Although blockchain as the underlying technology that enables cryptocurrencies was first introduced in 2009 with the advent of Bitcoin, the concept had been around long before that. In fact, the history of the blockchain industry dates back to 1991 when two academic researchers introduced a computationally practical solution with a temporary stamp for digital record keeping. A year later, the technology was updated to include Merkle trees, allowing documents to be collected in a single block of data. Unfortunately, the technology was not used in practice and the first patent for a blockchain system dates back to 2004. That’s when Hal Finney introduced Reusable Proof Of Work, which many consider a significant early step in the history of cryptocurrency. However, in 2009, Bitcoin (BTC), the world’s first blockchain-backed cryptocurrency, was introduced, and the world of finance has been changing rapidly since then.
Although BTC is a highly volatile digital asset that not everyone understands, many businesses have recognized the potential of blockchain, the technology behind it. The pioneering technology has enormous potential to be used in customer and channel relationships, for value transfer and integration with financial processes. From tracking transactions and deals to forecasting operational data and optimizing working capital, the technology is well-established for a variety of finance applications. As the global financial industry changes its face, it’s worthwhile to learn how blockchain is changing the rules of the game. We are here to explain what blockchain is, how it works and what benefits it offers to the financial markets.
What is Blockchain and How Does It Work?
In simple terms, it is a distributed ledger where transactions are stored. Because it works like a distributed database, there is no central node capable of changing the structure or any records. While traditional centralized databases reside on a specific server on the internet, blockchain is distributed to all nodes connected to the network. Each node in the network has a complete copy of the network, which is constantly updated as new transactions are added.
The blockchain has a fairly simple structure and is a daisy chain of blocks with each one storing a certain number of records. The blocks are connected to each other with immutable links in chronological order, with the first block being the genesis block. The main purpose of the technology is to provide more efficient, faster, more reliable and lower-cost transactions, without intermediaries. Originally used solely for cryptocurrencies, today it is a technology with many applications, including cybersecurity, user authentication, and various finance services.
Features of Blockchain Operation
So, it is a distributed ledger that can be integrated with multiple business processes. It operates as a network where each participant is identified using a set of crypto keys. Blockchain employs a consensus protocol whereby any new entry made into the distributed ledger is verified by each participant. It is always available on each participant’s device as a complete copy of the ledger. Newer versions of blockchain – such as Ethereum one – can apply rules to process transactions. Such rules are digitized business rules called smart contracts. A smart contract is a self-executing and self-sufficient algorithm that executes when the conditions of a business rule are met. For a better understanding of how blockchain works, we will look at its structural features:
- Block. It is a blockchain structural unit designed to store records. In the Bitcoin network, transactions are only considered complete once their format and signatures have been verified. As a result, they are grouped into a structure called a block. Each block, in addition to a list of records, also contains supporting information including hash, transaction hashes, a hash of the previous block and some other data needed to form a chronologically correct block sequence that cannot be changed from the outside. In order for a new block to be accepted by all network members, the numeric value of its header hash must be equal to or less than the target number, which may be adjusted from time to time. As the result of the SHA-256 function used in many blockchains is irreversible, a brute force procedure involving multiple iterations is used to find the closest number to the target one. When one of the nodes on the network responsible for verifying the transaction (the mining node) finds the number it is looking for, a new block is created. The network sends this block to all members of the network for additional verification. If successful, the block is added to the chain with a hash to be included in the next block.
- A chain of blocks. Blockchain is a continuously growing chain of blocks with each block containing a set of validated transactions. In fact, the blockchain is a chronologically verified history of digital asset ownership. Since the network has a large group of miners responsible for verifying proceedings (and then creating blocks), it is possible to grow multiple branches of a single blockchain in parallel, with duplicate transactions in different blocks. There is a mechanism for rejecting branches with duplicate data. In this way, the technology operates as a database with information in blocks stored in unencrypted form. However, the correctness of the block sequence is determined by verifying the cryptographic data (hash chain). In addition to the hash, each block contains a sequence number. Given the structure of the blocks and how they are interconnected, the problem of double-spending is eliminated, because, in order to make changes to one block, all previous blocks in the chain must also be edited.
- Transaction confirmation mechanism (mining). Each time one member of the network initiates the transfer of a certain number of digital assets (tokens) to another member, a new transaction is created. Until the transaction is included in a new block, the accounts of the sender and recipient of the digital assets remain unchanged. Although a participant can create several token transfer transactions, only the one entered into the new block is considered confirmed. All other proceedings initiated by the sender are considered invalid. As the blockchain takes into account the transaction execution time, in case a transaction is in several blocks (main chain and branch chain), only the transaction in the block in the main chain will eventually be considered correct. Thus, each new block additionally confirms the correctness of transactions contained in previous blocks.
While all of the above sounds a bit unusual to untrained ears, it is impossible to understand new blockchain system without this deeper look at it. Moreover, by understanding how it works, you will be able to discern its promise for use in a variety of applications. However, as Satoshi Nakamoto envisioned blockchain to make a new kind of money work, it is in the finance industry that the technology has the most application.
Blockchain in Finance Services
The traditional financial system is something of a huge machine with many documents making it slow and inert. This has a negative impact on the productivity of business processes. For example, traditional letters of credit involve a huge amount of documentation and are therefore very slow to execute. A typical example of traditional system inefficiencies is the accounts payable and receivable calculation function which performs a huge amount of sender and recipient data validation. Most inefficiencies in traditional finance markets can be eliminated by providing access to a single source of reliable data. And this is where blockchain service shines. It is an emerging industry with the potential to significantly improve a huge range of financial processes due to the following features:
- High security through the use of cryptography tech. With the increasing number of transactions on the Internet, the World Wide Web is becoming more and more conducive to fraudsters wanting to steal data and assets. All payments and money transfers via a distributed ledger are faster and well traceable as most of the information is public. That said, a pair of public and private keys are required to access any blockchain data (both for reading and writing). The public key acts as a link to where the data is stored. The private key is used for authentication and works as a strong password that is virtually impossible to crack.
- No intermediaries. Traditional financial services have many intermediaries through which vast amounts of financial info flow. The more intermediaries in the value chain, the greater the risk of interception of critical information. Blockchain is decentralized in nature, eliminating intermediaries. In addition, traditional systems have for many years faced the challenge of finding so-called ‘clean audit trails’, resulting in financial losses due to malicious or negligent actions. Combining the system with machine learning significantly reduces the risk of financial loss.
- Transparency. As a public, distributed ledger, it creates more transparent financial services. A major problem with the traditional financial system is that it is closed, making inefficiencies and fraud very difficult to detect. Thanks to transparency, distributed ledger helps to reduce risk and improve the efficiency of financial services based on the technology. Therefore, there is great potential for the application of blockchain in banking.
- High performance and scalability. It is a network capable of passing through a huge number of transactions per unit of time and still successfully handling peak loads. Although there are many different blockchains (for example, Ethereum is not the same as Bitcoin), technologies already exist that allow different distributed ledgers to interact with each other and integrate into a common network.
- Lower transaction costs. By eliminating intermediaries, transactions are cheaper than those conducted through traditional bank systems. According to Jupiter Research, banks could save as much as $30 billion in cross-border payments by 2030 as they adopt the system. This shows great promise for blockchain in banking.
As digitization and automation technologies penetrate bank systems, the distributed ledger will play an increasingly important role in the financial sector. As the role of the fintech industry becomes more important, it will increasingly rely on the distributed database in the near future.
Why Digitized Financial Instruments are the Future
According to BCG, only one in five banks globally is embracing digitalization, with adoption occurring more rapidly in emerging economies. However, digitalization is improving competitiveness and profitability. Thanks to digitalization, financial institutions are able to save up to half of their operating costs by reducing offices and workspaces. What’s more, digitalization is making documents simpler, safer and more secure when all data is stored in one place. However, blockchain in finance world is the technology that can take financial services to a whole new level by providing connectivity and programmability between services, financial products and assets. So, here are the benefits of blockchain-based digital financial tools:
- All data in a single source. Because all proceedings reside in a single data source, you can easily track the origin of assets and the full history of transactions. At the same time, blockchain ensures data integrity and validation through the use of advanced technologies.
- Automation and optimization of the execution of most business processes. By implementing blockchain, financial institutions are able to perform calculations, audits and reporting on the fly with a low likelihood of errors and delays. At the same time, the decentralized nature of the technology keeps the number of intermediaries to a minimum.
- Cost-effectiveness. By eliminating intermediaries and automating most processes, transaction costs, as well as employee labour costs, are reduced.
- Flexibility. Because digital assets are easier and faster to create, issuers are able to produce more flexible products to meet all investor needs.
- Programmability. It is a technology that enables the creation of programmable digital assets and money. For example, programmability makes it possible to create assets that include incentives and functions (smart contracts) governing stakeholder participation rules.
So, the adoption of blockchain in banking and other financial services brings a number of benefits by providing more secure data storage, robust legal information protection, lower transaction fees and automation of most business processes.
Risks of Blockchain Implementation by Financial Institutions as an Industry as a Whole
It is a disruptive technology with the potential to impact many industries. However, there are many risks, both directly and indirectly, associated with the use of the technology. When we talk about blockchain, we are referring to a more general technology than the one behind cryptocurrencies. From product authentication and supply control to financial services, there are many different uses for blockchain. So, there are some risks associated with implementing the ledger in any project that you should be aware of:
- Lack of standardization and difficulties with integration. There are many variants of the distributed database with different structures, which makes it difficult to standardize systems. Moreover, it is a new technology that is not widely understood. Thus, a high level of integration is needed to integrate the ledger into the current system.
- Legal risks associated with the use of smart contracts. As the distributed ledger regulation differs from state to state, there may be legal challenges in resolving conflicts between parties located in different countries.
- The risk of blockchain developer bias. Because blockchain is an emerging technology, its future development is influenced by a large number of players. Since developers are responsible for making important decisions about the functionality of the blockchain projects they build, it can be difficult for end-users to trust these platforms.
- The increased role of end-users. While centralized online banking systems have a supervisory authority (e.g. the central bank), in blockchain, which is distributed ledger by nature, it is the user who is at the core. The users of decentralized networks take full responsibility for maintaining their accounts and keeping the private keys that provide access to sensitive data. As a result of the loss of a private key, there is no way to regain access to the account and search when it comes to blockchain-based systems.
- Transaction speed and network scalability issues. While high transaction speeds are a touted feature of blockchain-based projects, actual speeds can be slower. For example, Bitcoin proceedings can take anywhere from a few minutes to several hours, depending on how busy the network is.
- Security risks. Although distributed ledger is sought-after because of its advanced security, there are still risks of data theft attacks. For example, there are risks associated with human error because distributed ledgers must interact with people in order to work properly. There are also risks of theft of public and private keys stored on devices vulnerable to hacker attacks.
Finally, code quality is another major concern, especially when it comes to the use of blockchain in finance. For example, many remember The DAO hack that took place in 2016 and went down in history as the biggest theft of digital assets. Therefore, code quality and testing must be given special attention.
Closing Thoughts
As more companies see blockchain as a breakthrough technology, there are more uses of blockchain in finance and other industries. While the technology offers many benefits, such as automation and streamlining of business processes, low transaction costs and increased security, there are also risks to the technology adoption in existing and new projects. So, before evaluating the prospects of adopting the technology, you need to answer a series of questions regarding adoption, employee readiness for the new technology, availability of training materials, and the presence of interested customers. Ultimately, you will only reap the real benefits of the technology if it is really necessary for your business.
F.A.Q. Key Features of Blockchain Technology and Its Role in the Modern Financial System
What are the main features of blockchain technology?
Blockchain technology is a distributed ledger that allows data to be stored across a peer-to-peer network. Its key features include decentralization, which eliminates the need for a central authority, transparency, immutability, and security. These features ensure that once data is added to the blockchain, it cannot be tampered with.
How does the public blockchain network differ from a private blockchain?
A public blockchain network, like the Bitcoin blockchain, is open to anyone and operates without centralized control. In contrast, a private blockchain restricts access and is typically used within an organization. Public blockchains are generally considered more decentralized and transparent than private blockchains.
Can blockchain be used in supply chain management?
Yes, blockchain can significantly improve supply chain management. By using blockchain’s distributed ledger technology, companies can create a transparent and immutable record of transactions, ensuring the authenticity and traceability of products throughout the supply chain. This helps in reducing fraud and errors, and increases overall efficiency.
What are some common use cases of blockchain technology beyond digital currencies?
Beyond digital currencies, blockchain technology has diverse use cases including supply chain management, smart contracts, healthcare for secure patient data management, voting systems, and real estate for transparent transaction processes. Each use case leverages blockchain’s ability to provide secure, transparent, and tamper-proof records.
What is the significance of the peer-to-peer network in blockchain?
The peer-to-peer network in blockchain is crucial as it enables every participant on the network to hold a copy of the entire blockchain and make direct transactions with each other without the need for a central authority. This aspect of blockchain enhances its transparency and security, making it difficult to tamper with the data stored on the blockchain.
How can businesses leverage blockchain technology for their operations?
Businesses can leverage blockchain technology to enhance transparency in their operations, streamline processes, reduce costs, and improve security. For example, blockchain can be used to track the authenticity of goods in a supply chain, execute smart contracts automatically, and securely store and share data.
What is a consortium blockchain, and how is it different from other types of blockchain?
A consortium blockchain is a type of blockchain where the consensus process is controlled by a pre-selected set of nodes. It is different from a public blockchain, which is completely open, and a private blockchain, which is controlled by a single organization. Consortium blockchains are often used by groups of organizations for collaborative purposes.
What are some benefits of blockchain technology in terms of security?
One of the key benefits of blockchain technology in terms of security is its resistance to tampering, thanks to its decentralized nature and cryptographic hashing. Each block is linked to the previous one, creating a chain that is extremely difficult to alter. This makes blockchain technology highly secure and trustworthy for storing sensitive data.
How has the adoption of blockchain technology evolved over the years?
The adoption of blockchain technology has evolved from being primarily associated with digital currencies to a wide range of applications across various industries. This evolution is due to its transformative potential in providing transparency, security, and efficiency in processes. Industries like finance, healthcare, and logistics are increasingly adopting blockchain to improve their operations.
What is the role of smart contracts in blockchain applications?
Smart contracts in blockchain applications play a crucial role as they automatically execute, control, or document legally relevant events according to the terms of a contract or an agreement encoded within them. This feature of blockchain enables secure, automated, and efficient transactions without the need for intermediaries, which is particularly useful in areas like finance, real estate, and legal processes.