Derivative Blockchaining and Meta Distributed Ledgers

Payments Leader

Posted on April 7, 2016

blockchain

Interoperability on a Distributed Array of Distributed Ledgers

 

As distributed ledger-based financial services emerge from the hype and begin to grow into real systems and solutions, banks are actively exploring the diverse opportunities that decentralized, blockchain solutions will bring. What started as a precocious and disruptive new currency in the form of Bitcoin is now being recognized as a powerful new technology whose impact is only just beginning to be understood. The challenge is finding a way to harness the benefits, ensure the absolute essentials that maintain trust in financial services – security, compliance and resilience – are met.

While Bitcoin is still prominent in the blockchain news feeds, fintech investment in the blockchain arena is growing quickly. For some of the very same reasons that the Bitcoin model is such a revolutionary and effective way to create and manage cryptocurrency, it does not travel well to other financial silos—proof-of-work based trust and consensus and anonymity, for example. There is an endless list of emerging and established fintech companies creating new, flexible, powerful and dynamic distributed ledgers for purposes that go beyond the capabilities of a cryptocurrency. While the Bitcoin Blockchain is capable of managing the execution of a wide variety of simple as well as exotic transactions, subsequent iterations of blockchain and distributed ledger technology go even further, to include more extensive business logic and intelligence.

Financial institutions are looking to exploit many of the advantages of blockchain technology across multiple domains. Additionally, distributed ledgers will inevitably operate on national, regional and global levels, and be delineated by verticals. Consequently, large numbers of distributed ledger solutions are in development across the globe – specialized blockchains, bespoke to their function, and all subject to unique and still evolving regulatory controls. The issue is now centering on how trust can be maintained across these diverse systems. There is increasing recognition that distributed ledgers will need to be interoperable, with meta ledgers spanning multiple private vendors and consortiums.

Privatize to Securitize

As distributed ledgers have moved beyond cryptocurrency, the need to operate in a more controlled ecosystem has come front and center. The advent of private distributed ledger architectures has removed many of the problems inherent in public blockchain solutions, such as Bitcoin. Within a private realm, all nodes can be known and trusted, making consensus and trust faster and cheaper to reach. With public blockchains, all nodes in a distributed system must be treated as untrusted and anonymous.

These networks use processing to reach consensus. The processing power to win the proof-of-work race increases as the number of nodes on the ledger increases.  This is why the performance of public blockchains is inherently constrained compared to a modern financial processing environment. Private blockchains will have no such inherent performance constraints. Furthermore, with the enhanced machine intelligence that is being built into the current generation of private blockchain code and the use of smart contracts in these distributed ledgers, programs can be hosted on the blockchain that automatically respond to events and maintain ledger entries. This enables distributed processing for complex jobs and handles much of the interoperability concerns.

Interoperability of Meta Blockchains

We will soon be banking in a world underpinned by numerous distributed ledger solutions developed by a variety of banks and fintech companies. In more controlled and private ecosystems that prioritize trust and inclusions, consortiums of providers will develop far-reaching but more specialized solutions. But isolation holds back innovation. The emergence of derivative blockchains, or distributed arrays of distributed ledgers, promotes a need for interoperability between multiple providers, often from different sectors, and each with its own unique expectations. By connecting blockchains into larger distributed entities – all the while ensuring trust between nodes within each individual distributed ledger, and between the different vertical blockchains – larger consortiums can combine to present more compelling service levels and rewards. Parties can sign up, and drop out as needed, assuming they meet audit criteria and readiness.

Take a case study around loyalty. Many parties need to be involved to define a viable business case and also ensure consumer appetite. For example, a small consortium of service providers could handle all aspects of a business trip while providing genuine cost benefits to the consumer and locking in their loyalty. In our example, an airline, a taxi booking application, a hotel group, a restaurant chain and a bank team up to make an irrefusable offer: take our taxi, fly our airline, eat at our restaurant, sleep at our hotel and you receive a reduction of what you pay to our bank and enhanced loyalty rewards.

In this scenario, blockchaining protects not only the consumer data, but also the parties that combine to present the proposition. With the use of smart contracts and the protection of different distributed ledgers, each party in the consortium can encrypt their own information, but share selected data on the customer. At any time, participants in these temporary coalitions can drop out with the assurance that previously shared information is now obfuscated. The ability to wind-back the sharing of information ensures that no other parties within the ecosystem have access once they leave the blockchain.

Global Fraud Eradication

Amongst the more exaggerated claims for distributed ledgers is that they will remove fraud from the equation. While it is true that the transparency and decentralized nature of blockchains are inherently more secure and verifiably more risk averse than traditional centralized systems, imaginative new forms of fraud are inevitable. Absolute security is a laudable aim, and a blockchain-based service ensures new levels of information obfuscation across multiple systems, But criminals are not the only parties concerned about the security question. Nation states across the globe are rushing to get a handle on recent developments and understand the extent to which blockchains could allow their citizens to go about their daily lives without government surveillance. There are currently controls on data transfers across boundaries, and financial cross-border payments are subject to even stricter regulatory control. This is not going to go away anytime soon, and many countries are already pushing back with legislation, signaling the aim to regulate heavily.

Beyond Payments

Payment applications for blockchain are second only to cryptocurrencies, but many aspects of financial services seem set for the distributed ledger makeover. The benefits of reduced counter-party risk and increased security are compelling. Areas such as capital markets, settlement, KYC, syndicated lending contracts, foreign exchange, post trade derivatives, corporate liquidity, asset servicing, documentary trade and securities settlement are lining up.

Further afield, blockchain looks set to alter our notions of personal digital identity. Combining secure and verified KYC, connecting consumers and services to the Internet of things, and utilizing blockchain to underpin distributed data maintenance becomes a more compelling proposition. When linking closed systems into a more cohesive whole, there is a need to maintain absolute trust between participating parties. With the potential for immutable, irrevocable and real-time proof of identity and transaction history – combined with the automated execution of terms and conditions – it is easy to see why the predictions are so all encompassing. This really could change the world.

More to Come

Some of the hype surrounding distributed ledger systems may be exaggerated, but don’t use that as an excuse to underestimate the groundswell. The blockchain tidal wave is coming. The distributed ledger systems being created globally are an important new force in the financial industry and other sectors. There may be a large number of verticals beginning to build solutions based on blockchain, but there is widespread belief that we are only scratching the surface of its potential application.

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Payments Leader

Payments Leader from FIS provides insights on credit, loyalty, fraud and emerging payments strategies through blog posts from our industry experienced authors.