A lifecycle of a transaction on the Blockchain

The previous blog argued that crypto assets can have various implications on the today’s globalized economy and society (read here). In order to understand how crypto assets enable this, it is important to understand how the process of a Blockchain-based crypto asset transaction differs from the traditional way of transferring values, e.g. money. Author: Fabrice Gürmann

Close-up of a person's hand holding a computer mouse

This blogpost discusses this difference in detail to provide a better understanding why the public, unpermissioned Blockchain technology is considered one of the key enabler for the digitalization of business operations.

The transfer of money is one of the most often referred to applications of the Blockchain technology. This blog post aims to explain in detail how the transfer of money works, to highlight today with well-known instruments such as credit cards or bank transfers and how it compares to its Blockchain-enabled equivalent. It offers an evaluation of it’s the pain points of the current, traditional process and, argues the solution that Blockchain and crypto currencies propose.

A process using a third party in the traditional world 

A traditional money transaction can be summarized into three steps:

  1. authorization,
  2. clearing,
  3. settlement.

This post introduces an abstract of these three, for a detailed elaboration please see here or here. The lifecycle is illustrated in Figure 1. For the sake of clarity the blog post exemplifies the lifecycle with the example of a book purchase on Amazon.  

Authorization. Sometimes it takes a couple clicks to purchase a book and other times you would use what Amazon calls the “1-click®” purchase. Now you might ask yourself: how does Amazon know that you have enough money to buy the book? Amazon’s bank sends a request to your bank to check whether you have enough money to buy said book. The bank can then approve that you have the necessary amount. If it does, one can say that the transaction has been authorized. Now, you can receive the book and the receipt, but the transaction between Amazon’s bank and your bank has not been completed. This will happen in the later stages where you, as the customer, are no longer directly involved.

Figure 1: Transaction Lifecycle (Mastercard, 2012)
Source: MasterCard

Clearing. Once the authorization has been completed, the transaction has to be cleared. This means Amazon’s bank sends the purchase information to your bank*. This exchange of information is required to verify the amount that you owe to Amazon. Correspondingly, in this stage of the transaction life cycle, Amazon’s bank can submit their claims which in turn is verified by your bank’s validation system to determine that the information is correct. This process is known as clearing.                                                   

Settlement. The last step in the transaction lifecycle is the actual movement of funds from the buyer’s account to Amazon’s bank account. The posting of credits and debits in the accounts is based on the clearing data and involves interactions from the financial institution and the settlement bank, as well form my bank and Amazon’s bank. The figure below shows involved intermediaries in the transaction lifecycle. Important to note is the interchange fee. You do not pay your bank to complete the payment, but Amazon has to pay their bank. Therefore this fee is necessary to incentivize banks from issuing cards to customers.

Figure 2: Simplified abstraction of the transaction lifecycle

Pain points of a traditional process

Even though, the above description of a transaction seems fairly straightforward, it simplifies the actual complexity.  To perform the authorization, companies such as Amazon usually partner with front end processors who process the payment information on behalf of Amazon. For that, the front end processor has to check with the credit card provider (e.g. MasterCard) to make out the purchasers issuing bank. Hence, just by analyzing the very first process in a bit more detail, one realizes that three different entities are involved in the first part of the transaction. By the time the settlement has been reached, up to seven entities have been involved in the process, which of course results in delays (up to three days for the process) and in transaction costs (between 1 and 3%) paid by the merchant. The purchaser on the other hand, pays hidden fees such as the card issuance fees or interest on overdue credit card bills. Even though the costs and complexity seem already very high, it is even worse if a customer makes a purchase in a foreign country, where exchange brokers, currency messaging services and foreign exchange settlement operators cut further pieces of the pie.

Even though this post only gives a brief overview of how the transaction works, the description already illustrates the complexity involving plenty of intermediaries and processes along the way. This leads to the transaction process being non-transparent to customers and arguably relatively more costly. The blog summarizes the “pain points” of the lifecycle below:

  1. Individuals must trust our third party that they fulfill their task carefully. Even though the reliability is pretty high, the long list of intermediaries that require interaction results in an increased likelihood of errors. This makes it near to impossible to obtain a flawless process.
  2. Reconciliation periods, such as payment information synchronization between the multiple parties involved are long and costly, which results in time delays and high costs for merchants and clients and even more expensive for purchases in foreign countries.

The lifecycle of a transaction on the Blockchain

The above described pain points, especially the trust in third parties gave rise to many years of research on how to provide a disruptive innovation that can improve upon the current state of art payment routine. Bitcoin’s underlying technology proposes a new way of handling interactions between customers and suppliers. This new way is a decentralized ledger that is handled by an algorithm which is run by a multitude of servers / computers rather than multiple layers of intermediaries. This in turn decreases the rate of errors committed by social functions. As everybody has access to this ledger, it builds trust based on a decentralized network and removes as much direct human involvement as possible.

Reexamining the example above, the purchase of a new book at Amazon will look quite differently if you decide to use the Bitcoin payment option, the transaction lifecycle can be summarized as follows:

  1. The Bitcoin transaction is sent (broadcast) to all participating computers in the specific Blockchain network.
  2. Every verifying computer (i.e full node) in the network checks the transaction against some validation rules that are run by each verifying computer in the network. For example, the verifying computer will check your current balance to make sure you have enough money for the broadcasted transaction. It is very important that the verifying users are not able to deduce that you are buying a book, hence some privacy is provided.
  3. If the conditions specified in the rules have been met, transactions are stored in a block and cryptographically sealed with help of a specialized algorithm dedicated to this process. This process is also known as mining.
  4. The newly mined block is broadcast to every computer in the network. The computers check the block against some specific validation rules (I.e. if the seal on the block is valid) and propagate it to their peers if valid.
  5. Each verifying computer in the network that receives notice of the new block being mined checks the block against specific validation rules (I.e. if the seal on the block is valid), and adds it to their memory of the longest chain.
  6. Now the transaction is part of the Blockchain and can’t be altered in any way.

The verification and settlement happens with no direct human involvement and is thus less prone to human error than the traditional approach. Also, the Blockchain-powered scheme operates without any trusted third parties and is highly transparent for every user, yet pseudonymous. On this note, the blog summarize the benefits of the Blockchain below:

Benefits of the Blockchain for the clearing and settlement of a transaction

  1. Currently, the process from authorization to settlement involves multiple parties, making the process relatively expensive and slow. The Blockchain combines the authorization to settlement in one process that lasts on average 10 minutes instead of 3 days as depicted by MasterCard above**, making the lifecycle more time efficient. Furthermore, the automated consensus mechanism allows users to synchronize their data in real time, which removes the requirement for resource intensive reconciliation and governance schemes.
  2. Third parties are required for our traditional payment systems to convey trust between buyers and sellers. Blockchain solves the problem by asking the entire network of computers if the transaction is valid, therefore decentralizing the management of the credit balance of users. This does not only allow independence from banks, it also offers a cheaper payment service which is highly beneficial for services such as remittance payments.

Even though the Blockchain technology is immature and still needs to solve a number of challenges, the highlighted benefits show there is a clear potential to change the way money can be transferred. Clearly, Blockchain, and particularly its first application Bitcoin, aren’t yet able to compete with traditional payment providers in terms of transaction throughput and scalability. Regardless, new technological advancements such as zero-knowledge proofs and off-chain computations will potentially solve issues around scalability, security and transaction volume. The most recent proof for the maturing of the technology is, that MasterCard they is experimenting Blockchain based payment systems to assess whether permissioned Blockchain is actually able to replace their old method of handling transactions.

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.

*As aforementioned, keep in mind that the money has not been moved yet, even though you are already in possession of the book.
** Example Bitcoin.