Since its invention back in 2008, blockchain technology has been trying to disrupt a number of industries with varying degrees of success. Core features of blockchain, such as decentralization and immutability, make this technology especially appealing for
the financial sector.
On paper, blockchain is a perfect solution for the majority of pain points present now in the banking system. That’s why it comes as no surprise that the financial services industry spends about
$1.7B per year on blockchain solutions, according to a Greenwich Associates report.
While this technology has the potential to revolutionize the banking system, it still has a number of hurdles on its way. Blockchain’s decentralized structure presents unapparelled challenges for both financial institutions looking to adopt this technology
and the regulatory organizations in charge of controlling it.
Currently, three major blockchain limitations for banking include the lack of governance, non-scalability, and regulatory compliance risks.
Although the decentralized nature of blockchain is frequently considered as its core advantage, it poses certain limitations for the financial sector. Without a central decision-maker, members participating in a blockchain-powered financial transaction might
have misaligned motives, which can become a serious bottleneck.
This is what happened in 2016 and became known as the DAO Hack.
To give a little more background, DAO stands for a decentralized autonomous organization. The purpose of this organization was to eliminate the need for governance by creating an automated decision-making system based on certain rules.
This is how a DAO works:
- A group of professionals create smart contracts that autonomously run the organization.
- The project gets funded through an ICO, and the token holders become members of the organization.
- After that, participants can propose how the DAO should spend the money, and the sponsors of the project can vote to approve or disapprove those proposals.
Because of the vulnerability in the code behind the DAO created by German startup Slock.it, the system was hacked, and around a $50 million worth of cryptocurrencies got stolen. In order to refund the DAO investors, the majority of the community voted for
‘hard fork’ (a change in the protocol that makes previously valid blocks invalid), leaving the rest of the community unacknowledged.
This situation raised many red flags. The whole purpose of the system was to enable effective and fair governance without human interference. However, it became apparent that any such system is still vulnerable to lobbyists and traditional majority-based
voting mechanisms. This makes the principle unacceptable for most financial institutions.
Due to the fact that blockchain is a distributed system, its cumulative processing power directly depends on the computational power of the devices involved. In comparison to Visa’s 1,700 transactions per second, blockchain can process around 4.6 transactions
per second on average. This gap implies a huge challenge for the adoption of blockchain for banking on a global scale.
With the increasing popularity of blockchain, the scalability problem only becomes more apparent. Although a multitude of scaling methods has been proposed, each of them comes with its limitations. One of the most notable ones is known as ‘sharding’.
In the context of
blockchain development, sharding is a way of splitting computational and storage workload into parts (shards) across the P2P network so that each node would process transactions only related to its shard. The purpose of this method is to free each node
of the requirement to process the blockchain in its entirety, thus significantly increasing the transaction throughputs.
The main challenges of sharding are related to security and communication. When a blockchain is split into shards, each behaves as an individual blockchain network. This adds an extra layer of complexity for developers because it requires a special communication
The other challenge is security. Because of the splitting, the hash power of the blockchain nodes decreases. This makes it much easier for cybercriminals to hack any single shard, which will inevitably lead to a permanent loss of data.
Although the brightest minds are working on the solutions to these problems, only the time will tell whether it’s actually possible to scale blockchain to Visa-like proportions.
Policies and regulations
Financial institutions also face a lack of clarity around regulations. At the moment, there are no regulations when it comes to transfers made with cryptocurrencies and smart contracts. Until a proper regulatory framework is established, it won’t be possible
for financial institutions to use blockchain.
For example, last year the EU enacted the General Data Protection Regulation (GDPR) re-enforcing EU citizens’ data privacy. This new EU law immediately sparked the attention of blockchain advocates for these two reasons:
- The GDPR requires an identifiable unit of responsibility against whom EU citizens can exert their rights under the EU data protection law. Due to the fact that blockchains don’t have central governance units, it’s difficult to assign responsibility. This
alone makes it hard for blockchain technology to comply with the EU legislation.
- One of the key GDPR requirements is that personal data should be modifiable and erasable, which directly contradicts the principle of blockchain data immutability. A breach of this stipulation would result in significant losses for any financial organization
—a €20 million fine or 4% of the organization’s total revenues.
Although the aim of both blockchain and the GDPR is to protect data, the enacted legislation may dramatically limit the adoption of blockchain in global banking. The European Parliament released
a study on blockchain and the GDPR, aimed at resolving this conflict. While it mentions plenty of ways to address the ongoing clash of interests, it is more than likely that deep changes to blockchain technology will be required to solve all such concerns.
Despite being successfully adopted in a number of ways across different industries, blockchain is still immature in the context of the financial sector. The main concerns related to the adoption of blockchain by financial institutions include effective risk
management, scalability, and compliance. Permissionless blockchain systems in particular won’t be able to meet these requirements unless significantly reworked. In addition, it’s important for regulators to find a different approach to this emerging technology
because of its decentralized structure.
Although there are major hurdles on the way, the blockchain-powered banking future is inevitable. Thomas Power, the board director of the Blockchain Industry Compliance and Regulation Association and one of the leading voices in blockchain innovation, believes that
blockchain is here to stay: “All of this will seem like trivia in 2038.”