Distributed ledger technology (DLT) holds tremendous promise for the financial services sector. At its core, a distributed ledger is a system for keeping track of transactions without the need for verification by a third party. Distributed ledgers come in many flavors, depending on who can access and use them, and how they verify transactions. The best-known use case for distributed ledgers is cryptocurrency like Bitcoin, Litecoin, or the more recent generation of stablecoins pegged to the U.S. dollar. But there are many more applications beyond currency. Distributed ledgers can help coordinate cross-border payments, finalize and execute smart contracts, and disburse payments in response to real-world events. Because distributed ledgers can be more secure and more efficient than their centralized counterparts, financial technology companies are seizing the opportunity to leverage their potential.
The terms “distributed ledger” and “blockchain” are sometimes used interchangeably; blockchain technology is a specific kind of distributed ledger where transactions are verified by consensus. Each “block” in the chain is timestamped by a majority of the nodes in the network by means of solving a cryptographic puzzle; the nodes “prove” they are legitimate verifiers by expending processing power on this puzzle. Once a block is formally approved, it is added to the chain, and any other conflicting blocks (i.e., attempts to spend the same coin or verify some other contradictory transaction) are dismissed. As the chain of blocks grows larger, it becomes harder to falsify transactions, because a fraudulent actor would have to convince the entire network to abandon the former chain and adopt theirs.
The Blockchain on which Bitcoins are exchanged is a public network, meaning that anyone can participate as long as they demonstrate “proof of work” (i.e., through solving the cryptographic puzzle used to timestamp transactions). Such schemes, however, can consume a great deal of energy – as much as 2.5 GW as of mid-2018.
"The technology has created a unique space where fledgling start-ups and corporate giants alike, can launch sophisticated financial products that not only benefit existing consumers but also make it easier and more affordable for a whole new audience to access the financial system"
Other distributed ledgers rely on “proof of stake” rather than “proof of work” to verify transactions. “Proof of stake” assumes that the majority of nodes in the network are altruistic and assigns blocks based on a node’s age in the system or accumulated wealth. Because of this assumption of altruism, proof of stake verification works better with relatively closed systems – where Blockchain is public, proof of stake systems tend to be federated or entirely permissioned. Federated ledgers, like r3’s Corda, are controlled by a group of entities (usually private companies) that decide who gets access to the ledger. Permissioned ledgers, like Ripple (which is primarily used for real-time cross-border settlements) are typically controlled by a single organization.
So, distributed ledgers vary in two ways: firstly, by their type of ownership/control (public, federated, or fully private/permissioned); and secondly, by the rules, they set to verify transactions (“proof of work” versus “proof of stake”). There are many other varieties and axes of differentiation when it comes to distributed ledgers, but these are the main ones where financial services technology is concerned.
Federated and permissioned ledgers can more easily layer other services on top of the underlying network. Smart contracts are one critical feature. Using a distributed ledger, one could set up a contract that is automatically executed when certain obligations are fulfilled – such as a rental agreement that releases a digital key when the deposit is received or issues a refund to the renter if the landlord does not release the key in time. One could imagine a contract that releases certain documents – a driver’s license, for instance – when the right combination of information and payment is received. Smart contracts allow for a wide range of sophisticated financial products to be built on distributed ledgers.
Oracles are another innovative feature of distributed ledgers. An oracle is essentially an agent or system for transmitting real-world data onto a distributed ledger (not unlike an API). An oracle can feed all kinds of information into the ledger, from stock prices to weather information to IoT sensor readings and more. An oracle would enable an insurance company to make disbursements to policyholders affected by an earthquake or a drought. Oracles are vital to the effective deployment of smart contract, but they do introduce an element of risk, because the data they transmit cannot be verified by the ledger itself, but only by a third party.
This is just a small sampling of how distributed ledger technology is revolutionizing the financial services sector. The technology has created a unique space where fledgling start-ups and corporate giants alike, can launch sophisticated financial products that not only benefit existing consumers but also make it easier and more affordable for a whole new audience to access the financial system. Distributed ledgers have created a new infrastructure for trusted digital transactions online. There is no doubt that this technology and its applications will continue to evolve – and we eagerly await the new possibilities that this evolution will bring.