Nov 2015 – Blockchain your way into Financial Services
In the last few months, there has been a tremendous rise of interest in the Blockchain technology from the Financial Services industry. Banks, Payments giants, Insurance providers, Exchange platforms as well as Fintech startups are working on various forms of distributed ledger systems, exploring several uses such as smart contracts for the transfer of ownership of assets, global remittances services and many more. Major financial groups have already started testing the waters of how to best leverage Blockchain for their development… or is it survival?
What is “The” Blockchain? Blockchain is essentially a distributed ledger registered in a network of computers (“nodes”) that verify, broadcast and record transactions (data) in “blocks” (group of transactions, records of the data), which are then linked to a sequential chain of blocks. The different nodes “agree” on the content of each block, according to a pre-set set of rules (“consensus protocol”).
“The” original Blockchain is used to record transactions in the digital currency bitcoin (BTC): Blockchain network nodes validate bitcoin transactions, add them to their copy of the ledger, and then broadcast these ledger additions to other nodes. The trust among the network is ensured through a proof-of work scheme: in order to be accepted by the network nodes, each block includes a cryptographic signature (hash) that is very costly and time-consuming to compute (the “mining” process) but easy to check by the participants. Each block’s signature includes the signature of the previous block, chaining the blocks together. The difficulty of the mining combined with the chaining of the blocks make any attempt to rewrite or alter the transactions history practically impossible.
It is based in a peer-to-peer decentralized architecture: all network nodes share a copy of the ledger, the system works without a middleman or central repository. It is more effective than the exchange networks in the current financial system where you need a trusted third-party to centralize and clear transactions between participants. It adds trust among the participants by avoiding manipulations by a dominant party in the network.
It is a public / permissionless ledger: it contains the open list of all past transactions, and everyone can read, send transactions and participate in the mining process. Each participant in the system uses a string (the hash of his public key) as his identity. When bitcoins change hands, they are moved from one such identity to another. Anyone can verify the identities involved, because the blocks have their signature on it, but only the actual owners can unlock what’s inside the container using their private keys.
The Blockchain is pseudonymous: there is no clear mapping between your real-life identity and your identity in the Blockchain system, but there are some methods to unmask pseudonyms and map them to real identities based on their being persistent across uses. In addition to it, bitcoin trading platforms require a real identity in order to buy and sell bitcoins using fiat money.
The transaction processing time corresponds to the time needed to generate a block: by design it is set to be around 10 minutes. This limit was defined as a good consensus to account for slow connections in the network and avoid forks. This processing time is much more efficient than the current delay for the settlement of securities (3 days for US equity markets!) or transfer of money across the globe.
Blockchain/Bitcoin main limitations:
Scalability: Blockchain is by design very energy intensive. As the ledger will become bigger and bigger the network will require more and more power to verify the transactions. Also the block size has been set to 1MB to reduce the threat of spam and potential denial-of-service attacks on the network. However as the number of transactions increase, bitcoin’s blocks are filling up towards this 1MB limit, resulting in more transactions being delayed awaiting inclusion in future blocks. The Bitcoin community has not reach a consensus on when and how to increase the block size.
Governance: Blockchain is an open source system independent of any particular corporation or government. In theory, it is the community of users and core developers of the Blockchain who control the software. But in reality it is the mining power which is driving the adoption of new versions of the software. The concentration of miners and the structure of incentives around mining (which is a costly process) could be a matter of concern in the future.
Beyond Blockchain, the Financial use cases for distributed ledgers
To overcome Blockchain limitations and expand its use beyond the exchange of bitcoin currency, various system alternatives are being explored, from applications built on top of the Blockchain to new distributed infrastructures inspired by the Blockchain protocol.
We present below what we think are the four most promising use-cases for distributed ledgers for financial services, as well as the Fintech involved:
1) The transfer of ownership of any digital token of value, assets and securities. This is the most obvious use case as the bitcoin does not carry any intrinsic value, but rather a specific set of properties that give this digital asset its value. Exchanging bitcoins can be seen as the transfer of ownership of a set of properties.
Nasdaq Linq is a ledger technology that leverages Blockchain to issue and record the transfers of shares of privately-held companies on The NASDAQ Private Market. It is built in collaboration with Chain.com. Chain framework allows enterprises to build their own private Blockchain network. This startup has been funded by Visa, Nasdaq, Fiserv, Citi and Capital One.
Hyperledger has just won the Innotribe Startup Challenge at Sibos conference. It is developing a distributed ledger platform aiming “to move value across the world as quickly and easily as sending an email”.
Other recent examples: Blockstream launched the “Sidechains”, Coinprism unveiled “Openchain” and ItBit is developing a “Bankchain”.
2) “Smart contracts” are programs that automatically execute the terms of a contract. They can have many applications in finance from syndicated lending to trade finance
Ethereum is a programming framework using its own token “Ether” allowing a network of peers to manage their own smart contracts in the absence of a central authority. Microsoft has partnered with Consensys and Ethereum to provide development tools for Microsoft’s enterprise customers.
Symbiont is an issuance and trading platform for “smart securities”, which are smart contracts modeling the complexity of financial instruments.
More examples: Eris software, Digital Asset Holdings (offers a system to settle corporate syndicated loans) and Blockstack (recently acquired by Digital Asset Holdings).
3) Cross-border payments, especially correspondent banking, business-to-business payments and remittances
Ripple is an open source protocol allowing for payments, exchanges and remittances. It supports any kind of token (including fiat currency or any unit of value). Santander is one of Ripple’s investor. Fidor Bank, CBW Bank, WestPac, ANZ Bank, Rabobank and Cross River bank are reported to implement or experiment with Ripple’s solution.
Setl is an institutional payment and settlement infrastructure based on Blockchain technology. It is reported to have broken the 1 billion transactions-per-day capacity barrier last October.
More examples: Align Commerce and Abra (American Express is an investor in Abra).
4) Trusted registries of identity and ‘know your customer’ data about individuals or companies; compliance and risk management solutions
Tradle is looking to secure KYC requirements using Blockchain technology coupled with a simple smartphone interface that can send electronic documentation to banks instead of relying on paper-based communication.
Chainalysis offers due diligence and transaction-based risk scoring for financial institutions. It has recently partnered with Barclays.
More examples: Credits (KYC on the Isle of Man) and Deutsche Bank (reported to investigate KYC and AML registries).
How Financial Institutions are reacting
Almost all major Financial Institutions have shown interest in the distributed ledgers technology, with different approaches:
Investing in specialists (Goldman Sachs in Circle Internet Financial, Santander Inno Ventures, BBVA Ventures …);
Working with blockchain start-ups through an accelerator program (UBS, Barclays, …);
Partnering with a provider (WestPac and Fidor Bank with Ripple, …).
At the same time, a consortium of 25 large banks has joined the distributed ledger startup R3CEV to work collaboratively on research and experimentation, and potentially establish a set of standards.
The common point between all these initiatives and experimentations? Financial Institutions almost exclusively focus on permissioned / private ledgers: distributed networks in which only selected nodes are allowed to participate (the Financial Institutions themselves), obeying a defined consensus protocol. These permissioned ledgers are suitable for the exchange of tokens of value within a network in which all participants are known and have contractual obligations with each other. These networks don’t offer the same level of openness and decentralization as the Blockchain, but have also a number of advantages:
The validators are known
Transactions offer a higher level of privacy
Transactions are cheaper and faster (given the limited number of well-connected nodes)
Distributed ledgers are setting the stage for smart contract execution, real-time settlements and international money transfers. When a viable solution will become available and get the approval from regulators, it will have a significant impact in the Financial Services value chain, starting with collateral management, custodian services and central counterparty clearing. In the long term it may go way beyond and redefine our relationship with the concepts of identity and ownership.
Today the technology is being experimented by major financial institutions, and consortiums are emerging hoping to control the future standards. Indeed it is absolutely key for Financial Institutions to stay alert and anticipate this wave of innovation.
What are your views about the future of Blockchain technology? Email us, we would be happy to have your insight.
The CH&Co. Editorial team
The Latest on Fintech Startups
R3, a start-up with a focus on distributed ledger-based systems, is now being backed by 25 of the world’s largest global banks.
Ripple, recently released the Inter Ledger Protocol (ILP) that provides a top-layer cryptographic system allowing funds to move between ledgers. Full article here
Visa launches a new proof-of-concept to facilitate car leasing: users can now rent a car, buy auto insurance, and pay parking and tolls using the Blockchain technology. See demo video here
Blockchain has the potential to be the next big thing like Google, Amazon, Facebook and Uber, according to Union Square Ventures (USV)’s founder Fred Wilson. Read his blogpost here
Eric Van Der Kleij, who was leading Canary Wharf’s Level39, Europe’s largest tech accelerator space, leaves to work on innovation company Entiq, focusing on Blockchain. Full articlehere
Chris Gledhill, an ex-innovation technologist at Lloyds, launched Secco Bank, based on ‘blocktree’ technology. Press release here
London-based Blockchain start-up Setl broke through the 1 billion transactions per day barrier. Full article here
Highlights of the Month
Blockchain Alliance, a new public-private forum between law enforcement & bitcoin firms, has been formed. Members include US Justice Department, FBI, Secret Service and CFTC, and firms such as Bitpay, Circle, Coinbase and Xapo. Full article here
Harriet Baldwin MP, economic secretary to the UK government’s economic and finance ministry, speaks about the benefits of digital currencies and Blockchain technology. Full article here
In a landmark ruling, the European Court of Justice exempted bitcoin transactions from VAT, recognizing Bitcoin de facto as a legal medium of exchange. Full article here
Russian Ministry of Finance aims to punish Blockchain users with a fine of 500,000 rubles or a 2-year community service, and a prison sentence up to 4-year. Full article here
Santander’s innovation arm, InnoVentures, pumped in $4m in Ripple’s Series A funding, bringing the technology provider’s total funding round to $32m. Press release here
Rabobank is embracing the challenge presented by Blockchain technology: it launched a type of “WhatsApp” for group payments, an application that support coins, loyalty cards and coupons as well. More details here
Ratan Tata and American Express recently made strategic investments in US-based cryptocurrency startup Abra. Abra uses bitcoins to power its money remittance system. Read article here
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Chappuis Halder & Co. is a consulting firm specialized in Financial Services with offices in North America, Europe and Asia. We help our clients in several industries: Corporate & Investment Banking, Commodity Trading, Insurance and Retail & Private Banking, with a permanent focus on expertise and research, especially in the Digital area.
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