Understanding Blockchains

May 06, 2016

Following on from our Fintech blog, this week we are taking a look at blockchains.

Have you heard of blockchains? Well, until a month ago I hadn’t, but I had heard of Bitcoin, the virtual currency, and Bitcoin is a, or rather, ‘the’ blockchain.

Simply put, blockchain technology refers to a type data structure, much like a distributed database, made up of nodes called blocks. I’ll paraphrase a very (over)simplified analogy I found on Coindesk:

The ‘blocks’

Say I take a digital photo of an apple. Let’s pretend that the photo is valuable and this value is intrinsically linked to there being only one, original photo. You want it. I send it to you. The photo has moved from my possession to yours. However, given the digital nature of the photo, you need a way of confirming that I haven’t sent you a copy of the original photo, or that I didn’t also send the photo someone else, or put it on the Internet where it’s been downloaded by a million people, thereby devaluing it. Plainly put, we need to validate our transaction, i.e., confirm that the exact photo I had in my possession is no longer in my possession, and is now only in your possession.

The ‘chain’

Following Bitcoin protocol, all transactions are recorded on a public ledger, which can be accessed by thousands of people, who manage the ledger. This means that if I try to send my photo to multiple recipients, the mismatch in my balance will be flagged by the rest of the people managing the ledger. A transaction can only be completed in the ledger when there is general consensus on its validity and all users know who owns every block, at any time. This theoretically makes the block chain extremely secure.

So what is all the fuss about?

Many of the companies which invested in Bitcoin start-ups were actually buying into their blockchain capabilities. Why? Well, blockchain technology has enormous potential for transforming the efficiency of banking, insurance and financial services in general.

Let’s start with banking: the likes of JPMorgan Chase and Goldman Sachs have begun trialling blockchain technology in an effort to cut cost and time of trading, the inherent transparency of the technology being very attractive. Asset management firms are also investigating the technology, not only for cost-cutting, but also in a bid to cut down on money laundering and fraud.

In insurance, London start-up Everledger is using blockchain technology to tackle the diamond industry's expensive fraud and theft problem. According to a 2012 study from the Association of British Insurers, around 65% of fraudulent claims go undetected, at an expense of £2bn to insurance companies annually. Already, over 800,000 diamonds of significant size and quality have been tagged and uploaded on the company’s ledger. It doesn’t seem a stretch to think this could be applied to valuable artwork, for instance. For inventory management of ‘priceless’ commodities, it seems a good idea.

Within the London Market, blockchain technology will be considered as part of the TOM programme, potentially with a focus on secure document sharing and storage.

Clearly, the transparency and security of blockchain technology is a main drawcard. However, since its inception, Bitcoin has been successfully hacked a number of times. As blockchain technology advances, along with its cybersecurity, so hackers become more sophisticated as well.

Because the rewards are potentially off-the-scale, financial institutions have little choice but to seriously evaluate the benefits and applications for blockchain technology. It remains to be seen however, just how far those applications can stretch, and ultimately how secure they will be.

 

Penelope Mantzaris, Director at Gracechurch.