The inner workings of the financial sector are a major reason that Bitcoin and other cryptocurrencies came to exist. Bitcoin, and the release of its white paper by Satoshi Nakamoto, came about in 2008 as a reaction to the global financial crisis. Bitcoin was an Austrian economic solution to the Keynesian economics that have governed our country since The Great Depression in the 1920’s. The solution? Create competition to the government issued fiat by creating a money supply that cannot be controlled, seized, taxed, or devalued through inflation. That’s why Bitcoin and other cryptocurrencies have a set number that will ever exist; they are deflationary.
Bitcoin’s roots are important to know when looking at blockchain based projects in the financial sector. Some projects aim to be compliant with the government and use blockchain technology to help add transparency to the current financial system. Others have no intention of working together with the banks but aim to put them out of business. There are even projects that aim to be a bridge between the two mindsets.
So what is the blockchain and how is it going to affect finance? The blockchain is the technology that Bitcoin and other cryptocurrencies were built upon, essentially it is a distributed ledger. It is a continuously growing list of records, called blocks, which are linked and secured using cryptography. Blocks are added to the Blockchain in a linear, chronological order. Removing a block from the chain will show that data is missing or corrupt. Imagine how this type of record keeping could have helped the housing market back in 2008.
Private vs Public Blockchains
In the world of business and finance it is important to know that there are private and public blockchains. The main difference concerns who is allowed to participate in the network, execute the consensus protocol, and maintain the shared ledger.
A public blockchain allows anyone in the world to participate in the consensus process, which determines what blocks are added to the chain. A private blockchain network requires an invitation and must be validated by either the network starter or by a set of rules put in place by the network starter. Private blockchains will be used for database management, auditing, and other day-to-day record keeping internal to a single company. The Linux Foundation’s Hyperledger Fabric is an example of a permissioned blockchain framework. Private blockchains are more efficient in terms of scalability and compliance, but are vulnerable to network manipulation because of having centralized control. Some people see private blockchains as an amazing tool for businesses and some see it as a violation of the core values that focused on decentralization and privacy. Both of which private blockchains can never fully offer because they are not open to everyone.
So besides transparency and reduced fees, what other issues with the industry will blockchain technology help remedy for those within the financial sector? In addition to cutting processing fees and commissions and gains on foreign transactions, this technology will help eliminate inefficient and redundant paperwork. This new process will also cut down on the time loans take to process along with the unnecessary middlemen and the fees associated with them.
Uses in Today’s World
Credit Suisse, the second largest bank in Switzerland, is one of 19 financial institutions working with Synaps to begin putting syndicated loans on the blockchain. For more information, you can read Credit Suisse’s 100+ page document entitled Cryptocurrencies are only the beginning. The challenge here is finding a way for separate blockchains to communicate with each other so that changes to a loan’s ownership can be quickly reflected across all systems.
We have Equifax, Transunion, and Experian, but they don’t always communicate with each other. In addition, hacking is a major concern because each platform is centralized. This also causes variations in consumers’ credit ratings as some events might not get reported to all three bureaus.
Central banks are also feeling the heat of Bitcoin and other cryptocurrencies, and are starting to take their network effect seriously. This has resulted in banks launching their own digital currencies.
The part that scares me is that they allow for a central authority to freeze your account if you do something that a company or the government disagrees with. This goes against the whole purpose of Bitcoin and other coins which allow you to be your own bank and act as digital cash.
Switzerland’s UBS has come up with the “utility settlement coin” which aims to create a digital currency for use in financial markets by issuing tokens into cash on at central banks – rivaling with Ripple.
The Future of Banking
Ripple is trying to move money globally as quickly as possible with nearly free transactions with no chargebacks. It can settle a transaction in as fast as 3.5 seconds. Ripple’s focus is on targeting institutions instead of individuals. Unlike Bitcoin, Ripple doesn’t rely on proof of work because it isn’t mined. The 100 billion XRP coins were issued at inception similar to how a company offers stocks when it incorporates. XRP is a native token that uses the Ripple protocol but banks don’t have to use the XRP in order to use the protocol.
So why talk about Ripple if it doesn’t use the blockchain? Well, it is already affecting the finance industry, and it helps to know a little about Ripple to learn about Stellar because one of the founders Jed McCaleb also co-founded Ripple and Mt. Gox.
Stellar is an open-source payment system, while Ripple is a closed system. Both offer fast payments with low fees and confirmations 3-5 seconds. Stellar, like Ripple, offers a consensus protocol and all of the Stellar Lumens or XLMs were issued at inception. Ripple uses a for-profit model and Stellar is a non-profit focusing on micropayments and serving the underbanked.
Stellar also differs from Ripple by using a Federated Byzantine Agreement. Instead of having a predetermined set of validators, the nodes can choose who they trust. This established trust is known as a “quorum slice”. Slices then talk to each other and form quorums within the network.