It’s small wonder then that the information technology researchers at Gartner placed blockchain, the enabling technology behind the digital currency Bitcoin, as nearing the “Peak of Inflated Expectations” on their 2016 Hype Cycle for Emerging Technologies curve slightly ahead of smart robots and just behind machine learning and autonomous vehicles.
In fact, blockchain may be one of the most hyped technologies that a surprising number of people have never heard of, and few understand. In a 2017 survey by Deloitte, nearly 40% of business executives said they had little or no knowledge of blockchain, while 25% regarded it as a top-five priority for 2017.
According to CB Insights, investors have poured more than $1.3 billion into Bitcoin and blockchain-based start-ups since 2012, highlighting the craze surrounding the technology. Last year, the top five largest Bitcoin and blockchain rounds accounted for $264 million in funding, representing over 60 percent of all funding to companies in the FinTech space including Digital Asset Holdings’ $67 million funding round, Circle Internet Financial’s $60 million Series C and Blockstream’s $55 million Series A.
Evangelists say that blockchain’s distributed electronic ledger could help Wall Street cut billions of dollars of costs related to post-trade settlement and reconciliation processes and cut processing time down to seconds, rather than days. They have also proposed that blockchain has the potential to transform the payments industry, remittances, trade finance, insurance, smart contracts, health care, land registry, music, and device security, to name a few.
However, today, though more than 100 top financial institutions and tech firms along with a growing number of companies from other industries are engaged in blockchain initiatives, Bitcoin, the stateless currency most often associated with the “dark web” and Ransomware payments since its launch in 2009, remains the only commercial application of the technology. But experts predict that the situation will change over the next three to five years as enterprises focus on adapting and applying blockchain’s unique properties to their business processes and many see 2017 as a turning point.
In this post, we present a basic overview of blockchain technology and its origins, identify some of the important industry consortiums and pilot projects that have been formed to move the technology forward, and discuss some of the financial use cases that represent “sweet spots” for the technology and are likely to hit the market first. And it won’t cost you a single Bitcoin!
What is Blockchain Technology?
At its basic level, a blockchain, sometimes called a distributed ledger, is a shared transaction database or ledger, typically running in the cloud, that has some unique properties. First, it’s shared, that is, all of the participants in the relevant network, be it consumers or a select group of companies, can access the ledger and propose transactions. Second, it’s distributed, i.e. all participants have a copy. Third, the copies are synchronized as information is added to the ledger according to specific protocols.
How Is Blockchain Secured?
Finally, the security of the database is protected by cryptography. Transactions are secured through a unique digital signature and then pooled into groups known as blocks and validated through a group consensus mechanism or algorithm. Participants are able to verify the identities of the parties in a transaction, using a public and private cryptographic key, and also the validity of the transaction, i.e. that the relevant party has the asset or value to transfer.
Once a block of transactions has been validated, it is timestamped and indelibly linked to the previous block, creating a “chain” of records in chronological order that cannot be altered, reordered or erased. If a participant tried to falsify a past transaction, it would break the chain, alerting others. The timestamp mechanism also helps prevent the “Double Spending” problem, where one party tries to transfer the same asset twice.
How Did Blockchain Originate?
Blockchain’s properties were not randomly chosen. The technology was invented to solve a specific problem. While the Internet enables individuals and organizations to share information, historically there was no way to digitally send and receive units of value, be it a digital currency or digital representation of some other asset, be it property or service, without a trusted third party such as a bank, financial institution or other intermediary to validate the transaction.
The solution couldn’t have emerged at a more auspicious time.
In the fall of 2008, as the world’s most trusted financial institutions teetered on the edge of collapse, Satoshi Nakamoto, the pseudonymous and so far unidentified inventor or collective, published his groundbreaking white paper, “Bitcoin: A Peer To Peer Electronic Cash System” in an obscure cryptography mailing list. The paper described how the digital currency could be exchanged anonymously without being diverted to the wrong account or spent twice by the same person using cryptographic methods. Most importantly, Bitcoin could accomplish this feat without recourse to trusted third parties, which stand behind conventional exchange systems.
The following January, the first underlying blockchain was established and Bitcoin 1.0, which included a generation system that would create a total of 21 million Bitcoins through the year 2040, was released.
A few days later, Nakamoto conducted the first Bitcoin transaction with developer and cryptographic activist, Hal Finney.
Today, Bitcoin owners can purchase everything from Microsoft apps, Dell computers, Overstock.com merchandise, satellite TV service, business gift cards, London theater tickets, jewelry, and sports tickets. Bitcoin is also the currency of choice for Ransomware hackers and for making illicit purchases on the dark web. However, the so-called cryptocurrency is still in the early stages. In January, the number of global Bitcoin transactions reached nearly 300,000 a day; by comparison, PayPal averaged about 16.8 million transactions a day in 2016.
However, it’s important to realize that Bitcoin is only one application or use case for blockchain technology, and arguably not the most important or lucrative. But before discussing potential use cases, it is useful to take a closer look at some of the industry consortiums and pilot projects that have been formed to move the technology forward.
Which Major Companies Are Engaged in Blockchain Initiatives?
Today, there are a number of high-profile industry consortiums that have been formed to help facilitate the development of blockchain technology and its application to a wide variety of industries and business processes. Some believe that 2017 could be the turning point to bring some of these alliance initiatives to fruition in the form of productized applications. Some of the key alliances are these:
- Founded in 2014, the R3 consortium represents of more than 75 of the world biggest financial institutions, including Bank of America, Credit Suisse, Deutsche Bank, JP Morgan, and others, and focuses on the application of blockchain to global financial markets through research, design and engineering. The consortium is led by R3CEV LLC, a distributed database technology company that has developed an open-source distributed ledger platform called Corda.
- Hosted by the Linux Foundation, the Hyperledger Project, which was launched in December 2015, is an open source collaborative effort of more than 100 tech and financial services companies including Accenture, American Express, Cisco Systems, Intel, IBM, Intuit, VMware and others, that was formed to create an enterprise-grade, open-source distributed ledger technology. Hyperledger members are committed to sharing best practices and providing assistance with use-case development, Proof-of-Concept (POC) testing, and adoption of Hyperledger. Currently they are focused on financial services and healthcare use cases.
- The Wall Street Blockchain Alliance is an alliance of financial professionals whose mission is to guide and promote comprehensive adoption of distributed ledger technology across financial markets. They do this by engaging with market participants, regulators, policymakers and technology innovators to guide the public dialogue about blockchain, distributed ledger and smart contract technology, so that the financial markets can realize the full potential of these capabilities. Key initiatives include hosting working groups such as the Blockchain Assets Working Group, educational events and blockchain technology certification for talent development and best practices.
- Founded by blockchain and cryptocurrency advocates, the Chamber of Digital Commerce and Coin Center, the Blockchain Alliance is a public-private forum created by prominent companies in the blockchain community to make the blockchain ecosystem more secure and to promote further development of the technology. Their mission is to provide a forum for open dialogue between industry, law enforcement and regulatory agencies, in order to help combat criminal activity on the blockchain.
- In January, Cisco Systems teamed up with BNY Mellon, Bosch, Foxconn Technology Group, Gemalto NV and several blockchain startups to form a consortium that plans to develop a shared blockchain protocol aimed at securing Internet of Things (IoT) products. The consortium grew out of a meeting “New Horizons: Blockchain x IoT Summit,” held in Berkeley in December, which represented the first collaborative effort addressing the application of blockchain to IoT. The meeting included presentations from blockchain and IoT-focused startups on their established use cases, industry findings, and identification of common needs.
How and When Will Blockchain Technologies Be Implemented?
Though much of the focus of blockchain technology has been in financial services, particularly with regard to settlements and payment processing, CB Insights identified 27 industries that could benefit from blockchain technology, including cybersecurity, networking and IoT, academic records, voting, car leasing, forecasting, ride sharing, real estate and insurance. But regardless of the sheer number of potential opportunities, individuals familiar with the technology say the first implementations will likely be made to improve existing processes, and the financial world will likely be the first market(s) where this occurs.
According to a 2015 Euro Banking Association report, Cryptotechnologies, a Major IT Innovation and Catalyst for Change, “the first wave [of innovation] will concentrate on deeper automation of existing processes. The second will arise from new innovations based on the application of the exclusive features of crypto-technologies.” Said another way, blockchain technology will likely impact financial services first by making existing processes more efficient, secure, transparent, and less costly, and later help create entirely new applications and products.
However, as participants have pointed out, there still remain a number of technical, business and regulatory challenges that must be addressed in order to adapt the technology for use with current business processes.
How Will Blockchain Impact Settlements?
As discussed above, securities trading has been identified as one of the “sweet spots” for blockchain or distributed ledger technology that could bring massive savings to financial institutions. Analysts have estimated that the total cost to the finance industry of clearing, settling and managing the post-trade environment to be between US$65 billion and $80 billion per year. The back office elements of much current post-trade activity are based on archaic and complex processes, many still lacking automation.
Last year, Digital Asset Holdings, whose investors include Accenture, Broadridge, BNP Paribas, Citi, Goldman Sachs, IBM and JP Morgan and others was awarded a contract to replace the Australian Stock Exchange’s (ASX), clearing and settlement systems with its blockchain-based software. Digital’s platform enables traders to use blockchain technology without giving out confidential information on their trades. Confidentiality is one of the issues holding back adoption of the nascent technology in financial markets.
In blockchain’s original Bitcoin implementation, all participants in the network potentially have access to the details of every transaction. While this would ensure the integrity of records held by different firms, it also makes it inadequate for use in certain securities markets where participants would be at a disadvantage if they disclosed their positions. Digital’s platform solves this privacy issue by dividing the blockchain ledger of transactions into two components: one where participants can confidentially store their transactions data, and another that is shared by all participants without the confidential data, according to reports.
However, a recent report said that ASX, which is also a Digital investor, was getting pushback about replacing its existing Clearing House Electronic Subregister System [CHESS], with blockchain. The concern is ASX’s ability to maintain its profit margins during the experimentation process and possible switchover of its financial market software. ASX is currently the world’s most profitable major stock exchange despite its traditional and largely manual CHESS-based clearing system. Reportedly, its chief executive is under pressure from the company’s shareholders to maintain the high profit margins and dividend payout ratio that makes ASX appealing to retail investors, particularly as the company has been granted an 18 month extension of its monopoly on clearing and settlement.
Digital is also working with the Depository Trust & Clearing Corporation (DTCC), which oversees the clearing and settlement of upwards of $1.4 quadrillion in US securities to test a distributed ledger solution for managing repurchase (repo) agreements.
What about Payments Applications?
The payments industry is another application that has been identified as a “sweet spot” for blockchain technology and a number of trials and pilot projects have been conducted or are currently underway. For the most part, today’s payment systems are centralized, i.e. money transfers are cleared through the central bank. When banks and financial services firms do business with each other, the work of synchronizing their internal ledgers can take several days, which ties up capital and increases risk.
Distributed blockchain ledgers that settle transactions in minutes or seconds could go a long way to solving such problems. Experts say they could also save banks money. According to one estimate, blockchain ledgers could cut the industry’s bills by up to $20 billion a year. Not surprising, a number of big banks and financial services companies are involved in pilot projects.
Early last year, the R3 consortium conducted a test of a private blockchain among 11 banks including Barclays, UBS and HSBC, using the open-source blockchain technology from Ethereum, the brainchild of 21-year old Canadian programming prodigy Vitalik Buterin. Ethereum ‘s platform can handle more sophisticated data than Bitcoin, reportedly enabling users to create and execute smart contracts.
In the test, which ran over a virtual private network in Microsoft’s Azure cloud, banks operating over four continents were able to settle the transactions almost instantaneously compared to settlement times of days or even weeks, depending on the asset class, with the current systems used by banks. R3 said the technology could be used by banks to transfer real assets within the next one or two years.
In October, the consortium announced that it was conducting another trial looking at alternative traditional interbank global payments, using the blockchain platform developed by a company called Ripple along with its associated digital currency XRP. Ripple is one of the first blockchain start-ups focused on settlement mechanisms and has partnered with UBS, Santander, and Standard Chartered.
Reportedly, 12 banks participated in the trial including Barclays, BMO Financial Group, Bank of Montreal, CIBC, Royal Bank of Canada (RBC) and Westpac Institutional Bank. The purpose was to explore how the use of a digital currency could potentially reduce the cost of traditional cross-border payments practices.
Banks usually keep foreign currency reserves in what are called “nostro accounts” in order to be ready to fulfill a cross-border payment. According to the R3, this practice essentially forces banks to trap capital. The digital currency XRP, which offers settlement speeds as fast as five seconds, (Bitcoin can take up to 10 minutes) offers banks an alternative.
The trial, which was successful, demonstrated that banks could make markets for fiat currencies using XRP and the Ripple network complete authenticated payments without multiple nostro accounts, enabling them to cut costs and develop additional revenue opportunities.
Also in October, Visa announced a new partnership with blockchain software provider Chain to develop “a simple, fast and secure way to process B2B payments globally.” The new service, which is expected to be rolled out in 2017, will enable banks and other financial institutions to make near real-time payments and settle funds across borders using Chain’s scalable blockchain infrastructure called Chain Core. In doing so, it offers clear cost benefits, improved delivery time and visibility into the transaction process, ultimately reducing the investment and resources required by banks and their corporate clients to send and receive business payments.
Capitalizing on some of the key features of blockchain technology, Visa emphasized that the new service would be:
- Predictable and transparent: Banks and their corporate clients will receive near real-time notification and finality of payment
- Secure: Signed and cryptographically linked transactions are designed to ensure an immutable system of record
- Trusted: All parties in the network are known participants on a permissioned private blockchain architecture that is operated by Visa
“The time has never been better for the global business community to take advantage of new payment technologies and improve some of the most fundamental processes needed to run their businesses,” explained Jim McCarthy, Visa’s executive vice president for innovation and strategic partnerships.
If services such as these catch on, it will likely only be a matter of time before blockchain-based payment systems eventually compete with traditional inter-bank transfer mechanisms such as the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network, which connects 11,000 financial institutions in more than 200 countries and territories, and exchanges an average of over 15 million payment messages per day.
However, blockchain proponents say that the technology is not yet ready to handle financial transactions at scale. The international payments firm currently enables more than 1,000 of the largest financial institutions and intermediaries as well as thousands of global merchants to transact trillions each day in payments and securities. and it’s now exploring the use of blockchain technology as a means of delivery.
Large global banks have done tests and POCs, but they haven’t gone further yet. It’s a waiting pattern, a holding pattern for the maturity of the technology to catch up. In addition to being too slow, the calculations inherent in blockchain’s consensus algorithms are too CPU-intensive. The algorithms need to be more efficient.