Major Financial Institutions Cautiously Court Blockchain Technology

When a hacker siphoned over $50 million from a digital money experimental project last June, many saw the development as a near-fatal blow to the prevailing hope in virtual currency. For a crowdfunding project that was to prove that virtual currency is safe and secure, the experimental cryptocurrency project was a huge failure.

This event made many doubt, not only the viability of cryptocurrencies, but also the effectiveness and safety of using the technologies behind them, including Blockchain.

Yet, just last month, the Depository Trust and Clearing Corporation (D.T.C.C.) announced its plans to replace one of its databases with fresh software that uses blockchain, the technology behind most cryptocurrencies.

D.T.C.C. is the company that manages most of the back-end services for the majority of trading firms on Wall Street. The New York firm is involved in recording and reporting of most stock and bond trades in the United States. Additionally, it trades most of the valuable derivatives in the market.

D.T.C.C.’s decision to replace a central database with a blockchain-based software was seen as the first step by the biggest banks in the world towards shifting a portion of their financial infrastructure to the virtual currency world.

While there are significant differences between this blockchain technology and the blockchain technology that bitcoin uses, the guiding principles are the same.

D.T.C.C.’s blockchain is referred to as a distributed ledger and will only be used by financial institutions. Another big difference between a distributed ledger and bitcoin’s blockchain is that to be a participant, a bank will need to be invited.

Nevertheless, the technology will allow financial institutions to update as well as view the ledger simultaneously, just like bitcoin’s blockchain.

You can think of it as a modified blockchain that will only be used as a replacement for Trade Information Warehouse. Trade Information Warehouse is a database that records every piece of information regarding trading of credit default swaps coming through the D.T.C.C.

Understanding Blockchain

More than any other function, blockchain seeks to solve the problem of trust in financial transactions. In order for two parties to undertake a successful financial transaction, they need to trust that both of them will go through the whole process to get their intended result. By design therefore, successful financial transactions need trust.

In the traditional approach to financial transactions, people use financial institutions or other third parties to ensure that the product or service on offer is genuine and the promised financial pay-off is real.

If the transaction involves large sums of money, each side will typically require that a record be made as proof that the transaction took place. The record needs to be transparent and auditable, lest one party later decides to deny that such a transaction ever took place.

Blockchain technology is designed to create an environment of trust for financial transactions. Instead of using a third party like a bank, blockchain will let all parties involved in a transaction to sign a contract electronically.

Verification of a transaction is “crowdsourced” through mining, where all computers in the network become “witnesses” of the transactions and retain a copy of it as evidence that certain goods and services changed hands.

This makes it extremely difficult for any of the parties involved to create non-existent transactions or manipulate the record.

The principle that governs blockchain technology

Unlike the traditional approach to transactions where a third party, trusted by all involved parties in a transaction, is introduced, blockchain uses a system that works around common greed. This is how it works:

• As a public ledger, blockchain transaction records are copied to thousands of computers from around the world. These copies are identical and public.
• To make a single change to the blockchain, permission must be granted by every computer in the network. This makes unilateral changes practically impossible.
• Because blockchain is cumulative, it is not possible to go back in time and change a record. The only thing you can do is add to whichever record that is already in existence.
• Every new transaction appears as a block. This block is, by design, a cryptographic challenge that needs to be solved. It is broadcasted across the entire network allowing the nodes on the network to compete as they seek to lead in solving the challenge.
• Every solution is broadcast to the entire network for verification. After the completion of universal verification, the block is approved to be added to the blockchain. The node that won the challenge is awarded with bitcoins.

As you may have noticed, there is no part of the blockchain ecosystem where trust is necessary. Instead the desire of every node/actor in the network to use its computer resources towards verification of transactions is what creates the integrity of the system.

This desire is driven by the potential earning of freshly mined bitcoins. Consequently, this change of rules eliminates the need for a third party like a bank or a government.

In a perfect world, this blockchain ecosystem would create an environment where it is possible to achieve complete transparency, eliminate bureaucracy, bring down the cost of transactions and speed up the entire process.

Risks and challenges of blockchain and distributed ledger technologies

Security remains the biggest challenges that makes financial institutions reluctant to embrace blockchain technology. In the blockchain ecosystem, once a person gets access to a network, it is not very hard for them to find a way to acquire blanket access to every part of that network.

While you could create protections within the system to protect it against hacks, doing so would defeat the purpose for which the blockchain is intended.

Furthermore, some people have found ways to go around blockchain records and make changes. When a hacker found a way into the software that controls Ethereum, a cryptocurrency by the Ethereum Foundation, the foundation rolled back the clock and gave people back their money.

It then went ahead to create another version of the ledger. By doing this, some people exploited the two versions of the ledger that became available, some even managed to double their money.

Unlike in other industries where companies can do disruptions and later ask to be forgiven, players in the financial sector cannot afford to do that. With every new innovation, regulations must be put in place before rolling out to the masses. Blockchain technology will be no different.

For the public to enjoy all its benefits, regulations must be put in place so as to maintain the integrity of the financial systems. In some cases, laws will need to be changed to accommodate this phenomenon that is still in its infancy, but which could revolutionize financial transactions around the globe.

How some major financial institutions are embracing blockchain

NASDAQ

In May 2015, NASDAQ said it was planning to use blockchain to enhance its capabilities on its Private Market Platform. This platform is designed to make it possible for private companies to trade before an IPO.

In June, the same year, the stock exchange company announced that it had partnered with Chain. Chain is a vendor of blockchain infrastructure for enterprises and financial institutions. Additionally, the firm said it would make use of the Open Assets Protocol to make its private exchange platform.

Goldman Sachs

Late last year, Goldman Sachs filed a patent of its latest innovation that would increase privacy for parties involved in a financial transaction. The innovation uses blockchain technology and is meant to streamline transactions in foreign exchange.

Moreover, Goldman Sachs has been publishing a lot of content regarding blockchain and bitcoin, perhaps, an indication of its plan to incorporate these technologies to its business systems.

US Federal Reserve

Just last December, the US Federal Reserve published new research (PDF) on blockchain technology. The research paper covered the applications of distributed ledger tech in settling transactions and payments. Moreover, the new research included a top-down perspective of the principles and concepts that govern blockchain.

This research paper plus the news that the bank was collaborating with IBM to develop a digital system of payment that has roots in blockchain technology, are the clearest signs yet that the US Federal Reserve may be planning to start rolling out this tech for use in certain sections of the banking sector.

Citi

Towards the end of 2016, Citi invested an undisclosed amount of money in Cobalt DL. This is a startup based in London that is seeking to use blockchain to make it easier and simpler to do foreign exchange trading.

Barclays

In September, 2016 Barclays Bank reported that it had successfully carried out the world’s first financial trade using blockchain. Instead of taking 10 days, the transaction is said to have taken less than 4 hours.

Deutsche

Deutsche bank recently reported that the blockchain project it has been working on had now moved from the proof of concept stage, making a significant milestone. While the bank’s executives insisted that the widespread use of distributed ledger tech was still over five years into the future, the anticipation for the widespread use of these disruptive technologies is rising in the financial sector.