What role will government play in the future of blockchain?

As blockchain technology becomes more widely used, some researchers recognize that cooperation and collaboration among all stakeholders, including governments, are essential for the technology to realize its promise of increased efficiency.

The report [PDF], Blockchain Technology — What Awaits Canada’s Economy and Financial Markets?, authored by Thorsten Koeppl and Jeremy Kronick of the CD Howe Institute, identifies challenges facing policymakers and regulators.

Koeppl is an associate professor at Queen's University and an RBC fellow, while Kronick is a senior policy analyst at the CDHowe Institute.

The authors begin their 28-page report by noting that it is unclear how the benefits of the technology will be realized and applied across the economy. The three main challenges facing policymakers and regulators are:

1. Design a principles-based regulatory system that provides high standards of security, legal certainty and a stable environment for transactions.

2. Ensure technology delivers cost benefits to end users and not just redistributes profits among middlemen.

3. Identify areas where government involvement could help, such as a facilitating role in the development of public or private distributed ledgers, or acting as a direct central node for applying the technology but maintaining a monopoly on managing entries on the ledger.

Safe and accurate

Since public ledgers are traditionally operated by third parties, the key challenge is how to ensure that public ledgers are secure and accurate. Blockchain can be used to solve this problem. It is a technology based on encryption and peer-to-peer networks that creates an online ledger that, once distributed among network participants, can verify transactions without the need for a trusted third party.

While regulation should not hinder experimentation, there are benefits to creating legal frameworks and standards that provide stability and security.

Policymakers must ensure that blockchains are not adapted at the expense of users, but rather are truly cost-effective. One way to achieve this is to engage in public-private partnerships to create stable systems, address teething issues related to network effects, and support competition by ensuring access to blockchain-based systems.

The technology can improve existing systems, but its application in critical infrastructure areas often requires direct government involvement.

Policymakers must determine to what extent small-scale private networks can provide blockchain-based services and how governments can engage with these networks. Examples include the Bank of Canada’s Project Jasper, which is exploring an interbank settlement engine, and several foreign government projects aimed at streamlining online identity processes.

The recurring costs of blockchain

One problem is that many costs in distributed ledgers are often duplicated. The main flaw of Bitcoin, the first application of blockchain, is that the cost of updating its ledger is duplicated. When network nodes compete for the right to update the ledger, some resources are wasted, which is not a problem when a third party handles the task.

There are additional costs when using the Proof of Work protocol as it takes some time for confirmations to occur.

But these costs have been partially reduced over the past few years. Alternative applications have reduced verification and confirmation times while maintaining the proof-of-work protocol. Second, alternative protocols have been introduced that avoid duplication of work.

Blockchain Evolution

An important challenge is how a blockchain can evolve dynamically over time. Potential participants must coordinate on its design as well as the participants who are authorized to access it. As a distributed system, consensus among a critical number of participants is required to make changes or adjustments.

When some participants gain enough power within the network, they can decide how the system runs and is updated. This creates a public system where only a few members retain all the power, or reverts back to a centralized system where there is a third-party node that manages the ledger.

A restricted blockchain would alleviate most of these problems by only having a subset of the chain directly accessible. Imagine a hybrid form of a distributed ledger with tiered access for participants. The core of the network would be responsible for the design of the ledger.

Experience in the payment field

The payment sector is an area where blockchain technology has been deployed.

Cryptocurrencies are used for retail transactions because they can be done at a much lower cost than traditional payment systems. Examples include the use of Bitcoin for person-to-person international remittances and the Ripple Transaction Protocol, which allows banks to transfer money across borders without the need for a communicating financial institution.

These developments are already creating turmoil in the financial sector. Intermediaries are being forced to make retail and cross-border payments easier, safer and cheaper. Settlement and communication platforms such as Western Union, SWIFT, Visa and Mastercard are at risk of becoming obsolete once cryptocurrencies become more common for cross-border payments.

Besides security issues, what prevents blockchain technology from being more widely used for payments are limitations on transaction throughput, high confirmation delays and variability in confirmation times at high transaction volumes.

Startups are working to address these issues.

It is less clear how blockchain technology will benefit the high-volume payments industry, as payments are not instant and therefore pose non-zero risk to counterparties.

One reason is the time gap between processing a transaction and confirming its finality. Second, with blockchain technology, forks can occur. Previously confirmed transactions may no longer be valid. In the most advanced large-value payment systems, a third party such as a central bank can guarantee the immediacy and finality of payments.

Permissioned blockchain

Permissioned consensus ledgers offer an alternative to traditional blockchains. A network of small nodes maintains the ledger, so faster consensus protocols can reduce latency and enable greater scalability. Settlement finality in such a system is more achievable because the central node is known and can resolve inconsistencies more quickly.

Blockchain can revolutionize corporate governance. Traditionally, governance is conducted in the form of annual shareholder votes, usually conducted through proxy servers. With a distributed ledger, direct shareholders can participate in voting more frequently.

Corporate decisions can be pre-programmed and automatically executed through voting schemes. The blockchain implementation gives users tokens that they transfer to a specific address to vote on issues before a deadline.

There are also attempts to use distributed ledger technology to enable the exchange of financial securities. Cryptographic keys can be used as a messaging system to sign transaction agreements in the ledger for transactions to be later confirmed by a central node.

In addition to trading financial instruments, the technology is expected to enable real-time processing of financial transactions. Post-trade requirements for clearing and settling trades often involve cumbersome procedures. By using smart contracts to trade, traders can calculate risk exposure and margin calls, and directly automate the transfer process of cash and securities in the transaction pair payment mechanism.

Recently, blockchain solutions have been tested to link multiple ledgers that hold information about assets, collateral, and the cash positions of market participants. In the United States, the Depository Trust and Clearing Corporation (DTCC) and Digital Asset have collaborated to demonstrate the potential for settling and clearing repurchase agreements via a distributed ledger.

Security and Accessibility

The biggest concerns are security and accessibility of the ledger. Users must be able to trust the accuracy of the information in the distributed ledger so that they can reliably use the information to participate in transactions. A similarly critical aspect is that users can easily and inexpensively access the information when necessary.

Over time, standards must be developed to protect consumers from insecure implementations. This requires developers, regulators, and users to maintain an ongoing dialogue in the creation of applications. This also requires a level of monitoring to ensure that network security and stability protocols are being followed.

Considerations around coordination issues and networking raise the question of whether distributed ledgers for critical infrastructure can be developed in a decentralized manner.

Applications may also be driven by new or existing businesses. Therefore, it is reasonable to expect that future blockchain applications will rarely have secure public networks where every user has unrestricted access. Therefore, private networks that retain the distributed nature of the ledger but restrict modification and update permissions are the most likely outcome.