How Blockchain Technology Works to prevent money laundering
22 September 2016, Bachir El Nakib (CAMS) Senior Consultant Compliance Alert LLC
The leading venture capitalist Marc Andreessen described blockchain as the most important invention since the internet itself. If internet changed the way we transfer information, blockchain is changing the way we transfer value. So, let’s learn about how it works.
While talking about blockchain technology, people sometimes mean different things and it can be very confusing. Sometimes they are talking about the Bitcoin‘s Blockchain, sometimes about crypto-currencies in general, and sometimes they are talking about distributed systems. At a very high level, blockchain is generally referred to a decentralized ledger of all transactions across a peer-to-peer network. Blockchain technology is not the same as Bitcoin. Instead blockchain is the technology underlying Bitcoin and other crypto currencies. Using this technology, participants such as buyers and sellers can interact and transfer value directly to each other over the internet without the need for a third-party intermediary. Let’s see how it works.
The blockchain technology facilitates peer-to-peer transactions without any intermediary such as a bank or a governing body. The blockchain technology makes it possible to remove all middlemen when transacting between two parties. As I mentioned earlier, Bitcoin is an application that makes use of the blockchain technology to send money around and enable transactions between two parties. In fact, it is the first application of blockchain technology applied to money.
At its core, the blockchain is essentially a database of all transactions happening in the network. The database is public and therefore not owned by any one party. It is distributed, that is, it is not stored on any one computer owned by somebody. Instead it is stored on many computers across the world. The database is constantly synchronized to keep the transactions up-to-date, and is secured by the art of cryptography making it hacker proof. These four features make this an exceptional technology.
Blockchain works as a network of computers, all of which must approve a transaction that has taken place before it is recorded, in a “chain” of computer code. In case of bitcoin, cryptography is used to keep transactions secure and costs are shared among those in the network. After the transaction is validated, the details of the transfer are recorded on a public ledger that anyone on the network can see.
In the existing financial system, a central ledger maintained by the institution acts as the custodian of the information. But on a blockchain the information is transparently held in a shared database and no one party acts as a middleman. This increases the trust among parties, as there is no possibility of abusing the system by anyone.
Let’s understand the blockchain technology in a bit more detail by looking at the example of how a transaction happens using Bitcoin. Anybody can download a simple piece of software and install it on their computer to use Bitcoin. Because it is a decentralized, peer-to-peer system, you do not need to register an account with any particular company or hand over any of your personal details. Once you have a wallet you can create addresses which effectively become your identity within the network.
Let’s say Party A wants to send money to Party B in the form of bitcoins. This is a transaction which will eventually change the bitcoin balances for both Party A and Party B. The transaction is collected in a block. A block records some or all of the most recent Bitcoin transactions that have not yet entered any prior blocks. The new block is then broadcasted to all the parties or so called nodes in the network. The parties in the network approve that the transaction is valid through a process called mining. With Bitcoin, miners use special software to solve math problems linked to blocks which is the basis for approving the transactions. The minors are issued a certain number of bitcoins in exchange of doing this work. Once the transactions are approved, the new block is added to the block chain, which is the ledger of all the past transactions. Once the block is added, the ledger balances are updated to reflect the new balances for all parties. The process goes on and a new block is formed every 10 minutes with a new set of transactions.
Financial institutions such as banks and brokerage firms have long held the role of trusted intermediary third parties that validate the authenticity and accuracy of a transaction. However, blockchain simply eliminate the need for third parties. Initially banks looked at the technology as a threat, however, they have now started embracing it. The world’s biggest banks are looking for opportunities in this area by doing research on innovative ways blockchain can be used in banking and finance related applications. For example, blockchain technology significantly increase the speed of execution of securities settlement. It can also help reduce the capital, that banks have to hold, against each trade. Infact, in 2015, Nasdaq formally debuted its blockchain product, Nasdaq Linq, which be the first major global stock exchange to publicly trial blockchain technology.
Banks didn’t plan for the blockchain. It just happened in front of them in 2015. But, they have been thinking a lot about its implications.
2015 was the year that banks started to wonder about their blockchain strategy. Banks that didn't have such a strategy were considered laggards.
But despite its revolutionary prognosis, the blockchain doesn't signal the end of banking, because the banks aren’t going to use it to disrupt or obsolete themselves.
Rather, they will guide it to live within the regulated constraints of their world.
The good news is blockchain implementations help banks strengthen and defend their positions. But here's the footnote: Innovation must permeate faster than the Internet infiltrated banking from 1995 to 2000.
In 2015, banks became interested in blockchain startups, fueled by their larger interest in FinTech activity.
Some banks invested in startups, including startup accelerators (eg Barclays' work with TechStars), but that only gives them a spectator seat, not a player one. The jury is still out pertaining to the direct benefits they'll gain, besides marketing visibility.
Blockchain and old constructs, such as clearing houses and private exchange networks (eg SWIFT, CCP, FIX, DTCC) are like oil and water: They will not mix well because one is based on centrally trusted intermediaries, and the other is based on exchanging intermediaries for peer-to-peer trust.
It is easier to start implementing blockchain solutions in new segments, without internal integrations.
So, here’s a thought: why not start with no baggage, and earn new customers that want to try something new?
Having the blockchain without bitcoin is like having your cake and wanting to eat it too.
Banks rejected bitcoin as a knee-jerk reaction, rooted by regulatory compliance requirements, and fears they would lose control of the financial system. Both are valid concerns in the short term.
But bitcoin is a rich blockchain laboratory. Bypassing it results in a steeper learning curve.
Proofs-of-concept (PoCs) are timid experiments that don’t show commitments. They won’t always allow banks to see the potential benefits, so it’s better to implement smaller projects end-to-end, where results can be more visible. That said, POCs can be used to narrow down the portfolio of committed projects.
Venture capital may not be attracted to private blockchains because the banks are spending money on it. But many startups are going after the capital markets space, and most of them are getting funded by banks or private equity. That’s not a necessarily good sign.
Implementing the blockchain is 80% business process, 20% technology. Not the other way around.
The biggest risks lie in seeing banks not directly getting their hands dirty with the new technology. Banks need to learn how to write smart contracts, and they should not outsource these tasks. Otherwise, they would be outsourcing their education.
Few people understand the blockchain within the average large bank, and while some entities have internal innovation groups that are leading the way, the question is whether their work will permeate the rest of the bank. Banks should take a page from the reengineering craze days, when a "Reengineering Czar" was a required person.
Appoint a Blockchain Czar position, especially if the CIO is not yet a blockchain enthusiast. (That person’s role is outlined the SlideShare below).
As far as anti-money laundering (AML) and know your customer (KYC) practices, network-wide analytics are now possible, across institutions, providing an opportunity to reduce KYC requirements, while increasing monitoring and analysis.
But questions remain whether law enforcement authorities, financial institutions and regulators will embrace this paradigm shift by seeing its potential benefits.
Don't ask: What problems is the blockchain solving. Rather, think what opportunities does it create? (That’s a tough one to answer).
As for my thoughts on the year ahead, some might be controversial, but here they are:
Compliance will move to intelligence. Regulation will show signs of reinvention. That's because you can monitor better with blockchain analysis software, and across institutions; something you can't do well with AML monitoring. (see slide #61)
$1.5bn in non-currency assets will be transacted on blockchains. Already Overstock announced that $500m will be pegged to the blockchain. That number will get big quick.
VC investments in blockchain related startups will exceed $2.5bn. This doesn't include what the banks will spend from their operating budgets, but it's not the same metric. Banks fund implementations, with large overhead costs.
Some FinTech companies will be challenged by blockchain contenders. Surprise! The blockchain also competes with traditional FinTech companies.
Some consortia will start delivering. But it’s not a panacea for everything. Banks were driven to consortia for fear of missing out, but they will have limitations that prohibit them from truly capitalizing on the tech.
Some blockchain startups will start to fail (visibly). This is good for the ecosystem, because we learn from failures, and it means we have pushed the envelope in order to figure out what the real boundaries are.
Bitcoin as a digital currency will enter online banking. All it will take is one bank to take the lead, and the rest will follow. It's not a technical issue, but a regulatory one that is holding them up.
In closing, the blockchain is not a lethal threat to banks, but it presents challenges and signals turbulent times for technology adoption.
It might be the last chance for banks to ride a significant technology-based innovation cycle. If the banking sector fails to embrace the blockchain, the field of "alternative financial services" (aka FinTech) will accelerate its growth even more, meaning that banks will have a smaller share of the overall financial services market.