Bitcoin and Blockchain

 

by Sven Korschinowski, Partner, and Johannes Nöbel CFA, Financial Services Consultant, KPMG Germany

In 2009 the first bitcoins went into circulation around the world. Bitcoins were a revolutionary breakthrough because they allowed the transfer of a digital currency from one person to another in a safe way without using an intermediary such as a bank. Today bitcoins are transferred in large amounts and are the well-known example of a digital cryptocurrency [1]. But bitcoin was only one example and just the start for the underlying evolving technology of distributed ledgers. Distributed ledger technology based on blockchain is a very hot topic and it is getting very much attention lately as it will be used in many scenarios throughout the whole financial services sector and will certainly change the way business is done in many areas.

Blockchain – a distributed ledger technology 

What is a blockchain? For transferring money through the internet the bitcoin network uses a distributed ledger technology – a blockchain. The blockchain stores information about all past transactions and gets distributed and replicated across many computers. In the case of bitcoin everyone can join and participate in the blockchain network with a computer and a special software. 

The transfer of payments from one person to another requires a transaction between the participants of the blockchain network. These transactions need to be validated and they also need to be stored so that it is clear whom the transferred amount currently belongs to. For amounts to be transferred the respective transaction is validated by the network and then stored in a so-called ‘block’. All of these blocks are stored with a timestamp and connected in a cryptographic way to each other so that the transaction can’t be altered (called immutability). Together all these single blocks form a chain that represents the current state of the whole ledger – the blockchain. 

All the computers on the network have exactly the same information about transactions stored in a chain of blocks. The information about transactions in a blockchain basically resembles a ledger, hence the blockchain is a type of a distributed ledger technology. 

The creation of single blocks for a blockchain is mathematically complex and time consuming for computers to calculate. The process of building these blocks is called ‘mining’. Since the mining process is crucial to the network each successful miner and his provided computing power is rewarded by the network.

In short the blockchain is a distributed ledger technology that enables a network of computers to do transactions that are validated and stored with a cryptographic audit trail.

 

Technology and features of blockchains

During the last years many different kinds of blockchains were created. They hold different features and can be used for various scenarios. Bitcoin, the classic example of the blockchain network, is a permissionless public peer to peer network that everyone can join anonymously. It is called permissionless because everyone has the right to join the network, commit transactions, verify transactions and create new blocks. For financial institutions in most cases a different variant of blockchain is preferred. For example, private blockchains are preferred to public blockchains since the network can be restricted to certain partners of trust and the counterparty of the transactions in most cases must be known. 

Blockchain technology is based on various pillars that evolved over the last decades and blending these pillars has enabled the creation of the blockchain. One important pillar is the public-private key cryptography – well known for the encrypted transfer of emails. Another important pillar lies in the method of consensus for transactions. 

Consensus describes the trust mechanism and the prerequisites for validation and storage of transactions in a distributed network. Especially the methods of consensus have experienced rapid development and determine to a large degree the features and performance of a blockchain [2]. The consensus mechanism defines amongst others the means of authentication, integrity, privacy, security, scalability and fault tolerance. 

 

Notes

1. By using cryptographic mechanisms it can be ensured that transactions with bitcoin can only be done by their respective owners and that there are never multiple units of the same bitcoin. It is therefore a cryptocurrency.
2. Examples of consensus methods are ‘Proof-of-Work’ which is used by bitcoin, federated consensus – ‘ripple consensus ledger’ used by Ripple and ‘N2N’ used by R3CEV Corda.

 

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The importance of the consensus mechanism is especially obvious in regard to performance. A usual bitcoin transactions using ‘Proof-of-Work’ consensus can take minutes or hours to be validated and stored to the system. Private blockchains using different consensus methods can process transactions in fractions of seconds. One way to speed up transactions is to rely on tokens for consensus instead of the time-consuming mining process. 

Today there are many different types of blockchains available. They offer different features and use different underlying technologies and they are largely defined by the method of consensus.

Many use cases are possible using the distributed ledger technology of blockchain. The next section will shed a light on just a few of them.

 

Fig 1 - Blockchain

 

Use Case 1: Interbank transactions and payments

The transfer of payments using blockchain technologies is well known. It is widespread and many services are offered. In the last years many networks for payments based on blockchain emerged and it is very natural for banks to be involved in the development of a trusted secure payment system considering the vast experience and knowledge in that field. 

Ripple is one example of such a blockchain network. Developed in 2012, Ripple offers a unique consensus mechanism and relies on tokens instead of mining. This makes Ripple payment transactions much faster to complete (a few seconds compared to minutes). It uses a distributed public ledger and has the feature of cross-currency conversion. Ripple is already used by UniCredit and other major banks and has been increasingly adopted by banks and payment networks as settlement infrastructure technology. It can be used for cross-border payments for retail customers, corporations, and between banks as interbank payment solutions (today, SWIFT is the dominant channel for those payment transactions). 

Another example of banks working together on blockchain is the R3 consortium. The consortium is formed by more than 40 global financial institutions, including UniCredit. It serves as a standard-setting body for the industry. The R3 consortium also has created a blockchain called Corda, and there is a difference between Corda and the other blockchain networks. Unlike bitcoin and Ripple, the Corda system is designed as a private network where not every participant is holding a full version of the blockchain. And Corda can be used for more than just payments but also for the next generation of blockchain use cases.

It is important to recognise that a lot of blockchain providers are in the (global) market. The challenge for the banks is to choose the appropriate one with the most promising tech stake.

Use Case 2: Smart contracts

The next generation of blockchain is not just about currency and simple payments but about contracts and objects of value. The smart contract concept enables entities to represent value from tangible and financial goods in contracts and then use a blockchain to distribute it. The smart contracts business terms (i.e., contract rules) can be embedded in the blockchain and then executed with transactions. Furthermore smart contracts are self-enforcing and no human interaction is necessary. The smart contracts are modelled in contract terms and triggering events.

Two examples for such applications as smart contracts on the blockchain are letters of credit in trade finance and swap contracts in mutual agreements.

In a letter of credit agreement in most cases four parties are involved: a seller of goods and services; a buyer and the respective financial institutions of buyer and seller. The financial institutions reduce as intermediaries the risk for both counterparties. While the buyer wants to make sure that the good or service is delivered, the seller needs to reduce the risk that a buyer does not pay. Usually trade finance processes are complex, lengthy and very much paper-based. But if the terms of the letter of credit are embedded in the rules of a smart contract and distributed using the blockchain the rules will make sure that as soon as the shipment documents (the triggering event) are added to the blockchain the transfer of money will be automatically done.

In a swap contract two parties agree to the exchange of cash flows. The details of the swap contract can be modelled in a smart contract so that each party automatically receives the amount owed according to the contract. 

 

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Use Case 3: Distributed ledger for legal entities

The services of financial institutions are in most cases defined by the agreements that exist between them. Transactions according to those agreements are recorded by both institutions in their own systems (or ledgers) - which could lead to slightly different records because the involved systems communicate by exchanging messages. To make sure nothing goes wrong during communication a reconciliation is needed between the financial institutions. 

One very obvious application of distributed ledgers is the use as an immutable shared ledger for companies of a corporation. The trusted shared ledger will hold the same information about a transaction and the balance will be exactly the same in all companies involved. For example, the introduction of a shared distributed ledger to the subsidiaries of a bank could make month end balance reconciliation between them superfluous. There is no need for a time consuming reconciliation between a bank entity in Germany and a bank entity in Austria at month end as the balance is already ensured to be the same. 

A shared distributed ledger can reduce costs and the time involved for reconciliation purposes. The privacy of the shared ledger can be granted due to the cryptographic features of the underlying blockchain. Furthermore, access to the ledger could be granted to all involved parties, auditors and regulators. 

 

Wrap-up

Bitcoin gave rise to the blockchain, a very versatile technology with different features and possible applications. It is viewed as a key technology for transactions in the future. The design of the blockchain and especially the consensus mechanism can have strong influences on performance.

The blockchain technology can be used for various use cases. The most likely use cases can be found whenever counterparties may not trust each other but still want to execute safe transactions without a third party’s involvement. And there are many more possible applications for a bank. A look at all the payment and transaction streams within a bank and to counterparties would certainly show up many cases where a blockchain would improve them.

The last years have seen strong market developments, many new start-ups and a growing regulatory interest as well. Time will tell which blockchain applications and use cases will succeed and the ways in which they will be applied. 

 

Sven Korschinowski  Partner, KPMG Germany Sven Korschinowski is a Partner with KPMG in Germany and responsible for the fintech and blockchain activities in Germany. He focuses on strategy consulting, digitalisation, payment transactions and innovation. He is Vice-Chair of Bitcom Digital Banking group.

 

Johannes Nöbel CFA Financial Services Consultant, KPMG Germany Johannes Nöbel is a financial services consultant for analytical banking solutions at KPMG in Germany, with experience as a consultant and auditor in accounting and payments. He is currently implementing projects with analytical banking solutions for compliance with several regulatory requirements.