Blockchains are a new solution to a fundamental question in the digital world: how do you establish trust between parties over the internet’s untrusted network? More specifically, how do you get perfect, simultaneous, shared data between a number of different people, devices or businesses?
There are two stages of blockchains, and these impact the financial sector in two distinct ways. The first are cryptocurrencies and the second are blockchain applications. Cryptocurrencies are a new type of asset, currency and value exchange medium. They’re a digital token – secured with cryptography – that can be exchanged in a borderless and completely peer-to-peer way, and managed without need for a bank.
Their relevance to banking institutions is straightforward – the value that goes through cryptocurrency markets could completely circumvent the traditional finance value chain. While their penetration isn’t very high yet, some countries’ central banks are even considering cryptocurrencies as a national standard. Removing banks from this trusted central position requires them to do some real soul-searching and reconsider their value proposition. The most innovative incumbent financial institutions will offer cryptocurrency-based services by absorbing or partnering with service providers like cryptocurrency exchanges, wallets and micropayment services, while responding to challenges of Know Your Customer regulations (KYC) in pseudonymous systems and Anti-Money Laundering (AML) data analysis on blockchains’ new structure.
Blockchain applications are the second wave of blockchain technology, and are based on abstractions of the concept of a blockchain ledger. They address a number of historic challenges in finance. These abstractions are possible using smart contracts, a type of blockchain-enforced code, to define the terms and formats of transactions, and often use cryptocurrencies as the incentive or fuel for the application’s infrastructure. The most basic component of almost every financial service is the transaction, whether it’s of a valuable resource or purely data.
Blockchain applications can lend the power of the data structure’s verifiable history to any number of back office systems and records. The opaque systems that govern settlement and payments, and the challenges of reconciliation between multiple parties can be entirely replaced.
Broadly, the reasons these systems haven’t been updated in the past is one of consensus. Connecting systems from many independent banks to each other scales terribly – each new entrant must connect to each of the myriad existing entrants. Blockchains’ immutability allows the creation of a single shared ledger, for which each institution needs only make one connection to, a smart contract based core which sometimes replaces an old monolith like a traditional clearing house’s systems. Some of the most powerful short-term conceptual proofs being developed are around settlement and clearing, with companies like t0 and SETL offering solutions that would offer uncompromising transparency to audit and regulation.
While there’s still some standardisation yet to take place, institutions like R3’s finance blockchain consortium have demonstrated banks’ willingness to work together towards the common goal of benefiting from this disruptive technology. They have a significant stake in the Hyperledger blockchain protocol being developed by IBM, the Linux Foundation and Digital Asset Holdings amongst others. What’s clear is that participation will be the surest route to setting the agenda and staying at the forefront of blockchain technology’s impact.