The UCT law library computer room in 1992, was a dark place stuck away at the end of the corridor and usually somewhere where you had no problem finding a spare seat or two. This was a place of floppy disks, commodore 65s and the DOS operating system. Remember those first websites like the one below? Not much to look at and not that user friendly. Technologies have to start somewhere and often when they are in the early phase of development it is difficult to foresee where they might end up and how they might change our lives. In many ways we are at the early stage of the technology known as “blockchain”. We and financial institutions know that it is going to change the way business is conducted but we are still trying to figure out how it will create that change.

But what is the Blockchain; what does it do and why are financial institutions taking it seriously?

The cryptocurrency Bitcoin was, according to its pseudonymous founder Satoshi Nakamoto, created in order to achieve “A purely peer-to-peer version of electronic cash which would allow online payments to be sent directly from one party to another without going through a financial institution”.

The price of Bitcoin has followed a roller coaster trajectory in the past 18 months. Its erratic behaviour as well as Bitcoin being an anonymous, open, unregulated self-declared “currency”, backed by no government or central bank has left doubts as to whether cryptocurrencies are an asset class worth considering.

What is worth considering, and what may disrupt the way the financial services industry works, is the technology that underpins Bitcoin known as the blockchain and its underlying ledgers. The finance industry is built on ledgers. Most financial transactions are concerned with guaranteeing and tracking assets as they move from one ledger to another. Bitcoin’s public ledger is distributed across millions of computers, recording every Bitcoin transaction – at little or no cost. Blockchain could be used as a way to authenticate digital transactions, offering irrevocable proof of ownership with a traceable history. This ability to move value across ledgers cheaply and publicly has multiple uses. It can be used as a tool to provide improved visibility on the flow of funds between parties. This could provide unprecedented transparency and regulatory oversight in, for example, foreign exchange markets.

Blockchain technology is complex, but the idea is simple. At its most basic, blockchain is a vast, global distributed ledger or database running on millions of devices and open to anyone, where not just information but anything of value – money, titles, deeds, music, art, scientific discoveries, intellectual property, and even votes – can be moved and stored securely and privately. Each time a transaction is executed, that information is recorded on a ‘block’ through a kind of time-stamp. Users known as ‘miners’ use specialised software to look for these time stamped ‘blocks’, verify their accuracy using a special algorithm, and add the block to the chain. The chain maintains chronological order for all blocks added because of these time-stamps. It therefore becomes a chronological record of all transactions executed.

On the blockchain, trust is established, not by powerful intermediaries like banks, governments and technology companies, but through mass collaboration and clever code. Blockchains ensure integrity and trust between strangers. They make it difficult to cheat.

Many leading banks have sensed that they can’t be left out of the blockchain technology and are experimenting with blockchain technology as an alternative way of transferring money, particularly internationally. Ironically Bitcoin’s blockchain was set-up in order to circumnavigate the financial institutions.

So banks are taking the technology seriously and making initial studies into what the technology may provide. A recent April 2016 report by SWIFT (the global provider of secure financial messaging services) is very helpful and succinctly details some of the issues that will need to be overcome for the blockchain technology to gain industry-wide adoption.

STRENGTHS

The SWIFT report states that the blockchain or distributed ledger technology (DLT) has the potential to bring new opportunities and efficiencies to the financial industry. The strengths of the technology, include:

  • Information propagation – DLTs allow the latest data to be updated and replicated in close to real time.
  • Full traceability – Participants such as regulators are able to trace information flows back through the entire chain. Entries can be added to, but not deleted from the distributed ledger making ledger information immutable.
  • Simplified reconciliation – Access to complete and verified data could ease reconciliation processes since information is mutualised and all participants are working from the same data set in real time or near-real time. Current reconciliation processes, which require significant human intervention, could be optimised and perhaps eliminated altogether. This could result in huge savings in the banking industry.
  • Trusted disseminated system – Participants are able to trust the authenticity of the data on the ledger without recourse to a central body.
  • High resiliency – Operates seamlessly and removes dependency on a central infrastructure for service availability. Distributed processing allows participants to operate seamlessly in case of failure of any participants.

 

FACTORS TO ADDRESS

So whilst acknowledging that DLTs have the capacity to open up considerable opportunities for the financial industry the SWIFT report identifies the following eight critical factors that need to be addressed for there to be an industry wide adoption of DLTs:

  • Strong governance – Governance models need to clearly define the roles and responsibilities of the various parties as well as the business and technical operating rules. Not everybody should be allowed to have sight of a ledger.
  • Data Controls – Controlled data access and availability to preserve data confidentiality.
  • Compliance with regulatory requirements – The ability to comply with regulatory requirements (e.g. Sanctions, KYC, etc.).
  • Standardisation – Standardisation at all levels to guarantee straight-through processing (STP), interoperability and backward compatibility.
  • Identity framework – The ability to identify parties involved to ensure accountability and non-repudiation of financial transactions.
  • Security and cyber defence – The ability to detect, prevent and resist cyberattacks which are growing in number and sophistication.
  • Reliability – Readiness to support mission-critical financial services.
  • Scalability – Readiness to scale to support services which process hundreds or thousands of transactions per second.

 

THE FUTURE

In the UCT law library in 1992 those early websites did not give much indication of the world of Facebook, Twitter and on-line banking. In much the same way we know that blockchain technology is here and will change the financial sector in that transactions can happen close to real time, information is immutable and can be trusted, cost savings are made through simplified reconciliations and there is trust in the authenticity of the data on the ledger without recourse to a central body.

Whilst there are still many challenges, both operationally and legally, to overcome before a universal application of the blockchain technology can be made in the financial sector we cannot deny that blockchain technology will change business transactions in the future. We are not sure yet when that future will be but financial institutions must be prepared for that future.