14 March 2016

Chain reaction

This article was written by King & Wood Mallesons FinTech group including partner Andrew Wingfield and associate Matt Clift in London, alongside partner Scott Farrell and associate Anna Bennett in Sydney. This article first appeared in Luxury Briefing magazine. 

Best known as the technology that underpins digital currencies, blockchain had a breakthrough year in 2015, with investors waking up to its vast potential beyond payments, in particular as a 'smart' trust network. 

As a market where trust is everything, the potential of blockchain to transform the luxury space cannot be ignored. Provenance, quality, material, ownership, place of manufacture – from diamonds to watches to haute couture fabric, whether you’re buying, selling or wearing, these details matter. Blockchain has the key attributes for successful application to the luxury market: providing a safe, efficient and independently verifiable record of trade and ownership. It is a technology for truth, for a world where not everything can be trusted.

What is a blockchain?

Simply put, blockchain is a really clever technology. The world’s most famous blockchain application is the “bitcoin” cryptocurrency. Blockchain is the technology that works out who owns what bitcoins and who has paid them to whom. It uses a distributed ledger of ownership. In a way, the concept is not new to mankind. A useful analogy can be made to the coins used on the Micronesian island of Yap —Rai Stones— which weighed four tonnes. As they were impractically difficult to move, transferring ownership relied on informing each of the island’s inhabitants of transactions and the upkeep of a shared mental ledger.

Blockchain relies on the same simple principle – without the giant rocks and using shared electronic, rather than organic, memory – where people can share and verify communal knowledge stored in a digital ledger. While bitcoin has struggled with a reputation as a black market currency, fraught with pseudo-anonymity and criminal product purchases on the mysterious “dark net”, its technological engine, blockchain, is going from strength to strength in its other uses. And it is the blockchain technology, and not the particular use for bitcoin, which is capturing the minds (and infrastructure builds) of the world’s financial markets, investment firms, banks, insurers and more.

There are three key elements to blockchain technology: the “chain”, the “block” and the “distributed ledger” which records them.

  1. The “chain” - The “chain” is a record of transactions, each one following the one before. Ownership comes from the chain of previous transactions. Just as early land title was documented through a package of deeds showing all of the transactions which led from the original grant to the current ownership, so operates this chain. Take diamonds (which we consider in more detail below) – each dealing can be documented through a chain of ownership from the ground to the miner, to transportation, jewellers, private ownership and so on. Each step in the process is documented one by one, rather than with a digital record showing only the present owner.
  2. The “block” - The transactions (or links in the chain) are verified by third parties to ensure that the necessary requirements are met, for example that a seller is the owner of the diamond which is being sold. This verification is done in order and bundled into “blocks” of data for a number of transactions. Once verified, these blocks are added to the chain of previous transactions, lengthening the “blockchain”. Continuing the analogy, this is like those packages of land deeds being checked by other people each time a transaction happens, to make sure that the transaction is valid.This verified record of transactions is the blockchain.
  3. The “distributed ledger” - Crucially, the blockchain (record) is not just held in one place but held in many places at once, digitally. Each time a block of transactions is verified then it is added to the blockchain (in encrypted form) held in all of those places. This is like creating multiple identical copies of that deed package on the internet, with each of them being a “true” record of the history and current ownership. Safety is enhanced as fraudulent changes to one copy in one place is not enough to change the record. Key details for establishing ownership, place of origin, and quality of product cannot be tampered with by makers, owners, buyers, insurers or other interested parties.

From these blockchain cornerstones, a blockchain creator makes a series of choices. A key decision relates to the “open" or “closed” nature of the blockchain itself. Bitcoin uses an open blockchain, meaning that anyone with access can participate and reflecting the public-spirited nature of the Bitcoin platform. Alternatively, blockchains can be closed or private, such that only persons invited or entitled to access the blockchain are able to do so. A third option is to use a hybrid platform, with sensitive information such as policy details and police reports held on a private network, and the physical identifiers of the recorded object committed to and cross-referenced against the freely accessible public blockchain.

By creating a collaborative record of transactions, blockchain enables decentralised shared record-keeping infrastructure. Each participant in the blockchain agrees to verify transactions or dealings with the products as a community, or network.

How can blockchain be used in the luxury market: diamonds (and beyond…)

Insurance fraud is a multi-billion pound problem, with circa. £100 million per annum being paid out by insurers in relation to jewellery theft alone. Checking and certifying the provenance of an article in a fast and cost efficient manner is the key to eradicating or, in the least, notably reducing this problem.

In this context, blockchain-based businesses such as London-headquartered startup Everledger are developing solutions to help market participants fight back, starting by committing literally hundreds of thousands of diamonds to a distributable ledger, immutably recording multiple, cross-referencable data points about each diamond (from the carat size, cut, colour and clarity to the 40-odd metadata points that identify the stone). This ledger will be shared with insurers, auction houses and crime agencies in order to validate diamond trades. With these verified records in multiple places, the ledger can be consulted easily and affordably by the stakeholders. Participants can be named or anonymous, and transactions can be publicly viewable or not. Each part of the market benefits: insurers can trace ownership, serial codes and valuations before agreeing to insure, and price accordingly; buyers can prevent fraud; and sellers can ensure they receive market value.

And for Everledger, diamonds are just the beginning. It hopes to develop its platform for recording provenance to all types of valuable goods, from fine art to high-end clothing, in essence trust-stamping objects with a guarantee of their provenance, providing the end-consumer with a reliable source-to-sale narrative.

Of course, as with any evolving technology it is important to be mindful of the issues it may face in delivering on its promise and achieving its full potential as envisaged by its backers. Blockchain-driven businesses both inside and outside the luxury space will find it crucial to tie prototypes and concepts to demonstrable revenue streams if they are to survive and thrive. And legal and regulatory hurdles will need to be negotiated, too, particularly for blockchain startups seeking to provide services to banks and insurers, who will be particularly conscious of perceived security and personal data vulnerabilities.

That said, in an otherwise stagnant investment environment, blockchain is a technology that offers truly exciting opportunities and has the prospective power to transform the world as we know it. Based around a simple idea, it has the potential to deliver real benefits to consumers across a range of markets, facilitating fast, open access to reliable, authenticated information. As demand in the world’s luxury market continues to grow, issues such as the fraudulent trading and counterfeiting of goods will continue to lead to losses for producers, consumers and insurers. The blockchain provides them with the tools to fight back – and that's something we should all celebrate.

Data Central

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