Abstract:Financial services industry is currently the leader in experimentingwith the technology. Today’s digital age and hyper-connected environmentrequires banks to re-imagine their business continuously. So let us considerthe emerging blockchain technology that underpins bitcoin and othercryptocurrencies in revolutionizing the digital world bringing a newperspective to security, resiliency and efficiency of systems.
Bitcoin may haveattracted great hype but alongside there are many doubts rising on theunderlying technology, there may be some drawbacks but it is only when thepossibilities are explored in more detail that the true scale of possiblechange can be appreciated.This paper deals with this technology’s characteristicsand its potential to solve various weaknesses in existing financial sector. Inthis context it is also equally important to stress on the concerns around privacy and scalability issues surrounding thetechnology, regarding which there is intensive research going on by differentcompanies. Key words: Block chain technology, security, privacy andscalability. INTRODUCTION:Blockchain was first conceptualized by Satoshi Nakamoto in 2008,followed by implementation in 2009 with the Bitcoin.Block chain is an opendistributed ledger that can record transactions between two parties efficientlyand in a verifiable and permanent way.
For use as a distributed ledger, ablockchain is typically managed by a peer-to-peer networkcollectively adhering to a protocol for validating new blocks. Once recorded,the data in any given block cannot be altered retroactively without thealteration of all subsequent blocks, which requires collusion of the networkmajority.How it works? A blockchain system iscomposed by two types of entities: • Participants, who perform transactions.• A peer-to-peer network of nodes, who validate transactions and participatein the consensus process.
To understand where the name “blockchain” comes from, it isnecessary to visualize how validated transactions are recorded. Transactionsare grouped into blocks that are submitted to a network of validating nodes.Every time a block is validated, it is broadcasted to the network and added ontop of the blockchain.
Since every block contains a timestamp and a referenceto the previous block, the blockchain is fundamentally a time stamping systemrepresented by the chain of all blocks, starting from the first block. The peer-to-peer network guarantees transactional securitythroughout the consensus process. Every time a new block is validated, eachnode verifies the block and updates its local copy of the database, adding anew block to the chain. Nodes follow the protocol that is embedded in theblockchain software, which determines a single state of the database even ifthere is no single authoritative copy of it. While in a centralizedarchitecture there is a single authoritative database operated by a singleentity, in the blockchain every node has a local synchronized copy.Once a block is validated, it is infeasible2 to change theblockchain without any tampering evidence. Immutability property is achievedthroughout the combination of public-key cryptography and digital signatures.• A private key, which the user must not reveal, since it is used tosign transactions and to unlock cryptocurrency funds.
• A public key, which corresponds to the address of the associatedaccount. It is used from participant to identify the receiver of a transaction.Also it uses cryptographic hash functions and consensus mechanism toguarantee transaction security and ledger integrity.Cryptographic hash functionBlock chain is tamper evident ledger, to achieve this feature ituses cryptographic hash functions, this function maps inputs with a fixed size hash tags. Any minordifferences in the input will exhibit major difference in the hash tag, thuscreating tamper evident structures.
Consensus mechanismBitcoin follows a standard majority consensus, where each miner maychoose which block in the chain to append to, and eventually the longest chainsustains. It is widely believed that as long as honest parties control majorityof the computing power, the longest chain will grow and outperform other forks.Also each node is required to perform a certain amount of computational work inorder to create a valid block, controlling a large part of the network for amalicious actor would be costly, difficult and would probably lap the gainedadvantage.Classification of blockchain ledgersBlockchain architecture may be classified broadly into threecategoriesPublic blockchains:A public blockchain is a blockchain that allows anyone in the worldto read, send and participate in the consensus process – the process fordetermining what blocks get added to the chain and what the current state is.As a substitute for centralized or quasi-centralized trust, public blockchainsare secured by cryptoeconomics. These blockchains are generally considered tobe “fully decentralized” and permissionless network.
Private blockchains: A private blockchain requires permission from either network starteror authorised party involved. Depending on the usage, existing participants maydecide new entrants, or a consortium and regulatory authority could makedecisions instead. But once entrant has joined the network, they maintain theblockchain in decentralized manner.Consortium blockchains: Consortium blockchain tries to remove the sole autonomy in privateblockchain. So Instaed of having one in charge, we have a group involved, whichcome together and make decisions for thebest benefit of whole network.
Such groups are called consortiums. consider aCentral Bank which allows only specified, trusted Banks to provide thenecessary calculations and thus verify transactions before adding them to theblock. Thus making it partially decentralised. Applications of blockchain in banking and finance:A Permissioned blockchain technology is often far more appealing toenterprise and financial services. It has potential to address certainlimitations of current process by simplifying the traditional design of theindustry.
Know your customer process:According to a ThomsonReuters Survey , financial institutions spend on average $60 millionon KYC and customer due diligence while some banks spend up to $500 million peryear. Thus by developing KYC processes on Blockchain technology, banks canreduce operational costs and also can increase efficiency of compliance processas when one bank verifies a new client , it can be accessed by other banks andaccredited organizations , without the need for the KYC process to be startedall over again by each individual party.A report given by investment bank Goldman Sachs states that a 10percent headcount reduction would be achieved by introducing blockchaintechnology in KYC procedures, which would result in annual saving of $160million. Reduction of fraudOne of the primary issues that the banking sector is facing today isthe increase in fraud and cyber-attacks.
Currently, most of banking systems are built on a centralizeddatabase, which makes them more susceptible to cyber-attacks as all informationis stored locally in one place. Also, many banking systems are outdated,therefore making it more vulnerable to new forms of cyber-attacks.By building new banking systems on top of blockchain technology, thechance for data theft and fraud can be curtailed substantially as thedistributed ledger technology secures the records by encrypting and verifying everysingle bit of data in a transaction. Therefore if any data breach or fraudulentactivity occur, it will be intimated to all parties who have permission toaccess the transaction data on the ledger.Payment clearing system: distributed clearing mechanismInterbank payments often involve intermediary clearing firms, which isfollowing a complicated process of bookkeeping, balance reconciliation, transactionreconciliation, payment initiation, etc. Thus making the process lengthy andcostly.
Lets consider cross-boarder payments, in these payments as the clearingprocedures for each country is different, a remittance requires nearly3 days to arrive. This demonstrates the low efficiency of the processunderneath.Block chain implements point to point payments, thus eliminating theintermediary link of third-party financial institutions, which will greatlyimprove service efficiency and reduce the transaction costs of banks. This willalso enable to create rapid andconvenient payment clearing services for cross-border commercial activities.
McKinsey has made an estimation which shows that the cost of each transactionin Cross-Border business can be greatly reduced due to the application ofblockchain, the details are shown in Fig. 3.Application of Blockchain in Cross-Border Payments.
Source: McKinsey(Reportby McKinsey: Blockchain—Disrupting the Rules of the BankingIndustry,2016-05.) Capital market: Capital markets have a complex structure of interconnected banks andintermediaries. Each transaction involves multiple intermediaries maintainingdifferent database, with unnecessary reconciliation errors , duplication ofdata and delay of settlements.Blockchain has the potential to address thesechallenges by eliminating multiple intermediaries and reducing settlement time.Integrating documentation frameworks within an enterprise:As the Transactions in the capital market involve transportation ofdocuments between parties, cryptographic system in blockchain helps securetranspotation . here all documents are stored in a ledger and are keyed toconcerned key party or signatories involved. Also only certified parties canadd the documents through a common consensus avoiding duplication of documents.Faster clearing and settlement:As there is swift record of submission and confirmation on ablockchain , settlement time can be drastically reduced.
This further improvesliquidity And promote better capoital usage . In present traditional systempayment setlements happen only when banks are open. But through blockchainwhere with one accounting for ownership of money and other accounting forownership of securities, a settlement at any time in a matter of seconds withlegal finality and certainity. Trade finance:Trade finance is one such area which is full of inefficiencies andopen to fraud. Letter of credit and bill of lading are the traditional methodswhich are managing the trade of goods and services domestically and acrossboarders, which involve large volumes of paper based documentation takingseveral weeks to process, involving high cost and making data vulnerable tomanipulation and errors. This inefficient trade practice making it difficultfor companies to access financing and limiting their ability to trade acrossboarders and grow revenues.Blockchain technology can solve these issues in trade finance to agreater extent.It creates a feasible decentralised distributed ledger , which substitutesthe single master database, making itmore simplified, secure and reliable.
It also provides unique non forgeableidentities for assets along with an inalienable record of ownership, thisability of transparency and consensus will help reducing current documentary fraud.Smart contracts have the potential as the self executing contracts triggered byexchange of digital data, thus replacing the traditional letter of credit. Thusallows real time settlement for transactions, reduces counterparty risks andtransaction costs.
To bring out the full potential of block chain, industry widecollaboration platforms like R3 consortium plays a major role.one companyworking with this consortium and trying to enter trade finance is TradeIX. Thiscompany is rewriting the traditional trade finance ecosystem by establishinga secure and connected infrastructurefor corporates, financial institutions, and B2B networks by leveragingblockchain technology. Limitations:Scalability:There are two bottlenecks which are hindering the scalability ofblockchain; latency and throughput.Latency is the time taken for processing a transaction. Throughput is the number oftransactions that can be processed in a particular amount of time.
Inbitcoin whenever transaction is received it requires confirmation from othernodes that it is valid. This involves hashing calculations that serve as theproof of work. Thus new block is created, which is the way of verifying atransaction.
In bitcoin it takes 10 minutes to confirm transactions, and canachieve 7 transactions/sec maximum throughput, whereas mainstream paymentprocessor such as visa processes 2000 per sec on an average. This problem isbecause of the limited block size. In order to become a real-world paymentalternative, blockchain must support at least the transaction volume of creditcards. When we look at larger scale capital market use, it is clear that thereis a need for further innovation aroundperformance and scalability.Privacy:Blockchain’s potential impact on the confidentiality and informationtransfer about record changes may also be of concern to some users. Forexample, in finance, the acquisition and data analysis are key to a firm’scompetitive advantage.
Some firms may not be ready to participate in a shareddatabase if there is leakage of information that could cost the firm’sbusiness.Regulatory and legal complianceAt the moment there is a lot of uncertainty towards the use ofblockchain technology. For the blockchain based solutions to work, there is a needto ensure that they comply with allregulatory and legal compliances. Without any legal cover, it would be riskyfor businesses to adopt these technologies because their investment will gowaste if the relevant authorities do not consider it permissible. Thus there is a need formechanisms or solutions to handle enforcement, dispute resolution, andaccountability in this technology. Conclusion: As a part of the naturalcycle of evolution. Blockchain, as a new technology that has real potential,has to go through the Gartner cycle. However, the full potential of blockchaintechnology will only be realized through cooperation among market participants,regulators and technologists, and this may take some time.