Trust is the underlying factor supporting financial systems – from the value of currency and financial transactions to public spending. Similarly, trust underpins almost all information transfers, and money is a medium that allows people to ‘communicate’ value throughout an economy, says financial services firm Investec Bank economic strategist Chris Becker.

Transactions and commercial informa- tion sharing are usually facilitated by intermediaries, such as central banks, owing to the need to ensure trust in the process. The reputation of the interme- diaries is key to the smooth functioning of the system and flow of transactions.




However, intermediaries drive up costs and the time for transactions to be carried out, notwithstanding that the actual processes used to facilitate transactions are not always public or transparent, although they are subject to stringent regulations.

“Every time there has been an innovation in financial systems, the costs of transactions were reduced, which led to greater economic activity,” highlights financial services firm Efficient Group chief economist Dawie Roodt.




New information technologies, such as the encrypted, distributed-ledger tech- nology known as blockchain, can remove the need for central facilitators by providing a framework in which secure transactions can be done directly between parties and reduce the costs of transactions.

“A blockchain acts as a decentralised, automated ledger that records and verifies digital events and transactions, and stores them in a secure global network. It is a globally accessible, but secure, database that acts like an electronic filing cabinet,” says information technology services multinational Wipro Technologies global payments practice executive head Mary Ann Francis.

Blockchain systems use a “trust protocol” and all information recorded and stored by a blockchain is done by consensus. The process is not centralised, without the need for organisations to validate the entities or the transactions, or to manage the reconciliation of ledgers, and makes payments and settlements faster, cheaper and more transparent, she says.

“The beauty and elegance of the solution lies in the fact that all parties agree that the information captured within a ‘block’ and representing a transaction or trans- actions is an objective representation of the transactions cryptographically secured and stored in an external, public ledger. The transactions and money transfers can, therefore, be tracked and verified,” says enterprise data management solutions firm Epi-Use manager Phillip Loots.

Trust in a blockchain system is ensured through the underlying protocol of the blockchain. Each subsequent ‘block’ in the chain refers to and builds on earlier blocks, each of which is encrypted, which means that a blockchain becomes exponentially more difficult to compromise as it grows, says multinational law firm Hogan Lovells South Africa partner and technology, media and telecommunications head Leishen Pillay.

DISRUPTING GOVERNMENT AND FINANCE FUNCTIONS

Blockchain systems will impact on financial institutions and financial transactions, but can also be applied to any process that requires a secure exchange of information, including government services, the medical industry, utilities, insurance, property trading and telecommunications, and most supply chains, will change significantly as a result of blockchain technologies, adds trade technology specialist firm Andile Solutions founder and executive head Andries Brink.

South Africa has about 12-million people who are not part of the formal banking system – about 23.5% of the population – and using blockchain technologies can provide a secure, low-cost platform to make financial services available to them, says Francis.

“In August 2016, South African Reserve Bank (SARB) governor Lesetja Kganyago said that the central bank was “willing to consider the merits and risks of blockchain technology and other distributed ledgers”. This indicates a desire to keep up with the rapid pace at which technology is developing to drive financial inclusion.

“Financial inclusion and reducing the risks of using physical cash are compelling reasons to research the use of blockchain technology in South Africa,” she emphasises.

The SARB started researching the technology and cryptocurrencies in February. Further, in August, the Association of African Central Banks, comprising 35 African central banks, including South Africa’s, chose financial technology innovations, cybercrime and challenges experienced by central banks as one of two topics for its 2018 symposium.

“The costs to establish a trusted transaction and information transfer framework using blockchain are a fraction of the current costs of existing systems, and this alone will dramatically change the business models of financial institutions, stock exchanges and financial services firms. It removes the need for these organisations to function as facilitators and intermediaries,” states Pillay.

Blockchain systems can replace various government functions, such as identification, the issue of birth certificates, property deeds registration and licensing processes, and allow for the services to be scaled, almost without limit, thus enabling faster and cheaper public services to be delivered in a visible manner to participants – in this case, citizens, he explains.

Such a system will also enable citizens to “own” their personal data and control who is permitted to access and/or use it. Without permission, their information will remain secure and inaccessible.

“The blockchain model is well suited to providing an immutable tracking and tracing platform to provide verification of the origin of products. It can easily be retrofitted to existing product authenti- cation systems in supply chains, similar to how personal identification blockchain systems would function, whether linked to government or not,” says Pillay.

BLOCKCHAIN IN BUSINESS

Centralised transaction models have come under attack. The interbank transfer service, Swift, was hacked and subverted by cybercriminals to steal millions of dollars.

To counter attacks on central transaction models, financial services firms in US and European capital markets are shifting to blockchain platforms, with similar activity in markets such as Japan, despite the sector being conservative and compliance-focused, says information technology services multinational Dimension Data Group chief technology officer Etienne Reinecke.

“Cybercriminals who perpetrated the recent WannaCry ransomware attack demanded payment in Bitcoin – a crypto- currency based on blockchain. If cyber- criminals are confident that Bitcoin provides a safe mechanism for the payment of ransoms, it indicates how secure the distributed ledger approach is.”

Further, in Internet of Things (IoT) systems, millions of small transactions are generated and collected from a distributed set of sensors. It is not feasible to operate these systems using a centralised transactional model. It is too slow, expensive and exclusive. The cost of the transaction has to be near-zero or free, and the cost elements of a centralised model do not support the potential business model in IoT, Reinecke explains.

He adds that interesting applications of blockchain and IoT in the area of cybersecurity will emerge in 2018. “Significant attacks have been launched from low-cost IoT end points, and there is very little incentive for manufacturers of these devices to incur the cost of a security stack, which leaves them extremely vulnerable. Blockchain can play a fundamental role in securing IoT environments.”

THE LIMITS

The most glaring omission around blockchain currently is the lack of regulation and legislation, emphasises Pillay.

The need to ensure the security of these platforms and their conformance to national laws is important to ensure the protection of the digital identities of people, their transactions and activities on blockchains.

Any distributed ledger used by an enterprise or industry needs to conform to data requirements in the countries in which it operates, states Baker McKenzie Johannesburg partner and technology, media and telecommunications practice head Darryl Bernstein in the ‘Fintech Report 2017’ White Paper, written in collaboration with fintech company R3.

He explains that existing blockchains, such as cryptocurrencies Bitcoin and Ethereum code bases, can indiscriminately broadcast private data to all participants of a network and, therefore, may not always be suitable for use in financial services.

“Distributed ledgers have been developed that share certain data only with participants who need to see it. These distributed ledger technology implementations are more flexible and can more easily meet existing and potential future data requirements,” adds Bernstein.

Meanwhile, the potential of using secure blockchains to be used to hide and/or move money illegally across borders must also be addressed, as merely buying cryptocurrencies makes the funds internationally tradeable, confirms Roodt.

“Enforcement is always catching up with fraudsters: they change their tactics to stay ahead of fraud prevention technology and regulation,” notes Wipro Technologies banking and payments chief executive advisor Hari Subramanian.

“What if events that would trigger certain enforcements in a smart contract never reach it? What if someone suppresses an event if it is likely to increase liabilities, reduce asset values or cause margin calls? How can the system ensure that someone owns a physical asset in the real world even if the person’s ownership of the corresponding digital asset inside a blockchain is verified?”

To combat potential fraud, the likely fraud triggers, loopholes and design workarounds for each use case must be addressed. These could be in the form of vulnerability or conformance testing of contract code, certifying data and event sources as well as determining suitability of delivery channels.

“Evaluate the speed and accuracy of alternative event sources, such as from regulators, participants (through code of conduct enforcement) and public sources to determine the resolution of verification processes and the associated risks,” says Subramanian.

NEW FUNCTIONS FOR OLD INSTITUTIONS

Current thinking regarding blockchain is that banks and other nodes connected to blockchain networks will perform their own screening “at the gates” where value enters and leaves the blockchain networks, and that regulators are totally separated from this flow, says Subramanian.

“However, in future, a case could be made for regulators to be part of blockchain networks, performing all these screening functions on behalf of other participants. This could significantly bring down the cost of screening and other functions, leading to real savings in the cost of fulfilling payment transactions. Similarly, in settlement, today’s powerful intermediaries are likely to find some niche role for themselves in blockchain networks as well.”

One could argue that such regulators would be ‘interceptors’, not ‘interme- diaries’, and they would continue to add value to blockchain networks by removing the need for replication of functions and investments across network participants.

“Their power might be reduced, as they may not be able to exert power by withholding information from others, given that blockchains promote data transparency, but they are likely to continue to add value,” he concludes.