The stuff of ledgers: cryptocurrency and blockchain

/ 23 February 2018

Nick Bishop

Behind the growth of cryptocurrencies like Bitcoin is an equally radical technological advance: distributed ledger technology (DLT), better known as blockchain. How does it work and how will it change the business world, especially financial services?

A brief history of blockchain

Blockchain was born in the aftermath of the 2008 financial crisis when confidence in the world’s financial institutions hit a new low. Traditionally, the movement of most forms of capital has involved relying on a bank or similar institution to act as an intermediary and to record the transaction accurately in their ledgers. Blockchain was developed with the aim of creating an open, distributable digital ledger that records transactions efficiently and in a verifiable way, effectively cutting out the traditional financial institutions which previously held this role.

This involved setting up a network where transactions are entered using a digital asset that is passed through, verified and recorded by an independent network. In practice, when a transaction is made, this is broadcast to a network of nodes: computers which all independently verify the transaction and add it to the copy of the ledger they each maintain.

Each transaction is combined with a number of other transactions into a block and ‘locked’ via a 32 character code called a hash. The locked block is added to the previous block to form the blockchain.

Each node keeps a copy of the entire blockchain. The hash verifies the data held within the blockchain, so if the data on one node is corrupted or hacked then the hash on that block will change along with each subsequent hash. This process of verifying transactions and finding each hash is called mining.

Where do cryptocurrencies come in?

When creating blockchain, there was one obvious stumbling block: how to persuade people to lend their computer processing power in order to verify and keep a record of all the transactions. The answer is to pay them in the digital currency that is traded across that particular blockchain. This monetises the mining operation and incentivises people to join it.

How is the world of blockchain developing?

The technology behind blockchain is evolving. Cryptocurrency is not the only thing that can be traded over blockchain. For example, Ripple is a blockchain that can trade any currency or commodity, making it particularly attractive to financial institutions.

Blockchains are now being set up where the public are no longer the miners. Instead, the creators of the blockchain choose and vet the nodes themselves. As long as everyone using a private blockchain is satisfied that the nodes are independent, the blockchain operates without a cryptocurrency attached.

These private blockchains allow the creators to experiment further with the coding. For example, ‘smart contracts’ can now be written into a Blockchain, so if a verified event occurs then a payment is automatically released, or if a price drops below a certain threshold then that asset is automatically purchased.

Blockchain technology is also offering new opportunities to companies not traditionally associated with the digital age. Kodak has recently developed a blockchain to enable photographers to get paid directly for their images. De Beers is working on a blockchain to track diamonds from source and keep a record of their authenticity. This will give new meaning to ‘diamonds are forever’ thanks to a core characteristic of blockchain: the data cannot be altered, making it highly transparent and trustworthy.

What does the future hold for blockchain?

A key question for the future of blockchain is: how closely is it intertwined with the future of cryptocurrencies? If the related cryptocurrency has a sudden sharp decrease in value, will it still be profitable to mine the data? If it isn’t economically viable to mine then how will the integrity and storage of the data be maintained?

Private blockchains, which select and vet their nodes, won’t have the same issue. But they are subject to wider challenges. For a supply chain to be truly effective as a blockchain, all the supply chain companies would need to be part of it. The more complex the supply chain, the harder this will be to achieve.

In 2018 we will see blockchain technology being integrated into the processes around us. It is still very much in its infancy, with experimental blockchains being tested and refined. It’s not a headline technology which people discuss the way they do cryptocurrencies, but it’s quietly bringing about major technological advances which will have an effect on most industries.

One of those is certain to be the financial industry, over and above cryptocurrency trading (considered in our earlier article). Blockchain is already provoking a mixed reaction: according to last year’s survey by Cognizant, 47% of financial services professionals expect improved data management, yet 53% expect understanding blockchain use-cases to get in the way of adoption.

As we mentioned above, the traditional third-party role of financial institutions is set to be disrupted. The high visibility, automation and reliability that are inherent to blockchain transactions will not only reduce costs but the human element too: many jobs in compliance and reconciliation won’t be needed anymore.

While consumers can look forward to blockchain bringing long-term gain, financial services may have to endure short-term pain.

For more information, please get in touch with your usual BKL contact or use our enquiry form.

Nick Bishop

Partner, Financial Services

T +44 (0)20 8922 9350
E nick.bishop@bkl.co.uk

View Profile