“The blockchain is real.” J.P. Morgan Chase CEO Jamie Dimon told Fox Business on 9 January 2018. Has he contradicted himself? In the past he has called bitcoin a fraud. No, bitcoin is not blockchain. Bitcoin is a very clever application of blockchain technology to allow bitcoin to provide the functions of fiat money, i.e. as a medium of exchange and a store of value.
While government and established financial institutions are wary of bitcoins, many have embraced blockchain technology. They are exploring how they could use this nascent technology for financial services. Mr. Ravi Menon, Managing Director, Monetary Authority of Singapore, on 14 November 2017 announced that Singapore and Hong Kong will develop a blockchain-based platform for trade finance. Companies, like IBM, BOC, HSBC, UBS, DBS, Mizuho, and Microsoft, have also started exploring the use of blockchain technology to transform trade finance.
According to Caixin, the People’s Bank of China completed a successful trial run of blockchain-based digital fiat currencies in December 2016 with ICBC, WeBank and BOC. The Financial Times has reported that the U.K., Singapore, Sweden, Australia and Canada are also examining the feasibility of blockchain-based digital fiat currency. If it is successful the implications are likely to be profound. It would reduce circulation costs, increase transparency, change the approach to monetary policy strategies and have significant impact on the commercial bank business model.
Other applications of blockchain technology in financial services that are being explored include cross-border payment, trading share, bond and derivatives, clearing and settlement, issuing of share, fundraising, customer due diligence regulations, creating digital assets, and regulatory compliance. Almost every day, since early 2017, there will be news of the launch of a blockchain pilot project by a financial institution, fintech startup or a government agency. The financial industry seems optimistic about the potential of blockchain technology.
True, many of these projects are still in the proof of concept phase or have been hard-pressed to find users. As a whole, blockchain is still in its nascent stages. The verdict of this technology is certainly not certain.
However, if you are a finance professional, you should learn about this technology. There are signs that we are moving beyond the proof of concept era and if it does the financial industry is likely to be transformed in a very significant way. Don’t be left behind. Instead, you should be riding the exciting wave of this technology.
To help you start your learning journey, I provide below some key non-technical knowledge of blockchain.
What is blockchain technology? In substance, it is a technology that offers a new approach to store and manage data. It is built on decades of research in cryptography. There are two key components:
An immutable ledger means once data has been written to the ledger no one can change it. As a provider of data you can prove that your data hasn't been altered, and as a recipient of data, you can be sure that the data hasn't been altered.
Before we can discuss each of these two components in detail, we need to understand cryptographic hash functions, the cryptography underpinning blockchain.
What are cryptographic hash functions? They are functions that take an input or message of any size and return a UNIQUE fixed-size alphanumeric string. The fixed-size string is called the hash value, or simply “hash”.
A key property of cryptographic hash functions is that it is almost impossible to back-calculate the original input from its hash. Hence these hash functions are known as one-way hash functions. For example, bitcoin blockchain uses the SHA-256 cryptographic hash function. This SHA-256 function can convert a whole encyclopedia to a unique 64 alphanumeric characters (256 bits hash), but it cannot be decrypted back.
Any small change in the encyclopedia, such as an additional comma, will result in an entirely different hash. This is an important property we want from a cryptographic hash function -- if the input data changes in the slightest, the hash changes in an unpredictable way.
The cryptographic hash function is the basis of the security and immutability of blockchains. SHA-256 is designed by the U.S. National Security Agency and published in 2001 and is widely accepted as a very secured hash function. We are now ready to discuss the two key components of blockchain – digital signature and an immutable ledger.
What is a secure digital signature? It must be like a handwritten signature. First, only you can sign the signature; second, others can verify that it is your signature; and third, the signature is unforgeable. A digital signature scheme that provides the digital counterpart to handwritten signature generally consists of three operations:
- You generate a pair of private key and public key together through a good randomised algorithm. The public key is like your bank account number. It does not need to be kept secret. The private key is an alphanumeric number that corresponds to your public key. It is similar to a password and must be kept secret.
- You “sign” the digital signature using the cryptographic hash function (H). The digital signature is created by hashing the message that you want to sign together with your secret private key.
H (message, private key) = Digital Signature
This signature depends on the message, it will be different for every transaction, and therefore can’t be reused by someone for a different transaction (i.e. unforgeable). This dependence on the message also means that no one can modify the message, as any changes to the message would change the signature.
- Others verify your digital signature by employing another mathematical function (V), which takes your public key, message and digital signature as input, and return True if you are the true owner of the public key, and False otherwise.
V (public key, message, signature) = True (or False)
This allows other to verify that you owned the private key without actually seeing it. The message (or the transaction) is indeed from you.
How can a ledger be immutable? The idea of how to create an immutable ledger can be traced back to the scheme proposed by Harber and Stornetta in 1991. Under their scheme, after verifying that a transaction is valid, we hash the transaction using a cryptographic hash function. Instead of just hashing the current transaction, we include the hash value of the previous transaction in its hash, forming a chain. See figure below.
With this system, any changes to the earlier transaction, such as transaction 61, will make the record of transactions 62, 63 and all later transactions invalid. In this way each additional transaction we add to the ledger reinforces the ones before.
Instead of linking transaction individually, a more efficient way is to collect many transactions into a block and link blocks together in a chain. The integrity and the chronological order of the ledger are enforced with cryptography.
The blockchain can be managed by a trusted administrator. Such blockchain is called a private blockchain. There are potential weaknesses of having a trusted third party take responsibility for verifying transactions and updating the ledger. What if the trusted third party is not trustworthy? He or she can change the ledger arbitrarily, exclude certain transactions from the ledger, or play favorites in exchange for side payment. A crowdsourcing solution to create a distributed ledger that does not need a trusted administrator was proposed in 2008.
What is a Distributed Ledger? Satoshi Nakamoto (presumed pseudonym) in 2008 develops a very clever incentive-based crowdsourcing solution for bitcoin blockchain. Instead of having a trusted party keeping the ledger, under the bitcoin-incentive scheme, a network of members competes to create new blocks by racing to solve a mathematical problem. The first member to solve the problem gets the reward. He or she will then broadcast the result and propose what the next block in the blockchain will be. The network members after verifying the solution to the mathematical problem is correct and all the transactions in the proposed block are valid will signal their acceptance by extending their blockchains and including the proposed block. Since each network member keeps a set of the same ledger or blockchain, the ledger becomes a public ledger, also often known as the distributed ledger.
A blockchain with a distributed ledger is known as a public blockchain. Bitcoin is a successful public blockchain.
The Consensus Protocol of bitcoin blockchain can be summarized in the following simplified steps:
- New transactions (message and sender’s digital signature and public key) are broadcast to all network members
- Each member selects a set of new transactions to form a block and verifies the validity of these transactions
- They race to solve a mathematical problem
- The winner broadcasts his/her proposed new block to the network.
- He/she gets to create the next block and receives the reward in bitcoins
- Other members signal their acceptance by incorporating this proposed block in their extended blockchain. This would technically include the hash value of the proposed new block in the next block they create.
We can see that the beauty of this distributed ledger is that no trusted third party is needed. A distributed consensus protocol is followed by the network members to validate new transactions/blocks. Bitcoin’s distributed consensus protocol, also known as Proof of Work (PoW), has worked well since its inception. But, despite its success, there are serious issues with this protocol. It requires enormous amounts of electricity to solve the mathematical problem and it takes too long to process a transaction.
An alternative distributed consensus protocol to PoW is the Proof of Stake (PoS). In PoS the creator of the next block is generally selected by a combination of the size of their stakes (for example the number of coins they hold) and a randomized algorithm. The creator broadcasts the proposed block to the network. After it is signed off by the majority of the network members, the block will then be appended to the blockchain. Compare to Bitcoin’s PoW, PoS is more energy efficient. However, critics believe that this protocol is easier to be attacked. The search for a faster, cheaper, and more secure distributed consensus protocol is still ongoing.
Public, Private and Consortium Blockchain. A public blockchain, such as the bitcoin blockchain, is run on the internet and designed to allow anyone with a computer to submit transactions or join in with maintaining the ledger. No one member alone can temper with the ledger. Since there is no central bookkeeper, there is no single point of failure vulnerable to hacking or hardware failure. No monopolist transaction fee.
The distributed consensus makes public blockchain extremely secure, but it also makes it slow in processing transaction. Privacy is also a concerning issue. On the other hand, private blockchain can process transactions much faster and with much greater privacy, but it does not offer the same decentralized security as the public blockchain.
Recently a growing number of organisations are forming partnerships to develop consortium blockchains. Instead of allowing anyone with an internet connection to participate in the updating the ledger or allowing only one trusted party to do so, a few selected parties are given the responsibility. Hence it is partly private. The consortium blockchain provides similar benefits of a private blockchain, i.e. efficiency and privacy, without consolidating power with only one party. Different users may be given different types of permission, for example, some are permitted to view the ledger but not to add data. Such blockchains are more appealing to financial institutions as it allows them to retain control and privacy while enjoying the benefits of this technology.
In summary, public blockchain technology (secure digital signature, immutable ledger, and distributed consensus protocol) provides us with an approach to maintain a ledger that is transparent, reliable and immutable. These qualities are important to many financial services and transactions. If we adopt the public blockchain which is a trustless system that relies on network consensus and cryptography, we can do without trusted intermediaries in financial transactions. Such disintermediation, if it happens, will significantly reshape the financial industry. Fintech startups that can navigate the regulatory challenges will take away a large portion of the business of established financial institutions and may make many of them obsolete. But it is not clear whether the incumbents will be disrupted or they will embrace the new technology and transform from within.
- Alex Tapscott, and Don Tapscott, “How Blockchain Is Changing Finance,” Harvard Business Review, March 2017.
- Goldman Sachs Equity Research, “Profiles in Innovation: Blockchain,” 2016.
- Haber Stuart, and Stornetta W. Scott, "How to time-stamp a digital document," Journal of Cryptology, vol 3, no 2, pages 99-111, 1991.
- Johnson, Don, Alfred Menezes, and Scott Vanstone, “The elliptic curve digital signature algorithm (ECDSA),” International Journal of Information Security, vol 1.1 pp 36-63, 2001.
- Nakamoto, Satoshi, “Bitcoin: A peer-to-peer electronic cash system,” 2008.