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Banking's Bitcoin dilemmas

The banking industry is facing several dilemmas with distributed consensus ledger technology (the "blockchain"). Bitcoin has shown banks how the technology can be revolutionary, causing much excitement, and hype this year as banks scramble to find ways to adopt it. They tend to be enthusiastic about the technology, but are dismissive of Bitcoin itself (Bitcoin has an inconvenient history and has perceived features such as anonymity which don't fit well with the norms of the industry). The implication is that banks can avoid the Bitcoin network, and instead create their own private networks that use similar technology.

However, distributed consensus ledger technology itself is not particularly revolutionary or even new, but Bitcoin has shown that the way it is used in bitcoin payments is revolutionary. In particular, Bitcoin has three unique strengths that make it so:

1. The ability to transfer value, as payments, anywhere on the internet, at low cost, in near real time, without an intermediary

2. A consensus mechanism, proof-of-work, which ensures a permanent source of truth in a transparent, open, permissionless environment (anyone can participate in the consensus process)

3. A network that is virtually un-hackable, is permanently secure and that scales with advances in computing (no matter how powerful computers become, 51% of the computing power across Bitcoin miners is always needed to hack it).

The problem for banks is that none of these strengths are particularly useful to them in private networks – they can already transfer payments between each other efficiently and quickly (at least domestically); in a private network, the consensus mechanism does not need to be proof-of-work or permissionless; and a private network cannot be secured by similar levels of computing power as the public Bitcoin network.

This helps explain why there have not been any breakthroughs so far in using the "blockchain" in private networks and why many banks are still searching for use cases that bring them industrialised benefits, both in payments and in capital markets.

So, can banks benefit from distributed consensus ledger technology? In my view they can, at least in payments - a possible scenario starts with traction in cross-border payments (an area ripe for re-invention), then in inter-bank settlement, followed by account-to-account payments in a crypto-currency (perhaps Bitcoin, perhaps a bank/central bank-issued crypto-currency).

The dilemmas banks face in 2016 are twofold – firstly, do they invest in private networks where the benefits are not yet clear, or do they embrace public "blockchain" networks and exploit the strengths evident in Bitcoin? Secondly, do they use the technology to re-invent existing business processes such as payments or securities settlement, or do they use it to create new business models such as micropayments or machine-to-machine payments?

How the industry responds to these questions will become clearer next year, but my instinct is that by the end of 2016 banks will view Bitcoin and public networks a lot more favourably than they do today, and that new business models will dominate. 

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