Blockchain vendors shift strategy as banks raise privacy concerns

Rage Comment : One of the biggest selling points of blockchain is to make transaction information in the financial market more transparent, but banks are not buying it because all they have to do is protect sensitive information used. Regulatory financial institutions should implement blockchain technology in banks in a differentiated manner, protecting the information of important figures in regulatory agencies without affecting the open and transparent performance of blockchain. In the past decade, the relationship between regulators and the financial industry has been very tense. But blockchain may be an opportunity to improve the relationship between the two and allow them to work together to create a more constructive technology.

Translation: Nicole

One of the obvious selling points of blockchain technology is that it can bring greater transparency to financial markets, but it turns out that this feature is a bug for the institutions using the technology.

In the original Bitcoin blockchain, transactions are recorded on a public ledger for the world to see, but the identities of users are anonymous and verified only by alphanumeric addresses, which looks like a cat walking on thin ice on a keyboard. In the private or "permissioned" blockchains developed by the industry, only known trusted entities can participate. This can eliminate concerns about "bad guys" using the system, but it does not eliminate concerns that all participants can see who did what.

Keith Horowitz

Citigroup analyst Keith Horowitz said:

“Confidentiality is the main barrier – and that’s part of the sticking point for banks.”

As a result, major startups in this emerging field are trying to let users store sensitive data encrypted on distributed ledgers, or store that data off-chain, or a combination of these. This strategy raises another problem with the blockchain model: For institutions that process tens of thousands of transactions a day, storing such large amounts of transaction data is very expensive.

[To learn more about distributed ledgers, cryptocurrencies, and cutting-edge fintech, attend American Banker’s third annual Blockchain + Digital Currency Conference on July 28. Click here for the conference agenda and registration information.]

The potential downside of both approaches is that they undermine one of the advantages of blockchain, even if they protect other advantages (such as eliminating redundant data entry and ignoring the risk of single points of failure).

Caitlin Long

Caitlin Long, a former Morgan Stanley executive and self-proclaimed blockchain evangelist, wrote in a recent blog post:

“If regulators implement blockchain technology in a different way than financial institutions can, and do so in a way that protects the information of key regulators, then regulators will miss a once-in-a-generation opportunity to gain the tools necessary to keep the system secure.”

How blockchain vendors in emerging markets address privacy and storage-related issues has become a debate issue. Some believe that sensitive information should not be made public; others say that all data should be public, even if some of it needs to be hidden.

The same is true for Digital Asset Holdings (DAH), the organization run by former JPMorgan Chase & Co. CEO Blythe Masters.

Blythe Masters

Masters said in the email:

“Private contract data should be stored on a distributed ledger, or an encrypted ledger that can protect private information. The shared ledger should record as little information as possible, and only those who need and have access rights can operate it. Any operation must allow information notification, synchronization and confirmation to proceed.”

Symbiont, a company that develops self-executing smart contract software, is taking a completely opposite tack.

Mark Smith, CEO of Symbiont, said:

“We’ve been using very sophisticated cryptographic techniques to verify our theory that everything — and I mean everything — must be recorded on the ledger.”

Smith said:

“His competitors refer to this concept by saying ‘we want to take information off the ledger for confidentiality’. When you do that, you also destroy most of the value of the distributed ledger and go against the concept of all entities sharing information.”

When someone wants to encrypt information on a blockchain, it looks like a timestamp of a transaction, and nothing more. For example, a record can show that a participant on the network used a link to add certain information to the ledger at a certain time. Other participants in the network cannot see this information because it is encrypted. However, the participant who uploaded the information can give someone else (such as a regulator) a private key, which can be used to decrypt and view the encrypted information.

It can also be difficult to determine what sensitive data needs to be encrypted, and most blockchain startups and institutions that are researching blockchain technology have yet to decide on the best blockchain applications and use cases.

Charley Cooper

Charley Cooper, general manager of the R3 CEV blockchain consortium, said:

“This is an emerging technology with a wide range of potential applications. The type and amount of data stored on a distributed or shared ledger will depend on its use and the level of regulatory oversight required. Ultimately, this technology could significantly improve transparency in financial markets.”

But one of the purposes of creating R3 was to enhance confidentiality.

In September, R3 hired Richard Gendal Brown, formerly executive architect for banking innovation at IBM, who had previously created a distributed ledger platform called Corda to record and manage important information between regulated financial institutions. From R3’s perspective, that important information is financial agreements.

Richard Gendal Brown

Chief Technology Officer Richard Gendal Brown said in a blog post introducing the platform:

“There is no unnecessary global sharing of data in Corda: only those participants with a legitimate need to view data in the protocol are allowed to do so. We reject the notion that a copy of all data should be sent to all parties, even if it is encrypted.”

The Hyperledger Project aims to advance blockchain technology for recording and verifying transactions between industries, and to apply blockchain technology to a wider range of use cases, where all members of the network can share transaction data. Project executive Brian Behlendorf said Hyperledger does not use the ledger in a correct way because the situations between applications are different, but he pointed out that data storage volume will be one of the motivations for removing information from the ledger.

Behlendorf said:

“Storing large amounts of information on a blockchain is prohibitively expensive.”

In the worst-case scenario, off-chain data could disappear entirely. URLs fade into obscurity, people lose their domain names. Behlendorf said it’s difficult to store data for more than a decade, which is another reason he’s looking at solutions that write unencrypted information to the blockchain.

Behlendorf said:

“When you talk about using a ledger as a system of record to track assets, it doesn’t work well for encrypted information.”

Storing encrypted information on a blockchain is only useful for timestamping the content and proving the transfer of information at that time.

Furthermore, Behlendorf said:

“For a blockchain to share data with regulators, encrypting text is not a good idea, but it’s only part of what you want to achieve — which is why regulators should spend time and energy understanding blockchain technology and working with industry bodies to create a system together.”

The need for communication and transparency should be mutual, with technologies designed based on industry needs and acceptable to regulators. Regulators should work with financial institutions to access information in a way that does not compromise the integrity and security of blockchain systems.

Behlendorf said:

“Over the past decade, the relationship between regulators and the financial industry has been very tense. But blockchain may be an opportunity to reshape that relationship and allow them to work together to create a more constructive technology.”

Kevin Petrasic, partner at White & Case and head of the law firm’s global financial institutions advisory practice, said that while the industry understands that regulators will eventually have access to the information they need, regulators need to allow blockchain to do their jobs more efficiently.

Kevin Petrasic

Petrasic said:

“There are some big challenges that can be solved with blockchain because it allows you to protect information and anonymize it so you know the transaction took place, but you don’t know the details of the transaction. I think the challenge for the industry is that regulators still have access to the information they need — they need to be provided by law — and the regulators are given access to make sure that institutions are not doing something they shouldn’t be doing.”

Chris Giancarlo, chairman of the Commodity Futures Trading Commission, said he personally has no opinion on the evolution of open or closed blockchains. As a regulator, the CFTC will be a participant with a node on the blockchain, and the CFTC can see all transactions on the blockchain, whether it is open or closed. (By the way, most blockchain companies allow regulators to participate in observer nodes or communicate with them directly through the development process.)

Giancarlo said:

“We should fully engage with blockchain transactions as an observer as there are many use cases being tested now. We should improve our understanding of blockchain technology as it evolves; but we also want to understand how blockchain technology can deliver on the promise of counterparty credit risk transparency - something that was lacking during the financial crisis and that Title VII of the Frank Act aims to achieve.”

Title VII of the Dodd-Frank Act seeks to provide regulators with access to counterparty credit risk through swap data repositories (collection of information), so in future crises, regulators can see those credit risks and avoid them. There is no complete picture of the global swaps market, said Giancarlo, who has been touting blockchain’s ability to accurately report information in real time this year.

He said:

“If we have full transparency (Congress gave us access to information under Title VII of the Frank Act) blockchain can work for us. Whether blockchain is open or closed to market participants is determined by the market. Either way, we will need access to information on both sides.”

Giancarlo said that U.S. regulators should encourage more fintech innovation, learn from the blockchain learning curve of the United Kingdom, Australia and Singapore, which are far ahead, so as to better provide a friendly innovation environment for technology innovators. He added that the government does not have to force technological innovation, but it should not hinder other peers around the world from promoting blockchain technology.

It's a delicate balancing act.

Petrasic said:

“That’s the question, how do regulators work with financial institutions to get the information they want without denying the value of blockchain?”