Blockchains and Coordination Failure in Cross-Border Payment Systems: Overcoming the Penguin Effect

University essay from Handelshögskolan i Stockholm/Institutionen för nationalekonomi

Abstract: The blockchain has been described as a "foundational" technology that has the potential to fundamentally alter the banking system. Its core feature is the enablement of an electronic peer-to-peer money transfer system without the presence of intermediaries. It is potentially a lower-cost and more efficient alternative to the transaction infrastructure of current payment systems. In this paper I analyze blockchain's potential impact on remittances, which are an important component of the GDP of many developing countries. Remittances have operated in a suboptimal technology equilibrium, partly as a result of coordination failure. This market failure results in high consumer welfare costs. I use and adapt a Farrell and Saloner game-theoretic model to test this claim and demonstrate that, due to lower fixed costs and a lower critical mass than centralized technologies, blockchain reduces the excess inertia that has resulted in the persistence of the network effects that sustain legacy payment systems. As a result, correspondent banks face lower downsides to experimenting with blockchain and greater risks to remaining alone with the legacy technology, including disintermediation. Although it may have significant advantages over centralized technologies, the potential for a rapid and widespread adoption of a blockchain currency such as Bitcoin presents unknown risks for payment system resilience and financial stability. I present general policy suggestions describing how policymakers might overcome potential risks in the adoption of blockchain technology, in an attempt to help ensure that the system does not trade safety for greater efficiency.

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