“Let’s not throw the baby with the bath water”, is what the financial services industry seems to be saying. While they didn’t quite warm up to the Bitcoin, they are clearly embracing the Internet of Value that has been made possible by blockchain, the crypto-currency’s underlying technology, akin to internet/web for information. Today, blockchain is one of the most discussed technologies within the industry and is considered as one of the most interesting development on technology front. Even as we speak, many multinational banks have invested in proof-of-concept projects to explore potential applications for blockchain across the financial services value chain. In the recently held annual meeting of World Economic Forum (WEF-2016) in Davos, Switzerland, leaders of the world’s largest financial institutions, companies and organizations debated on blockchain technology as a disruptive innovation, which has potential to change the banking landscape.
While banks and financial institutions are busy testing out use cases, Central Banks of various countries have also shown interest in blockchain technology and have made statements that blockchain can provided great value to financial transactions, though they are still skeptical about acceptance of bitcoin as a main stream digital currency.
The fundamental idea of blockchain technology is to provide transparent and trusted dealings between trustless participants without the need for a centralized monitoring/regulating authority or an intermediary.
At a basic level, blockchain is a record or ledger of digital events/transactions that are shared with multiple participants/database. Each participant in the network will have a copy of the same ledger or in other words the ledger is replicated to all participants.
It is called a blockchain because transactions organized into blocks chained together and updated, with the longest chain representing the data that all computers use to validate new transactions.
Though bitcoin and other crypto currencies provides non-restrictive access to the network, banks/FIs and fintechs are also exploring permission based blockchain protocol, where entities can have different roles and access to the ledger.
The distributed ledgers that underpin blockchain technology have many transformative applications within the financial services industry. Let us briefly look at few of them.
Payments – This is a spac that has already been significantly transformed by digital innovation. But the focus has started to shift from proprietary payments services, or even regional hub and spoke partnerships, to a global model that enables real-time payments anywhere in the world. There are three ways in which blockchain technology can enable this transition. First, its near-real-time transaction processing capabilities can accelerate transaction validation and finalization to facilitate instant payments. Second, it eliminates the need for intermediaries by creating a decentralized network that enhances the trust and transparency of every transaction. Removing the intermediary will reduce transaction cost – cost of intermediation and risk pricing. Currently, due to cost structure prevailing in the money transfer framework, there is a limit to minimum practical transaction level. Thirdly, blockchain creates new sophisticated payment opportunities, such as smart contracts that automate payments.
But the value of distributed ownership in payments will really rise to the fore once the Internet of Things takes off. As machine to machine interactions become the norm, blockchain will be almost indispensable to enhancing the value of payments without compromising speed, integrity or transparency.
KYC/AML & Records Management – Blockchain could also help to address inefficiencies in the KYC and AML processes at financial services companies. Today, KYC is an expensive, time-consuming, high-friction process that has to be duplicated every time a consumer enters a new financial relationship with a service provider. Creating a centralized network-defined registry can make the entire process of establishing and validating identity simpler, faster and cheaper. The need for such a solution can be seen in the overwhelming reception forSWIFT’s centralized KYC repository, which has already been embraced by more than 2,000 financial institutions in over 200 countries and territories across the world. At the same time, startups, like Tradle and Polycoin, are also working on blockchain-based compliance solutions that will streamline KYC processes and even extend to AML procedures. But the key challenge that has to be addressed before blockchain becomes a key component of compliance technology is the inherent anonymity of transactions that can put regulators at odds with the technology, especially in areas like KYC and AML.
The rapid expansion of reporting and compliance regulations also opens up the possibility of a comprehensive blockchain-basedregulatory solution that automates and streamlines the exchange and consumption of information between financial service institutions and regulators.
Capital Markets – According to one report, blockchain adoption in capital markets is more a question of “when” than “if”. A consortium of 20 banks is already working with Fintech firm R3 to examine potential blockchain applications in capital markets. There are significant risk, efficiency and accuracy implications for deploying blockchain here. A consolidated and distributed data repository gives all users a unified and real-time view of all trade-related information, thus reducing the scope for error or disagreement and accelerating the settlement process. Asset transfers and transactions can be further optimized by embedding smart contracts that auto-execute based on predefined business logic. Users could judiciously share data that establishes their own value credentials with their trade counterparts to manage risk and credit exposures more effectively. Blockchain-based solutions also allow users to leverage currently non-tradable assets like invoices to extract more value.
Security custody, clearing and settlement in the capital market will see more efficient and faster processes with blockchain technology. Depository Trust and Clearing Corporation (DTCC) is one such financial services player, expecting to derive value in post-trade landscape of securities market, with the distributed ledger framework. The framework will allow in providing a common platform, common version of transactions, movement of asset, rightful owner of asset and uninterrupted trading cycle.
That being said, there needs to be a concerted effort to define a common transactional and regulatory framework before blockchain technology becomes a mainstream application in capital markets.
Trade Finance – Blockchain has the potential to revolutionize the trade finance industry, characterized by a complex network of players and several manual, paper-intensive processes. Many large banks, including Bank of America, Standard Chartered, Barclays and DBS, are already working on their proofs-of-concept to explore the possibilities of digitizing trade finance assets on a distributed ledger. Standard Chartered and DBS, for instance, are currently working on a Ripple-based blockchain solution to develop more efficient innovative trade finance services. Wave, a blockchain-based supply chain startup that has partnered with Barclays in trade finance, is already using the technology to take control of the ownership of goods and documents during shipping. The startup is replacing traditional shipping documents with electronic versions and has created a service that will track goods from port to port, record transactions, execute and update smart contracts, and even make payments at designated ports.
Syndicated Lending: Blockchain in syndicated lending envisages to reduce the settlement process on the sell-side and buy-side. This will enable in saving millions in capital cost, reduce transaction verification, settlement time, information exchange and transaction cost. Blockchain protocol will enable faster and accurate methodology for sharing of information among the counterparties. The counterparties need not maintain and update separate books. This also enables easy review/audit by the regulators. Here the parties can be part of a private blockchain network, with shared access to same ledger. The cryptography adopted by the protocol, will ensure authenticity of the transactions.
JP Morgan has invested in Digital Asset Holdings (DAH), a start-up run by Blythe Masters, former head of Global Commodities at JP Morgan (Blythe Masters is one of the financial engineers, who helped develop the credit-default swap).
Smart Contracts: Rules/Conditions can programmed in the blockchain and linked to specific events. Based on the outcome of the events and the rules defined, the contract can be executed automatically, which can result in transferring the underlying to the respective participant. This eliminates third party/intermediary authority for authentication of the contracts and the resulting fees/charges incurred. Etherium is a leading startup, who has developed blockchain protocol for providing a trusted and transparent contract between anonymous parties. This finds use cases in financial services for areas such as foreign exchange market, self-enforcing contracts etc.
Gift Card Issuance and Distribution: Retail gift cards are currently exposed to multiple agencies from issuer to distributor and retailer until it reaches the end-customer. Here the card numbers are exposed at multiple stages, with a possibility for card related fraud. Blockchain technology based network enables in transferring the value of gift card, without the need for sharing the card number. Using the public key and recipient private key, the gift card balances can be transferred securely to the recipient. Gyft Block, the blockchain-based gift card platform developed by Gyft specializes in mobile gift cards.
Many more use cases are being tested out by various banks, financial institutions and start-ups. Each player is trying out use cases at various levels of financial instrument life-cycle. The cases which provides greater efficiency compared to the existing processes will find execution in the immediate future.
The blockchain technology is being experimented at various locations and institutions around the world, it could take years to bring out a replacement for the existing processes. The core decentralized/distributed trust proposition of blockchain will allow financial services firms to extract more cost and operational efficiencies as well as create new opportunities for growth. But there are several challenges to be addressed before the technology goes mainstream. Few of the challenges faced currently are as follows:
Technology: The primary challenge is with the technology itself, which is still quite nascent. There is still way to go before all the components fall into place to enable standardized production-ready, enterprise-scale solutions. Further, integration with numerous existing institutional systems, safeguarding the security, is a herculean task.
Cost: The cost of developing and maintaining blockchain network with decentralized virtual machines is currently high. The speed of transaction is slow currently, considering the time for verification of the transactions. The computational power required is also high. This is a deterrent.
Scale of Operation: One of the biggest challenges of deploying blockchain is the need to build scale. For example, in trade finance. If these solutions are to deliver real and/or new value in trade finance, the ideal situation would be for everyone involved – corporations, shipping companies, customs agencies, banks etc. – to get on board.
Regulatory: There is a lack of regulatory framework to the blockchain environment. Few of the central banks around the world have given a positive view towards blockchain technology and their potential. As the technology evolves, regulations will have to keep pace and define a clear framework for adoption.
Security and Privacy: The sensitive transactions performed through the network, will be exposed to multiple participants. The legal modalities on performing such transactions is an open area. Further, an attacker with immense computing powers can hijack the system.
There could privacy concerns for large corporates on smart contracts provided through distributed/shared ledgers.
Legal Aspect: As there is no single central authority, which is confirming to the transactions, there is no legal standing when there is a loss/dispute. Previously these transactions were authenticated/validated by certain regulators/government authorities. Now this becomes a bilateral transaction, between pseudo anonymous participants.
Participants are nonymous: The information on the transaction, user identifiers and location are captured by the network as system generated algorithmic number. This is a pseudo-anonymous identification of entities and transactions. Here the issue of privacy of transactions and ledger balance need to be handled within the framework of traceability and authenticity of transactions.
Immutability: The data is fairly immutable. This may not be a practical option, since cancellation and amendments are common in real life. However, blockchain will enable the changes by consensus, to handle the issues on modification.
Inspite of the above challenges, both public and private sector are investing in new innovation/experimentation around blockchain technology. Apart from driving innovation, these institutions are looking at an early mover advantage, which will enable them to monetize benefits by reducing cost and offering the service to other institutions.
One thing is clear – blockchain is here to stay. So it may be a while before all this experimentation actually translates into large-scale adoption at various levels of financial sector. But there can be little doubt about the potential of blockchain technology to transform the financial services industry. As noted by Blythe Masters, “It’s analogous to e-mail for money”.