Blockchain technology and applications from a financial perspective pdf
The phenomenon of virtual currencies has to be distinguished from the underlying distributed ledger technologies. Bitcoin and other cryptocurrencies need to be subject to strict financial regulation and supervision to ensure investor protection. At the same time, distributed ledger technologies will shape the future of the financial services in many respects. The disruptive potential is illustrated for selected financial products and processes. The digitisation of the financial services industry is transforming the value chain of banks, insurance companies and other financial services providers.
Established business models are challenged by new incumbents such as start-ups "fintechs" and technology firms like Google, Facebook, Apple and Amazon. Hence, established players need to reinvent themselves by redesigning product offerings, modernising their IT infrastructure and restructuring the value chain. As a consequence, internal processes are being streamlined, non-core activities are being outsourced on a large scale and the customer interface has been digitised by smartphone apps such as personal finance tools or wallet apps.
Intelligent concepts for multichannel management, combining internet-based and physical distribution channels, have been a major challenge for financial institutions in recent years. The blockchain technology was originally developed for payment services based on virtual currencies, also called cryptocurrencies, as they use cryptographic methods to encode payments. Cryptocurrencies such as bitcoin were invented to facilitate instant payment services with no need for a central bank or financial intermediaries to execute payments.
Using cryptographic functions, every user of the bitcoin system can transfer units of the virtual currency globally on an anonymous basis. The technological foundation is a peer-to-peer computer network that validates and executes each and every transaction in a tamper-proof manner, almost instantaneously and at very low marginal costs. However, financial supervisory authorities are about to increase regulation of virtual currencies due to concerns that the anonymous character of the system facilitates money laundering and the financing of illegal transactions.
Nevertheless, the underlying blockchain technology, or in broader terms, the distributed ledger technology, has the potential for disruptive changes in several segments of the financial services industry and beyond. In the New York State Department of Financial Services approved a regulation that requires a business license BitLicense for companies in New York engaging in virtual currency activities — including storing, controlling, trading or exchanging bitcoins or any other cryptocurrency.
Nevertheless, both the US Federal Reserve and the Securities and Exchange Commission SEC keep a close eye on developments in the field of cryptocurrencies, occasionally commenting on specific features or events around cryptocurrencies, e. The European Banking Authority has repeatedly pointed to the risks of virtual currencies. On the other hand, critical voices are concerned that the new regulatory initiatives would endanger the development of the innovative distributed ledger technology in Europe.
The purpose of this paper is to investigate the future potential of virtual currencies as innovative payment systems along with the possible impact of the underlying blockchain technology on transaction processing and corporate finance. The disruptive potential of peer-to-peer networks and distributed ledgers is illustrated for payments, securities settlements, trade finance as well as primary debt and equity capital markets. Blockchain technology was originally developed as a platform for virtual currencies.
Bitcoin and other cryptocurrencies such as Ripple, Ethereum or Litecoin are not money in a traditional sense. Rather, they are units of account used as a medium of exchange in multilateral private networks, in which the users agree on the mutual acceptance of such virtual currencies. An approval of their introduction and utilisation by financial supervisory authorities is usually not required as long as the usage is limited to private agreements and no additional services, such as the operation of exchange platforms or brokerage services, are introduced.
Cryptocurrencies allow the initiation and execution of direct payments from senders to receivers of units of the respective virtual currency almost in real time and without financial intermediation. These web-based payment systems apply cryptographic methods in order to conduct payments safely, quickly and cost-efficiently through a peer-to-peer computer network. Bitcoin is the first and so far most popular cryptocurrency.
The open-source reference software Bitcoin Core was published in All transactions are irreversible. Every user of the network can view and check the validity of any transaction in the blockchain at any point in time. However, the personal identity of the owner of the bitcoins remains confidential.
New bitcoins are not generated through the interaction of monetary policy instruments of central banks, commercial banks and bank customers, but rather through a specific incentive system that rewards those nodes of the network that are the first to prove the authenticity of encrypted transactions with a mathematical algorithm.
The process of validating new transactions, combining them into new blocks and distributing the reward in the form of new bitcoins to the winning node of the network is called mining. Each participant in the bitcoin network must use a suitable software program "wallet" to get access to the bitcoin reference software that allows users to manage their own bitcoins and execute bitcoin transactions.
To execute a bitcoin transaction, the sender uses his wallet software to generate a cryptographic key pair, which consists of a private key and the corresponding public key. The private key is the private portion of a key pair which can create cryptographic signatures that other users can verify with the public key.
The transfer of bitcoins requires a bitcoin address of the receiver, which is usually a string of 34 digits generated by the wallet software using a cryptographic method. Bitcoin addresses are usually used only once for security reasons. Subsequently, the sender can generate a bitcoin transaction, which must contain the bitcoin address of the receiver in a predefined format, the amount of bitcoins to be sent and the references to all previous transactions, which confirms that the sender is the legitimate owner of the bitcoins to be spent.
Next, the sender uses the signing algorithm of his private key to generate a signature of the data, which is then sent as an encrypted message along with the public key to the receiver and to the whole bitcoin network. The receiver can then use the public key to verify the validity of the transaction, i. The receiver's wallet software displays the received number of bitcoins as spendable balance, which is categorised as "Unspent Transaction Output " by the network.
New transactions are broadcast in parallel to all nodes of the network, which check the validity of the transactions decentrally and try to combine them into a new block that will be added to the blockchain. The design of the blockchain for bitcoin also solves the " double spending problem", as it ensures that bitcoins can only be spent once. In order to ensure that all nodes have the same status of the blockchain at any given point in time and that the validity of all transactions — and ultimately of the blockchain as a whole — is continuously verified by the network, a proper incentive system is needed to generate new blocks.
This is accomplished by the so-called mining process, which stipulates that for the generation of every new block, a mathematical problem has to be solved by the miner with cryptographic hash functions. In order to generate a new block, a cryptographic function has to generate a hash value of the block header which is below a defined target value.
Hash values are generated by hash functions that use cryptographic algorithms to transform arbitrary data into strings that seem to be random but are deterministic. The bitcoin system uses the SHA security hash algorithm function that generates hexadecimal outputs with 64 digits and a length of bits. Each block has its own hash value that is a result of the hash values of all transactions in the block and the hash value of the previous block.
Thus, a linear chain of blocks is established which reflects the full history of transactions in a time-stamped and tamper-proof manner. Each block contains a number of new transactions that are saved in the transaction part of the block. Thereafter, copies of the transactions are repeatedly paired and hashed until a single hash value is generated.
This value is called the "Merkle root" of the corresponding "Merkle tree" that maps the transactions in the block. The Merkle root reflects the cryptographic image which is saved in the block header. Due to the characteristics of the SHA function, the miners have to solve this mathematical problem through a trial-and-error process. The costs associated with the process increase with the length of the blockchain and the determined target value for the hash value of the block.
The average number of hash operations increases as the blockchain gets longer and the target hash value is set lower. The process of solving the cryptographic problem is called "proof of work", as the generation of a new valid block is the proof that the miner has invested economic resources to generate a new block. This factor is essential to ensure that there is no easy way of changing the transaction history and hence manipulating the flow of bitcoins between legitimate senders and receivers.
If competing miners find a new valid block at nearly the same time, forks in the blockchain can temporarily arise. However, as the network always adds new blocks to the longest blockchain, such forks usually disappear quickly. A complete, tamper-proof transaction history mapped into a blockchain evolves from the process of generating individual transactions and combining them in new interlinked blocks.
Once the network has reached consensus on the accurate transaction history, each node of the network records a copy of the current status of the blockchain.
This is a distributed ledger which is publicly accessible but preserves privacy, as only the owners of the respective Private Keys can view the details of the transactions they are involved in.
The cryptographic chaining of transactions and blocks implies that single transactions cannot be modified ex post without changing the corresponding block as a whole and all subsequent blocks. This is theoretically possible but would be exorbitantly expensive.
The role of miners is pivotal to the integrity of the whole bitcoin system, as the miners, through the proof of work, ensure the authenticity of blocks, transactions and ultimately the entire blockchain. The miners, therefore, receive a reward in the form of new bitcoins for generating new blocks. The mining reward is halved everyblocks, and the maximum amount of bitcoins is 21 million. On the introduction of bitcoin inthe mining reward was 50 bitcoins, which was cut to 25 bitcoins in November In Julythe mining reward was cut again to As of 27 Novemberapproximately The lower the threshold for the target hash value of a new block is set, the higher the average computing time miners have to invest to find new blocks.
As the CPU power of the network increases over time, the difficulty of the proof of work has to be adjusted from time to time in order to keep the target average time of ten minutes to generate a new block. The usage of bitcoins, measured by the average number of daily bitcoin transactions, has visibly increased over recent years. However, the current level of approximatelytransactions per day is still low compared to established payment systems such as Visa, which handled almost billion transactions in Overall growth dynamics and the dissemination of bitcoins or other virtual currencies appear too low to expect established payment systems to be challenged in the foreseeable future.
A major barrier to a higher acceptance rate for bitcoin may be rooted in the anonymity of the system and the lack of intermediaries. While bitcoin promotors view this as a major beneficial differentiating factor compared to traditional payment systems, it is precisely this lack of properly regulated financial intermediaries and appropriate supervisory processes — which ensure the stability, credibility and integrity of any financial system — that causes mistrust and concern about the integrity of the system itself.
There is already evidence that users of virtual currencies may experience substantial economic damages, e. There are several prominent examples of the abuse of the system, including Silk Road, an exchange platform for mostly illegal transactions on the darknet that was closed inthe insolvency of the bitcoin exchange Mt. Although virtual currencies are not currencies in the sense of generally accepted mediums of payment, some customers, especially those with a limited level of financial literacy, might get the wrong impression.
This mistaken impression would be reinforced by the fact that a growing number of countries permit the establishment of bitcoin ATMs, which allow the exchange of cash in a traditional currency into bitcoins and vice versa. Instead, they allow the insertion of cash in exchange for bitcoins, which are given as a paper receipt or by moving money to a public key on the blockchain.
Since the introduction of bitcoin, a large number of new virtual currencies have been launched, the most notable of which are Ethereum, Ripple and Litecoin.
As of the end of Augustmore than virtual currencies have been registered. When it comes to offering a new virtual currency, barriers to entry are low.
All one needs is a cryptographic algorithm, a process of generating and distributing additional units of the respective currency e. The high number of virtual currencies casts some doubt on the viability of most of the business models being pursued. The level of uncertainty about the future of bitcoin is also reflected in the volatility of the bitcoin price.
This was followed by a sharp decline in September when BTCChina — the largest bitcoin exchange in China — stopped trading bitcoins following a ruling by the Chinese authorities. Other prominent cryptocurrencies, like Ethereum and Ripple, showed similar patterns of price developments. Market observers offer different explanations for the recent bitcoin boom.
One frequently cited factor is the split of the original bitcoin blockchain through the establishment of a parallel chain, Bitcoin Cash, on 1 August The reason for this split lies in an ongoing discussion about the best strategy to accelerate the transaction process without increasing transaction costs. While the core bitcoin developer team is in favour of separating the transaction data from the respective signature the so-called SegWit approachthe representatives of Bitcoin Cash have increased the average block size to free up capacity in the network.
Another explanation for the rising bitcoin price is the growing customer acceptance of the cryptocurrency, e.
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