Blockchain is a new mechanism for storing data, based on a decentralised ledger. This article seeks to explain, in layman’s terms, what this actually means. It also seeks to give guidance regarding how blockchain may impact on the financial services industry in general, and how United Kingdom and European regulators are reacting to its development.
Blockchain: how does it work?
The easiest way to visualise blockchain is to compare it with a simple bank account. A bank account is a ledger, in other words it is a record of information between the account holder and the bank. Blockchain, by comparison, is often referred to as a ‘decentralised ledger’. This means that it operates similarly to a bank account, except that instead of the record existing just between the account holder and the bank, there are many copies of the same ledger, each between the account holder and different ‘banks’, which are now called nodes. Many identical copies of the ledger exist, each held by a node watching the account. Also, the ledgers in a blockchain can hold any type of data, not just banking information.
This distinction from the traditional bank account is vital to blockchain, as can be explained using a further analogy, this time to a theatre performance. The performance on stage is equivalent to the data stored in the account, and the members of the audience are equivalent to the nodes. Each of the audience members (the ‘nodes’) is watching the performance (a block of data or ‘block’). When a transaction occurs, this can be seen as equivalent to someone walking onto the stage. If each member of the audience is asked what has just happened, they are likely to give matching descriptions of a person walking onto the stage. In the same way, when a transaction occurs in a blockchain, the nodes ‘watching’ this transaction are likely to each describe it identically. The scope of a misrepresentation is diminished using blockchain because an increased number of watchers need to be convinced of any change to the data before it is accepted.
Another aspect of blockchain is that all of the data in each block is encrypted under a pseudonym. This means that, although the data is public, the identity of whom the data relates to is not. This means that it can be used as a very confidential means of storing data.
How is blockchain distinct from bitcoin?
Blockchain is often linked to bitcoin. Bitcoin is a type of crypto-currency, which means that it is an electronic store of value, which is not tied to any particular government or bank. Crypto-currencies can only exist as a result of blockchain, because, without either a bank or a government to confirm a currency’s validity, blockchain is needed to perform this function and to prevent fraud. However, blockchain is far larger than simply a mechanism for validating crypto-currencies, as it can be used for all data, not just storing financial transactions.
Blockchain: how does it impact the financial services industry?
The effects of blockchain are likely to be wide ranging, as shown by the fact that a wide range of uses have been suggested by governments across the globe. These include using blockchain to provide notarization services (Estonia), to build a land title registry (Honduras), and a companies registry (the Isle of Man). It is not yet possible to state exactly what the impact of blockchain will be on the financial services industry, however, looking at the blockchain mechanism, the following predictions have been suggested:
- There could be a decreased roll for intermediaries. Intermediaries, such as banks and clearing houses, are often used as a way of verifying the authenticity of transactions. However, this role is challenged by blockchain, as it provides an alternative means of checking authenticity. The Nasdaq has opened up to investors buying shares using its Linq blockchain ledger, as part of exploring the use of blockchain as part of its infrastructure. This could lower costs, as most intermediaries charge a fee for their services.
- Value could be moved around more quickly. By removing the need to use an intermediary as a validation mechanism, blockchain is likely to speed up the rate at which, once agreed, transactions can be executed. This, in turn, reduces the amount market participants have to set aside at any one time in preparation for execution, freeing up capital.
- There could be less scope for cybercrime and fraud. Blockchain generally makes it far harder to alter data and reduces the scope for misrepresentation. As such, it could be that in the future it becomes mandatory, from a regulatory perspective, to use blockchain as a mechanism for keeping data secure.
- There could be increased scope for automated transactions. This includes programming blockchain so that dividends are paid on declaration, and shipment contracts paid on delivery. This saves cost and reduces the scope for error, as it removes the requirement for someone to independently execute these processes.
- There could be more flexibility for project funding. One example of this is the Lighthouse project, designed to enable decentralised crowdfunding, which uses blockchain to ensure that ventures are funded only once a minimum threshold of finance has been pledged – only on attaining this threshold does blockchain execute all of the relevant transactions, providing the necessary funding.
Although the potential positive consequences of blockchain are generally acknowledged, there are risks. Some question whether blockchain is really secure, as, although the data is encrypted, that encryption is unlocked using a private key, and so if the private key can be stolen the data is no longer secure. Hacking is also still possible if sufficient nodes can be convinced that fraudulent data is actually genuine, so that the blockchain is altered to reflect the inaccurate data. Another issue is the question of scale, in that currently blockchain is only used on a relatively small scale, and so there may be difficulties finding the efficiencies needed for blockchain to be practicable on the much larger scale envisioned by enthusiasts.
Focussing on the financial services context, if blockchain’s increased security causes it to become a popular store of money, this is likely to drain the money currently stored in traditional bank deposits. This could mean that banks would have less reserves on which to lend, harming their ability to lend. Also, some financial institutions have argued that blockchain should be standardised. The R3 CEV consortium, which includes around two dozen of the world’s largest banks, has been set up with the aim of achieving such standardisation through the creation of a private blockchain, only open to certain participants. The advantage of this development is that membership to the blockchain can be limited to trusted parties, meaning that less safeguards need to be built into the blockchain to prevent dishonesty.
Blockchain: the regulator’s response
Regulators are broadly supportive of increasing the use of blockchain, particularly in the UK. Christopher Woolard, the FCA’s Director of Strategy and Competition, has recently stated that blockchain could potentially revolutionise financial services, but that it needed to be and is being monitored by the FCA, particularly from the perspective of consumer protection. He recognised that blockchain is a growing industry, and so developers should be allowed space to develop solutions to the issues which arise, and it may well be that this is achieved through the FCA sandbox. He also mentioned that KYC and money laundering compliance were particular areas which could benefit from the introduction of blockchain technology. The Bank of England is also generally supportive, stating on its website that it will monitor developments in this area. For Christopher Woolard’s full speech, please click here; for a link to the Bank of England’s webpage on this area, please click here.
At the EU wide level, there are indications that a cautious approach may be taken to blockchain. The European Parliament’s Committee on Economic and Monetary Affairs has released a draft report on crypto-currencies and blockchain which, although recognising the positive impact which these developments could have for consumer welfare and economic development, calls for regulation to deal with the risks they could entail. In particular, the issues of money laundering, terrorist financing, fraud, governance gaps, systemic risk, regulator resources and legal uncertainty were highlighted. For the full draft report, please click here.
Overall, despite the cautions above, we believe it is likely that blockchain will play a significant regulatory role in the future. This is because it helps ease many current regulatory issues, including by increasing transparency (as much of the data in the blockchain is public), boosting liquidity (as delays to allow for execution are minimised), facilitating trust between market participants (as there is stronger identity validation), potentially helping data to be more secure (as the system is encrypted) and improving accessibility to the markets (as it becomes cheaper to transact).