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Distributed Ledger: The technology behind virtual currencies: the example of blockchain

Luisa Geiling, BaFin

Date: 01.03.2016

Virtual currencies have attracted much public attention in recent years. Distributed ledger technology (DLT) is also receiving more attention as the technological basis for virtual currencies.

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In April 2015, the European Securities and Markets Authority ESMA began a consultation that looks inter alia at the perception among market participants of how DLT works and how it can be deployed both within and outside of virtual currencies. The consultation served as a basis for a further analysis of this technology and examined the question of whether regulatory action may be required.

This article explains how DLT works, how it can be applied and what effect it may have on the financial market.

How the distributed ledger works

In order to complete a digital transaction, each user needs an address – the equivalent of a traditional account number. Each address is associated with a public key and a private key. These correspond to one another cryptographically. Each transaction is digitally signed using the private key. Other users can review it using their public key.

The problem: although the payment recipient can be sure that they are entering into a transaction with a legitimate (and identified) partner, they are unable to determine whether the digital funds or item to be transferred is actually in the partner’s possession, and therefore whether these funds have already been previously spent (double-spending problem). This problem is solved using an innovative transaction accounting process: instead of having each individual transaction recorded, reviewed and approved via a trustworthy accounting point such as a clearing office using a master ledger, DLT provides an option whereby the assets to be transferred are booked and confirmed on a distributed basis via processes that are intrinsic to the system. This allows the relevant transactions to be sped up.

Distributed ledger and blockchain
A distributed ledger is a book of accounts that is managed as a public distributed ledger. It is the technological basis for virtual currencies and is used to record user-to-user transactions in the area of digital payments and business operations, without requiring a central point that authorises each individual transaction. The virtual currency Bitcoin is based on the distributed ledger blockchain.

The blockchain

How does DLT work? This can be illustrated using the Bitcoin blockchain as an example. In the case of the blockchain, all mandated transactions initially wait in a pool before being confirmed. The transactions can only be executed following the confirmation.

To this end, all of the computers working in the Bitcoin network – i.e. those computers that provide the computing capacity to process the transaction via the Bitcoin software – check whether the transactions pending review are contrary to the existing transaction history. This is done by comparing the ledgers stored on all of these computers with the transaction history. The transactions are confirmed if they appear to be legitimate, i.e. because a majority of the computers classify them as free from contradiction to the existing transaction history. The computers working in the network compete for the transaction val-idation with this. The operator of the fastest computer receives a few Bitcoins as consideration for their effort. This acts as an incentive to ensure that enough computing power is provided in the network at all times for the legiti-macy check. The computational task of checking the legitimacy is also known as mining, while the computer operators are known as miners – in a reference to gold digging.

The fastest computer records the validation for the transactions in the form of a transaction bundle known as a block. The individual pieces of information are collated and coded (hash) by the miner through solving an arithmetical problem. The hash of the newly created block is distributed to all other computers across the entire network. As such, the new information is not saved centrally but can be accessed by each computer on the network on a distributed basis. This ensures that the other miners build on the last block to be created from a chronological point of view. This mechanism is used to create a chain of blocks that are built upon each other, i.e. the block chain. The first block in this chain is known as the genesis block.

In the event that two miners create a block simultaneously from the same transactions, then the other computers only continue building the chain on one of these blocks. The other one becomes an “orphan block”. Transactions that are only part of the orphan block and do not at the same time feature in the “sister block” that has become part of the main chain return to the pool of open transactions that have not yet been confirmed. As a result the transaction is only ever safely confirmed once multiple blocks are built on the block that includes the transaction in question, i.e. if it has actually become part of the main chain.

Restrictions on access

Parties are not required to trust their counterparty when using the blockchain in the Bitcoin universe. As a result of the miners generating the hash stated above for each block, there is a safety mechanism that each computer that takes part in the transaction validation process must run through (proof of work). There are therefore no restrictions required on access to the blockchain system (permissionless).

However, there are also DLT systems that feature restricted access (permissioned). Instead of using a proof of work, these use a proof-of-stake mechanism, whereby the participant in the transaction must prove that they have special authorisation to take part in the system. They obtain this from a central authorisation point, i.e. from the institution controlling the system. This way only those individuals whom the counterparty can trust gain access to systems that feature restricted access.

Virtual currencies
Virtual currencies are cryptographic (i.e. encrypted) substitute currencies that now permit a wide range of goods, services and IT applications to be acquired on the internet. They are produced using a mathematical computer-assisted process. Transactions and credit are managed in a distributed network, and therefore there is no central bank involved. The most well-known virtual currency at the moment is Bitcoin. Other examples of virtual currencies include Litecoin and Ripple. Virtual currencies are among the business models employed by FinTechs, i.e. young companies that offer specialised and specific customer-oriented financial services using technology-based systems.

Application options

Through its system-based confirmation of transactions, DLT not only allows direct trade between two parties on the internet without requiring a central third trusted party or middleman. The transaction history of a particular item can also be recorded via the distributed ledger, meaning that it acts as a distributed register.

As a result of both these functionalities, DLT could also provide versatile appli-cation options for the future, such as in trading on the financial market, in digital payment transactions and in interbank trading.

Trading on the financial market

The ability for two parties to enter into a transaction directly without an intermediary could speed up trade on the financial market. It could become easier to identify potential purchasers and sellers through distributed storage of assets and their owners in the DLT.

However, it is not yet clear how a market price could be established for trade through the use of DLT – when using Bitcoins for example, there are no fixed transactions that can be settled by Bitcoins in the DLT. On the contrary, the various prospective parties would have to be merged by the DLT, in a process which is comparable with bid and ask prices. In addition the arithmetical problem that the computer has to solve in order to create a block could also present a problem. The degree of difficulty for the problem increases as the block chain increases in length, meaning that this rises sharply with an increasing number of transactions. More computing capacity and time are therefore required to complete the transaction, which is also associated with greater energy costs. This is primarily because of the integrated safety mechanism that generates additional computing effort with each operation. The process would therefore be slower and more time-consuming than the transaction processes currently in use. This problem can be reduced by using a system with restricted access as the proof of work does not apply in that case. However, this in turn requires a centralised authorisation point that categorises the participants in the network as trustworthy. It remains to be seen how future innovations in DLT solve this problem.

In addition to this, processing a transaction through subsequent clearing and settlement may no longer be necessary in future. However, payment of the purchase price, i.e. the second part of the securities transaction, would need to be integrated into the DLT from a technical point of view or otherwise combined with the DLT, unlike the case with Bitcoins for example. The computers could reconcile their relevant ledgers with the transaction history automatically via the DLT and either confirm or not confirm the transaction for the asset. As such, the trading cycle for a transaction related to the asset would already be completed at the start of trading. Nowadays by contrast it generally takes two days to process a transaction. However, clearing and settlement for large numbers of financial instruments are subject to statutory provisions, e.g. due to systemic risks. The extent to which the existing risks can be reduced through the use of DLT cannot yet be assessed conclusively at the present time.

In addition, a distributed ledger would also allow for distributed, chronological and direct recording of all transferred assets. They could therefore also be used as public registers, e.g. for distributed property records. Each transaction could be underpinned with additional data, e.g. on the parties involved, the item purchased and the purchase price. This would then also be set out in the ledger.

Saving of trading data

DLT is already being applied or tested in a number of projects related to trading on the financial market. Bitcoins are being used here as ‘free-rides’ – as the storage medium for trading data (known as a coloured coin). If the coloured Bitcoin is transferred then this also happens automatically with the associated asset. As such, the blockchain transaction and validation system can also be used for other assets.

The US electronic stock market, the Nasdaq, started using the Bitcoin system this way at the end of 2015. With Nasdaq Linq it created the first trading platform that is based on the blockchain. Trading in securities is recorded there on a distributed basis in the trade repository based on the blockchain. The first private securities issuance by an undertaking via Nasdaq Linq took place on 30 December 2015. Decentralisation of the registry entries may make the system more resilient to cyber attacks and system failures: system functionality would not be affected in the event that an individual server failed. However, the (cyber) risks to which a trade repository based on DLT is exposed cannot be foreseen as yet. If an attacker was in possession of more than 50 per cent of the computing power of all computers on the network then they could e.g. considerably influence the blockchain in line with their own interests.

Digital payment transactions

DLT could also be used for digital payment transactions. The FinTech industry is focusing on international transfers in particular.

The payment and currency exchange network Ripple for instance already offers services today such as currency exchanges and international transfers. It attracts customers with its low costs and direct execution.

Interbank trading

Finally DLT could also be suitable for interbank trading and for internal banking systems. Market players see considerable potential for DLT here also in terms of simplifying transaction accounting and acting as a common standard for communications or business relationships between banks.

An international banking consortium has now been formed under the aegis of start-up company R3, and includes Bank of America, Barclays, Deutsche Bank, Commerzbank and UBS. The aim of the initiative is to promote cooperation between banks in the area of virtual currencies and DLT. The focus in particular is on developing standards for blockchain-based technologies. Integrating DLT could enable faster and more efficient processing for interbank trading, which is associated with lower labour costs, as there is no central accounting point involved.

Potential impact on the financial industry

The impact on the financial industry of increased or even full-scale deployment of DLT cannot be foreseen as of yet. However, it seems that it has the potential to establish a new standard in the financial market.

Keeping an eye on the possible risks right from the start is more important than ever. Data protection in transactions must e.g. be guaranteed and systems must also be protected from cyber attacks. Adherence to regulations on anti-money laundering, governance and compliance as well as for clearing and settlement must also be ensured. The lack of a central authority on conduct and regulations could pose problems here in particular.

BaFin’s focus on DLT

BaFin has been focusing on DLT for the past few months as a result of its innovative capacity. It is monitoring the latest developments in the FinTech industry very closely and is engaged in discussions related to DLT with other supervisory authorities.

BaFin is also actively in contact with experts and market participants for the purposes of identifying any potential supervisory problems.

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