It seems like we can’t go a single news cycle without a dozen or so articles outlining the catastrophic plunge or meteoric rise of any one of the hundreds of cryptocurrencies now flooding the market. While it’s great to see innovation in the financial arena, I can't help but wonder: should the payments sector really be a place where anyone can invent a currency and companies are encouraged to “move fast and break things?”
Let’s back away from the crypto-craze for just a moment and consider the distributed ledger that’s helping power the creation of the coins; the blockchain. As a protocol, the blockchain is rife with potential. There are no limits to the imagination on uses for the technology, particularly when it comes to payments and the role blockchain might play in improving cross-border transactions. Financial institutions are increasingly giving blockchain their blessing, leading pundits to speculate that the protocol has industry-altering potential. But is technology enough to revolutionize the payment space? In solving one problem, does blockchain introduce another? To truly understand what blockchain could mean for payments, we need to look at one of the main issues that the technology might address: transaction speed.
Does decentralization work for payments?
On a domestic basis, most developed (and an increasing number of developing) countries have an interbank clearing network that facilitates the transfer of payments between banks. In most cases, each bank holds an account with that country’s central bank (for example, the ACH network and the Federal Reserve in the United States). When banks transfer funds between themselves, their respective balances at the central bank are adjusted accordingly.
The situation is vastly different in cross-border payments, where each bank keeps its own set of transaction records. A bank in Canada might hold an account with a bank in the United Kingdom and vice versa. Each of those corresponding banks maintains a balance in their respective accounts with each other. When transactions occur, they don’t actually move physical funds, but rather update those account balances - essentially, it's a massive IOU system. But the costs can be high for banks to tie up funds with another bank, rather than monetizing those funds through loans and investments.
Furthermore, each relationship between counterparties is a direct bilateral agreement, governed primarily by the terms of that specific agreement. As a result of that fragmentation, there is no way to automate this process, which is why cross-border transfers are notoriously slow.
Blockchain and cross-border payments
With its decentralized ledger, blockchain has the ability to act as a single source of truth; as a single record, the blockchain’s authority is verified and recognized by every participant, thanks to its visibility into all sequential transactions. Many have compared the blockchain’s contribution to payments to what the SMTP protocol did for email. In the early days of email, messages were restricted to people within the same network (like AOL or CompuServe). With the introduction of the SMTP protocol, the barriers were broken so anyone with an email address could send messages across domains.
The difference is that payment relationships are anchored in trust, and counterparty risk is inherent. Blockchain enables every financial institution to operate on a standardized, publicly accessible record. In addition, when that protocol has its own currency (e.g., Bitcoin) that enables value to be transferred digitally, and settlement can occur faster. In theory, transactions are verified, entries are updated, and funds can move instantly with virtually no disputes between banks. But the reality is that any such solution still requires a set of network rules that foster a safe environment for every participant.
And what about these cryptocurrencies? The debate continues as to whether they are more speculative assets, a store of value, or a medium of exchange. The wild volatility of some of the most popular coins in the last year would seem to limit crypto's viability as anything other than a speculative investment vehicle. In order for it to become even close to a mainstream currency, it would need to be easily convertible to fiat currencies that the general public can carry in their wallets, use at their local merchants, or use to pay their bills. While there is no shortage of exchanges that facilitate these conversions, they largely operate under their own rulebooks and security standards. That lack of regulation will limit both consumer and merchant adoption, as well as keep other stakeholders in the ecosystem at bay, as clearly evidenced by the prohibition of some of the largest credit card issuers from allowing their cardholders to use their products to buy cryptocurrencies.
The case for network rules
The concept of payments flowing freely in an ungoverned or self-governed environment has a finite life. As liberating as it might seem ideologically to transact on an open peer-peer network, there are major limitations and problems associated with such a practice. First, it’s much easier to get away with nefarious activity (the most obvious of which is money laundering) without a secure, governing body. This is part of the reason that banks and regulated entities haven’t exactly jumped into the blockchain pool with both feet. A few institutions have experimented with closed, controlled versions in their own ecosystem, but bank-to-bank global correspondence is virtually nonexistent on the blockchain due to lack of oversight. Banks transact based on trust—no trust means no banks, and no banks means limited reach and adoption.
Still, it's possible that a decentralized ledger could co-exist with a centralized network. In the
Ripple system, for example, every participant must abide by a set of common network rules in order to use the protocol. The protocol doesn’t eliminate the requirement for each pair of counterparties to establish their own trusted account-based relationships, which is a big selling point for banks. Through the use of this trust mechanism, blockchain can actually make it easier for banks to facilitate transactions within a properly-governed network. In this instance, the blockchain is used to augment the traditional cross-border payment process, rather than replace it. The more practical future for the blockchain will be one that makes things better and faster, without necessarily having to break it first.
From possibility to reality
While breaking things isn’t a prerequisite in the world of blockchain, the ability to “move fast” certainly is. Even with trust-based networks like Ripple, the practical capabilities of transferring money on the blockchain is limited to those banks who have joined a respective network. And while banks are slowly being onboarded to these platforms, adoption takes time - lots of time. If blockchain is going to save payments, it will be through the partnership of trusted, rules-based protocols, with alternative payment companies who have already established their own extended network of financial partners and streamlined onboarding and compliance workflows.
Blockchain is a revolutionary innovation toward a digital commerce utopia, but moving payments around the globe on a massive scale will require more than just 1’s and 0’s.