Blockcain technology and its applications to financial services

Abstract

A transaction always comes with risks. The so-called transaction risk is associated with the delay between the moment the transaction is initiated and the moment it is settled. This risk can arise from many sources: credit, liquidity, operations and business. To reduce those risks, trusted third parties are needed. Recently, Blockchain Technology has been presented in the news as a way of protecting corporates from these risks while providing a faster, cheaper and more efficient process by removing the use of a trusted party. Blockchain is a distributed ledger secured by cryptography. It is shared on a network and every time the ledger is modified, the new statement is encrypted and spread among the nodes of this network. Blockchain works on a consensus protocol to validate the transactions. As a result, we can say that the network owns the power of its own statement. On top of that, every statement of the network is linked and stored in a chain allowing anyone to go back in time and chronologically see the evolution of the ledger through time. This way, Blockchain ensures certain characteristics, the most important being distribution, immutability, and security. Blockchain Technology combined with the use of other technologies forms the Blockchain environment. As a result, APIs, smart contracts, cloud computing can be used together with Blockchain to create powerful tools. Together with Blockchain, we can create an automated protocol combining the self-execution of contracts and the automated verification, safety, and distribution of a transaction. The most common understanding of Blockchain is its public form, created and used in the Bitcoin Network. However, Blockchain being a protocol, it is possible to create an infinite number of Blockchains with varying rules, resulting to other forms such as consortium and private Blockchains. Those forms are not necessarily open source and consensus rules are fixed in a protocol defined by the controlling nodes. There is a debate whether these forms are true Blockchains in the sense that it does not respect the original spirit of the technology (which is creating a decentralised network where the control is spread among the network) but it provides paths for applications that better suit financial services actors. Based on these considerations, we established a checklist to assess the utility of any Blockchain project. We concluded that Blockchain is only valuable when there is a need of a database storing information for multiple writers that do not trust each other. We conducted an in-debt analysis of the advantages and the limits of this new phenomenon. The biggest advantages of Blockchain stands in its architecture and the way the protocol is set. Therefore, Blockchain provides a network that enables untrusted parties to transact without the intervention of a trusted third party due to its decentralized architecture. As a result, Blockchain reduces the frictions of transactions. Moreover, Blockchain Technology combines cryptography based on public/private key protocol leading to a certain privacy of the users. Actors involved in the Blockchain are not totally anonymous but pseudonymous (through their public key). The ledger on the other side can totally be encrypted and thus provides some confidentiality for the data and transactions history. Next, Blockchain, once again due to its architecture, is immutable. It is not possible to alter the history once it is spread through the network. We keep some reserve here with the potential creation of fork but we will not expand on this point. Because Blockchain is a chain of block that are chronologically linked and that the transactions are timestamped, it is possible to track the history of transactions. In terms of limits, it comes out that Blockchain may be overhyped for the moment, leading to an over implementation of the technology. It is relevant to invest in Blockchain solutions only if there is a real need. In term of governance, having no centralized authority to regulate the Blockchain may slow down the development of the technology. Furthermore, there is a problem of interoperability between different Blockchains because they are using different protocol, different architecture and different languages. Next, there is a problem of scalability. There is a trilemma in Blockchain: you cannot be fully decentralized, secure and scalable. Therefore, current Blockchain protocols focus on decentralization and security losing scalability with an example like Bitcoin being able to process only seven transactions per second against thousands for VISA. In term of privacy, as transactions are immutably written in the Blockchain, we foresee some problems for private data management. Lastly, one of the limits of the Blockchain stands in its immaturity. We do not know how it will evolve, if it is viable on the long run and if the use of energy will not go out of control. After setting up a detailed definition of Blockchain, the solution it brings to the users and the limits of the technology, we have analysed concrete potential applications for financial services. There is no totally effective application that is widely used with Blockchain but the most advanced project in Belgium is Know Your Customer (KYC). Indeed, it already exists small initiatives run by some agents. This application of Blockchain will reduce cost of KYC processes that are very heavy nowadays and very redundant as well from the customer perspective. The second application concerns interbank payments and clearing & settlement. Blockchain would allow a faster, cheaper and disintermediated process. Finally, we described already existing proof of concept being Corda, FundsDTL and E-Estonia. Those applications give us great inside of the potential uses of Blockchain in financial services. We conclude our report being critical about Blockchain. It is an amazing innovation that may disrupt some industries but will not replace banks neither will disrupt financial services. We are convinced that it will incrementally impact financial services leading to a faster, cheaper and more efficient way of communicating information and processing transactions. Blockchain in its pure form (public Blockchain) is very unlikely to reach the banking industry but more structured forms like consortium and semi-private Blockchain applications are very likely to emerge and provide value to the industry. Therefore, we recommend financial services actors to stay aware about Blockchain, have a moderate understanding of it because even if it may not directly be implemented by banks, IT providers may create useful platform using Blockchain. Understanding Blockchain is thus a competitive edge in case of emergence in the near-medium future.