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August 5, 2016

Future Scenarios: The Blockchain Becomes Bankable

Blockchain-Banking

This is a ‘Future Scenarios’ post where we break down a conceptual future scenario and ask ‘what if.’  The idea is to challenge the political narratives surrounding economic development, whereby all forecasts are built on constant, linear growth, and the continuous expansion of the industrial economy without any real thought to emergent social, cultural and environmental constraints. By challenging these narratives that exist, Future Scenarios emerge that shed light on new models for growth and economic development. 

Let’s cut to the chase on this Future Scenario and identify a scenario where the blockchain becomes bankable – ie. you would be using a pure Blockchain Bank to deposit your money.

In the last Future Scenario post, we analyzed what would happen if there was some sort of banking crisis that led to a sudden shift towards localized digital currencies on a platform like Colu.

Future Scenarios: Digital Currencies as the Medium of Commerce

Earlier, we had looked at the possibility of the breakdown of the megalopolis cities we live and work in to a series of interconnected villages:

Future Scenarios: The Breakdown of Villes and Villages

Combining the themes of the past, we continue down the trajectory where a series of seemingly random events in one part of the world cause as seismic shift in another part of the world, as dictated by the Chaos Theory.  In this scenario, we are going to be less cathartic and ask What If  central bank stimulus continues to create relatively stable economic conditions, yet their new Negative Interest Rate Policy (NIRP) creates the need for a parallel system to store money and assets because people refused to pay a tax on their money.  In this scenario, the question is, will the blockchain be bankable?

Negative Interest Rates

negative_interest_rate_cartoon_04.21.2016

Hedgeye Cartoon

Despite the desired stimulative effects of monetary policy globally following the ’08 Meltdown, there have been many unintended consequences, principally the advent of negative interest rates.

Who would have seen this coming?

The Danish Central Bank was the first to take interest rates below freezing when they slashed their rate to negative in July of 2012. As a result, banks like Danske have been forced to absorb the NIM (Net Interest Margin) hit for the sake of their customers:

“The bank has so far absorbed much of the cost of negative rates itself, rather than risk alienating retail clients by asking them to pay for their deposits.” Danske CEO Bracing for Longer Negative Rates

After Denmark, Sweden and Switzerland went negative; the European Central Bank took rates negative in 2014 and began charging banks to hold their money – the rate currently sits at -0.4%. Most recently, in early 2016, the Japanese Central Bank shocked markets and went sub zero.

Why?

One word – deflation.

The worst of enemy of every central banker, a deflationary cycle causes prices and wages to drop, thereby having an enormous effect on consumer psychology and the velocity of money in the economy.  As a response, they went extreme, assuming that if they drop rates to negative, businesses and consumers will borrow more and stimulate the economy.

“Negative interest rates are an act of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored”  QuickTake – Negative Interest Rates

But the inverse can happen. People can end up hoarding money in order to avoid the ‘tax on money,’ and in extreme cases lead to a bank run.  Next-gen economic think tanks such as Hedgeye, Real Vision and Armstrong Economics all expect NIRP to blow up in the ECB’s face. Here is Mr. Armstrong’s take:

“Low rates will NOT encourage borrowing when banks have too much bad debt to begin with. The negative rates are sending savers to hoard cash outside of banks.” ECB Brings European Banks to the Brink of Disaster 

So when we look for a catalyst to making the blockchain bankable, we need look no further than the ECB and NIRP.

Can a blockchain handle bank volume?

In the world of blockchain, there are two dominant public players: Bitcoin and Ethereum.

NEM

But lesser known NEM, or the New Economy Movement, launched a successful blockchain experiment with SBI Sumishin Digital Bank of Japan, along with Mijin and Dragonfly Fintech:

“SBI Sumishin Net bank has conducted 3-months long demonstration experiment with Dragonfly Fintech and NRI from December 2015. 2.5 million virtual bank accounts and environment with capacity to process 90,000 transactions every hour were built. 6 nodes was set up in AWS, fault tolerance and availability were tested, and it was confirmed that everything went smoothly.” SBI Sumishin Net Bank succeeds in using blockchain for mission-critical systems. 

The NEM blockhain was built 100% from scratch on a web architecture and uses a Proof of Importance (comparable to Proof of Stake) mechanism to validate transactions, unlike bitcoin that uses Proof of Work. For this little known crypto-entity to launch a full-scale blockchain experiment in normal banking conditions is beyond impressive.

While the R3 consortium – a private blockchain syndicate funded by global TBTF Banks – has indicated that they will be ready to launch commercial banking applications starting in 2017, a small dedicated team in Japan is beating them to the punch. With the help of its partners, Mijin and Dragonfly, who are building financial applications on top of the NEM blockchain, NEM is looking to move its technology from the edge of cryptography into the mainstream:

“We are the first private/public blockchain, which is the same system that was used to create Linux, widely accepted as the most secure OS in the business world. NEM was built by experienced developers and was built for scalability and stability from day one. We are also currently the only platform that has been stress tested by banks and approved for financial use. Other currencies have been tested, but haven’t shared any proof, but all of our tests are open for anyone to see the results for.” What’s the difference between XEM, BTC and ETH?

The question becomes, in a world where you had a viable Blockchain Bank built on a completely unknown and distributed entity like NEM, would you trust it?

Trust – Public Blockchain Versus Private Blockchain

In the last few years since people started to parse out blockchain as the technology from behind bitcoin, everyone from the world’s top bankers to amateur cypherpunks have been weighing-in on ‘the future of money.’ It’s obvious at this point, if you follow even a fraction of the global activity, that blockchain entering mainstream currency and financial markets if not a question of if but when and by who.

Who being public or private, or some combination of both?

blockchain

A private blockchain is a blockchain like R3, where the banks themselves are the nodes, and work collaboratively to validate each transaction. In a scenario where you had, for example, 30 banks on a private blockchain like R3, no one single bank could corrupt the blockchain and reverse any transaction. But the banks as a group could collude. If it was in all their best interests to manipulate the blockchain, they could theoretically manipulate transactions in their favour.

On a public blockchain on the other hand, it would be almost impossible for a group of actors to collude and manipulate the blockchain. It would take some form of very aggressive attack – such as a 51% attack where an attacker gained control of more than 50% of the nodes – in order to corrupt the blockchain and reverse transactions; therefore there is more trust, from a public perspective, in a public blockchain. The risks around a public blockchain revolve more around reliability and security than trust.

NEM is a rare public/private blockchain, comparing itself to Linux in the early days of the Internet.

The key difference between public and private is that on a public blockchain, the transactions can be validated publically by any individual who has the txid (transaction id).  On a private blockchain, only the private actors can validate a transaction, which is in practice exactly how the current system works.

So when it comes to the public versus private blockchain debate, it’s unlikely that it will be either/or.  On one hand, individuals will require a level of privacy for their banking transactions, while on the other hand there is a tremendous public benefit to having a fully auditable blockchain that can’t be tampered with by powerful global TBTF Banks. Thus, if it is not one or the other, it depends how the blockchain becomes bankable.

Chaos Theory > Blockchain Banks

“Chaos theory is the field of study in mathematics that studies the behavior and condition of dynamical systems that are highly sensitive to initial conditions—a response popularly referred to as the butterfly effect.”Wikipedia

The butterfly effect is when ‘small causes can have large affects’ leading to scenarios where future behavior is fully determined by initial conditions. The result is chaos (from a physics perspective).

The name, coined by Edward Lorenz for the effect which had been known long before, is derived from the metaphorical example of the details of a hurricane (exact time of formation, exact path taken) being influenced by minor perturbations such as the flapping of the wings of a distant butterfly several weeks earlier.” Wikipedia

Butterfly-Effect

In this What If Future Scenario, we are trying to analyze what could happen if economic conditions stay stable but the effects of NIRP foster the growth of a parallel economic system to store money and assets ie. Blockchain Banks.

In this case, the butterfly flapping its wings is likely to be negative interest rates leading people to pull money from the banks in one country and causing ripple affects to others around it. Judging by recent headlines, that country is likely to either be the UK, post Brexit, or Italy:

“Natwest has become the first bank to warn business customers it may charge them negative interest rates on money held in current accounts.” Savers fear negative interest rates as Natwest warns businesses might have to pay to hold cash

“If the ECB keeps interest rates negatives, the margin for error on every single loan is zero,” told me a senior official at a local bank in Piedmont, one of the richest and fastest-growing Italian regions.” Politico Morning Exchange – Bad Italian Job

If customers in these regions started to pull their money from banks, there are several possible outcomes:

  • Challenger banks‘ would step up and offer customers above zero rates
  • The central bank itself would offer a mechanism to start accepting deposits, such as the RSCoin Cryptocurrency that the Bank of England has been developing for several months
“We study the macroeconomic consequences of issuing central bank digital currency (CBDC) – a universally accessible and interest-bearing central bank liability, implemented via distributed ledgers,that competes with bank deposits as medium of exchange.” Staff Working Paper No. 605 – The Macroeconomics of central bank issued digital currencies
  • Or a new ‘Blockchain Bank’ begins to surface and leverages the distribution power of decentralized blockchain tech to begin taking deposits in some sort of Cryptocurrency

There would be too many factors in play to analyze what could play out, but judging by recent market moves, it’s not as unfeasible as you may think for a pure Blockchain Bank to start to emerge from the chaos.

Market Moves

While we haven’t yet seen any entity market themselves as a ‘Blockchain Bank’ and start trying to take customer deposits, the move may not be that far into the future. Take two recent moves in the market, one by a private institution, one by a public institution.

Recently, Deloitte announced plans with New York-based ConsenSys, an Ethereum development consultancy, to create its own blockchain-based digital bank.

“The firms’ collaboration will focus on helping clients reimagine the core banking environment and consulting on how blockchain technologies can improve their traditional financial products and services, including in the lending and savings areas.” Deloitte to build Blockchain-based ‘Digital Bank’

Deloitte is working with five startups specifically, focusing on areas such as digital identity and new financial products in relation to lending, escrow, etc.

On the other side of the border, The Bank of Canada (BoC) recently debuted its very own blockchain-based ‘digital dollar’ in collaboration with the Canadian banks:

“A slide posted by Forbes provides more details, indicating that the Bank of Canada is testing a system in which participants would post cash to be held by the bank that would then be converted into CAD-coin.” Bank of Canada Demos Blockchain-Based Digital Dollar

What makes CAD-coin interesting is that the Canadian banks would be the parties who process the deposit, but since CAD-coin was a digital currency backed by the BoC, it could theoretically be deposited anywhere once someone held it.

If you were to combine the two – the infrastructure being developed by Deloitte and Consensys, and central bank-backed digital currency – a new ‘Blockchain Bank’ could theoretically start taking on deposits, assuming they had a banking license of course. Simultaneously, the central bank could monitor currency flows in real time

From there, the Blockchain Bank could integrate with services such as Circle that would enable P2P money transfers between individuals and you would have a full-service bank account that is blockchain backed. The advantage here would be the liquidity of a digital currency, backed by the central bank, which would enable an individual to store money in their local currency securely on the blockchain and presumably not be affected by negative rates.

Circle App

This scenario is all based on the assumption that the underlying economy and base currency remain stable during NIRP, yet the aversion to negative rates causes people to start pulling some deposits. And while it’s not a radically new Blockchain Bank that starts accepting deposits in a digital currency like Ether or Bitcoin, it does open up possibilities in the future for new entrants to emerge on public blockchains, like something built on NEM.

Future of Money 

When you start analyzing a scenario like this, you can see that the effects of QE and monetary policy by central banks will force us into uncharted territory.  With the inception of blockchain into the global financial sphere, it creates an array of possibilities that enable the movement of money outside of traditional counterparties, creating an environment where anything can happen.

Blockchain-Banking

Thanks to the digitization of cash, the effects of monetary policy, and the inception of digital currencies, the very definition of money itself is changing. The future will no longer be about us taking our hard-earned physical dollars and depositing them in massive banks with branches on every corner.  A good portion of our dollars will likely become digital, and we will need to find new places to store them to avoid being subjected to the conditions of this large-scale central bank experiment.

In the future, we will return to saving money with real interest rates, storing it in entities that we trust, and having the ability to move that money around without being subject to government controls and monetary experiments. Blockchain Banks may be there, one day, to help restore confidence in the financial sector and create a new banking experience.

On verá!