08 Dec Blockchain, Cryptocurrency, and the future of the capital and financial markets
The arrival of a growing number of new technologies in the financial market is a is a topic to be analyzed, especially after the advent of technology that tries to replace intermediaries in the financial system, such as Blockchain. Blockchain is the technology that underpins bitcoins, the cryptocurrency of the moment. It is a new technology that has proved to be reliable in comparison to bitcoin and all controversy that surrounds it. Interestingly, reliability is precisely the controversy: bitcoin can be (and has been) used in illicit commercial transactions, but thanks to blockchain, it would not be possible to make such transactions with fake bitcoins. Additionally, the blockchain technology has various uses besides the creation of a cryptocurrency, as it will be discussed in the present article.
What is Blockchain?
Simply put, blockchain is a record system for transactions, such as a ledger, that is public and shared by all those who operate under its terms. Each “block” is a single record of cryptographed information. To be validate, each record connects with the preceding block chronologically, forming a sequential chain of records, which is stored in a network that cannot be broken (hence the name blockchain). The characteristics of this chain are:
- Chronology: each block has an exclusive identification and a reference link (hash) to the previous block;
- Irreversibility: each time a block is validated and added to the chain, it cannot be removed or modified;
- Sharing: each node of the network (or each party in the system) has an identical copy of the chain: also known as a distributed ledger, in other words a shared ledger;
- Decentralization: none of the network node can operate alone as a “trusted party” that has a master copy of block chain;
- Transparency: all registered transactions in the block chain are visible to all nodes in the network; and
- Inviolability: it is extremely difficult to insert a fraudulent transaction or even a transaction error in the block chain.
Based on such characteristics of blockchain, there are still questions to be answered: (i) how is a new block added to the chain? (ii) how can we ensure that transactions in the chain records are reliable? (iii) who can ensure the chain participants are anonymous? and (iv) what is the practical applicability of this technology and what does the financial market have to do with it?
The uses of Blockchain
To understand the uses of blockchain, it is necessary to distinguish the concepts of transactions and information. A transaction, or transfer, is nothing more than an exchange between two or more parties. In most cases, a transaction demands a trusted third party that can validate the transfer. The presence of such trusted third party to ensure the validity of a transfer is essential to authenticate various commercial transactions that occur today because parties in many transactions do not know each other and, therefore, have no reasons to trust one other. There are records of titles and deeds, real estate records, engaged intermediaries and banking agents, all present to, among other reasons, reduce information asymmetry and trust between the parties.
Consequently, the validity or effectiveness of transactions, according to the examples above, is always verified by a trusted third party: a bank, securities distributor, registry office, over-the-counter market, lawyer, the state, federal or local governments.
In theory, blockchain technology could make the presence of these third parties unnecessary, in order to:
- Transfer or proof a title: if a system, based on blockchain, kept purchase and sale deeds and property records, similarly to registry offices, the transaction costs in a property transfer would be reduced and made in real time within the blockchain network;
- Transfer or proof of a right: the issuance of public documents within the chain, such as birth certificates, identity cards, driver’s license, would facilitate the validation of public information, and it would prevent fraud because the data in the chain is, in theory, unbreakable; and
- Transfer or proof a party’s commitment: lease agreements between parties, registered in blockchain, in addition to being linked to the property records, could be amended automatically, as it would be the application of fines to the lessee. The assignment of rights or subletting could also be processed automatically.
The greatest innovation provided by this technology is filling the so-called trust gap in negotiations that up until then was filled by trustworthy intermediaries.
The possibility of scrapping the need for third parties, while keeping the essence of trust allows the sharing and distribution of accounting ledgers among all the parties in the chain in a manner that is decentralized and guarantees the authenticity of the conveyed information.
How to validate a transaction?
Chain transactions are validated by public and private cryptographed keys. Each blockchain member must have two keys: (i) a public key, an exclusive identifier shared in the block chain; (ii) one single private key, available only to the member. To operate the system, the member inserts information into the system function that requires his signature, and his own private key in the cybernetic signature system function that, in turn, comes back with an exclusive electronic signature.
With this at hand, the member can make transactions in the chain with his/her signature and public key. If someone wishes to verify whether the transaction was indeed issued by the owner of the public key, he/she must look for the transaction, the issuer public key and the signature in another system function named “Validate”. If the signature and public key match, the result is “True”, if not the reply is, “False.”
It is noteworthy that the system respects the members’ confidentiality. The public key is simply allocated in the system but does not disclose the owner’s identity.
Smart Contracts
If we see Blockchain as a platform behind a succession of relatively simple transactions, such as “A transferring B an x amount of funds, a possible use of the blockchain would be the preparation of smart contracts with protocols capable to unleash actions based on its current status and triggering events. This kind of transaction is already possible to be executed based on a system called Ethereum.
A smart contract, in a simple contract, for example, could apply a 1% fine of the amount of rent if the lessee is late on the payment of rent. It could establish that if a debtor renegotiates a debt, interest payments would be triggered, and a new fine would be calculated. In addition, it could automatically control mechanisms that anticipate maturity of contracts, carrying out activities previously conducted by third parties.
Blockchain and the Financial Market
A blockchain system that proves to be efficient and eliminates the trust gap could securely manage transactions. The application of smart contracts by the financial market can be properly enjoyed if financial agents understand such applications.
Currently, what takes place is the dissemination of projects involving mainly electronic payment arrangements in blockchain, like bitcoin itself, but in such cases financial agents control the mechanism. However, we can contemplate additional applications of blockchain to financial markets, as follows:
- Blockchain technology could represent progress in the transparency involving assets securitization and securities transactions, acting as an over-the-counter market that can identity the owner of the contract and/or the asset at all times;
- A blockchain system could take on the role of an asset depositary center to control the transfer of title following a purchase or sale of securities;
- Blockchain could be used to register and negotiate shares and/or quotas by growing companies that are not yet listed; and
- Blockchain could be used to transfer and regulate the exercise of rights in general.
Blockchain and Banking Regulations
Central Banks have shown signs of toying with the digital market. After setting up a research team in 2014, the People’s Bank of China – PBOC tested its own cryptocurrency. The Bank of England, among others, has followed suit.
The involvement of large regulators in this technology shows that change is happening, but progress is a debatable issue. In order to eliminate the so-called trust gap, we observe a cybernetic race for chunks of the market and consumer trends in the financial markets.
Accordingly, it will be necessary for financial markets regulators, such as the National Monetary Council, the Brazilian Securities Commission, and the Central Bank to create specific regulations for blockchain technologies or accommodate such technology under current regulations. The regulator must supervise the practices and systems being developed not to lose control of the transactions carried out (as mentioned above regarding illegal bitcoin transactions).