High-Level Debate Bitcoin Blockchain for Distributed Clearing: A Critical Assessment Journal Robert Sams RECIPIENT OF THE APEX AWARD FOR PUBLICATION EXCELLENCE INDUSTRIALIZATION AND TECHNOLOGICAL INNOVATION IN FINANCE Download the full version of The Journal available at CAPCO.COM/INSIGHTS #42 10.2015 FIS IS YOUR COMPETITIVE ADVANTAGE for an industry that is in constant motion. Your trusted strategic partner worldwide FIS™ is proud to be named the No. 1 financial services technology provider for the fourth consecutive year. Our focus is solely on understanding and serving your unique needs and helping you thrive in times of unprecedented change. Putting our clients first is key to continued success. © 2015 FIS and/or its subsidiaries. All Rights Reserved. www.fisglobal.com The Capco Institute Journal of Financial Transformation Recipient of the Apex Award for Publication Excellence Editor Prof. Damiano Brigo, Editor-in-Chief of the Capco Journal of Financial Transformation and Head of the Mathematical Finance Research Group, Imperial College London Peter Springett, Managing Editor Sam Price, Assistant Editor Head of the Advisory Board Dr. Peter Leukert, Head of the Capco Institute, Head of the Editorial Board of the Capco Journal of Financial Transformation, and Head of Strategy, FIS Advisory Editor Nick Jackson, Partner, Capco Editorial Board Franklin Allen, Nippon Life Professor of Finance, The Wharton School, University of Pennsylvania Joe Anastasio, Partner, Capco Philippe d’Arvisenet, Adviser and former Group Chief Economist, BNP Paribas Rudi Bogni, former Chief Executive Ofcer, UBS Private Banking Bruno Bonati, Bruno Bonati Consulting owner and Chairman of the non Executive Board at Zuger Kantonalbank Géry Daeninck, former CEO, Robeco Stephen C. Dafron, CEO, Interactive Data, former Global Head of Operations, Institutional Trading & Investment Banking, Morgan Stanley Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance, Graduate School of Business, University of Chicago Elroy Dimson, Emeritus Professor of Finance, London Business School Nicholas Economides, Professor of Economics, Leonard N. Stern School of Business, New York University Michael Enthoven, Board, NLFI, Former Chief Executive Ofcer, NIBC Bank N.V. José Luis Escrivá, Director, Independent Revenue Authority, Spain George Feiger, Former Executive Vice President and Head of Wealth Management Zions Bancorporation Gregorio de Felice, Head of Research and Chief Economist, Intesa Sanpaolo Hans Geiger, Professor Emeritus, Department of Banking and Finance, University of Zurich Peter Gomber, Full Professor, Chair of e-Finance, Goethe University Frankfurt Wilfried Hauck, Chief Financial Ofcer, Hanse Merkur International GmbH Pierre Hillion, de Picciotto Chaired Professor of Alternative Investments and Shell Professor of Finance, INSEAD Thomas Kloet, Former Chief Executive Ofcer, Retired at TMX Group Inc. Mitchel Lenson, Non-executive Director, Nationwide Building Society Donald A. Marchand, Professor of Strategy and Information Management, IMD and Chairman and President of enterpriseIQ® Colin Mayer, Peter Moores Professor of Management Studies, Saïd Business School, Oxford University Pierpaolo Montana, Chief Risk Ofcer, Mediobanca Steve Perry, Chief Digital Ofcer, Visa Europe Derek Sach, Head of Global Restructuring, The Royal Bank of Scotland ManMohan S. Sodhi, Professor in Operations & Supply Chain Management, Cass Business School, City University London John Taysom, Visiting Professor, Deptartment of Computer Science, UCL Policy Fellow, University of Cambridge, CSaP Board, The Web Science Trust High-Level Debate Bitcoin Blockchain for Distributed Clearing: A Critical Assessment 1 Robert Sams – Founder and CEO, Clearmatics Abstract There has recently been a dramatic increase in interest in the idea goal of censorship-resistant digital cash. It then shows that cen- of using distributed consensus technology to facilitate the settle- sorship-resistant consensus has no mechanism for enforcing the ment of fnancial transactions. One strategy that has been advocat- correspondence between blockchain reality and legal reality that ed attempts to use the Bitcoin blockchain, running meta-protocols of-chain assets require. It also suggests that the security of the on top of that network, so that of-chain assets such as securities Bitcoin network itself would be compromised by such an attempt. and property titles can leverage the same transaction protocol used by the endogenous on-chain cryptocurrency asset. This article ex- plains Bitcoin’s unique favor of distributed consensus algorithm 1 This is an edited version of a blog that originally was published at http://www.clearmatics. (hash-based proof-of-work) and how it was motivated by a design com/2015/05/no-bitcoin-is-not-the-future-of-securities-settlement/ 39 The Capco Institute Journal of Financial Transformation Bitcoin Blockchain for Distributed Clearing: A Critical Assessment BITCOIN BAD, BLOCKCHAIN GOOD? provide part of the solution, but the main benefts are lost if a trusted third party is still required to prevent double-spending. Bankers can be forgiven for being confused about blockchain tech- We propose a solution to the double-spending problem using nology. For months they’ve been told that blockchain and other a peer-to-peer network. The network timestamps transactions distributed consensus technology can revolutionize the payments, by hashing them into an ongoing chain of hash-based proof-of- clearing, and settlement infrastructure of the fnancial system, but work, forming a record that cannot be changed without redoing that the bitcoin blockchain just won’t do. This suits bankers fne, as the proof-of-work. The longest chain not only serves as proof of few were ever anything but dismissive of the world’s most popular the sequence of events witnessed, but proof that it came from cryptocurrency. the largest pool of CPU power. As long as a majority of CPU pow- er is controlled by nodes that are not cooperating to attack the But then earlier this year, Nasdaq (2015) announced a project that network, they’ll generate the longest chain and outpace attack- will actually use the bitcoin blockchain to “facilitate the issuance, ers.” transfer, and management of private company securities” on their Nasdaq Private Market platform. So, what is going on? This article breaks down this abstract sentence by sentence and gives a non-technical explanation of how bitcoin works and why it’s No sooner had the press release circled around the small and interesting. Then there will be a discussion to explain why the idea sometimes befuddled group of fnancial types devoted (or at least of using the bitcoin blockchain for securities settlements is mis- instructed) to exploring this technology, when IBM’s Richard Brown guided. This is not meant to knock Nasdaq for choosing a bitcoin (2015) comes out with the warning to “ignore Bitcoin at your peril.” meta-protocol for their project. It’s a good way for them to cut their And then this was followed by Chris Skinner’s (2015) post, which teeth in this area without devoting much capital expenditure. How- suggests that the bankers’ confusion is really just a case of the f- ever, those who think that this news portends a future securities nanciers having never understood the inner workings of bitcoin in settlement architecture based on the bitcoin blockchain couldn’t the frst place: be more wrong. “So why would someone as intelligent and informed as Reid Hofman – and Marc Andreessen, Richard Branson, Wence Ce- sares, Jon Matonis, et al – be so pro-bitcoin when the banks are A SIMPLE INTRODUCTION TO THE BITCOIN PROTOCOL not. My answer is that most of the people dissing bitcoin haven’t looked under the hood. The frst two sentences of Nakamoto’s abstract make clear the de- sign objectives behind bitcoin. So here are two test questions for all of you reading this and thinking Bitcoin Bad, Blockchain Good. “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another One, have you actually read Satoshi Nakamoto’s white paper? without going through a fnancial institution. Digital signatures Two, can you explain to me exactly why the blockchain is good? provide part of the solution, but the main benefts are lost if a I don’t do this, as I don’t want to embarrass anyone, but I’m trusted third party is still required to prevent double-spending.” guessing that 99% of the Bitcoin Bad, Blockchain Good people [Nakamoto (2008), 1] would answer no to both questions.” It has been known for a long time, mainly because it is rather ob- Leaving the provocative aspect aside, he’s probably right in that vious, that cryptographic signatures and public keys can be chain- most bankers would answer “no” to his two questions. This might linked to form an unforgeable record of transactions for, say, digital also be true for the majority of bitcoin’s most vocal cheerleaders. cash (or any ledger record for that matter). Crypto proof replaces Skinner then proceeds to the argumentum ad verecundiam and the notary. Counterfeiting ledger assets is impossible, and theft or quotes the abstract of Nakamoto’s’s (2008) famously elegant white- misappropriation cannot happen without gaining access to the as- paper: set owner’s private key [see appendix]. “A purely peer-to-peer version of electronic cash would allow But you still need an authoritative record of these transactions online payments to be sent directly from one party to another somewhere, such as a database, or else there is no way to prevent without going through a fnancial institution. Digital signatures someone from spending his or her digital cash more than once (a 40 The Capco Institute Journal of Financial Transformation Bitcoin Blockchain for Distributed Clearing: A Critical Assessment “double-spend”). If one party gives as second a crypto-proof that understand a timestamp to mean something generated by an ac- some asset belongs to it and that it has been sent to the second par- curate clock. But this, remember, is a peer-to-peer network, so it ty, the second party has no way of knowing that the frst party hasn’t doesn’t have a clock.