With the emergence of innovative and disruptive technologies, an increasing number of financial service providers are adopting distributed ledger technologies (DLTs) as part of their long-term business strategies. Bearing in mind that all compliance officers and financial crime officers will someday be using this software in the course of their daily duties, we include a refresher of it here.

The benefits of DLT (such as blockchain) have been widely written about in recent years.  This article explores some of the less-publicised potential uses of blockchain technology in the financial services sector and, in particular, how such technology might assist when things go wrong, such as in cases of fraud and corporate insolvency.

What is a blockchain?

Perhaps the most concise and jargon-free definition of blockchain technology is the following: "an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.”

Unlike traditional financial ledgers and transactional processes, there is no requirement for a central trusted authority to verify information such as the existence and ownership of assets. Instead, each transaction is verified by a majority of unrelated participants (called nodes - sometimes referred to as 'miners'). In essence, therefore, this is a democratised system. It is a peer-to-peer network whereby data is distributed amongst equally privileged nodes, each with its own copy of the ledger and predefined rules to facilitate a consensus and ensure the authenticity of the data.
 
Within this set-up there are both public and private networks. Public, 'permissionless' blockchain ledgers allow anyone to become part of the network; Bitcoin operates on such a ledger. Private, 'permissioned' ledgers might be used by a group of independent businesses for the purpose of transparent record-keeping, for instance, between a manufacturer, suppliers and distributors.

Let us consider how information is recorded on a blockchain. Each block contains cryptographically 'hashed' data (a digital fingerprint) and is built upon the previous block in the chain - this renders the blockchain indelible.  Every block of the chain contains the hash of the previous block and the 'append-only' nature of the database makes it impossible to modify any of the data on a block without changing the entire chain.

Each time a node seeks to add a new block to the ledger, all users must authenticate the block using a common protocol. Typically, nodes reach a consensus regarding the validity of a new block using either the 'proof-of-work' or 'proof-of-stake' consensus algorithm. If the block is valid, the nodes will add it to the blockchain.

The potential uses of the blockchain

Distributed Ledger Technology such as blockchain has the potential to revolutionise the way the world functions on a day-to-day basis, much as the Internet did from circa 1993 onwards. The financial services sector, in particular, is ripe for change in a number of ways. We explore some of the possibilities below.

Economic transactions: verification, execution and recording

Aside from the use of cryptocurrencies as a means of making global payments cheaper and easier, we are now seeing more and more financial institutions adopting DLT. For example:   

• Mastercard has built its own blockchain network to facilitate cross-border payment of fiat currencies (such as Euros or US dollars) between banks and merchants;
• Visa's B2B Connect platform uses IBM's Hyperledger Fabric blockchain for business-to-business payments;  
• JP Morgan has created a digital coin (JPM Coin) which operates privately for the purpose of facilitating money transfers between institutional accounts. The JPM coin will be issued on a blockchain network called Quorum (and subsequently operable on all standard blockchain networks), which requires permission from JP Morgan for various things; and
• Northern Trust recently used its Guernsey-based private equity blockchain (also using IBM's Hyperledger) to process the first live capital call using DLT for Emerald Cleantech Fund III LP. This allows investors to negotiate, review and digitally execute contracts in a manner which allows all parties to see the details more clearly than elsewhere, with greater security and efficiency.

Investment and fund managers could also see significant benefits by using blockchain technology. The standard settlement time for many investment vehicles is two days, meaning that transactions may be completed at a different rate than envisaged and funds are unavailable to any party while a transaction is being cleared. However, transactions can be completed on a blockchain in almost real time, which makes the assets with which a manager can transact more liquid. With markets in perpetual motion, the ability to immediately reinvest liquid funds could be vital for investors as they strive for ever-higher returns.

Tokenisation could also alleviate liquidity problems. Digital tokens can represent tangible or intangible illiquid assets (such as real property, art or intellectual property) and be used as tender for trading on the blockchain. A practical example of this is the way in which Ripple uses XRP (its digital currency) to transfer value from one user to another. This means that fiat currency can be displayed by a user at one end, converted into XRP and traded through RippleNet (an open-source ledger) where it is then converted into (possibly a different) fiat currency and deposited with the recipient. This facilitates a much quicker and cost-effective currency conversion than would occur through conventional channels, ultimately making traditionally illiquid assets more liquid.

Many tasks conducted by 'middlemen' can also be expedited or negated. For instance, there will be no need for administrators to independently verify the existence and value of assets held in a fund by reference to emails and spread sheets. Instead, this will all be done by the participating nodes with a permanent record built into the blockchain, making administration much quicker and more cost effective.

Finally, data security is a particularly prevalent concern for businesses at present and the use of blockchain technology could help significantly. This is because all data is encrypted and distributed to participants on the blockchain, as opposed to being stored on a single, central database that might fall victim to a cyber-attack.  

Fraud prevention and asset tracing

With financial transactions being securely and transparently recorded to an immutable ledger with a solid verification process, asset-tracing has the potential to be much more straightforward than is presently the case. When one looks at some real cases from the world before the blockchain, it is obvious that DLT could have prevented fraud and helped investigators trace assets more easily.

Bernard Madoff was convicted of securities fraud in 2009, having engineered a pyramid investment scheme whereby early investors took money (falsely categorised as profits) at the expense of new entrants. Investors are estimated to have lost up to US$65 billion and the asset tracing exercise is still being conducted. Had smart contracts been available and adopted at the time, auditors and compliance officers would have seen more, with pre-determined rules and parameters of the fund set out in unalterable code and adhered to by the participating (and incentivised) nodes. This would have ensured that the assets could only be invested according to those predefined rules, thereby making it almost impossible to claim title to an asset or to dispense with an asset in a manner which was not in accordance with the established protocol.

In the case of Enron, Arthur Anderson was supposed to act as a gatekeeper by verifying the accounts and protecting investors. Instead it colluded in Enron's crimes and was found guilty of obstructing justice after shredding thousands of audit documents. Using distributed ledger technology and smart contracts, this auditing process would have been much cheaper and harder to falsify. If the data had been recorded on a public ledger, the transactions would have been visible publicly and the participants would have detected Enron's frauds quickly. If Arthur Andersen had used a 'permissioned' network, it might not have been free to stand idly by while Enron executives embezzled funds. With certain blockchain technology, for instance, participants would have been issued with cryptographic identity cards to enable them to view all or some transactions. However, even such users would be unable to add to the blockchain without consensus, meaning that the majority of participants would have had to conspire to commit fraud if they were to stand a chance of success. In either case, the encrypted information would have remained indelible and the parties involved identifiable, meaning that anyone who tried to commit fraud would have had nowhere to hide.

While governments claim to be worried that the anonymity/pseudonymity of most cryptocurrencies might allow people (such as terrorist financiers and money launderers) to misuse them, this does not mean that the users of cryptocurrencies are untraceable. Indeed, when people use cryptocurrency exchanges to store payments and effect transactions, the authorities might ask those exchanges to give them such information as personal details, wallets, Bitcoin addresses and transaction IDs to help them trace digital assets. This is going to become particularly relevant when the European Union's fifth Anti-Money Laundering Directive comes into force.

Blockchain technology cannot prevent fraud - ultimately it will depend upon the integrity of the participants - but it can make it much more difficult to commit and remain undetected.

Corporate insolvencies

As a side-note to the use of the blockchain to offset and solve fraud, it is perhaps worth noting that financial firms can find company administrations and liquidations extremely difficult and time-consuming (usually at the expense of creditors such as them). Blockchain technology could have a significant effect in this area by simplifying the insolvency process and improving returns to creditors.

In the first instance, the job of determining whether a company is in fact insolvent ought to be an abridged process (in Guernsey, a company fails the solvency test if it is unable to pay its debts as and when they fall due (the cash-flow test) or if its liabilities exceed its assets (the balance-sheet test). With an incorruptible digital record of all transactions, anyone who applies to place a company into administration or liquidation may be able to adduce legitimate and compelling evidence to a court of its financial status more easily.

The blockchain might make it easier for a financial institution to prove the veracity of creditors' claims. The evidentiary trail of transactions arranged between companies and purported creditors will be accessible on the blockchain. This could negate the need for creditors to provide documentary evidence of their debt (which may or may not still exist).

Retention of title claims may also be more straightforward to evidence using blockchain ledgers. With the use of smart contracts, a particular asset can be digitally tagged as belonging to the seller until such time as a specified condition is met. If that condition (e.g. payment) is not fulfilled, it is then clear that the asset still belongs to the seller. This digital mark is visible to the successive recipients of the asset and to the respective nodes that try to validate any subsequent transaction, meaning that the asset could not be sold on to a third party if title remains with the seller.

Company directors owe duties to the companies that they serve. Company legislation creates potential personal liability for them if their companies trade whilst insolvent or do something similar. If board decisions (and the reasons for taking them) are recorded on the blockchain (e.g. using a dApp called Boardroom) then it will be far easier to gather evidence for allegations or defend oneself against them. Meanwhile, the paramount need to keep accurate and thorough records remains, however those records are stored.

A reasonably fast revolution

There is some way to go before blockchain technology completely revolutionises the financial services sector, but we are seeing a gradual increase in its use.  
It is inevitable that Distributed Ledger Technology will play an increasingly significant role in business, but the financial services sector is particularly likely to see a revolution in the coming years.

* Tim Molton can be reached on tim.molton@careyolsen.com or at +44 (0)1481 732085