for dark web commerce, as a latter-day Semper Augustus – its technological underpinnings remained obscure to all but the most dedicated cryptoheads. As far as the media was concerned, Nefarious Ross Ulbricht and Mysterious Satoshi Nakamoto were the story, not some programming minutiae whirring in the background.

At some point, unfortunately, blockchain-hype outstripped analysis. What exactly is this “technology behind bitcoin” that banks, governments and a generation of next-big-thing seeking MBA grads are piling into? Are we all talking about the same thing, or are some of these blockchain-mongers using the buzzword of the year to sell old tech? (See also, Blockchain: The Backbone of Finance’s Entire Future.)

The Rise of the “Permissioned Blockchain”

Bitcoin’s blockchain, a form of distributed ledger technology, allows thousands of people who do not know or trust each other to transact with one another. Normally such a network requires a trusted intermediary to keep bad actors from spending their funds twice or laying claim to money that isn’t theirs. Not so with bitcoin. Through clever cryptography, bitcoin’s proof of work system allows an arbitrary number of strangers to exchange bitcoin without placing trust in a bank, broker or clearing house. (See also, How Bitcoin Works.)

Compare that open, permissionless blockchain to the “private” or “permissioned” blockchains that established tech and financial services players, along with a gaggle of startups, are developing on their own or through consortia. Rather than a trustless network of thousands of strangers, they propose to build small networks of known, vetted actors – or in some cases, to keep the blockchain to themselves. The result makes compliance with Anti-Money Laundering and Know Your Customer laws easier (and elicits Pavlovian responses from investors), but at some point, these purported blockchains have little to do with the innovation that underpins bitcoin.

“Permissionless and permissioned blockchains are technically very different beasts,” Arvind Narayanan, assistant professor of computer science at Princeton and author of a textbook on cryptocurrencies, told Investopedia via email. “It is unfortunate and confusing that the same term is used to refer to both of them.”

Old Tech, New Buzzwords

In a paper co-authored with Jeremy Clark, Narayanan describes a long series of innovations that preceded bitcoin and were combined to develop the first blockchain – or “Nakamoto consensus,” since the word “blockchain” did not appear in Satoshi Nakamoto’s 2009 white paper proposing the original cryptocurrency. These blockchain precursors include Merkle trees and Byzantine Fault Tolerance, which Narayanan and Clark identify as key elements of both permissioned blockchains and permissionless ones like bitcoin’s.

The fact that the two categories of blockchain share these innovations, however, does not make them the same thing. Merkle trees and Byzantine Fault Tolerance date to the 1980s, decades before bitcoin.

“Many proposed applications of blockchains, especially in banking, don’t use Nakamoto consensus,” Narayanan and Clark write. To do so with a small network of known counterparties, they add, would be “overkill.”

Because It’s Trendy?

Bitcoin is designed to be “totally censorship-resistant,” MIT assistant professor of technological innovation, entrepreneurship and strategic management Christian Catalini told Investopedia by phone. That resistance is expensive: Digiconomist estimates that, as of Sept. 25, the bitcoin network is consuming electricity at a rate of 18.1 terawatt hours per year – a similar rate to all of Syria.

Narayanan and Clark are probably right that a similar system would be “overkill” for a single firm or small consortium of firms. Mining, as this energy-intensive proof of work system is known, ensures accuracy and deters fraud in a network of thousands of nodes that don’t know or trust each other. A bank’s back office knows and hopefully trusts itself; six to eight banks can build relationships pretty quickly if they haven’t already. In such situations, mining solves a problem that doesn’t exist.

“The folks that are going to enter into agreements for a permissioned blockchain tend to trust each other already,” Asheesh Birla, head of product at Ripple, told Investopedia by phone. (Ripple operates a permissionless blockchain that aims to facilitate cross-border payments for banks; its consensus mechanism is not based on proof of work.) 

“Some of these platforms are developed to be kind of replicas of the old system,” Catalini says, “where the trusted intermediary has almost the same control, or exactly the same control, it would have had in the old system. And then you’re wondering, why are we switching to a less efficient IT infrastructure? Because it’s trendy?” (See also, Microsoft, Bank of America Team Up on Blockchain Technology.)

What If They Did Work Like Bitcoin?

As Narayanan and Clark point out, many permissioned blockchains do not use mining or other aspects of Nakamoto consensus. Instead they use other, often much older, techniques that are confusingly lumped in with “blockchain technology.”

If they were to use a blockchain like bitcoin’s however, that blockchain would likely be insecure because the parties know and trust each other. Permissionless blockchains like bitcoin’s are vulnerable to 51% attacks, in which a party or a group of colluding parties controls the majority of the network’s computing power and can therefore alter the ledger. If a single entity were to run an in-house, bitcoin-style blockchain, it would control 100% of the network’s power and the blockchain would be inherently compromised – not that that would matter much to the network’s sole participant, who would enjoy full control over a very expensive spreadsheet.

The same issue would likely arise in permissioned blockchains maintained by small consortia. “If the nodes collude, or nodes are compromised, you can just rewrite history,” says Catalini. “So if you’re a regulator, maybe you wouldn’t want a set of banks or a set of financial institutions to be able to collude and rewrite the ledger. It’s not even a 51% attack – they already have the keys to the dataset, so you may not even need the majority to fool the system.” The LIBOR rigging scandal is just one example of why regulators might worry about bank collusion in permissioned blockchains.

Crypto-standardization?

Permissioned blockchains give up the trustless advantages of open blockchains, though in all likelihood, as Birla points out, the participants trust each other anyway. Blockchains are also slower than traditional databases. In 95% of cases, Birla suggests, it’s better to just use a database. “I’ve seen a lot of use cases out there to use permissioned blockchains,” he says, “and when I look at the problem they’re trying to solve, I feel like, wow, there’s a company out there that can solve that problem. That company is Oracle.”

There may be method to the seeming madness of permissioned blockchains, however. Birla, Catalini, Narayanan and Clark all mention the possibility that “blockchain tech” is just sexy packaging for an attempt at industry standardization. “If calling it a distributed ledger is getting people around the table,” says Catalini, “I think that’s a good thing.”

Remember Intranets?

The contours of the permissioned-permissionless blockchain debate are often compared to the tension between the open Internet and the walled-off intranets of the 1990s. “Big companies desperately hoping for blockchain without Bitcoin is exactly like 1994: Can’t we please have online without Internet??” Marc Andreessen tweeted in December 2015.

Catalini expects that the open platform will again win out against siloed alternatives, though he does not mention bitcoin specifically. “I’m pretty convinced now that if you look 10, 15 years down the road, the only true innovation that we will see out of this will come out of the permissionless ones,” he says. (See also: Opinion: Bitcoin vs. Big Finance.)

Birla also expects history to repeat itself, pointing out that Cisco, “pre-internet, was a company that managed intranets.” In other words, companies that are currently developing permissioned blockchains may eventually move to permissionless ones. Making that transition could be challenging, since the regulations that make permissionless blockchains tricky for banks remain in place. 

Taming the Blockchain

Regulation is probably not the driving concern for banks and other established players confronted with Nakamoto’s invention, however. Bitcoin is “the first networked digital platform that we have on the planet where the network wasn’t created by a big player making investments in infrastructure,” says Catalini.

The introduction of a system that allows individuals to transfer funds around the world without a central, trusted authority is an inherent threat to the banking system. It’s far from a lethal one, at least for the time being: bitcoin transactions are slow; the currency’s value is so volatile that you risk losing a chunk of the money you’d like to transfer; the market is small and illiquid; the community is prone to schism; and you have to rely on an exchange to obtain the kind of currency any merchant or tax collector will actually accept. 

Even so, for the first time, there exists a high-tech alternative to the banking system. The industry may see co-opting the terminology of the blockchain – without actually adopting the blockchain – as a way to tame the wild technology, if not kill it. JPMorgan CEO Jamie Dimon has publicly called bitcoin a “fraud” and predicted that governments will crack down on it; his firm, meanwhile, is developing a permissioned version of the ethereum​ blockchain called Quorum.

As Catalini puts it, the established players are “taking the new paradigm and taking out the parts that are disruptive for incumbents.”

The B-word

Not everything that calls itself a blockchain really is one, as one of the earliest permissioned blockchain efforts shows. In November 2016, the fintech firm R3 led a consortium of 75 financial institutions under the aegis of its product Corda. At the time, the company’s CTO said its mission was “to understand, apply, and develop blockchain technology.” By February 2017 that was no longer the case: a company presentation caused a stir with a slide saying, “No ‘block chain’ because we don’t need one.” Today R3 describes Corda as a “distributed ledger platform,” omits almost all mention of the b-word and insists Corda “was never designed to be one.” Others should follow suit.

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