The swollen tide of cryptocurrency mania appears to be receding, leaving perhaps the firmer ground of blockchain behind. But blockchain tides are also turning. Blockchains are slow, expensive and dumb. People are successfully making them fast, inexpensive and smart.
This has largely been achieved by returning to antecedents of cryptocurrency systems from the 1980s and 1990s, distributed databases and ledgers. The systems that are moving into commercial applications are far removed from the cryptocurrency world.
Smart ledgers are “the thing”.
Smart ledgers are based on a combination of mutual distributed ledgers – blockchain or multiorganisational databases with a super audit trail – with embedded programming and sensing, thus permitting semi-intelligent, autonomous transactions.
Smart ledgers are touted as a technology for fair play in a globalised world. Some implementations can work at speeds up to one trillion database transactions a day at a cost of millicents per transaction, with complex instructions embedded in the database itself. This compares with the few transactions per second and enormous energy cost of “public” blockchains, such as bitcoin or Ethereum. (Bitcoin approaches the energy consumption of the Netherlands or Switzerland). In fairness, the public blockchains have plans to improve, but private ledgers are well ahead.
But why use smart ledgers? Go back to the definition above, multi-organisational databases with a super audit trail and some embedded code. To understand the deep interest in smart ledgers, one needs to understand the most common approach people have used for millennia to handle multiparty transactions: “central third parties”. Examples of central third parties in action include lawyers holding escrow accounts, banks providing letters of credit, or exchanges trading and central counterparties clearing.
Often the central third party sits at the center of a large network, e.g., SWIFT (The Society for Worldwide Interbank Financial Telecommunication) or credit card processors. Insurers also have a role in these processes – for example, proving that an asset has cover by providing certificates of insurance.
Central third parties are a well-known approach to trust problems and often work well, sometimes earning the sobriquet “trusted third parties”. Central third parties typically do three things in financial services:
- They preserve the definitive set of market transactions. This raises the prospect of charging market participants to “get their own data back.”
- They safeguard the definitive set of market transactions against alteration. This raises the threat of being bribed or rewarded for falsifying transactions.
- They validate new transactions and authorize their addition to the definitive set of market transactions. This raises the possibility of falsifying assets or admitting maleficent participants.
Further, central third parties frequently become natural monopolies. A natural monopoly is a supplier whose costs are lower than the alternative of multifirm provision. Natural monopolies are not inherently evil, but two aspects are clear: First, a natural monopoly creates at least the three temptations to cheat enumerated earlier.
Before you find this extreme, remember the scale of the FX or Libor scandals just to get started. This is one reason monopolies attract social attention and in turn regulatory attention. It is also the reason natural monopolists are often paid well by members. If they get caught cheating, they put a cushy life at risk. The second temptation is to extract excessive “economic rents.”
Economic rents are payments to an owner or factor of production in excess of the costs needed to bring that factor into production. This economics jargon means central third parties can charge much more than things cost. Banks, for example, have long complained about the charges of SWIFT, credit card processors and exchanges.
Switching suppliers in financial services incurs the cost of changing processes for a new supplier or finding a new supplier with the same level of connectivity, but one of the biggest switching costs is historic data. Often, only the central third party has the authoritative dataset.
The advantage of smart ledgers lies not in being cheaper or faster. The advantage of smart ledgers is that they allow organisations to work together without giving central third parties a strong natural monopoly. Smart ledgers do this by giving everybody an immutable copy of the data they need while also reducing switching costs.
To switch to a new supplier, customers need to merely appoint a new central third party, not be hostage to a monopoly on historic data. The London market in wholesale insurance is a classic example of how this mistrust bites.
One view of the history of market reform is that insufficient attention has been paid to ensuring proposed central third parties will not obtain natural monopolies. Thus, proposed central clearing and exchange ideas are never sufficiently trusted and do not achieve critical mass.
Smart ledger hype can only be fulfilled if numerous groups of organizations want to work together mutually and decide that smart ledger technology will help them avoid much of the natural monopoly problem described above.
Some of the emerging applications that could create large mutual networks include:
- Private or public-private international identity systems for both corporates and individuals. Regulations around anti-money laundering, know your customer and ultimate beneficial ownership increase legal and regulatory costs and hassles. Ninety percent of businesses responding to the International Chamber of Commerce’s 2016 Global Survey on Trade Finance pointed to anti-money laundering as the most significant impediment to trade. The 53 Commonwealth nations are exploring how this might be shared.
- Trade facilitation infrastructure. These trading systems can be almost “unowned Alibabas or Amazons,” or deep wholesale trading markets for specialist players in reinsurance or commodities or other narrow-but-capital-intensive markets. Singapore already has a trade facilitation system for SMEs based on smart ledger technology, FastTrackTrade.co.
- “Internet of Record” services or timestamping. The States of Alderney has been operating such a system, MetroGnomo.com, since 2015.
From Toys to Tools
However, it’s unlikely to be an overnight revolution. A distributed ledger is an order of magnitude more complicated than a traditional database. Multi-organisational projects are also an order of magnitude more complicated than projects within a single organisation. Combined, smart ledger projects could crudely be estimated as 100 times more difficult than traditional projects.
While pilot and proof-of-concept projects abound, they remain mostly baubles and toys. The real action is in insurance clients. Smart ledger trade system announcements from governments, shipping firms, large IT firms and the like are where the action is at. Why should payments, banking and insurance think they should lead the introduction of a universal technology?
When databases were introduced in the 1970s they affected payments, banking and insurance, but databases also affected every other commercial and government organization. It’s true that wholesale insurance markets are full of bureaucratic inefficiencies. It’s true that many of these inefficiencies are due to historic attempts to prevent Goliath central third parties controlling the market. It’s true that smart ledger might help increase efficiencies by providing more mutual solutions. In fact, Z/Yen believes that identity, documentation and agreement exchange via smart ledgers is the most likely area for “killer apps.”
But why is all the smart ledger talk about insurance processing? Isn’t there insurance business? Insurers should start discussing the business opportunities of insurance in smart ledgers. They are numerous. This is a potential new class of business insurance for the mutual structures that support smart ledgers. (“Ecosystems” is the current jargon for many coin, token or ledger clubs.) Classic cover could be extended – business interruption, third-party liability, property losses, intellectual property losses, credit insurance, custodial insurance, professional indemnity, and errors and omissions.
There are numerous new risks. Is the ledger truly immutable? Who indemnifies who for data entered on the ledger – e.g., insuring the quality of anti-moneylaundering data? What about systemic failure? And there are some potentially big solutions out there that insurers can provide. One such approach is to consider having the major ecosystems use structures conceptually equivalent to shipping’s protection and indemnity mutuals. These ecosystem P&I clubs would effectively cross-underwrite one coin or token system’s catastrophic failure by reimbursing customers with a basket of coins or tokens from the group.
Another big area for consideration is the use of insurance-linked securities (ILS) for ecosystems. Z/Yen is working with a reinsurer to build a pilot smart ledger cyber-catastrophe ILS trigger. The smart ledger polls IP addresses across a network in a geographical area to determine whether the network is functioning correctly.
The polling system will publish a controlled index of the state of the network and will trigger if a threshold of IP addresses is not functioning. This trigger could, in turn, be linked to a contract payment backed by a tradeable security. The ILS could be used to provide cyber business interruption cover by carriers. Smart ledgers are ideal for these types of applications because the information provider cannot extract excessive rents if the index becomes highly valuable as a reference.
A further area is clients using smart ledgers to meet their contractual terms. There is talk, for example, of shipping companies perhaps using “geostamping” – i.e., a timestamp with a location recorded on a smart ledger to ensure that they meet their exclusion requirements or trigger additional cover if they move into an excluded area.
Already, clinical assessments are being recorded by our clients for healthcare regulators in North America and Europe. This basic use of timestamping and geostamping will emerge as a condition of cover in many areas. Another example is gambling companies that have cover for the quality of their random number generators being required to timestamp the numbers provided to customers as a condition of their policy.
In conclusion, smart ledgers will be of increasing importance to the business of insurance. While the technology will help remove paperwork and inefficiencies from insurance over time, it will be a slow evolution to remove incumbent processes. The technology will also show up in areas related to insurance, such as identity systems for anti-money-laundering and know-your-customer operations.
However, the biggest area of all may be the most traditional – selling risk management products to the very “ecosystem” mutuals that are at the heart of all this hype.
Professor Michael Mainelli is Executive Chairman of Z/Yen Group and Principal Adviser to Long Finance.