How Blockchain Could Disrupt Banking
Blockchain technology has received a lot of attention over the last few years, propelling beyond the praise of niche Bitcoin fanatics and into the mainstream conversation of banking experts and investors.
Last September, JPMorgan Chase CEO Jamie Dimon took a stab at Bitcoin: “It’s worse than tulip bulbs. It won’t end well. Someone is going to get killed.” Lloyd Blankfein, head of Goldman Sachs echoed that thought, saying, “Something that moves 20% [overnight] does not feel like a currency. It is a vehicle to perpetrate fraud.”
Despite the skepticism, the question of whether blockchain and decentralized ledge technology (DLT) will replace or revolutionize elements of the banking system remains.
And this very loud and public backlash against cryptocurrencies from banks begs another question: What do banks have to be afraid of?
The short answer is “a lot.”
Blockchain’s role in banking
Blockchain technology provides a way for untrusted parties to come to agreement on the state of a database, without using a middleman. By providing a ledger that nobody administers, a blockchain could provide specific financial services — like payments, or securitization — without using a middleman, like a bank.
Further, blockchain allows for the use of tools like “smart contracts,” which could potentially automate manual processes, from compliance and claims processing, to distributing the contents of a will.
For use cases that don’t need a high degree of decentralization — but could benefit from better coordination — blockchain’s cousin, “distributed ledger technology (DLT),” could help corporates establish better governance and standards around data sharing and collaboration.
With global banking currently a $134T industry, blockchain technology and DLT could disintermediate key services that banks provide, including:
- Payments: By establishing a decentralized ledger for payments (e.g. Bitcoin), blockchain technology could facilitate faster payments at lower fees than banks.
- Clearance and Settlement Systems: Distributed ledgers can reduce operational costs and bring us closer to real-time transactions between financial institutions.
- Fundraising: Initial Coin Offerings (ICOs) are experimenting with a new model of financing that unbundles access to capital from traditional capital-raising services and firms.
- Securities: By tokenizing traditional securities such as stocks, bonds, and alternative assets — and placing them on public blockchains — blockchain technology could create more efficient, interoperable capital markets.
- Loans and Credit: By removing the need for gatekeepers in the loan and credit industry, blockchain technology can make it more secure to borrow money and provide lower interest rates.
- Trade Finance: By replacing the cumbersome, paper-heavy bills of lading process in the trade finance industry, blockchain technology can create more transparency, security, and trust among trade parties globally.
Read on for a deep dive into how blockchain technology could turn the traditional banking industry on its head while enabling new business models through technology.
- Blockchain technology offers a high-security, low-cost way of sending payments that cuts down on the need for verification from third parties and beats processing times for traditional bank transfers
- 90% of members of the European Payments Council believe blockchain technology will fundamentally change the industry by 2025
Today, trillions of dollars slosh around the world via an antiquated system of slow payments and added fees.
If you work in San Francisco and want to send part of your paycheck back to your family in London, you might have to pay a $25 flat fee for a wire transfer, and additional fees adding up to 7%. Your bank gets a cut, the receiving bank gets a cut, and you’re charged exchange rate fees. Your family’s bank might not even register the transaction until a week later.
Despite more recent fluctuations, the number of confirmed Bitcoin transactions per day has grown roughly 6x from just over 50,000 in the summer of 2014 to ~290,000 as of December 2018. Source: Blockchain.
Facilitating payments is highly profitable for banks, providing them with little incentive to lower fees. Cross-border transactions, from payments to letters of credit generated 40% of global payments transactional revenues during 2016.
Cryptocurrencies like Bitcoin and Ethereum are built on public blockchains that anyone can use to send and receive money. In this way, public blockchains cut down on the need for trusted third parties to verify transactions and give people around the world access to fast, cheap, and borderless payments.
Bitcoin transactions can take 30 minutes or up to 16 hours — in extreme cases — to settle. That’s still not perfect, but it represents a leg up from the average 3-day processing time for bank transfers. And due to their decentralized and complex nature, crypto-based transactions are difficult for governments and regulatory bodies to control. In other words, they can’t shut down these almost-instantaneous transactions.
More importantly, developers are working on scaling cheaper solutions for cryptocurrencies — like Bitcoin and Ethereum — to process more transactions, faster. Other cryptocurrencies, like Bitcoin Cash and TRON, already have low-priced transactions.
EXAMPLES OF IMPROVED PAYMENTS THROUGH BLOCKCHAIN
While cryptocurrencies are a long way from completely replacing fiat (like the US dollar) when it comes to payments, the last couple of years have seen mostly upward growth in transaction volume for cryptocurrencies like Bitcoin and Ethereum.
Some companies are using blockchain technology to improve B2B payments in developing economies. One example of this is BitPesa, a blockchain company focused on facilitating B2B payments in countries like Kenya, Nigeria, and Uganda. The company has processed millions of dollars in transactions, reportedly growing 20% month-over-month.
Another example is BitPay, a Bitcoin payment service provider that helps merchants accept and store Bitcoin payments. The company has over 40 integrations, partnering with e-commerce platforms like Shopify and LemonStand to facilitate Bitcoin payments. Additionally, Ohio has become the first state in the US to accept Bitcoin tax payments, and the transactions are enabled by BitPay’s platform.
One big reason behind the coming disruption of the payments industry is the fact that the infrastructure supporting it is just as liable to disruption — the world of clearance and settlements.
2. Clearance and Settlements Systems
- Distributed ledger technology could allow transactions to be settled directly, and can keep track of transactions better than existing protocols, like SWIFT
- Ripple and R3, among others, are working with traditional banks to bring greater efficiency to the sector
The fact that an average bank transfer — as described above — takes 3 days to settle has a lot to do with the way our financial infrastructure was built.
It’s not just a pain for the consumer. Moving money around the world is a logistical nightmare for the banks themselves. Today, a simple bank transfer — from one account to another — has to bypass a complicated system of intermediaries, from correspondent banks to custodial services, before it ever reaches any kind of destination. The two bank balances have to be reconciled across a global financial system, comprised of a wide network of traders, funds, asset managers and more.
If you want to send money from a UnicaCredit Banca account in Italy to a Wells Fargo account in the US, the transfer will be executed through the Society for Worldwide Interbank Financial Communication (SWIFT), which send 24 million messages a day for 10,000 financial institutions.
Source: Aite Group
Because UnicaCredit Banka and Wells Fargo don’t have an established financial relationship, they have to search the SWIFT network for a correspondent bank that has a relationship with both banks and can settle the transaction — for a fee. Each correspondent bank maintains different ledgers, at the originating bank and the receiving bank, which means that these different ledgers have to be reconciled at the end of the day.
The centralized SWIFT protocol doesn’t actually send the funds, it simply sends the payment orders. The actual money is then processed through a system of intermediaries. Each intermediary adds additional cost to the transaction and creates a potential point of failure — 60% of B2B payments require manual intervention, each taking between 15-20 minutes.
Blockchain technology, which serves as a decentralized “ledger” of transactions, could disrupt this state of play. Rather than using SWIFT to reconcile each financial institution’s ledger, an interbank blockchain could keep track of all transactions publicly and transparently. That means that instead of having to rely on a network of custodial services and correspondent banks, transactions could be settled directly on a public blockchain.
Further, blockchain technology allows for “atomic” transactions, or transactions that clear and settle when a payment is made. This stands in contrast to current banking systems, which clear and settle a transaction days after a payment.
That might help alleviate the high costs of maintaining a global network of correspondent banks. Banks have estimated that blockchain innovation could cut at least $20B worth of costs from the financial sector by providing better infrastructure for clearance and settlements.
EXAMPLES OF IMPROVED TRANSACTIONS THROUGH BLOCKCHAIN
Ripple, an enterprise blockchain services provider, is the most prominent player working on clearance and settlement. While the company is best known for its associated cryptocurrency XRP, Ripple — the venture-backed company — is building out blockchain-based solutions for banks to use for clearance and settlement.
SWIFT messages are one-way, much like emails, which mean that transactions can’t be settled until each party has screened the transaction. By integrating directly with a bank’s existing databases and ledgers, Ripple’s xCurrent product provides banks with a faster, two-way communication protocol that permits real-time messaging and settlement. Ripple currently has over 100 customers signed up to experiment with its blockchain network.
R3 is another major player working on distributed ledger technology for banks and wants to be the “new operating system for financial markets.” It raised $107M in May 2017 from a consortium of banks like Bank of America Merrill Lynch and HSBC. It’s also lost some key members, such as Goldman Sachs, which departed because it wanted more operational control over R3.
Projects like Ripple and R3 are working with traditional banks to bring greater efficiency to the sector. They’re looking to decentralize systems on a smaller scale than public blockchains by connecting financial institutions to the same ledger in order to increase efficiency of transactions.
Blockchain projects are doing more than just making existing processes more efficient, however. While still in their early days — and while we continue to see mostly experiments, pilots, and proofs-of-concepts (PoCs) take form— they’re creating entirely new types of financial activity. The fundraising space is a notable example of this.
- In initial coin offerings (ICOs), entrepreneurs raise money by selling tokens or coins, allowing them to fundraise without a traditional investor or VC firm (and the due diligence that accompanies an investment from one)
- Blockchain company EOS raised over $4B in its year-long ICO ending in 2018.
Raising money through venture capital is an arduous process. Entrepreneurs put together decks, sit through countless meetings with partners, and endure long negotiations over equity and valuation in the hopes of exchanging some chunk of their company for a check.
In contrast, some companies are raising funds via “initial coin offerings (ICOs),” powered by public blockchains like Ethereum and Bitcoin.
In an ICO, projects sell tokens, or coins, in exchange for funding (often denominated in Bitcoin or ether). The value of the token is — at least in theory — tied to the success of the blockchain company. Investing in tokens is a way for investors to bet directly on usage and value. Through ICOs, blockchain companies can short-circuit the conventional fundraising process by selling tokens directly to the public.
Some high-profile ICOs have raised hundreds of millions — even billions — of dollars before proof of a viable product. Filecoin, a blockchain data storage startup, raised $257M, while EOS, which is building a “world computer,” raised over $4B in its year-long ICO.
Still, regulators are putting a serious damper on ICOs.
Additionally, funding has falling significantly since peaking in early 2018.
At the same time, initial coin offerings represent a paradigm shift in how companies finance development.
First, ICOs occur globally and online, giving companies access to an exponentially larger pool of investors. You’re no longer limited to high-net-worth individuals, institutions, and others who are able to show the government that they’re credible investors.
Second, ICOs give companies immediate access to liquidity. The moment you sell a token, it’s priced on a 24-hour global market. Compare that to ten years for venture-backed startups. As Earn CEO Balaji Srinivasan says, “the ratio between 10 years and 10 minutes to get the option of liquidity is up to a 500,000x speedup in time.” We’re already seeing the impact of ICOs on the fundraising market.
Venture capital firms have taken notice, with Sequoia, Andreessen Horowitz, and Union Square Ventures, among others, all directly investing in ICOs, as well as gaining exposure by investing in cryptocurrency hedge funds.
Venrock partner David Pakman has said, “There’s no question that crypto will disrupt the business of venture capital. And I hope it does. The democratization of everything is what has excited me about technology from the beginning.”
EXAMPLES OF IMPROVED ICO PROCESSES THROUGH BLOCKCHAIN
While the majority of ICOs thus far have been for pre-revenue blockchain projects, we’re seeing more and more technology companies build around a paradigm of decentralization.
Telegram, the messaging app, for example raised $1.7B via ICO. The idea behind the ICO is to sell tokens to users and bootstrap a payment platform on top of the messaging network. If, as blockchain advocates predict, the next Facebook, Google, and Amazon are built around decentralized protocols and launched via ICO, it will eat directly into investment banking margins.
Several promising blockchain companies have emerged around this space. Companies like CoinList, which began as a collaboration between Protocol Labs and AngelList, are helping bring digital assets to the mainstream by helping blockchain companies structure legal and compliant ICOs. CoinList has facilitated more than $400M in token sales since August 2017.
Demand for Filecoin’s ICO on CoinList was so high that it caused server overload within an hour of launch. Filecoin ultimately raised over $257M via ICO.
It has developed a bank-grade compliance process that blockchain companies can access through a streamlined API, helping projects ensure everything from due diligence to investor accreditation. While CoinList’s platform is designed for blockchain projects, its focus on reducing the logistical and regulatory load around fundraising is being mirrored in the public markets. Investment banks today are experimenting with automation to help eliminate the thousands of work hours that go into an IPO.
And CoinList is just the start. A number of companies are emerging around the new ICO ecosystem, from Waves, a platform for storing, managing, and issuing digital assets, to Republic.co’s crypto initiative, which is aimed at helping people invest in ICOs for as little as $10.
Of course — given regulatory pronouncements — ICO activity should be taken with a grain of salt, and the rapid rise of ICOs over the past year looks like it was a bubble. And there’s no doubt that many of these projects will fail altogether. What’s interesting is that they’re testing out blockchain technology that could replace functions of traditional banks. This is not just limited to company fundraising, but also to the underlying fabric of securities.
- Blockchain removes the middleman in asset rights transfers, lowering asset exchange fees, giving access to wider global markets, and reducing the instability of the traditional securities market
- Moving securities on blockchain could save $17B to $24B per year in global trade processing costs
To buy or sell assets like stocks, debt, and commodities, you need a way to keep track of who owns what. Financial markets today accomplish this through a complex chain of brokers, exchanges, central security depositories, clearinghouses, and custodian banks. These different parties have been built around an outdated system of paper ownership that is not only slow, but can be inaccurate and prone to deception.
Say you want to buy a share of Apple stock. You might place an order through a stock exchange, which matches you with a seller. In the old days, that meant you’d spend cash in exchange for a certificate of ownership for the share.
This grows a lot more complicated when we’re trying to execute this transaction electronically. We don’t want to deal with the day-to-day management of the assets — like exchanging certificates, bookkeeping, or managing dividends. So we outsource the shares to custodian banks for safekeeping. Because buyers and sellers don’t always rely on the same custodian banks, the custodians themselves need to rely on a trusted third party to hold onto all the paper certificates.
To settle and clear an order on an exchange involves multiple intermediaries and points of failure.
In practice, that means that when you buy or sell an asset, that order is relayed through a whole bunch of third parties. Transferring ownership is complicated because each party maintains their own version of the truth in a separate ledger.
Not only is this system inefficient, but it’s also imprecise. Securities transactions take between 1 to 3 days to settle because everyone’s books have to be updated and reconciled at the end of the day. Because there are so many different parties involved, transactions often have to be manually validated. Each party charges a fee.
Blockchain technology promises to revolutionize financial markets by creating a decentralized database of unique, digital assets. With a distributed ledger, it’s possible to transfer the rights to an asset through cryptographic tokens, representing assets “off-chain.” While Bitcoin and Ethereum have accomplished this with purely digital assets, new blockchain companies are working on ways to tokenize real-world assets, from stocks to real estate to gold.
The potential for disruption is massive. The four largest custody banks in the US — State Street, BNY Mellon, Citi, and JP Morgan — each oversees over $15+ trillion worth of assets under custody. While fees are typically lower than .02%, profits come from the sheer volume of assets. Using blockchain technology, tokenized securities have the potential to cut out middlemen such as custodian banks altogether, lowering asset exchange fees.
The four largest custodian banks in the US each manage $15+ trillion in assets under custody. Source: Trefis
Further, through smart contracts, tokenized securities can work as programmable equity — paying out dividends or performing stock buybacks through a couple lines of code. Finally, putting real-world assets on blockchain technology has the potential to usher in broader, global access to markets.
EXAMPLES OF IMPROVED SECURITIES PROCESSETOKENSS THROUGH BLOCKCHAIN
Polymath is one of the blockchain technology companies that wants to help migrate trillions of dollars of financial securities to the blockchain. Polymath is building a marketplace and platform that helps people issue security tokens and implement governance mechanisms to help these new tokens meet regulations. So far, Polymath has announced partnerships with Blocktrade, Corl, and Ethereum Capital to launch security tokens on the platform.
The slide above from Polymath predicts that the market for security tokens will grow to $10 trillion by 2020.
Meanwhile, financial institutions themselves aren’t sitting still. The Australian Stock Exchange announced an effort to replace its system for bookkeeping, clearance, and settlements with a blockchain solution developed by Digital Asset Holdings.
In June 2017, enterprise-focused blockchain company Chain — since incorporated into a new company called Interstellar — successfully orchestrated live transactions between the Nasdaq and Citi’s banking infrastructure via integration. Meanwhile, Overstock’s CEO launched a trading platform called tZero, which wants to create a blockchain-backed dark pool, or private exchange, for securities that might be listed on the Nasdaq.
While tokenized assets are a hugely promising use case for blockchain technology, the biggest hurdle is regulatory. It’s still unclear if ownership blockchain technology is legally binding, while tokens remain an ambiguous term that don’t currently have legal standing. Regulatory and legislative guidance will be key to the success of these nascent projects.
The worlds of the consumer, the financial institution, and blockchain are slowly converging. Another space where that convergence has the potential to completely upend the way finance operates today is lending and credit — a domain that’s no stranger to disruption.
5. Loans and Credit
- Blockchain-enabled lending offers a more secure way of offering personal loans to a larger pool of consumers and would make the loan process cheaper, more efficient, and more secure
- The first live securities lending took place in 2018 with a $30.48M transactionbetween Credit Suisse and ING
The worlds of the consumer, the financial institution, and blockchain are slowly converging. Another space where that convergence has the potential to completely upend the way finance operates today is lending and credit.
Traditional banks and lenders underwrite loans based on a system of credit reporting. Blockchain technology opens up the possibility of peer-to-peer loans, complex programmed loans that can approximate a mortgage or syndicated loan structure, and a faster and more secure loan process in general.
When you fill out an application for a bank loan, the bank has to evaluate the risk that you won’t pay them back. They do this by looking at factors like your credit score, debt-to-income ratio, and home ownership status. To get this information, they have to access your credit report provided by one of three major credit agencies: Experian, TransUnion, and Equifax.
Based on that information, banks price the risk of a default into the fees and interest collected on loans.
The five biggest US banks control $3.7 trillion worth of commercial lending.
This centralized system is often hostile to consumers. The Federal Trade Commission estimates that one in five Americans have a “potentially material error” in their credit score that negatively impacts their ability to get a loan. Further, concentrating this sensitive information within three institutions creates a lot of vulnerability. Last year’s Equifax hack exposed the credit information of over 145 million Americans.
Alternative lending using blockchain technology offers a cheaper, more efficient, and more secure way of making personal loans to a broader pool of consumers. With a cryptographically secure, decentralized registry of historical payments, consumers could apply for loans based on a global credit score.
While blockchain projects in the lending space are still in their infancy, there are a couple of interesting projects out there around P2P loans, credit, and infrastructure.
The Bloom protocol seeks to issue credit based on a track record of successful identity attestation on the network, without trusted third parties.
EXAMPLES OF IMPROVED LENDING THROUGH BLOCKCHAIN
One project, EthLend, raised $16.2M via ICO. EthLend wants to build a decentralized peer-to-peer lending application on top of Ethereum. This is how it works: when a borrower issues a loan request, a smart contract is created with the loan amount, interest rate, and time frame. The borrower puts up tokens of EthLend as collateral. If the loan isn’t paid in time, the lender receives tokens as collateral.
Dharma, for example, is a protocol for tokenized debt. It aims to provide developers with the tools and standards necessary for building online debt marketplaces. Meanwhile, Bloom wants to bring credit scoring to the blockchain, and is building a protocol for managing identity, risk, and credit scoring using blockchain technology.
While most of these projects focus on creating liquidity through loans around people’s existing crypto assets, they’re also jumpstarting the infrastructure that will enable bigger disruption in loans via blockchain.
6. Trade Finance
- The use of blockchain and distributed ledger technology (DLT) can support cross-border trade transactions that would otherwise be uneconomical because of costs related to trade and documentation processes. It would also shorten delivery times and reduce paper use.
- With approximately 80 to 90% of world trade relying on trade finance, the influence of blockchain on the market would be felt globally throughout all industries that use cross-border trading
Trade finance exists to mitigate risks, extend credit, and ensure that exporters and importers can engage in international trade.
It is a pivotal part of the global financial system, and yet it frequently still operates on antiquated, manual, and written documentation. Blockchain represents the opportunity to streamline and simplify the complex world of trade finance, saving importers, exporters, and their financiers billions of dollars every year.
Blockchain technology has had an increasingly regular presence in trade programs for a year now, but its mainstream role in bills of lading and credit has only recently begun to firm.
Like many industries, the trade finance market has suffered from logistical setbacks due to old, outdated, and uneconomical manual documentation processes for years. Physical letters of credit, given by one party’s bank to the other party’s bank, are still often used to ensure that payment will be received.
Blockchain technology, by enabling companies to securely and digitally prove country of origin, product, and transaction details (and any other documentation), could help exporters and importers provide each other with more visibility into the shipments moving through their pipelines and more assurance of delivery.
One of the greatest risks to trade parties is the threat of fraud, which is greater because of a lack of confidentiality and little oversight on the flow of goods and documentation. This opens up the possibility of the same shipment being repeatedly mortgaged, an unfortunate occurrence that happens so often that commodity trade finance banks write it off as a cost of business.
Through blockchain technology, payments between importers and exporters could take place in tokenized form contingent upon delivery or receipt of goods. Through smart contracts, importers and exporters could set up rules that would ensure automatic payments and cut out the possibility of missed, lapsed, or repeatedly mortgaged shipments.
The adoption of blockchain technology in trade finance could mean greater trust between trade parties, increasing global business, while also hiding confidential information such as pricing and trade secrets when necessary.
It would also give buyers better insight into where their goods originate from and when they’ve been shipped. Under traditional systems, this information is often incomplete. But blockchain would enable consumers to be updated at each step of the trade, further increasing trust and transparency.
EXAMPLES OF IMPROVED TRADE FINANCING THROUGH BLOCKCHAIN
Arguably, the time has come for blockchain in trade finance, with multiple companies and banks weighing in to find a solution that will stick.
Standard Chartered and HSBC are two banks that have joined consortia dedicated to using blockchain technology to fix trade finance.
One of those consortia is Voltron, run by R3 and CryptoBLK, which operates a blockchain platform for digitizing paper letters of credit.
Fintech companies such as Israel-based Wave have developed platforms that enable finance groups to provide letter credit transactions as a blockchain solution.
With this platform, EuroFinance in Barcelona was able to provide a blockchain solution to Ornua and Seychelles Trading Company to streamline their supply chain, reduce transaction costs, nearly eradicate their documentation error, and quickly transfer documents to customers around the world.
With Wave’s platform, the trade process for almost $100,000 of cheese and butter, from the issuing of the letter of credit to the approval of it, took less than four hours, drastically down from the traditional time of seven to 10 days.
Blockchain and DLT have also enabled trade between Australia and Japan by facilitating trade-related processes from letter of credit issuance to the delivery of trade documents. In this instance, the trade process was carried out by IBM’s Hyperledger Fabric — built on the Linux Foundation’s open source version — and secured by IBM.
Beyond the hype
Disruption doesn’t happen overnight. Blockchain technology is still in its infancy, and a lot of the actual technology has yet to be perfected. Die-hard believers in cryptocurrency believe that it will replace banks altogether.
Others think that blockchain technology will supplement traditional financial infrastructure, making it more efficient. One thing is clear, however: blockchain technology will indeed transform the banking industry.
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