I’ve seen the future of large-scale financial transactions, and it’s not the future anymore—it’s the now. Distributed ledger technology (DLT) turns the concept of counterparties in transactions on its head and spins it right out of the room.
Historically, a transaction required a trusted third party to validate the fund’s transfer. If you wrote your broker a check for a trade, the broker trusted that your financial institution could provide the funds; the bank was the counterparty in the transaction. DLT removes the counterparty from the equation, creating a peer-to-peer contract. Distributed ledger technology also removes banking fees since there’s no third party involved, so that’s a lesser win (but a win just the same).
Distributed Ledger Technology, Explained
For my purposes, distributed ledger technology (DLT) is a new way to manage transactions across different currencies, time zones, and other factors that have always made trading such an operational mess. With a distributed ledger and set cryptocurrency, the transactions and record-keeping are peer-to-peer, either in the individual or corporate sense, without that third-party intermediary to oversee the process. Before I get too deep into DLT, let’s review the blockchain concept. It’s still new and evolving enough that many investors don’t have a great grasp of the concept. I’m not worried about the technology; that’s for bigger brains than mine to explore.
Blockchain
A blockchain is a unique data storage and transmission unit—a block—that holds each data package in its own space—the block. The blocks link to each other in a sequential chain. The math geniuses that developed and run blockchain use quantum-level math, cryptography, and algorithms to record and synchronize the data in the network chain in an “immutable” manner. It becomes something that people can’t change unless all the other blocks in the chain agree to the changes. Immutability is what makes blockchain so cool—it’s damn near impossible to break the chain.
A Bit About Ledgers
There are two types of ledgers in blockchain: shared and distributed. I’m focusing on distributed ledgers because this isn’t about the technology, per se; it’s about what the technology does. Distributed ledgers are decentralized databases around the globe that are all on a singular shared network. It’s like the cloud to the nth degree, except that all the servers, or nodes in this case, stay synchronized.
A general ledger, if you recall Accounting 101, is how a company records its financial information—debits, credit, and account balances. Back when clerks kept books on paper, this centralized process was the only game in town.
Automating ledgers is a really great idea. Leaving the number-crunching to computers does bring an extra layer of validity to a company’s books. The problem is that centralized systems are easy to break into (think First American Financial, LinkedIn (twice), Experian, Target, Equifax… and these are just the ones that were publicized) since there is one single point of failure for the whole thing to collapse.
The Start of Distributed Ledgers
Centralized ledgers were still the only game until the concept of blockchain was happened upon by a couple of mathematicians (mathletes are truly superheroes) back in the days of Atari in 1991. But it idled on the back burner until 2008, when an anonymous developer, or two, or ten (working under the name Satoshi Nakamoto) published a white paper introducing the concept of a blockchain as a public ledger for trading in cryptocurrencies. A few years later, Nakamoto spun off from solely currencies, seeing the potential for using public distributed ledger technology for interbank transactions: Blockchain 2.0, or distributed ledger technology.
Nakamoto went silent in 2011 and is still anonymous (but probably filthy rich with Bitcoin). And no, it’s not Elon Musk. I don’t think.
Anyway, I digress.
These blockchain ledgers are called “distributed” because they are spread out, and there is no singular governing authority. Multiple institutions in the blockchain are constantly reorganizing the data. Every transaction adds another link to the chain. You can see how this is a better mousetrap. With a decentralized ledger that grows with every transaction, it’s exponentially more difficult for a bad actor to break the chain.
A Small Shoutout to the Venture Capitalists
For what it’s worth, Ethereum was the first crypto on board the DLT train. They implemented Nakamoto’s theory of creating digital cash that users could transmit peer-to-peer without using a central bank in charge of the ledger. Ethereum funded the software that allows the blocks to represent various financial instruments—bonds, bills, and the like—in the first smart contracts.
Benefits of Distributed Ledgers
I’ve already touched on a few of the benefits of DLT. But these are really just the beginning of how DLT could and should change the way we move money around. Let’s go into a little more depth on these first advantages and then explore the less obvious ones.
Counterparties Are Obsolete
The smart contract capability that Ethereum has developed allows companies to codify and validate a given transaction between peers. It eliminates many of the cumbersome processes of a legacy system.
- There’s no need for a time-consuming counterparty reconciliation.
- The almost instantaneous settlement eliminates the time gap between the front and back office functions, a huge advantage with international trades.
- Hyper-quick settlement speed frees up capital by reducing the need for cash buffers that are often required to reduce settlement risk.
DLTs Are Super Transparent and Immutable
Again, there are no third=party counterparties in DLT. Once a record goes into the chain, it’s there forever and can’t be changed in any way. This means there is one confirmed client record of the event and nowhere for friction in relationship management to develop. Everybody is singing from the same bouncing ball.
All of the data stored in the ledger is viewable by all parties. So there is built-in transparency that the financial services industry finds useful. With a distributed ledger, regulators can get in the loop and continuously monitor risk with real-time ledger access.
The Regulators Weigh In
To paraphrase, if the regulators aren’t happy, ain’t nobody happy. Globally, regulators are positive about the potential of DLT infrastructure, although they have been loudly skeptical about cryptocurrencies. I was surprised to learn that some regulators are working directly with DLT partners to build sandbox projects (working test scenarios) for the technologies.
There Is Inherent Security in Decentralization
Many points of entry are inherently more secure than one. But mature distributed ledgers have tens of thousands of access points. A bad actor would have to break into every single one to break into the chain and alter any data.
Permissioned vs. Permissionless Distributed Ledger
There are two types of DLT—permissioned (think JP Morgan’s DL or Onyx), which is centralized within the distributed ledger technology, and permissionless (like Ethereum and Bitcoin), which is decentralized.
But wait, you’re saying. I thought the whole point was decentralization. Well, it is. But the technology has to meet the consumers where they are. At the moment, that’s within a slightly more centralized framework in the distributed ledger space.
Which One Is Better for DLT?
Each type of ledger comes with unique advantages, and those advantages shift with differing scenarios.
A permissioned system better manages data privacy and identity verification. But since there is a digital administrator, the security risk factor is enhanced as there is that pesky single point of failure. But since the network is private, with multiple cryptokeys required to access the data, it’s not like it’s open season on the data. These networks use publicly-traded stablecoins—Tether and USD Coin are two—or their own cryptocurrency in these networks, such as JP Morgan.
Other benefits of permissioned blockchains:
- They are more nimble than public, or permissionless networks—the data packets are smaller, and there are fewer transactions.
- Financial institutions can easily identify customers—each one has a public and private cryptokey, so the risks of identity theft are minimal.
- Compliance is much easier to document in a closed network.
The final reason I’m kind of a fan of a permissioned blockchain is that they are more energy-efficient. They do not rely on large-scale mining proof of work but rather a multi-party confirmation process.
Of course, on the downside, a private network does have a greater risk of failure. There is no way around that fact. But financial entities running permissioned blockchains are confident that their safeguards will stand up to bad actors.
That said, that single point is a target for a cyberattack. Just ask Axie Infinity, an NFT game that someone hacked into to the tune of $600 million just a bit ago.
Benefits of a Public Blockchain
Proponents of an open blockchain point to this sort of hack as an example of the fatal flaw in permissioned distributed ledgers. These public entities are open for anyone to join, and they are truly the democratic ideal of a public ledger. There is no central authority running the show. That is all well and good (and yay for democracy), but ultimately, the permissionless blockchain 2.0 is not as reliable as a private network.
For one thing, anonymity and privacy are ever harder to maintain in an open network. Also, because this distributed ledger is open to all comers, the possibility for hackers and fraudulent participants grows; there is no oversight. Although it’s still one hell of an uphill climb to break into a public blockchain, it’s still possible for a bad actor to break in from the inside and steal those tokens.
Final Thoughts on Distributed Ledger Technology and Transactional Markets
I am ultimately pro-DLT. It’s not a perfect solution to recording and managing transactions, but it’s the best one I’ve ever seen. Private, peer-to-peer networks create channels for the easy flow of digital currencies that blow past all the old barriers of time gaps, conversion math, and all the other little nitpicks that made business across borders such a pain.
I’m also watching how blockchain technology moves away from the financial sector into new industries. At the moment, the quants—today’s Nakmotos—are applying technology to digital identity indicators (vital records, national ID, and the like) so I’m curious to see how we’ll see it deployed for daily use.
