Presenting a live 90-minute webinar with interactive Q&A Emergence of Blockchain in Banking and FinTech: New Applications and Issues for Counsel Leveraging DLT Platforms for Recordkeeping, Payments, KYC and More; Concerns With Regulation, Privacy, Adaptation TUESDAY, SEPTEMBER 12, 2017 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Ralph F. (Chip) MacDonald, III, Partner, Jones Day, Atlanta Stephen J. Obie, Partner, Jones Day, Washington, D.C. & New York Ralph A. Daiuto, Jr., Chief Operating Officer and General Counsel, t0.com, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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5 Emergence of Blockchain in Banking and FinTech
Faculty Dzmitry Maroz, Senior Manager, Deloitte Advisory US Dzmitry, senior manager in Deloitte & Touche LLP, has over 15 years of experience designing and developing financial technology solutions. Dzmitry has actively participated in the development of the loan market s FpML standard and is a Deloitte Advisory Blockchain Fellow. Ralph A. Daiuto, Jr., Chief Operating Officer and General Counsel, tzero.com, New York Ralph is an accomplished attorney and business leader with over two decades of experience in the securities industry, establishing and managing several broker-dealers and innovative technology companies and overseeing their daily operation, including legal, compliance, and regulatory matters. tzero, a fintech subsidiary of publiclytraded Overstock.com, is a world pioneer developer of Blockchain based technology. Ralph is also the General Counsel of SpeedRoute, LLC and PRO Securities, LLC, both broker-dealers registered with FINRA & SIPC. Ralph F. (Chip) MacDonald, III, Partner, Jones Day, Atlanta Chip's practice emphasizes securities, mergers and acquisitions, corporate governance, financial institutions (including REITs, investment managers, and broker-dealers), and financial products. He is a frequent speaker and author on matters related to financial and investment services and products. Stephen J. Obie, Partner, Jones Day, New York & Washington, D.C. Steve advises multinational corporations and individuals on U.S. securities and commodities law compliance. He led the team that obtained the first ever effective registration statement that contemplates a public offering utilizing blockchain technology. 6
Blockchain/DLT overload? 7
What we will cover What terms will we use? What is Blockchain? What problems does Blockchain aim to solve and its advantages? Blockchain vs.bitcoin How Blockchain transactions work Blockchain in action What are some of the challenges to implementation? Questions and contact information 8
What terms will we use? Distributed Ledger shared/consensus record simultaneously maintained and auditable by its participants Blocks encrypted transaction record that, once validated, is built upon to create a chronological chain which constitutes the entire history Hash function a one way function that maps/represents data in a Block as data of a fixed size Hash value the value created by a hash function that can be used to substantiate transactions Smart Contract computer code of terms and conditions that lead to self-executing transactions 9
What terms will we use? Immutable Data can only be appended to the Blockchain but cannot be edited or deleted Timestamped Transactions on the Blockchain are time stamped, making it useful for tracking and verifying information Encrypted Encryption is used to protect information stored on the network and make it tamper-proof Consensus-based verification Transactions must be verified and agreed upon as valid, by majority of the network to avoid malicious activities in the network 10
Centralized System Central intermediary A central intermediary (e.g., a bank, government agency) transfers actual value between two parties Separate ledgers All parties involved in a transaction maintain a separate ledger with central intermediary often used as the final authority on correct version of the ledger Single point of failure When a party loses its database and does not have a backup, information is lost Typical examples of centralized databases are relational databases we are all familiar with. When Financial Institution A buys an asset from Financial Institution B, both parties A and B will have separate records of their transaction in their separate databases 11
Decentralized System Think of a group of friends sharing a ledger. Each person in this group has their own copy of the ledger where they record every new transaction among group participants. Each person in the group independently verifies every new transaction before recording it into the ledger. Digitally distributed Immutable Timestamped Encrypted Consensus-based verification 12
Distributed Ledger Centralized databases have one authoritative copy of a ledger maintained by a trusted party such as a central bank Blockchains are decentralized databases where a ledger is stored by all users on a common network Bank Ledger Dan Laura Date Person Amount 2016-01-05 Dan 40 2016-01-11 Laura 29 2016-01-15 Jen 82 2016-01-28 Dan 17 2016-02-02 Jack 21 2016-02-05 Laura 42 2016-02-11 Jen 8 Jen Jack 13
What is Blockchain? 14
What is Blockchain? A type of distributed ledger technology ( DLT ) It is a collection of technologies that allows information sharing between users on a network (e.g., public-private key encryption) A Blockchain is a shared list of sequential records called Blocks Each Block contains a validated record/data and a link to the previous Block Blocks are linked together into a Blockchain where changing or removing a Block may invalidate others within the chain The chain may then be revalidated by the user making the change and others (consensus) Consensus creates consistency and reliability in recordkeeping Blockchains can be shared publicly or privately with selected users internet versus an intranet 15
Advantages of Blockchain 1. Near real time - Efficiency Blockchain enables the near real time settlement of recorded transactions, removing friction and reducing risk. 1. Near Real time Blockchain The Internet of Value 5. Immutability 2. No intermediary 4. Irreversibility 3. Distributed ledger 2. No intermediary - Disintermediation Blockchain technology is based on cryptographic proof instead of trust, allowing any two parties to transact directly with each other, without the need for a trusted third party. 3. Distributed ledger Audit trail The peer-to-peer distributed network records a public history of transactions. Blockchain is distributed and highly available. The Blockchain does not typically preserve the identities of the parties nor the transaction data, only the proof of the transaction existence. 4. Irreversibility Audit trail The Blockchain contains certain and verifiable records of every single transaction ever made. This helps prevent double spending, fraud, abuse and manipulation of transactions. 5. Immutability Audit trail The daisy-chained cryptographic framework prevents past blocks from being altered. 16
Blockchain vs. Bitcoin While Bitcoin is still the most well known implementation of Blockchain technology it is important to remember that the two are not synonymous. Blockchain technology has many potential applications outside of Bitcoin. Blockchain Bitcoin Distributed ledger, which means it is copied to all participants on the network. Applications often extend beyond financial use cases Leading digital currency Has existing ecosystem with numerous consumer-facing applications Industry adoption with institutional participation 17
How Blockchain transactions work Transaction is initiated Transaction is placed into a queue Transaction is verified and placed into a block. Nodes verify transactions Valid blocks are added to the ledger All blocks are linked to each other 1 2 3 4 5 6 18
Blockchain transaction Transaction is initiated Two parties exchange data; this could represent money, contracts, deeds, medical records, customer details, or any other asset that can be described in digital form. 1 A simple example is Person A buying a product from Person B for 10 dollars. When transaction is submitted to the Blockchain, each party is represented by their public key identifier that is unique to each participant. Person A 03c6691ebdd1613 63457e3c73a8ed4 4186536cf9 Person B 6025f94596c2445f 0a776d9bac92982 9de3 19
Blockchain transaction Transactio n is initiated Transaction is placed into a queue 1 2 Depending on the network s parameters, the transaction is either verified instantly or transcribed into a secured record and placed in a queue of pending transactions. In this case, nodes the computers or servers in the network determine if the transactions are valid based on a set of rules the network has agreed to In this step, we simply confirm that transaction is properly formatted and has all the necessary attributes. It is similar to verifying a check before depositing it. Before we can process the check we need to confirm that all required data is there date, amount, payee and payer. 20
Blockchain transaction Transaction is initiated Transaction is placed into a queue Transaction is verified and placed into a block In this step transactions are added to a block and encrypted. Block is now ready to be validated and confirmed by the miners/verifiers 1 2 3 Each block is encrypted using an algorithm agreed upon by the network. A block contains a header, a reference to the previous block s hash, and information that is being recorded to the Blockchain. The sequence of linked blocks creates a secure, unique signature. Block 1 Block 2? 21
Blockchain transaction Transaction is initiated Transaction is placed into a queue Transaction is verified and placed into a block Mining explained If we go back to our example of friends sharing a ledger, you can think of mining as a competition of who can verify new transaction first. 1 2 3 Every time new transaction is announced, friends compete against each other to verify if transaction is valid. First person to confirm new transaction informs everyone A process that allows anyone to verify transactions else and asks them to confirm their result. Miners sometimes earn money for their verification services Process is made intentionally difficult in open systems to prevent cheating (proof of work) Proof of work is only relevant to open systems like Bitcoin 22
Blockchain transaction Transaction is initiated Transaction is placed into a queue Transaction is verified and placed into a block Nodes verify transactions 1 2 3 4 Blocks must first be validated to be added to the Blockchain using consensus or other agreed upon validation method. If a block does not meet validation requirements, it is rejected by the network and discarded from transaction queue Block 1 Block 2 Block 3 23
Blockchain transaction Transaction is initiated Transaction is placed into a queue Transaction is verified and placed into a block Nodes verify transactions Valid blocks are added to the ledger 1 2 3 4 5 When a block is validated, the miners that solved the puzzle are rewarded and the block is added to the Blockchain. Block 1 Block 2 Block 3 24
Blockchain transaction Transaction is initiated Transaction is placed into a queue Transaction is verified and placed into a block Nodes verify transactions Valid blocks are added to the ledger All blocks are linked to each other 1 2 3 4 The block is added to the Blockchain is distributed through the network. Each node adds the block to the majority chain, the network s immutable and auditable Blockchain. Once the block is added to the chain, each participant on the network has the same copy of the ledger 5 6 Each block in the Blockchain references previous block. With every new block, Blockchain becomes more tamper-proof. 25
Blockchain in action Blockchain is being used today Bitcoin Everledger Transfer and custody of physical assets Issuance and transfer of securities 26
Blockchain in action (tø) Overstock preferred offering using Blockchain Eliminates T+3 and DTC, now T0 Track and confirm shares, holders, and transactions 27
Application to securities transactions Proof datasets/distributed ledger created hourly 28
Blockchain in action Smart contracts Electronic contracts with transfer of ownership provisions coded into the contract itself. Both tamperproof and self-executing, without the need for trusted third-parties. Identity management A cryptographic distributed etwork could be used to verify people s identities, such as passports, social security numbers, tax id numbers and driver s licenses IMPACTS Lower transaction costs Increased information sharing Elimination of requirement for trusted third-party intermediaries Intellectual property Encrypted and time stamped documents stored on the blockchain can be used to document ownership of IP without revealing the information it contains. Medical records Patients can hold the private key used to encrypt their medical data, using public keys to share selected information with doctors only when desired Transfer of property Fractional bitcoins marked with certain properties, also known as colored coins, are use to represent digital or physical assets such as a house or a car. 29 Foreign exchange The ability to securely clear and settle transactions bilaterally using the blockchain opens the FX market to non-bank market makers, tightening spreads and lowering transaction costs
Potential FinTech Opportunities Blockchain Startups Focus on digitizing assets, improving anti-counterfeit measures, and digitalizing transfers of company equity and ownership Bitcoin Startups Hybrid Startups Focus on payments, exchanges, trading, and other uses of digital currency Focusing on both of the above
Applications to KYC Currently Banks & Institutions perform KYC individually and upload information Blockchain Potential Creation of central customer registry with each customer having a unique identification number Benefits Remove KYC duplication efforts Allows distribution of encrypted updates to client details Provide historical record of client documents and compliance activities
Dealing with Real World Assets Land registration Identity management Foreign exchange, money transfer, securities transactions Medical records Voting Smart Contracts
Application to securitizations Red = Payment Blue = Contract Borrowers/Mortgagors Funds Mortgage Loans Loan Originator/Seller Funds Mortgage Loans Funds Securities Investors P&I P&I (Principal & Interest) Contract Depositor/Sponsor Funds Mortgage Loans Trust (Loans & Foreclosed Properties) P&I P&I Contract Paying Agent Trustee Contract Master Servicer/Servicer Contract Custodian 33
Application to payments The future of financial infrastructure, WEF (August 2016) 34
Application to payments The future of financial infrastructure, WEF (August 2016) 35
Blockchain and the Gramm-Leach-Bliley Act The Privacy Rule Limits the means of disclosure of non-public personal information about a consumer to non-affiliated third parties Requires the disclosure to consumers of certain privacy policies and practices regarding the same Must provide consumers with the ability to opt-out of the disclosure The Safeguards Rule Compliance with regulatory standards relating to administrative, technical, and physical safeguards of consumer records and information Appropriate due diligence on third-party service providers 36
Blockchain and the Gramm-Leach-Bliley Act Blockchain can help Track information sharing with third-parties, disclosures to consumers, and opt-outs Compliance with standards through encrypted Blockchain/DLT and private network GLBA, FCRA, and the SEC's "Regulation S-P" all require personal financial data to be redactable BUT, might be difficult on an immutable platform 37
Smart Contracts Smart contracts are computer protocols that execute transactions when a set of predetermined conditions are met. These electronic contracts are tamper-proof and selfexecuting, without the need for trusted third parties 38
Dealing with Real World Assets Smart Contracts Smart Contracts build off of Blockchain, like macros to an Excel file Automated contracts Working with real-world assets, when a pre-programmed condition is triggered the smart contract executes the corresponding contractual clause (life insurance payout upon death) 39
Dealing with Real World Assets A smart contract between a bank and a car buyer provides legal ownership to the buyer as long as the person makes loan payments to the bank. An external trigger in the shape of a late payment will automatically block use of the car by black-box engine communication. In case the buyer fails to make up the payment default, the smart contract automatically returns the legal ownership of the car to the bank. The processes are transparent, absolutely clear, and automatically executed. 40
Smart Contracts Peer-to-Peer Contract Creation Fulfilment Traditional Contracts Third Party Contract Creation Trade-off exists between the level of guarantee of fulfillment and transaction costs / speed Program protocols to execute transactions when a set of predetermined conditions are met. These electronic contracts are Blockchain Smart Contracts Programmed Smart Contracts tamper-proof and self-executing, without the need for trusted Decentralized third System parties. Self-executing automated contracts provide high-level of guarantee of fulfillment at low costs The degree of reliance and efficiency is dependent on thirdparty intermediaries capabilities Build on the strengths of the Blockchain technology (i.e., unbiased, programmable, immutable, and immediate) Types of Smart Contracts Time Locked Service Assets are put on hold based on contractual terms for a specified period of time Third-party Service Utilizes a trusted third-party information feed to trigger contractual payouts Escrow Service A trusted third-party helps mediate the execution of the contract Examples of Potential Applications Banking Payback schedule built into Claims payout based on loan contracts, executed automatically based on interest rate feeds Insurance trusted data feed (e.g. for crop insurance using weather data) Real Estate Immediate property deeds transfer tied to settlement of funds Capital Markets Automated execution, clearing and settlement of financial derivatives 41
What are some of the challenges to implementation? Blockchain will NOT happen overnight But it is coming Nearly nine out of 10 senior executives in financial services and information technology believe that blockchains will be used on a daily basis in the finance industry by 2026 42
What are some of the challenges to implementation? Practical Translation to different business functions Adoption by major market players Cost of systems & implementation Integration into risk management framework Talent acquisition and development Technological Cyber security Systems acquisition & licensing Replacement of legacy systems Interoperability with internal & external users Data storage requirements Regulatory/Legal Cyber security standards & compliance Regulatory recognition or rules Nature of the asset (property v. personal rights; documentary intangibles; possession, delivery or ownership) Courts differing views on the nature of the asset and enforceability of agreements. 43
What are some of the challenges to implementation? Jurisdictional Liability Regulated Products Cybersecurity & Data Privacy Intellectual Property Governing Law? Place of performance? Nature of asset transferred? Enforceability Technology or design failure Performance In or out of regulation? Reporting The rise of ICOs and issues with securities laws Ensuring compliance with state and federal regulations Data and verification breaches? Patent acquisition Patent litigation Open source 44
Legislation/Licensure Arizona Delaware New Mexico New York Vermont Washington 45
Financial Regulators Federal Reserve OCC Distributed ledger technology in payments, clearing, and settlement FinTech Charter CFTC SEC FINRA 46
More regulation and legislation is coming 47
Questions? 48
Thank You! Dzmitry Maroz (212) 436-2442 dmaroz@deloitte.com Ralph Daiuto, Jr. (347)694-7816 rdaiuto@tzero.com Chip MacDonald (404) 581-8622 cmacdonald@jonesday.com Steve Obie (212) 326-3773 sobie@jonesday.com 49
Law/regulation is stated as of September 2017, is intended as general guidance only and should not be relied on in respect to any specific matter. Views expressed are those of the individual presenters and not those of Jones Day or their respective clients. 50
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