Revolution or paper tiger?
Blockchain technology first appeared in the headlines as the basis for the bitcoin cryptocurrency. At its core, it is nothing more than a web-based, decentralized, public accounting system.
Originally, the idea of shared, cryptographically secured transaction processing was eyed with mistrust or even derision. Since then, however, many startups in the fintech and insurtech sectors have demonstrated the benefits of this technology in supporting their innovative business models.
Blockchain technology's main potential is seen in its ability to weed out inefficiencies in transaction processing. The startup scene talks about robobanking, P2P funding, P2P insurance, P2P lending and other similar business models for transactions with no broker. Even established financial institutions are hoping to achieve massive savings by eliminating auditors, clearing institutes and other middlemen.
Blockchain-managed assets have reached the impressive total of USD 1.6 billion worldwide, with 1,600 percent growth between 2013 and 2016. And more than USD 1.4 billion in venture capital has flowed into startups in the blockchain sector in the past three years.
Among the most important features of blockchain engineering compared with other information processing systems is its ability to include and implement so-called smart contracts. These contracts contain data and self-executing code, information that rests in the blockchain until a determined trigger event occurs. The many promising business models for smart contracts include:
While many of these application scenarios are still largely untested, initial experiences are encouraging.
The financial sector is the field in which blockchain technology has made the greatest impact so far. This is where the most sophisticated and varied applications are found, where large sums are in play rather than just niche offers. A few examples can serve to illustrate.
Crowdlending: You no longer need to go to the bank to get a loan these days – P2P lending companies make this possible. There are more than USD 50 billion in P2P loans worldwide today. More than €660 million has been distributed through crowdlending in Germany alone. And in Switzerland, the crowdlending volume nearly doubled last year from SFR 3.5 to SFR 7.9 million, as measured by the IFZ (Zug Institute for Financial Services) at the Lucerne University of Applied Sciences. Study director Andreas Dietrich predicts this figure will double once again in the current year. Blockchain technology is likely to give this budding industry an enormous boost.
IBM Global Financing Unit: Blockchain technology has proven itself at IBM as a system for tracing transactions. Every year, IBM's Global Financing Unit processes USD 2.9 million in payables for the group, and is responsible for granting credit to more than 4,000 suppliers. With blockchains, IBM has succeeded in reducing dispute settlements from 40 days to ten days, and freed up some USD 100 million in previously committed capital for other purposes.
Allianz Risk Transfer: Insurance firm Allianz, which generated €152 billion in revenue in 2015, is another pioneer in blockchain technology. Because premiums must be invested in the capital markets so as to produce payouts in case of an insurance claim, Allianz is also one of the world's largest asset managers, with more than €1.24 trillion in capital.
The firm has tried out blockchain engineering in a pilot project of its subsidiary Allianz Risk Transfer with investment company Nephila Capital, which involved smart contracts for catastrophe bonds and catastrophe swaps. These two financial instruments transfer the risk to a third party upon the occurrence of a previously defined catastrophe. The bond creditors step in for the insurer if the event occurs, and otherwise they gain earnings.
By removing “human intervention” from the execution of such contracts, Allianz benefits from lower interface losses and a decreased error rate, while also boosting speed and efficiency. The low transaction costs should make it possible to transfer risks to investors and offer protection from non-fulfillment of these contracts. With blockchain-supported catastrophe bonds, even mediation and monitoring functions could be turned into software code, rather than performed by banks, brokers, auditors and clearing houses.
Blockchain consortium: Financial institutions from around the world have joined together in the fintech startup R3 to promote collaboration within the sector around blockchain issues, and develop standards for blockchain-based solutions. Banks are looking to achieve faster and more efficient execution of interbank trades at significantly lower cost, because a central accounting body could become superfluous. Consortium members include Deutsche Bank, Commerzbank and UBS.
Today all transactions that take place in the economy are registered internally in the proprietary ledgers of individual market participants. Blockchains' full potential truly takes effect when accounting stretches past the boundaries of this ecosystem, as IBM writes in a recent study (Fast forward: Rethinking enterprises, ecosystems and economies with blockchains, IBM Institute for Business Value, 2016).
The Linux Foundation's HyperLedger project, which Deutsche Börse and SWIFT are also part of, should make this integrative accounting a reality. IBM is hoping for automation of all processes in the value chain using cognitive IoT systems. This means RFID-equipped components, manufacturing robots, measurement instruments, wind turbines, autonomous vehicles and other remote-controlled electronics. In IBM's vision, these would be connected to its Watson AI system, which could then conduct comprehensive value chain optimizations. According to IBM, this would have many benefits:
One thing that is clear, however, is that large companies are more likely to benefit from blockchain-based accounting and its corresponding process transparency, than smaller suppliers and businesses. So consumers are unlikely to see lower prices at the cash register from these changes.
For all its demonstrated potential, blockchain technology is still subject to growing pains. And it brings new kinds of risk into play. This is why the German Federal Financial Supervisory Authority (BaFin) watches blockchain-related fintech innovations very closely. Says BaFin President Felix Hufeld: "Supervisory authorities must always take into account such aspects as consumer protection and money laundering regulations, when considering innovations."
Richard Lumb, Group Chief Executive Financial Services at IT consultancy Accenture, predicts for his part that the immutability of blockchains, which is praised as protection from manipulations, could "turn out to be its worst enemy." He believes that smart contracts are susceptible to human error, and even the most sophisticated IT architectures could lead to results whose effects would need to be reversed.
To his mind, blockchain immutability is also not necessarily compliant with applicable law, such as the "right to be forgotten," users' rights to privacy and self-determination that are granted to EU citizens.
Other experts, such as researchers Ittay Eyal and Emin Gün Sirer at Cornell University, warn against trusting too greatly in blockchains' immutability. They demonstrated years ago that attackers using selfish mining attacks could – at least in theory – take over the computing power of a blockchain network, to then reverse transactions and steal from other users.
And one technical problem remains unsolved: The degree of difficulty of blockchain calculations greatly increases as the blockchain lengthens, i.e. as the number of completed transactions rises. So more computing power and more time are needed to execute transactions, and the energy demand grows. To illustrate: the mining network behind the bitcoin digital currency today processes some 225,000 transactions per day, in part with delays of up to a half-hour.
According to analysts, the issue of low scalability could be mitigated by a restricted access system with a limited number of nodes. But in that case a central legitimation site would be needed, to evaluate the trustworthiness of blockchain participants – which would eliminate many of the advantages of blockchains in the eyes of some proponents.
Mike Hearn, long one of the most important bitcoin developers, is particularly vocal about the shortcomings of blockchain technology. For him, bitcoin has already failed – and he also thinks he knows what is at fault: "What was meant to be a new, decentralized form of money that lacked 'systemically important institutions' and 'too big to fail' has failed due to a lack of functioning security mechanisms." The bitcoin system is controlled by a handful of people, deplores Hearn. Even worse, the bitcoin network is on the verge of technical collapse. "The mechanisms that should have prevented this outcome have broken down. And as a result there's no longer much reason to think Bitcoin can actually be better than the existing financial system," concludes Hearn.
Serious risks still exist when it comes to blockchain engineering. Insiders and observers therefore agree: If the providers of distributed ledger platforms truly roll up their sleeves and remove blockchain design flaws, the technology will progress across a wide swath of the economy, bringing with it new efficiencies and transformational change to many sectors. Many established business models are facing a complete overhaul. The fintech and insurtech pioneers have shown the way: With blockchains, companies can completely redefine their cost structures and gain unprecedented proximity to their customers.