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U.S. Economic Watch
10 July 2015
Digital Banking
Blockchain Technology: The Ultimate Disruption in
the Financial System
Nathaniel Karp
• Blockchain ledgers bypasses centralized financial infrastructure
• This leads to the development of new businesses and the overhaul of existing ones
• For the financial sector it could imply the biggest disruption to date
“I have now no doubt whatever that private enterprise, if it had not been prevented by government, could and would long
ago have provided the public with a choice of currencies, and those that prevailed in the competition would have been
essentially stable in value and would have prevented both excessive stimulation of investment and the consequent periods
of contraction.”
–F.A. Hayek
“… the key innovation of digital currencies is the ‘distributed ledger’ technology that allows a payment system to
operate in an entirely decentralized way, with no intermediaries such as banks.”
–Bank of England
What is Blockchain?
Blockchain is a peer-to-peer public ledger maintained by a distributed network of computers that requires no
central authority or third party intermediaries. It consists of three key components: a transaction, a transaction
record and a system that verifies and stores the transaction. The blocks are generated through open-source
software and record the information about when and in what sequence the transaction took place. This “block”
chronologically stores information of all the transactions that have taken place in the chain, thus the name
blockchain. In other words, blockchain is a database of immutable time-stamped information of every transaction
that is replicated on servers across the globe. This technology is the foundation of bitcoin, a crypto currency.
1
In traditional transactions such as money transfers or foreign currency, there is usually an intermediary or a
centralized entity that records the transmission of money or currency that exist apart from it. In blockchain, the
token or digital coin itself is what has value, which is determined by the market. This is what makes the system a
truly decentralized exchange. When people buy or sell bitcoins, a secret key or token is broadcast to the system.
“Miners” use nodes, computers or devices linked to a network, to identify and validate the transaction using
copies of all or some information of the blockchain. Before the transaction is accepted by the network, miners
have to show “proof of work” using a cryptographic hash function –a special algorithm- that aims to provide high
levels of protection. Miners receive some form of compensation for their computing power contribution, avoiding
the need to have a centralized system. New protocols such as Ripple rely on a consensus process that does not
need miners nor proof of work and can agree on the changes to the blockchain within seconds.
1
For more information on Bitcoin see Bitcoin: A Chapter in Digital Currency Adoption
U.S. Economic Watch
10 July 2015
In any case, the blockchain offers an inherent level of trust for the user, eliminating the need for the middleman
and mitigating the risk of human error. In this public ledger, the data is protected against tampering and revision,
and individuals cannot replace parts of the blockchain as the cost of doing so is significant – hypothetically one
would need to control more than half of the “nodes” to surreptitiously alter the block chain. This ensures no
double-spending. However, some research shows that defrauding the system by creating false transactions may
be possible depending on computing power, position of the attacker and the timing of the attack.
Chart 1
Bitcoin: transactions per day & hash rate (TH/s)
Chart 2
Cost of cash in the U.S. ($bn, annual)
Source: blockchain.info Source: BBVA Research and Fletcher Institute
The Disruption
While bitcoin itself has received a lot of criticism, the blockchain technology is thought to offer great potential,
attracting the attention of governments, businesses and venture capital at a rapid pace. Some ideas developed
in recent years include a pay-as-you-go system that allows users to stream live video; a structure that allows
sharing space-program information; or ways to record business information such as audits. In most cases, these
options are thought to offer greater security, speed and reliability at a fraction of the cost of more traditional
infrastructures.
Other ideas include the possibility to rent out excess storage capacity; create digital identities that could
substitute dozens of usernames and passwords while offering greater security features; and “smart contracts”
with self-executing properties that would make the contract “unbreakable”. In addition, there have been
significant advances in creating a highly secure digital voting system. Voters register online and receive a unique
electronic vote or vote-coin. The electronic votes are recorded in the blockchain, reducing the possibility of fraud
while allowing quick and reliable verification by the network. This could be attractive considering that significant
anomalies have occurred even in well-established democracies (for example, the 2000 U.S. Presidential
election), as each voter would be able to verify its decision. This could increase participation and reduce costs.
In the financial industry, institutions were slow to recognize the potential of blockchain technology; however,
dozens of large banks have now invested significant amounts of money in this technology. The attention is likely
the result of how disruptive this technology is to the financial sector, particularly if it allows massive simplification
of banking processes and significantly reduces costs.
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
0
50,000
100,000
150,000
200,000
250,000
2009 2010 2011 2012 2013 2014 2015
Transactions (lhs)
Hash rate (rhs)
0
20
40
60
80
100
120
140
160
180
200
$55bn
$43bn
$101bn
U.S. Economic Watch
10 July 2015
The first levels of disruption seem more likely in the payments space where traditional transactions such as
money transfers, credit and debit card payments, remittances, foreign currency and online payments, require an
intermediary such as a clearing house or a financial institution. In these cases the transaction would occur
directly between the buyer and the seller without any intermediary and the validation of the transaction would
happen in a decentralized way or “distributed ledger”. This would result in significant infrastructure savings for
banks by allowing them to bypass payment networks that are oftentimes slow, cumbersome, and expensive.
However, the biggest potential impact of a public ledger may extend beyond the payment system. Given that the
majority of financial assets such as bonds, equities, derivatives and loans are already electronic it may be
possible that someday the entire system is replaced by a decentralized structure. In fact, the latest innovations
are using tokens to store and trade assets like shares, bonds, cars, houses and commodities. These so-called
“colored coins” attach additional information on the asset, generating “smart property” or the ability to record and
transact these assets using “smart contracts”, which are enforced by complex algorithms, through distributed
platforms without a centralized register, thereby increasing efficiency. In this environment, the current system
where financial institutions record individuals’ accounts in a centralized fashion and the banks’ reserves are
stored by the central bank (i.e. Federal Reserve) would be replaced by the “internet of money” or the “internet of
finance” –a fully decentralized financial system.
Risks and Challenges
The likelihood of a decentralized system to become commonplace is not obvious as it would have to offer the
same or higher level of trust and protection than the current one. For this to happen, the system would have to
possess a massive amount of computer power and efficiently cope with the enormous energy consumption
required to support it. In addition, it is not clear how this system would deal with legal and regulatory concerns,
as well as with matters of national security, such as money laundering, fraud, tax evasion or terrorism. Moreover,
digital currencies would not be exempt from potential crashes; like the current system, if their usage reaches
substantial levels, these shocks could generate systemic risk and severe economic downturns. In this scenario,
monetary policy would not be able to respond effectively if it fails to boost demand among a large share of
economic agents that use digital currencies.
Nonetheless, improvements and modifications in blockchain technology could overcome some of these
obstacles and lead to broader acceptance. Therefore, the key question is not how, but when the disruption will
become far-reaching. As other industries that have been transformed by new technologies and digitization,
blockchain technology could reshape the financial industry well beyond the payments system.
DISCLAIMER
This document was prepared by Banco Bilbao Vizcaya Argentaria’s (BBVA) BBVA Research U.S. on behalf of itself and its affiliated
companies (each BBVA Group Company) for distribution in the United States and the rest of the world and is provided for information
purposes only. Within the US, BBVA operates primarily through its subsidiary Compass Bank. The information, opinions, estimates and
forecasts contained herein refer to the specific date and are subject to changes without notice due to market fluctuations. The information,
opinions, estimates and forecasts contained in this document have been gathered or obtained from public sources, believed to be correct by
the Company concerning their accuracy, completeness, and/or correctness. This document is not an offer to sell or a solicitation to acquire or
dispose of an interest in securities.

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Blockchain Technology: The Ultimate Disruption in the Financial System

  • 1. U.S. Economic Watch 10 July 2015 Digital Banking Blockchain Technology: The Ultimate Disruption in the Financial System Nathaniel Karp • Blockchain ledgers bypasses centralized financial infrastructure • This leads to the development of new businesses and the overhaul of existing ones • For the financial sector it could imply the biggest disruption to date “I have now no doubt whatever that private enterprise, if it had not been prevented by government, could and would long ago have provided the public with a choice of currencies, and those that prevailed in the competition would have been essentially stable in value and would have prevented both excessive stimulation of investment and the consequent periods of contraction.” –F.A. Hayek “… the key innovation of digital currencies is the ‘distributed ledger’ technology that allows a payment system to operate in an entirely decentralized way, with no intermediaries such as banks.” –Bank of England What is Blockchain? Blockchain is a peer-to-peer public ledger maintained by a distributed network of computers that requires no central authority or third party intermediaries. It consists of three key components: a transaction, a transaction record and a system that verifies and stores the transaction. The blocks are generated through open-source software and record the information about when and in what sequence the transaction took place. This “block” chronologically stores information of all the transactions that have taken place in the chain, thus the name blockchain. In other words, blockchain is a database of immutable time-stamped information of every transaction that is replicated on servers across the globe. This technology is the foundation of bitcoin, a crypto currency. 1 In traditional transactions such as money transfers or foreign currency, there is usually an intermediary or a centralized entity that records the transmission of money or currency that exist apart from it. In blockchain, the token or digital coin itself is what has value, which is determined by the market. This is what makes the system a truly decentralized exchange. When people buy or sell bitcoins, a secret key or token is broadcast to the system. “Miners” use nodes, computers or devices linked to a network, to identify and validate the transaction using copies of all or some information of the blockchain. Before the transaction is accepted by the network, miners have to show “proof of work” using a cryptographic hash function –a special algorithm- that aims to provide high levels of protection. Miners receive some form of compensation for their computing power contribution, avoiding the need to have a centralized system. New protocols such as Ripple rely on a consensus process that does not need miners nor proof of work and can agree on the changes to the blockchain within seconds. 1 For more information on Bitcoin see Bitcoin: A Chapter in Digital Currency Adoption
  • 2. U.S. Economic Watch 10 July 2015 In any case, the blockchain offers an inherent level of trust for the user, eliminating the need for the middleman and mitigating the risk of human error. In this public ledger, the data is protected against tampering and revision, and individuals cannot replace parts of the blockchain as the cost of doing so is significant – hypothetically one would need to control more than half of the “nodes” to surreptitiously alter the block chain. This ensures no double-spending. However, some research shows that defrauding the system by creating false transactions may be possible depending on computing power, position of the attacker and the timing of the attack. Chart 1 Bitcoin: transactions per day & hash rate (TH/s) Chart 2 Cost of cash in the U.S. ($bn, annual) Source: blockchain.info Source: BBVA Research and Fletcher Institute The Disruption While bitcoin itself has received a lot of criticism, the blockchain technology is thought to offer great potential, attracting the attention of governments, businesses and venture capital at a rapid pace. Some ideas developed in recent years include a pay-as-you-go system that allows users to stream live video; a structure that allows sharing space-program information; or ways to record business information such as audits. In most cases, these options are thought to offer greater security, speed and reliability at a fraction of the cost of more traditional infrastructures. Other ideas include the possibility to rent out excess storage capacity; create digital identities that could substitute dozens of usernames and passwords while offering greater security features; and “smart contracts” with self-executing properties that would make the contract “unbreakable”. In addition, there have been significant advances in creating a highly secure digital voting system. Voters register online and receive a unique electronic vote or vote-coin. The electronic votes are recorded in the blockchain, reducing the possibility of fraud while allowing quick and reliable verification by the network. This could be attractive considering that significant anomalies have occurred even in well-established democracies (for example, the 2000 U.S. Presidential election), as each voter would be able to verify its decision. This could increase participation and reduce costs. In the financial industry, institutions were slow to recognize the potential of blockchain technology; however, dozens of large banks have now invested significant amounts of money in this technology. The attention is likely the result of how disruptive this technology is to the financial sector, particularly if it allows massive simplification of banking processes and significantly reduces costs. 0 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 0 50,000 100,000 150,000 200,000 250,000 2009 2010 2011 2012 2013 2014 2015 Transactions (lhs) Hash rate (rhs) 0 20 40 60 80 100 120 140 160 180 200 $55bn $43bn $101bn
  • 3. U.S. Economic Watch 10 July 2015 The first levels of disruption seem more likely in the payments space where traditional transactions such as money transfers, credit and debit card payments, remittances, foreign currency and online payments, require an intermediary such as a clearing house or a financial institution. In these cases the transaction would occur directly between the buyer and the seller without any intermediary and the validation of the transaction would happen in a decentralized way or “distributed ledger”. This would result in significant infrastructure savings for banks by allowing them to bypass payment networks that are oftentimes slow, cumbersome, and expensive. However, the biggest potential impact of a public ledger may extend beyond the payment system. Given that the majority of financial assets such as bonds, equities, derivatives and loans are already electronic it may be possible that someday the entire system is replaced by a decentralized structure. In fact, the latest innovations are using tokens to store and trade assets like shares, bonds, cars, houses and commodities. These so-called “colored coins” attach additional information on the asset, generating “smart property” or the ability to record and transact these assets using “smart contracts”, which are enforced by complex algorithms, through distributed platforms without a centralized register, thereby increasing efficiency. In this environment, the current system where financial institutions record individuals’ accounts in a centralized fashion and the banks’ reserves are stored by the central bank (i.e. Federal Reserve) would be replaced by the “internet of money” or the “internet of finance” –a fully decentralized financial system. Risks and Challenges The likelihood of a decentralized system to become commonplace is not obvious as it would have to offer the same or higher level of trust and protection than the current one. For this to happen, the system would have to possess a massive amount of computer power and efficiently cope with the enormous energy consumption required to support it. In addition, it is not clear how this system would deal with legal and regulatory concerns, as well as with matters of national security, such as money laundering, fraud, tax evasion or terrorism. Moreover, digital currencies would not be exempt from potential crashes; like the current system, if their usage reaches substantial levels, these shocks could generate systemic risk and severe economic downturns. In this scenario, monetary policy would not be able to respond effectively if it fails to boost demand among a large share of economic agents that use digital currencies. Nonetheless, improvements and modifications in blockchain technology could overcome some of these obstacles and lead to broader acceptance. Therefore, the key question is not how, but when the disruption will become far-reaching. As other industries that have been transformed by new technologies and digitization, blockchain technology could reshape the financial industry well beyond the payments system. DISCLAIMER This document was prepared by Banco Bilbao Vizcaya Argentaria’s (BBVA) BBVA Research U.S. on behalf of itself and its affiliated companies (each BBVA Group Company) for distribution in the United States and the rest of the world and is provided for information purposes only. Within the US, BBVA operates primarily through its subsidiary Compass Bank. The information, opinions, estimates and forecasts contained herein refer to the specific date and are subject to changes without notice due to market fluctuations. The information, opinions, estimates and forecasts contained in this document have been gathered or obtained from public sources, believed to be correct by the Company concerning their accuracy, completeness, and/or correctness. This document is not an offer to sell or a solicitation to acquire or dispose of an interest in securities.