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Financial Innovation: Blockchains

February 2nd, 2017

Ari Paul
Obsolete Fintech
The Problem

Financial technology appeared strangely stagnant in 2008.

Compared to instant and free communication via email, transferring


electronic money was incredibly slow:
4 days to transfer money between bank accounts via ACH?
6+ hours and a $15+ fee to transfer money domestically via Wire Transfer?
24+ hours and $35+ fee for international Wire Transfers?
24+ hours and a $35+ fee to transfer cash to another country via Western
union?

Capital markets appeared similarly archaic:


3 days to settle a stock trade?
24+ hours to settle a treasury trade?
Cascading treasury failure to delivers?
Traders shortselling more equity in a company than actually exists?
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Obsolete Fintech
A Lack of Trust: Doublespending

These inefficiencies are caused by problems of trust. Why is it


so hard to move money?
The doublespend problem: A Citibank account has $1,000 in it. Citibank sends the
$1,000 to a Chase account in Mexico, and at the exact same moment, sends the same $1,000 to
a Wells Fargo account in Canada. What prevents the same $1,000 from being spent over and
over and over?

Before 2008, to prevent doublespends there needed to be some grand arbiter who could see
every balance and every transfer and confirm that nothing is being spent more than once. In the
US, that arbiter is the Federal Reserve. Every single Wire Transfer is first reviewed by the Federal
Reserve before being executed. The ACH system works similarly, and uses a combination of the
Federal Reserve and the Electronic Payments Network (EPN) to check every single ACH transfer
for doublespends. For international transfers, banks communicate with their own central banks
and utilize bilateral and multilateral international agreements like SWIFT.
US CB MEX CB CAN CB
The current system relies on a central banks and/or various banking coalitions to monitor for
doublespends.
WellsFargo
Citibank
CA
USA
$1,000
Chase MEX
SWIFT
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Obsolete Fintech
Trade Reconciliation

Why are huge back offices and lots of manual intervention


necessary to settle financial transactions?
Every stock trade currently involves at least 7 different institutions, each of
which keeps a separate proprietary database of transactions. Any
discrepancy between any of the seven databases can require laborious
human intervention.

Invest Exchang Clearing


Broker
or e Corporatio
n

Depositor
y

Clearing
Custodian
Bank

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Blockchains
Whats a Blockchain?

A blockchain is a special type of database. It is a distributed


database that maintains a continuously-growing list of records that
are secure from tamper and revision.

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Blockchains
The Basics - Visuals

Source: Dion Hinchcliffe on ZDNet

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Blockchains
The Basics - Jargon

A blockchain is a special type of database. It is a distributed


database that maintains a continuously-growing list of records that
are secure from tamper and revision.
Distributed: identical copies of the database are maintained on many
separate computers; no single entity is trusted with keeping the definitive
copy of the blockchain.
Continuously-growing list: every new transaction is appended to the list of
previous transactions. Nothing is ever changed or deleted. This lets every
viewer of the blockchain confirm that every transaction is valid, because we
can examine each transactions link to its predecessors.
Secure from tamper and revision: each addition to the blockchain contains a
hash of previous transactions; if previous transactions are edited, we would
instantly spot that the hash is no longer correct.
Hash: a one-way function (i.e. a function that can be easily performed in
one direction but is practically impossible to perform in the other) that is
used to map data (like all previous blockchain transactions) to a fixed size
string. As a simple example, I can use an algorithm to create a hash of this
entire presentation that maps to a short text string like: gJakdIkleBNeJKa.
Anyone could use the hash function to confirm that the presentation has |not 7
been tampered with because the hash is correct, but they would not be able
Blockchains
Solving Problems of Trust

The Doublespend problem is eliminated because everyone can see every


transaction and confirm that there are no doublespends. The transactions
may be anonymized and the amount and timing of transactions may be
obfuscated, while still leaving it possible to mathematically confirm the
integrity of the monetary network. This removes the need for an arbiter,
and allows for nearly instantaneous monetary transmission.

Source: Financial Times

The Trade reconciliation problem is eliminated, because trade participants


can see the official recording of the trade in real-time. Additionally,
problems of failure to deliver or naked short-selling are eliminated, |8
because all market participants can immediately confirm asset ownership
Blockchains
Other Blockchain Uses: Internet of Things

Source: IBM White Paper

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Blockchains
Other Blockchain Uses: Cryptocurrencies and asset-
backed tokens
A cryptocurrency is a tradeable intrinsic token of a blockchain. An
intrinsic token is a token that is native to the blockchain. The most
famous cryptocurrency is Bitcoin (BTC) with a market cap of $16
billion. Bitcoins can be converted to US dollars on exchanges or
spent on products and services at thousands of retailers.

An intrinsic token can be thought of as a ticket at an amusement


park that can be spent at various rides or exchanged with other
patrons. Within the bitcoin network, bitcoins are spent to pay for
monetary transmission (currently about $0.10 per monetary transfer).
Within the ethereum network, Ether (ETH) pays for decentralized
computing power. Within the Factom network, Factom tokens (FCT)
pay for decentralized file storage.

In contrast, an asset-backed token may be added by a third party to


any blockchain to represent ownership in an asset like gold, US
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dollars, or real estate. Some companies are issuing gold tokens, that
Blockchains
Cryptocurrencies
The first cryptocurrency, bitcoin, was created in 2008 by pseudo
anonymous programmer Satoshi Nakomoto (real name unknown).
This was also the birth of the blockchain. Since then, more than 400
cryptocurrencies have been created, but only a handful have
achieved significance.

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Blockchains
Whats Next?
Most large financial and technology companies are in various stages
of implementing blockchains for a variety of purposes. Banks are
implementing blockchains to settle transactions between one another
and transfer assets more quickly and cheaply. IBM and Microsoft are
experimenting with blockchains for the Internet of Things.

For some use cases, blockchains will improve efficiency. For other
uses, they are likely to be wildly disruptive. What future does
Western Union have when monetary transfers become near-free and
instantaneous to anyone with a smart phone? How much will
financial back offices shrink when trade reconciliation becomes
simple?

One or more intrinsic token (like bitcoin) is likely to become viewed


as digital gold. More broadly, cryptocurrencies may facilitate many
decentralized services. For example, OpenBazaar is a decentralized | 12
Blockchains
Investing
Warren Buffett often emphasized that good investments The Internet
need a moat to allow them to capture the economic profit
generated by their activity. Without a moat, an industry Applications
Layer
may grow rapidly, but competition will cause the benefits to Value Captured

accrue to the consumers, not producers. Who will capture


Protocol Layer
the profits from blockchains?
Consulting: some companies, like IBM, hope to profit by offering With the internet, most value
was captured at the
blockchain expertise to customers, very similar to providing
Applications Layer. For
customization and support for any other piece of software. cryptocurrencies, the majority
may be captured at the
Services: other companies offer blockchain services protocol level. (Source: Joel
Monegro)
cryptocurrency exchanges, real estate record keeping via
Blockchains
blockchain, cryptocurrency transaction analysis for law
Applications
enforcement, etc. Layer
IT tool: for many firms, like banks, blockchains and/or
Value Captured
cryptocurrencies will be used behind the scenes to reduce Protocol Layer

costs/time of their operations.

Crowdfunding: Blockchains allow start-ups to raise equity-like


financing via native and asset-backed tokens. | 13