Hence we hope the papers published during the last months helped curious researchers and DLT stakeholders to understand the market insight over this technology and how Nfq is preparing to face all the upcoming challenges.
We would like our readers to remember that nothing is free, with every choice there is a trade-off. Within this context, recall that most of the public blockchains relay on the fact that the protocol guarantees that there is no need to trust anyone participating in that chain. In this context, we would like to emphasize the relevance of “trust”.
The more a user can trust certain nodes of the network, the easier it is for the network to come to a consensus of what is happening on it. What this means, is that, depending on the level of trust your network needs to rely on, you can achieve consensus with very different methods. There isn’t a single blockchain to rule them all, each use case may require the network to have different properties “set in stone”.
Public Blockchains may not be suitable yet for financial institutions since their design allows not to require trust in authority. Financial institutions exploit customer trust to back their businesses. The event where they decide to devalue that trust is highly unlikely.
However, they may define their own protocols to serve smart contracts to users supported by a proprietary infrastructure. So far we have covered a wide range of areas in our last papers, and in order to make sure we haven’t missed any important information about them, here’s a little summary of each chapter.
Chapter I: What is Blockchain and how it works
A blockchain is an open distributed ledger where transactions between two peers can be recorded in a trustworthy and immutable way. It is used to record transactions among all the computers of the network, so no transaction can be altered without altering all the transactions on the chain.
The actual revolution that blockchain introduced was that, for the very first time, Satoshi Nakamoto, designed a protocol with the characteristic that consensus could be reached with no trust between peers at all. In consequence, a fully distributed ledger without a central authority was possible for the first time ever in the history of mankind. This technological achievement was contemporary to many other social and economic changes.
The global financial meltdown had eroded the trust in financial institutions, including central banks. At the same time, many applications in P2P business were successful at avoiding human brokers and intermediaries, reducing the operational costs for all peers, but remind yourself that, every new technology that is found to be useful comes with a varying amount of hype attached.
There are very few pieces of technology with such a level of hype as distributed ledgers. This helps the technology to be more widely known, but at the same time reduces the signal-to-noise ratio of the information that non-tech-savvy perceive. In any case, users needing to store transactions and to reach a consensus have now an alternative to an appointed central authority.
However, removing trust from the “distributed ledger equation” comes at a cost, and to understand how much one has to pay, we must dive into the technical aspects of Blockchain and distributed ledgers.
Chapter II: Cryptocurrencies
The dream of digital money has been long waited and preached by the human race. The creation of Bitcoin in 2009 revealed that such dreams were finally fulfilled. Humanity has been waiting for a very long to have a trustworthy method to use digital money all over the world. Digital money had been predicted to appear in the future by many, in particular by one of the greatest economists the world has seen, Milton Friedman. As he stated in an interview back in 1999 conducted by NTU/F:
“The one thing that’s missing, but that will soon be developed, it’s a reliable e-cash. A method where buying on the internet you can transfer funds from A to B, without A knowing B or B knowing A. The way in which I can take a 20 dollar bill and hand it over to you and there’s no record of where it came from. And you may get that without knowing who I am. That kind of thing will develop on the Internet.”
The e-cash Friedman talked about has finally arrived in the form of cryptocurrencies. But, what is a cryptocurrency? A cryptocurrency can be defined as a digital currency designed to work as a valuable medium of exchange between unknown users over the Internet. It uses cryptography to secure the user’s transactions and to control the creation of additional coins.
The coins or tokens are a way for peers to interact with each other without the need of trusting one another. They also bring the possibility to send the tokens/coins to anywhere in the world within a matter of seconds. Cryptocurrencies are about to radically shift the way humanity transacts worldwide.
Chapter III: ICO (Initial Coin Offering)
Throughout the past year, Initial Coin Offerings (ICO’s) have been considered the gold rush of the 21st century. Millions of dollars have been raised by companies working with blockchain technology solutions, bypassing the entire financial industry without asking for permission. This new way of funding business has caught the attention of all the regulatory agencies over the world. But what exactly is an ICO? The ICO acronym translates to Initial Coin Offering, which goal is similar to any Initial Public Offerings with stocks.
The only problem is that almost all the money that is being raised does not comply with the existing regulatory framework. ICOs are the way for almost all blockchain ventures to find funding across the globe using cryptocurrencies or tokens.
This phenomenon has disrupted the entire Venture Capitalist system, now people all over the world can contribute to the funding of a project that promises to deliver a cutting-edge blockchain application. Recently, private investors (Hedge Funds and Business Angels among others) are welcoming the decentralization of the venture capitalist industry, which allows anyone across the globe to contribute to the projects they believe in.
A company/individual creates an ICO with two main goals:
- To raise capital to fund a project
- To create a particular token for the blockchain application or protocol they are developing
Normally, a team develops a smart contract that launches the token distribution once the sale/payment is completed. Users contribute with the amount they wish to invest in and deposit it on the company’s address using cryptocurrencies.
On the market, we typically see that the two main procedures for a token sale are the following: (i) companies will either put a hard cap (Limit Amount of money they would like to raise) on the smart contract or (ii) they will have an open cap (they will raise as much as people want to contribute to their project).
Chapter IV: Smart Contract and Regulatory Compliance
Smart contracts are computer protocols that facilitate, verify, and enforce the negotiation as well as the performance of a contract. Even though the term “smart” does not justify all the contracts that are out there, we are still far from having truly contracts that are smart. Quite the contrary, at this point in time smart contracts are quite “dumb” and full of vulnerabilities that can make people lose tons of millions of dollars.
Within the context of the Distributed Ledger Technology, DLT allows the implementation of a smart contract between parts that neither trust each other, in the context where a central authority used to be a fundamental requirement, nor want to have to trust each other.
An astronomical increase in regulation has left the financial markets in a huge uncertain operational field. Compliance teams are overloaded with work while struggling to meet the constant increase of the regulatory demands. That’s why they see Blockchain technology as the best ally for regulatory agencies due to the transparency and traceability that brings into the table.
Even Though many people in the space see the regulatory agencies as the enemy, regulatory agencies and blockchain are a fantastical match. Blockchain promises to disrupt the way companies deal with compliance requisites, allowing them to have the speed and flexibility needed to stay alive in the new global digital era. Thanks to the use of blockchain technology we can create an environment where market players and regulators have access to a trustable and auditable dataset.
An access to such thing would allow firms to get rid of all compliance duties and risks, as the regulator would have full access to all the data, instead of having to wait for the firms to send it. There are three main areas in which blockchain technology will impact mostly the regulatory compliance industry: reduction of fraud, knowing your customer rules, and auditability.
Chapter V: Application to Banking and Insurance
Blockchain technology has been acknowledged as one of the most disruptive innovations for current business models since the advent of the Internet. It has the potential to resolve many issues across different industries. Banks are eagerly desperate to join in the innovation trend going on nowadays but they do not exactly have much time for it. They are restricted to comply with an absurd amount of new regulations that have made them spend a lot of money to ensure they comply with the regulations.
Thanks to blockchain, its vision became more clear, and almost all of the banks out there in the world (not to say all) have started to work with the possibilities this technology offers them. Banks and financial institutions are still figuring out how to apply new technology to improve their core business and adapt it to the digital era. Most of the startups working to become the new retail banks of the 21st century are mainly focused on banking the 2.5 billion people out there who do not have access to financial products. Interesting times are ahead of us and so are the next generation of digital banks.
Not only the financial sector is interested in the development of this technology, it is important to also keep an eye on the development of blockchain for the insurance sector. Blockchain brings in to the table many key aspects for the insurance business models. Companies will be able to have automatic payrolls, traceability of assets and risk hedging, are among the many benefits. It will allow them to offer the insurer a very tailored type of insurance for their exact needs, instead of having generic insurances for everyone.
It will also allow the automation of many aspects of the industry, as well as a huge decrease in paper consumption to portray all the conditions of the contracts. Companies around the insurance sector are taking it very seriously and trying to implement the use of blockchain as fast as possible.
Overall Conclusion about Blockchain Technology
If there is an important message that this report wants to disclose is that Blockchain is not an enterprise-friendly technology yet, and those future products designed around the Blockchain protocol will make a lateral use of it.
They will often advertise some “cryptographically signed chain” or “secure protocol” suggesting the use of Blockchain, but it is very unlikely that all of the projects related with Blockchain will become useful, public and permissionned (perhaps some projects may achieve a rich business model while using a public decentralized blockchain). The most significant live technology that backs this educated guess is Ripple.
The Ripple protocol is a Byzantine Consensus protocol that assumes that regions of the network can be trusted, so a CP (consistent and partition tolerant) ledger can be constructed with significant low latency compared to the Blockchain protocol. However, most non-technical articles about Ripple mention the use of Blockchain, even though Ripple does not mention Blockchain in any white paper.
From the technical point of view, the Ripple consensus protocol has more to do with the Raft protocol than with Blockchain. It is now common that projects use Blockchain only as a marketing strategy, while then switching to other protocols that require a certain level of trust. This suggests that the intuition of the non-enterprise-friendliness of Blockchain due to its complexity and high latency may be real.
Services based on some DLT technology like Ripple, require some level of trust, which is also a big actors’ game too. Most of the infrastructure will be designed, maintained and operated by large consulting firms, regardless of the technology used. The high cost associated with these relatively large systems will motivate financial institutions to boost their infrastructure investment returns.
The consequence is that any DLT related project that is proposed to a large financial institution will have to be adapted to their proprietary implementation of DLT, regardless of the generality or suitability of the implementation, the same way that now applications have to be adapted to the customer’s licensed database. In consequence, DLT will be yet another technology crippled by the control exercised by big contractors on the financial institutions’ infrastructure.
The offspring of blockchain technology is digital currencies, signed storage and smart contracts. Digital currencies create a market for trading goods or capital based on a defined protocol, where the currency is the unit of value for the traded item. Signed storage exposes the capability of the ledger to store data that cannot be modified in the future, being useful for auditing and notarization purposes.
Finally, smart contracts simplify or allow the negotiation of a contract by two or several parties. The first two domains require some critical mass. In the case of digital currencies, the users have to be attracted to the platform, either by their own interest or due to a previous relationship with the service provider. The second case also requires the user to trust that the provider will not use the data for its own purpose.
Blockchain only avoids the double spending issue, therefore the application implemented around the ledger can be specifically designed to support, for instance, sophisticated variations of inside trading. Blockchain adds the guarantee that the data is safely stored (not the veracity of the data) and immutable, but it is naive to suppose that the application will be safer for that reason. In both cases, the provider offers a service to the users, and they must trust the infrastructure too.
Which is the Nfq Strategy?
It is not plausible to think that NFQ can be a service provider for trading or storage of sensible information. There may be room for some consulting in both cases, but one must consider that the bulk of the workload corresponds to the implementation of the application. The three pillars underpinning the Nfq’ strategy are i) business knowledge and experience, ii) capability to deliver and develop robust Solutions and iii) deep understanding of the new digital era and specially about the benefits of DLT.
Hence, our three business lines, Business advisory, Solutions and Digital have been researching in the last years about the most suitable solution for our clients according to our knowledge and experience. Our DLT Project Team is leveraging on market tendencies and practices to develop a bespoke solution for the financial industry through a smart contract platform, based on real use-cases.
A critical issue about current implementations of smart contract platforms based on a distributed ledger is the way the contract is deployed. The contract is submitted to the blockchain as code for some virtual machine, so the code is visible for anyone willing to execute the contract. Once this happens, the code is sealed forever, with the data it generates. In other words, a smart contract can be deployed only once.
Any modification, even solving a bug, requires the deployment of an old contract, and an agreement to migrate the data from the old contract to the new one. This has represented a gigantic security threat for any smart contract deployed so far, with a publicly known instance with the DAO crisis, that required a hard fork of the Ethereum’s blockchain.
This kind of crises will surely repeat because there is no way of writing bug-free software, and security threats are just a particular kind of bug. It is clear that attributes, methods, and states are not useful concepts to build applications, and this clear separation between these concepts and an actual contract are an opportunity. A real contract has clauses, conditions, consequences…
In this context, Nfq is heading to put in practice a smart contract solution for the Capital Markets industry as core of our business. Accordingly, we will develop a market solution based on Smart Contracts for OTC Derivatives transactions between counterparties, which will reflect the end-to-end deal process, from pre-deal contractual negotiation, valuation and post-deal processes (settlement and payment).
This solution is based on the development of an API on top of a Alastria´s blockchain, as well as a platform to manage and operate wholesale financial contracts that are self-valuable with the use of smart contracts and blockchain technology. We will provide more information about this topic as soon as the project progresses.
Keep the flame on.
