The Impact of Blockchain Technology on Capital Markets. A Transformation of our Financial System?

Table of Contents

Abstract

List of Abbreviations

List of Figures

List of Tables

1 Executive Summary

2 Introduction
2.1 Motivation
2.2 Objective
2.3 Structure

3 Theoretical Foundation
3.1 Blockchain Technology
3.2 Blockchain 1.0: Cryptocurrencies
3.3 Blockchain 2.0: Beyond Cryptocurrencies
3.4 Capital Markets

4 Methodology
4.1 Literature Review
4.2 Expert Interviews

5 Possible Applications of Blockchain Technology and Their Strategic and Operational Implications on Capital Markets
5.1 Current Status of Blockchain Adoption in Capital Markets
5.2 Fields of Application in Capital Markets

6 Challenges for the Wide Adoption of Blockchain Technology
6.1 Technological Challenges
6.2 Legal, Regulatory and Governance Challenges
6.3 Cultural Challenges

7 Impact of Blockchain Technology on Key Players in Capital Markets

8 Future Blockchain Adoption in Capital Markets: An Outlook

9 Limitations & Implications of the Research Paper and Future Research
9.1 Limitations
9.2 Implications
9.3 Future Research

10 Conclusion

Bibliography

Appendix
Appendix 1: Findings of the Literature Review
Appendix 2: Interview Guide for the Expert Interviews
Appendix 3: Transcripts of the Interviews

Abstract

Blockchain technology is perceived as a focal point in the emerging FinTech sector with the potential to disrupt financial markets. The objective of this research paper is to explore the impact of blockchain technology on capital markets. To do so, this paper identifies potential application fields of the technology in capital markets, evaluates their operational and strategic implications and analyses remaining challenges of the wide adoption of blockchain technology. The research methodology is based on a two-pronged approach: on the one-hand, an in-depth literature review provides the base for identifying relevant application fields and their challenges. On the other hand, twelve interviews with experts allow to validate and to complete the findings. Three application fields were identified as the most influential ones in descending order: Equity Post-trade Processes, Equity Financing, and Syndicated Loans, their major implications being time- and cost savings as well as technology modernization, which result in risk reduction and the improvement of competitiveness as well as better relationships with regulators. Major challenges for the wide adoption are the scalability, the creation of a regulatory framework as well as the development of interoperability standards. Investors and regulators are likely to benefit from the technology, whereas CCPs and custodian banks will have to reassess their market position, if the technology becomes widely spread.

List of Abbreviations

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List of Figures

Figure 1 Global Google Search Interest

Figure 2 Total global deal volume and count of investments

Figure 3 Simplified blockchain network diagram

Figure 4 Comparison of a traditional central database

Figure 5 Simplified visualization of the block the creation process

Figure 6 Simplified visualization of the PoW process

Figure 7 Energy consumption of Bitcoin mining in TWh per year

Figure 8 Simplified visualization of the PoS process

Figure 9 Comparison of permissioned and permissionless blockchains

Figure 10 Matrix to categorize different types of blockchains

Figure 11 Decision path to determine the applicability of blockchain

Figure 12 Market price of Bitcoin (in $) between October 2013 and May 2018

Figure 13 Comparison of traditional contracts with smart contracts

Figure 14 Lifecycle of a smart contract

Figure 15 Implementation of Dapps into a blockchain

Figure 16 Monthly investment volumes of ICOs

Figure 17 Distinguishing of financial markets by security type and market level

Figure 18 Structure of capital markets

Figure 19 Capital Markets Ecosystem differentiated by the value chain

Figure 20 Key players in the primary market of capital markets

Figure 21 Key players in the secondary market of capital markets

Figure 22 Breakdown of revenue drivers in capital markets ecosystem

Figure 23 Distribution of the results of the literature review by year

Figure 24 Blockchain adoption status of financial institutions

Figure 25 Impact of different blockchain application fields

Figure 26 Mapping of the three application fields to the areas of the capital markets

Figure 27 The four phases of the equity post-trade

Figure 28 Future process of equity post-trade processes

Figure 29 Example network topology with a single operator

Figure 30 Usage of gold as collateral for trading

Figure 31 Total ICO deal funding per year (in $m)

Figure 32 Investment process from idea to IPO

Figure 33 Process of an ICO

Figure 34 Market share of blockchain platforms for ICOs

Figure 35 Stages of companies at which they conducted an ICO

Figure 36 Funds raised for ICO projects in 2017

Figure 37 Current process of syndicated loans

Figure 38 Future process of syndicated loans

Figure 39 Three key challenge area for wide adoption of blockchain technology

Figure 40 Most important challenges for adoption of blockchain technology in capital

Figure 41 Conceptual visualization of the interaction between a blockchain and sidechain

Figure 42 : Number of global job openings for blockchain developers from 2010 to 2018

Figure 43 Categorization of key players into effect categories

Figure 44 Blockchain technology on the Gartner Hype Cycle 2017 (simplified graph)

Figure 45 Potential adoption timeline of blockchain technology

Figure 46 Expected investments and potential for disruption for selected application fields

Figure 47 Utopian view of capital markets using blockchains

List of Tables

Table 1 Overview of the ten highest valued cryptocurrencies

Table 2 Comparison between a traditional company and a DAO

Table 3 Overview of the results of the different steps in the systematic literature review

Table 4 Overview of the identified application fields

Table 5 List of participants of the expert interviews

Table 6 Overview of capital markets application fields mentions in the literature review

Table 7 Overview of adoption status of blockchain technology for selected banks

Table 8 Key stakeholders of equity post-trade processes

Table 9 Controversial sales techniques to boost the price of ICOs

Table 10 Current status of regulation of ICOs in selected countries

Table 11 Key stakeholders of syndicated loans

1 Executive Summary

A blockchain is a digital, distributed database, containing a list of ordered records. The technology is recently experiencing a significant increase in interest, as it is perceived as a focal point in the FinTech sector with the potential to disrupt financial markets. Therefore, exploring its potential impact on capital markets is of high interest not only for the key players of the market but also for our everyday life, as capital markets are the “fuel of our economy” (Donohue, 2016).

The objective of this research paper is to explore the impact of blockchain technology on capital markets. For this purpose, four research questions have been developed: The main applications fields of the technology in capital markets will be identified (RQ1), and their operational and strategic implications will be evaluated (RQ2). As blockchain technology is a rather young technology, the challenges of its broad adoption in capital markets (RQ3) play a considerable role when considering its impact. The direct influence of the adoption of blockchain on the key market players and the market structure (RQ4) represents the last aspect of the impact analysis. To answer the questions, a two-pronged exploratory research methodology has been developed: first, an in-depth literature review about blockchain technology in capital markets has been conducted to derive relevant application fields and their implications. Second, twelve interviews with experts of blockchain technology in capital markets served to generate new insights and to validate the results derived from the literature review as well as to ensure that the findings are up-to-date, as the field of study is evolving at fast pace.

Three fields of application with a significant impact on capital markets could be identified : Equity Post-trade Processes, Equity Financing, and Syndicated Loans. The implementation of the technology in capital markets may provide several benefits, especially regarding time, cost and technology modernization. These aspects translate into reduced risk, enhanced competitiveness and improved relations with regulators.

However, several major challenges have to be overcome for blockchain technology to become widely adopted in capital markets. These can be divided into technological-, legal-, regulatory-, governance- as well as cultural challenges, most important being the improvement of the blockchain technology, the creation of a regulatory framework and the development of standards. If implemented successfully, investors and regulators are most likely to benefit from blockchain technology, whereas CCPs and custodian banks will probably have to have to reassess their market position in the future.

2 Introduction

“Blockchain has the potential to be truly disruptive; it is like the internet in the mid-90s – on the verge of revolutionizing the way we live.” – Steve Johnson, Author for the New York Times

In the global financial markets, every day, trillions of dollars are moved, and billions of people are served (Tapscott and Tapscott, 2017). However, the financial system is facing serious threats such as fraud, regulatory costs (Clark and Tan, 2014) and developed inefficiencies created by its antiquated, exclusionary and centralized systems (Tapscott and Tapscott, 2017).

It might be due to these challenges, that over the last years, various new technologies emerged: innovations, which resulted in new business models being able to disrupt entire industries – and capital markets are no exception. Blockchain technology^[1] is one of them and is perceived as a focal point in the emerging FinTech sector (Gupta, 2017) while having a “disruptive potential in financial markets”, as said by Yves Mersch, member of the executive board of the ECB. This “disruptive potential” has almost become common sense among industry experts by now, as it removes the intermediaries and creates an open and transparent system which vanishes large inefficiencies (Ito, Narula and Ali, 2017). While this process is only at the beginning, it is taking up at considerable speed.

A blockchain is a digital, distributed database that contains a list of ordered records, also called blocks, which continuously grows (Narayanan et al., 2016). The most popular application of blockchain is the cryptocurrency Bitcoin, which has shown enormous popularity as well as high volatility in the last years (Brown, 2017). Still, blockchain technology is more than Bitcoin and innovations, such as smart contracts and smart properties arose in different sectors ranging from the food industry to real estate (Lakhani and Iansiti, 2017).

Notably, in 2017, interest in blockchain technology and related topics increased exponentially as seen in figure 1. With its peak in December 2017, public interest decreased in the last months as a phase of “disillusionment” started (Haynes, 2018). Nevertheless, the popularity of the technology is still rising among companies with a steady increase of mentions in the company earnings reports and calls (Wong and Karaian, 2017). This research paper wants to analyze the potential impact of blockchain technology on financial markets and, especially on capital markets.

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Figure 1 Global Google Search Interest

(indexed) for blockchain and number of mentions of blockchain in earnings reports/calls of S&P 500 companies^[2]

2.1 Motivation

“If we don’t find new ways of innovating, and co-innovating, we run the risk of becoming ideally suited for a world that’s passed us by.” – Kevin Hanley, Director of the Royal Bank of Scotland

The motivation for this research paper stems on the one hand from the fascination for the blockchain technology and its above-mentioned “disruptive potential” for capital markets, an industry that faces serious challenges. On the other hand, the motivation comes from the interest for considering and unveiling the discrepancy between the “hype” and true potential of blockchain technology.

Financial markets are one of the oldest industries in the world, but never really experienced proper disruption until the last decade. Nevertheless, several institutions see financial markets on the edge of a major disruption (Paine, 2017). Technological innovations can be one major reason for disruption. "Large financial institutions are like museums of technology,” said Barclays, CEO Antony Jenkins (Hirt and Gruber, 2017). Blockchain technology is among the most cited major technological innovations, others being robots, augmented/virtual reality, artificial intelligence, 3D printing and drones (Harvey et al., 2015). This explains the general interest in the technology and its potential impact. Cavallo (2016) cites increasing regulation and openness as the two other main reasons. While the newly introduced Payment Service Directive (PSD2) in Europe that forces banks to open more widely, further threatening their monopoly, is cited as the most common example for major regulatory disruption in financial markets (Mersch, 2015).

The fact that financial markets, and notably capital markets, are particularly prone to disruption can also be seen when looking at the emergence of FinTech startups, which secured investments of more than $100 billion in the last three years as shown in figure 2 (Fortnum et al., 2017). It is important to notice that more than $1.4 billion of it has been invested to explore and to implement blockchain technologies (Mulligan, 2017), so the technology is expected to play a major role. The focus on capital markets is inspired by the fact that the disruption potential seems to be particularly high in this segment, but also by the fact, that most literature focuses on financial markets in general, so the specific impact of blockchain technology for capital markets does not seem to have been explored in sufficient detail up to date.

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Figure 2 Total global deal volume and count of investments

in FinTech companies from 2010 - 2017^[3]

Nevertheless, the discussion about these new technologies, especially about blockchain technology, seems overheated: the recent example of the ice tea company Long Island Iced Tea shows how a company managed to increase its company valuation by 500% by just adding the term “blockchain” to its name (Buhr, 2017). The second part of the motivation is, therefore, to unveil this hype by taking an objective look at the impact of blockchain technology. The ensemble of these motivations inspires the author of his research paper to analyze the potential impact of blockchain technology on capital markets.

2.2 Objective

The objective of this research paper is to analyze the potential impact of blockchain on capital markets. The research is carried out by conducting an exploratory study which aims to answer the following four research questions:

RQ1: What are the possible fields of application of blockchain technology in capital markets?

RQ2: Which operational and strategic implications arise from the adoption of blockchain technology in these applications?

RQ3: Which challenges must be faced for the wide adoption of blockchain technology in capital markets?

RQ4: How will blockchain technology affect the key players in capital markets?

The research questions will be answered on the base of a two-pronged research approach. First, with an in-depth literature review, research reports on blockchain technology in capital markets will be analyzed, allowing to identify relevant application fields. Second, to validate the results derived from the literature review and to generate new insights, interviews with different experts from the industry will be conducted, allowing to validate these application fields and to derive information about the challenges and the future of blockchain technology in capital markets.

2.3 Structure

To reach the objective explained in chapter 2.2, the research paper is structured as follows:

The first chapter provides an executive summary which summarizes the paper on one page. It is followed by a chapter that introduces the motivation, objective and structure of this research paper. In chapter 3, a more elaborate definition of the key concepts – a theoretical foundation – is introduced as a cornerstone and base for a common understanding of the topic. In the following chapter, the methodology used to answer the research questions is presented. In the following three chapters, the research questions are answered. In chapter 5, RQ1 and RQ2 are addressed by identifying and explaining the possible applications of blockchain on capital market s in more detail based on the results of the literature review and the expert interviews. For each of the application fields, the impact on capital markets will be explored. In chapter 6, the general challenges for the wide adoption of blockchain technology in capital markets are explored, thus answering RQ3. Chapter 7 finally discusses RQ4, the impact of blockchain technology on the key players in capital markets. Chapter 8 eventually considers how blockchain technology will evolve in the next years. Finally, chapter 9 critically discusses the impact of the findings for practice and theory, its limitations, as well as the fields for future research. The conclusion in chapter 10 completes the research paper.

3 Theoretical Foundation

The theoretical foundation is conceived as a critical part of this research paper that combines two rather technical fields: blockchain technology and capital markets. Despite the increasing popularity of blockchain technology in the last years, the majority of people still lacks a basic understanding of the underlying technology. Often it is even confused with its applications, such as Bitcoin. Likewise, the functioning and challenges for capital markets as a part of financial markets can be quite complex, especially when considering the relevant fields for blockchain technology. The technical foundation is therefore provided even before presenting the research methodology in order to allow a shared understanding of all underlying important concepts and notions. The chapter contains a detailed and comprehensive explanation of blockchain technology and capital markets.

3.1 Blockchain Technology

3.1.1 History

“The main event is not Bitcoin. It is using the blockchain to disrupt other industries and Wall Street.” – Patrick M. Byrne, CEO of Overstock.com

The first paper related to blockchain technology was published in 2008 by Satoshi Nakamoto and was entitled “Bitcoin: A Peer-To-Peer Electronic Cash System”. The author’s name is an alias, and until now, the true identity of the person or group behind the name has not been disclosed (Crosby et al., 2015). The paper describes a peer-to-peer system in which online payments can be sent directly from one party to another without going through a financial institution (Nakamoto, 2008).

In 2009, the protocol was implemented as an open-source program called Bitcoin, and soon after, the first transaction on this blockchain was executed. The use of blockchain technology for the creation of Bitcoin made it the first digital currency, which solves the problem of double spending without requiring an intermediate (Brito and Castillo, 2013). In the following years, Bitcoin experienced a significant uptake as, e.g., in 2010, the first real-world payment was executed in which a pizza was delivered for 10,000 BTC. Likewise, in 2011, dark web marketplaces such as Silk Road launched with Bitcoin as a primary payment method giving it until today a specific image. The market capitalization of Bitcoin increased significantly and reached a valuation of $1 billion in May 2013, which equals a 1,000% growth in less than two years (Mann, 2016). Nevertheless, until the end of 2013, the general public focus remained on cryptocurrencies. This changed when at the beginning of 2014, blockchain startups emerged, and the R3 consortium was founded, which explores and implements blockchain technology for use cases in financial markets. From this point onwards, experts talked about the blockchain 2.0 era (Bheemaia, 2015), as it enables the "exchange of value without powerful intermediaries acting as arbiters of money and information” (Tapscott and Tapscott, 2016). This second-generation blockchain technology is implemented in the form of smart contracts, digital identity, smart properties and distributed apps and also evolved outside financial markets, such as in the healthcare or food industry (Miles, 2017).

3.1.2 The Technology Explained

"The practical consequence […is…] for the first time, a way for one Internet [sic] user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate." – Marc Andreessen, Co-founder of Netscape

The technology behind a blockchain is a continuously growing list of records, called blocks, which are linked and secured using cryptographic technologies. Each block links to the previous block and contains a timestamp as well as transaction data (Narayanan et al., 2016). This developing blockchain is managed in a peer-to-peer network, in which new blocks have to be validated by a consensus mechanism before they are added. The consensus mechanism does not allow any changes on any given block retroactively, as this would require a collision of the network majority. Therefore, a blockchain is “an open, distributed ledger that can record transactions between parties efficiently and in a verifiable and permanent way” (Lakhani and Iansiti, 2017).

One could also think about a blockchain as a solution for a more challenging version of the “Byzantine Generals Problem”, which is a classic computer-science problem. In this problem, a group of generals and troops of the Byzantine army camp around an enemy’s city. They can only communicate through a messenger to agree upon a joint battle plan. Nevertheless, one or more of them may be traitors and will try to confuse the others by sending contradictory messages. The question arising from this situation is how the loyal generals can reach an agreement and can be sure that traitors will not mislead them (Lamport, Shostak and Pease, 1982). In fact, blockchain technology would have been a very reliable way for Byzantine generals to exchange information (Mearian, 2017): every participant in a blockchain can review new transactions, and new blocks can only be added by a consensus of a majority of participants. The information which is once entered in a blockchain can never be erased and therefore, a blockchain contains an accurate and verifiable record of every transaction ever made.

Figure 3 visualizes a blockchain in a simplified way by the example of Bitcoin: each member of the network, called a node, holds the chain of blocks, called blockchain, in which each block consists of a link to the previous block (in the form of a hash), a timestamp and several transactions. One transaction includes, besides the information of the sender and receiver, the actual data, which is saved. For example, the account balance of a Bitcoin account which is cryptographically secured (Lewis, 2014).

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Figure 3 Simplified blockchain network diagram

and content of a block exemplified by a Bitcoin blockchain^[4]

3.1.3 Characteristics of the Blockchain

“The blockchain [technology] symbolizes a shift in power from the centers to the edges of the networks.” – William Mougayar, Board Member Stratumn

Blockchain technology has four main characteristics which are briefly explained in the following chapter.

First, a blockchain is distributed and synchronized evenly between all parties and, therefore, is ideal for networks in which multiple parties are involved, such as in supply chains or financial markets. This distribution allows the storage of data redundantly and encourages participants to share data more openly (Pattison, 2017). Figure 4 visualizes this characteristic by comparing a traditional central database with a centralized ledger to blockchain technology with a distributed ledger.

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Figure 4 Comparison of a traditional central database

with a distributed database of a blockchain^[5]

Second, blockchain technology is programmable, which means that it allows the inclusion of a computational logic as, e.g., “smart contracts” which enable defining types of transactions a node can execute and therefore helps to build confidence that all nodes play by the same rules. This characteristic allows to execute a computer code automatically and will be described in detail in chapter 3.3.2 (Bauerle, 2017a).

Third, transactions are validated by a process known as consensus mechanism, in which an agreement between all nodes has to be reached. This helps to keep inaccurate or fraudulent transaction out of the blockchain and leads to trust, which allows executing such transactions without an intermediary. The consensus mechanism is essential for a blockchain as several important factors are based on it, such as the transaction speed and security. Therefore, the consensus mechanism determines the use case. There are many different types of consensus mechanism and a more detailed description of these as well as which consensus mechanism can be used for which use cases is given in chapter 3.1.5 (Baliga, 2017).

Fourth, agreed and recorded transactions can never be changed, making a blockchain immutable. It is possible to record a subsequent transaction, which allows changing the state, but the original transaction can never be hidden. This translates into the principle of the provenance of assets, which means that for any asset in the blockchain, it can be told where it is, where it has been and what happened with it throughout its life (Sharma, 2017).

3.1.4 Life of a Blockchain Transaction

The life of a blockchain transaction can be divided into five steps as it is visualized in figure 5. In the first step, two parties need to conduct a transaction of any type. An example of a transaction could be the transfer of coins (for a cryptocurrency, such as Bitcoin). In the second step, both parties assign cryptographic keys to the transaction. In the third step, the transaction data and the cryptographic keys are broadcasted to the blockchain network which then proves the authenticity of the transaction. Several proved transactions are pooled together to create a new block which is then, in the fourth step, broadcasted again to the distributed network and validated by the consensus mechanism. In the fifth and last step, the block is appended to the blockchain, also called block chaining, creating a permanent record of the transaction and completing it (Standard Chartered, 2017).

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Figure 5 Simplified visualization of the block the creation process

3.1.5 Consensus Mechanisms

In current transaction systems, the validation and verification of transactions are handled by an intermediary, such as a clearinghouse. Blockchain technology has no traditional middlemen to verify and approve the transactions. Instead, validation mechanisms were introduced to be able to carry out the verification within an anonymous environment. These validation mechanisms are called consensus mechanisms (Kostarev, 2017) and will be explored in more detail in the following. Consensus mechanisms minimize the amount of trust required from any single actor in the system, which is why blockchain technology is often referred to as being a “trustless” system.

The selection of the right consensus mechanism is the most crucial aspect when developing or choosing a blockchain platform, as it safeguards the transactions and block order and thereby determines all main properties of the blockchain (Baliga, 2017). Therefore, depending on the type of the blockchain and use case, a different consensus mechanism is used. The most used mechanisms are the Proof-of-Work (PoW) and Proof-of-Stake (PoS) consensus mechanisms which will be introduced in detail in the next chapters (Hammerschmidt, 2017).

Three fundamental properties determine the applicability and efficacy of a consensus mechanism (Baliga, 2017). First, a consensus mechanism is determined safe, if all nodes produce the same output, and this output is valid according to the rules of the protocol. Second, a consensus mechanism guarantees liveness, if all nodes which are not faulty, eventually produce a value. Third, a consensus mechanism provides fault tolerance, if it can recover from the failure of a node. The scholars Fischer, Lynch, & Paterson (1984) proved that no deterministic consensus mechanism can guarantee all three properties in an asynchronous system. Therefore, in distributed systems, the selected consensus mechanism chosen is always a trade-off between these three fundamental properties (Kim, 2014).

A poor choice of a consensus mechanism can lead to a useless blockchain platform, compromising the data recorded on it. Some of the issues which can arise are a blockchain fork which can result in nodes with different versions of a blockchain in the systems leading to an inconsistent view of data recorded, and thereby force applications to behave unpredictably (DeMartino, 2014). Furthermore, a poor choice can lead to a consensus failure when, e.g., the algorithm requires a supermajority, but because of network failures or non-compliant nodes, this majority is not reached, and the block is not added (Cawrey, 2014). Next, the consensus round can be manipulated by a single or group of entities, if it is not designed against a so-called Sybil attack ^[6], where these entities generate millions of identities to validate transactions by their own rules (Douceur, 2002). Last, the design of the consensus mechanism can also lead to poor performance (regarding latency) when nodes turn malicious or a network partition delays messages that are exchanged between nodes (Scherer, 2017).

3.1.5.1 Proof-of-Work (PoW) Mechanism

The Proof-of-Work (PoW) consensus mechanism is one of the most used mechanisms as it is used by cryptocurrencies such as Bitcoin and Ethereum. It was first published by Dwork & Naor (1993) and received its name in 1999 (Jakobsson and Juels, 1999). The key idea is that the nodes of a blockchain must perform “hard work” and are rewarded for it. For Bitcoin, this “hard work” is carried out by mining and the reward are coins. In the mining process, cryptographic puzzles must be solved. Specifically, the goal is to find a hash for a block that meets specific requirements. This hash serves as a proof for the conducted work. Computing the hash is difficult, but verifying it is easy. Furthermore, the difficulty of this work increases from time to time, to keep the creation of blocks at a constant rate (Kuznetsov, 2017).

Bitcoin uses the “Hashcash” algorithm which was initially developed to prevent email spam and is conceptually visualized in figure 6 (Back, 2002). First, the block header (which includes data, such as the link to the previous block and the timestamp) is combined with a counter, also called nonce, which starts at 0. In the second step, from this data package, a hash is calculated by applying the SHA-256 algorithm. The resulting hash is checked if it meets specific requirements which are set by the network. These requirements are called target. If the calculated hash does not match the target, the nonce is incremented and the second step is repeated until the requirement is met. As the SHA-256 algorithm is a one-way algorithm and only allows encryption but no decryption, random guessing of the nonce is the only possibility to meet the target. When the hash finally complies with the target, the block is linked to a local copy of the blockchain and propagated to the entire network. For Bitcoin, approximately every 14 days (which equals precisely 2016 blocks) the target is dynamically adjusted by the difficulty to always guarantee a constant generation of one new block every 10 minutes (Blockgeeks, 2017). The network participants involved in the verification process are called miners. As an individual miner, it is nearly impossible to find the target as professional miners increase their chances by adding more performance to their mining equipment. That is why mining is normally carried out in mining pools, where a group of miners work together to mine and share the rewards based on the number of hashes everyone has calculated (CoinDesk, 2014).

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Figure 6 Simplified visualization of the PoW process

The PoW consensus mechanism has certain limitations, as it is not safe from the previously explained Sybil attack and requires a lot of resources, as the algorithm must carry out useless work to proof the “hard work”. Furthermore, in January 2018, the energy consumption for the mining process of Bitcoin was enough to power 3.5m U.S. households (Digiconomist, 2018), and by early 2020, it will need as much electricity as the entire world does today if the price is still rising. Figure 7 visualizes the rise of consumed energy in the last years. The world’s bitcoin miners spend around $50,000 per hour on electricity. That is $1.2 million per day, $36 million per month and ~$450 million per year (Holthaus, 2017).

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Figure 7 Energy consumption of Bitcoin mining in TWh per year

Another issue regarding the PoW consensus mechanism is that experts are not sure what happens once all units of a reward (e.g., coins in a cryptocurrency) are mined as the supply is finite. Some researchers think that rewards for mining will continue to incentivize miners, whereas the costs will also increase sufficiently. But this opinion is not shared by all experts. This question will be answered when the first blockchains based on the PoW will reach their finite supply. Bitcoin is expected to reach its limit in 2140 (Bauerle, 2017a).

3.1.5.2 Proof-of-Stake (PoS) Mechanism

Due to the limitations of the PoW mechanism, especially due to the high energy consumption and the danger of the Sybil attack, the Proof-of-Stake (PoS) mechanism was proposed as alternative mechanism and is planned to be implemented in the cryptocurrency Ethereum (with the “Casper” update) in the second half of 2018 (Dale, 2017). The main benefits of PoS include security, reduced risk of centralization and energy efficiency (Castor, 2017).

The process of this second consensus mechanism is visualized in figure 8 and works by having a blockchain keeping track of a set of validators. Anyone who locks away a part of its stake of the blockchain (e.g., coins for cryptocurrencies) as collateral can become a validator. A stack can be locked by sending a particular type of a transaction to the blockchain, which then uses this stack as collateral (Kronovet, 2017). For every block creation process, a node is pseudo-randomly chosen by the PoS mechanism. The higher the collateral of one validator, the more likely the validator is selected to create the next block. For the creation of the block, the validator receives a transaction fee independent of the amount of work. Therefore, the ability to create a block is directly linked to the amount of stake committed. Comparing the PoS mechanism to the PoW mechanism, the PoS mechanism guarantees the validity, by requiring validators to invest a significant stake as collateral, whereas the PoW mechanism ensures validity by requiring a high input of work (Manning, 2016).

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Figure 8 Simplified visualization of the PoS process

This leads to reduced energy consumption and reduced centralization risk, as economies of scale are much less of an issue and also, the Sybil attack is less likely as it is becoming more expensive (Buterin, 2016a). Nevertheless, the most significant theoretical problem of the PoS mechanism is the “nothing at stake” problem, which arises due to the existence of multiple competing chains. Validators are incentivized to try creating blocks on top of every chain as they will receive the transaction fees for them. Thus, theoretically, an attacker might send a transaction in exchange for a digital good (usually another cryptocurrency) and then start a fork (a split of a blockchain) from one block behind the transaction and send the money to themselves instead. With only 1% of the total stake, the attacker's fork would win because everyone else is mining on both blockchains (Nicolas, 2014).

3.1.5.3 Other Consensus Mechanisms

In addition to the PoW and PoS mechanism, several other consensus mechanisms exist, such as the Practical Byzantine Fault Tolerance (PBFT) and SIEVE consensus mechanism (Baliga, 2017). All mechanisms serve specific use cases and have their advantages and disadvantages. Due to the limited scope of this research paper, only the two most popular consensus mechanisms were introduced.

3.1.6 Types of Blockchains

“With private blockchains, you can have a completely known universe of transaction processors. That appeals to financial institutions that are wary of the Bitcoin blockchain.” – Blythe Masters, CEO of Digital Asset Holding

As mentioned in the previous chapter, the selection of the consensus mechanism highly depends on the type of the blockchain (Baliga, 2017). Therefore, this chapter will introduce the different existing types of blockchains. A common categorization of types of blockchains does not exist yet. Nevertheless, one approach to determine the different types of blockchains is to categorize them by their level of anonymity and trust in validators (Kravchenko, 2016).

Blockchains with a high level of anonymity are called public, meaning that everybody can join and participate, whereas blockchains with a low level of anonymity are called private, meaning that only designated parties can join and participate.

A high degree of trust in validators leads to a permissioned blockchain, which is a close-ended system, meaning that the access of each participant is, based on roles, well defined and differentiated whereas a permissionless blockchain is an open-ended system and allows everybody to create a block and interact with the network (Allaby, 2016). Figure 9 visualizes the differences between a permissioned and permissionless blockchain and compares both types in more detail.

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Figure 9 Comparison of permissioned and permissionless blockchains

Considering both dimensions simultaneously, four different types arise, which are visualized in figure 10.

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Figure 10 Matrix to categorize different types of blockchains

Low trust and high anonymity lead to a permissionless and public blockchain. As the trust is very low, there is no punishment for attacking the system except for the fact that the mining equipment would become worthless, if the attack would be successful, which means that the consensus is created by a PoW mechanism. Such structure is suitable for entirely anonymous systems, which are out of the control of governments. An application of this structure are cryptocurrencies, such as Bitcoin or Ethereum (Bauerle, 2017b).

High trust in validators and still high anonymity leads to a permissioned and public blockchain, allowing everybody who meets specific pre-defined criteria to download the protocol and validate the transactions. An example for a criterion would be to buy a coin before a participant can start to mine, which increases the trust, as the coin serves as a security deposit if the participant tries to attack the network with a double spending attempt. The consensus is created by the PoS mechanism, and the structure allows community governance, execution of contracts and private money systems. Applications of this are other cryptocurrencies, such as Bitshares and the next generation of Ethereum (Jayachandran, 2017).

Low trust and low anonymity lead to a permissionless and private blockchain. Even though the identities of the participants are known, they have almost nothing to lose and therefore the consensus is carried by the Federated Byzantine Agreement. This structure can be applied to build national or multi-national blockchains such as a system for digital identities (Mulligan, 2017).

High trust and low anonymity lead to a permissioned and private blockchain. This means that the validator has to be a part of a limited group. The consensus is created by a multisignature algorithm. Applications are enterprise blockchains as developed by IBM and Microsoft, to name an example (Arnold, 2016). Most of the applications for the capital markets are based on a permissioned and private blockchain, as it brings the privacy and control needed for sensitive applications of the capital markets. The most popular example of this type is Hyperledger Fabric which is a framework developed by the Linux Foundation and delivers enterprise-ready network security, scalability, confidentiality, and performance, in a modular blockchain architecture (Linux Foundation, 2018).

3.1.7 Comparing Blockchain Technology with a Traditional Database

“The old question 'Is it in the database?' will be replaced by 'Is it on the blockchain?'” – William Mougayar, Board Member Stratumn

In 2017, interest in blockchain technology exponentially increased as discussed before. Companies and governments started to develop use cases and prototypes, but blockchain technology is not always needed: “You force a way to look for opportunities to use the technology in any way you want because you think this technology is the savior that solves all problems” (Interview #7).

This chapter aims to discuss the benefits, but also the disadvantages of blockchain technology when compared to a traditional, centralized network or database.

First, the technology leads to cost improvements, as it removes the intermediaries (Standard Chartered, 2017). Furthermore, the costs can be decreased as business processes can be simplified and automated by smart contracts (Buterin, 2016a). Still, depending on the consensus mechanism, the maintenance of a blockchain can be expensive, as, e.g., the creation of one block on the Bitcoin blockchain did cost around $15,000 in January 2018, mainly due its energy consumption (CoinDesk, 2018).

Second, speed benefits can arise due to real-time processing and distributed processing. Nevertheless, when comparing to relational databases, depending on the consensus mechanism, blockchains are relatively slow as they have to prevent attacks such as the Sybil attack (TechBeacon, 2017). Enterprise databases can execute a couple of million transactions per second, whereas blockchains nowadays do not have this ability (IBM, 2017b).

Third, the data quality and transparency are improved as records are immutable, and transaction histories are public. This decreases the risk of corruption with transactions and boosts competition as the asymmetrical distribution of information is reduced. Moreover, regulatory compliance is easier as a blockchain is fully auditable (Myler, 2017).

Fourth, there is increased security arising from the consensus mechanism for validation, the non-existence of a point of failure, due to its distributed architecture, and the cryptographic architecture. Until now, no blockchain was hacked due to its concept. However, this only holds as long as the blockchain is also implemented with rigor. As this is not always the case, blockchain implementations were already hacked. The reasons were a bad implementation but not the theoretical concept (Joshi, 2017).

Overall, when comparing blockchain technology with a traditional centralized database or network, it depends on the use cases if a blockchain is the better option. From the current research, a decision path can be derived, which is visualized in figure 11 (Wüst and Gervais, 2017).

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Figure 11 Decision path to determine the applicability of blockchain

According to this decision path, a blockchain is a suitable solution, if there is a need to store a specific state, if there are multiple writers, if it is not possible to always use trusted third parties, and if all writers are not known, or if they are known but not trusted. Depending on the other factors, a specific type of blockchain is recommended as already introduced in chapter 3.1.6 (Wüst and Gervais, 2017).

3.2 Blockchain 1.0: Cryptocurrencies

“Cryptocurrencies are only the beginning.” – Charles Brennan, Analyst Credit Suisse

The root of blockchain technology and until today the most popular application are cryptocurrencies. This chapter wants to introduce the concept of cryptocurrencies briefly and to give an overview of them. It is important to note that the focus of this research paper is not on cryptocurrencies. However, as blockchain technology arose from them, it is important to briefly introduce them as part and initiator of the blockchain technology. Cryptocurrencies can be defined, from a technical perspective, as a “type of digital currency, which relies on cryptography, usually alongside a proof-of-work scheme, to create and manage the currency. A decentralized network of peer-to-peer computer nodes working in sync creates and verifies transactions of transfer of said currency within the network” (Kim et al., 2016). From a more practical perspective, a cryptocurrency “can be transferred instantly and securely between any two parties, using the internet infrastructure and cryptographic security, with no need for a trusted third party. Its value is not backed by any single government or organization” (Ametrano, 2014).

Bitcoin was the first cryptocurrency and was introduced by Satoshi Nakamoto in 2008. Since then, it has experienced a parabolic growth as visualized in figure 12 (Lee Kuo Chuen, 2015). The market capitalization of Bitcoin reached a value of $250 billion in January 2018, but sharply dropped to $150 billion in May 2018 (CoinMarketCap, 2018).

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Figure 12 Market price of Bitcoin (in $) between October 2013 and May 2018

Furthermore, Bitcoin becomes also slowly linked with the traditional financial system with the introduction of Bitcoin Futures in December 2017 with a trading volume of $75 million on the first day (Meyer and Stafford, 2017). Also, several investment banks are planning trading desks for cryptocurrencies, although they did not announce them publicly yet: “there lies a chance for investment banks as in my opinion it is just a matter of time until trading desks for cryptocurrencies as Bitcoin or Ethereum will come into the banks” (Interview #10).

However, there are significant challenges as Bitcoin experiences high volatility, has no underlying securities and is not yet regulated sufficiently. Therefore, some experts speak of Bitcoin as “the biggest bubble of our lifetime by a long shot” (Wigglesworth, 2017) and the term “bitcoin mania” is widely used, hinting to the tulip mania 400 years ago, as, e.g., mentioned by Jamie Dimon, CEO of JP Morgan: “It’s a fraud and worse than tulip bulbs” (Cheng, 2017).

Besides Bitcoin, hundreds of other cryptocurrencies emerged, called altcoins, which is an abbreviation of the term “alternative coins”. The market tracker CoinMarketCap lists 1,590 different cryptocurrencies with a total market capitalization of $390 billion in May 2018 (CoinMarketCap, 2018), with Bitcoin leading the list but other currencies gaining traction. Table 1 gives an overview of the ten cryptocurrencies with the highest market capitalization in May 2018.

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Table 1 Overview of the ten highest valued cryptocurrencies by market capitalization on 1th of May 2018^[7]

Especially Ripple, Ethereum, and Cardano experienced significant growth in the previous months for various reasons. Ripple is backed by more than 100 financial institutions, Ethereum is developing a platform for decentralized applications, and Cardano benefits from its high-security approach (Cuttonaro, 2017; Johnson, 2017).

3.3 Blockchain 2.0: Beyond Cryptocurrencies

“One year ago, there could have been managers that would have said: No, Blockchain, Bitcoin, we do not do this – without the ability to differentiate. Moreover, you can also notice this on conferences and how presentations are titled and topics on which people work – then compare that to one year ago.” – Interview #7

As mentioned in chapter 3.1.1, blockchain technology roots in the cryptocurrency Bitcoin. However, from the end of 2013 onwards, the era of blockchain 2.0 started with applications emerging beyond cryptocurrencies. As blockchain technology is still in a development phase, there is no standard categorization of its fields of application. Nevertheless, besides cryptocurrencies, two major areas of application evolved (Deloitte, 2018). These two areas are discussed in a short and non-exhaustive way in the following chapters.

3.3.1 Smart Properties

Most smartphones will refuse to start and release information if they are not unlocked with the right password or finger print, making it useless when stolen. Blockchain technology can apply this concept of controlling the ownership to any physical asset such as cars, phones or houses, but also non-physical assets such as shares in a company or access rights to a computer (LegalDesk, 2017). Smart properties remove an intermediary and allow the use with less trust, leading to a reduction of fraud (Bitcoin Wiki, 2018).

An application of Smart Properties is realized by the startup Factom, which allows retaining documents, files, and data securely within their data centers while providing trusted access. This facilitates the reduction of the costs of document assembly and consolidation yet decrease the risk of loss, deterioration and information leakage (Fink, 2017).

Another example of the application area is shown by the hack of the credit reporting service Equifax in September, leaking 143 million personal records of consumers (Riley, Robertson and Sharpe, 2017). The current process of saving personal information is highly vulnerable and smart properties would allow securely saving a digital identity in a way, to give a proper control and present just the minimum amount of information to parties needing to identify the person (R. Miller, 2017).

The first application of smart properties on a national level was the creation of the e-Residency from the Estonian government at the end of 2014. This digital identity allows non-Estonians to securely access government services from Estonia, such as to found a company, to do online banking, and to process tax payments. Until May 2018, over 33,000 people from 154 countries applied for the e-Residency and founded more than 5,000 companies (The Republic of Estonia, 2018). In the future, even voting could be carried out on a blockchain as startups are trying to develop such an application (B. Miller, 2017).

Other examples of the concept on a national level are the use of the technology in Sweden and Honduras as a land registry as well as the incorporation of companies in the U.S. state of Delaware (Wieck, 2017).

3.3.2 Smart Contracts

“Cryptocurrencies such as Bitcoin are really nice, but what really gave us a powerful tool where smart contracts. They are the base the disruption in the capital markets.” – Interview #11

Smart contracts are the key innovation of the blockchain 2.0 era and are defined as “autonomous computer programs that are capable of facilitating, executing and enforcing the negotiation or performance of an agreement (i.e., contract) on conditions defined beforehand using blockchain technology” (Kehrli, 2016).

These computer programs can be written in any programming language and use computer code conditions, such as loops, function calls and more. Therefore, they extend blockchain technology by the ability to store and automatically execute any agreement between multiple parties (Blockgeeks, 2017).

Figure 13 compares a traditional contract with a smart contract when buying a house. In the conventional process, several intermediaries are involved, such as a lawyer to prepare the contract and, an insurance company and the notary to validate the transfer. If this transaction was executed with a smart contract, all these intermediaries would be removed as the conditions of the contract have to be translated into computer code and the execution would be carried out automatically and secure (CB Insights, 2017b).

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Figure 13 Comparison of traditional contracts with smart contractson the example of buying a house^[8]

The lifecycle of smart contracts consists of four broad phases, which are visualized in figure 14 (Sillaber and Waltl, 2017).

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Figure 14 Lifecycle of a smart contract

In the creation phase, a smart contract is negotiated, implemented, tested and finally submitted to the blockchain. In the following freeze phase, the smart contract is persisted by a majority confirmation of the participating nodes, and these nodes take the role of a governance board, ensuring that the preconditions to execute the contract are met. If the preconditions are met, the execution phase starts, and the computer code is executed. The execution results in a set of new transactions, as well as in a new state of the smart contract, which is submitted to the blockchain and is validated by the consensus mechanism. In the last phase, the finalization phase, the resulting transactions are stored in the blockchain and prior committed digital assets (e.g., coins) are transferred back to the accounts (Sillaber and Waltl, 2017).

The benefits of smart contracts are lower executing risks, as a smart contract makes it impossible to tamper or hack the contract terms. Furthermore, the automated execution leads to higher accuracy and higher speed as well as lower cost, as it ensures a secure escrow service so that the execution happens in real time at almost no costs and without intermediaries (Pinna and Ruttenberg, 2016).

Smart contracts can be applied in a variety of fields and allow entirely new business processes. For example, smart contracts could help to secure voting systems, which would also allow voting online, as it does indeed require excessive computing power to access votes and to identify the identity of the voters (Buterin, 2016b).

However, smart contracts do also have challenges. For example, they could have bugs in the code, leading to vulnerabilities. For example, a recent study found 34,000 vulnerabilities in the one million smart contracts on Ethereum (Nikoli et al., 2018). Moreover, government regulation and taxation could result in further problems (Marino, 2015).

[...]

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^[1] Sometimes also called „Distributed Ledger Technology” (DLT).

^[2] Adapted from Google Trends.

^[3] Adapted from Fortnum et al. (2017).

^[4] Adapted from (Frøystad & Hol (2015).

^[5] Adapted from Harrison (2016).

^[6] Also called 51% attack.

^[7] Adapted from CoinMarketCap (2018).

^[8] Adapted from CB Insights (2017b).