Blockchain and Distributed Ledger Technology in Fintech

One of the most revolutionary advancements in recent years is the emergence of distributed ledger technology (DLT). This technology and blockchain are transforming financial transactions and opening up new possibilities across various sectors. In this article, I will explore the world of blockchain and DLT, and their benefits, highlighting some of the exciting use cases they offer in fintech.

Why Were Centralized Systems So Popular?

Imagine an ancient city under siege, surrounded by four divisions of a mighty army, each led by a different general. The fate of the entire campaign hinges on a crucial decision – whether to attack the city’s walls or retreat from the battlefield. All four generals must agree on the course of action for the mission to succeed. This intriguing scenario, known as the Byzantine Generals’ Problem, sheds light on why centralized information-sharing systems prevailed before decentralized alternatives emerged.

In this experiment, the challenge lies not just in the decision itself but in the uncertainty surrounding the generals’ intentions and the trustworthiness of messengers traversing the battlefield. If one fails to communicate effectively, the entire army faces defeat. 

This scenario’s lack of a reliable consensus mechanism underscores the difficulty of reaching a unified decision.

Consensus refers to an agreement among multiple participants or nodes within a network. Consensus mechanisms are pivotal when diverse participants must converge on a collective truth, despite challenges like unreliable communication channels, flawed nodes, or intentional attacks. The attainment of consensus is paramount, as it guarantees the integrity, security, and reliability of the entire distributed system.

The Byzantine Generals’ Problem is a compelling allegory of decentralized systems and blockchain technology. Just as the generals must overcome communication barriers and uncertainties to achieve their goals, modern distributed networks grapple with challenges to establish consensus. 

Blockchain Emergence

Blockchain technology has revolutionized sharing, validating, and securing information across networks. At its core, a blockchain is a digital infrastructure that creates an unalterable record of transactions. Each transaction is stored as a block, linked to the previous one through cryptographic hashes, forming a chronological and tamper-proof chain. This structure ensures transparency, security, and immutability, making it a foundation for various network applications.

Blockchain technology has changed the security of a network’s ability to share and operate securely. This is done by distributing the information throughout a network, with members cooperating to verify the data.

How Blockchain Works

1. Two parties propose a transaction.
2. Miners verify the transaction by ensuring the parties’ accounts can complete the transaction.
3. Miners complete a complex mathematical puzzle to add a new block to the chain.
4. The solution to the puzzle requires computational power, resulting in the production of a hash function. This algorithm transforms an input of numbers or letters of any length into a fixed size.
5. This hash function then confirms the authenticity of the transaction. A hash function’s input will always produce the same output, but only one piece of information will generate a singular production. Furthermore, a hash function’s output cannot be reverse-engineered to have the input.

What are blocks?

A “block” is a bundle of transaction data. Most closely associated with Bitcoin, a blockchain structure connects blocks such that each block includes the previous block’s hash value, thereby forming a chain of valid transactions.

“Miners” create new blocks by validating transactions through a Proof of Work (PoW) exercise. This PoW exercise allows anyone (without permission) to create valid blocks if they can expend the required computing power (calculating hashes). This resource-intensive process also creates a financial barrier to deter malicious actors from adding fraudulent blocks.

Why aren’t they necessary?

In trusted, private distributed ledger networks, PoW and global broadcast of transactions are optional – it does not make sense to group unrelated transactions into blocks that are then shared with many unrelated parties. Those private blockchain systems that use blocks most likely use the Bitcoin structure without considering why Bitcoin works the way it does.

1. Simplicity and Efficiency: In some distributed ledger setups, especially those with a small number of participants or specific use cases, the complexity of organizing data into blocks and maintaining a chain might not be necessary. Simplifying the data structure can lead to more efficient operations.
2. Consensus Mechanism: While blocks are commonly associated with consensus mechanisms like Proof of Work (PoW) or Proof of Stake (PoS) in blockchain systems, other distributed ledger technologies might use different consensus mechanisms that don’t require the sequential arrangement of data into blocks.
3. Use Case Specificity: Some applications require a different level of security and immutability than those provided by blockchains. If data verification and consensus can be achieved without blocks, a simpler data structure might be more appropriate.
4. Scalability: In some scenarios, the block structure of a blockchain can hinder scalability due to the sequential nature of adding blocks. Different data structures or approaches might better handle large amounts of data or high transaction throughput.
5. Flexibility: Certain distributed ledgers might prioritize flexibility over the rigid structure of blocks. They may want to adapt and modify the data structure more freely as the technology evolves.

What is Distributed Ledger Technology (DLT)?

Distributed ledger technology is a broader concept encompassing blockchain and other similar technologies. In a DLT system, multiple participants or nodes collaborate to maintain a shared record of transactions. Unlike traditional centralized systems, DLT distributes the control and validation of transactions across the network, enhancing transparency and reducing the need for intermediaries.

The distinction between blockchain and DLT

Blockchain:

1. A blockchain is a specific type of distributed ledger technology.
2. It is a linear chain of blocks, where each block contains a set of transactions or data.
3. Blocks are linked together using cryptographic hashes, forming an immutable and chronological chain.
4. Consensus mechanisms like Proof of Work (PoW) or Proof of Stake (PoS) ensure agreement on the state of the blockchain.
5. Blockchain gained popularity as the underlying technology for cryptocurrencies like Bitcoin, but its applications extend to various sectors beyond finance.

Distributed Ledger:

1. A distributed ledger is a broader concept that encompasses various technologies, including blockchain.
2. It refers to a decentralized system where multiple participants maintain copies of the ledger and work together to achieve consensus.
3. Distributed ledgers can use different consensus mechanisms, not limited to the Proof of Work used in most blockchains.
4. While blockchains are structured as a chain of blocks, distributed ledgers can have different structures like Directed Acyclic Graphs (DAGs) or Hashgraph.
5. Distributed ledgers find applications in supply chain management, healthcare, identity verification, and more beyond the scope of cryptocurrencies.

Use Cases of This Technology in Fintech

Now that you understand blockchain and how it is only a part of the broader term DLT, let’s see how it’s applied in fintech. The vast number of possibilities is astounding.

However, some cases are seen more often than others. 

Cross-Border Payments: 

This is the most common use of blockchain and is popularized using bitcoin as a payment method. This use offers the potential for blockchain to efficiently process cross-border payments. Cross-border payments involve a long and costly process and require various intermediaries. This process can increase costs by around 10%, which will not be finalized until the funds are received. With blockchain, the payment could happen in real-time without intermediaries and, therefore, at a much lower cost. The process is secure and verifiable, as all members of the network can track the payment transaction as it happens (Allayannis & Fernstrom, 2017).

Smart Contracts: 

Blockchain can also be used in the operation of “smart contracts,” a series of automatic processes executed upon certain specified conditions. They are not like legal contracts but rather a selected state or set of procedures to be followed when certain conditions occur. Think of smart contracts as an “if…, then…” statement written in a computer’s code. If certain conditions are fulfilled, then a particular process will occur. They are powered by the code that creates the block. A transaction is triggered once a specific set of obligations has been fulfilled and detected by the code. This could help revolutionize dividend payments to shareholders since the transaction should occur once a share price reaches a certain level. Other application examples include those in the logistics industry, such as processing shipping documentation.

Blockchain Bonds: 

A digital asset is a liquid, digital representation of a traditional asset, typically transformed into a token – a process known as “tokenization.” When a traditional asset is tokenized, it becomes easier to trade and may be bought in smaller fractions. The tokens are registered on a blockchain network, on which they may be traded.

Instead of physical certificates, blockchain bonds are issued as tokens registered on a given blockchain network, and investors would pay for the tokens’ ownership using traditional fiat currency. On the blockchain, the tokenized bonds could be traded on secondary market platforms, reducing the need for traditional intermediaries and their associated costs.

Non-Fungible Tokens (NFTs): 

One example of a digital token that is quickly rising in popularity is an NFT. An NFT can tokenize nearly any form of media – a drawing, a music clip, a video recording, a newspaper article, a poem, or CryptoKicks Nike sneaker. They are similar to collectibles, such as baseball cards or Pokémon cards. Artists can upload their creations to the blockchain to sell to receive payments from an original sale and secondary sales for a fee. Buyers can purchase an NFT for a flat fee or at an auction for basic user rights, such as using the picture as your Twitter profile picture.

Distributed ledger technology is reshaping the fintech landscape by offering enhanced security, transparency, efficiency, and innovation. These technologies can potentially revolutionize various aspects of financial services, from cross-border payments to smart contracts and beyond. As the fintech ecosystem evolves, embracing blockchain and DLT can unlock new opportunities for efficiency, inclusivity, and growth in the digital economy.