Finance is too fragile. Bring on the blockchain.

How does blockchain establishes trust in a new way? Photo / Getty Images
How does blockchain establishes trust in a new way? Photo / Getty Images

Could the technology behind bitcoin, the alternative currency much loved by anarchists and drug dealers, make the world less vulnerable to financial disasters?

Surprisingly enough, it could.

In the eight years since the crash, regulators have made some progress in strengthening the global financial system, but the structure is still not as robust as one might wish. In principle, new technologies -- including blockchain, the idea that underlies bitcoin -- could help fix some of this fragility. It's a possibility well worth pursuing.

In what way is the system still weak?

Crucial functions -- such as payments and trading -- remain concentrated in large, undercapitalized banks or other central hubs; despite regulators' efforts, losses at those institutions could still have economywide repercussions.

To make matters worse, the authorities don't yet have a clear real-time picture of what's happening in financial markets or where risk is concentrated. Blockchain technology is capable of addressing both issues.

Finance is all about trust: Essentially, financial institutions evolved to enable transactions with strangers. Centralized intermediaries of various kinds solved that problem, keeping track of who owns what and who owes whom.

But centralised intermediaries also create points of systemic vulnerability. Regulators continue to wrestle with this underlying -- and hitherto unavoidable -- dilemma.

Blockchain establishes trust in a new way. It creates a so-called distributed ledger, which maintains a complete history of all participants' transactions -- a history that's verified and recorded across a network of computers spread around the world. There's no need to trust a single source. The record resides in so many places that it can't be lost or tampered with.

Now imagine all financial transactions -- from paychecks to derivative contracts -- residing on a public distributed ledger.

Everyone, including regulators, would be in a much better position to see (and to head off) dangerous exposures. If a major bank ran into trouble, authorities wouldn't have to worry about the impact on vital payment or ledger systems.

Governments would be more able to let large financial institutions fail, restoring market discipline to risk-taking and allowing financial regulation to be much simpler.

Technically, this seeming utopia is within reach. The question is how to make it happen.

Big banks and exchanges are participating in various projects to build private blockchain systems, including ones aimed at processing trades in credit derivatives, stakes in private companies, and Australian equities. The spur is greater efficiency and lower back-office costs. This kind of closed-architecture innovation, welcome as it may be, is unlikely to be transformative in itself. It's aptly known as blockchain on "training wheels."

Independent startups are working on public blockchain applications, which have greater potential -- but current financial regulations put them at a disadvantage.

For example, any company that moves money must be registered in each country where it operates and must comply with all their separate rules. In the US, the requirements are state by state. This makes experimentation needlessly expensive. It might be enough to suffocate, or at least seriously delay, a technology whose most promising uses are global.

The UK Financial Conduct Authority has found an elegant solution: A "regulatory sandbox," where companies can test new concepts without submitting to the full compliance burden. This approach needs to go international, with different jurisdictions agreeing to allow experiments with cross-border blockchain applications. If the US took the lead in this effort, others would sign up for fear of being left behind.

The blockchain really could change the world, making financial crises much less damaging and reducing frictions in global commerce. It could also fade into the relative obscurity of narrowly conceived technical innovation. The technology deserves to be properly explored. Regulators can make the difference by giving it some space.

- Bloomberg.

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