Blockchain on the rise: Making sense of the tech behind cryptocurrencies

The emergence of blockchain technology as a tool to transfer data and value between parties could prove transformative for industries on a global basis, including financial services.

A recently published primer on blockchain from the Organisation for Economic Co-operation and Development, an international organization focused on a range of economic, social and environmental challenges, highlights the array of opportunities and challenges that blockchain’s growing popularity could have on the financial industry, among many other fields.

Not just for cryptocurrency

Blockchain uses distributed ledger technology to store information that is verified using cryptography among a group of users. So far, blockchain is most widely known for its use with digital financial asset applications (cryptocurrencies such as Bitcoin and Ethereum).

However, the OECD and others have noted that the potential uses for blockchain are wide-ranging because it can diminish the role of intermediaries in the transfer of data and improve the security and cost of those transfers.

“Blockchain has the potential to transform the functioning of a wide range of industries,” according to the OECD. “Its features can increase the transparency and traceability of goods, data and financial assets, facilitate market access and improve the efficiency of transactions.”

Blockchain operates as a shared ledger of transactions between parties in a network. All transactions between the parties in the network are stored and recorded in the network without a central authority, and each party has access to all the same records.

Because of blockchain’s basic characteristics, the OECD sees far-reaching potential for blockchain in the global economy.

“The areas where major blockchain progress is taking place are as diverse as the applications they are creating,” according to the OECD. “The global nature of blockchain’s development can help distribute opportunities for wealth creation and economic development more widely than before.”

Basics of blockchain

Blockchains can vary in the way they operate, ranging from fully open and public networks that allow anyone to contribute and add data to the ledger to closed blockchains that are restricted to a limited group of participants with authorization to participate.

The open networks include such public, well-known examples as Bitcoin, while an example of a private blockchain might be multiple banks operating a shared ledger, according to the OECD.

A blockchain consists of three basic layers:

• Protocol layer: provides the structure of the blockchain, including its computing language and computational rules.
• Networking layer: sets the network’s rules and implements the structure of the protocol layer.
• Application layer: where the applications are built that users ultimately interact with.

The database in a blockchain is maintained and held by all the nodes in that blockchain’s network. One of the prime strengths of blockchain is its immutability, which makes it nearly immune to being compromised by hackers, according to the OECD.

Once a transaction is made to the ledger, it largely cannot be undone. In a traditional database, someone who is able to gain access to the centralized server potentially could change data without detection.

The digital currencies that so far are the most prominent blockchain applications essentially serve as peer-to-peer currencies that give users the flexibility to transfer value to one another without the use of banks.

Blockchain’s impact on financial advisors

For financial advisors, the new and emerging nature of cryptocurrencies create complex challenges when working with clients interested in investing in that area. The first U.S. bitcoin futures exchange-traded fund became available in October 2021, according to CNBC.

Forty percent of fund selectors report that clients are increasingly demanding cryptocurrency solutions, and 45% feel pressure to add cryptocurrencies specifically to appeal to younger investors, according to the 2021 Natixis Investment Managers Pro Fund Selector Survey, which surveyed 141 U.S. investment professionals representing $2.7 trillion in client assets.

Of those surveyed, 68% do not believe that individual investors should have exposure to cryptocurrency, and 70% say their firms need additional education in digital assets and cryptocurrencies before investing in them.

Dave Goodsell, executive director of the Natixis Center for Investor Insight, told CNBC that investment professionals’ reluctance to embrace cryptocurrencies can be traced to challenges associated with their relative lack of transparency and regulation.

About 87% of those surveyed by Natixis said crypto assets need to be more transparent, and 84% think they will need some type of regulatory oversight.

“I think that makes it challenging to recommend such things if they’re in a fiduciary role,” Goodsell said, referencing the legal duty some firms owe their clients. “I think that’s where the hesitancy comes from.”