Blockchain for Bankers
The financial services industry is huge, moving trillions of dollars daily. It is also cumbersome, and in some ways antiquated. Let’s say you are a big technology corporation, like Apple, and one of your subsidiaries wants to send some money to another subsidiary in another country. For this, they need to operate hundreds of bank accounts in different currencies all around the world just to facilitate their normal operations. It isn’t simple.
Bank wire transfers are needlessly complicated and take days, sometimes weeks to settle, based as they are on ancient computing technologies and often paper-based systems.
Transfers often need to go through various intermediary banks to do so, adding complexity, and of course bank charges.
Brokers trade securities on different online exchanges around the world: these buy or sell orders take microseconds to transact, but then three days to settle. Disputes happen all the time, needing the intervention of back-office personnel and often regulators to clear up the mess.
The financial system is one area which is very likely to feel the impact of disruptive/productive innovation based on new technology, particularly blockchain.
Erik Voorhees, a bitcoin pioneer, says, “It is faster to mail an anvil to China than it is to send money through the banking system to China. That’s crazy! Money is already digital, it’s not like they’re shipping pallets of cash when you do a wire!”
Banking is a Dinosaur
Like dinosaurs, the industry is immense, lumbering, and due to extinction. Large financial institutions monopolize the sector. In the UK only one new bank — Metrobank — has been set up in the last 50 years, because of the barriers to entry, both financial and regulatory, are so large.
In most other industries, many smaller players have sprung up, utilizing technology and agility to compete with larger entities. This is not the case with banking: established players rule the marketplace: Barclays and HSBC banks, for example, VISA and Mastercard, Western Union and Moneygram, Goldman Sachs, the big accountancy firms like PWC, and other institutions comprising brokers, insurers, legal services, asset managers, and consultants. These monopoly players slow the system down, add costs, and of course generate out-sized benefits for themselves. They have no incentive to improve their products, increase efficiency, listen to feedback from customers, or adopt newer technology.
The Financial Sector’s Vulnerabilities
Banks exist for several reasons, dating back hundreds of years to the first modern banking systems in Renaissance Italy in the 1600s. They are trusted third parties; they hold ledgers to account for transactions between individuals and companies; they facilitate trade in real-world goods and services, as well as financial intangibles like options and futures; they manage risk between parties; they act as a repository for fiat currency and other valuables; they loan money for commercial and individual needs.
Blockchain technology can do all this quicker, and at a lower cost.
Banks are going to find their 400-year monopoly challenged, and it will happen quite rapidly over the next decade. The FT’s Martin Arnold says, “The [Blockchain] technology, which underpins cryptocurrencies such as bitcoin, was initially treated with skepticism by banks. However, this has changed dramatically. The blockchain is the hottest buzzword in the sector…”
Challenges the Bankers Face from Blockchain
1. Authenticating Identity and Value
By using cryptocurrencies and blockchain, peer-to-peer networks can eliminate the “Trusted Third Party” structures of banks. Where necessary cryptography verifies this aspect of transactions, through public and private key systems.
2. Moving Value
Blockchain can do this better than the current systems: quicker, lower cost and more reliably. Bitcoin and other cryptos are immune to “double-spending” and many other errors that creep into conventional banking transactions.
3. Storing Value
Instead of having bank accounts, people can store value on their smartphones, thumb drives, and many other computing devices. Properly backed-up, these will be the “banks” of the future, particularly for the “Unbanked” in developing countries, where the progress of technology has leaped over conventional banking structures and rendered them obsolete: people use their smartphones for transactions instead, like the MPeso in Kenya.
4. Lending Value
Banking institutions currently lend credit to individuals and businesses, such as mortgages, equipment loans, and corporate bonds.
On the blockchain, using smart contracts, anyone will be able to issue, trade and settle debt instruments, cutting out the middleman and reducing costs. Consumers will be able to access loans from peers, which will benefit the unbanked, and entrepreneurs, who traditionally have difficulties in obtaining start-up finance from existing banks.
5. Exchanging Value
Financial institutions globally exchange trillions of dollars of money, and other financial assets, via mechanisms like investment, speculation, arbitrage, hedging, and clearing, settling and storing value.
Blockchain-based technological innovations can do all this better, quicker, cheaper and importantly, reduce errors to a minimum.
6. Funding and Investing
Conventional forms of raising funds, via banks, angel investors, and IPOs are complex and require various expensive third parties: investment bankers, venture capitalists, and lawyers, and suchlike.
New blockchain technologies will automate many of these functions, and enable new models for peer-to-peer financing, and could also make payments of dividends and profits more efficient, transparent and secure.
7. Ensuring Value and Managing Risk
Risk Management, of which insurance is a major component, protects companies, organizations, individuals, and governments from losses resulting from uncertainties and unforeseen events. Advances in blockchain structures will improve risk management, and make it more transparent and secure. The insurance industry will be able to make better decisions because it will have a fuller picture of the risks involved in an enterprise.
8. Accounting for Value
Measuring, processing, analysing and communicating the financial value of companies, commodities and assets will be disrupted — and improved — by new accounting methods based on blockchain’s distributed ledgers and will make audits and financial reporting quicker, and importantly more transparent. This will also make external financial scrutiny available to regulators, stakeholders, and the public: a considerable step forward over current arrangements.
The current model, pioneered by bitcoin, and adopted by most cryptocurrencies to date is the peer-to-peer distributed, transparent ledger. Financial institutions have seen the benefits of the blockchain, but many of them would prefer restricted-access private blockchains.
This is a private blockchain, created by R3, a consortium of 70 financial institutions, including Barclays, JP Morgan, Credit Suisse, UBS and many other majors. It enables the financial world to handle more complex transactions and restricts access to transaction data. It is open-source.
Another, linked project is Hyperledger, a project by the non-profit Linux Foundation to set common standards for blockchain projects. Universal standards have been extremely effective in advancing global technology, for example in DVDs, or 2/3/4G phones, so everyone can get in on the market and know that their products will work everywhere if they adhere to the standards.
The Blockchain Middle East Forum (BMEF)
This entity suggests that blockchain use across the Middle East will accelerate. Emirates NBD, one of the United Arab Emirates’ largest banks, is currently testing blockchain technology across multiple banking and payment services. The pilot programme has been steadily introducing blockchain technologies to an increasing number of banking organizations. “We anticipate blockchain to be a potential game-changer in creating a secure, scalable, cost-efficient and time-efficient digital ecosystem for government and businesses,” said Emirates NBD chairman Sheikh Ahmed bin Saeed Al Maktoum. Dubai and Bahrain are also looking at blockchain projects, although some conservative bankers in the region have expressed the usual fears about cryptocurrencies facilitating crime.
Anti-Money Laundering (AML) and Know Your Customer (KYC)
Although one of the benefits of bitcoin is its supposed “anonymity” that is not quite the case: the transactions are transparent, it is just who is making them that is not, and unless the wallet holder was very careful about how they conducted cryptocurrency transactions, the police, for example, would be able to track down the person who owns the wallet, so it is actually not the best method for conducting criminal transactions. That remains cash.
Financial crimes such as fraud and tax evasion will be harder to commit to a blockchain financial structure. Over the past few years, with the Panama Papers and Paradise Papers scandals, among others, it has become apparent that large numbers of companies and wealthy individuals are exiting the tax system, reducing government revenues, and therefore services. Blockchains will make tracking money across the globe easier. Together with new systems, such as country-by-country reporting for businesses, instituted by the EU in 2014, will make shifting money to evade tax much more difficult.
SWIFT stands for the Society for Worldwide Interbank Financial Telecommunications. Formed in 1974, as a cooperative of banks, it is the dominant method for validating money transfers worldwide. However, it’s structures and methods are a little outdated. In recent years it has proved vulnerable to cyber attacks.
For political reasons, the Chinese and others want to have their own interbank transfer structure, immune to Western sanctions, as they invest in infrastructure in the giant Belt and Road project to create a trading route from Asia to the West. They are building a new financial infrastructure to mirror the physical one.
Last year SWIFT responded to the market challenges by launching SWIFT gpi, which stands for “global payments innovation” to improve international transfers. With over 100 banks in 200 countries it may well be a significant development, but does it go far enough? We will be assessing its prospects in future articles.
Swift has dabbled in blockchain technology, but it faces the classic dilemma of a market leader with an aging technology base: does it write off its own investment, or try to struggle on while updating existing systems. What usually happens is that a more agile competitor, without legacy issues, outmatches the dinosaur and it becomes obsolete. Investment bank Credit Suisse said, “Interbank payment systems such as SWIFT are old, inflexible, slow, and increasingly prone to cyber attacks at a time when banks are under tremendous pressure to cut costs and protect customer data from hackers, which blockchain could achieve.”
This is the third largest cryptocurrency, by market cap, after bitcoin and etherium. Ripple (XRP) is a decentralized solution for banks and financial institutions that is fast (4 seconds) and scalable (1,000 transactions per second). It avoids some of the drawbacks of traditional financial movements. Transactions are settled within seconds on the Ripple network even though the platform handles millions of transactions frequently. This is unlike banks which could take days or even weeks to complete a wire transfer. The fee to conduct transactions on Ripple is also minimal, with the minimum transaction cost required for a standard transaction set at 0.00001 XRP — small compared to the large fees charged by banks for conducting cross-border payments, which on Western Union and MoneyGram can be up to 29% of the transfer.
Blockchain will inevitably disrupt the existing financial systems. Meant for a world of ink and quill-pen ledgers, they have managed for many years to occupy a central position in economies, and various economic commentators believe that having a large financial sector is actually a drain on the productive economy of creating goods and services, because of onerous interest and financial charges. This is likely to change. We have seen how smartphone transaction networks in the developing world, such as Kenya’s MPeso, have rendered traditional banking obsolete. The advent of blockchain-derived systems could be very disruptive to banking institutions, as they struggle with legacy software and hardware, as well as a reluctance to abandon existing methods which have been very profitable for them in the past. Or they could move swiftly with the times and use their market-leading clout to ensure that they remain dominant.
The deadly example of Eastman Kodak remains in front of them: one of the earliest film companies, formed in 1888, creator of the “Box Brownie”: one of the first consumer cameras which brought photography to the masses, they were dominant in the marketplace for a century. They pioneered digital cameras. Unfortunately, they did not see the merits of their own invention and were unenthusiastic about promoting digital imaging. With the demise of film sales and cameras, they filed for Chapter 11 Bankruptcy in 2012. Their 120-year reign was over. Financial institutions face the same potential fate if they do not embrace the opportunities that blockchain presents.
Ali H. Askar
AWS Cloud Solutions Consultant, Zero & One