Why am I hearing about ‘blockchain’?

Published at Mar 24, 2016, in Features

If you’ve been scanning the financial pages lately, you would have seen the word ‘blockchain’ come up time and time again – but...what is it, exactly?

In a nutshell (it does get a lot more technical than this), it’s the architecture underpinning the bitcoin revolution.

You can find out more about bitcoin and the potentially game-changing effect of bitcoin here.

The blockchain makes the whole Bitcoin platform fly, and gives it the mandate to claim that it is a truly universal currency instead of being regulated by a central power.

The short version is that the blockchain is a public distributed ledger of all transactions made, by everybody, since inception – and it’s visible to everybody.

Once a transaction is made, the blockchain generates a unique number code. This code is authenticated by a network of computers. Once authentication is made, the transaction is recorded on the ledger.

An increasing number of computers are joining the network as users are incentivised to run authentication on their transactions in order to acquire more bitcoins. This can only occur once there is authentication of a block.

In effect, you have more and more users authenticating each transaction, every time a transaction is made.

As the ledger is held and visible by all users on the blockchain system (and universally updated in real time), it makes it harder to game that system.

Every single transaction is held by multiple computers, or users, meaning that if you try to pull off a dodgy transaction such as being paid twice – people will notice.

So, to re-cap.

  • A transaction between two parties begins by the users involved in the transaction generating a code.
  • That code is then authenticated as genuine by a vast network of computers and their incentivised users.
  • Once the code is authenticated, the trade is made.
  • The trade is placed on the ledger, which all users in the bitcoin system have access to.

So, why is every start-up and their dog trying to find a way to apply this system to other financial problems?

The big banks are getting involved

In recent times, several industries have been disrupted by technology allowing the provision of services in different ways.

The TV and movie industries were disrupted by Netflix, whose streaming technology allowed a subscription business model to thrive – instead of an ad-supported model.

The taxi industry has been disrupted by Uber, whose tech platform allowed anybody to become a taxi driver and whose back-end system allowed those drivers the security of knowing their cab fare was already paid.

In a way, the big banks have been given the luxury of sitting back and watching this technology develop in an eco-system which isn’t necessarily about making a profit, but instead more of a philosophical play.

That being said, bitcoin and blockchain could still disrupt the banks’ way of doing business.

The big banks are now in the process of either working with start-ups or in-housing their own divisions on how to best replicate the blockchain architecture.

Their point of view is that bitcoin isn’t that interesting to them, but the blockchain architecture is.

At the moment, settling transactions between two financial institutions (or two individuals with accounts from said institutions) runs into all sorts of problems, such as all banks having their own ledger.

In the digital age this is all taking place a lot quicker than it was in pre-internet days, but each bank needs to verify the transaction, update their own ledger, and then make sure the ledger matches up with the other institution’s ledger.

If it sound like a bit of a nightmare, well, that’s because it is.

Investment bank Goldman Sachs has been particularly vocal about the potential for blockchain to change the way banks settle transactions.

In an in-house podcast (linked above), co-head of the bank’s technology division, Don Duet, explained why the banking sector is getting pretty excited:

“At the centre of much of the financial services world are effectively many sources of record where asset transfers and many types of assets need to be recorded and understood and those are distributed because you have many players and different people involved...the counterparts,” Duet said.

“In order to facilitate the growth of our industry, much of that has been formed around concepts of having multiple sources or, you know, multiple parties owning a definition of truth, so the Bank of New York will own a big part of the reconciling of the ledger of who owns what stocks in the US, and so would other institutions around the world.

“You have this situation where you have multiple versions of the truth, which means that everyone needs to reconcile with each other to ensure that they all have the right set of information — who actually owns that asset, when did it get transferred — and it also creates a certain degree of just temporal delay. It’s not possible to be done right away.”

So where there are multiple parties with multiple ledgers, there is a time delay in authentication – and time is money.

If there was, for instance, one central ledger such as blockchain could lead to savings for both institutions and, ultimately for customers.

What does this excitement look like?

The thing about blockchain is that everybody is trying how to apply it to more established ways of conducting business – basically anything where two parties exchange value.

So it’s not just the financial sector looking at it – but it is at the vanguard of a lot of investment.

A series of 42 investment banks around the world (including Australia’s own Westpac) have signed onto the R3 Consortium, which is trying to come up with a standard set of rules for banks trying to use blockchain technology.

Promisingly, earlier this year 11 of those banks ran mock trades using a blockchain-esque system – an important first step.

Meanwhile, the Australian Securities Exchange has gone public with its plans to build a blockchain system for Australian equities. Ex-CEO Elmer Funke Kupper told the Australian Financial Review earlier this month that blockchain could save as much as $5 billion from trades.

Outside of the established players, the fintech start-up scene is also racing to find the best ecosystem to fit the banks’ needs – one such start-up is being backed by ex-JP Morgan banker Blythe Masters.

Digital Asset Holdings raised $50 million in a recent funding round, and has the ASX as one of its investors.

It’s increasingly clear that the way this is playing out is that the financial system is bringing the funding weight to the party, outsourcing the intellectual weight to the start-up scene.

After all, bankers are too busy being bankers to dabble in theoretical banking systems.

It’s one of the hottest segments of fintech, and you’re going to hear a lot more about it in the future.

S3 Consortium Pty Ltd (CAR No.433913) is a corporate authorised representative of LeMessurier Securities Pty Ltd (AFSL No. 296877). The information contained in this article is general information only. Any advice is general advice only. Neither your personal objectives, financial situation nor needs have been taken into consideration. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs, before acting on the advice.

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