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Angela Walch: Three Risk Factors to Consider Before Replacing Financial Infrastructure With Bitcoin

Blockchain - Angela Walch: 3 Risk Factors to Consider Before Replacing Existing Financial Infrastructure With Bitcoin Blockchain Technology

While Bitcoin may not replace the U.S. dollar anytime soon, the underlying technology of the blockchain is certainly generating hype among mainstream financial institutions. 

Startups experimenting with blockchain technology for financial institutions are already receiving funding from banks like JPMorgan. In fact, in an Emerging Theme Radar note sent to its clients, Goldman Sachs has declared that the technology has the capability of drastic change.

“While the Bitcoin hype cycle has gone quiet, Silicon Valley and Wall Street are betting that the underlying technology behind it, the Blockchain, can change… well everything.” the note reads.

But, amid all the hype and excitement lie several legal and compliance issues that mainstream financial institutions will have to address if they choose to adapt the bitcoin blockchain technology as a replacement for the current financial infrastructure.

In a recent research paper exploring the complications that banks and other financial institutions could face switching to a virtual ledger based on the bitcoin blockchain, Angela Walch, an attorney and assistant professor at St. Mary's University School of Law, said that while the existing financial system infrastructure is obsolete and needs to be upgraded, any replacements to the existing financial system should be reliable.

“But in all the excitement over this technological boon, we must keep in mind the enormous importance of reliable financial market infrastructure, and ensure that replacements to existing financial market infrastructures can be counted on,” Walch said.

Walch said that since using a single ledger, or blockchain, is not akin to signing a contract with a third party for a service, financial institutions might face complex legal and compliance snags while switching to a virtual ledger like the bitcoin blockchain.

According to Walch, some of the bitcoin blockchain’s basic features, including its status as software, its decentralized structure and its open-source software development process, creates various technology and governance risks against its potential as a financial infrastructure.

Bitcoin Blockchain’s Upgrade Process

Walch said that like any other software, the bitcoin blockchain, too, is vulnerable to bugs and attacks. Besides that, blockchain software is ever changing through new releases, and this may create a dispute and cause a split or fork in the network.

“The evolving nature of software through new releases may be a bigger problem for decentralized Bitcoin than it is for more centralized financial market infrastructures,” Walch said.

“Since controversial new releases of Bitcoin software may be unevenly adopted, there would seem to be potential for periodic forks in the network when consensus cannot be found amidst the parties in the network. This undermines the reliability of the Bitcoin blockchain, as has already been demonstrated in the March 2013 fork."

The Bitcoin Blockchain’s Decentralized Structure

According to Walch, bitcoin blockchain’s decentralized structure means it does not have an official organization or party that operates it, and the lack of any entity or organization bound by legal obligations to keep the blockchain software operational can become a major risk for financial institutions looking to adopt the bitcoin blockchain technology.

“With existing centralized financial market infrastructure, it is at least clear who has the responsibility to manage and repair it, and it is possible to impose risk-management obligations on someone,” Walch said. “Maintaining the functionality of financial market infrastructure is hugely important, and having no one specifically tasked with the responsibility for achieving this for blockchain is a significant risk.”

Bitcoin’s Open-Source Software Development Process

Walch says that similar to the bitcoin blockchain’s decentralized structure, its open source software development process creates a situation where everyone interested may participate in the development and maintenance of the software, but no one is legally obligated to do so. 

“If a crisis related to Bitcoin’s operation or value should arise, there are no financial systems or payments experts who would necessarily be involved in reacting to the crisis.” Walch said.

“It seems to make sense to have people with an in-depth understanding of the world financial and monetary systems as a whole, involved in making decisions about how it operates. Functioning financial market infrastructure benefits everyone who uses it, and users of a particular payment system or central clearinghouse are crippled if it stops working.”

Even though banks or other financial institutions can address some of the operational issues above by creating private blockchains and hiring software coders to create the ledger and keep up with maintenance, Walch says that questions about fiduciary responsibilities will always come into play with such a highly regulated industry working with a decentralized process.