Ideas & Updates

DLT: Keep Calm and Let the Evidence Speak

Blockchain Series: Blog 3

Distributed Ledger Technology (DLT), often referred to as blockchain, has garnered a lot of attention in the past few years. Is it just “a solution in search of a problem” or, does it offer answers for real-world policy questions such digital identity and remittances? This six-blog series, by Rodrigo Mejia Ricart and Camilo Tellez, aims to foster a better understanding of the technology. The first three blogs discuss what is DLT, the debate around key stated benefits and the evidence around different use cases. The last three blogs discuss DLT for digital identity, supply chain and remittances in detail.

For all the expectations that distributed ledger technology (DLT) will deliver sweeping economic, social and political changes, many still remain to be convinced. Greta Bull, CEO of the Consultative Group to Assist the Poor, has eloquently asked: Is blockchain a solution in search of a problem? This points to the central question of the debate:

What can DLT solve that we couldn’t solve otherwise?

In the absence of an effective or trusted central authority, a distributed ledger creates a shared record of events among parties that don’t know or trust one another. DLT also enables the emergence of unique digital assets—such as currency units or property titles—that can’t be duplicated. This is a central feature of DLT. In the digital world, information and assets are easy to duplicate and reproduce. The current way individuals are prevented from spending stored digital value twice is by having a central, trusted authority to oversee and validate what belongs to whom. It creates assets that can’t be duplicated without the need of a central registry.

As a consequence, DLT solutions help build trust through the transparency[1] and immutability of the ledger. DLT solutions also allow for the traceability of transactions and provide each participant in the network with an updated copy of the ledger at all times (i.e., synchronization). The technology enables users to verify and validate transactions, creating a consensus record of exchanges. The technical characteristics of DLT could also provide users with a unique digital identification mechanism that ensures greater control over personal data. These qualities seem to match the needs of in three use cases, as follows.

Digital Identity. Another area with significant growth potential is at the intersection of digital identification and financial inclusion. BanQu and AID:Tech, both startup companies, are using DLT to provide verifiable digital identification that offers a reliable and traceable record of transactions for vulnerable groups who lack recognized forms of identification. Digital identification can serve as a gateway to financial services, entitlements, and broader social and economic engagement. As a result, DLT solutions that can support or drive innovation in this area could provide significant social and economic value, as long as the challenges can be overcome (see Blog 4: Distributed Ledger Technology and Digital Identity: Prospects and Pitfalls Ahead).
Supply-chain innovation. Similarly, many companies are experimenting with DLT to enable reliable traceability through their supply chain, helping to ensure that minimum standards are met by their suppliers. These DLT-solutions can help coordinate and build a consensus of objective knowledge among the many stakeholders in a given value chain. Walmart for instance, has implemented the largest DLT supply-chain proof of concept to date. Preliminary results indicate that Walmart’s solution has allowed it to identify the origins of mangoes in a matter of seconds, instead of a week. In the process, it has also helped the company identify opportunities for efficiency gains in its supply chain.(see Blog 5: Distributing Production: Can Distributed Ledgers Fuel a New Wave of Supply-Chain Innovation?)
Cross-border payments often present challenges of the type DLT-based innovations seek to solve. The current system of cross-border payments is fragmented and frequently includes several intermediaries (i.e., correspondent banks) without a single central authority. This architecture can lead to slow settlements, limited transparency and high transaction costs. DLT-based cryptocurrencies could serve as a bridge for cross-border payments connecting banks directly to one another. If this proved to be viable solution, it would allow banks to save on compliance and reconciliation costs, and unlock capital blocked in correspondent accounts (see Blog 6: Paying Across Borders: Can Distributed Ledgers Bring Us Closer Together?).

There’s no guarantee of success

For all its potential, DLT has many challenges to overcome. In many instances, the technology is not yet fit-for-purpose, even when the use case suggests reasonable chances of success. Viable use cases that have a proven ability to scale are still scarce. Even if these barriers can be overcome, the technology must still then demonstrate it is the most cost-effective option, compared with other solutions.

In particular, it may be difficult to make a strong business case for distributed ledgers where existing systems are already efficient, enjoy high levels of user trust and serve their intended purposes reasonably well. For example, the use of DLT for land registries has shown greater promise in places where official registries are inefficient or lack trust than in places with already robust institutions and records (see BenBen in Ghana).

Another significant challenge for DLT applications is governance. Several DLT applications have resulted in systems that give more weight to users with more powerful technological equipment or who have been a participant in the network for longer. Also, as the financial industry in nearly all markets is heavily regulated, and those regulations are frequently updated, DLT-based financial services must prove that they are flexible enough to adjust to changing regulations. In the case of some distributed governance frameworks, this has proved to be a challenge. Furthermore, the broader legality issues in each market need to be addressed.

To address these challenges, DLT will stand a greater chance of success and scalability if its protocols (the rules of the application) are transparent and perceived to be fair. Protocols should also be able to comply with existing legal frameworks and easy to adjust to changing regulatory frameworks. Most importantly, updates and changes to system operations should be transparent for all participants in a network, especially when financial or property assets are at stake.

Test, learn, iterate

There is still much to learn about the potential applications of DLT. The Better Than Cash Alliance’s scoping exercise suggests that DLT projects and solutions entail a number of trade-offs. It also highlights that returns on investment in DLT are contingent on many variables, including market characteristics, the nature of the problem the DLT is seeking to solve, and the degree of specialization of the solution to a specific use case.

Experimenting with different use cases on a small scale can provide valuable insights to underpin improvements. Progressive iterations, prototypes and proofs of concept are, and will remain, essential to inform effective decision-making. Similarly, openness to new technologies requires an enabling regulatory environment, taking a principle-based approach that balances innovation and risk mitigation to ensure competitive markets, productivity, consumer protection, financial stability and integrity, as the World Bank-IMF Bali Fintech Agenda suggests. The blog posts in this series will focus on specific use cases and pilots, and the lessons that can be drawn from them.

As the debate and evolution of DLT continues, it is important to keep in mind that technology should be viewed as a tool to achieve a specific objective, rather than as an end in itself. Technological experimentation plays a critical role in assessing and improving its efficacy and to undertake comparisons with other options so that it can be discarded in favor of better options if needed. To reap the potential benefits of DLT, it is vital for all stakeholders to remain open-minded, and to provide innovators with the necessary room for experimentation, while effectively managing risks.

[1] See previous post for a more detailed assessment of some of the benefits of DLT systems.