Blockchain, the Technology that is Revolutionizing Finance

At a recent roundtable in Geneva, Patrick Maes of Credit Suisse considered that Blockchain could be the most significant innovation in banking since the beginning of money.

Chances are that if you have heard about Blockchain that you have heard it in relation to Bitcoin. Whilst Blockchain is the technology behind Bitcoin, it has uses that go much further than Bitcoin and other cryptocurrencies. In the last few years these uses of Blockchain have been evolving and have been making news.

What is Blockchain?

A transfer of value needs to involve the gain of value by one party and a corresponding loss of value by the other party. In the physical world, this transfer of value is straight-forward as a physical item is handed from the seller to the purchaser. In the virtual world, this is more complicated as a perfect copy of an item may be transferred and so there is no loss in value to the seller.

Blockchain is a method of authenticating this transfer of value in the virtual world.

Blockchain involves the following elements:

A digital ledger that keeps a record of all transactions taking place on a peer-to-peer network.
All information transferred via Blockchain is encrypted and every occurrence recorded, meaning it cannot be altered.
It is decentralized, so there’s no need for any central, certifying authority.
It can be used for much more than the transfer of currency; contracts, records and other kinds of data can be shared.
Encrypted information can be shared across multiple providers without risk of a privacy breach.
How is Blockchain Evolving?

Blockchain was introduced in Satoshi Nakamoto’s 2008 research paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System”.

A second-generation Blockchain system called ethereum introduced the idea of “smart contracts.” These are little computer programs built directly into Blockchain that allows financial instruments, like loans or bonds, to be represented. The ethereum smart contract platform has hundreds of projects being developed.

The original Blockchain is secured by “proof of work”, in which the group with the largest total computing power makes the decisions. These groups are called “miners” and operate huge data centres to provide this security in exchange for crypto-currency payments. These data centres consume large amounts of energy and so are located in countries like Iceland or China to take advantage of cheaper energy. The new “proof of stake” systems replace these data centres with complex financial instruments to provide the security.

Currently in Blockchain, every computer in the network processes every transaction which is slow. Blockchain scaling would accelerate the process by figuring out how many computers are necessary to validate each transaction and dividing up the work efficiently. To manage this without compromising security and robustness is a challenge.

Blockchain continues to evolve. We are moving from proof of concept to real applications that will revolutionize finance. Our next article will look at some of the implications for finance.

What are the main possible uses of Blockchain in Finance?

According to the World Economic Forum, 80% of financial institutions in the world are doing Blockchain research at the moment.

In their book “Blockchain Revolution: How the technology behind bitcoin is changing money, business and the world”, Don Tapscott and Alex Tapscott identify eight core functions of financial services ripe for disruption.

Authenticating Identity and Value – Today powerful intermediaries establish trust and verify identity in a financial transaction. Blockchain lowers and sometimes eliminates trust altogether in certain transactions. It also enables peers to establish identity that is verifiable, robust, and cryptographically secure and to establish trust when trust is needed.

Moving Value – The financial system moves money around the world daily. Blockchain can become the common standard for the movement of anything of value – currencies, stocks, bonds, and titles. Blockchain can do for the movement of value what the standard shipping container did for the movement of goods: dramatically lower costs, improve speed, reduce friction, and boost economic growth and prosperity.

Storing Value – With Blockchain, individuals need not rely on banks as the primary stores of value and institutions will have a more efficient mechanism to buy and hold risk-free financial assets.

Lending Value – Ancillary to the lending business are institutions that perform credit checks, credit scores and credit ratings. On the Blockchain, anyone will be able to issue, trade and settle traditional debt instruments directly, thereby reducing friction and risk by increasing speed and transparency. This facilitates peer-to-peer lending.

Exchanging Value – Blockchain cuts settlement times on all transactions from days and weeks to minutes and seconds. This speed and efficiency creates opportunities for a more widespread participation in wealth creation.

Funding and Investing – Raising money normally requires intermediaries such as investment bankers, venture capitalists and lawyers. The Blockchain automates many of these functions and enables new models for peer-to-peer financing.

Ensuring Value and Managing Risk – Risk management, of which insurance is a subset, is intended to protect parties from uncertain loss or catastrophe. Blockchain supports decentralised models for insurance, making the use of derivatives for risk management far more transparent. Using reputational systems based on a person’s social and economic capital, their actions, and other reputational attributes, insurers will have a much clearer picture of the actuarial risk and can make more informed decisions.

Accounting for Value – Accounting is the measurement, processing, and communication of financial information about economic entities. New accounting methods using Blockchain’s distributed ledger will make audit and financial reporting transparent and occur in real time.

Blockchain and Trade Finance

Geneva, Switzerland is a major centre for commodity trading. How will Blockchain impact this industry?

Today, trade finance is paper-based and non-standardized. It is estimated that the cost of postage alone to the industry is $40 billion per year. To this cost you must add the cost of manually processing this paper in banks and corporations. Blockchain technologies can digitize this paper. Trade finance involves many counter-parties: governments, laws, ports, and banks. There is no logical point to centralize around. Blockchain technology lends itself to being a network without an obvious central point.

Bringing down transaction time – a test case

Mercuria, a global commodity trading group, together with ING and Societe Generale banks, tested oil trading through Blockchain technology earlier this year. The experiment involved an oil cargo shipment containing African crude which was sold three times on its way to China, and included traders, banks as well as an agent and an inspector, all performing their role in the transaction directly on the platform. The results of the experiment demonstrated that the platform can greatly improve the efficiency of certain processes, bringing the average total time for a bank to complete their role in the transaction down from approximately three hours to 25 minutes.

Blockchain technology is set to revolutionize trade finance. However, the challenge is to move from a successful experiment to a worldwide standard. One of the major challenges was that current ERP systems were not compatible with Blockchain technology. SAP has recently announced a Blockchain service in the cloud.

What are the implications for the Finance Function?

My first role after qualifying as a Chartered Accountant included manually keying in numbers received by fax into a management accounting system. This was both time-consuming and involved great concentration as the poor quality of the fax meant that certain numbers were difficult to differentiate from one another. Technologies have evolved to eliminate such non-value added work.

Blockchain technologies will similarly eliminate unnecessary work.

Information about the transaction is captured at source and so does not need to be re-input into other systems.
Validation of a step in the process is done automatically by the technology and does not require paperwork.
Two companies transacting with each other currently hold two sets of books that summarize these transactions. Finance teams of one company will reconcile trade creditors to their counterparties trade debtors. As the Blockchain holds the information in one ledger there is no need for reconciliation.
This means that finance teams will have more time for analysis and providing support to the business. Increasingly this analysis will involve sources of information not previously available and will be more sophisticated than those in the past. So-called soft-skills will become more important to the finance team as they seek to influence decision-makers in the business. This of course is the subject of a future article.

Along with many in the industry, I am very excited about Blockchain and other technologies as they will revolutionize the finance industry and the finance function for the better.

Mark Kissack, Senior Consultant