Blockchain - A Beginner's Guide
Blockchain has been heralded as one of the most fundamental technological innovations ever, even more so than the creation of the internet. It represents revolutionary if not evolutionary opportunities in a multitude of industries to remove the need of a trusted middleman and applies authenticity through the distributed nature of the network supporting it. While the technology behind it may appear quite mysterious and difficult to comprehend, it is relevant and will affect the investment management industry on many levels and therefore needs to be understood.
The most common example of a blockchain that exists today is Bitcoin. This is a form of digital currency (or cryptocurrency) that is created and held electronically on a decentralised network. The primary difference to conventional money is that no single institution (bank, clearing house or central bank) controls it or its network. It is also transferable electronically, almost instantly and for very low transaction fees. Each transaction made is shared with everyone on the network and once validated, is stored on its public ledger/ blockchain. Its primary principles allow anyone access and with it being relatively anonymous and unregulated (no central overseeing authority), there have been examples of it being used for money laundering or other criminal activities. As a result, while some are keen to consider this fledgling technology, many in the financial world have dismissed it as a serious alternative to existing process solutions, resulting in a limited understanding of the underlying mechanics that support Bitcoin and the potential benefits this represents.
So what is a blockchain? At its most basic level, it is a list of transactions (financial or otherwise) that is replicated in real time across a number of computers as opposed to a central server - also known as a 'Distributed Ledger'.
In layman's terms, each computer or server within a blockchain system contains a regular database. Each will also have software that adds new rows to this database, validates that the new rows adhere to pre-agreed rules, and listens for and broadcasts new rows from or to its peers across the network, ensuring that all peers have the exact same data in their respective databases. The system will have protocols to ensure authenticity through the use of cryptography and digital signatures and will employ mechanisms to restrict the ability to change validated records and simplify traceability should any attempt be made to change such records.
In order to facilitate this transparency and validity, each block in a blockchain might contain one or many transactions and also data about the block itself (meta-data). Amongst other things, the block meta-data references the preceding block in the chain and also contains a digital 'fingerprint' of the data contained within the block - a reference which is compiled based on the contents of the block. The meta-data reference to the preceding block uses the preceding block's fingerprint which facilitates the validation of the data. Where fingerprints are consistent with the data and fingerprints join up in a chain, data integrity and immutability are assured. Where any historic record is changed, all fingerprints from that point forward will also require changing and the resulting blockchain will look different (this could be permissible should the blockchain's business rules allow it). A further security benefit of the distributed structure of blockchain is that each transaction is encrypted, whereas in a traditional database, once its security layer has been compromised, all data would be accessible.
So how could this be of benefit to the investment management industry and what can we expect to see in the near and longer term?
While the Bitcoin example is a public network with 'untrusted' parties where immutability is key, the same technology can be employed in a private trusted network of peers (e.g. across one or many institutions) where a central party (e.g. a department, regulator or industry body) can control logic and business rules, determine new entrants and control what each participant can see and do.
This technology therefore represents many opportunities within the investment management industry. A number of potential uses exist within organisations, across their service providers and also at an industry wide level. Due to the level of cooperation involved and conflicts of interest that will arise from instigating the latter, it is more likely that we will see individual organisations developing internal or service provider based applications using this technology in the short term. This will allow them to reap the benefits in these lower risk areas while becoming acquainted with the technology ahead of the anticipated larger scale applications impacting the whole sector. The more blockchain systems are implemented, assuming these are successful and therefore increase the level of confidence around the technology, the more this will lead to an assessment of where benefits can be further realised. Some examples that have currently been mooted or are even under development include; internal data management; KYC and AML verification; regulatory reporting; client portals for real time reporting; processing of corporate actions; cross-border payments; and real time settlement.
If you would like to discover more about blockchain and its potential impact on real time settlement, please kindly refer to our other article; Blockchain - Could Real Time Trade Settlement Become a Reality?