Blockchain has garnered a lot of attention in recent years for its potential to disrupt several core services within the financial services industry. Despite all the buzz, many do not understand what Blockchain is and therefore have a difficult time anticipating how it will most likely affect our economy and the FinTech industry.
What Is Blockchain?
Blockchain itself is not a cryptocurrency; it is a platform with a number of unique characteristics:
Digitally native. Because Blockchain is digital in nature, it knows no physical borders. Within the domain of financial services, it is quite controversial to operate outside of the jurisdictional and regulatory boundaries of nations
Can represent any form of value. Blockchain is a ledger system that can be used to audit and track “things of value”. This is obviously inclusive of currencies, but Blockchain can also be used to track non-currency-based forms of value (e.g., objects, intellectual property, etc.)
Each transaction “block” is validated through algorithms (fancy math) that maintain the “chain”. The internal validation and integrity-maintenance of the “blocks” in the “chain” is one of the most unique characteristics of Blockchain
Distributed ledger. Each Blockchain ledger is replicated dozens or hundreds of times, and each copy is maintained simultaneously, in real time. The existence of multiple identical copies of each ledger protects against fraudulent corruption. The divergence of any one Blockchain ledger from the rest of its identical mirrors would instantly identify the fraud
Infinitely divisible. Because the Blockchain value is digital in nature, it can be divided into infinitely small (or large) component parts. This stands in sharp contrast with sources of physical value (e.g., gold), which have subdivision limits
Instantly transmissible. Another consequence of its digitally-native form is that Blockchain value can be instantly transferred between parties
Anonymous. Blockchain is designed to function as a transmission platform between anonymous parties. While there is nothing in Blockchain that is inherently incompatible with having named users, this functionality is not essential to the platform.
Know more about Blockchain and FinTech at Encora's perspective: "Encora's Key Factors to Fintech Success".
The Power of Blockchain
These characteristics give Blockchain some strengths that may have significant influence over digital innovation in the years to come.
“Open” security. Blockchain’s internal integrity management, combined with the large number of distributed copies of each ledger, make it impractical for would-be bad actors to perpetuate fraud. This “open” approach to security is fundamentally different from the traditional approach to security (especially within financial services), which involves consolidation of things of value in a single location with layers of protection around this location. By contrast, Blockchain’s security is assured through maintenance of a large volume of identical copies of each internally-validated ledger.
Automatable. One of the virtues of a digitally-native ledger system is that it lends itself to automation. For example, Ethereum (ETH) is a cryptocurrency that introduced the concept of Smart Contracts, which use objectively-measurable triggers to automate pre-agreed transactions. This construct has a broad range of applications, including (for example) transfers of property titles upon satisfactory completion of all specified steps.
Detailed audit logs, at any level of granularity. Blockchain also creates a mechanism for the perpetual tracking of any and all subdivisions of value. Even as such subdivisions themselves sub-divide, each resultant volume can be tracked independently across future transactions. This is a departure from traditional ledger systems, which focus only on totals. Blockchain allows for persistent tracking of each source of value, across all transactions, from party to party to party, ad infinitum.
Complexities of Blockchain
Blockchain is commonly associated with cryptocurrencies and there is an assumption that its most significant impacts will be in financial services. Bitcoin and other cryptocurrencies have the potential—or at least the aspiration—to establish a global currency, and in support of our increasingly-globalized economy.
While there are many who are seeking to make this happen, there are some complexities that must be addressed before Blockchain is likely to be adopted to support widespread financial transactions:
Know Your Customer (KYC) regulations. Financial institutions are required to “know” the true identity of their customers. This is at odds with a platform that brokers financial transactions between anonymous parties.
Anti-Money Laundering (AML) regulations. Financial institutions must have a number of controls in place to prevent money laundering (i.e., conversion of funds from illegal or illegitimate sources to legitimate ones). Such functionality varies by regulatory jurisdiction and is not built into the core of the Blockchain platform.
Regulated purchases. Certain types of financial transactions are regulated (e.g., the sale of alcohol to minors, the sale of firearms, etc.). There must be mechanisms to identify and then govern these types of transactions, else a platform like Blockchain has the potential to circumvent such regulations.
Tax-related oversight. Another attribute of financial transactions is that they have tax implications, within the jurisdictions in which the transactions take place. Governments must be able to monitor, flag, investigate as appropriate and tax transactions. Otherwise, they could lose the mechanism by which they collect the taxes that fund them. (All of this setting aside the notion that digitally-native transactions potentially have no “location”)
Merchant registration. Merchants must be identifiable, with documentation about ownership, industry, and commercial transactions. This is critical for tax, fraud prevention and other reasons. Again, these represent functionalities that must be built on top of the core Blockchain platform.
These issues will be satisfactorily resolved, it is only a matter of time. In fact, the cryptocurrency Ripple (XRP) is leading the way in bridging these gaps with global banks. By 2020, more than a third of the world’s banks (by assets) had tested or started using Ripple in cross-border transactions. Over time, this penetration will continue to grow, and broaden across cryptocurrencies.
Blockchain Use Cases and Applications
Having said that, it is our belief that there are several Blockchain use cases that are more likely to provide near-term value in the global economy:
Loyalty program pseudo-currencies. Loyalty programs are nearly ubiquitous in our economy, and many feature point-systems that have no “cash value” but still deliver value to program members. The absence of cash value enables these pseudo-currency systems to sidestep several of the financial service regulations that are in place (e.g., redemptions are not taxable). Blockchain provides solid points-bank functionality, and can support the seamless transfer of incrementing points (“earned”) or decrementing points (“redeemed”).
Supply chain tracking. Supply chain complexity is increasing as the economy becomes more globalized. Companies are sourcing component parts from an ever-widening array of suppliers, and using sophisticated logistics-management software (often powered by AI and ML) to optimize efficiency. Blockchain potentially provides an elegant extension of these emerging functions as an intelligent tracking ledger.
Complex financial tracking and auditing. One of the major sources of financial instability underpinning the Great Recession of 2008 was investors’ (and regulators’) visibility into the risk profile of mortgage-backed securities. Portfolios of property loans were created and sold across a range of investors, then repackaged and resold again. There was no mechanism by which to track and measure the consolidation of risk inherent in the resultant securities. Blockchain’s auditing capabilities could potentially be used to track and measure the risks associated with such transactions in the future.
Voting. In the wake of the Coronavirus, there has been a mass migration away from in-person voting towards mail-based and early voting. A natural extension of this shift is to electronic voting. A successful transition will require robust voter identity verification functionality, and integration with state/local regulators, both of which could be built in Blockchain. Benefits of such an architecture would include fraud protection and instant results tabulation.
Our Encora's Key Factors for FinTech Success has a complete section about FinTech and Blockchain.
- Although Blockchain has garnered a lot of attention in recent years, many do not understand what Blockchain is and therefore have a difficult time anticipating how it will most likely affect our economy.
- Blockchain is a platform with a number of unique characteristics, including: digitally native, can represent any form of value, each transaction “block” is validated, distributed ledger, infinitely divisible, instantly transmissible, and it is anonymous.
- These characteristics give Blockchain some strengths that may have significant influence over digital innovation in the years to come, including "open" security, automatable and detailed audit logs.
- Some of the complexities of Blockchain that anyone thinking of using it should understand include KYC regulations, AML regulations, regulated purchases, tax-related oversight, and merchant registration.
- There are several Blockchain use cases that are more likely to provide near-term value in the global economy, including loyalty program pseudo-currencies, supply chain tracking, and complex financial tracking and auditing, and voting.
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