While the notion of blockchain may seem novel, the underlying technology is not new. It is the combination of proven, existing technologies: peer-to-peer networking, asymmetric cryptography and cryptographic hashing (see: In plain English). Bitcoin was the innovation that combined these technologies, offering the ability to transfer value, while preventing double-spend in a trustless, pseudonymous, publicly accessible system. In contrast to Bitcoin, blockchain applications in wholesale banking and capital markets are seeking to keep the decentralized nature of the network and immutability of the underlying ledger, while reinstating accountability and governance models that allow legal recourse and support existing regulatory frameworks. We see the most promise for distributed ledgers existing within a permissioned environment of known participants who can transact privately among one another, while selectively granting visibility of their own data to regulators and third parties, such as analytics providers.
Peer-to-peer network: A group of computers that can communicate among themselves without relying on a single central authority or having a single point of failure
Asymmetric cryptography: A way to send a message encrypted for specific recipients such that anyone can verify the sender’s authenticity but only intended recipients can read the message contents
Cryptographic hashing: A way to generate a small, unique “fingerprint” for any data allowing quick comparison of large data sets and a secure way to verify data has not been altered
purposes of this report, we take a pragmatic approach and define blockchain by its fundamental impacts: creation of secured, shared data with common standards; reduced need for reconciliation; and seamless transfer of digital assets. By focusing our definition in this way, we look to drive emphasis on the near- and medium term practical applications currently being explored, rather than the less easily digestible, more distant scenario of a fully decentralized financial system that this technology may or may not eventually enable.
The driving force behind the recent fame and success of blockchain technology is the wide range and flexibility of protocols that can be realized using the basic data structures defined in the previous section. To understand the blockchain protocols, we need to define some essential functional components, as follows:
The blockchain protocol, in its most generality, establishes a consensus over a decentralized network of members involved in the respective protocol. The members participating in the protocol may have various roles and actions in managing the authenticated data structure, as specified in the protocol. Such roles and actions may depend upon a prespecified access control mechanism, or a set of permissions, as and when applicable, to make the protocol fully flexible. Consequently, the structure of the blockchain network may be peer-to-peer (flat) or hierarchical, as and when required by the respective protocol.
A mutual contract struck between any set of entities in the blockchain network is generally termed as a transaction. Owing to the historical origin of blockchain technology from Bitcoin, any such contract is called a ‘transaction’. However, in its most generality, a transaction can be a complex multiparty contract encoded as a Boolean logic, implemented in the form of an executable script. These generic blockchain transactions are also called Smart Contracts. The transactions are the fundamental atomic components of a blockchain protocol, and the other structures in the protocol are built on top of transactions. One may in fact view a blockchain platform as a tamper-evident distributed ledger of transactions.
A collection of transactions in a blockchain network is generally stored in the form of a Merkle Tree, to ensure tamper-evidence of the set of transactions using a constant size commitment (hash pointer to the root of the tree). Each such set of transactions, recorded as a Merkle Tree, is included in the data segment of a block, and these blocks are stored chronologically (as per their time-stamps) in a blockchain ledger, that is, in the form of a tamper evident
Blockchain is inherently meant to be a decentralized ledger of transactions. Thus, each transaction or contract between two (or more) members in the network requires verification or validation by the network itself, without going through an independent arbitrator. This is achieved by incorporating a verification scheme in the protocol. In practical blockchain schemes, this verification s c h e m e i s o f t e n implemented as a part of the transaction in t h e f o r m o f a n executable script, which results in either a c c e p t a n c e o r rejection of the specific transaction. In certain practical a p p l i c a t i o n s o f b l o c k c h a i n t e c h n o l o g y, t h e verification routine also connects the current transaction to previously existing transactions in the blockchain, which have been verified earlier as inputs. These connections have been depicted by the dotted lines in Figure 4. Depending on the application, the verification scheme may be designed in such a way that the transactions admit to public verification, or it may be entirely permissioned.
The transactions are grouped together in a Merkle Tree, and the block containing this tree is recorded in the blockchain ledger. It is to be noted that in a distributed network, the task of creating a block and appending it to the ledger should also be natively decentralized. The blockchain technology is flexible enough to accommodate a suitable form of decentralized appending process, known as mining in general. Irrespective of the exact mining process that updates the blockchain ledger, it is imperative to ensure that the ledger is universally accepted across the network at any given point of time. This warrants for a consensus scheme in the protocol. This decentralized consensus mechanism ensures a consistent version of the blockchain ledger amongst all members of the network, and provides the most important tamper-detection and tamper-resilience property to the blockchain. In fact, if any member introduces an inconsistency in the ledger through the mining process, the other members have the power to negate the block appended by that member, and rectify the ledger by forking the chain. Depending on the nature of the application and the structure of the network, specific consensus schemes may be constructed for the blockchain to ensure tamper-resilience. Note that the mining and consensus schemes constitute the backbone for any blockchain protocol, and hence should be chosen carefully.
“A smart contract is an agreement whose execution is both automatable and enforceable. Automatable by computer, although some parts may require human input and control. Enforceable by either legal enforcement of rights and obligations or tamperproof execution”. (definition by Barclays).
Smart contracts are pieces of software, that extend blockchains’ utility from simply keeping a record of financial transaction entries to automatically implementing terms of multi-party agreements. Smart contracts are executed by a computer network that uses consensus protocols to agree upon the sequence of actions resulting from the contract’s code. With a shared database running a blockchain protocol, the smart contracts auto-execute, and all parties validate the outcome instantaneously and without need for a third-party intermediary.
Based on the choice of the functional components described above, blockchain architectures may be classified broadly into two categories – public and private. In case of public architectures, the process of generation and verification of transactions is publicly available, so that anyone in the network may perform these actions. In fact, the mining process is also open to anyone in the network. However, most often, the mining process relies on some proof-of-work concepts, which may be monopolized by supremacy in financial or computing power. In case of private blockchain architectures, the processes involving the generation and verification of transactions may be access controlled, and restricted to only a fraction of the members on the network. Quite often, this results in a simpler consensus mechanism, which may or may not require a competitive mining at all. Another popular nomenclature in this line classifies the blockchain architecture as permissioned and permissionless. A blockchain is said to be permissionless if the transactions can be made or verified by anyone in the network, while a blockchain is said to be permissioned if the transactions can be made or verified by predetermined authorized entities. In addition, the permissioned blockchains might include specifically designed access control structure to determine who in the network can view the blockchain ledger, mine blocks and verify blocks. In permissionless blockchain protocols, like Bitcoin, majority consensus is followed in general, where the longest chain sustains. In case of permissioned blockchains, the miners and auditors are trusted entities, and hence the consensus scheme may be designed to be much simpler in such cases. In fact, the mining may be a delegation scheme, instead of a competitive scheme, in a permissioned setting.
Financial services industry is currently the leader in experimenting with the technology. A number of initiatives that are already underway are driving its progression to an industrial solution which will yield several important benefits in the context of transfer of assets within business networks. Blockchain holds the potential for all participants in a business network to share a system of records which will provide consensus, provenance, immutability and finality around the transfer of assets within the business network. The reason blockchain can be potentially disruptive is that the distributed ledgers may lead to new business models and the existing processes could move away from a hub and spoke model with intermediaries. Typically, in the banking industry/financial services, the key transactions in the processes are to underpin asset ownership and asset or value transfer. In order to conclude/settle a transaction, data messages are exchanged between the banks/financial institutions, sometimes including ‘trusted’ intermediaries. Despite the efforts to reduce the complexities and increase the interconnectedness of participants’ transaction records, business networks are still typically exchanging data or messages between them to conclude transactions. As a result, the processes are sometimes inefficient, expensive, and vulnerable. BCT has the potential to address certain limitations of the current processes by modernizing, streamlining and simplifying the traditional siloed design of the financial industry infrastructure with a shared fabric of common information. The advantages brought by BCT can be broadly classified into cost savings, efficiency, and transparency.
Fraud Prevention: As BCT is built on the concept of sharing information across parties and consensus during transactions; it saves on reconciliation cost between banks and prevents losses because of documentary frauds. Save costs on forex volatility: BCT used in cross border payments can help the consumers and banks to take advantage of the forex marketplace to get the best deal transparently from the market players. Since the transactions are processed in near realtime, the players need not suffer through the vagaries of currency volatility. Save costs over delayed settlements: In case of a distributed payment network, BCT ensures the transaction settlement information is also processed simultaneously along with the payment messages. Since, the payments and settlements happen in realtime, he participating banks and financial institutions can enjoy reduced pressure on the treasury management to keep their settlement accounts well-funded.
Resilience through redundancy: Being a distributed architecture by design, BCT enables the network to be operated by all permissioned nodes in the ecosystem. All the important members of the payment ecosystem – banks, financial institutions shall effectively become the participating nodes in the BCT network. In the case of an untoward event affecting the ecosystem (like war, floods, earthquakes, cyber-attacks), even if some nodes of the network are unavailable, the consensusalgorithms built as a part of the BCT network ensure a transaction can be approved by the remaining nodes in the network. BCT also brings in a high level of redundancy in the network, as the copy of the ledger is available with all the nodes in the network.
Reduced time for processing: Most of the conventional banking processes are linear and hierarchical, akin to the assembly line of the manufacturing industry, e.g., maker-checker/cross check/approval processes. While the makerchecker- approver process helps the banks and FIs to gain control and puts the emphasis on wnership of decisions, it delays in decision making and can lead to longer processing time, costs and lower customer satisfaction. BCT can radically alter the way such transactions are processed by banks and FIs today. In BCT, the transaction is relayed to all the approving nodes simultaneously, as and when the approvals are provided, the information is updated in the ledgers of all the nodes, instantly. Thus, BCT can help in improving the speed of processing transactions by reduction in decision making time across the organizations resulting in reduced cost of processing and enhanced transparency of decisions to all participating nodes. Smart Contracts are business terms that are embedded in the transaction database and gets automatically executed when certain business conditions are met. Smart Contract feature in the BCT enables speed of processing and helps banks to create and execute complex business rules that have minimal human intervention and it can address the market needs that could not be satisfied before.
Faster settlements: Blockchain can also help to address KYC and identity management challenges as a lot of the data to prove identity is already in digital form and BCT could enable instant verification. Use of BCT can reduce duplicative recordkeeping, eliminate reconciliation, minimize error rates and facilitate faster payment/asset settlement. In turn, faster settlement means less risk in the financial system and lower capital requirements. One of the most frequently suggested example where BCT can be readily applied to banking is in the Trade Finance area. A trade finance solution with letter of credit, bill of lading and multi-signature solutions based on BCT would include the following features: Carriers issue bill of lading on the BCT as a digital asset Banks issue letter of credit as a digital asset on the BCT Multi-signature contracts Smart-contract-enabled, event-based fund release to ensure speed and transparency.
Saving in decision making time: BCT helps in improving the rate of processing transactions by reducing decision making time, thus resulting in reduced cost of processing and enhanced transparency of decisions to all the participating nodes. As BCT brings transparency to the system, availability of audit trails brings in the necessary control and trust to the participating members which may help improve the services through continuous innovation.
Immutable Transactions: Maintaining an immutable record of transaction events in a chronological order being a main pillar of its architecture, BCT guarantees much desired attributes to banking and financial transactions such as immutability and finality.
Although blockchain is imagined as an open system for transaction processing across the financial system, banks are initially looking inward, experimenting with the distributed ledger approach to create efficiencies and a single version of digital truth. Subsequently, onboard other external parties in the ecosystem for mutual benefits with a- permission-based ledger system that can move cash and assets in real-time to settle market transactions.
Provenance: In the area of payments, while the exchange of messages reasonably offer clarity on each step in the payment process, BCT could add to it by providing provenance and auditability for these messages and thus bringing about transparency and efficiency in the processes leading to reduction in overall settlement time and risk. Provenance ensures the finality of the ownership of the asset and it saves efforts and processes to prevent double collateralization of the same asset. As a ledgering technology, blockchain will not replace the payment systems or the messaging systems deployed by banks, but these systems will connect to the blockchain, augmenting existing business networks and providing increased discoverability and trust.
TradeFinance:One of the most frequently suggested examples of where blockchain can be applied is in the trade finance area. If some banks decide to put the letters of credit – on the blockchain, then that is pretty powerful – but to be really powerful the big corporates, the big shippers, and manufacturers, need to be on board, as well as the customs authorities. As both letters of credit and bills of lading have very complex and intricate information flows, even if only a few participants were using a blockchain solution this would generate significant advantages.
Barclays and an Israel-based start-up company have carried out what they say is the world’s first trade transaction using BCT, cutting a process that normally takes between seven and 10 days to less than four hours. The transaction guaranteed the export of almost $100,000 worth of cheese and butter from Irish agricultural food co-operative Ornua – formerly the Irish Dairy Board – to the Seychelles Trading Company. The deal was executed via a blockchain platform set up byWave, a firm that came through a Barclays development programme. Bank of America, Merrill Lynch, HSBC and the Infocomm Development Authority of Singapore have claimed success in demonstrating the application of distributed ledgers to replace paper-based Letters of Credit in trade finance transactions. The application enables exporters, importers and their respective banks to share information on a private distributed ledger. The trade deal can then be executed automatically through a series of digital smart contracts once certain conditions are satisfied. The parties involved in the transaction can visualize data in real-time on their devices and see the next actions to be performed. The application uses the open source Hyperledger as blockchain fabric, supported by IBM Research and IBM Global Business Services.
Cross-border Payments: Ripple is using distributed ledger technologies to transform the cross-border payment business, to make international payments easier and faster and has added a few banks to its network. The recent cyberattacks in Bangladesh, Vietnam and Ecuador have highlighted the vulnerabilities in cross-border transaction banking. Distributed ledgers present an opportunity to help banks partially overcome such vulnerabilities in the future. Santander Bank launched a new app to facilitate live international payments (foreign remittances), powered by BCT. The app uses core technology provided by Ripple.
FX Trading: Currently multiple records for currency trade have to be created for buyer, seller, broker, clearer and third parties and then continuously reconciled across multiple systems. Cobalt DL uses BCT, eliminating multiple trade records for buyer, seller, broker, clearer and third parties from each transaction. By presenting a shared view of a trade, Cobalt DL frees up back- and middle-office resources that are currently overwhelmed by the need for continuous reconciliation across multiple systems. This is backed by eight major banks and financial institutions. The technology is designed to integrate seamlessly with all trading sources and venues, providing immediate efficiency benefits, analysis of which has shown to deliver a significant cost reduction when
compared with existing infrastructure. FX market participants incur multiple unnecessary license fees, ticketing charges, IT overheads and staff costs as a result of the complexity of existing structures.
Capital Markets: R3 is a financial innovation firm that leads a consortium partnership with over 50 of the world’s leading financial institutions, to work together to design and deliver advanced distributed ledger technologies to the global financial markets. BCT can revolutionize the Capital Market trading processes. There are several intermediaries involved in a trade, like exchanges, central counterparties (CCPs), central securities depositories (CSDs), brokers, custodians and investment managers. For correct accounting and to complete the business transaction, intermediaries need to update their respective ledgers based on the messages exchanged between them. This creates a delay and also additional cost. Sometimes, to enable a particular transaction and the corresponding ledger updates,intermediaries may need to complete a few additional ledger transfers in the form of realignment, securities borrowing or cash management. This introduces additional delays in the transaction lifecycle, increasing the time for final settlement. BCT will benefit Capital Market Services at all stages of Trade and securities servicing.
IBA is suggesting an innovative usage of BCT – Monitoring of Financial Transactions of a borrower financed by a consortium of banks. This will help in preventing “diversion of funds”, which is a major concern of the banks today. The borrower moves funds from one bank to another and the end-usage is not known to the lenders. In the absence of a central entity, it is not operationally feasible to securely and reliably track the movement of money between accounts maintained across multiple financial institutions. A collaboration-based approach among financial institutions, on the other hand, can enable them to monitor money movement and perform the desired analytics thereon to detect anomalies as per the mutually agreed rules and patterns. The blockchain-based collaboration can also assist the participating banks/institutions to have bettervisibility of the use of loan money provided to corporates by tracking the movement of funds and analyzing how the said money was spent/paid and generating leads therefrom for auditing and scrutiny. Use of BCT will make the information of movement of funds available to all consortium members and help strengthen the monitoring mechanism.
The increasing cost of regulatory compliance isamong every banker’s top concerns, having to comply with regulations such as Anti-Money Laundering (AML) and Know Your Customer (KYC). Every bank and financial institution has to perform the KYC process individually, and upload the validated information and documents to the central registry that stores digitized data tagged to a unique identification number for each customer. By using this reference number, banks can access the stored data to perform due diligence whenever customers request for a new service within the same banking relationship, or fromanother bank. A blockchain-based registry would remove the duplication of effort in carrying out KYC checks. The ledger would also enable encrypted updates to client details to be distributed to all banks in near real-time. he KYC ledger would provide a historical record of all documents shared and compliance activities undertaken for each client. This will form the evidence to be provided to the regulators. It would be useful to identify entities attempting to create fraudulent histories. The data within it could be analyzed to spot irregularities or foul play – directly targeting criminal activity. SWIFT launched the SWIFT KYC Registry in December 2014, and more than 2000 banks have already enrolled with it. Banks are struggling to manage and integrate all the data required for KYC compliance to obtain a consolidated view of the customer, which explains the popularity of central registries like the one managed by SWIFT. SWIFT is now exploring the use of BCT for the same.
A suggested roadmap for the adoption of BCT to Indian banking is as follows:
Banks may setup a private blockchain for their internal purposes. This not only helps them to train human resources in the technology, but also benefits by enabling efficient asset management, opportunities for cross-selling, etc.
Proof-of-Concept implementation and testing may be carried out in the following order of increasing application complexity – mainly because of the number of stakeholders involved in the transaction. entralized KYC: Secure, istributed databases of lient information shared between institutions helps educe duplicative efforts in customer onboarding.Secure codification of account etails could enable greater transparency, efficiency in transaction surveillance and simplifies audit procedures.
Cross-Border Payments: BCT enables real-time settlement while reducing liquidity and operational costs. Transparent and immutable data on BCT reduces fraudulent transactions. Smart contracts eliminate operational errors by capturing obligations among FIs to ensure that appropriate funds are exchanged. BCT allows direct interaction betweensender and beneficiary banks, and enables low value transactions due to reduction in overall costs.
Syndication of Loans: Underwriting activities can be automated, leveraging financial details stored on the distributed ledger. KYC requirements can also be automatically enforced in real-time. BCT can provide a global cost reduction opportunity within the process execution and settlement sub-processes of syndicated loans.
Trade Finance: BCT usage for trade finance enables automation of LC creation, development of real-time tools for enforcing AML and customs activities, and associated cost savings.
Capital Markets: BCT brings the following advantages in the clearing and settlement processes – reducing or eliminating trade errors, streamlining back office functions, and shortening settlement times. ASX (Australian Securities Exchange) has been working on a blockchain based test-bed to be a potential replacement for CHESS. Further areas where BCT can be applied advantageously in BFSI sector would be supply chain finance, bill discounting, monitoring of consortium accounts, servicing of securities and mandate management system.
In a bid to evolve towards a cashless society, many central banks around the globe including Canada, England, Sweden, and Netherlands have started exploring the use of BCT for digitizing their currency, and many more are converging to the idea. From a technological perspective, we feel that BCT has matured enough and there is sufficient awareness among the stakeholders which makes this an appropriate time for initiating suitable efforts towards digitizing the Indian Rupee through BCT.
Secur ity Aspects of a BlockchainDeployment
Financial institutions rely heavily on security procedures and technology to ensure the safety of their data. BCT provides a secure and naturally decentralized framework for transaction processing. One of the major advantages of BCT is integration of data processing, consistency and security into an algorithmically enforced protocol. Blockchain systems can be public (or permissionless) or permissioned in nature. Participants in permissionless blockchain are anonymous by default and anybody with a valid version of the software can participate and create transactions. Due to legal and technical concerns, institutions that operate financial ledgers or registries may be inclined to utilize permissionedblockchains as they form a more controlled and predictable environment thanpermissionless blockchains. Blockchains have the potential to address the holy grail of Info Security – the CIA trinity (Confidentiality, Availability and Integrity). Being a fundamentally distributed system, blockchain ensures high availability and integrity of the transaction data. As all nodes are in essence agreeing to the state of records based on a historical ‘chain’ of transactions – integrity of the data is maintained. By appropriate use of cryptographic keys, confidentiality of transactions can also be addressed. This makes blockchain systems robust from an InfoSec perspective. However, while considering security in blockchain systems, a holistic view is essential. One needs to look beyond traditional endpoint protection and adopt a holistic approach that includes authentication and authorization of entities accessing the blockchain, transaction and communication infrastructure security, businesssecurity through transparency and audit, and security from malicious insiders, compromised nodes or server failure. Security in general needs to be multi-level and one that encompasses all components and entry points in the system. Let us take a look at the different levels at which security aspects need to be addressed in detail.