Scott Stornetta - Change is Coming
There is an undeniable presence of looming disruption. As Richard Turrin beautifully articulated in the previous issue of this trade journal, China's CBDC (Central Bank Digital Currency) is an example of a new technology coming to the financial payments system. The question is, what will the response of the payment’s community be to this coming change?
I do not claim to understand the payments and cards ecosystem in all of its details. But I do bring to bear expertise of a different kind. Long before the development of bitcoin, I, along with my colleague Stuart Haber, played a role in the early development of blockchain, or distributed ledger systems. In fact, many are surprised to learn that systems now identified as blockchains have been in continuous commercial operation since 1995.[https://www.vice.com/en_us/article/j5nzx4/what-was-the-first-blockchain] So I bring a longer-term perspective to the underlying value creation of blockchains and their gradual adoption. In addition, I now work closely with technology startups seeking to disrupt existing players, as well as advise incumbents on strategies for responding to startups. It is from these vantage points that I offer some perspective about the impact of blockchains, or distributed ledgers, on the financial payments system, and how to respond to these challenges and opportunities.
A blockchain, or more particularly, a distributed ledger is a single record, jointly created and maintained, between two or more parties who have, typically, a business relationship. In the words of one thoughtful advocate, Richard Grendal Brown of R3, it is for situations "especially when those parties trust each other enough to trade but not enough to have their counterparty maintain all the records."[https://www.r3.com/wp-content/uploads/2019/06/corda-platform-whitepaper.pdf] This is in contrast to systems of accounts maintained separately by the various parties, and then reconciled after the fact. Instead, a blockchain allows the single shared record itself to constitute the primary record of accounts between multiple parties. This distributed ledger is thus a single shared database, available and trusted by all participants.
Why has it taken until now for CBDCs and other blockchain applications to emerge? The answer is two-fold. First, overall progress in connectivity and large-scale storage makes it possible to have a shared record on a vast scale. Second, blockchain techniques ensure the necessary integrity of the record and therefore confidence in it. As a result, the mechanisms of settlement and reconciliation of accounts, whether at the end of the day, month, or quarter, can be eliminated. With a distributed ledger, an atomic settlement is near-instantaneous and final. The operating costs are also minimal, at least for systems that have efficient consensus mechanisms, unlike bitcoin's mining.
Now many say, “I have heard the hype about blockchain for years, and yet no real change has occurred. Why should I worry?” A fair question. The idea that nation-states would be toppled and that all of the current Internet giants, such as Facebook and Google, would simply be disintermediated, was never a plausible near-to-mid-term scenario. But just because initial blockchain enthusiasts had unrealistic expectations does not mean change is not coming. That is because the timing of change is dictated, not by the technology tempo, but rather by the years it takes to make legislative changes, overcome regulatory hurdles, and gradually develop viable business models. Near-instantaneous reconciliation and settlement, at very low cost, is all but inevitable. The real question is not if, but when?
China's CBDC is just the first of many changes affecting the world’s payment networks. This change might not come soon for the U.S. dollar, but other countries are likely to follow China's path in short order. Soon, related projects will facilitate transfers between nations, such as project UBIN in Singapore, and the ripples from this will affect SWIFT as well. SWIFT can either adopt the more efficient single ledger or risk being bypassed by those who do, but one way or another, interbank payments will be transformed. And it will not stop there. Eventually, VISA and its kindred ilk will have to face the same dilemma as SWIFT: either adopt the single record and accept dramatically lower margins in their business model or risk being bypassed by those who build a viable low-margin business based on the single record. Whether the Facebook-affiliated Libra succeeds after its botched introduction is less significant than the fact that Libra-like systems of transfer will arise.
Even banks will not be immune to this inevitable change. The irony is that commercial banks, warned about their downfall at the hands of crypto startups, could face their greatest competition from their heretofore trusted, reliable allies, the monetary authorities of the various countries. CBDCs open the way for individual citizens to have direct accounts with their respective national monetary authorities, potentially taking away the exclusivity commercial banks have had on personal bank accounts.
The concept of the single shared record among parties in an ecosystem will eventually touch every facet of payments and accounting. And so, the need arises to ask how best to prepare, both defensively and proactively, for coming challenges and opportunities this will create. In this regard, Brant Carson and others at McKinsey Consulting have framed a strategic response well worth reading. [https://www.mckinsey.com/business-functions/mckinsey-digital/our-insights/blockchain-beyond-the-hype-what-is-the-strategic-business-value])
How companies should respond to this coming change depends on where their organizations fit in the ecosystem. Those who own the end-user customer relationship are in a relatively strong position. They are less likely to be disintermediated. These companies should remain actively attuned to the coming changes, on the lookout for new intermediaries who can work on behalf of their customers at substantially lower margins. For those that function as intermediaries, whether white-label or otherwise, they should actively ask how their systems can operate on larger scales and with lower margins.
But it is not all gloom for those worried about their higher-margin business being commoditized. Shared ledgers create opportunities for new value-creating services. This is a simple consequence of the fact that the shared records will be of substantially greater scale, and the records themselves will become standardized in format and widely accessible. Smart contracts are but one possible example of the new value-added services.
In summary, if you own the customer relationship, strengthen it. Be on the lookout for new, lower-cost intermediaries to manage transactions. If you are an intermediary, embrace a lower margin core business and look for value-added services to expand into. Disruption can be a bit of a bumpy ride, but you can prosper by understanding the forces driving it and the likely outcomes. But make no mistake: change is coming.
Dr. Stornetta is considered by many to be the co-inventor of the Blockchain. Dating back to 1991, his pioneering series of papers and patents helped lay the foundation for Bitcoin and other digital currencies. Dr. Stornetta consulted for many years, evaluating the commercial potential of emerging technologies on behalf of universities, commercial research labs, and venture capital interests. He is currently a partner and Chief Scientist at Yugen Partners.
About Yugen Partners:
Yugen Partners is a venture capital firm focused on early-stage companies in the B2B enterprise blockchain space.