Blockchain technology and Financial Services
Written by Leithland Thomas
Director, Architecture at Fundserv Inc.
Blockchain technology has gained enormous traction in the Financial Services industry in the past several years. Most, if not all major financial organizations are at various stage of testing, and/or implementing proofs of concepts in Payments, Clearing, Settlement, and Supply Chain Management. Similarly, we have seen a number of interesting projects in the public sector space where governmental organizations in countries such as Honduras, Sweden, Republic of Georgia are implementing Blockchain projects to support land and other public registries. These activities are leading to the normalization of Blockchain as a truth machine, moving the technology away from the realm of the techno-geeks and into the mainstream.
What is Blockchain?
We often hear speakers talk about Blockchain as a monolithic technology implementation. Just as there are many different fiat currencies in the world with their own characteristics, there are also different types of Blockchain implementations with their own uniques characteristics. Bitcoin is the most widely known implementation, but there are other interesting public and “permissioned” Blockchains such as – Ethereum, HyperLedger, Ripple, and many others. The convergence of a number of technologies such as – digital signatures, consensus systems, cryptography, p2p, storage, time-stamping techniques etc., play a critical role in the technical underpinning of Blockchain.
Outside of the technical underpinning, it’s conceptually best to think of Blockchain as a decentralized database or ledger (can be private or public) of transactions shared across a peer-to-peer network of computers. Depending on the type of Blockchain, it can operate in a distributed manner without the need for a central authority or intermediaries. Transactions in the ledger are available to all concerned parties. Because the system relies upon verification, instead of trust, it is possible to have a more secure, resilient, frictionless, and cost efficient network where the need for central authority is not required as part of the transaction process.
To put this into concrete terms, let’s say Bob and Sally wanted to enter into a transaction to purchase an item of value. Without the establishment of trust and a contract, Sally will not turn over funds to Bob without delivery of the item of value first, and similarly, Bob will not turn over his asset, without receipt of the funds. So what do they do, in today’s world they would find a financial intermediary to broker the transaction, essentially a party that will inject “trust” into the arrangement between the two parties. This adds time, cost, and other friction into the process. In the Blockchain world, the same transaction would be facilitated through a self-executing “smart contract”. Essentially a program that would encapsulate the agreed transaction logic (e.g. terms, payments, etc), which would automatically execute once the condition(s) of the transaction have been fulfilled by both parties. The execution would be added to the Blockchain as irrefutable evidence, and a transfer of ownership from one party to the other would happen automatically. In this scenario, the “smart contract” functions as the trusted intermediary. This simple concept can be extended to all manner of transactions that, today, requires an intermediary.
Basics of Blockchain
The Blockchain ledger is composed of sequential blocks of transactions that are linked together. When a transaction is made, it is first verified before it is accepted and a new “block” is added to the end of the “chain” in a sequential order. In order to prevent tampering of the Blockchain, each transaction is mathematically scrambled, also known as a cryptographic hash. Think of the hash value as a digital fingerprint for that transaction.
The cryptographic hash function takes an input of an arbitrary size, however, the output message will always be of a fixed size. For the purpose of illustration, this entire post was run through a cryptographic function, the digest, or fingerprint that it produced was:
the literal word “Blockchain” was passed through the same cryptographic function, and here is the output that was created:
as you can see, it produced the same sized output, but the value is dramatically different. Similarly, hashing the value “Blockchain”, and “Blockchain1” would produce the same sized output, but the hashed value, or fingerprint would be dramatically different also. This is a desirable attribute of cryptographic hash functions. Cryptographic functions are also deterministic in nature – which means that for a given input, you will always get the same output. The corollary is if there’s any difference in the input value, regardless of how minor, the outputted hash value will be different in an unpredictable manner. If not for this randomness it would be relatively easy to infer patterns, more importantly, the randomness makes it mathematically improbable to find the input value from the hashed, or fingerprint value.
Each block in the chain contains the digital fingerprint of the previous block. The chaining of the digital fingerprints from block to preceding block is what makes a Blockchain.
Given the explicit linking, it is possible to traverse the chain from the current block to the genesis block – the very first block.
The question that might arise at this point is what’s to keep a nefarious operator from altering a prior transaction. If you recalled from our earlier discussion of cryptographic hash functions, any change, no matter how minor, would result in a new hash code, or fingerprint for that block. Because the fingerprint of the prior block is used in subsequent blocks, this would cause the following blocks fingerprint to also be different. Essentially, the dishonest node would have to recreate the Blockchain faster* than the rest of the honest nodes in the network is adding new blocks. The attempt to cheat the system would be noticed by the rest of the network, and the transactions would be rejected through the network consensus mechanism.
Why is there so much focus on Financial Services
In order to appreciate why Blockchain technology promises to revolutionize financial services, we need to look at the current transaction processes. Transactions are often cleared through multiple centralized counterparties, through a maze of complex payment system across multiple currencies with each participant working from their own bespoke sets of data, and through various regulatory authorities. The aforementioned create significant friction and inefficiencies.
The shift towards operating on common shared golden data removes friction, cost, and other inefficiencies from the various counterparties in certain financial transactions. According to a research paper titled “The Fintech 2.0 paper: rebooting financial services” authored by Satander Innoventures,
distributed ledger technology could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15-20 billion per annum by 2022.
Beyond the immediate benefit accrued to the counterparties, the technology creates additional improvements to the overall system by potentially removing the reliance on central authorities such as Central Counterparty (CCP) in certain types of transactions. Similarly, it presents opportunities to change the nature and functions of Central Securities Depository (CSD) to more of an asset oversight and issuance.
We are seeing financial services reshaped before our eyes, it’s not certain what the new system will resemble in the end, however, there is no denying that Blockchain technology is playing an important role in reshaping the traditional landscape in both predictable and unpredictable manner. The important thing for industry participants is comprehension of the technical signals of disruption, and to define clear strategies to seize new opportunities presented by the technology, or run the risk of being disrupted.
* Theoretically it is possible to reverse transaction, or create double spend opportunities through a “51% attack”, but that is a discussion for a different day.