By Noah M. Huisman & Kaleb E. Rumicho
Blockchain technology has created quite a stir. Entire industries are scrambling to understand how blockchain works and how it affects their universe. Blockchain has the potential to cure many of the inefficiencies that exist in the “pre-blockchain” world. But what is blockchain? How does it work? And why is it important?
At its simplest, blockchain is a digital, decentralized transaction ledger database that is shared across a network of computers (commonly referred to simply as “blockchain”). The ledger consists of records and encrypted data stored in “blocks,” which are recorded one after another in a chain of blocks. The links between blocks and their content are protected by cryptography, so it is impossible to manipulate or change previous transactions in that chain. As a result, the ledger and the transaction network are trusted without a central authority who would normally verify the transaction. In this way, blockchain is essentially a means of crowdsourcing the verification of transactions by leaving it to the masses to verify (or reject) transactions.
To illustrate, let us look at an example of a transaction between two parties under blockchain. First, A sells his TV to B for $20. The record would list the details of this transaction, including a digital signature from each party. Second, the record is checked by the network. The computers in the network, called “nodes,” check the details of the transaction to make sure it is valid. Third, once the transaction is accepted as valid, the accepted records are added to a block. Each block contains a unique code called a “hash.” A hash is created by a math function that takes digital information and generates a string of letters and numbers from it. The block also contains the hash for the previous block in the chain. The hash has two important characteristics: first, no matter the size of any original file, a hash will always be of a uniform length, and second, any change to the original input will generate a new hash. As such, any changes to the hash will break the existing chain. To restore the chain, one would need to recalculate the next block and all subsequent blocks. Finally, the block is then added to the blockchain, completing that particular transaction. No changes can be made to that transaction thereafter.
In the pre-blockchain world, trust in transactions is generally derived from intermediaries. Because we often do not know the parties across the table from us, we are used to relying on third parties—banks, escrow service providers, etc.—to vouch for strangers, oversee transactions, and maintain records related to our transactions. The use of blockchain eliminates the need for these gatekeeper institutions.
Blockchain offers a few remedies to some of the market’s ails, such as transparency, decentralization, and efficiency. In blockchain, everything is transparent, as everyone can see what is happening. This decentralized system allows everyone to be a check on manipulation. Decentralization also allows for efficiency; it cuts out the middlemen and the excess costs associated with introducing a third party into any given transaction.
With that in mind, the banking and financial services industries are square in the sights of disruption at the hands of blockchain, disruption that offers extraordinary opportunities for financial services providers willing to leverage the characteristics that blockchain brings to the table. Blockchain is transforming everything from payments transactions to how money is raised in the private market. The Institute for Development and Research in Banking Technology workshopped the use of blockchain in the banking industry, and the results were encouraging, providing both comfort and confidence in injecting blockchain into everyday use in the industry. Below are just a few ways we expect blockchain to affect banking and finance.
Blockchain may reduce costs and improve the inefficiencies in the operation of financial transactions. The financial system moves money from ledger to ledger to ensure that no dollar is spent twice. Blockchain can become the standard for the movement of anything of value—currencies, stocks, bonds, titles—in batches big and small, to distances near and far, and to counterparties known and unknown. In the pre-blockchain market, the path to moving value (e.g., title) from one party to another is riddled with third parties, all of which increase the transaction costs and any of which may be the source of painful delay. By offering a peer-to-peer alternative, blockchain can dramatically lower cost, improve speed, reduce friction, and boost economic growth and prosperity.
Blockchain may provide an alternative or complement to traditional banking. The average person relies on banks to store valuable items or information in a safety deposit box, a savings account, or a checking account. With blockchain, individuals would not need to rely on banks as the primary stores of value (as it can be held and evidenced on the distributed ledger) or as providers of savings and checking accounts, and institutions would have a more efficient mechanism to buy and hold risk-free financial assets.
Blockchain allows transparency in accounting and financial reporting. New accounting methods using blockchain’s distributed ledger could make audit and financial reporting transparent and occur in real time. Blockchain could also dramatically improve the capacity for regulators and other stakeholders to scrutinize financial actions within a corporation.
Further, blockchain cuts settlement times on all transactions from weeks and days to minutes and seconds. This speed and efficiency creates opportunities for unbanked and underbanked individuals to participate in wealth creation. For the previously unbanked, a new world of financial services becomes available, and for institutions, an entire new market of individuals gains access to their services.
There are still many hurdles to overcome in the private and public sectors before blockchain transforms the banking and financial industries. The potential benefits to the global financial market in the private sector are so appealing that many financial institutions are investing resources to research the practicality and implementation of this technology. In the public sector, where the regulatory environment remains in flux, policy makers and regulators around the globe are working to understand and regulate this technology.