Understanding Distributed Ledger Technology And Its Alternative Uses In Finance

Distributed Ledger Technology

Financial industry has seen a great emergent from the digital world, which has garnered it gaining a lot of attention of all those tied to this industry. Digital innovation has brought Distributed Ledger Technology (DLT) proving it to be the most essential tool for the payment, clearing, settlement processes (PCS) (Mills 2016). DLT is also widely famous as Blockchain technology. This essay portrays DLT as a combination of certain components which includes distributed data storage, peer-to peer networking and cryptography which changes the idea of secure data storage and record keeping. However, it is its requirement which makes it so important in today’s global finance industry.

The need for more efficient and non-erroneous ways of payment, clearance and settlement became the driving force for the deployment of DLT in PCS processes. The financial and operational inefficiencies in today’s financial management formed the way for DTL (Collomb and Sok 2016). A friction was witnessed in the methods of recording, transferring and storing of the digital assets. The essay has clearly identified the characteristics, foundational properties and its variations. The issues and challenges introduced by the system have also been noted here. The essay throws light on its disadvantage in comparison to centralized system.

For a better evaluation of this technology, it is essential to understand every element of the PCS processes and how it’s every element is related to all the technological and key components of DLT (Manning, Sutton and Zhu 2016). The essay has been organized skillfully to analyze every aspect step by step in a good flow with all related points like potential uses of DLT, adoption of DLT, its implementation and all the various technology, business and financial designing challenges of DLT.

Distributed ledger technology also famous as Blockchain technology can be called as union of shared, synchronized and imitated digital asset disseminated across multiple countries institutions or sites geographically. This does not have any kind of centralized storage or administration (Badev 2016). Basically, a digitized record of what is owned by who is known as distributed ledger. This is far away different from the traditional database technology approach. This contains all Bitcoin transactions ever executed which keeps growing constantly as new completed block is attached to it having new set of records. This is why it is also called blockchain. Linear, chronological order is followed for the addition of the new blocks or records (Brainard 2016). In this technology the Bitcoin or the digital currencies have mentioned a better approach of recording or tracking transactions. With this technology every transaction executed in that particular currency is replicated and stored as digital ledger which the currency users share later on. ‘Distributed’ under the context of Information technology suggests some sharing of digital asset among multiple systems situated in various locations. This is usually conducted over a network connecting multiple systems (Drescher 2017). The distributed processing here uses parallel processing technique that means more than single computer is used to run an application at once. This whole process goes around for the transaction of Bitcoins.

Key Features of Distributed Ledger Technology

The Bitcoin can be defined as digital currency which is not supported or dealt by the central bank of a country or government. It is also known as virtual currency and was developed by Satoshi Nakamoto a software developer (Leinonen 2016). It is an electronic paying system which works on the basis of some mathematical proof. This kind of transactions of bitcoin occurs through the bitcoin wallet attached to the blockchain which takes place with certain proof of their origin. The bitcoins are created through mining which is a decentralized and a competitive method. The process involves rewarding of the individuals for the services provided by them. These kinds of transactions are continuously being handled by the bitcoin miners who look after the transactions and its security with help of specialized hardware (Reid and Harrigan 2013).

Further in the discussion it is important to add on some key features or properties of the Distributed Ledger Technology which showed keen potential in the development of the post-trade ecosystem.

Built-in asset: The Bitcoin network completely deals with the management and production of the Bitcoins. Hence, it makes the transactions easier to check on the quantity and history of movement of every Bitcoin. This is verified mathematically from the Distributed ledger’s history in the Bitcoin network. 

Party Identity Abstraction: Here, identity of the individuals is kept secure and hidden. The platform has built in security by obscurity feature. The individuals are provided with the security keys which allow access to the output of the transactions (Leinonen 2016). Only key holders have the opportunity to send or receive the Bitcoins.

Transaction linkage: Every ledger entry is linked to the previous one and has a standardized participating node which is retraceable and also can be reconstructed.

Transaction script: This can be called the set of standardized rules and terms which is applied to every transaction. Any movement of Bitcoins in the Bitcoin network is done under the consideration of these rules (Reid and Harrigan 2013).

Transaction distribution: The standard network protocol takes care of the validation of the rule and sanction of every participating nodes transaction.  

Blockchain: This is also sometime known as ‘Distributed Ledger’. Blockcahin represents how a node records the ledger data in compliance with the set of standard rules (Zheng 2016). The new blocks or records are kept on adding to the previous one with a link or connection.

Decentralized Consensus: This refers to the set of rules for swapping of the Blockchain information for every node. Each node has to agree on the integrity of the data which is validated with the help of mathematical model (Pilkington 2015). The key point of this platform is to validate all the transaction and ensure that every transaction is added in the chain only once. This model does not give the liberty of omitting any transaction or spending a Bitcoin twice.

Trust versus No Trust: The reference to the public access and open access to the internet on which the network of the Bitcoin is built is given in the “No Trust model”. The open sources software can join and downloaded by everyone. The construction of the network of the Bitcoin is done to distrust the nodes (Lemieux and Lemieux 2016). The implementations that are trusted or are being permissioned are considered as significant modification of the model. In addition to this it the servers are required to be on-board and approved for participation.

Decentralized Consensus and No Trust Model

In short, one can call Distributed Ledger as a database and a network which on the basis of built-in security and some rules maintains transaction history and data integrity. This has helped in the up gradation of current PCS process.

Regardless of the type of asset, financial transaction has some key components for the clearance and settlement. These are network of participants, sets of asset or asset being transferred among the participants, and a validated process with the right obligations and procedures for the transaction. The direct participants here refer to the brokers, banks or dealers while the indirect participants are the end users for example household or business. The Assets is the financial instrument which can be security, monetary, derivative or commodity. The communication of such instruments takes place between the participants through network with help of electronic messages, statements, and acknowledgements.

Payments processes is the first step which includes four conceptual steps namely submission of payment, validation of payment, conditionality and payment settlement. After submission of payment message, the message is passed on to the validation system which checks its integrity.

Post trade process is step of the processing gives out confirmation on the trade terms, settlement and clearance. Most of the time such processes occurs through the intermediaries like Security settlement systems (SSSs), central counterparties (CCPs) and others. This whole process involves agreement between the relevant parties, over the statement and trade obligations (Lemieux and Lemieux 2016). Settlement comes after the clearing process for which obligations assigned have to be fulfilled by delivering the commodities and security. This depends and differs from contracts to contract depending on the counterparties. Finally, when the transfer becomes steady and unconditional every step of the transaction occurs. When there are many transactions taking place the delivery-versus- payment process are used for coordinating the settlements.

The institutions like banks, broker-dealers play an intermediary’s role for the end users. This includes brokers, banks or the dealers who stores, manages, records and updates it on the behalf of the actual asset holder. The FMI acts like a central hub here. Every bank, broker-dealer interacts and works with the end users going through this (Ammous 2016). Since banks and dealers are available in different financial markets. Therefore they have to deal through multiple FMIs. This may also work crossing the boundaries and different jurisdictions.

Over passing centuries the whole PCS process has developed to great extent. The complexity and volume of the financial transactions has also increased. This created frictions in the financial market like operational and technological in efficiencies. The participants were founded to be seeking for more profitable alternative which would not only reduce the cost but also deal with inefficiencies being faced.

Distributed Ledger Technology (DLT) can be in some broader sense described as a union of several components like distributed data storage, cryptography and peer-to-peer networking which have the potential to change the way of storing managing and accessing the digital data. These arrangements can be conducted through several ways. The present or existing intermediaries can take up certain components under their consideration for the present running structure or technicalities of the business. These kinds of measured changes may not entirely affect the working or operational and behavioral practices which go in hand with the PCS process (Crosby 2016). Under such consideration the arrangement can be made so that the traditional methods being managed earlier can be taken over by DLT with help of existing intermediaries. Sooner, the use banks for payments may become obsolete.

Alternative Uses of Distributed Ledger Technology in Finance

With above future aspects of the development of the DTL the architecture of financial industry now may witness some changes with maturity of the technology. The impact level has to be divided on the basis of which the technology is being adopted and how the firm may proceed with the adopted technology (GIFFORD and CHENG 2016). Very soon, the various components of the mentioned technology will be used for various different purposes. Therefore it is important to review some key components of the Distributed Ledger Technology.

The connection of the peers in the technology occurs via nodes. Nodes can be defined as the different devices which are connected through different networks running the DTL technology. These devices maintain the database records. This structure allows different entities like banks, financial institution and end users to share records and manage records among each other on peer-to- peer basis (McLean and Deane-Johns 2016).  It contradicts the traditional method of data being shared through only a single central hub which acts as an only source for control and valid information. This component increases the operational resiliency by letting a end-user control its database records beyond multiple nodes.

Participants in a DLT arrangement can be permitted to play different roles or functions regardless whether the DLT is open or closed arrangement. Those arrangements where participants are allowed for all the activities are known as permission less while where participants are restricted are known as permissioned (Massacci, Ngo  and Williams 2016). This can be explained taking examples of the participants who are allowed to have nodes for only sending and receiving asset transfer of the existing asset while others may be permitted for issuing new assets. Beside this some may be allowed to read the ledger while some can write on it too. The crypto currency arrangements in DTL are the example of the permission less system. The financial market is an example of the permissioned system.

The assets are designed in various ways. It can be traded or issued directly in the ledger or can be presented as an asset outside the ledger. Indifferent to it the information of ownership of asset is or can be stored in the ledger. This enables maintaining the ownership hierarchy of participants in the system (Fanning and Centers 2016). The owners of the assets are the financial intermediaries like banks or broker-dealers.

Cryptography in DLT arrangements are used for various reasons. It may be used for identity verification or it can be used for encrypting data. Public key cryptography is such a kind of cryptography which is the base of the validation of transaction process (Herbert and Litchfield 2015). For transfer of assets participants can create digital signature with private key which is a non-shared cryptography key. Others who validate the transfer can decrypt the ledger entry with help of mathematical algorithm (Bott and Milkau 2016). Cryptography in the arrangements proves to be an important tool which will provide certain degree of privacy required.

The records of transaction history and ownership of the asset is shared which actually lays the foundation of distributed ledger. The sharing of such information across different nodes is the main priority of this technology. It gives the power to the participants with some security barriers to read or write in the ledger (Swan 2015). Despite the availability of the complete ledger many participants may not get hold of asset due to encryption and only authorized participants can check it.

Advantages and Limitations of DLT

The PCS processes in DTL arrangements are coded. This forms the set of procedures called protocol which deals with the interaction of participants. For any kind of payment transfer the conditionality checks and the validation checks occur (MacDonald, Allen and Potts 2016). This kind of protocol ensures a mannered procedure for the clearing, settlement and confirmation of the transfer.

Smart contracts are programs that initiate the pre-defined transactional contracts which are automated and can be used on event-basis on the agreed terms. This can self-execute in respect to the received information into the ledger (Seijas, Thompson and McAdams 2016).  

An API which are set of rules, protocols or tools help in building the software applications. This decides the interaction of the DTL components. It lets the addition of new enhancements or features which are not present in the DTL protocol. It gives a user-friendly interface which makes it easier for different set of users in accessing this technology.

Blockchain though are in much hype today but yet there are some facets where the centralized system does leave it behind. If a careful analysis is done and the issues over robustness and trust are overlooked, it would be clearly visible that the decentralized system does not do much new. The confidentiality and the performance are of the prime importance and centralized system effectively delivers it (Wright and De Filippi 2015). Rather, these acts as an advantage over the blockchains. The centralized system offers confidentiality the same way blockchain does. Every transaction is restricted centrally and can be performed only with central update. The entire database is only visible at the central location and can access only with the central permission which may be rejected on fit basis.

The extra security procedure in the distributed ledger slows its performance. The three extra steps in the blockchain which may reduce the performance are signature verification, redundancy and the consensus mechanism. Other than these mechanisms, the entire working system of the centralized system is same as the block chain.

Distributed Ledger Technology since its innovation is being seen as the ultimate panacea for today’s business challenges. The technology drags people in to this hype and overlooks the challenges it faces (McLean and Deane-Johns 2016). Some of the key challenges have been highlighted below:

Scalability and latency: Few of the Distributed ledger application have been reviewed of suffering from transaction process delay and latency (Collomb and Sok 2016). Some of its existing applications have been scaled poorly for the processing speed.

Readiness: DLT requires all transaction and records in the digital form which contradicts the present scenario of organization still being dependent on the manual paper work and documents. Along with that many other organizations require overhauling the outdated legacy system before it implements the DLT system.

Understanding: The understanding of the DLT is still lacking in the mainstream. People and participants engaged with it do not understand the technicalities of the distributed ledger and are not able to analyze certain root cause for the issues.

Conclusion

Collaboration: To deliver the proper usage of the Distributed ledger different participants financial institutions and firms require working together. The challenges here creep up due to the competitive nature of today’s business market (Massacci, Ngo and Williams 2016). The institutions are more into competing with each other rather than collaborating for the sake of better performance of the distributed ledger.

Standardization: Presently, no standard tools or interface is there for distributed ledger. Hence in order to make the distributed ledger to work in the financial sectors it is required to set up some shared standards.

Interoperability: The power of the DL can be maximized only through interoperability with the other ledgers. In regards to which, the agreements and policy should be formed and the implementation should take place (Sas and Khairuddin 2016).

Energy: The DLT technology is being assumed to be leaving an enormous carbon footprint on the world. The energy requirement for running such a technology is immense. The computing power being used in the processing of the bitcoin requires working of the 500 fastest supercomputers at once.

Privacy: The data being stored in the system is publicly open and is accessible by all. The transaction data are published openly which may be seen by all. The security features provided may be ignored out of negligence and may result in loss of privacy (Aune 2017). The security features requires enhancing and be implement ted properly with understanding.

Illegal information: The incorporation of illegal data into the blockchain might destroy the data authenticity and gets published on every machine (Zhao, Fan and Yan 2016). In addition, its recording nature may disallow the editing of the erroneous entry and it may disturb the whole and may stay there forever.

Encryption: Encryption leads to certain issue need to be address. Anyone who gets the encryption key may access the data entirely also if the key is lost the data may be lost and cannot be accessed (Elliott 2016).

Finding information: Along with the addition of information some reliable source of finding information should also be there. The blockchains created may be indexed and can be formed into searchable database (Drescher 2017). This requires every user to have the entire blockchain into their database and will require huge search index.

Conclusion

Analyzing the whole process of distributed Ledger Technology one can have a clear picture of all the properties and its characteristics. In regards to payment DTL do have potential to drive through new ways for enhancing the productivity the present system provide. The ownership of the digital asset, its security and proper settlement and clearance process through cryptography, peer-to-peer networking has been well handled.

Since the technology is still in its developing stage it requires much time to mature to provide its best. The challenges and limitation mentioned has to overcome for the potential to be developed in to productivity. All the technical hurdles and operational risks and legal considerations requires immediate addressing, overcoming those may make the technology much stronger.

Conclusively, it can be said that the DLT technology has much potential for driving the change and structuring the finance industry in a far more efficient way.

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