Blockchain. The disruptive potential in the financial sector

Table of contents

List of abbreviations

List of figures

1 Introduction
1.1 Background and relevance of the blockchain
1.2 Procedure

2 Blockchain technology
2.1 Blockchain at a glance
2.2 Consensus mechanisms
2.2.1 Hashing
2.2.2 Proof of Work (PoW)
2.3 Ownership and encryption

3 Importance of blockchain in the financial sector
3.1 Disruption through Distributed Ledgers
3.1.1 Payment transactions
3.1.2 Securities trading
3.1.3 Smart Contracts
3.2 Challenges and risks

4 Conclusion

Bibliography

Internet Sources

List of abbreviations

BTC Bitcoin

DLT Distributed Ledger Technology

NONCE Number Only Used Once

Pow Proof of Work

P2P Peer-to-peer

SHA Secure Hash Algorithm

List of figures

Abbildung 1: Veränderung des Transaktionsmodells durch die Blockchain

Abbildung 2: Der Lawineneffekt

Abbildung 3: Blockchain mit temporären Abzweigungen

1 Introduction

1.1 Background and relevance of the blockchain

"The one thing that's missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A"¹ Milton Friedman, the American economist, predicted the introduction of virtual cryptocurrencies as early as 1999. Under the pseudonym Satoshi Nakamoto, today's best-known digital currency "Bitcoin" BTC was presented in 2008. For a long time, however, little attention was paid to this digital currency. It was only through an exponential increase in the exchange rate in 2013 that Bitcoin became more and more the focus of various economic actors and was increasingly perceived as an investment investment.

The underlying technology of Bitcoin is the blockchain. It is the technical realization of a distributed database in which the integrity of the contained data is ensured by cryptographic procedures. This type of database was developed in various theoretical papers in the 1990s and finally described in general by Stefan Konst.²

As a decentralized database, the blockchain allows a transfer of values, rights or property without the intermediary of an intermediary. Not least because of the disruptive potential for the classic financial transaction sector attributed to it, it is becoming increasingly important. However, the possible applications go far beyond the application of crypto currencies. Especially after the massive surveillance by the secret services became known, many network activists are increasingly calling for a decentralized solution for the management of sensitive data of all kinds.³

1.2 Procedure

The present work takes on the task of providing an overview of the essential possibilities and limits of the blockchain and, on this basis, evaluating the disruptive potential that can be attributed to the technology in the financial sector. In order to achieve this goal, conceptual and theoretical foundations are first described. The functionality of the blockchain is explained using the example of Bitcoins in order to be able to discuss the potential fields of application and their importance for the financial sector in the following. Finally, core statements are to be encoded.

2 Blockchain technology

2.1 Blockchain at a glance

In public discussions, the terms blockchain and distributed ledger technology (DLT) are often used interchangeably. DLT is a distributed data structure in which all participants act together to reach a consensus on the validity of the shared data. The DLT uses a peer-to-peer (P2P) network to distribute the data and a consensus mechanism to ensure the integrity of the data held by all peers The blockchain represents the best-known possible realization of DLT. However, not every distributed ledger uses a blockchain.⁴

Put simply, the blockchain is a decentralized network of databases for the exchange and distributed storage of information, in which the records are divided into blocks (Block) packed and in a chain (Chain) can be organised. Cryptographic signature ensures that new blocks can only be added at the end of the chain, but cannot be inserted or removed from within the chain. The resulting chain is applied to all participants (Nodes) of the network and stored redundantly. Decentralization is intended to prevent manipulation of the system. Another effect of decentralisation is that no intermediary authority, a so-called intermediary, is required for the transmission of information between two actors A and B (see Fig. 1). For this reason, when using cryptocurrencies, no bank is required that represents the intermediary in classic financial transactions. Basically, however, any kind of digital property right can be transferred in a distributed database. The application possibility of blockchain technology is thus not limited to the function of a financial transaction book, but goes far beyond this area of application.⁵

Abbildung in dieser Leseprobe nicht enthalten

Figure Changing the transaction model through the blockchain

Source: Kastrati, G., Weissbart, C., Brief on the climate: Blockchain, 2016, p. 74.

So-called smart contracts are intended to enable various management and process applications, with which, for example, leasing contracts can be organized and controlled in real time via a blockchain. Accordingly, the interest of states and companies in researching this technology has increased immensely. The main reasons for this are the increase in efficiency, transparency and security, because every entry ever made into a blockchain is openly visible and can no longer be deleted or changed.⁶

You have to keep in mind that there is no such thing as "one blockchain". A blockchain used in an administrative authority must meet completely different requirements and will therefore be implemented differently than a blockchain for a cryptocurrency such as BTC.

In order to better explain the concept of blockchain technology, the following refers occasionally to the functioning of the crypto currency BTC. It is the first practical application of the blockchain and thus offers itself as a comprehensible example.

The basis of a functioning currency is that the existing money supply is regulated while maintaining a number of security features. In the case of a conventional currency such as the euro, this is, among other things, the task of the European Central Bank. Exactly this problem is also one of the biggest challenges of a decentralized and digital network such as the virtual currency BTC. Only by reaching a consensus between the individual nodes on who is to be assigned which property at a certain time can a decentralized payment system function properly. With a blockchain, this security function is not ensured by a central authority, but by purely technological processes. To this end, the technological processes must implement two essential mechanisms:

- the Consensus mechanism ensures that the integrity of the data is ensured on all nodes, even though the nodes cannot trust each other.
- A mechanism for validating the Ownerships of units of the digital currency ensures that only those who own them can dispose of such units.⁷

2.2 Consensus mechanisms

In a decentralized database system such as the blockchain, there can be no central location that trusts all other nodes and thus ensures that the consistency and integrity of the distributed data is ensured. In principle, each participant can manipulate the data before it is redistributed, so that all nodes of the network must distrust each other. In order to ensure consistency and integrity of the data on all nodes, a consensus mechanism is implemented in the network. In the case of Bitcoin, this consensus mechanism is affected by the Hashing, a cryptographic signature of the stored data, and the so-called Proof of Work Realized.⁸

In addition to preventing manipulation of the blockchain, in the case of Bitcoin, this mechanism also solves the problem of Double-Spending disabled.

In the case of the Double-spending problem the point is that the recipient of a transaction cannot verify whether the initiator has previously sent this digital value to a third person. It is therefore possible that the order of persistence of transactions does not correspond to the order of initiation.⁹

Suppose person X transfers a unit of money to person Y. Once the block containing the information about this transaction has been inserted into the blockchain of the node of Y, person Y sends the goods. Person X then sends the same order to another account. There is a risk that the second transaction will be forwarded faster in the system and will first be persisted by the majority of nodes and thus accepted by the network. In this case, person Y is not assigned a monetary unit of X by the network, since the monetary units used in the transaction have already been assigned to the third account.

2.2.1 Hashing

In order to prevent manipulation of the blockchain, it must be ensured that blocks are only added at the end of the blockchain, but not inserted, removed or changed elsewhere can. To achieve this, a cryptographic signature of the previous block is stored in each block. When determining the cryptographic signature of a block, the value of the cryptographic signature of its predecessor block is also included, so that a Chain is created in which the modification of a block affects the cryptographic signatures of all blocks following it. As a result, manipulation of a block requires the recalculation of all subsequent blocks of the blockchain.¹⁰

The cryptographic signature of a block is replaced by a so-called Hash function Calculated Hash Realized.

A hash function must have the following properties:

1. The hash value always has the same length, regardless of the input.
2. A certain input always gives the same hash value and different inputs never give the same output (collision resistance).
3. The hash value does not allow any conclusions to be made about the input (one-way function).
4. Similar inputs do not have similar hash values (avalanche effect).¹¹

These properties also make the hash value a cryptographic signature of the input data. In the case of BTC, the Secure Hash Algorithm (SHA) 256 is applied. The input set of the algorithm can be arbitrarily large, but the output (hash value) has a fixed length of 256 bits. Figure 2 illustrates the effects of a minimal change in input on the generated hash value. It can be seen that even a small change in the input has a significant consequence for the output.

[...]

¹ http://www.coindesk.com/economist-milton-friedman-predicted-bitcoin/, accessed on 13.06.2017.

² cf. Konst, S., Secure log files based on cryptographically concatenated entries, 2000.

³ cf. Sauerland, A., Möglichkeiten und Grenzen, 2017, p. 108.

⁴ cf. Bolesch, L., Mitschele, A., Revolution oder Evolution, 2016, p. 35.

⁵ cf. Jörn, T., Blockchain in der Finanzbranche, 2016, p. 37.

⁶ See https://www.btc-echo.de/was-ist-die-blockchain/, accessed on 13.06.2017.

⁷ cf. Sixt, E., Bitcoins and other decentralized transaction systems, 2017, p. 31 f.

⁸ cf. Nakamoto, S., Bitcoin: A Peer-to-Peer Eeletronic Cash System, 2008, p. 1.

⁹ cf. Sixt, E., Bitcoins and other decentralized transaction systems, 2017, p. 43.

¹⁰ cf. Brühl, V., Bitcoins, Blockchain and Distributed Ledgers, 2017, p. 137.

¹¹ cf. Kerscher, D., Bitcoin: Functioning risks and opportunities, 2013, p. 21 f.