Jan 29, 2016

Most of the financial services world has heard of Bitcoin, a digital currency that has gained much attention over the past few years. Fewer, however, have an understanding of the underlying technology and its wider application to data and finance. While our previous article explained the basics of how the technology works, this article looks to delve deeper into some of the practical applications of this new technology. It will also examine some of the issues and problems associated which might cause a delay on blockchain being the next ‘big thing’.

Definitions:

To recap – a blockchain is a method of storing information in a decentralised manner that relies on consensus between participants to make any changes, which is both cryptographically verifiable and unalterable. This may be worth unpacking:

  • Decentralised – every participant has their own ‘ledger’ containing a record of all data within the chain – this makes falsification difficult as amending the chain would require amending the ledger of multiple participants simultaneously rather than one central database as with more traditional systems
  • Consensus – participants must agree via a validation process what the current state of the blockchain is before any change is confirmed (what constitutes consensus depends on the application). This process is Byzantine Fault Tolerant[1], utilizing an algorithm to account for the possibility that participants may send incorrect records, whether deliberately or not
  • Cryptographically verifiable – every amendment is time-stamped with the identity of its author – this allows other participants to check that the author is entitled to make that change
  • Unalterable – data within a chain is never altered, only added to. This allows all participants to see all data in the chain going all the way back to the original ‘genesis’ block.

Applications:

In a recent report from the UK Chief Scientific Adviser,[2] blockchain technologies are recommended for ‘collecting taxes, delivering benefits, issuing passports, recording land registries, assuring the supply chain of goods, and generally ensuring the integrity of government records and services.’ In each of these applications, a distributed ledger system would avoid the ‘single point of failure’ risk that is inherent to large centralised systems. It concludes that ‘distributed ledger technology provides the framework for government to reduce fraud, corruption, error and the cost of paper-intensive processes. It has the potential to redefine the relationship between government and the citizen in terms of data sharing, transparency and trust. It has similar possibilities for the private sector.’

A system that is not only easy to verify, but also eases administrative burdens, appeals to both governments and private sector entities. A number have already begun taking advantage of this technology. The Estonian government currently uses a distributed ledger system called KSI to maintain and verify records on government databases. In the private sector, Everledger is a blockchain system used to verify the origin of diamonds, which maintains records of ownership, prevents forgery and helps to reduce the prevalence of blood diamonds in the market. Financial service institutions are currently devoting huge resources to the process of settlements, maintaining client data and servicing transactions. The promise of blockchain to reduce these costs explains their interest and investment in the technology.

An obvious use of blockchain technology could be in the AML/KYC space. A distributed ledger of KYC data could prevent duplication of efforts, allow the sharing of information (both past and present), and alert participants to changes. Information about an entity, for example credit history, convictions or any certifications would be viewable, as would the identity of any participant attempting to add new information.

Furthermore, a private blockchain (one which, unlike Bitcoin, controls access rights and thus restricts who is allowed to participate in the chain) could be used to create smart contracts - legal contracts that are self-fulfilling and impossible to alter without the consent of all parties. When you purchase insurance or make a claim, an insurer is needed as an intermediary to act on that contract. The fundamental concept of a smart contract is writing the contract into a digital environment in which the conditions and execution of the contract can be automatically processed by software in a fast, transparent and low-cost manner. For example, a life insurance policy could automatically pay out when the software, which monitors death registers in real time, detects the policy holder’s death.[3] Similarly, bonds created in such a manner could verify the owner, issuer and holders of all bonds and execute and validate all coupon payments automatically.

Concerns:

However, there are a number of challenges facing this emerging technology. In any system where all previous states are also stored, the computing infrastructure required is many times greater than for a system that only requires storage of the latest state, as in a centralized ledger. Furthermore, one of the greatest strengths of blockchain – the consensus requirement – can also be a weakness. What does one do if some of the participants are slow to process and agree to a change, or were brought offline before they could confirm? For example, one could hypothesise a situation in which a large number of contracts needed to be amended simultaneously due to a credit event, such as a bank’s default. Would a bank’s IT system be able to validate, confirm and settle all transactions quickly enough or would the processing power required cause failure, preventing all transactions from being confirmed? Any serious blockchain-based systems handling large numbers of transactions would require huge infrastructure investments from institutions.

It has also been suggested that blockchain may not in fact be as resistant to malicious activity as has been claimed. Given that one of the main advantages of the technology is that it does not rely on human intervention, if it is demonstrated to be vulnerable to hacking this will discourage investment by institutions, which may prefer to hold onto the centralised storage systems they currently control. In the AML / KYC space, a distributed database containing the private details of clients may not be desirable, even if it can only be viewed rather than edited easily. Ultimately, although blockchain has been a bandwagon held up for a number of years as the future of data management and transaction processing, it will be a number of years before both the technology is proven to be safe and institutions have the internal infrastructure to utilise it.

[1]Byzantine Fault Tolerance – a mathematical solution to the problem of potentially having participants sending incorrect information. Named after the Byzantine General’s problem, which posits a number of armies attempting to besiege a city when some of the generals may be lying and not passing on the correct messages (ie. ‘Attack’ or ‘Retreat’) to each other

[2]https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/492972/gs-16-1-distributed-ledger-technology.pdf

[3]http://en.finance.sia-partners.com/impact-blockchains-smart-contracts-insurance