Distributed Ledger Technologies — The Next Wave to Transform Financial Inclusion?

(My guest post as Senior Advisor to Encourage Capital, for its October newsletter).

As long-term investors with a commitment to impact through financial sector development, we are spending increasing amounts of time thinking about how decentralized ledger technologies or “DLTs” — including bitcoin, blockchain and various applications — should play into our strategy. Even at this early stage, it seems that DLTs may have a significant impact on how we assess investments, who we invest in, and even how we invest.

The headlines make this work seem timely. China recently announced a ban on “Initial Coin Offerings”, and powerful bankers call bitcoin a fraud. On the other hand, the head of the IMF recognized the power of DLTs and made ‘virtual currencies’ one of three key factors for the future of central banking during a speech last week.

But while the media highlights bitcoin price swings and pronouncements of doom, we’re mindful of Bill Gates’ advice not to be “lulled into inaction” by overestimating “the change that will occur in the next two years and [underestimating] the change that will occur in the next ten.”

It doesn’t take an expert to realize how transformative DLTs could be for industry after industry.

Fundamentally, DLTs enable decentralized networks that aren’t controlled by a central corporate or government entity.

Telecoms provides a simple analogy. Earlier, fixed-line operators built copper lines and direct pipes to carry traffic. Then TCP/IP (internet protocols) emerged to let nodes across the network assemble packets and interpret data themselves. Suddenly any node could communicate with another, without a Bell company’s private lines and costly infrastructure. This led directly to the world wide web, e-commerce, Skype, and our economy today.

DLTs such as blockchain are driving a similar revolution in how trust is organized in the financial sector. Banks lack mutual trust and rely on intermediaries like Visa and Swift to guarantee payments. But a decentralized and automated ledger, in which cryptography records data verifiably and permanently, with no administrator to play politics: this could be just as trusted and much less costly. As Christine Lagarde of the IMF explained, “Citizens may one day prefer virtual currencies, since they potentially offer the same cost and convenience as cash — no settlement risks, no clearing delays, no central registration, no intermediary to check accounts and identities.”

Bitcoin is the ‘virtual currency’ getting most of the headlines, but it’s just one example of the power of decentralized ledgers. Bitcoin is a network with rules for transactions (a protocol), stored on the bitcoin blockchain, and a currency (or token) used to power that network. Now imagine other networks built on decentralized ledgers — a network of identities stored on a blockchain, or a network of secure credit histories that can’t be corrupted, a network of stock market predictions by analysts, a network for merchant finance transactions between banks. These and more are being developed, many financed by the issuance of a new Bitcoin-like token.

Such networks set rules for participation (such as a protocol for recording information in the ledger) and often distribute the token to software developers, investors, network users, and other service providers in a kind of mini-economy to pay for servers, computation and other tasks. As the network grows, the token becomes more valuable. Ethereum is a decentralized ledger and programming platform on which other networks can be built, powered by the ethereum token (which has seen a price rise from $12 to $300 in the past year). [NB: This was from Oct. Ethereum passed 600 this week].

Financial sector networks built on decentralized ledgers are in their infancy — the technology is new, governance needs to prove itself, and regulators are figuring out the right response. But the explosion of activity by startups, banks and regulators implies that major changes to industry structure may be forthcoming. Functions such as payments, savings mobilization and credit could be unbundled and performed by different entities. Banks with deposit insurance might be restricted to deposit-taking and safe investments, while lending is done by private credit funds and online or automated lending platforms. DLTs can make this possible by enabling safe and transparent digital transactions, lowering transactions costs and increasing speed of service delivery, all of which can enable financial institutions to better serve mass market consumers and small businesses.

A decade ago, mobile money was in its earliest stages, and a decade before that, individual and group micro-lending were still maturing. Decentralized ledger technologies are a strong candidate for the next wave to transform financial inclusion, and we will continue to keep a close eye on them. We agree with Christine Lagarde’s assessment that “for now, virtual currencies such as Bitcoin pose little or no challenge to the existing order of fiat currencies and central banks… they are too volatile, too risky, too energy intensive, and… the underlying technologies are not yet scalable… But… Not so long ago, some experts argued that personal computers would never be adopted, and that tablets would only be used as expensive coffee trays. So I think it may not be wise to dismiss virtual currencies.”