Whether Big Banks Can Go Bye-Bye With Blockchain

Karen Shaw Petrou's memorandum to Federal Financial Analytics clients on whether big banks can go bye-bye with blockchain.

TO: Federal Financial Analytics ClientsFROM: Karen Shaw PetrouDATE: March 4, 2016

Whether Big Banks Can Go Bye-Bye With Blockchain

In my memo last week, I counselled that Neel Kashkari's TBTF initiative must consider the critical, if unheralded, role big banks play preserving the financial-market infrastructure on which payment, clearing, and settlement depend along with the rest of us. This generated a lot of comment from proponents of big-bank break-up, who countered that nice though infrastructure is, we don't need big banks for it because blockchain can make them disappear. Maybe so, but we were all supposed to have flying cars by now. A couple of flying cars do indeed dot the horizon, but no one's now quite sure they want one. So it may well go with blockchain – not only might it not work as well in practice as in theory, but – depending on how it is implemented if it is implemented – it could also do so much damage to financial intermediation that even the most vociferous industry critics might come to miss a big bank or two.

Although most of what I learned at MIT is either lost in the mists of time or is so out-of-date as to be downright funny, one thing I do remember: physics is divided into two branches – theoretical and experimental – for a reason. That which can be clearly and definitely drawn on a blackboard (remember them?) can take decades to come into being, if ever it does. I know a lot of people who wrote brilliant dissertations in the 1970s on making fusion (which powers the H-bomb) the next source of limitless clean energy. As of today, fusion remains a pipe dream despite the billions poured into trying to make a great theory into a practical reality.

Blockchain isn't fusion, but it's no belt-clip coin-changer either. It's got many advantages and could even take on some of the systemic operational risk that now dogs the settlement, clearing, and payment system – even a bit of blockchain could make a meaningful dent in the $54 billion or so this costs now and reduce time lags, opacity, and counterparty risk across the spectrum of these infrastructure services. In the near term, blockchain might also take on specialized services – handling cumbersome syndicated-loan documentation, for example.

But, in this potential application as in many others, blockchain or other distributed-ledger systems would be closed – that is, only entities cleared by the ledger's operators would be allowed access. Further, with the exception of one possible application to the Australian stock exchange, all of the actual uses to which distributed-ledger systems are likely soon to be used are not only closed, but very limited. In biomedical research, these distributed-ledger efforts would be called Phase 1 clinical trials that prove only safety, not whether the medical device actually works (which can take years and millions to determine). For the dreams of those who want to make big banks disappear by way of distributed ledgers to be realized, we will need more than a few high-flying venture-capital projects and tentative closed-loop trials by big-bank consortia.

We will also need to think very carefully through whether distributed-ledger systems that could transform the financial-market infrastructures in paradigm-shifting fashion might have unintended consequences. That's one reason biomedical trials move so carefully and, sadly, even when drugs come on to market after years of hard work, they all too often turn out to be toxic. Financial innovation is no different – wanting something because you've seen a glittering advertisement doesn't mean it's necessarily a good idea.

For an important, thoughtful discussion of the pros and cons of fully-developed digital ledgers, take a look at a speech given earlier this week by a senior Bank of England official, Ben Broadbent. He too sees a lot of potential in limited-purpose blockchain-style systems, but he makes clear also what might happen if this technology proves so successful that it essentially creates a new form of transaction-executing money. Even if we Luddites keep a bit of physical cash under our mattresses, this new money could seamlessly – could being the operative conditional – make money move just the way flying cars were supposed to clear Manhattan's streets. Central banks would probably run this network because no one would really need private banks and getting rid of them would wash liquidity risk out of the financial system along with a lot of solvency worries.

The catch – who would make loans? Without deposits – banks would no longer take money because money would move without banks – the funds for financial intermediation would be housed at central banks. Either they would need to go into the leveraged business of being fractional-reserve lenders – a new central-bank construct with profound implications for traditional free-market countries – or we would bring back the narrow banking that 17th-century merchants found to be such a constraint that they invented fractional-reserve banking in the first place.

Maybe that's what break-up folks want – narrow banks. There was indeed a vigorous call for them in the 1980s, the last time we had a systemic crisis in the U.S. Happily, we thought better of that, although unhappily we also went too far allowing fractional-reserve banking to become highly-leveraged, unregulated finance. Wanting to make risk disappear by way of the financial market's equivalent of fusion is sweet, but it's not that easy to make finance not only safe and sound, but also fuel for economic growth. To make money, one must take risk. If we want banks without risk, then we may well need Daddy to do it by way of central banks using blockchains to supplant banks. But, let's think that one through long and hard.

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