15/12/22, 19:36 Gary Gensler: How blockchain can solve the payments riddle -

COMMENT & PROFILES / VIEWPOINT

Gary Gensler: How blockchain can solve

the payments riddle
Gary Gensler | 3/09/2018 9:00 am

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Peer-to-peer electronic cash systems could lower costs, risks and economic rents in the financial
system – if the technical and security challenges can be overcome.

Pizza Hut launched PizzaNet and made its first online sale in 1994, but money still changed hands
with delivery. Amazon and eBay opened in 1995. Commerce was quickly looking for solutions to move
payments across this new network. The internet and World Wide Web are built on open protocols –
without trusted central intermediaries – and exchange data in the form of information packets. Efforts
to achieve peer-to-peer payments, such as DigiCash and CyberCash, failed. By 1996, new
cryptographic protocols such as SSL/TLS secured communications and payments on the internet, but
payments still relied on traditional credit card and banking rails.

The riddle – how to move value peer-to-peer on the internet without any trusted central intermediary
– would remain until October 31, 2008. Unnoticed at the nadir of the 2008 financial crisis, Satoshi
Nakamoto released to a cryptographers' e-mail list a nine-page paper entitled ‘Bitcoin: A peer-to-peer
electronic cash system’ (Satoshi Nakamoto is a pseudonym; the identity of the author or authors is still
unknown).

A payment revolution

So what does this mean for money and finance? A decade later, the Nakamoto innovation must be
taken seriously. Commonly referred to as blockchain technology, it establishes a consensus protocol
among multiple, possibly distrusting, participants to build an immutable chain of blocks containing
data (a ‘blockchain’) forming an auditable database. In Bitcoin, that is a record of who owns which
coins. This database is secured using cryptography, so every entry can be widely verified. 

Modestly, Nakamoto started that ground-breaking 2008 e-mail with this: “I've been working on a new
electronic cash system that's fully peer to peer, with no trusted third party.” The first recorded
transaction of Bitcoin for a physical good was in 2010: 10,000 Bitcoin for – yes – two pizzas.
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Money is but a social and economic construct built on consensus, having taken on many forms and
technologies over the millennia. Africans used cowrie shells, and on the island of Yap, large disks
known as rai stones were money. The Chinese, Greeks and Romans minted money from bronze, silver
and gold. Paper money was an innovation representing a store of value in a central repository. This led
to privately issued bank notes and fiat currencies issued by governments. With the coming of the
telegraph and Morse code, we had the first electronic money transfers. Today, the principal methods of
payments and most money are electronic. 

Cutting out the middleman

Regardless of whether Bitcoin and other cryptocurrencies yet adequately exhibit the three roles of
money – a store of value, a medium of exchange and a unit of account – blockchain technology does
provide a means to move value and run computer code on the internet without relying upon a central
intermediary. 

That ties blockchain technology and cryptocurrencies directly to the essential plumbing of the
financial sector, which at its core has the role of efficiently moving and allocating money and risk
within an economy. Though there are many technical and commercial challenges – scaleability,
efficiency, privacy, security, interoperability and governance – to overcome, I’m optimistic. This new
technology could lower costs, risks and economic rents in the financial system, which represents 7.5%
of US gross domestic product (GDP).

Modern financial systems bring great benefits to economies, but also, repeated, instability and
occasional crises. The 2008 global financial crisis wreaked havoc, affecting millions of bystanders far
and wide.  Fiat currencies have had bouts of inflation associated with unsound monetary or fiscal
policies. Centralised intermediaries concentrate risks and collect economic rents. The World Bank
estimates that payment systems cost 0.5% to 1% of GDP and that 1.7 billion people were unbanked in
2017.

Potential uses of blockchain technology include cross-border payments, clearing and settlement
systems, digital identities, trade finance and supply chain management. In the 21st Geneva Report on
the World Economy, colleagues and I review a wide range of applications.

Crypto finance’s $250bn market cap, though modest in comparison to global debt and equity markets
of more than $300,000bn, has caught the attention of financial sector incumbents due to its volatility,
wide margins and public interest. Crypto-exchange Coinbase has 20 million accounts – about the
number of accounts at Fidelity Investments and twice as many as Charles Schwab. The
Intercontinental Exchange, which owns the New York Stock Exchange, recently announced a new
venture together with Microsoft and Starbucks to bring cryptocurrency investing and payment
systems to the retail public. MasterCard was awarded a patent for managing 'blockchain currency'
fractional reserves. 

Guarding against the illicit

To reach its potential and gain public confidence, though, the world of crypto finance must fit into
long-established public policy frameworks. As with any other technology, we must guard against illicit
activities such as tax evasion, money laundering, terrorist financing and avoiding sanctions. We must
ensure financial stability. And we must protect investors and consumers.

Cryptocurrencies have given bad actors new ways to conduct old crimes. Dark markets conduct sales
of illegal drugs and other contraband using cryptocurrencies. State actors, such as Venezuela and
Russia, have used crypto finance to undermine US policies. And it adds new challenges to global tax
compliance.    

Most crypto exchanges are unregistered, manipulative behaviour goes unchecked, and billions of
dollars in customers’ tokens have been stolen. Illicit activity is particularly challenging to thwart on
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new, decentralised crypto exchanges. Safeguards to date – treating crypto exchanges and digital wallet
providers through money transmission laws in the same manner as Western Union or MoneyGram –
have been unsatisfactory. Crypto activity is more complex and harder to trace than traditional money
transfers.   

Through a new form of crowdfunding, thousands of initial coin offerings (ICOs) have been issued,
raising more than $20bn and counting. Debates have ensued about how this new form of
crowdfunding fits within existing securities and derivatives laws, but one thing is clear from academic
and market studies: the ICO market is rife with scams and frauds.

Furthermore, it is a false distinction that so-called ‘utility tokens’ sold for future consumption are not
investment contracts. By their very design, ICOs mix economic attributes of both consumption and
investment. ICO tokens’ realities – their risks, expectation of profits, manner of marketing, exchange
trading, limited supply and capital formation – are attributes of investment schemes. In the US, nearly
all ICOs would meet the Supreme Court’s ‘Howey test’ defining an investment contract under
securities laws. In essence, as poet James Whitcomb Riley wrote more than 100 years ago: “When I
see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck.”

Central banks are studying blockchain technology and expanding their use of central bank digital
currency (CBDC). They already issue digital currencies in the form of bank reserves, so the strategic
consideration is whether (and if so, how) to give the public access to central bank payment systems
and digital reserves.

Reacting to rapid changes in payment methods, such as mobile payments and digital wallets, central
banks may also find themselves competing with private sector issuance of ‘stable value’ tokens backed
by fiat currency. In some countries, commercial banks are experimenting with issuing digital currency,
such as the Philippine ePiso and Senegal eCFA. With half of sub-Saharan Africa unbanked and about
half of the unbanked having mobile phones, Safaricom’s M-Pesa has led the way in providing mobile
digital wallets and payment solutions. Tunisia is experimenting with e-Dinar mobile prepaid wallets. 

Token experiments

While no retail CBDC has yet been issued, the ongoing work of two countries – one in distress and one
strong – is noteworthy. Venezuela, facing hyperinflation and economic instability, is promoting public
use of an oil-backed token, Petro. In Sweden, use of paper-based krona has declined and the Riksbank
(dating from 1668, the world’s first central bank) has an e-Krona project.

Central bankers are concerned that public access to CBDCs will affect commercial banks’ deposits,
funding models and credit allocation.  There are also pros and cons to consider regarding monetary
policy implementation and payment systems resilience. Foremost, in times of stress, retail CBDCs
might add to pro-cyclical runs on commercial banks. While these challenges are significant, it is quite
conceivable we will see an adoption of retail CBDCs over time.

Nakamoto’s innovation, now 10 years old, can be a catalyst for change in the world of money and
finance. Blockchain technology goes directly to the plumbing of finance, providing a peer-to-peer
alternative to centralised ‘costs of trust'. Broad adoption, though, will mean complying with public
policy norms, particularly guarding against illicit activities and protecting investors. Furthermore,
private sector cryptocurrencies and public sector CBDCs, though still largely a social, economic and
technological experiment, cannot be ignored. Though first used for two pizzas, they are perhaps yet
another step in the long evolution of money.

Gary Gensler is senior adviser to the director of the MIT Media Lab, senior lecturer at MIT Sloan
School of Management, chair of the Maryland Financial Consumer Protection Commission, and
former chair of the Commodity Futures Trading Commission.

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