At the close of 2022, it has become clear that the financial markets are taking a deep breath and several steps back in the wake of the many problems in relation to digital systems. Both blockchain and cryptocurrencies are certainly not living up to their promise and this could set the digital financial market back for a decade or more.
Last month, I went to a lecture organised by the Queensland University of Technology (QUT) where Federal Reserve Governor of the USA, Christopher J. Waller deliver a talk on central bank digital currencies (CBDC). Dr Waller took office as a member of the Board of Governors of the United States Federal Reserve System in December 2020 — a post he will hold until 2030. He called his presentation ‘Demystifying Central Bank Digital Currency’.
He had previously expressed some scepticism regarding the creation of a U.S. central bank digital currency and expressed doubt that the U.S. dollar would lose its prominent role in international markets unless a U.S. digital currency is issued. This was based on questions raised by senators regarding the Chinese Bank launching such a project for its currency.
Dr Waller spent quite some time explaining that CBDCs are totally different from cryptocurrency. A CBDC is simply digital fiat, whereas cryptocurrencies are digital assets on a decentralised network. CBDCs are only used for transactions between commercial banks and the Reserve Bank. They could extend that to other users, but there are few advantages to doing that, so in countries that have introduced CBDCs it most likely will remain a bank-to-bank system.
What cryptocurrencies and CBDCs do have in common is that they both can use blockchain as a distributed ledger system. These use independent computers (referred to as nodes) to record, share and synchronise transactions in their respective electronic ledgers (instead of keeping data centralised as in a traditional ledger). Using blockchain can help to increase efficiency and create more secure payment systems.
While unrelated, days after Dr Waller did his presentation, the Australian Securities Exchange (ASX) pulled the plug on a seven-year project to replace the ageing C.H.E.S.S. system – which transfers ownership and manages payment for equities – with a new system based on blockchain. The Reserve Bank mentioned that it was very disappointed, especially that the ASX pulled the plug so late in the game, as it would undermine the trust in the Stock Exchange.
Again unrelated, in the same month, we saw the collapse of the crypto exchange FTX, dragging down the value of a wide range of cryptocurrencies that also operate on blockchain technology. This puts the question if it is worthwhile to use systems that replicate banks. Early investigations of FTX show massive fraud, money laundering and mismanagement. Its founder, crypto billionaire Sam Bankman-Fried, is now in custody.
What brings all of these systems together is the use of blockchain and also here some serious questions are raised.
The theoretical benefit of blockchain is that it is decentralised, however, this seems undesirable in the case of ASX — and most likely many more financial trading systems. But as we see with FTX, almost all blockchain activity is done in centralised places anyway; it is just a more complicated way to do something simple. This problem of complexity was also mentioned as a key reason for ASX to put a hold on its blockchain project.
According to my colleague, Fred Goldstein, projects like this typically fail because the fundamental architecture is wrong. If architecture is done first – before design – and the data relationships are mapped out carefully, the rest should come pretty easily. But the more common modern approach seems to be to build something small around some idea, then try to expand it to scale and this is often where such systems fail.
While the Federal Reserve in the USA keeps on investigating the possibilities of blockchain, it has also mentioned that it is not necessary to use that technology and the recent events will certainly lead to a review of the technology for use in financial market systems. I am also sure that they will have a good look at what went wrong with the ASX system.
One of the advantages of the blockchain system is that it is based on the anonymity of the identity. This, however, is something that is the opposite of what stock exchanges and banks need. So, it will take quite some time to work out the architectural challenge that Fred mentioned. It looks like this is a major issue, as the system basically grew in such a way that it was no longer manageable.
At the end of his lecture, Dr Waller’s message was that it is up to the politicians to make up their minds about what role they see for digital currencies. There are several options in relation to retail and wholesale financial services as well as currency options such as digital versions of currencies, something that China already has implemented.
It is clear that these are not technical but policy matters and only after those strategic decisions are made can a proper technology path be designed and implemented. The year 2022 has made it clear that the industry needs to take a breather and review the way forward for what most certainly remains an exciting technology.