Blockchain Technology
Blockchain technology is making headlines this week as UBS, Bank of America, and HSBC have all jumped on the bandwagon. This activity continues a recent trend suggesting that this technology may very well revolutionize how financial transactions are processed. Before we get into the recent activity, however, it is important to understand Blockchain technology itself.
So what is Blockchain? Essentially, it is a system of recording and verifying transactions in a distributed public database through an integrated network without a central authority.
Before we expand further on Blockchain, it is important to understand the traditional banking model.
Traditional Banking
Currently, payments are still dependent on traditional banks. The initiator of a payment (the “Payor”) will see the amount deducted from their account balance while the receiver (the “Payee”) gets the amount credited to their account. These transactions can occur in the form of physical checks, ACH transactions, and wire transfers for example. Depending on the banks involved and their location globally, the length of time to process these transactions can range from several hours to a few days.
Behind the scene, the senders’ bank updates its records (reducing the bank balance of the Payor) and the receiving bank receives the transaction and updates its own records (increasing the bank balance of the Payee). Because not all banks are connected to each other, sometimes transactions are processed through correspondent banks. This is the equivalent of two banks across the globe using a common bank they both work with to facilitate the completion of a transaction to move money. Utilizing correspondent banks increases the length of time to complete transactions.
So how does blockchain compare to today’s traditional banking model?
Blockchain is essentially a publicly distributed ledger, the “Blockchain Ledger”. All parties involved have access to this single distributed public ledger, so each party involved sees the same thing. This would be the equivalent of all banks globally updating a single ledger when processing transactions.
This means that if one party wants to make a transaction with another party, the Blockchain Ledger (essentially a public database) can be updated and shared / distributed throughout the world. When this update is agreed to by the participants, the ‘new’ state of the Blockchain Ledger is accepted. In this Blockchain Ledger, the transactions are public but the parties involved are kept anonymous. This is a significant risk addressed later in this article.
Now that we’ve explored traditional banking and the Blockchain, it’s important to understand how Blockchain works.
What is Block-Data
Blockchain is a public ledger comprised of “block-data” or “data-blocks” which is a form of structuring transaction data in a linear, chronological chain of data blocks, like placing a continuous chain of Lego blocks one on top of the other with each block representing different components of the blockchain. The compilation of these blocks is recorded in the public/distributed digital ledger, the Blockchain Ledger.
The big draw of Blockchain technology is speed, reliability, anonymity, and decentralization with special emphasis on the “trust” of the Blockchain Ledger. There is no central authority that can manipulate transactions or make mistakes. Instead the system relies on validators known as ‘nodes’ which validate transaction data (payments), as well as a block-data (additions to the ledger). These nodes consist of any computer participating in the peer-to-peer network by relaying transactions and block-data.
Transactions are approved by consensus. Transactions using Blockchain are always accounted for because the record is permanent and cannot be corrupted [i].
Parting the Clouds
A common misconception is that Blockchain refers to some company or entity, rather than a technology. There are several companies offering different variations. Many also confuse Blockchain with Bitcoin because of how often they are mentioned together, but they are entirely separate concepts. Bitcoin is a form of cryptocurrency and Blockchain is the technology used by Bitcoin to process transactions. Bitcoin is a simple application that is leveraging the Blockchain technology to send money around. The same way that an email application leverages the internet to send emails.[ii] Bitcoin was the first application built on Blockchain back in 2008. Since that time, many financial institutions have seen the potential for this technology and have begun researching how to integrate it.
The rise of Bitcoin was fueled by the ability to make transactions in a very cheap, fast, and reliable manner. These features belong to Blockchain technology and not Bitcoin itself. Blockchain could just as easily be using “real” currency instead. This begs the question: if a Bitcoin can be transferred quickly, inexpensively, and safely then why can’t a Euro or Dollar?
Using Bitcoin as an example, the acceptance is done by nodes as mentioned before. The nodes validate the transaction via sophisticated cryptographic encryption and the process is complete. A transaction is fully validated in approximately eight minutes. Compare that to the hours and, in some cases, days that it takes banks to complete the same task and you can see the potential[iii].
Since most established Blockchain services are peer-to-peer (P2P), many businesses are working to develop their own Blockchains to reap the benefits of fast transaction processing when conducting business-to-business (B2B) transactions.
The Market for Blockchain
Blockchain technologies could reduce banks’ infrastructural costs by $15-20bn a year by 2022, a new report from Santander InnoVentures claims, replacing ACH transaction processing. UBS has indicated that they are developing a “smart bonds platform” using Ethereum technology. Ethereum is one of the variations of Blockchain. UBS is using this technology to build a smart bonds platform that enables the issuance of bonds distributed via a digital ledger. The bonds are to be ‘smart contracts,’ meaning that they pay out coupons automatically. The platform also offers various features including smart contract functionality and execution of peer-to-peer contracts. Instead of Bitcoin, it uses its own cryptocurrency called “Ether.”
Separately, Bank of America and HSBC have entered the Blockchain discussion as well. Teaming with R3, another Blockchain tech company, they hope to develop a way to greatly reduce the cost of international trade. R3 claims they will be able to simplify and speed up trade finance processes significantly by using Blockchain for bank transactions. Execution of letters of credit (LOC) transactions have already been run with Infocomm Development Authority of Singapore. LOC transactions are one of the most commonly used payment methods to reduce risk between importers and exporters, but the process is sluggish and creates a long paper trail[iv].
The Bottom Line
Reliability, and the possibility of billions of dollars in reduced cost accompanied with increased speed in processing trusted transactions along with heightened security are all reasons why Blockchain has seen increased interest from the big banks and financial services providers globally. This technology has the potential to greatly strengthen the global financial system. For now, trading and payments remain mostly concentrated in the banking center.
While the upside is high, authorities are still trying to understand the risks. With anonymity playing a key role in conducting transactions using the Blockchain technology, money laundering has become a key concern which needs to be addressed as part of financial service provider’s anti-money laundering (AML) program.
With so many potential solutions addressing the current challenges in the payment processing sector, the future of this technology looks both clear and bright regardless of the AML risks. As more banks build and test their own private Blockchain systems, it is very possible that eventually this technology will become the standard in finance.
[i] https://www.bloomberg.com/view/articles/2016-06-06/bring-on-the-blockchain-future
[ii] https://www.youtube.com/watch?v=40ikEV6xGg4
[iii] https://www.gtnews.com/articles/b2b-blockchain-based-payment-can-it-beat-the-banks/
[iv] https://www.reuters.com/article/us-asia-trade-blockchain-idUSKCN10L17D
