Juan Antonio Ketterer and Gabriela Andrade specialize in financial markets for the Inter-American Development Bank, the largest source of development financing for Latin America and the Caribbean.
The following article is an exclusive contribution to CoinDesk’s 2017 in Review.
Improving access to productive finance in Latin America and the Caribbean is the bottom line of our work.
The reason is simple: access to finance is essential for an economy and, therefore, a key determinant of its productivity and economic growth. The problem is that the financing of productive activities, particularly small- and medium-sized enterprises (SMEs), can be jeopardized by issues related to the quality of information and contract execution, which hinder the tasks of credit selection, monitoring and asset recovery.
This, in turn, drives up financing costs and sometimes it makes financing inviable. This problem is particularly prevalent in Latin America and the Caribbean, where it’s critical development challenge that needs to be solved.
It is thus not surprising that over two years ago we got very intrigued, and eventually rather enthusiastic, about the potential of blockchain to address these problems. We became the first among multilateral development institutions to entertain the idea that if there was one strategic use case worth piloting, it was blockchain for asset registries.
Importantly, though, we were not restricting our thoughts to land registries. These class of registries have been one of the most discussed applications, but they face severe challenges in our region given the particular nature of that specific asset and the registry: blockchain cannot not solve the “original owner” problem should disputes arise.
We refer here to a broader class of assets, such as moveable assets, warehouse receipts, invoices, etc., that could be used as collateral to access finance but remain largely untapped because their registries are untrusted and costly to operate, the information is difficult to verify and are prone to fraud.
Enter blockchain.
The promise
At a conceptual level, it is not difficult to see why the properties of blockchain make it particularly suitable candidate for the task of maintaining a collateral or asset registry:
- The system is resilient, without a single point of failure or corruption
- Cryptographic proofs provide integrity to the information contained in the ledger
- The information is traceable and auditable, thereby providing enhanced transparency.
Moreover, smart contracts can further contribute to the efficiency of asset registries by allowing automatic execution of pledged collateral or its automatic un-pledge and re-pledge. These properties can dramatically decrease the costs associated with collateral management and improve efficiency.
The premise then, seemed clear: More transparent and more efficient registries of assets pledged as collateral could diminish constraints rooted in information asymmetries and thus facilitate access to finance.
In other words, if blockchain could facilitate more accurate and trusted information regarding borrowers and contract execution, there would be many more SMEs in the economy that could access credit. This quickly evolved into a project with a vision: support the development of a foundation for a public, open-source infrastructure for asset registries using blockchain designed to support different applications for different type of assets, and implement a pilot to test it.
What ensued was a journey that, frankly, was very similar to the famous Gartner hype cycle in the sense that while we began intrigued, we quickly got very excited and eventually a bit disillusioned.
The certification problem
There were different drivers that took us to the “trough of disillusionment,” continuing with the analogy.
First, the avalanche of positive news that started in mid-2016 regarding the successful use of blockchain in different applications contributed to our inflated expectations.
But, we soon discovered that this news mostly referred to proof-of-concepts that were far from being piloted in real life, let alone in production. While this did not affect our intention to continue with the project, it showed us that there were not that many precedents we could built on.
Second, during the process of actually designing the project, we started to realize that the devil is in the details, and that very few people were talking about these details. For instance, the “garbage in-garbage out” problem is not easy to solve. The objective is to have more trusted and transparent asset registries, but it all depends on whether the initial information registered is correct or has not been altered.
The problem is that, at least at the entry point, we still need to engage and trust third parties that the technology is touted to eliminate. And while there are interesting and novel ways to use different technologies to put a limit on potential corruption at entry, at the end of the day this problem is not fully solved, and if garbage gets in, it will get out, and possibly on a higher standing as it was “blockchain certified.”
Nonetheless, if the entry point issue is solved, then the system is indeed helpful as it will provide integrity to the information.
Practical concerns
More broadly, though, there are several issues arising from the “off-chain/on-chain” interactions, especially when the main data resides, and the main transactions occur, off-chain.
A promising avenue to address this problem is to design the off-chain transaction systems in such a way that they automatically generate smart contracts to settle the transactions on chain, but this is the subject of further research that we are conducting.
Another major, practical, issue relates to the costs and uncertainties when undertaking a pilot in the real world, even more so in the context of a developing economy. Let’s start with transactions costs. Imagine we want to use the bitcoin blockchain.
Well, the price per bitcoin has increased more than 2,000 percent since we started thinking of the pilot, and despite batching and other techniques, the price increases and volatility of public blockchains affect transaction costs for a project like this, and they are not easy to plan or budget.
This holds true even in hybrid models because even if most activity occurs in the private blockchain, a reference still needs to be registered in a public blockchain. But well beyond these transactions costs, running a blockchain pilot does not come cheap.
A pilot, by definition, entails a small-scale, short-term experiment undertaken to learn how it might work in practice. This means that whatever system is built to be piloted, it would need to operate as a mirror of current systems.
Furthermore, a pilot like this needs to connect the systems of several stakeholders (for instance financial institutions, government dependencies, users and other players, depending on the use-case), which is usually not easy or cheap.
Charging ahead
Yes, undertaking a blockchain pilot entails investing a non-trivial amount of resources. Moreover, there is a multiplicity of risks to plan for and the reality is that the conclusion of the pilot might not be positive.
So, is the endeavor worth the cost and the trouble?
We think it is indeed. Not only because the potential development gains can be very high if it works, but because right now there is need for more basic research and experimentation with blockchain without worrying about direct commercial applications.
Moreover, the timing is ripe for pursuing an initiative aimed to support and test an open-source, public infrastructure that allows for greater innovation at the edges (i.e. the application layer), while offering the opportunity to start thinking about standards at the foundational level.
Also, the trait of an extensible, open and public infrastructure is very relevant for applications that entail public interest or development objectives, as the main code can be reused, improved, and adapted to the specific needs of different countries.
As such, and considering that many asset registries would benefit from enhanced auditability, traceability, and transparency, through this project we seek to contribute to the pioneer testing of blockchain in registries with high development impact potential.
We are hopeful that, if all works as intended, we will be able to enter a plateau of productivity sooner than later.
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