Blockchain and digital disruption in the financial world

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Based on a conference by the Solvay Digital Society: “Technology Meets Finance”, in Brussels.

Trading in 1929 was quite different from what it is today. The Internet had not been invented yet, neither had been the modern definition of computers. At the time, Alan Turing was only 17 and Steve Jobs was not even born. Yet, investing in the stock market was already popular. Indeed, the “Roaring Twenties” were a period of astonishing growth in the United States from which everybody wanted to profit. However, people had to run to their broker and sometimes wait in line to make a trade. Decisions to sell or buy shares were made hours after events happened, when the paperboy brought in the printed issue of the investors’ favourite paper. Stock quotes were sent through ticker tapes over telegraph lines and printed on meters long pieces of paper.

Since then, technology revolutionized the financial world, disrupted the banking sector and  transformed the way businesses sell goods and services. The latest craze is all about the Blockchain, a technology on which Bitcoin is based.  Some aficionados claim that the Blockchain is the biggest invention since the Internet.

What is the Blockchain and how does it work ?

Blockchain simply is what its name stands for: a chain of blocks. Each block stores information and everyone has access to it. Indeed, the Blockchain is available to everyone and each individual using it has a copy of the chain on their computer. It is commonly called a distributed ledger, a replicated digital copy of all the data ever imbedded in the system, synchronized continually on all the computers using this technology worldwide. Since all the participants in a blockchain have access to the same information all the time, no central trusted party is therefore needed to store the data. This is why we call this technology decentralised. Blockchain is a new powerful accounting tool that replaces lists, registers and databases in a more efficient way.

Jean-Luc Verhelst, blockchain consultant for Monitor Deloitte Belgium, describes the blockchain as a complex database distributed on a network, in which every computer on the network receives an exact replica of the chain. The strength of this system is that the blockchain cannot be modified because a modified copy would be immediately different from the others. Each time the blockchain receives a new block, a checking process is performed through the network to ensure the validity of the newly created chain. Each computer screens all the other copies of the blockchain and the law of large numbers makes them almost all identical. If a copy is not the exact replica of the widely adopted chain, it is rejected by the system.  All the data stored in the blocks is therefore impossible to remove, giving that each “user” has the complete history of all information ever embedded in the system.

Furthermore, the blocks are linked together in a sequential order: When two blocks are simultaneously added at the end of the chain, algorithms decide which one gets added first. The chain therefore remains a continuous line and each copy of the blockchain is synchronised so that everyone has the same version at any time. To avoid tampering, each block receives a hash pointer, a cryptographic key, that leads to the next block and lets the network verify that/if the sequence is correct.

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Jean-Luc Verhelst defines three distinct kinds of blockchains:

  • Public Blockchains let everyone access them without any permission granted. For instance, cryptocurrencies use public blockchains.
  • Permission Blockchains require a permission, a link or a private network to access them. For example, some major companies use internal blockchains to deal with their domestic activities.
  • Private Blockchains are privately owned blockchains which let the owner control everything.

What is the blockchain for?

One of the most famous use of the blockchain is through cryptocurrencies such as Bitcoin, Bitcoin Cash, Ethereum, Ripple and many more. Nonetheless, the blockchain has other purposes as well. Indeed, as an intangible way of storing information, blockchain technology can be applied to any sector and banks as well as corporations are already using it.

IntellectEU, a Belgian firm represented by Dirk Avau, works with IBM, JPMorgan and other big companies on a “Hyperledger” that Mr Avau describes as a suite of technologies on the blockchain. They aim at integrating the blockchain into already existing banking systems. In finance, there are many standards and protocols that govern how banks manage the flow of transactions. “IntellectEU looks at all the banks’ protocols around the globe to make transactions work end-to-end”, said D. Avau. By partnering with SWIFT, which manages the SWIFT network used to convey the financial messages necessary to make transactions between different banks, IntellectEU developed cutting-edge technology to ease the execution of international payments. Considering that the issue of privacy is crucial in the financial world, all the information can be encrypted cryptographically on the blockchain.

From the perspective of big banks and corporations, this technology is quite disruptive and requires a transitional period. Nonetheless, many businesses are already connected through private networks and a permission blockchain could be a solution to speed up their communication and prevent errors. The advantages of a permission blockchain are that the organisation can decide who can access the ledger, that they can hide some information and keep an identity management system with, for example, an electronic ID, face recognition or biometrics authentication.

Smart contracts – digital contracts with lines of codes implemented in a block and executed when fulfilled – are another possible application of the blockchain technology. Because the information entered in the blockchain cannot be modified or deleted and is accessible to anyone, it is almost impossible to bail out from a smart contract. Indeed, the computer checks the code and automates the contract. If the contract involves a transfer of value, the computer could, for instance, operate the wiring of money to another account itself. No paperwork is therefore needed, and smart contracts can be applied to virtually everything. For instance, platforms such as Airbnb could use them for smart keys and locks. The customer would book a rental, pay and receive a unique code to open the door. Then, the smart lock would know it is the correct person with the correct code and would open. Another example to be considered is the rise of AI in driverless cars. When taking a driverless taxi, smart contracts could allow the car to have its own bank account and charge the customer itself. Even though those smart contracts could make our lives easier, Jean-Luc Verhelst warns that any small mistake in a contract’s code would have tough consequences. It is indeed very difficult to modify anything that has been put on the blockchain. Therefore, in case of imprecisions or errors, both parties of the contract could find themselves in problematic positions.

Dirk Avau expands the usability of the blockchain technology to many other sectors: he believes that any firm managing a supply chain could benefit from it, with each product receiving an ID and therefore being easily traceable. In aeronautics, if a defective piece is found, all the planes that received that specific piece could be grounded for check up in a matter of minutes. It would indeed be easy to determine which pieces were made at the same period and at the same location because all that information would be centralized and kept on a blockchain. Moreover, government services could also be transferred on a blockchain. With a virtual ID, citizens could be allowed to vote online at the elections. Zug, a town in Switzerland, recently started using the blockchain technology to digitally identify its inhabitants. It grants them access to e-services such as proof of residency and online voting.

Finally, this technology could also make it easier for banks to comply with regulatory requirements on knowing their customers and anti-money-laundering rules. When banks share a ledger, rather than keeping their information in separate databases, it is easier for regulators to observe financial flows. On another level, central banks could create money directly on a ledger on the blockchain, decide how to spread this new money and send it to financial institutions, which would have immediate access to the funds. Central banks would not use new cryptocurrencies, but they would rather create their own digital currency, the digital representation of a real currency. In a world where digital coins replace cash, central banks would have powerful and effective means to implement monetary policies by monitoring the value of the digital coins. In a recession, the coins could be programmed to depreciate if they are not spent within a certain time, therefore increasing demand.

What about cryptocurrencies?

The most obvious application of the blockchain is in the field of cryptocurrencies. The recent craze about them highlighted the technology on which it all lies: a decentralized system, a public ledger, a peer-to-peer network, a world without intermediaries. On the blockchain, there is no central trusted party. As previously mentioned, everyone is certain that the others follow the rules by using the law of large numbers.

Cryptocurrencies attract many investors for several reasons. Many believe they are the money of the future. Jean-Luc Verhelst even says: ”Bitcoin is to money what internet is to information”. Bitcoin was in fact created shortly after the crisis of 2008 when the trust in banking institutions was at the lowest point. The core characteristics of cryptocurrencies (i.e. not being regulated, requiring no central trusted party and not being emitted by a government) interested people who were looking for a change. However, the major struggle for such currencies is to gain the trust of a large number of users. There are many different cryptocurrencies, some more famous than others, some with different goals, but they all need faith to survive. If the population does not believe a currency will have value in the future, it will eventually crash.

                                               “Bitcoin is to money what internet is to information” 

                                                                                                   Jean-Luc Verhelst

There are currently more than 1500 cryptocurrencies, totalizing almost $400 billion in market capitalization. Bitcoin is the most famous of them, taking 37,9% of the capitalization share, after a sharp decline in its price since mid-December 2017. Bitcoin, like other cryptos, lets people transfer money without intermediaries. No banks are therefore needed and there are consequently no inflation goals or monetary policies dictated by a central bank either. There are only algorithms to solve to create new Bitcoins. This process is called mining. It is the idea that a computer needs to carry the task of collecting all the transactions of a period in a new block and append it to the blockchain. Many miners perform this task but only one block will be added at the end of the chain. It creates a competition between miners who have to solve algorithms in order to be first to fulfill all the requirements to add their block. The minor who successfully performs this task is rewarded with a defined amount of Bitcoins which were not on the network prior to the mining. This is how new Bitcoins are created. In 2140, the maximal number of Bitcoins ever available will be reached: 21 million BTC. That seems far from now but there are already more than 17 million BTC available today. Bitcoin had its glory days back in December 2017 when its price peaked at more than 19K$. Many thought the bubble popped when it lost 45% of its value a month later. Bitcoin faced a lot of criticism due to its high volatility. Other drawbacks of the currency are its slow transaction speed and its time/power consuming algorithm solving process. Moreover, Bitcoin is not  as anonymous as many think it is. Indeed, since every transaction is stored on the blockchain, everybody knows who owns what amount of the currency. However, names are replaced with a unique ID so that confidentiality is kept.

The blockchain is not perfect

Innovative technologies can be very promising but answers to problems always need to be found. Blockchain is no exception. Mr Avau brings attention to four key elements on which improvements still need to be made: performance, scalability, security and usability. As a matter of fact, as we make more and more transactions blockchains become longer and longer. With time, they will take up more space and everyone needs to be able to store them. Dirk Avau also points out that if the blockchain becomes a global technology used by financial institutions, they would need to be able to deal with thousands of transactions per second. Current blockchains cannot manage such a big amount of data simultaneously. Another issue is security. Data is cryptographically encrypted on a blockchain, but some sensitive information need to be even more protected.

Other technologies

Blockchain is not the only technology that is going to disrupt the financial industry. Digital transformation is changing the way we do business and, if companies want to survive, they need to embrace this revolution. Tomorrow’s world will increasingly be in the hands of data scientists, IT experts and programmers. New fintech companies emerge constantly and the biggest capitalizations are no longer in steel and oil as they were in 1929. We could say that the world went from mining coal to mining Bitcoins.

Furthermore, Professor Nicolas van Zeebroeck points out five important forces challenging today’s industries:

  • The rise of automation in every sector
  • The shift to a virtual world where the law of information rules
  • The ability to mass-produce and customize at the same time
  • The new way of charging usage instead of ownership
  • The increase in efficiency pulling down transaction costs

To cope with these challenges, firms can react either by challenging their own core business or by investing more in IT than their competitors. As Pr. Van Zeebroeck suggests, “The biggest payoffs are for the ones who turn digital!”, The FAANG (Facebook, Apple, Amazon, Netflix and Alphabet) prove that statement. It only is a matter of time before those companies disrupt the banking sector as well.

What next?

Only time will tell if the blockchain technology will replace all existing systems. It is clearly an innovation that is going to disrupt the whole finance industry. Firms will need to adapt and deal with an increasingly digital world. It is possible that, one day, all transactions will be made with cryptocurrencies. However, there are still problems to be solved such as the scalability of the blockchain or the volatility of cryptos.

But, as always with technology, the biggest question remains: how long will it take before it becomes obsolete and replaced by something new?

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