Blockchain in payments: a tale of unfulfilled promises

@LawAhead

Digital currencies and cryptocurrencies such as Bitcoin, Ethereum and Litecoin, as well as their underlying technologies distributed ledger and blockchain have so far failed to revolutionise the international payment system. Now that the hype seems to be gone, is there a future for those innovations in the payment industry?

Author: Bernardo Correia Barradas, lawyer specialised in banking and finance law. Consultant at the Payment Systems Development Group at the World Bank

 

I must acknowledge that I used the term “blockchain” in the title in the hope to garner more interest to this article considering that the hype around Bitcoin and its cryptocurrencies cousins has died down somewhat (luckily), as very well illustrated by a simple search in Google Trends:

Google Trends: Interest over time in worldwide web search from 1 January 2015 until 14 April 2019 for the term Bitcoin.

Google Trends: Interest over time in worldwide web search from 1 January 2015 until 14 April 2019 for the term Blockchain.

 

 

Google Trends: Interest over time in worldwide web search from 1 January 2015 until 14 April 2019 for the terms Blockchain and Bitcoin.

A more correct term to be used in the title of this article would be Distributed Ledger Technology, or DLT. A distributed ledger is a decentralised record-keeping system, where the ledger can be regarded as a file (for example a Microsoft Excel worksheet) that starts with an initial distribution of a specific digital or crypto asset and records the history of all subsequent transactions. Each user stores an up-to-date copy of the entire ledger (hence “distributed”). With a distributed ledger, peer-to-peer exchange of digital assets without the need for an intermediary is possible since each user can directly verify in their own copy of the ledger whether a transfer took place and that there was no attempt to double spend.[1]

The “blockchain” is a specific type of DLT that is updated in groups of transactions called blocks, each block comprising a certain number of transactions. The various blocks are then chained sequentially via the use of cryptography to form the blockchain. This concept was first laid out for the case of Bitcoin in 2008 Satoshi Nakamoto’s white paper,[2] and has since then been adapted to countless other cryptocurrencies.[3]

It is worth mentioning that blockchain is not a technology per se but a concept that makes use of different technologies, some of them with several decades such as the cryptographic links that assure the entries in a block, known as “Merkle Trees”, proposed for the first time in 1979.

 

Blockchain and Bitcoin

Bitcoin, in the words of its programmer (or group of programmers under the pseudonym of Satoshi Nakamoto) was designed as a “purely peer-to-peer version of electronic cash (that) would allow online payments to be sent directly from one party to another without going through a financial institution”. Designed to replace the current trust model by a decentralised trust system that would make central banks and financial institutions obsolete and unnecessary, it has failed thus far quite spectacularly to reach its stated initial goals.

Nothing could be more symptomatic of Bitcoin’s failure that when in early 2018 the organisers of the North American Bitcoin Conference in Miami stopped accepting bitcoin in lieu of payment for the conference’s US$ 1,000 tickets. The organisers justify their decision with the high transactions’ fees and processing times.[4]

Bitcoin, and other cryptocurrencies based on blockchain face unyielding economic limitations that may explain their lack of success (at least vi-à-vis their intended initial purposes). First of all such limitations are the enormous cost of generating decentralised trust, where, due to its proof-of-work process undertaken by miners, Bitcoin, the largest of the cryptocurrencies was, in mid-2018, consuming a total amount of electricity similar to Switzerland, in what has quickly become an environmental disaster.[5] In addition to energetic costs, in order to serve as a means of payment and enabler for economic activity, the cryptocurrencies have shortcomings in other three fundamental areas: scalability, stability of value and trust in the finality of payments. Inefficiencies that arise from the extreme degree of decentralisation and that, notwithstanding the possibility that some issues may be addressed in the future through new protocols and other technological advances, seem inherently linked to the fragility and limited scalability of such decentralised systems.

At the time of writing, Bitcoin is valued at US$ 5,140.32 (losing more than US $20 in the last hour alone) and down from a maximum of US$ 18,877,72 in late 2017,[6] executes less than 4 transactions per second (against VISA’s more than 3500) and was not able to replace the current institutionalised arrangements and sovereign currency as neither a unit of account, a means of payment or a store of value.

blockchain lawahead innovation tehnology regulation bitcoin

Private and Public Ledgers

Although almost unanimously accepted that cryptocurrencies do not definitively work as money and their shortcomings render it and ineffective replacement to sovereign currency, the underlying technologies may still have useful applications in the payments’ industry.

There are two main classes of conceptually different distributed ledgers, the public (or permissionless) and the private (or permissioned).

The public/ permissionless ledgers, or public blockchains, are peer-to-peer networks where each node stores a full and updated copy of the entire ledger (or blockchain) and every proposed local addition to the ledger by a participant is communicated across the network to all nodes. Usually, nodes try to collectively attempt to validate the addition through an algorithmic consensus mechanism and, if validation is accepted, the new addition is added to all ledgers to ensure data uniformization across all network.

Differently from the public ledgers (of which, the blockchain in which Bitcoin runs is the most well-known), private or permissioned ledgers are similar to conventional payment mechanisms, which, to prevent misuse and failures to the network, the ledger can only be updated and the network rules changed by trusted participants (trusted nodes), selected and subject to oversight by a central authority – thus emptying blockchain major promise to provide a reliable, decentralised and efficient payment system without the need for governments, central banks or financial entities.

Permissioned DLT, when compared with traditional centralised solutions, have the potential to be efficient in specific niche markets in which the benefits of decentralised access exceed the higher operating, technological end energetic costs of maintaining multiple copies of the same ledger. Two good examples of such niche markets are low-volume cross-border payment services and small-value cross-border transfers. Remittances are a very relevant example of the latter, being sometimes the biggest source of income for countries with a large diaspora.

United Nations World Food Programme launched in May 2017 its Building Blocks project in Jordan, using a private blockchain that transfers WFP food vouchers to Syrian refugees that can then make payments from their associated accounts to buy food in local grocery stores using biometric data’s readings to confirm their identity. The project was scaled to serve 100,000 Syrian refugees as of January 2018, with the aim of reaching half a million by the end of that year. [7]

WFP’s Building Blocks is a non-profit private, or permissioned DLT, and it is a payment solution, not a cryptocurrency, since the unit of account and means of payment for food aid serving Syrian refugees in Jordan through the Building Blocks is sovereign currency. As BIS Economic Report 2018 points out, it is a “cryptopayment” system. Nonetheless, it constitutes one (of the few) good examples of a practical application of crypto technologies to payments, and, eventually, an omen of things to come.

Contrarily to public ledgers, private distributed ledgers have also the possibility to cope more easily with the current applicable legislation applicable to payments, in the European Union case the most relevant being the settlement finality directive (SFD),[8] E-money Directive (EMD),[9] the second payment services directive (PSD2),[10] and the related national transposition measures.

PSD2, a very impressive legislation that is perhaps the most comprehensive and updated international standard of best practices regarding payment services – in Spain, PSD2 was recently transposed through Real Decreto-Ley 19/2018, de 23 de noviembre, de servicios de pago y otras medidas urgentes en materia financiera – defines a series of rules, namely on the exclusivity of the provision of payment services by payment service providers; duties of report and notification to public authorities; AML/FCT obligations; information duties; liabilities of the parties; authorisation of payment transactions, etc. that cannot, by concept, be fulfilled by a public distributed ledger. Perhaps this specific topic deserves a more comprehensive treatment in a future article. For now, it suffices to state that PSD2 is a very modern piece of legislation. It is the result of negotiations among the 28 Members States and aims to address very relevant public interests such as the promotion of competition, consumer protection, financial and market stability and the prevention of fraud and criminal activities within the European payment system. Public blockchains – but crucially not private blockchains – are by default designed in a way that contradicts most of the objectives pursued by the directive.

 

Conclusion

While DLT and related crypto technologies have the potential to play a role in Klaus Schwab’s fourth industrial revolution[11], hand-to-hand with AI and the Internet of Things (for example by replacing escrow agents or with smart contracts embedded in insurance agreements),the concept by itself failed to meet the stratospheric ambitions in the payments’ area laid down by its more enthusiastic devotees. However, assuming that no new technologies or arrangements came into place (which I see as the most probable outcome), private ledger technologies may still have an opportunity to showcase its value and utility in cross-border payments and remittances, one of the few areas in payments nowadays still facing dramatic shortcomings in terms of efficiency, speediness and cost structure at an international level.

On the other hand, public or permissionless distributed ledgers, such as Bitcoin’s and other cybercurrencies’ blockchains, will not be able to be officially adopted in the payment industry without a massive change in the political, social and regulatory landscape. They would also need to be able to overcome the current shortcomings in terms of energetic efficiency, speediness, scalability and trust in order to provide realistic alternatives to the existent systems.

Bernardo Correia Barradas is a lawyer specialised in banking and finance law and a consultant at the Payment Systems Development Group at the World Bank. Bernardo studied Law, European Law and Economical Criminal Law at the University of Lisbon, University of Buenos Aires and Catholic University of Portugal. Since 2013 his focus of study and research have been in payment systems and payment services, financial inclusion, fintech and blockchain/DLT, with several courses attended and/or organised in the US, Spain and Portugal. Bernardo is currently a student at IE’s first Master in Legal Tech.

Note: The views expressed by the author of this paper are completely personal and do not represent the position of any affiliated institution.

[1]Cryptocurrencies: looking beyond the hype”, Bank for International Settlements Annual Economic Report 2018
[2] Nakamoto, S (2009): Bitcoin: a peer-to-peer electronic cash system, white paper
[3] Such as Bitcoin Cash, EOS, Monero, Ethereum and Litecoin
[4] New York Intelligencer, January 11, 2018
[5] Carstens, A (2018): “Money in the digital age: what role for central banks”, lecture at the House of Finance, Goethe University, Frankfurt, 6 February
[6] Source: coinbase, 15 April 2019, 17:54 (GMT +0)
[7] https://www1.wfp.org/countries/jordan
[8] Directive 98/26/EC. A consolidated version can be found here
[9] Directive 2009/110/EC
[10] Directive 2015/2366/EU
[11] Klaus Schwab, founder and executive chairman of the World Economic Forum

 

References and further readings

Riding the rollercoaster – Bitcoin has lost most of its value this year” in The Economist (29 November 2018)
Cryptocurrencies: looking beyond the hype”, Bank for International Settlements Annual Economic Report 2018
The future of money and payments”, speech by Agustín Carstens, General Manager, Bank for International Settlements, Central Bank of Ireland, 2019 Whitaker Lecture