About this Article
The beginning of January 2019 will mark the 10-year anniversary of the introduction of Bitcoin as well as the underlying technology: blockchain. Since its inception, many things have been promised about the technology. However, in terms of real change in banking and finance, relatively little progress has been made, aside from the facilitation of easier payments of illicit goods and services. But the possibilities, as well as the risks, seem to get clearer by the day, which this 421 perspective aims to outline. But first, let’s cover the basics.
There are many different versions of blockchain, each having different attributes; decentralized, centralized, public, private, semi-private and the list goes on. But in its core, blockchain is an immutable database, where data goes in and subsequently cannot be changed. This has the potential to increase trust among parties as well as even completely remove trust from the equation in certain circumstances.
Decentralized vs. Centralized
One of the biggest, if not the biggest differentiating factor among blockchains is the difference between centralized and decentralized blockchains. In a decentralized blockchain, all blocks are verified by computational power, which is supplied by so called miners, who are rewarded for lending their processors to the blockchain with tokens from that blockchain.
In a centralized blockchain, all new blocks are verified by a central entity, thus requiring no computational power but however requiring trust in the central entity. Evidently these two blockchain variations have different valid use areas. For one, as a decentralized blockchain has no central entity to verify the validity of all transactions, brute force calculations performed by the miners must do that, which uses a lot of energy. This is not sustainable when considering the carbon emissions of that energy usage. However, the clear benefit of a decentralized blockchain is the lack of trust required in a central entity. This would mean that the decentralized structure would best suit nations where trust in institutions is low as well as in supranational projects without a trusted overseer. Centralized blockchains are better used when there is a clear central and trusted institution, for example a central bank or a joint venture among participating firms.
Public, Private & Semi-Private
The second big distinction differentiating blockchains is whether the data in the blockchain is visible for all, for none or for some. An example of a public blockchain is Bitcoin, where anyone can download the full transaction log from the entire history of the digital currency. Anyone can thus see how much was transferred to whom (an address) and at what time. An example of a private blockchain is Monero, another digital currency. In that blockchain, all transactions are verified the same way as with Bitcoin, but no one can see who sent money to whom, only that money was transferred. That blockchain is thus private. Then there are the semi-private blockchains, where selected information is available to selected entities. Because someone needs to decide who sees what information, this type of blockchain has to be centralized. An example of such a blockchain could be used in international trade to inform trading partners, freight providers, customs, financiers etc. of the information they need regarding that trade.
General Challenges, Limitations and Criticisms with Blockchain Implementation
“Its garbage in, garbage out” – Chris Taylor, COO Everledger, a firm trying to use blockchain to track diamonds and other assets. What he means is that a blockchain is an immutable system, so any wrong input made is forever stored as the wrong input. Just because it is on the blockchain does not make it true. Therefore, the challenge remains to make sure that what is entered into the system is correct to begin with. Some trust is thus needed and the promise that blockchain will remove trust from the equation is likely overblown.
“It doesn’t solve entirely problems that couldn’t be solved in other ways” – Dr Grammateia Kotsialou, a blockchain researcher at King’s College London. What he refers to is the fact that blockchain in its essence is an immutable database. If there is a trusted entity at the center of things, many of the problems that blockchain can solve could just as well be solved with a database. Take the supply chain example mentioned before, this could be solved with a centralized and semi-private blockchain system. However, it could also be solved with a centralized and semi-private database. What is central in both instances is that correct data needs to be inputted, thus requiring trust.
The point is not to say that blockchain does not have viable use cases, because there are many as we will cover in the next section. However, it is to say that blockchain solutions should be scrutinized carefully before implemented as there may be cheaper solutions to the blockchain ones.
Blockchain for Banks
Now that we know what blockchain is, which different kinds of variations are possible as well as understand a few considerations, we can start to tackle how blockchain could be implemented in banks as well as which risks it poses. So, let’s cover the good, the bad and the ugly of blockchain from the perspective of banks.
There is a lot of room for improvement today in finance as a lot of the processes used are outdated in comparison to other industries, for example tech. Blockchain presents some solutions to these problems even though the problems may have other solutions as well. Here are a few of the places blockchain could transform banking:
International transactions are today often done with US dollars as the settlement currency or by exchanging domestic currency. However, in either case, the transacting banks need to verify the transaction together, which is an inefficient process. Blockchain could here help if banks agreed to use a digital currency as the exchange currency. Doing it this way, international transactions could be easily settled by all banks holding a certain amount of the digital currency and sending some of it when executing an international trade. In this case, the blockchain would verify the transaction without the counterparty needing to verify it as well. Transactions would be cheaper and faster.
Two alternatives for this solution is Swift and Ripple. Swift is the incumbent and the current used platform for national and international interbank messaging, which is developing a blockchain based solution for international transactions. Swift is owned as a cooperative of the banks using the service, Ripple is the challenger, which has caused a lot of stir in the media since it launched its own centralized digital currency targeted for international interbank transactions. Ripple currently has a market capitalization of 24 billion USD; which solution is likely to come out on top is anyone’s guess but there is a good chance that one of the technologies will prevail, thus resulting in a more efficient infrastructure for international transactions.
Payments have similar problems as international transactions, described above, where banks have to approve the transaction before it can take place. A cost and time saving solution could be to settle both bank payments and card payments on a blockchain. One example of this is the Utility Settlement Coin created by UBS, an investment bank. The solution is intended as an improvement to interbank transactions in the financial markets and one coin is always equal in value to one domestic currency unit. Another example is the blockchain API solutions offered by Visa and Mastercard aimed at improving peer to peer and B2B transactions.
Clearing and Settlements of Equity and Fund Shares
Another use area for blockchain is in the clearing and settlement of assets such as equity stakes or shares of a fund structure. Today the process is rather outdated and often managed with a myriad of messages and manual reconciliation. There is a large potential benefit from blockchain solutions in this area, mostly at stock exchanges but also at fund exchanges and investment banks. Preferably, smart contract solutions could tie the equity or fund share to a certain value and securely move that to another individual when a transaction occurs. For example, SEB has initiated a project with Nasdaq to settle fund shares in the blockchain environment.
Trade Finance involves any trade of a good, financed by a bank or other financier, international or domestic. Transaction times for such trades often take about seven days because several parties need to sign off when receiving the right documentation. Those parties may involve buyers, sellers, their banks, transporters, inspectors, regulators and more. A blockchain solution could drastically shorten the time for the financing to go through, as all parties can access the information they need in the same system. An example of this is Batavia, which is a blockchain based Trade Finance platform created by a consortium of five banks (UBS, Bank of Montreal, CaixaBank, Commerzbank and Erste Group) built on the IBM blockchain. Batavia has already been used to settle two international trades, thus proving its usefulness initially. The next development process will be spent on commercializing the platform further.
Getting financing through a syndicated loan, with several bank parties, is today a slow and costly process with very long settlement times between banks. This is partly because of the non-standard communication that is typically used..
In this case, blockchain offers a natural solution where a centralized and semi-private application could store information and distribute the right information to the right entities, while verifying and settling transactions. An example of such a platform is Synaps, created by a consortium of 19 banks and the blockchain company R3, to act as a blockchain platform for launching and managing syndicated loans.
Identification Registry for Improved KYC
Know your customer (KYC) is today done through individual registries within every bank’s onboarding procedures. The required information is often vague, so most banks collect different information when building their KYC profiles. This slows down transaction processes and increases administration and risk. The current setup could be improved by collecting KYC information on a common database, or blockchain, shared among the banks. In a setup of shared customer information, all banks would benefit.
One of the possible solutions is to set up a joint venture to facilitate a centralized and semi-private blockchain where customer information can be accessed by the banks if authorized by the potential client. An example of a currently proposed setup is a joint venture among the major Nordic banks, which is currently early in the planning phase.
Regulatory compliance is part of our core business expertise here at 421, which means we have seen the field develop hands-on over the years. For example, we have seen that regulatory compliance is commonly seen as a pure cost and is reluctantly handled by the banks by throwing money and resources in the direction of the problem to address the demands, short term.. A better solution is to start seeing regulatory compliance as an area to invest and build competitive advantage through carefully integrating the latest technologies whilst optimizing business processes. We have written extensively on this topic in an earlier ‘RegTech’ perspective, available here (link).
Technologies in this space are often thrown under the umbrella of ‘RegTech.’ so unique technologies are not always highlighted individually. Blockchain is regularly seen as one of the more promising technologies in this space. An interesting use case would be to establish a shared blockchain system between the regulator and the bank, thus a centralized and public or semi-private blockchain, if several banks are included in the same blockchain. The benefits of such a system is that record keeping would be kept in one immutable and common system, thus not requiring both regulators and banks to keep separate yet identical records for verification and in turn decreasing resource efforts and cost. Furthermore, blockchain could play an interesting role in building the technological platforms for EU-wide initiatives such as BIRD (Banks Integrated Reporting Dictionary). You can read our point of view on this subject here (link).
However good the technology may be, some things with blockchain are undeniably challenging for banks. Though, with smart investments, a threat can be managed better than competitors and thus lead to a competitive advantage. Here are some challenging aspects that may come with increased adoption of blockchain:
Anti-Money Laundering (AML) in the Age of Digital Currencies
Digital currencies built on decentralized blockchains are arguably here to stay. As there are currently no central entities to take over or sanction, governments can only ban citizens from holding the assets, not ban the asset itself. That is to say that banning anything to do with cryptocurrency would even be a relevant action to take, which does not appear to have much support outside of China. The reality is thus that digital currencies are here to stay and potential use cases range from generally accepted methods of payment to strategic transactions.
In all use cases, the risks increase for people to commit anti-money laundering (AML) activities, evade taxes, finance terrorist organizations or evade sanctions. Banks are today the important watchdog in the fight to control such flows. When banks suspect illicit transactions, they are required to report the incident to the national financial crime fighting agency of the country where the transaction occurred. This is challenging enough without the existence of cryptocurrencies, due to the immense number of transactions being made, the limited budgets of national financial crime fighting agencies and the laws restricting information sharing among banks.
What complicates things with cryptocurrencies is that people can easily transfer their money to a digital currency and send that to an address owned by an individual on a terrorism or sanctions list for example. One could also transfer illegally made money to cryptocurrencies and then back to fiat currency to mask the origins of that money and make it appear as legally obtained.
Both of these options are possible today but what may become more prevalent in the future as adoption spreads, is that everyday transactions are done outside of the banking system. At that point, it could be very difficult to track which money was made legally, which money has been taxed, where the money came from etc. This problem exists today with cash, with the difference that large sums of cash are difficult to transfer, especially abroad, and are difficult to spend at large quantities. Cryptocurrencies, without the proper regulations, do not have these limitations.
As it currently stands, banks are ultimately responsible for the money that passes through its products. Therefore, in the advent of these increased risks, more stringent processes are necessary. Moreover, in the advent of AML V, exchange providers between cryptocurrencies and fiat currencies will be more tightly regulated, thus requiring banks to better cooperate with said exchanges. You can read more on AML V in our perspective, available here (link)
Central Bank Issued Digital Currencies
A central bank issued digital currency can take many shapes and sizes. However, the most likely option is as a substitute for cash when a society closes in on total cash-lessness . The currency would be worth the same per unit as a conventional bank note but with the difference that it is held at the central bank rather than at a conventional bank.
A national e-currency involves a whole other set of challenges aside from the digital currencies covered in the last section. The problems with anonymous ownership could be circumvented by only allowing verified individuals to hold the currency. Though, there is a larger risk that people would exchange their bank money for central bank money, or the e-currency in times of great uncertainty, much like conventional bank runs which have occurred throughout history. The big difference is the speed at which this could take place digitally. In the advent of such a currency, banks would likely be required to hold more reserve capital or supply more money to various resolution funds, to prevent catastrophic bank failures.
We call it the ugly because it has immense potential to improve the functioning of banks whilst being very unlikely to be implemented in reality. Sometimes the challenge is too great and that is an ugly thing for the institution and consumer.
National Anti-Money Laundering (AML) Registry
To prevent financial crime, banks invest large sums of money to track, flag and report transactions and suspicious activities to financial crime-fighting authorities. However, a number of transactions could be completely legitimate whilst looking suspicious and clean-looking transactions could be foul play without getting detected. Banks are currently operating with a flawed toolbox, which makes these predictions far from perfect and leads to inefficient AML spending.
A better, or idealistic, solution could be one that logs all bank and consumption activities of each client in a semi-private and nationally centralized blockchain. Banks could get access to some or all of this data as necessary if the information is requested by the bank and approved by the individual, who’s data it is, or by financial crime-fighting authorities. With all that data, banks can easily follow transactions and money from account to account. As a result, financial crime would be a lot harder to commit.
Furthermore, there wouldn’t necessarily be a challenge with regards to GDPR, because the individual could approve the banks to share all the data with each other. The problem arises if the individual does not approve this, which would likely require a more senior regulation to trump GDPR in this regard. Another problem is that none of this is even legal under Swedish current regulation if we overlook GDPR. The bank secrecy act forbids banks from sharing account information with one another. Norway is a different story in this aspect but challenges remain.
Then there is the interbank cooperation required, where questions remain if such incentives really exist in the market. It is not unreasonable that banks would be reluctant with sharing account information as this could be seen as a competitive secret.
In conclusion, there is clearly potential here but there are many challenges that stand in the way. Never stop dreaming though. Regulators, take note.
Ending on a positive note
As we have outlined, there are many possible and exciting use case areas for blockchain. However, as we have also discussed, a modern database could also solve many of the problems stated. The fact that paperwork is still commonly used in 2018 is not because of the lack of blockchain technology but rather the lack of digital investments at all. But the fact that banks have still not solved many of their complex processes digitally may be good news for blockchain. Let’s compare with the adoption of mobile technologies in many African countries. There, the development to a large extent skipped the land line telecommunications technology, which is so prevalent in the west and instead went straight for mobile. Another example is China, which largely skipped the card-based payment system used in the west and instead went straight for mobile payments. As a result, mobile payments are a lot more prevalent in China as compared to the west.
The same development procedure may be relevant for banks. Instead of using a digital database solution as a middle step in the development towards fully digitized processes, why not adopt blockchain from the start?