Blockchains Could Save Millions in Data Security Costs

Tuesday, December 26, 2017

This year has seen the proliferation of proposed applications and startups using blockchain technology. Predicting which will succeed and which will fail with 100 percent accuracy is, of course, impossible. But the likeliest candidates for success are the cases where the benefits of not relying on a central intermediary most exceed the extra costs of using a blockchain to process transactions. Will our health records and deeds to our homes end up on blockchains? The answer will depend greatly on these costs and benefits.

The benefits of not relying on a central intermediary are often larger than we first assume. Let’s look at the most well-known blockchain application — payment processing — and one of the most important functions of today’s intermediaries, namely keeping our data secure.

We use central payment-processing systems such as credit cards, PayPal, or bank transfers all the time, almost without thinking about it. As we do so, we implicitly trust these intermediaries to protect our personal and financial data from being stolen and to not misuse the data themselves. Data hacks of epic proportions do happen, but let’s assume that the probability of something bad happening when we use one of these intermediaries is very low. Does that mean the cost of relying on these intermediaries to secure our data is low? Not necessarily.

We place our trust in these intermediaries because they have made costly investments over time to engender that trust. Firms that centrally process payments spend millions per year on hardware, software, employees, and research and development to communicate to customers that their data is safe in each transaction. And all the major credit cards require their e-commerce merchants to meet the Payment Card Industry Data Security Standard, first rolled out in 2004. Merchant compliance, which includes network security, monitoring, and several other standards, is expensive. For the smallest e-commerce merchants (defined as under 20,000 transactions per year) accepting Visa, MasterCard, or Discover, becoming compliant costs an estimated $75,000 to $90,000, and maintaining compliance costs an additional estimated $35,000 annually. For the largest merchants (processing over 6 million transactions per year), the costs are estimated to be 10 times as large.

Intermediaries pass security costs along to consumers in the form of credit card or banking fees. But if blockchain technology’s advocates are correct and if a network has enough independent computing “nodes,” we can avoid these costs while providing perhaps even greater security.

Data security is, of course, just one problem with relying on centralized intermediaries. Financial intermediaries can grow large enough to dictate fees to consumers or influence government policy, and many people have privacy and other concerns. And intermediaries often cost more than we initially think.

But these problems are just one side of the story. Central intermediaries generally process data at a lower cost per transaction than blockchains (Jeffrey Tucker, our newest addition to the AIER family, recently described the latest news in the battle over scaling Bitcoin’s ability to process transactions).

The market will ultimately determine whether the benefits of decentralization outweigh the costs in payment-processing and other industries, but intermediaries often cost more than we initially think.

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Max Gulker, PhD

Max Gulker joined AIER in 2015. His primary research areas are applied microeconomics and industrial organization. Max previously worked as an economist for Keystone Strategy, supporting expert testimony for antitrust and intellectual property litigation in high tech industries. Prior to that, he worked on financial litigation matters with NERA Economic Consulting. Max holds a PhD in economics from Stanford University and a BA in economics from the University of Michigan. Follow @maxgAIER.