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How the blockchain can transform the financial world

July 12, 2016 10:03 IST

The blockchain, the public ledger that tracks every bitcoin transaction, is changing commerce as we know it, says Devangshu Datta.

Bitcoins

Photograph: George Frey/Getty Images

Columbus famously found a new continent while looking for a new route to reach an old one.

Alexander Fleming discovered penicillin by leaving a petri dish unwashed.

In years to come, the blockchain will be added to such lists of serendipitous discoveries.

The blockchain is a digital ledger. It was invented to track a digital currency, the bitcoin. Yet, the blockchain's utility potentially far outweighs that of the bitcoin itself. The blockchain is changing the dynamics of many business sectors.

The bitcoin was dreamt up in a paper released in late 2008 as the global financial system tottered.

There has been much speculation about the pseudonymous Satoshi Nakamoto who wrote that first paper. The Bitcoin has since become popular and also suffered notoriety for helping to finance dark markets dealing in illicit drugs and murder for hire.

Bankers and law enforcement authorities have a love-hate relationship with the bitcoin. But there is absolute consensus on the brilliance and ingenuity of the design.

Nakamoto, whoever he or she may be, solved many thorny problems by inventing the blockchain. In fact, 'he' found potential solutions to problems that ‘he’ may not have even considered.

The Bitcoin has no central database or bank. The blockchain is a distributed digital ledger. It is open source. Anybody can download a copy. It is constantly updated and re-synchronised.

Every bitcoin transaction ever made is recorded with a time-stamp in the blockchain. Every new transaction is verified via the blockchain.

Every transaction entry is stored at a unique address.

Every unique address is associated with a 'bitcoin wallet', which is the equivalent of a bank account.

Every user owns a bitcoin wallet (wallets are also free to download).

The bitcoin is a unique code-string, like the unique serial number on a banknote. Bitcoins are 'mined' -- coins (meaning code-strings) are generated and handed out as rewards to users who give computer resources for maintaining the system.

In a transaction, bitcoins are transferred from one blockchain address to another address. A transaction starts with a message to all users, saying something like 'Wallet X transfers three bitcoins from address A to address B (controlled by Wallet Y).'

Cryptographic methods are used to verify the message is from Wallet X. Users then check respective blockchain copies to see if the funds exist at address A. When a majority of users concur the message is okay, the transaction is verified and the blockchain is updated to reflect the transfer.

A complicated mathematical game is played during this process by the computers. As transaction blocks build up, these are connected cryptographically to earlier blocks. Hence the name, blockchain.

Anyone can check the code and transaction history. Every entry is unique. It is very hard to tamper with entries due to the cryptography, peer-to-peer checking and synchronisation.

An attempt to secretly change a prior entry will immediately show up as a discrepancy to multiple users.

Importantly, the same coin cannot be spent twice; coins are unique and transactions time-stamped.

So this is a so-called 'trustless system'. Strangers can deal with each other anonymously, without trusting each other. Note that the owner of a 'wallet' can be anonymous.

This may be very useful in other contexts like dealing with data privacy, sidestepping censorship and surveillance and conducting secret-ballot elections.

Bitcoins

Photograph: Sean Gallup/Getty Images

It was only after a few years that the potential of the blockchain was realised.

It doesn't matter what the entries are on a given blockchain: Each entry is unique; each unique entry is verifiable by many; each entry is tamper-proof.

What is more, time stamping allows future obligations to be met (as with post-dated cheques or escrow accounts). Any blockchain address can also be associated with multiple 'wallets' (like a joint bank account).

A blockchain can track mobile phones, bond and share certificates, cross-border remittances, credit card use, wine, road stretches, cars, real estate, windscreen wipers, frequent flyer miles, signed paintings, scientific papers, legal documents, cement bags, eggs, pieces of music.

These are all uses that have cropped up. Entrepreneurs will surely find more. For example, hot concepts like Uber, Kickstarter, Airbnb are all built around centralised lists. Decentralised blockchain-lists may replace such services.

Blockchains also enable new types of 'smart contracts' and even fraud-proof elections (see Smart Contracts below). Some startups are looking at ambitious ideas like reworking the way the Internet exchanges files and the creation of absolutely private but open databases.

There is a 'world identity' concept in the air, where users create an address on a global blockchain. If documents are lost, refugees can still prove their identity.

There are concepts in the air for smart power grids, with every pole listed on a blockchain.

Billions are now being invested in blockchain ideas.

The first 'adaptees' included investment banks looking to reduce internal fraud and to make it easier to reconcile trades with each other. This includes at least 25 major investment banks including UBS, HSBC and Goldman Sachs, which have joined a startup, R3 CEV, to develop common standards. Such ledgers could cut bank's bills by at least $20 billion.

Infosys may be a big player here. Its subsidiary, EdgeVerve, has created a blockchain framework.

Another set of users comprises financial exchanges, clearing houses and depositories. This includes the New York Stock Exchange, NASDAQ, US Depository Trust & Clearing Corporation (the national American registry for share and bond certificates) and Russia's National Settlement Depository. All have successfully experimented with blockchains, which have already been deployed in some cases.

Blockchains are also catching on in public governance, with land registries and municipalities. Sweden's National Land Survey is working towards a blockchained land registry. Estonia has started using blockchains for its marriage registry system.

Obviously the blockchain could be a major tool that changes commerce in many ways and even improves public governance. Of course, it will not be a trivial challenge creating hacker-proof systems for all these things.

Regulators and legislators will also have to get their heads around the ways in which this could change business systems. But the concept does promise a great deal.

The blockchain doesn't seem revolutionary or sexy at first, or even second, glance. But it could alter society in the same seminal way that other boring concepts like double-entry book-keeping, joint-stock shareholder companies and insurance did.

How It Works

Everybody can access the blockchain database.

Every transaction is messaged to everybody.

A new transaction is allowed only when users agree it is valid.

Then the blockchain is updated to reflect the transfer.

Startups doing interesting things

Provenance.org

It certifies branded products and materials using blockchain technology.

As something is manufactured, it is registered on a customised blockchain. So, manufacturers can source materials across supply chains with a strong guarantee that the materials are not counterfeit. At the same time, a retail customer can also buy branded goods with similar assurances of genuineness.

This concept could be extended to prove the provenance of everything, from mundane bags of cement, branded liquor and farm produce to signed oil paintings by artists. It could even be adapted to help cut down on plagiarism and aid in patent applications by registering documents with time-stamps.

Enigma.media.mit.edu

A project of the MIT media lab, Enigma has put together a decentralised cloud platform which supposedly guarantees absolute privacy of data. Instead of a central data repository (which could be hacked), the Enigma concept splits up the data and keeps it decentralised.

Nobody has access to the raw data and nobody has access to more than certain slices of the entire data. That offers a lot of comfort to users who are terrified of identity theft or credit card hacks.

Enigma uses blockchain technology but it adds on a lot of complicated mathematical bells and whistles. This technology could have obvious applications in multiple spheres across finance, health, and civil services.

Consider for example, how such a technology could bring comfort to all those who are worried about the privacy and security aspects of Aadhaar, or of the US Social Security system.

Smart contracts

Smart contracts use blockchains to make it easier to fulfil certain types of agreements without any (or much) human intervention.

In fact, a smart contract can be defined as a self-executing contract. Instead of legal documents with binding provisions, a smart contract is programmed, usually on top of a blockchain or some similar mechanism.

Using digital cash makes it easier to write smart contracts. But it is also easy to build in an automatic 'conversion,' where the transaction is denominated in digital cash but it is paid in rupees or dollars as suits the participants.

For example, rental payments can be structured round a smart contract. In that case, instead of handing over post-dated cheques, an auto-payment mechanism is set up with the rental amount transferred at the agreed time.

Alternatively, a parent may set up a smart contract to pay school fees for her ward. Or an NRI could use a smart contract for remittances.  

All these things are normally done using the banks, lawyers or real estate agents. But the fees, paperwork and general hassle can be much reduced by a smart contract.

How does this work? A system is set up for an automatic transfer of cash which may be held in escrow (ideally, digital bitcoin-type cash is used but there are ways to use 'normal' cash) on the receipt of a signed message (or multiple signed messages in some cases).

Any blockchain message is seamlessly verified as authentic and 'signed'. It is coded using a private key known to only one person and it can only be decoded using a public-key associated with that person.

Smart contracts can also enable micropayments that are a hassle to account for, otherwise. For example, a publishing house may pay royalties per book/per download using a smart contract.

Auctions, web-gambling and prediction markets are other places where smart contracts can make a difference.

An auction can be set up to automatically verify that a bidder has funds and the auction can close at a set time. In a prediction market, funds can be held in escrow, to be settled as and when the predicted event happens. For example, once the next US president is announced, a prediction market with people betting on the US presidential elections can be settled.

In gambling, the open nature of the blockchain also helps a casino to prove that the games are fair -- every bet is recorded. It also allows customers to retrieve money if the site closes down suddenly.

Most intriguingly, smart contracts may improve local governance.

For example, say a municipality hires somebody to repair a road (or a sewage system). The municipality can put the payment in escrow with release requiring the signoff of say 70 per cent of tax-paying citizens living on that road. If citizens are happy, funds are immediately released, cutting down on corruption.

Devangshu Datta
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