Global menu

Our global pages

Close

Blockchain: an introduction

  • United Kingdom
  • Financial institutions - Digital Financial Services
  • Technology, Media and Telecoms - Disruptive Technology

11-07-2017

Blockchain is a new mechanism for storing data, based on a decentralised ledger. This article seeks to explain, in relatively simple terms, what this actually means. It also seeks to give guidance regarding how blockchain may impact on the financial services industry in general, and how United Kingdom and European regulators are reacting to its development.

What?

Blockchain: how does it work?

The easiest way to visualise blockchain is to compare it with a simple bank account. A bank account is a ledger, in other words it is a record of information between the account holder and the bank. Blockchain, by comparison, is often referred to as a ‘decentralised ledger’. This means that it operates similarly to a bank account, except that instead of the record existing just between the account holder and the bank, there are many copies of the same ledger, each between the account holder and different ‘banks’, which are now called nodes. Many identical copies of the ledger exist, each held by a node watching the account. Also, the ledgers in a blockchain can hold any type of data, not just banking information.

This distinction from the traditional bank account is vital to blockchain, as can be explained using a further analogy, this time to a theatre performance. The performance on stage is equivalent to the data stored in the account, and the members of the audience are equivalent to the nodes. Each of the audience members (the ‘nodes’) is watching the performance (a block of data or ‘block’). When a transaction occurs, this can be seen as equivalent to someone walking onto the stage. If each member of the audience is asked what has just happened, they are likely to give matching descriptions of a person walking onto the stage. In the same way, when a transaction occurs in a blockchain, the nodes ‘watching’ this transaction are likely to each describe it identically. The scope of a misrepresentation is diminished using blockchain because an increased number of watchers need to be convinced of any change to the data before it is accepted.

Another aspect of blockchain is that all of the data in each block is encrypted under a pseudonym. This means that, although the data is public, the identity of whom the data relates to is not. This means that it can be used as a very confidential means of storing data.

How is blockchain distinct from bitcoin?

Blockchain is often linked to bitcoin. Bitcoin is a type of crypto-currency, which means that it is an electronic store of value, which is not tied to any particular government or bank. Crypto-currencies can only exist as a result of blockchain, because, without either a bank or a government to confirm a currency’s validity, blockchain is needed to perform this function and to prevent fraud. However, blockchain is far larger than simply a mechanism for validating crypto-currencies, as it can be used for all data, not just storing financial transactions.

So What?

Blockchain: the impact

The effects of blockchain are likely to be wide ranging, as shown by the fact that a wide range of uses have been suggested by governments across the globe. These include using blockchain to provide notarization services (Estonia), to build a land title registry (Honduras), and a companies registry (the Isle of Man). It is not yet possible to state exactly what the impact of blockchain will be on the financial services industry, however, looking at the blockchain mechanism, the following predictions have been suggested:

• There could be a decreased roll for intermediaries. Intermediaries, such as banks and clearing houses, are often used as a way of verifying the authenticity of transactions. However, this role is challenged by blockchain, as it provides an alternative means of checking authenticity. The Nasdaq has opened up to investors buying shares using its Linq blockchain ledger, as part of exploring the use of blockchain as part of its infrastructure. This could lower costs, as most intermediaries charge a fee for their services.

• Value could be moved around more quickly. By removing the need to use an intermediary as a validation mechanism, blockchain is likely to speed up the rate at which, once agreed, transactions can be executed. This, in turn, reduces the amount market participants have to set aside at any one time in preparation for execution, freeing up capital.

• There could be less scope for cybercrime and fraud. Blockchain generally makes it far harder to alter data and reduces the scope for misrepresentation. As such, it could be that in the future it becomes mandatory, from a regulatory perspective, to use blockchain as a mechanism for keeping data secure.

• There could be increased scope for automated transactions. This includes programming blockchain so that dividends are paid on declaration, and shipment contracts paid on delivery. This saves cost and reduces the scope for error, as it removes the requirement for someone to independently execute these processes.

• There could be more flexibility for project funding. One example of this is the Lighthouse project, designed to enable decentralised crowdfunding, which uses blockchain to ensure that ventures are funded only once a minimum threshold of finance has been pledged – only on attaining this threshold does blockchain execute all of the relevant transactions, providing the necessary funding.

Although the potential positive consequences of blockchain are generally acknowledged, there are risks. Some question whether blockchain is really secure, as, although the data is encrypted, that encryption is unlocked using a private key, and so if the private key can be stolen the data is no longer secure. Hacking is also still possible if sufficient nodes can be convinced that fraudulent data is actually genuine, so that the blockchain is altered to reflect the inaccurate data. Another issue is the question of scale, in that currently blockchain is only used on a relatively small scale, and so there may be difficulties finding the efficiencies needed for blockchain to be practicable on the much larger scale envisioned by enthusiasts.

Blockchain: a regulatory response?

The government is broadly supportive of increasing the use of blockchain, and recognises the benefits of blockchain solutions.

The regulator which, so far, has shown the greatest interest in blockchain is the Financial Conduct Authority (“FCA”). The FCA generally takes a “technology neutral” approach to regulation, however the unique nature of blockchain has raised the question of whether a change in approach is necessary, so that use of blockchain is regulated in and of itself.

The FCA recognises that there may be specific areas where blockchain does not fit with current legal and regulatory requirements but still achieves the desired outcomes. It is thus considering whether its rules prevent or restrict sensible development that would benefit consumers and hence whether changes may be needed. Currently, the FCA does not see a clear need to consider generally altering the regulatory framework to accommodate blockchain solutions, but intends to explore emerging business models in terms of:

• What new risks and opportunities does blockchain present to the FCA’s statutory objectives of market integrity, consumer protection and competition? Can blockchain support more effective competition, financial system integrity and deliver better consumer outcomes? How can regulated firms mitigate any risks?

• Do any of blockchain’s characteristics make it challenging to fit blockchain solutions into the regulatory framework, despite the FCA’s approach of ‘technology neutrality’?

To navigate these issue, the FCA is seeking to start a dialogue on the potential development of blockchain, to coincide with the expected movement from blockchain applications from the proof of concept to the real-world deployment stage during the second half of this year. The focus will be on what the real benefits and risks of blockchain technology will be, removing the hype surrounding the technology, particularly in the context of the FCA’s objectives. We have fed into this discussion, which closes for comments on 17 July 2017.

For more information contact

< Go back

Print Friendly and PDF
Subscribe to e-briefings