20 November 2015
There’s been a lot of talk about cryptocurrencies in recent years (especially Bitcoin) but it’s the blockchain technology which provides the platform for cryptocurrencies that’s currently getting the most attention. It’s becoming more likely that blockchain will have the largest impact on mainstream financial services in the future.
There’s a continuous stream of news articles on the potential of this new technology and a large portion of the global fintech conference, Money 20/20, held last month in the US, was dedicated to the subject. We thought we’d join the discussion and share what we’ve learned about blockchain and the opportunities it presents for financial services.
We’ve come up with a six word description for blockchain: ‘A tamper-proof, transparent distributed ledger’. But, to do the technology justice, it probably does need a little more explaining.
Blockchain is a method of validating transactions and recording ownership. It is a large database that contains a log of all the transactions ever made in a network (e.g. the Bitcoin network).
New transactions are gathered up into a group called a block. Each new block references the one before it, forming a chain. The chain is a permanent record where the flow of all transactions ever made can be traced.
Blockchain is often referred to as a ‘distributed ledger’ because each of the blocks are validated by a large distributed group of users. The user community’s computers run automated software to reconcile the ledger by validating each and every block through a system that is like voting, where the majority rules. To help this reconciliation and validation, the blockchain is made transparent and is usually open to the public. The public ledger is maintained by everyone, but controlled by nobody. The blockchain network uses a mix of encryption, robust mathematics and majority-rules principles to ensure the resilience of the system.
The fates of cryptocurrencies and blockchain are set to diverge, with each existing independently (not necessarily interdependently) of one another.1 While cryptocurrencies such as Bitcoin will continue to grow in prevalence and are likely to remain a permanent feature of the world’s financial landscape, they are still fringe alternatives in the context of the world’s total financial activity. Unless cryptocurrencies can address their current well-documented constraints, they are likely to remain on the fringe.
Blockchain will continue to enable cryptocurrencies, but this same technology is being used more and more as a source of innovation in mainstream financial services activity, including enabling payments in central bank currencies. The Bank of England, while acknowledging the economic flaws of cryptocurrencies, considers blockchain technology to have considerable promise in other types of transactions as they have shown it is possible to transfer value securely without a trusted third party.2 This view is echoed by the Federal Reserve Bank of Boston who, according to recent reports, put more confidence in blockchain’s ability to accelerate the development of better technologies for making payments, than in the survival of any specific cryptocurrency.3
Putting cryptocurrencies to one side, let’s now consider the development of blockchain technology. The following is based on the premise that “it is often the case that the bulk of the gains from the introduction of a new technology do not arise immediately because processes that make use of the technology also need to be rethought.”4
There’s no doubt that a huge amount of innovation and change is occurring in the payments industry. Much of this happens on top of or within existing infrastructures, networks and payment instruments. For example, Apple Pay, Google Wallet and Samsung Pay all leverage existing card networks. But, from time to time, an entirely new way of transacting is developed that bypasses established infrastructures altogether, with potential to enable revolutionary new ways of making payments. This can be described as the creation of a ‘new sandpit’.
Blockchain technology has the potential to disrupt how payments are currently made by providing competing operating models for both cross-border and domestic payments, which could have significant implications for the financial system as a whole.5 Blockchain has the potential to be the new sandpit, as its decentralised network bi-passes the centralised automated clearing houses and existing clearing and settlement payment infrastructures that exist today.6
At its core, an electronic payment involves reducing the balance of one customer’s account and increasing the balance in the recipient's account by the same amount. Today’s payment systems generally operate on a ‘central ledger’ basis, with settlement between participating financial institutions ultimately taking place at the central bank. In contrast, a blockchain sees any transfer of value verified by the entire community (instead of through just one trusted third party).
Much of the development currently underway with blockchain is based around the idea of taking the useful parts of the technology and integrating them with businesses that have legal reputations.7 Blockchain technology, in theory, could simplify processes and cost systems across a range of financial transactions that involve counterparties.8 Santader InnoVentures captures this succinctly by stating “it is only a matter of time before distributed ledgers become a trusted alternative for managing large volumes of transactions.”9
Blockchain technology has the potential to be used in a range of mainstream financial services, including:
There are two ways distributed ledgers (i.e. blockchain) can be designed. Distributed ledgers can be open, verifying anonymous network participants, or they can be closed and require network participants to be known. An ‘open’ ledger is ‘permissionless’ and can be used by anyone (most cryptocurrencies use this model). By contrast, closed or ‘permissioned’ ledgers use a defined and limited group to validate transactions, providing an official record of asset ownership and legally accountable participants, regardless of the asset being exchanged (such as the dollar).
The ‘permissioned’ approach allows participating counterparties to be authenticated (as per anti-money laundering requirements) and ensures the transmitting customers have known legal identities (as per ‘know your customer’ requirements).16 Accordingly, ‘permissioned’ distributed ledgers are more aligned with existing financial and payment systems, and therefore provide more likely potential to existing financial institutions.17
From a payments perspective, ‘permissioned’ distributed ledgers has several attractive features that could see clearing and settlement achieved in a very efficient manner,18 including:
While it is hard to dispute the potential of blockchain technology, many challenges and concerns still remain, including:
A wide range of explorative and commercial activity is now underway to consider and develop innovative uses of blockchain technology for central bank currencies and other financial assets. Those developments are not just among fintech and startup companies, either. There is a significant amount of activity occurring within incumbent banks and large technology firms, for example:
The fintech sector is very active in developing commercial propositions based on blockchain. For example, Clearmatics has developed a platform for clearing and settling over-the-counter derivatives.32 Ripple33 works with incumbent financial institutions to enable near instant cross boarder transactions in central bank currencies.
It is clear that the wider application of blockchain technology is in its infancy. It is hard to know what impact it will have, how quickly its impact will occur, and who will be the main actors in its evolution. One thing for sure, is that it is highly interesting and worth following its evolution as financial services organisations around the globe continue to consider its merit. The Economist magazine captured the future of blockchain best by saying; “Just as nobody forecast social networks, blogging or Netflix in the 1990s, the absence for now of any tangible applications other than bitcoin for the blockchain merely points to humankind’s deficient imagination.”34
1. Tim Swanson ‘Consensus-as-a-service: a brief report on the emergence of permissioned, distributed ledger systems’, April 2015.
2. Bank of England, One Bank Research Agenda, February 2015, page 31.
3. Federal Reserve Bank of Boston, ‘Bitcoin as Money?’, April 2014, page 19.
4. Bank of England, ‘Innovations in payment technologies and the emergence of digital currencies’, Q3 2014, page 10.
5. Institute of International Finance, ‘The Internet of Finance: Unleashing the Potential of Blockchain Technology’, April 2015.
6. Euro Banking Association, ‘Opinion Paper on Next Generation Alternative Retail Payments: Infrastructure Requirements’, December 2014, section 5.13.
7. American Banker, Tim Swanson interview, ‘Banks Can Cherry-Pick the Best Bits from Bitcoin: Report’.
8. Euromoney, ‘Exit Bitcoin, enter block-chain technology’, January 2015.
9. Santader InnoVentures, ‘The Fintech 2.0 Paper: Rebooting Financial Services’, page 14.
10. Euro Banking Association,‘Cryptotechnologies, a major IT innovation and catalyst for change’, May 2015, page 14.
11. As provided by Ripple today.
12. The Economist, ‘Money with no middleman: Beyond Bitcoin: the revolutionary potential of the blockchain’.
14. Diginomica, ‘Death to databases come the blockchain revolution?’, June 2015
15. TechCrunch, ‘Everledger Is Using Blockchain To Combat Fraud, Starting With Diamonds’, June 2015.
16. The American Banker, ‘Banks Can Cherry-Pick the Best Bits from Bitcoin’, April 2015.
17. Tim Swanson ‘Consensus-as-a-service: a brief report on the emergence of permissioned, distributed ledger systems’, April 2015.
18. Euro Banking Association ‘Cryptotechnologies, a major IT innovation and catalyst for change’, page 14.
19. Santader InnoVentures, ‘The Fintech 2.0 Paper: Rebooting Financial Services’.
23. Bank of England, One Bank Research Agenda, February 2015.
25. Forbes Magazine, Nasdaq Unveils Blockchain-Enabled Platform Linq, October 2015.
26. International Business Times, ‘Codename Citicoin: Banking giant built three internal blockchains to test Bitcoin technology’, July 2015.
27. International Business Times, ‘Barclays talks blockchain, bitcoin and distributed ledgers’, July 2015.
28. IBM, ‘Device democracy- Saving the future of the Internet of Things’, July 2015.
29. Euro Banking Association,‘Cryptotechnologies, a major IT innovation and catalyst for change’, May 2015.
30. The Telegraph, Visa uses bitcoin's blockchain technology to cut paperwork out of car leasing, November 2015.
31. Markets Media, ‘Distributed Ledger Group Eyes Open Source’, November 2015.
34. The Economist, ‘Blockchain: The next big thing’, May 2015.