Blockchain is capturing the imagination of the financial services for its potential to reduce risk and decrease costs. It’s easy to consider blockchain as a unicorn – elusive, never seen and no one seems to quite know its capabilities. Blockchain is a type of distributed ledger technology (DLT), but what exactly is blockchain and DLT? And how can they be used by mainstream companies?
How does distributed ledger technology work?
The financial services industry operates around ‘centralised ledgers’, books and records held by one trusted entity that is the true source of the information. Centralised ledgers cannot easily be changed, as all records go through a single point of authority who is responsible for maintaining the records.
Distributed ledger technology (DLT) operates in a completely different way. There is no formal definition but the UK’s financial services regulator, the Financial Conduct Authority (FCA) describe it as:
‘a set of technological solutions that enable a single, sequenced, standardised and cryptographically-secured record of activity to be safely distributed to, and acted upon by, a network of varied participants.’
Unless you have a technological background, this definition may not be particularly helpful. The key points that are relevant to consider are that instead of relying on one source of information, you take a group of peers who maintain a shared database. The consensus of the group is the record; there is no single trusted source. The beauty of this is that it is less vulnerable to hacking or tampering, as someone wishing to alter a record would have to get access to every copy of the database, and the likelihood of this happening before someone notices the difference is very low.
Blockchain in particular has additional features which leaves it less vulnerable to record tampering. The beauty is that each transaction forms a block and these blocks are essentially ‘chained’ together through a complex mathematical algorithm. The new block can only be created when all peers agree and each new block receives a unique digital signature.
As this digital signature is unique, even if you did try and change the record, a new digital signature would be issued, which would show that a change had been made.
DLT: the crime fighter?
DLT has the potential to assist firms in the fight against financial crime. Customer information can be coded, but each transaction on the blockchain would be available to see by all participants. Imagine the possibilities if we were able to see a transaction flow through banks and you can see why some technology-savvy AML professionals are excited about the future.
Advocates of blockchain have said that it has the ability to lower the cost of transactions (as it removes manual processing) and the requirements for middlemen, potentially speeding up the process.
The downside, however, is that it is slow; it can take time to add to the ledger.
How can blockchain help in the fight against financial crime?
Transaction monitoring is an unwieldly beast at many large banks. The infrastructure to analyse thousands upon thousands of transactions to identify unusual activity is costly and time consuming. One of the major issues when trying to identify financial crime is that typically, one bank will hold only a small part of the puzzle. Techniques used by money launderers often include transferring their ill-gotten gains through multiple accounts in multiple different banks. Now imagine a world where a ‘public key’ is used to identify a customer; this public key can be seen on the blockchain and it can be used to trace a transaction.
This however would require a network of banks to adopt the blockchain solution. They would also have to clearly identify and understand each of their AML related roles and responsibilities. It’s unknown territory.
Is there a future for blockchain?
Absolutely, although due to the strict regulation of the financial sector, it may be a while until it is implemented and being used universally. Nonetheless, most banks are currently investigating the use of DLT to streamline processes and reduce costs and the potential for it to be used in almost every industry is endless, for example it is being looked at for trade finance and logistics, in healthcare, medicine and insurance.