This article first appeared in Russell Investments' Communiqué. It is reposted here with permission.
By Ronal Prasad*
The difference can be explained using an analogy – blockchain is to Bitcoin what a combustion engine is to a car. While the combustion engine became mainstream through its use in cars, the technology also transformed other industries such as manufacturing and agriculture.
Similarly, blockchain is what’s under the hood of Bitcoin – it gives Bitcoin the power to facilitate secure financial transactions. Much like the combustion engine, blockchain is not limited to digital currencies and can be applied to a wide range of services such as supply chain management, legal contracts and rights to property.
In this article, we first explain conceptually how blockchain works using a payments system example. The second part of the article focuses on how blockchain is currently being pursued in one aspect of financial services - securities trading.
Traditional payments system - centralised
In a traditional payments system, if John wants to transfer funds to Mary, the transaction would typically go through a financial intermediary – in most cases a bank.
Figure 1 – Traditional payments system
Figure 1 illustrates the flow of information in a traditional payments system. Firstly, John notifies the bank to transfer funds to Mary. Next, the bank checks if John has enough money for the transfer. The bank can verify the balance because it stores all of John’s transaction records (i.e., the ledger). Once the balance is confirmed, the bank transfers funds to Mary. The settlement date of the transaction varies, with some international transfers taking a couple of days to complete. The bank is incentivised to facilitate the transaction because it earns a fee for intermediation. As depicted in figure 1, the bank holds the ledger, the bank verifies ownership of funds and executes all transactions. This is a centralised payments system.
How blockchain is used in payments - decentralised
In contrast, a blockchain payments system transfer funds without the reliance on a financial intermediary. Furthermore, blockchain settles transactions faster and more cheaply than the traditional system. Blockchain technology is based on the concept of a decentralised distributed ledger, which is available to each participant in the network. To understand how blockchain works conceptually, let’s assume there are four participants in a public network transacting amongst themselves.1
Figure 2 illustrates how transactions are stored and appended in the blockchain ledger. At the inception of the network, block #1 shows that John has $100. Each subsequent block lists the transactions made in the network. For example, block #2 shows that John transferred $50 to Mary and $10 to Lucy. Block #3 records further transactions. As shown in Figure 2, each list of transactions is linked to previous transactions all the way back to the first transaction.
Note that the storage of data in the blockchain is not limited to financial transactions and can also include changes in ownership of assets such as shares of a company or property.
Figure 2 – Blockchain ledger
In contrast to the traditional payments system where the bank is the only one holding the ledger, the blockchain ledger is distributed to all participants in the network. Everyone can see the history of transactions and, more importantly, anyone can decide whether a transaction is valid.
Figure 3 – Decentralised distributed ledger
For example, let’s say Mary wants to transfer $30 to Tom. First, Mary broadcasts the transaction to the network. As in the banking system, it must be proved that Mary has $30 to spend. Since all other participants have a copy of the ledger (Figure 3), they can calculate Mary’s balance. From the open ledger (Figure 2), everyone knows that Mary has $30 ($50-$20) to spend.
The participant verifying the transaction broadcasts Mary’s balance to the rest the network. If most of the participants in the network agree that the transaction is valid — that is, Mary’s balance matches their copy of the blockchain’s history — then the new transaction will be approved, and a new block created and linked to all previous transactions.
In blockchain, as in traditional systems, participants are incentivised to verify transactions because they earn a fee for the service.
The ledger is synchronised across the network every time a new transaction is validated. The ability to prove ownership of an asset – in this case money – is one of blockchain’s core capabilities. Furthermore, in the example, the fact that a participant is transacting with the entire network and not just through one financial intermediary significantly reduces the risk of counterparty default.
So how does blockchain ensure that no participant in the network can manipulate the data to his or her benefit?
To secure the system, blockchain uses a mathematical function to ensure any manipulated data is not accepted by the network. The function essentially generates a block ID that is unique to all the data in that block.
It is worth emphasising “all” because even a single change in data in the block, even adding a punctuation mark, will generate an entirely different ID. For example, if Tom alters his copy of the ledger, his block IDs will not match the rest of the network invalidating his subsequent transactions. The unique block IDs and chaining of blocks (Figure 2) ensures any altering of data by one participant is noticeable to the rest of the network. You can think of blockchain as an append-only system, where there is a single source of truth and proof of ownership can always be traced back to its inception.
Application of the blockchain in securities trading
Blockchain’s ability to prove ownership of an asset through its immutable distributed ledgers has many uses in financial services. For example, the financial crisis revealed that it is not always possible to identify the correct present owner of a security.
Furthermore, securities trading often requires the use of brokers, exchanges, clearing houses and custodians. In the current system, trades are often verified by a central clearing house that maintains its own central ledger. The involvement of so many intermediaries creates a drag on efficiency and increases the cost of facilitating transactions. Today, it may take up to two days to transfer the ownership of an asset.
Blockchain has the potential to streamline this process by tracking ownership of securities and distributing the ledger to many users in the network – as it was in the payments system example.
While the payments system example was in a public network, banks and market operators can build private networks where each user in the network has varying degrees of autonomy when it comes to updating and maintaining the ledger.
Many of the world’s exchanges are already exploring blockchain solutions to make the trade settlement process efficient by reducing the replication and verification of information by multiple parties, hence reducing settlement time. Table 1 describes the blockchain developments currently being pursued by different organisations (including disruptors) in securities trading.
Table 1 – Securities trading and settlement2
Potential implications for investors
Even though it’s in its early stages, blockchain has the potential to reduce costs and improve the efficiency of trade settlements.
The ability to settle trades intra-day would allow investors to manage transition exposures in their portfolios better and at a lower cost than previously.
Furthermore, blockchain developments in the private securities market reduce costs and improves the ability to buy and sell private securities. With more and more companies remaining private, the enhancement in liquidity broadens the universe of securities available to investors.
While blockchain is promising, the technology does have a few hurdles to overcome including network adoption, cybersecurity and legal and regulatory compliance. Notwithstanding these hurdles, blockchain is leading a revolution that will change not just the financial services industry, but the way we do business.
References:
ASX. (2016). ASX’s Replacement of CHESS for Equity Post-Trade Services: Business Requirements. ASX. Retrieved from: http://www.asx.com.au/documents/public-consultations/ASX-Consultation-Paper-CHESS-Replacement-19-September-2016.pdf
Irrera, A., Kelly, J. (2017). London Stock Exchange Group tests blockchain for private company shares. Reuters. Retrieved from: https://www.reuters.com/article/us-lse-blockchain-idUSKBN1A40ME
Nofer, M., Gomber, P., Hinz, 0., Schiereck, D. (2017). Blockchain. Bus Inf Syst Eng 59(3):183–187.
Norton, S. (2016). CIO Explainer: What Is Blockchain? WSJ. Retrieved from: https://blogs.wsj.com/cio/2016/02/02/cio-explainer-what-is-blockchain/
Olsen, T., Ford, F., Ott J., Zeng, J. (2017). Blockchain in Financial Markets: How to Gain an Edge. Bain & Company.
Notes:
1. Note that the example overlooks some details of the blockchain technology such as anonymity and accessibility and the focus of the example is on the underlying framework of blockchain.
2. Other exchanges pursuing blockchain solutions include: Japan Exchange Group, Korea Exchange, National Stock Exchange (India), Moscow Exchange, Santiago Exchange and Luxembourg Stock Exchange.
Ronal Prasad is an investment analyst at Russell Investments in Auckland. This article first appeared in Russell Investments' Communiqué. It is reposted here with permission.
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