If you’re baffled by how bitcoin actually works, you’re not alone. Yet the technology behind the virtual currency could soon allow companies to execute financial transactions in a totally new — and secure — way.
It’s called blockchain, a geeky term for what is basically a digital bank vault or ledger that any participant can access but can’t change or tamper with.
Many financial services companies are looking closely at the technology. Major banks and technology companies are investing huge amounts of money, talent and resources in its development.
The reason: Blockchain has the potential to revolutionize financial transactions. Instead of relying on a third-party clearinghouse, financial institutions can use blockchain to execute and verify transactions among themselves safely and discretely.
Here’s how it works: A group of institutions forms a network and agrees on the value of certain assets, data and financial transactions. This “consensus mechanism,” which is turned into a digital algorithm, allows members to conduct business with each under the same set of rules and procedures.
The record of these transactions, known as a “distributed ledger,” is shared among the members. And because this network has no central database, it is secure from theft and tampering.
Consensus ledger technology, as it is called, is still a work in progress. As such, companies can’t just plug into one. There are also a number of different versions — blockchain is just one — with no clear indication of which is best.
On top of that, financial institutions face a number of roadblocks in using the technology. The main obstacle is that the industry is heavily regulated, which means many of its transactions have to be transparent and validated by third parties.
There’s also the question of privacy. It may be difficult to satisfy participants who don’t trust each other but want to conduct safe transactions without a third party.
And there’s the issue of network stability. Because of the huge volume of financial transactions, the system can’t stop or slow down — even for a second. That may limit adoption in cases where speed and volume are essential.
Despite these limitations, blockchain and other platforms are becoming part of the financial services industry. Right now, most distributed ledger technology is being used by banks to automate and streamline back-office operations.
The technology is also spreading to other industries, where new business models based on blockchains are being developed. The hope is that it will eventually transform inefficient ways of conducting transactions.
A lot will depend on which consensus mechanisms end up being adopted. Regulators, consortia and industry groups may have to set certain standards.
Ultimately, there may be some transactions that lend themselves to this new technology and some that don’t. The best solution may be to operate both. Companies will just have to decide which works best for them.
For more on the potential of blockchain, click here.
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First appeared at Forbes