Tuesday, October 17, 2017

Building trust with blockchain

by Erich Schnoeckel, manager accountancy program ecosystems, Exact

Central to any business transaction is the notion of trust. Without it the wheels of commerce simply can’t turn. However, in today’s digital business environment, there are fewer physical and tangible things that we can use as proof points to establish and support trust in trading relationships.

Paper trails, trading histories, physical movement of goods and physical working actions are just part of what used to play a role in establishing trust between one party in a transaction with another party that may not have direct prior knowledge or experience of the first party.

This is particularly true in banking and financial services, where lines of credit such as an overdraft, loan or invoice factoring are frequently extended to a party based on trust, rather than on securitisation.

Everything from orders to invoicing, as well as the provision of many business ‘services’ can be entirely digital rather than a physical movement of goods from A to B. This can make it hard for a business – especially a small business – to win the trust of a lender or business banker.

Without tangible evidence of business activity to point to, it’s difficult for a small business to prove itself to be a sound investment risk for a bank. Demonstrating that the business has a real pipeline of work and invoiced revenue is challenging, or at least inefficient.

A pile of crumpled invoices on non-headed paper is a fixed point that a bank is unlikely to trust as the basis for lending money.

In this environment, today’s businesses need a different way to access the liquidity and vendor trust that they need to thrive. We in the accountancy technology sector are working with practitioners to develop solutions that will enable this to happen. One such solution is triple entry accountancy. A

notion first explored in the late 1980s, technology has now caught up to enable the idea of an accountancy model where all accounting entries involving outside parties are cryptographically sealed and verified by a third entry.

This approach can be used to confirm that a logged transaction – such as an invoice or order – is a genuine transaction with a real expectation of payment.


The role of triple entry accountancy

Triple entry accounting is a concept for small business accounting that uses blockchain to provide a means for trading entries to be verified by all parties involved in the transaction. Put simply, blockchain is a tamper-proof distributed digital ledger.

Born out of the bitcoin cryptocurrency, blockchain was the underlying ledgering system – that allowed all users of the bitcoin currency to record and keep track of transactions involving the currency. However, blockchain is far more useful than as a way to keep bitcoin honest.

With a blockchain, multiple parties (such as banks, accountants and traders) can write entries into a record of information, and a community of users can control how the record of information is amended and updated.

No one body, like a central bank, controls it, so a single point of failure won’t cripple the whole system. Entries can’t be hacked or surreptitiously altered without breaking the chain, as each record is authenticated by the transaction before and after it – interlinking every entry.

Blockchain-based triple entry accountancy therefore provides a single shared version of the truth, based up by the incorruptible technology of a ledger that can’t be tampered with.

It is a way for SMEs to gain quick access to funding, as well as provide financial information to lenders and other creditors that can be verified as accurate and truthful.

It uses blockchain technology to create an audit trail of transactions that can be verified by the host company, the company being invoiced, and by third parties such as banks and credit insurers looking to confirm the financial health of a business.

Companies using triple entry bookkeeping gain two immediate benefits. First, auditing is simplified, as more of the verification work normally done in an annual audit is already there – reducing the time and cost of the process as external auditors can quickly and easily verify financial statements.

Triple entry accounting won’t do away with the process of an annual audit, but it will reduce its complexity and criticality, as verification of accounts is continuous via the blockchain rather than annual.

Second, it can help reduce internal fraud. Income and expenses cannot be falsified if they require the encrypted signature of a counterpart in order to be accepted as valid.

Blockchain ledgering has its origins in bitcoin, where transactions only occur and exist when verified bitcoin currency is transferred between parties. Only at that point is the entry signed and inserted into the ledger.

There is simply no incentive to undertake the immense work needed to fraudulently tamper with existing entries. The unique cypher used to sign each transaction and interlink with the transaction before and afterwards means any tampering immediately shows up as it breaks the chain of transactions.

Taken together, these factors make it easier to borrow money and access bridging loans, invoice factoring and so on. Essentially, it becomes simpler to get up-front payment on invoices based on trust rather than having to secure money against physical assets.

By allowing all parties to verify and confirm a transaction, the accounts can serve as a trusted and independently-verified record of a business’s trading – something that can be trusted by a lender or credit insurer. It also supports the ability of the seller and buyer on a wholesale level to stagger their payments, building trust along the way.

For example: say Company A in the UK orders goods from Company B in China, an action that would normally involve paying up-front for the goods, often before they’ve even been made. Company A then waits anxiously for the shipping container to arrive from Company B, not certain that what was ordered is what is in the box.

With a blockchain-based transaction system like triple entry accounting, Company A can do staggered, verified payments to Company B. Company A reduces its risk, but Company B can be increasingly sure that payments are being made as the order reaches fulfilment, instilling trust in the transaction and using the blockchain-based accountancy system as a transparent record.


Trust still has risks

Even with triple entry accounting, there is a risk that one half of the transaction might try to defraud the other. A blockchain ledger won’t stop this, but it will create a fixed trail of events and of the break in trust and reputation, meaning that the defaulting party will not be able to walk away from the black mark on their record.

It will also show that the defrauded party entered into the transaction in good faith, and represented the validity of the transaction to lenders, insurers and suppliers genuinely.

Blockchain provides a trust element that allows debt to be traded as a commodity more reliably, without the need for third party credit assessment.

It means that small business debt can be sold on or traded on open exchanges, with more transparency than we have seen with things like mortgage-backed securities.

Widespread use of triple entry accounting will allow people to have better access to money, as well as know more about the people they are doing business with. Ultimately, it is a mechanism whereby banks and insurers can extend responsible lines of credit to a company.

Where the notion of trust can be based on tangible evidence, even in a digital workflow with no physical product being moved from A to B.