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As a society we are becoming increasingly digital! Due to which, financial service providers are being forced to look for more efficient, secure, and cost effective ways to offer the same services to which customers are already accustomed.
This is where blockchain technology comes into picture!
Blockchain is a term that has gained tremendous hype in the recent times in the financial world. It was the backbone on which the crypto currencies operated. But over the course of time various opportunities in the financial sector have been identified and are now being explored. In the last few years, while banks have greatly been investing in blockchain technology in the hopes of reaping its benefits in the near future; the past couple of years have also seen the emergence of new blockchain based startups as well.
What is Blockchain?
By definition - Blockchain is an incorruptible digital ledger (a digital record) of all the economic transactions being executed and can be programmed to record not just financial transactions but virtually everything of value, on a real time basis.
In simple terms, it facilitates secure online transactions, and helps to guarantee the validity of a transaction by recording it digitally. This is not only recorded on a main register but a connected distributed system of registers, all of which are connected through a secure validation mechanism.
The entries to the ledger are time-stamped and contain digital signatures to ensure the validation of its users. These ledgers are immutable, hence when data is entered into them; it cannot be modified, unless there are embedded rules which allow such changes to take place.
Blockchain maybe public or private - public blockchains are permission-less, open networks which can be accessed by everyone, and private blockchains are a permission system which ensures controlled access by a limited set of users.
Constituents:
The blockchain space is known to be complicated and confusing, and undoubtedly the fundamental mathematics and low-level programming involved to implement a blockchain ecosystem comes with a considerable degree of difficulty.
Figure: Blockchain
Below mentioned is a simplified explanation of the purpose of the individual logical components that make up all blockchain ecosystems.
Blocks:
The data within a Blockchain is stored as blocks, which are distributed across multiple nodes (computers). Each block consists of two parts – the header and its content. The header contains the hash of the data stored in the block, the timestamp, the hash of the previous block and the nonce, which ensures that each block is connected to the previous block through the hash pointer and also prevents any modification in the block sequence within the blockchain. The content contains the transaction details, like the terms, amount and the parties involved. It may also include the smart contracts.
Hash:
A hash function converts an input of any length into an output of a fixed length. It is a 'one way', and a 'collision resistance' function! 'One way' ensures that given the output, it would be impossible to derive the input. While 'collision resistance' ensures that no two input messages generate the same hash output.
Nonce:
Nonce is a number which is included in all the blocks and is used in the generation of the specific hash value which must be smaller than a certain limit. Since nonce is difficult to calculate it is also referred to as the proof of work and it makes the replacement of blocks impossible as the nonce would then have to be recalculated for all the subsequent blocks.
Smart Contracts:
Smart contracts are self-executing; tamper proof transaction agreements which are embedded into the blockchain. This results in automatic execution of the transactions on the fulfillment of pre-defined criteria without the need for any external intervention.
Figure: Smart Contract
Benefits:
The benefits of blockchain include reduction in operational and compliance costs, reduction in processing time and increase in efficiency due to the automation of the processes. The automation of the processes result in reduced manual processing and minimizes the use of paper, while also reducing the role of the intermediaries.
Blockchain would also result in the reduction of fraud as each transaction would have a unique identifier while also being encrypted and traceable. It would also create an audit trail which would enable the validation of the transactions.
Figure: Encryption and Decryption
Applications:
There are currently various 'proof of concepts' being created by Banks and Fin-techs depicting the use of blockchain across various applications. Some of the major applications are trade finance, remittances, KYC, insurance and supply chain finance among others.
Within trade finance, Blockchain would result in a transformation of the current system which is a time and labor intensive processes and involves multiple checks and documentations.
Application - Letter of Credit (LC):
The steps involved in LC using Blockchain would be as follows:
1. The buyer (importer) would log into blockchain’s mobile application and click on the create LC button
2. Data entry would be created in the distributed ledger with a unique code
3. Notification would be sent to the buyer’s bank for review
4. Once reviewed, access is automatically provided to the seller’s bank for approval
5. If the seller’s bank approve the LC, the exporter is then prompted to view the LC requirements
6. Seller ships the goods
7. Documents are validated online and sent to the seller’s bank for their approval
8. If approved, the Buyer’s bank and the Buyer will review the documents online
9. If approved, money will be automatically released to the exporter
Click here to know in detail about Kotak Mahindra Bank’s successfully issued first Foreign Letter of Credit (LC) in India using theBlockchain technology.
Future:
The banks would continue to perform their traditional roles of risk mitigation and financing, however we expect to have a network of interoperable private blockchain systems, which also provide the central regulatory bodies with means to monitor and regulate the transactions.
Blockchain is fast moving the financial sector from the present to the future and it is only a matter of when the entire banking ecology will run on blockchain, thus reducing time, costs and frauds while improving operational efficiency and customer experiences.
At Kotak, blockchain is an integral part of data management. Get in touch with a relationship manager to get yourself and your business aligned with the technology and use it to your optimal advantage.
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