Blockchains and Their Impact on the Finance Industry

There is a lot of talk about the impact blockchains will have on the finance industry. The same holds true for FinTechs. However, what will be the real impact? Will we still have the same banking system in five or ten years from now? Or will some groups of banks (the small community banks such as Volksbanken, the large banks such as Deutsche Bank) disappear and becoming replaced by new players? Or will the banks absorb the FinTechs? 

Before approaching this question, a brief overview of the fundamental characteristics of blockchains and key concepts is useful. A blockchain is a distributed data structure, brought to worldwide attention by the bitcoin cryptocurrency, that maintains a growing list of transaction records in a way that is extremely resistant to tampering. Algorithmic consensus is the key defining feature of a blockchain. While a public blockchain such as bitcoin’s is completely decentralised as well as distributed, the bitcoin blockchain’s is better defined as a specific type of blockchain: a distributed ledger. Consensus is key, as blockchains replace implicit trust with a consensus algorithm share by all participating nodes, be they public or “permissioned”. A permissioned blockchain is a restricted-access blockchain where, unlike bitcoin, only authorised node may perform or validate transactions on the blockchain.

Consensus is the mechanism by which all the participating nodes reach agreement about the integrity of the existing distributed transaction log and allow new entries to be written to this append-only, linear data structure. The only way that nodes participating in a blockchain can attain consensus is by the use of a published mathematical algorithm. The consensus mechanism is termed sometimes termed “trustless” – though not all blockchains only operate with completely anonymous/pseudoanonymous nodes – as the nodes do not need to trust whatever the other nodes state as truth, they only need to all share the same consensus algorithm which is used to verify blockchain integrity and permit new transactions onto the distributed log after a majority of nodes can perform the same algorithmic checks.

Another key feature is independently-verifiable tamper-evidence. It is trust mechanism for consensus that allows the other key feature of and independently-verifiable distributed log integrity. Just as the nodes make use of the algorithm for achieving consensus, a third party can audit a blockchain and be able to attest to its integrity.

 

Figure 1: Example of how a Blockchain works (Source: World Economic Forum)

 

While blockchains are seen by many as having the potential to be a key enabler for a wide range of applications, from the Internet of Things to Life Management Platforms, here the focus will be on key use cases in the Financial sector. With the above core concepts in mind, it is possible to examine some possible blockchain use cases in the financial sector.

Asset Registries

Blockchain technology asset registries could be deployed to manage virtually any asset class (e.g. ships, aircraft, automobiles etc.) and provide a complete unalterable audit trail of ownership, maintenance and valuation.

Regulatory Reporting

By its nature the Blockchain is an unaltered chronological record of transaction history, delivered in a fully transparent and accessible form.

Many regulatory processes require a document to have gone through certain states before any given state (e.g. AML, KYC processes).  Recording these state changes in the Blockchain conclusively demonstrates compliance with these processes without the need of an intermediary.  This could be extended to include proof-of-audit/control whereby each new version of a document could be denoted to have changed according to a defined set of rules.  The result of these rules-based processes could potentially dramatically reduce the cost of governing regulatory compliance

International Funds Transfer

The current process for cross-border payments, SWIFT, relies on intermediaries (correspondent banks) before reaching the ultimate physical location.  The process is slow with expensive customer fees and bank risks due to weaker banking standards in some jurisdictions. Blockchain offers a new approach, with no geographical borders, middlemen or opacity that has plagued legacy cross-border payments with the added benefits of fast processing and no correspondent fees.

Also, as the recent breach of the Bangladeshi Reserve Bank demonstrates, centralised systems for the processing of electronic payments are a key target for well-funded attacks by cyber criminals. The SWIFT system is geographically distributed, but it depends on trusted, centralised control nodes maintained by all banks participating in the payment network. By compromising a single node, the criminals were able to fraudulently make transfers of almost a billion US dollars. A decentralised system with a trustless consensus mechanism such a blockchain instead would require 51% of all the participating nodes to be compromised in order to be able to add fraudulent transactions to its distributed ledger.

Securities Issuance and Settlement

The Securities Exchange Commission has approved the issue of public securities via Blockchain-based technology.  This is often termed-post trade processing, allowing complex security agreement between multiple parties to be agreed to and stored in a distributed ledger, thus reducing administration costs and the risks of a party reneging on a trade.

Insurance Contracts

Blockchain can facilitate the setup and management of insurance contracts using Smart Contracts technology to ensure data accuracy, correct payment and settlement of premiums, brokerage, commissions and claims.  All parties to a contract will have access to identical exposure data which will resolve existing data quality issues and help to leverage better modelling models to measure aggregate exposures and to make capital allocation decisions. 

While the potential for blockhain technology to have disruptive effect on the finance sector, and rattle the up until now comfortable market position of the largest players in this market such as global banks and insurance companies, some researchers think it is too early to hail the demise of traditional financial services providers. They cite a number of challenges to mainstream blockchain adoption, the greatest of these is regulatory resistance to the use of blockchains. This position is understandable, not necessarily due to any inherent technical limitations, but largely due to a perception of blockchains that has been dominated by the bitcoin cryptocurrency and the difficulties of non-technical regulators to grasp the core concepts behind blockchains. A fundamental paradigm shift in thinking is required when examining algorithmic consensus systems and approaches to insuring information confidentiality. Blockchains, permissioned or public, can easily make use of hashing and cryptographic algorithms to store confidential data, and the very nature of consensus only works if the consensus algorithm is known by all the participating nodes and all third-party auditors.

Another key hurdle is standardisation. Blockchains must be seen as platforms, over which applications and ecosystems can be built to leverage its key strengths, and platforms, more than any other technology require the adoption of standards to provide business benefits. The blockchain landscape today is still very new, and quite far off from widespread agreement over the adoption of some of the many standards proposed. 


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