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Fintech

Blockchain answers, part 1: what can blockchain do for the financial system?

Alessandro Sanos, CAIA

April 15 2016

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Financial institutions are stepping up efforts to utilize blockchain, the technology on which bitcoin is built. In this three-part series, we examine the FinTech initiative, the regulatory landscape, and ask if blockchain can fight financial crime.

Since Bitcoin’s launch in January 2009, the crypto-currency has attracted its fair share of negative headlines.

There was the case of the Silk Road online black market in which the currency was used to buy illegal drugs, as well as the bankruptcy of bitcoin’s leading exchange Mt.Gox after a software flaw lost some 850,000 bitcoins.

But these issues haven’t stopped the financial sector and other industries from enthusing about what they see as the greatest innovation of bitcoin: the blockchain, the key technology behind the currency.

Landmark technology

The Bank of England has noted that blockchain could, in theory, be used without the creation of a new currency. Banks are interested in blockchain due to its potential to improve back office efficiency and to meet regulatory requirements on Know Your Customer and Anti-Money Laundering, among others.

Several institutions are working together in partnership with technology firms in order to explore blockchain’s potential.

They include JP Morgan, whose former head of commodities Blythe Masters is now chief executive of the blockchain start-up Digital Asset Holdings.

Ms Masters, who helped to pioneer credit default swaps in the 1990s, believes that blockchain is ‘as significant now as the internet was 25 years ago’.

She added that regulators were becoming more interested in seeing how the technology can improve transparency, audit trails and reduce operational risk.

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How does it work?

Until now, banks were trusted to ensure the validity of the digital records of conventional deposits.

A key innovation of blockchain is the introduction of a distributed ledger that allows the digital currency to be used in a decentralized payment system with no central bank or clearinghouse involvement, removing the need of a middleman.

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Source: Financial Times

 

By providing a distributed way to guarantee and verify transactions by making them publicly available, and by using cryptography and consensus among multiple computers, the system is considered immune to tampering, fraud, or political control provided that nobody controls more than 50% of the computing power of all computers on the network.

Efficiency drive

Financial institutions believe blockchain technology has the potential to make their operations faster, more efficient and more transparent.

Some of the world’s major banks and companies have already announced ventures into distributed ledger technology as they look for the opportunity to redefine transactions and the back office of a multitude of different industries.

For instance, banks could automate labor-intensive tasks and profit from substantial cost savings.

Eleven banks, part of a consortium of 42 major lenders brought together by the software company R3, have tested a blockchain system that could make trading much faster and less expensive.

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ICAP, the leading markets operator, has also announced it is distributing data on trades to customers using blockchain. To prove that the data is reliable and to give banks the confidence to turn off their in-house technology, ICAP said it would scale its distributed ledger system to cover all trades, not just new ones.

The potential benefit for regulators of being able to understand global transactions virtually in real-time, stretches to market participants who could use blockchain to meet their Know Your Customer (KYC), Anti-Money Laundering (AML), Countering the Financing of Terrorism (CFT), and Politically Exposed Persons (PEP) requirements.

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