There’s a lot of discussion happening in payments, financial services, and technology circles about the block chain and its utility for managing digital assets.

Since Chain.com is at the center of many of these discussions, I wanted to share our thoughts on why people are excited about digital assets, what the benefits of using the block chain are, and how it relates back to bitcoin.

It’s become widely known that, thanks to the bitcoin protocol, we can now send money over the Internet directly between two entities. The mechanism which enables this is the block chain, a shared ledger of linked addresses which correspond to privately controlled keys. To send money, a user takes her key and signs a transaction, directing funds from addresses she controls to a recipient’s address. No intermediaries — just the open network.

But here’s the big idea: using open source protocols which extend bitcoin, we can send any type of value the same way: stocks, reward points, prepaid minutes, stored value cards, dollars, etc.

Financial services companies have a lot to gain. By transferring assets digitally over Internet-based networks, they can avoid using costly clearing houses or doing complex integrations across entities. They’ll also be able to build more innovative products.

And that’s good for everyone else. When trusted institutions issue digital assets on the open Internet, financial services will be less expensive, more secure, work better together, and be accessible to more people around the world.

How exactly do you issue and transfer assets on the block chain?

Here’s how it works:

1. Creating digital assets. Digital assets are created by an issuer using a private key that is unique to the asset being issued. The assets are recorded on the block chain in a special metadata field of a bitcoin transaction — which can store 40 bytes of data, enough to encode the asset and point to anything else which is relevant about it (such as associated legal documents). This metadata field is a bit like the memo line on a check.
2. Issuers define the value of the asset. Unlike bitcoin, the face value of the asset is worth whatever the issuer says it’s worth. A real-world analogy is a $100 American Express Travelers Check, which is accepted as $100 USD around the world because everyone knows Amex is good for it. This is one reason financial institutions are interested in digital assets — they have a critical role to play as an issuer, especially if they have a strong brand and reputation in a particular market.
3. Bitcoin is the oil in the machine. When creating or transferring a digital asset, you use a standard bitcoin transaction as the mechanism, which requires bitcoins to pay the fee that keeps the network secure. But very little bitcoin is needed for any given asset transaction. Even if the issuance or transfer involves billions of dollars of value, only pennies worth of bitcoin are used. It’s like a postage stamp on an envelope full of assets.

Wait, how is this better than a database?

After all, the world already has “digital assets” — the assets just happen to be entries in databases at various financial institutions, processors, and others. How is the block chain any better?

Here’s the question we like to ask instead: Under what conditions is the block chain the best solution for managing digital assets in a market?

Based on our learning from projects with payments and financial services companies, we’ve found the block chain is ideal in markets with the following characteristics:

• There are many entities in the market
• Assets move frequently between these entities
• New parties regularly enter or leave the market
• There are different types of assets interacting

In markets like these, moving assets with a database requires either:

1. Using a third-party clearing house/escrow service (i.e., central database)
2. Integrating systems together across entities (i.e., many databases)

The first approach is common when the entities perform similar functions and are similar in size (see: Securities, Telecom, Energy, Banks). But clearing houses can be expensive and inefficient because the third party intermediary tends to become a monopoly and act like it: high fees, slow to innovate, hard to replace. On the plus side, it’s easier to add new entrants, and it pushes a lot of complexity out of the entities.

The second approach, integrating systems directly, is more common when there are entities at different levels in a market, for example, a card network and a merchant, an issuer and a distributor, a business and its customers. It lets the parties involved be in control of their own destiny. But the problem with system integrations, even if they are API-based, is that they’re expensive to build, hard to change once operating at scale, and difficult to integrate new partners into. It also tends to multiply points of failure and create more opportunities for fraud.

What we ideally want is a system which moves the complexity of transferring, settling, and recording assets out of the entities — like a clearing house — but allows for direct transfer of assets between entities — like an integration. And unlike both of these systems, we want a solution that is flexible, transparent, extensible, and inexpensive.

In other words, we want a block chain

The block chain offers the following unique benefits for asset transfer:

• Assets move directly between entities — transfer and settlement are one-and-the-same — eliminating counterparty risk
• Assets move instantly, and settlement time is ~10 minutes (settlement can also be instant if the parties trust the other won’t “double spend”)
• The transfer mechanism is public infrastructure and is always improving — everyone has a shared incentive to make it better, similar to Internet protocols like email and http
• Assets and end-user data are privately controlled, and strong security for assets can be achieved by using multiple signing keys across several parties
• Policy rules about the movement of assets can be enforced programmatically — whether those are “terms and conditions” or regulatory requirements
• Assets are fungible and play nice together — e.g., you can use reward points to buy mobile minutes
• A single transaction can include multiple entities and assets, on both sides of the transaction — e.g., you could execute a merger of two companies in a single transaction, with the inputs to the transaction being all stockholders across all share classes for both companies, and the outputs being all the newco shares going to all the new stockholders (again, no escrow service needed)
• Every transaction is added to an immutable record which, while anonymous, can be used to construct a perfect audit trail of an asset’s movement when combined with the private data held by the entities using the system — this defends against fraud, and also gives issuers transparency into asset movements
• It’s easy to integrate new parties
• Like the Internet itself, it’s a global system

The financial cloud

What this sums up to, in essence, is a financial cloud. We call it the financial cloud because it de-couples financial infrastructure from the products and services that run on it.

This enables innovation, since the product specs can dictate the implementation, as opposed to the current system where the particulars and history of the infrastructure dictate a great deal of the end-user experience. (Dissatisfaction with financial products is one reason fintech start-ups are “unbundling” the banks.)

Unlike traditional cloud computing, private data never leaves the company’s system thanks to the cryptographic model of the block chain.

What types of assets will migrate to the financial cloud?

Below are a few illustrative examples of assets that could soon be managed on the block chain.

As you’ll see, this isn’t about asking people to embrace bitcoin. Far from it, it’s about solving problems for consumers, businesses, and the institutions who serve them.

• Reward/loyalty points. Moving points to the block chain benefits the issuer because it makes it easier to integrate with partner programs, could expand the merchant network accepting them, and enables more customized, programmatic integrations (for example, improving the exchange rate for a special event). Consumers have more ways to spend points and could move them more easily between different digital wallets. And the bank issuing the points would have greater visibility into its liabilities and usage patterns.
• Securities. For private companies, the block chain could be used as an immutable cap table system, and would enable more efficient issuing, converting, and transferring of shares between investors, employees, advisors, etc. For public companies, block chain issued securities could one day eliminate many of the intermediaries that clear and settle securities, reduce margin requirements by eliminating counterparty risk, enable more sophisticated trades involving many assets at once, and — in the very long run — make the financial markets more transparent.
• Stored value cards. Cryptographically secured stored value cards would reduce fraud by eliminating the need to send plaintext static codes between entities, and would improve back-office operations by providing a transaction history of spending, something that is not possible today. Consumers would be able to use them more flexibly (e.g., combine various cards, hold them in different wallets, etc). Issuers could programmatically enforce regulatory requirements.
• Pre-paid minutes. Carriers could move pre-paid mobile minutes between subscribers on different networks without using a central clearing house, allowing their subscribers to more easily transfer them. Carriers could also allow for easy conversion of minutes to other assets, or allow subscribers to use them directly as a currency.
• Energy credits: Consumers and businesses generating green energy through solar or other means could begin to form marketplaces to buy and sell their energy. The block chain provides a mechanism for many small entities to store and trade these credits.
• Currencies: IOUs in any currency, issued on the block chain by a financial institution, would provide frictionless liquidity in all the above digital asset markets. They could also become the everyday digital currency in mobile-centric payments markets in the developing world.

Where to start?

Here are the steps for building a block chain based service:

• Define the problem. Understand the problem the block chain solves for your product and market (hopefully this article can help in this regard). Pick a small problem first to build momentum and understanding.
• Prototype solutions. Design and iterate with your customer at the center. Take advantage of the fact that it is easy to test and prototype on these open networks and build many possible solutions.
• Connect to the network. Run nodes and keep a real-time index of pre-computed balances and transaction history, including a full index of digital asset metadata. Ideally, run nodes all over the world and tune them to achieve as close as possible to a real-time view of new transaction activity.
• Manage address data. To ensure end-user and system privacy, it is critical to use a new address for every transaction (using what is called a hierarchical deterministic, or HD, wallet). Since systems will have thousands of users, it will require generating, managing, and tracking data relating to millions of public addresses.
• Securely sign transactions. Do not store all the private keys for a system in one organization. Separate the signing keys between at least two entities, and store a third key with an offline custodian. Use a transaction co-signer to enforce policies, like transaction limits.
• Operate the solution. Keep all the nodes online, regularly rotate the private keys, hold or buy bitcoin to power transactions, and ensure the data access patterns are as fast as possible.

Chain.com helps our customers do all these things. After all, the above components are all about execution, and none is a competitive differentiator — that comes back to your specific idea or product, brand, customer orientation, and the technology platforms inside your company.

Specifically, Chain.com serves as a transaction co-signer to strengthen security, a data provider to ensure privacy and availability, and as a design partner to help companies think through the ins and outs of a particular implementation. We also operate teams of on-call engineers to ensure the reliability of all these systems.

We love helping institutions large and small, across different industries and countries, to move more quickly, operate more securely, and build truly innovative products on the emerging financial cloud.

Feel free to get in touch.

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