A recent technological innovation called the "blockchain" hasthe potential to transform the way financial institutions processtransactions and corporations conduct business.

Financial institutions and corporations have traditionallyrelied on written documents exchanged during in-person closings tocomplete transactions and loans, and relied on written checks todocument the transfer of funds. Transactions are also subject totime-intensive, complex, and laborious regulatory and compliancereviews. Now blockchain technology offers corporations andfinancial institutions the opportunity to eliminate billions ofdollars in operating costs from the myriad transactions they engagein every year.

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Although blockchain was first introduced as the technologyunderlying cryptocurrencies, it is now being applied intraditional businesses. For example, a consortium of leading banks— including Morgan Stanley and Credit Suisse — recently partnered to apply the blockchain to streamlinecross-border payment settlement, with other banks such asGoldman Sachs and Banco Santander developing their own competing blockchain-based system.

Credit card companies are actively exploring blockchain-basedtransactions, with Visa–Europe actively seeking banking partnersfor a pilot of a blockchain-based interbank settlementsolution. Blockchain technology has also piqued the interest ofWall Street, which is studying the tradingof private stocks on a new kind of blockchain, as a means ofreplacing paper share certificates,substantially reducing the time spent managing the certificateprocess and even facilitating shareholder voting.

Use of a blockchain opens companies to new types of risks andhazards not contemplated by current risk management systems. Oneproblem is the lack of consensus on blockchain standards, with anumber of different startups developing technologies that use theirown standards.

New private blockchains, which are growing in popularity becausethey enable companies to streamline and share confidential andproprietary information in one place, may be especially valuablefor hackers, and so might result in catastrophic losses ifcompromised. Private and semi-private blockchains also presentconcerns around determining who has access to potentially relevanttransactional information and ensuring that limitations on accessare fully in place.

Another issue is the lack of a regulatory structure addressingauthentication requirements, risk transfer, and loss allocation.Financial institutions and corporations must consider these newsources of risk when reformulating their risk management systemsand insurance programs.

What is the blockchain?

The blockchain stores data about individual financial transactionsin a decentralized way that should, in theory, provide greatersecurity and limit the risk of fraud. And although it relies oncutting-edge cryptography, the basic concept underlying blockchaintechnology is similar to that of a simple Excel database. Thedifference lies in the way financial institutions, corporations,and individuals interact with the database and confirm transactionson that database.

Traditionally, global financial systems have always used acentralized entity to verify and memorialize every transaction. Incontrast, a blockchain stores data semi-publicly, transferringauthority and trust to a decentralized network. When a transactionis executed, it is signed with a private key unique to the sender.Then the transaction is broadcast between users and confirmedthrough a process called "mining," in which separate, independentsoftware systems ("miners") continuously and sequentially recordtransactions on a public (in the case of traditional blockchain)"block." These independent confirmations of the transactionpurportedly guarantee its authenticity.

Cryptography secures the authentication process. Beforerecording a block of transactions, miners authenticate them byapplying a mathematical formula that results in a seemingly randomsequence of letters and numbers known as a hash. The hash isproduced using the hash of the preceding block, in a math problem.Although the math is difficult to solve, the solution is easy toverify. Thus, the hash becomes the digital version of a waxseal.

After using this process to authenticate a transaction,miners store the "block," along with its hash, in a unique "chain."If you change just one character in a block, its hash will changecompletely. The ramification for security is that if someonetampers with the block, the change becomes public.

A blockchain documents each transaction's details, identifyingthe sender, recipient, input amount, and output amount. Only theparties to a transaction can unlock the contents of the blockbecause only they hold the private key necessary to open the data.But since each entry bears a hash, anyone can verify the existenceof a transaction within the block.

Ultimately, a blockchain behaves like a database, except for twocharacteristics: first, in traditional blockchain, the informationcontained in the "header" is stored publicly, and second,transactions may only be added — nothing can be deleted. Thus, ablockchain is the cyber equivalent of having a write-onlyspreadsheet with certain fields shared openly on the internet. Andbecause it enables users to verify the existence and authenticityof each transaction, a blockchain removes the need for a centralintermediary in the clearing of transactions.

Bitcoin: Infancy, publicization of theblockchain

For thousands of years, money has taken the form of eitherphysical objects whose supply is scarce (e.g., precious metals), orcoins and notes issued by a government. Cryptocurrencies that haveemerged in recent years, such as bitcoin, present an alternative medium ofexchange. They replace the physical forms of money with acomputer file that is accepted (by some sellers) in exchange forgoods or services. In doing so, they raise security questions thatnever come up for users of traditional currency.  

Cryptocurrencies such as bitcoins run through a blockchain, essentiallya global ledger through which a large peer-to-peer network verifiesand approves each transaction. The blockchain is public and resideson a network of connected computers around the world, rather thanin a single database. Every 10 minutes, the transactions areverified and a new link is created, permanently time-stamping andstoring the exchanges of value on the ledger.

When a physical object is offered as payment, there is rarelydoubt that the payer owns it, or that the payer hands it to therecipient. In contrast, a digital file is easily created andduplicated. The blockchain helps mitigate this risk by ensuringthat any time an owner of a cryptocurrency cedes that ownership toanother party, the transaction is validated and recorded. Thisprocess helps prove that the recipient subsequently owns thecryptocurrency.

Validation could be entrusted to a central record, as medievalmerchants did when they paid one another by transferring sums on abank's books, or as modern banks do when they settle theirtransactions on the books of the Federal Reserve. Instead, withcryptocurrency, the recording is decentralized. Proposedtransactions denominated in a cryptocurrency are broadcast to alarge network of miners on the internet. Every 10 minutes, theminers gather up the new proposed transactions and attempt to addthem to the blockchain.

The key to preventing falsification in the blockchain is to makethe additions costly. The mining process is expensive in terms ofcomputer hardware required, electricity consumed, and time expended— and the safety of this process has enhanced the reputation andviability of cryptocurrencies. Once a medium of exchange forcriminals, they are increasingly accepted by commercial entities —everyone from Microsoft to Overstock to AirBaltic.

The next blockchain frontiers

While blockchain was originally used solely to supportcryptocurrencies, it is now being applied in traditional business,to everything from the exchange of securities to supply chainmanagement.

Blockchain technology leapt toward mainstream acceptancewhen Nasdaq announced that it had experimented with incorporatingit into a pre-IPO trading arm. Nasdaq Private Markets, a subsidiarythat assists with investment in firms that are not publicly traded,started to document trades into a blockchain, in hopes that theprocess would "provide extensive integrity, auditability,governance, and transfer-of-ownership capabilities."

The blockchain usually logs the transfer of money, but it canalso hold other information, such as data around the transfer ofsecurities. Bob Greifeld, CEO of Nasdaq explained, "Utilizing the blockchain isa natural digital evolution for managing physical securities. Onceyou cut the apron strings of need for the physical, theopportunities we can envision blockchain providing stand to benefitnot only our clients, but the broader global capital markets."

Investment banks are now joining the revolution. Notably, thesebanks are not focused on currency. They are exploring ways toreshape daily operations, upgrade old back-office systems, andoutsource costs associated with contract execution. For example,more than 75 of the world's leading financial institutions havejoined in a partnership named R3 CEV. R3 CEV, which is led by the financialinnovation firm R3, seeks to create a distributed ledger system forthe financial sector that is based on adapted blockchaintechnology. This distributed ledger system, Corda, will record,manage and synchronize financial agreements between financialinstitutions.

As with blockchain, Corda will coordinate information betweenparticipants without a central controller. Corda will allowfinancial institutions to view the relevant details about atransaction into which they are entering; determine whether thatdeal is valid, based on the validation requirements entered by eachparty to the transaction; and determine whether the deal needs tobe agreed on by another party, or whether the transaction conflictswith an existing transaction. However, unlike traditionalblockchain technology, Corda will limit knowledge abouttransactions. Only those parties that need to know the data withinan agreement will be able to see the relevant information, andverification of transactions will be limited to the parties to thetransaction.

Although Corda appears to be a strong tool and is backed by manymajor banks, several investment banks such as Goldman Sachs and Banco Santander have withdrawnfrom R3 CEV. However, these banks do not appear to beabandoning blockchain technology. Rather, Goldman and Santander areinvestors in Digital Asset Holdings, a rival blockchain startupheaded by former J.P Morgan executive Blythe Masters. Therefore, it appears thatfinancial institutions will be using a variety of blockchain-basedsystems to replace their back-office software and databases, tosupport more accurate and efficient transactions, and to verifycompliance with internal requirements and the myriad of regulatoryrequirements.

Hu Liang, senior vice president and head of emergingtechnologies for State Street, suggests, "These new technologies couldtransform how financial transactions are recorded, reconciled, andreported — all with additional security, lower error rates, andsignificant cost reductions." The technology underlying thesefinancial transactions seems to also have potential use forbusinesses in other industries, which need to share information,enter into agreements, and validate transactions with the relevantparties.

The implementation of blockchain technology is not limited tofinancial institutions. Blockchain can provide a "single source oftruth," enabling a revolution in compliance and auditfunctions, and enhance the transparency and security of bankingactivities for financial institutions and corporations alike.

Blockchain technology is also being used by corporations to meeteveryday business needs. Walmart has unveiled a trial run of blockchaintechnology in its food safety supply chain for pork in Chinaand a "packaged produced item" in the U.S. Blockchain enablesWalmart to pinpoint the source of contaminated food and to quicklypull the affected products, increasing the accuracy and efficiencyof product recalls.

Blockchain technology is also behind supply chaintracking in industries ranging from the diamond industry to theautomotive industry. It's also in tamper-resistant pharmaceuticalsupply-chain-tracking seals. BHP Billiton Ltd. will start using blockchaintechnology to create a shared real-time system in which itsemployees can track rock and fluid samples and analyses to help thecompany determine where to dig new oil wells. Recognizing the widerange of potential uses of blockchain technology, the healthcare industry is exploring blockchain'sutility for facilitating clinical trials, securing and managingpatient health records, and improving claims processing.

Corporations are also using blockchain technology to issue stockand obtain stockholder approval for corporate decisions.Overstock.com Inc. is close to unveiling a securities-tradingsystem using the blockchain. The discount retailer announced thatit will issue a digital version of its stock that will then betraded on Pro Securities LLC, a trading system in which Overstockinvested. According to CEO Patrick Byrne, Overstock is "ready tostart a crypto Wall Street." He explains: "Like Jonas Salk injecting himselfwith polio, our first client is going to be ourselves." WhileOverstock's initial offering is limited to Overstock equity,Nasdaq announced in December 2015 that it hadused blockchain technology to complete and record a privatesecurities transaction.

Risk management challenges

Blockchain technology was created to transfer value and ensurethat each counterparty to a transaction fulfills its end of thedeal. However, the application of this technology creates aplethora of new concerns:

• Will there be a formal original agreement or other documentevidencing ownership, or will all information be encoded?
• If institutions rely on technological coding, how will theintegrity of this information be ensured?
• What if the securities or other assets memorialized in theblockchain are forgeries or misrepresentations? Does the blockchainensure adequate recovery for losses incurred when a party to atransaction makes decisions based on false information? This may beespecially top-of-mind for financial institutions that may beentering into transactions with parties using multipleblockchain-based technologies.
• How do parties to a transaction ensure that all requirementsfor validation and potential conflicts are properly encoded in theblockchain? Who bears the risk of an inaccurate or incompleteencoding of validation requirements?

The application of blockchain technology to the transfer ofsecurities and negotiable instruments could potentially increasethe risk of fraud. That's because a blockchain transaction may notundergo a comprehensive review looking for fraud, alteration, andforgery. The participating financial institutions may not receivethe original documents on which the transaction is based, and thusmay not have an opportunity to analyze those documents'authenticity. If the technology evolves such that originaldocuments are no longer provided, that could introduce thepotential for information to be lost through hacking or through atechnological failure.

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The efficiency advantages created by blockchain technologiesmust be weighed against the risks. (Photo:iStock)

Since financial institutions appear to be moving towardcompeting blockchain-based platforms, there is also a potential forassets to be double-pledged or for parties to enter intoconflicting financial transactions on different platforms. Forexample, the seller of a promissory note could use one proprietaryblockchain-based platform to sell a note.

Absent a means to compare transactions effected on one platformagainst transactions effected on another platform, the same sellercould attempt to sell the same note through a different proprietaryblockchain-based platform, thereby defrauding the purchaser (who,absent strict verification procedures, could be induced tounknowingly purchase a note the seller did not own). Such asituation would create room for error and fraud, so parties usingblockchain to validate transactions in the future may need to findways to compare information between different blockchain-basedplatforms. 

Allowing participants to encode their own validation andconflicts information could create a further risk of error orfraud. As an example, when forensic document examiners are tryingto detect alterations or forgery, they generally require originaldocuments. According to the National Forensic Science TechnologyCenter, "Original documents may bear defects, flaws, orcharacteristics that are not reproduced in a copy."

Every time a physical document is photocopied, a small amount ofinformation is lost. The issue is exacerbated withmultigenerational copies (i.e., copies of copies), many of whichcontain insufficient quality for forensic examination andcomparison. These types of original documents do not exist in thecontext of a blockchain transaction. Businesses engaging inblockchain-based transactions will, therefore, have to modernizetheir practices and adopt computer-savvy protocols to ensure thattransactions are properly verified and recorded, in order to avoidthe risk of invalid or fraudulent transactions.

The efficiency advantages created by blockchain technologiesmust be weighed against the risks. Blockchain provides a relativelysafe method for memorializing the chain of ownership and transferof securities. Still, banks and other financial institutions mayneed to obtain and review an original copy of all relevantdocuments prior to entering into a blockchain-based transaction.This would add an extra step to the transaction, but it would alsoprovide a greater degree of certainty.

As corporations and financial institutions move forward into thebrave new world of blockchain technology, they must remain mindfulof the fact that this is just another means of conducting businesstransactions, and the time-honored principle of caveatemptor still applies. Parties entering into blockchaintransactions should ensure that they are doing their due diligenceon the representations underlying those transactions. Thisincludes, when applicable, examining original documents on whichthe transactions are based. Also, participants should be mindfulthat if multiple blockchain-based platforms support the type oftransaction they're entering into, a competing or conflictingtransaction might be entered into on another platform.

Finally, in order to maintain prominence, all parties to atransaction may want to seek out others who are leading the way onthe use of blockchain technology, whether it is to stay abreast ofsolutions to industry problems or to use technology to increaseefficiencies in order to remain competitive.

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Scott Schmookler is a partner at Gordon &Rees. Based in Chicago, Schmookler's practice focuses on insurancecoverage, cyber security, and commercial litigation. Contact himat [email protected].

Greg Bangs is senior vice president,global crime product leader, and head of crisis management in theAmericas with global (re)insurer XL Catlin. He is based in NewYork. Contact him at [email protected].

Katherine Musbach is an associate inGordon & Rees' Chicago office. Her practice focuses oninsurance coverage, cyber security, and commercial litigation.Contact her at [email protected].