The end of the first decade of cryptography

Massimo Morini is a veteran of investment banks and financial institutions including the World Bank. Some of his blockchain research has been reported here and here.

The following is an exclusive contribution for the 2018 year of CoinDesk under consideration.

The end of 2018 is not the end of a year. It is the end of a decade, a decade that has changed the world of money and finance.

I do not mean the decade following the release of the Satoshi newspaper that CoinDesk rightly celebrated a couple of months ago. With the typical selfishness of young and brilliant innovators, the crypto community loves to think that this is the end of the first decade of the crypto. But the rest of the world celebrated a rather gloomy anniversary this autumn: the tenth anniversary of the Great Financial Crisis.

With Lehman's default, the world woke up and found that banks were not the safest industry in the world. They could not borrow huge amounts of money from the public and invest them in very uncertain financial markets without taking any material insolvency risk.

2008 has taught us that banks could run out of cash and capital needed to manage their risks and that they could enforce or demand taxpayers' money to be saved and avoid a default on their deposit liabilities.

What happened in the next 10 years? Have the banks disappeared? Has the commercial banking currency been replaced by a new global cryptocurrency? The financial markets, the one that ignited the flame of the crisis, have been replaced by a network of intelligent contracts without trust? No, the banks survived, as did the financial markets.

And now that banks and financial institutions seem to have discovered that blockchain is not magical software that easily gives security and efficiency to existing processes (nor is it the weapon of an overwhelming digital currency that crushes all the money in the existing world) , tend to ignore that this was also the decade in which concepts such as distributed systems, financial cryptography and consensus algorithms became part of a public debate.

Yet, 2019 may be the year when banks really understand what these concepts mean for finance. Remember, finance has had to pay a price to survive, as a review of financial markets has clearly shown over the past 10 years.

It became clear that the role of banks in creating money through deposits made them systematically too important and fragile to allow them to freely play the other roles of liquidity and value in space (through the help of efficient exchanges), in the time (through secure intermediation between investment and credit) and in different states of the future (through advanced derivative contracts).

They became overly regulated entities, their operating costs increased, their financing costs became much higher due to a new perception of their risk. Furthermore, their dependence on centralized entities has increased. Not only central banks, but also other institutions such as CCPs or CSDs (where the first "C" is always "central") are now dealing crucially with financial markets such as bonds, equities or derivatives. Centralization has been seen by regulators as the only way to increase the standardization, transparency and mutual sharing of resources of individual banks towards the management of market risk.

The concomitant single-burst effect was considered acceptable collateral damage. In the same years, the financial industry stopped being the darling of investors and was replaced by Internet companies, which now have a much higher capitalization than banks.

Crypto in the context

What does the decade of cryptography and blockchain have to say about these "old finance" topics?

We must go back to the roots of the blockchain and forget both the temptation to consider it "just a software", and the opposite temptation to consider it "heaven on earth". Probably Satoshi's paper was not the beginning. In the days when we celebrate Timothy May, we must recognize that some of the ideas we have developed today began to grow 30 years ago.

In this way, bitcoin is not a magical creation of perfection. Satoshi has noted that the Internet does not have some of the fundamental features needed to store and transfer value. An executive form of native identity is missing, a unanimous way of sorting messages in the absence of an official timestamp and an alternative to client-server architecture to prevent the value from being stored by a single entity for all users of a service.

Regardless of how early or limited, Satoshi has made a viable proposal to overcome the above problems. It was a mutation of the web in the value management environment, and it is thanks to the mutations that systems evolve.

In the past, while banks expanded their budgets by creating more money and taking more risks, some thinkers introduced the concept of Narrow Banking. This alternative idea of ​​the role of banks could have spared us some of the great financial issues of the last decade. Narrow bank means banks with a smaller role, more like the role they had in some moments of the past. Banks without huge budgets of passive deposits, used by everyone as money, combined with corresponding risky investments.

A tight banking activity would require a way to free the banks, at least in part, from the role of creating electronic money in the form of deposits.

The cryptic decade shows that forms of electronic money that do not take the form of a commercial bank deposit are possible and can be managed outside the balance sheets of commercial banks.

The application of this principle could free banks from their role of creating money and allow them to return to the role of real intermediaries, helping those who have money to take risks well managed and providing services to the economy real and digital, without huge books of assets and liabilities.

An early convergence

Yes, you read it correctly. I said that blockchain technology could help banks to resume their role as intermediaries. Read so much about blockchain technology that disrupts banks that this may seem strange.

However, today the systemic risk posed by banks does not derive from their rigid intermediation activity, but from their "technical" role in the creation of money. Technology alone can not avoid crises, but when it is used to make tight banks possible it can prevent a crisis from spreading systematically. There is no need to save the banks if we have reduced the connection between the financial markets and our money deposits.

If a form of digital money based on cryptography and managed on a distributed network was available to financial operators, it could be the level on which further reduction of systemic risk in financial markets becomes possible.

Today, systemic risk in markets such as derivatives or securities is often associated with the technological centralization that has developed over the last few decades. As mentioned above, the use of centralized infrastructures increased after the crisis, in order to collectively manage the guarantees provided by individual banks, in order to provide greater transparency to financial markets and to help standardize and coordinate risk management.

At the end of 2008, regulators thought that these targets could only be achieved through centralization, although this could make financial markets less resistant to systemic risk.

After the cryptic decade, lawmakers know that there are alternatives. The decentralized networks also allow the transparency, standardization and collective management of resources provided by the nodes of the network, through the appropriate use of smart contracts. They can allow forms of risk management and risk reduction that are unthinkable in the traditional world.

They may not yet have the required features in terms of scalability or privacy, but their technological evolution has come a long way from the original mutation.

So, the next few years could be the years of awareness.

No, the early cryptos and tokens are not an easy and fast solution for the future of finance. No, not even a slight splash of blockchain technology on old business models is not a solution.

A bit of work is ahead if we want to use the lessons learned in the last decade and see these two worlds, the world of finance and the encrypted world, and then converge into a new, safer financial system.

Do you have a strong vision of 2018? News via e-mail [at] coindesk.com to submit an opinion to our year under review.

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