Blockchain, Trust and Open Banking: a data-driven road to the next wave of FinTech?
by Licia Presutti
Blockchain: the technology
“Blockchains are distributed digital ledgers of cryptographically signed transactions that are grouped into blocks. Each block is cryptographically linked to the previous one (making it tamper evident) after validation and undergoing a consensus decision. As new blocks are added, older blocks become more difficult to modify (creating tamper resistance). New blocks are replicated across copies of the ledger within the network, and any conflicts are resolved automatically using established rules”[1].
Despite the hype related to this “disruptive” technology with lots of applications, it is useful to go on step beyond and give a simple overview of what blockchain is.
The blockchain is best known as the technology behind the bitcoin “described as a decentralized, peer-validated ledger providing a publicly visible, chronological and permanent record of all prior transactions”[2].
Broadly speaking, “blockchains are tamper evident and tamper resistant digital ledgers implemented in a distributed fashion (i.e., without a central repository) and usually without a central authority (i.e., a bank, company, or government)”[3].
Basically, what makes the technology peculiar is its ability to enable the creation of automated code-based systems that provide new financial and non-financial tools that could replace or facilitate key societal functions[4].
The idea of the blockchain originated from the white paper of Satoshi Nakamoto that aimed to find “a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions”[5]. Thus, the idea of the blockchain, originally correlated to the bitcoin, was to create “an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party”[6].
Generally speaking, there are two categories of blockchain: the permissionless and the permissioned.
Permissionless blockchains as Bitcoin and Ethereum are open and accessible to everyone, anyone can read and write to the blockchain without authorization[7]. Indeed, anyone can download the open-source software governing this blockchain and get involved in the network, without revealing their identity or asking for prior permission[8].
This kind of blockchain network is based on a multiparty agreement or “consensus” system that requires users to expend or maintain resources when attempting to publish blocks. This prevents malicious users from easily subverting the system. The consensus systems in permissionless blockchain networks usually promote non-malicious behavior by rewarding the publishers of protocol-conforming blocks with a native cryptocurrency[9].
By contrast, permissioned blockchain networks are not open for anyone to join and, in fact, a central authority imposes limitations on who can access or record information to the shared database[10]. For instance, the Ripple protocol uses a permissioned blockchain to facilitate the exchange of currencies, such as U.S. dollar or Euro.
Permissioned and permissionless blockchains share traceability of digital assets and the same distributed and resilient data storage system[11].
In fact, technically speaking, the permissioned blockchains, despite the smaller number of participants, are faster than the permissionless one. But the permissioned has one important drawback: it takes one party to validate and record the information to a blockchain and in this way, it becomes a point of control but also of failure (it could be hacked)[12].
Blockchain and the meaning of Trust
Broadly speaking, the blockchain provides “trustless trust”, in fact, “parties no longer need to know or trust each other to participate in exchanges of value with absolute assurance and no intermediaries”[13].
Indeed, one of the main concepts to focus on when we talk about blockchain is the meaning of trust itself. As Satoshi Nakamoto said: “we have proposed a system for electronic transaction without relying on trust”.
In fact, despite the willingness to build a trustless world, the rise and the development of the cryptocurrencies are based entirely on people’s trust to enter on a distributed digital ledger as real as money[14].
From a sociological perspective, trust is what makes human society itself possible (Niklas Luhmann). Indeed, “trust is the oil that lubricates social and business interactions and the factor that renders the boundless complexity of modern world tractable”[15].
Fukumaya describes trust as “a set of ethical habits and reciprocal moral obligations internalized by numbers of a community”[16]. In fact, “trust can fail in three ways: direct violations, opportunistic behavior and systemic collapse. Each will appear in the blockchain context”[17]. Indeed, “the rate of adoption for an emerging technology is influenced by how well it is understood and trusted”[18].
Thus, “trust is the willingness of a party to be vulnerable to the actions of another party based on the expectation that the other will perform a particular action important to the trustor, irrespective of the ability to monitor or control that other part”[19].
Indeed, in the banking sector, you trust the bank which is in charge of your money.
Moreover, as Kevin Werbach affirmed, there are three main architectures of trust: peer-to-peer (P2P), Leviathan and intermediary. The first one is based on shared ethical norms, a combination of formal rules and standards. The Leviathan came from the philosopher Thomas Hobbes, under this perspective, the state (the Leviathan) can enforce private contracts and property rights, thus people are willing to take risks inherent in trusting relationships. The third one relies on the presence of intermediaries, banks are the perfect example of intermediary trust, in this kind of environment they build and provide valuable services. In fact, in all these architectures, users give up some freedom to gain benefits or trust[20].
And after all this come to the blockchain architecture, it creates a new kind of trust.
Basically, in the blockchain, the system replaces the counterparty and intermediary with software code[21]. The transaction works through distributed software by unknown participants and transactions operate through smart contracts.
Blockchain’s trust is intangible. Thus, to accept a cryptocurrency transaction you must trust the network without necessarily trusting any individual participant or intermediary[22].
In this context, could the blockchain override the concept of trust?
In fact, in the permissionless scenario, you must trust the protocol itself to make payments. Indeed, blockchain enables this sort of trust: “we don’t know any bitcoin miners, for example, but we trust that they will follow the mining protocol and make the whole system work”[23].
In the banking sector, financial institutions must be compliant with laws, regulations and policies and this kind of environment foster trust and reliability. There are lots of security systems in place, from anti-counterfeiting technologies to internet-security technologies.
In the blockchain system, you need to trust the cryptography, the protocols, the software, the computers and the network[24].
As Michael J. Casey said “we will never remove the need for human trust. Blockchains just resolve one layer of the trust problem — the sequencing of transactions, the record of our exchanges of value with each other”[25]. He said, “I see blockchain technology as an enabling platform, not a complete replacement of that human trust element”.
Indeed, the blockchain technology is basically a tool, with benefits and setbacks, with a different concept of reliability and trust as mentioned before. It could be a great opportunity to increase the speed of the transfer and it could also foster the data sharing between banks and institutions in general. By contrast, it is essential to look at blockchain technology not as a “panacea” for all the societal problems. The blockchain could be viewed as a “tool to organize and coordinate activities on a peer-to-peer basis”[26].
In fact, trust is always involved: to the extent that you must trust the people who wrote the code and the information stored in the blockchain. Thus, humans and trust, in general, are always involved.
How the blockchain could be a trustworthy enabler to foster the FinTech industry in the Open Banking scenario?
The link between the blockchain technology and Open banking derives from history turning points, indeed financial innovations are usually connected to a broader evolution of a civilization. Thus, legislation results from techno-economic development, infrastructures adapt to the new paradigm and new regulations are needed to foster new market realities[27]. With the PSD2 directive, new technological developments were accounted, and this was the first step to get into the best-known Open Banking.
The directive requires that banks share data with third parties through an application programming interface (API), its purpose[28] is to increase competition and participation in the payments industry from innovative online and mobile payment service providers[29].
Generally speaking, “PSD2 seeks to improve competition in the payments industry by opening up the market to new players, lower the cost of payments, develop new payment services to cater to customer needs, improve consumer protection, and extend the reach of the regulatory regime”[30].
In fact, the concept of Open Banking refers to the sharing of data upon different actors in the banking sector. As Igor Pejic said, “by taking a stance with PSD2, the EU opens the doors for blockchain specialists to become part of the big payment system”[31].
At this point, the question will be: how could it be useful to rely on blockchain technology in this scenario?
In the Open Banking environment, a permissioned blockchain network could be introduced to foster the purpose of the directive itself and to introduce additional opportunities[32], such as a “secure and decentralized data store to record certified and authenticated information”[33].
Indeed, the open banking scenario is mostly based on data sharing and through blockchain-based system data could no longer be duplicated but instead synchronized and verified in multiple places by multiple sources, in this way also customers could have control over the data itself[34].
Moreover, it could be possible to use the blockchain in an on-chain system (tech-enabled), in this way all transactions between members are recorded on an immutable, shared, distributed ledger where activities between specific providers are only visible between permissioned parties[35]. In this way, the blockchain could replace fragmented systems that support transaction, payment or reconciliation processing with a distributed ledger system[36]. In fact, lowered cost and increasing speed are the game changers of the digital paradigm based on blockchain technology[37].
However, a way to foster innovation could be to focus on a hybrid blockchain. Indeed, hybrid blockchain resolves the shortcomings of all private (permissioned) and public (permissionless) blockchains and makes blockchain suitable for real-world applications, by combining the availability, transparency and decentralization benefits of public blockchain along with security, privacy and new features of private blockchain[38].
At this point, the question will be: how the blockchain technology could be disruptive in the open banking scenario?
In fact, the most relevant issue to think about is the best-known “disruptive innovation” concept by Clayton Christensen and how it could be effective in understanding the blockchain scenario in the financial services environment. According to him, disruption means “any innovation that transforms a complicated, expensive product into one that is easier to use or is more affordable than the one most readily available”. Disruption has three components: responding to competitors effectively; identifying new growth opportunities and improving understanding of what customers want[39].
On the one hand, the blockchain technology is an enabler of digital transfer of value. On the other hand, banks provide different services like value transfer, value storage, value provision, and value protection.
The blockchain enables value transfer with no fees or additional cost and could be more affordable for a huge range of people who do not have access to traditional bank services. In this way, the blockchain enables the erosion of national boundaries and permit fintech companies and data collectors to operate globally[40].
In fact, from a customer-oriented perspective, the blockchain could be not an innovation problem but a marketing problem for banks, because blockchain should not be approached as a new product to sell to existing clients but a way to find new markets and new customer groups[41].
Thus, fintech companies and tech giants could enter in the market with technological development but could not, probably replace the banks itself and the trust system, this because to be effective, a technology has to be trustworthy in a broader sense. Indeed, there are areas in which fintech companies could not compete with banks, for instance, customer intimacy, retail banking, strong brand, and financial resources and mostly the concept of trust.
Thus, when a disruptive innovation comes the only way to survive is to foster what actually are the customer needs and build the business on that. In this way, the blockchain could foster the value transfer but could not be useful for value provision (loan), value storage and value protection (trust concept itself).
In fact, “disruption can be a valuable way for banks to reinvent their organization by challenging competitors and identifying growth opportunities”[42].
Conclusion
At this point, we assume that the blockchain technology is a disruptive architecture that could foster lots of financial and non-financial solutions, for instance, data sharing between banks and finTech companies, enable transactions on-chain, but as mentioned before, the PSD2 might open up the playing field. But, the institutional imperative of money could continue to privilege the trust concept related to the banking sector that confers obligations and privileges[43].
To sum up, in the open banking scenario, “the blockchain might just be the technology to unlock the showdown between two groups of goliaths: banks versus data behemoths”[44].
References
“Blockchain Technology Overview” (Draft) NISTIR 8202, National Institute of Standards and Technology available at https://www.nist.gov/publications/blockchain-technology-overview;
“Blockchains: A Technology for Decentralized Marketplaces?”, by Eliza Mik in “Impact of Technology on International Contract Law: Smart Contracts and Blockchain Technologies”;
“Blockchain and the Law: The Rule of Code” (Primavera De Filippi, Aaron Wright), Harvard University Press, 2018;
“Bitcoin: A Peer-to-Peer Electronic Cash System”, by Satoshi Nakamoto;
“Blockchain Regulation and Governance in Europe”, by Michèle Finck, Cambridge, 2018;
“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
“Why Is It So Hard to Trust a Blockchain?” by Steve Daviesand Grainne McNamara, available at https://www.strategy-business.com/article/Why-Is-It-So-Hard-to-Trust-a-Blockchain?gko=00e74;
“There’s no good reason to trust blockchain technology”, by Bruce Schneier in Wired, available at https://www.wired.com/story/theres-no-good-reason-to-trust-blockchain-technology/;
“Blockchain: the trust machine? (after Snowden)”, by Simone Mazzata, available at http://www.bdpartners.it/2019/01/blockchain-the-trust-machine-after-snowden/;
“Blockchain Babel: The Crypto Craze and the Challenge to Business”, by Igor Pejic, Kogan Page, 2019;
“What’s Next for Open Banking? Open Banking Operating on a Permissioned Blockchain” by Zaid Mahomedy, available at https://medium.com/chainstack/whats-next-for-open-banking-665b10a883dd;
“A new phase of payments in europe: the impact of PSD2 on the payments industry”, by Adebola Adeyemi, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3375530;
“What’s the big deal with Blockchain and Open Banking?”, by Greg Ellis, available at https://www.covarius.com/insights/blogs/?zDispID=NewsArtWhats_the_big_deal_with_Blockchain_and_Open_Banking;
“Blockchain and disruption in the financial world: Will banks survive?”, available at https://www.finextra.com/blogposting/16658/blockchain-and-disruption-in-the-financial-world-will-banks-survive;
“Blockchain, Banks, and the Innovator’s Dilemma” by Billy Silva, available at https://medium.com/tradecraft-traction/blockchain-banks-and-the-innovators-dilemma-7c66d26d52f2;
“Blockchain and disruption in the financial world: Will banks survive?”, available at https://www.finextra.com/blogposting/16658/blockchain-and-disruption-in-the-financial-world-will-banks-survive.
[1]“Blockchain Technology Overview” (Draft) NISTIR 8202, National Institute of Standards and Technology available at https://www.nist.gov/publications/blockchain-technology-overview;
[2]“Blockchains: A Technology for Decentralized Marketplaces?”, by Eliza Mik in “Impact of Technology on International Contract Law: Smart Contracts and Blockchain Technologies”;
[3]“Blockchain Technology Overview” (Draft) NISTIR 8202, National Institute of Standards and Technology available at https://www.nist.gov/publications/blockchain-technology-overview;
[4]“Blockchain and the Law: The Rule of Code” (Primavera De Filippi, Aaron Wright), Harvard University Press, 2018;
[5]“Bitcoin: A Peer-to-Peer Electronic Cash System”, by Satoshi Nakamoto;
[6]“Bitcoin: A Peer-to-Peer Electronic Cash System”, by Satoshi Nakamoto;
[7]“Blockchain Technology Overview” (Draft) NISTIR 8202, National Institute of Standards and Technology available at https://www.nist.gov/publications/blockchain-technology-overview;
[8]“Blockchain and the Law: The Rule of Code” (Primavera De Filippi, Aaron Wright), Harvard University Press, 2018;
[9]“Blockchain Technology Overview” (Draft) NISTIR 8202, National Institute of Standards and Technology available at https://www.nist.gov/publications/blockchain-technology-overview;
[10]“Blockchain and the Law: The Rule of Code” (Primavera De Filippi, Aaron Wright), Harvard University Press, 2018;
[11]“Blockchain Technology Overview” (Draft) NISTIR 8202, National Institute of Standards and Technology available at https://www.nist.gov/publications/blockchain-technology-overview;
[12]“Blockchain and the Law: The Rule of Code” (Primavera De Filippi, Aaron Wright), Harvard University Press, 2018;
[13]“Blockchain Regulation and Governance in Europe”, by Michèle Finck, Cambridge, 2018;
[14]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[15]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[16]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[17]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[18]“Why Is It So Hard to Trust a Blockchain?” by Steve Davies and Grainne McNamara, available at https://www.strategy-business.com/article/Why-Is-It-So-Hard-to-Trust-a-Blockchain?gko=00e74;
[19]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[20]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[21]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[22]“The blockchain and the new architecture of trust”, by Kevin Werbach, The MIT Press, 2018;
[23]“There’s no good reason to trust blockchain technology”, by Bruce Schneier in Wired, available at https://www.wired.com/story/theres-no-good-reason-to-trust-blockchain-technology/;
[24]“There’s no good reason to trust blockchain technology”, by Bruce Schneier in Wired, available at https://www.wired.com/story/theres-no-good-reason-to-trust-blockchain-technology/;
[25]“Blockchain: the trust machine? (after Snowden)”, by Simone Mazzata, available at http://www.bdpartners.it/2019/01/blockchain-the-trust-machine-after-snowden/;
[26]“Blockchain and the Law: The Rule of Code” (Primavera De Filippi, Aaron Wright), Harvard University Press, 2018;
[27]“Blockchain Babel: The Crypto Craze and the Challenge to Business”, by Igor Pejic, 2019;
[28] Recital 6, PSD2 directive: “equivalent operating conditions should be guaranteed, to existing and new players on the market, enabling new means of payment to reach a broader market, and ensuring a high level of consumer protection in the use of those payment services across the Union as a whole. This should generate efficiencies in the payment system as a whole and lead to more choice and more transparency of payment services while strengthening the trust of consumers in a harmonized payments market”.
[29]“What’s Next for Open Banking? Open Banking Operating on a Permissioned Blockchain” by Zaid Mahomedy, available at https://medium.com/chainstack/whats-next-for-open-banking-665b10a883dd;
[30]“A new phase of payments in Europe: the impact of psd2 on the payments industry”, by Adebola Adeyemi, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3375530;
[31]“Blockchain Babel: The Crypto Craze and the Challenge to Business”, by Igor Pejic, 2019;
[32]“What’s Next for Open Banking? Open Banking Operating on a Permissioned Blockchain” by Zaid Mahomedy, available at https://medium.com/chainstack/whats-next-for-open-banking-665b10a883dd;
[33]“Blockchain and the Law: The Rule of Code” (Primavera De Filippi, Aaron Wright), Harvard University Press, 2018;
[34]“What’s the big deal with Blockchain and Open Banking?”, by Greg Ellis, available at https://www.covarius.com/insights/blogs/?zDispID=NewsArtWhats_the_big_deal_with_Blockchain_and_Open_Banking;
[35]“What’s Next for Open Banking? Open Banking Operating on a Permissioned Blockchain” by Zaid Mahomedy, available at https://medium.com/chainstack/whats-next-for-open-banking-665b10a883dd;
[36]“What’s the big deal with Blockchain and Open Banking?”, by Greg Ellis, available at https://www.covarius.com/insights/blogs/?zDispID=NewsArtWhats_the_big_deal_with_Blockchain_and_Open_Banking;
[37]“Blockchain Babel: The Crypto Craze and the Challenge to Business”, by Igor Pejic, 2019;
[38]“What’s the big deal with Blockchain and Open Banking?”, by Greg Ellis, available at https://www.covarius.com/insights/blogs/?zDispID=NewsArtWhats_the_big_deal_with_Blockchain_and_Open_Banking
[39]“Blockchain and disruption in the financial world: Will banks survive?”, available at https://www.finextra.com/blogposting/16658/blockchain-and-disruption-in-the-financial-world-will-banks-survive;
[40]“Blockchain Babel: The Crypto Craze and the Challenge to Business”, by Igor Pejic, 2019;
[41]“Blockchain, Banks, and the Innovator’s Dilemma” by Billy Silva, available at https://medium.com/tradecraft-traction/blockchain-banks-and-the-innovators-dilemma-7c66d26d52f2;
[42]“Blockchain and disruption in the financial world: Will banks survive?”, available at https://www.finextra.com/blogposting/16658/blockchain-and-disruption-in-the-financial-world-will-banks-survive.
[43]“Blockchain Babel: The Crypto Craze and the Challenge to Business”, by Igor Pejic, 2019;
[44]“Blockchain Babel: The Crypto Craze and the Challenge to Business”, by Igor Pejic, 2019.
