To understand how blockchain technology works and what its future impact will be on SMSFs, get ready to clear your mind.

Everything you read from here on will be counter-intuitive to your current perception of how an SMSF works in today’s capital markets.

In simple terms, blockchain technology enables an electronic transaction to be added to a decentralised global ledger that contains every transaction since its inception.

The transaction must be verified through a ‘proof of work’ protocol prior to being accepted to the continuously growing ‘block’ of electronic transactions that creates the blockchain.

Explanation through analogy

Let’s use email as an analogy to explain how the mechanics of blockchain technology works with BTC (without the blockchain jargon).

An exchange of BTC from one party to another starts when a transaction record is emailed from the sending BTC party to a global mailbox of BTC users.

The email must be formatted in line with a set formula and comply with a specific set of rules. Both parties are required to have their public and private digital signatures included in the email for identification purposes.

Before delivery, the email is encoded into a mathematical sequence by the BTC network.

This is where it gets more conceptual and interesting.

The email is added to the global mailbox, but in draft form.

And here’s the kicker: everyone works from a copy of the global mailbox that gets synchronised only after a BTC user verifies the mathematical sequence in the draft email.

In effect, thousands of versions of the global mailbox are being worked on at any one time.

The verification process is extremely complex and requires significant computational effort through proof of work protocols.

One of the processes includes reviewing every single email that’s already been verified, as well as those in draft form. This ensures there’s no double spending and reduces fraudulent transfers.

There are tens of thousands of BTC users attempting to verify the email. It usually takes about 10 minutes and the successful BTC user receives a fee for their efforts.

Once the email is verified as being true and correct, it’s added to the global mailbox with the most confirmed emails and re-synced.

All BTC users start working from the newly synced global mailbox, the account balances of both parties are updated and the transaction is complete.

And this is how that sounds in blockchain terminology: a transaction record is broadcast out through a peer-to-peer network to a specific set of nodes. A cryptographic hash function is applied to produce a block, which is verified by BTC miners through proof of work protocols. Once confirmed, the nodes integrate it into the blockchain containing the most blocks, which then becomes the accepted blockchain.

Application to SMSFs

One of the main advantages of blockchain technology is the availability of the electronic ledger. It’s located in a de-centralised system that’s continuously updated, open to everyone who uses it and those willing to download it.

By their very nature, the transactions are accessible, transparent, efficient, cheap, quick and don’t require a trusted third-party intermediary. The reason is that the system creates its own trust as each block in the ledger is verified through proof of work protocols.

The potential application of blockchain technology to the financial services industry, and especially SMSFs, is unlimited.

With more than 60 per cent of all SMSF transactions currently undertaken through banks, stock exchanges and other financial intermediaries, the potential to use proven blockchain technology could be revolutionary.

Developing the blockchain

It’s estimated that there are more than 750 blockchain start-ups, with total global investment in blockchain technology exceeding US$1 billion.

The regulators, along with the banks, are closely looking at the advantages offered by blockchain technology.

ASIC has recognised that blockchain technology will have profound implications for how they regulate in the future. They have responded by implementing education programs, providing guidance to the financial services industry, monitoring markets and reviewing policies.

The financial services industry is investing heavily in blockchain technology as it removes the ‘middle man’ and will save billions of dollars in transaction costs.

What are the risks?

Blockchain technology creates two-way accountability between parties by adding security and assurances for digital transactions.

While it’s extremely rare to defraud the blockchain, it’s not impossible.

Within the BTC community there have been documented occurrences of fraudulent behaviour including:

1. BTC insiders (or miners) stealing BTC;

2. hackers accessing private information from BTC trading companies; and

3. honest consumers purchasing goods and services from untrusted sellers.

However, widespread fraud is not prevalent because of the public nature of the ledger and the difficulty required to undertake high-volume illicit transactions.

The proof of work required to verify transactions is also designed to be hard and requires sophisticated hardware – not just the average laptop – to solve it.

And remember, the blocks are securely encoded (or hashed) and cannot be undone or changed. Once it’s in the blockchain, it’s there forever and on public record.

Risks for SMSFs

The biggest risk for the blockchain is the integrity of the system. Blockchain technology cannot and does not analyse or detect fraud.

We’ve already seen examples of illicit trading in BTC through the anonymous Silk Road marketplace; ransomware demands by hackers and scammers; money-laundering operations; gambling and drugs.

The main risk for an SMSF is when identification of the other party in the transaction results in compliance breaches:

1. Is it a related-party transaction?

2. Can contributions be accepted?

3. Has the fund lent money or provided financial assistance to a member or relative?

4. Has the fund borrowed money?

5. Has there been a charge given over the assets of the fund?

Luckily, this risk will be mitigated in regulated financial markets by creating trust using “permissioned ledgers” or blockchains with restricted membership.

But what about other assets that fall outside traditionally regulated trading markets?

Developers are starting to build overlay networks that work in parallel to the BTC blockchain to do things that BTC can’t.

Will we see a blockchain trading market where SMSFs can buy and sell non-traditional assets such as antique and collectibles? Will property ever be bought through the blockchain?

How far away are we from seeing and using blockchain as a platform?

The future for SMSF advisers and auditors

The evidence is that blockchain technology will change the SMSF landscape within the next two years.

In February this year, the ASX said it will be releasing a parallel blockchain trading platform to CHESS within six to 12 months. They will then decide whether to replace the CHESS system entirely within 18 months.

One of the big banks has indicated it will be introducing distributor ledger technology within 12 months.

SMSF advisers and auditors (along with the rest of the financial services industry) will have no choice but to adapt when the time comes.

For those SMSF advisers using an administration platform with direct feeds from regulated markets, there’s not going to be much difference: getting blockchain data onto a platform will be a job for administrators.

The real test will be assisting SMSF clients in understanding and using a new blockchain trading platform, similar to when CHESS was first introduced.

One thing’s for certain: the blockchain is going to reduce transaction costs and shrink margins in the financial services industry. SMSF trustees should get ready to pay more for services such as receiving paper-based communication and contacting a call centre.

For SMSF auditors, the changes will produce mixed results. Verifying SMSF transactions that aren’t on SMSF platforms may result in having to audit the blockchain to ensure compliance.

As there’s no available information on how this blockchain architecture is being designed, it’s difficult to understand how it will work in practice.

It could mean that SMSF auditors will have to request different information from SMSF trustees – such as their public key – to verify fund assets.

In any event, SMSF advisers and auditors should be aware the blockchain revolution is coming and prepare to adapt yet again. Denying that it’s going to be a game changer will mean getting left behind.

Shelley Banton, director, SuperAuditors