Is blockchain technology practical for banking?

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This article first appeared in The Edge Financial Daily, on December 7, 2016.

BANK Negara Malaysia (BNM) is getting ready for an impending game-changing impetus by finance technology (fintech) in the very near future. BNM governor Datuk Muhammad Ibrahim announced in May this year that the central bank was putting together a fintech regulatory framework for banks to comment on by July. When June came, BNM issued a discussion paper on regulatory sandbox guidelines for fintech. This took effect in October.

Now, in fintech, a major technology piece revolves around blockchain. I am sure most of us have heard of Bitcoin which is one of the most successful concept tests of blockchain technology in the world.


What is blockchain technology?
First of all, let us examine what is blockchain technology. A blockchain is a digital ledger of all assets that have ever been transacted in an implementation. Ledgers are how banks manage transaction information within their internal systems.

Briefly, this ledger is constantly growing as “completed” blocks of transactions are added to it with a new set of recordings. The blocks are added to the blockchain in a linear, chronological order.

One of the main attractions to users of blockchain technology is that there is no need for a central authority and much of this relies on highly secure algorithms to maintain check and balance in a P2P (peer-to-peer) method of transaction.

This seeks to recreate a physical world of money transactions in a digital sphere without the need of control by an authority like the central bank. In a public digital world, there are no geographical boundaries equated and as such, it becomes borderless in nature. And this is not what central banks want.

An example of how blockchain works would be one of the most infamous experiences of Malaysians of late. It is the paying of a “ransom” when a malware is introduced into corporate servers and “locked” up until the owners pay the perpetrators an amount valued in US dollars but paid in Bitcoin equivalent.

The reason this payment method is chosen is that it is not monitored by the authorities and it is journalled purely as a legitimate Bitcoin transaction.


Now, as blockchain technology evolves to strengthen its inherent weaknesses, there is presently a variety of platforms and implementations to prove that blockchain can actually be used in mainstream banking.

Examples of such implementations to prove that blockchain works include Bitcoin, NEM, Ethereum, Peercoin and Corda.

One of the most acclaimed blockchain platforms is NEM (a blockchain project) whose authors claim that it addresses all inherent weaknesses and has had a very successful live implementation of a global scale.


Strengths and weaknesses
Most blockchain implementations are focused on the workings of the blockchain itself. They seldom expand out of the core blockchain ideas. This makes implementation in real business applications limited as adjustments would need to be made to the blockchain and not the other way round.

Implementations are of a P2P nature and there is a necessity for a high-security measure. P2P is either permission or permissionless, but either way, it requires key algorithms to protect the integrity of each party as well as the information it carries.

This key algorithm uses cryptography science to manage and protect the data securely in a tamper-evident block of transactions. There are also public or private implementations, although banks prefer private implementations, for control purposes.

The use of this in real life is complicated and multidimensional. Current blockchain proof-of-concept is mainly narrow in scope and does not consider how a bank can actually practically and safely introduce into its highly regulated system.


Addressing blockchain weaknesses
It is important for any serious blockchain implementation to address all known weaknesses by constructing a totally brand-new platform core. It is generally recognised that there needs to be mechanisms better than proof-of-work (PoW) and proof-of-stake (PoS) to grow the digital economy implementation. These are two conventional methods currently deployed in many blockchain implementations.

PoW is achieved by using the computer to earn cryptocurrency by mining the coin — the bigger the better. It takes a lot of computing power and a lot of time to earn. This was introduced to deter any attacks on the blockchain because it will require an unfeasible amount of computing resources. However, it still rewarded the rich who had spent the money to buy the latest computing power to sign the next blocks and gained wealth faster than others.

PoS was introduced to prove how much cryptocurrency one possessed. It removed the need for big computing power as only the older and larger sets of coins had the higher probability of signing the next blocks. However, the main problem remained unresolved. The richer users were more likely to sign the next blocks, and the more blocks they get, the richer they would get.


A relatively new technique called proof-of-importance (POI) was introduced to address the above weaknesses. This system would not only reward those with a large account balance, but also take into account how much they had transacted with each other and who they had transacted with.

This means that those who actively help the digital economy benefit, meaning the right people, are rewarded. Each user is given a trust score; the higher it is, the more chance they have of being rewarded.

The good thing is that this will mean much more even wealth distribution; anyone who contributes can gain extra currency.

This technique is preferred because it gives similar opportunities to everyone. The main aim is to empower regular people and not just the rich. The activity goes beyond mining and harvesting, a process in which a node will calculate blocks and how they are added to the blockchain.


Application programming interfaces and private implementations
To make blockchain work in a more practical way in a banking environment, the ability to enable existing banking systems and regulations into the blockchain implementation is vital.

Banks will not want to amend their complex systems. Central banks will want to ensure their regulations are complied with.

Central banks must ensure AML (anti-money laundering) compliance and how that can be complied when blockchain is used.

The flow of information needs to be secure and private. As such, new blockchain implementations must enable a rich set of APIs to allow the banks to control what and how they exactly want to leverage this game-changing fintech.

Banks need to test the use of blockchains without fears of a public implementation as they do not have the need to be concerned about mining or harvesting. This becomes a bank-owned blockchain for the bank’s own use to serve their customers.


Major fear
One major fear of banks (and central banks) around the world is that a completely open Internet type of financial platform might operate with cryptocurrency in the future without them. This would lead to users of all sorts around the world  participating in transactions without any watchful eyes except for the technology in their hands.

It is the hope of central banks to negate that fear by embracing such fintech in the introduction of various regulatory frameworks and sandboxes.

Bitcoin has shown that the concept can work. In today’s generation of technology, the time it takes from an idea to proof-of-concept to commercialisation does not take decades. It is only a matter of years before user demands take over and leave banks — which are slow adopters — wondering what happened.


The need to be prepared
Banks in Malaysia have the opportunity to jump on board cutting-edge technology like blockchain and especially more advanced and open implementations such as NEM to complement their current systems. How blockchain can be leveraged by the banks is not well understood.

Ng Kien Lock ([email protected]), an IT industry veteran, is constantly on the lookout for technology to be leveraged for business pragmatism.