Blockchain, a type of distributed ledger technology, has garnered heightened interest as a secure method to conduct transactions. In this article, we provide an introduction to blockchain and its uses. In later articles, we will explore how this technology is being implemented to transform the financial services industry. We are also planning to host a series of seminars to explain how the financial services industry may be affected in a wide variety of contexts, taking into account the current regulatory environment and various other financial technology (“FinTech”) developments.
The financial services industry is already investing heavily into blockchain research due to real recognition of the benefits of blockchain technology. These benefits include lowering cost and risk and increasing efficiency, transparency and security when executing transactions. The best-known use of blockchain is Bitcoin, although many other cryptocurrencies have also been implemented via blockchain. It has since become clear that blockchain technology has various other uses and applications and may, as a result, change the ways in which, for example, data management is conducted, clearing and settlement of transactions are recorded, assets are maintained and transferred, and automated contracts (smart contracts) are concluded.
A blockchain is, in essence, a ledger (database) that is maintained in a decentralised manner. Transactions are stored on nodes (ie, the computers of users or participants), which are connected to a common network via the internet. This common network consists of peer-to-peer nodes operating under a strict protocol or set of rules.
Each user or participant on a blockchain sees and maintains the same copy of the ledger by reaching consensus. There is therefore no single database, but multiple copies of the same database shared among its users, which adds to the security of the technology. A cyber-attack will theoretically be successful only if all of the copies are simultaneously attacked. Security is further enhanced through the use of a public key and a private key. A public key is a type of encryption involving an identifier code that is known to others; ie, a public address. The private key is a code known only to the user. The user must present both the public and private keys for any transaction.
Consensus is reached through protocols or standards and rules for how every node exchanges information and validates transactions. A consensus mechanism can also be described as a method to authenticate and validate a transaction. Any user can request that a transaction be added to the blockchain, but transactions are accepted only if consensus is reached through the consensus mechanism used. Such a process removes the need for a centralised authority to conduct, authorise or validate a transaction.
Transactions in a blockchain are secured through the use of cryptography and are grouped together in a “block”. The blocks in a blockchain are organised in an orderly and sequential system, because each block is added in linear and chronological order as a link to a chain of blocks. The block is usually created and processed by a “miner”. Miners process transactions according to strict protocols set by the consensus mechanism to ensure accuracy and security. As transactions are broadcast through a network, miners group those transactions into blocks. Miners are incentivised in various ways to do this work, such as by earning a fee or a cryptocurrency. Adding a new block to the chain means updating the ledger that is held by all of the users. As mentioned above, users only accept a new block when it has been verified and validated through the consensus mechanism.
Some distributed ledger technologies do not rely on mining but use other processes, or even a permissioned system, to validate transactions. Blockchains can be public (“permissionless blockchains”); ie, they are decentralised and available to everyone. Anyone can participate in a public blockchain. In the case of private blockchains (“permissioned blockchains”), only authorised participants can access and add transactions to the ledger. In permissioned systems, all nodes must be known and identified to validate transactions, and mining is therefore not required. Permissioned blockchains are more popular with financial institutions because it allows them to exercise some control over the blockchain.
Each block on a blockchain further includes a cryptographic hash (reference point) to the last block. Any attempt to change a prior block has a flooding effect on each subsequent block. The obvious benefit is therefore that transactions held in a blockchain are considered to be immutable; ie, they cannot be altered, cancelled or revoked.
In conclusion, products and business models that may be created through the application of blockchain technology will definitely require consideration of how existing regulatory requirements will apply. The focus should be on identifying applicable laws that may pose hurdles to development in this regard. There is no doubt that regulators will also have to address the challenges posed by the use of blockchain technology, particularly in the financial services industry.