The blockchain revolution in financial services.
Updated: Jan 4
The workflow and processes in the financial services industry, Tasks once handled with paper money, bulky computers, and human interaction are now being completed entirely on digital interfaces. Given how pervasive financial services are across the globe, the disruption opportunity. Almost every type of economic activity — from banking to payments to wealth management and more is being re-imagined. Meanwhile, the old guard is trying to solve a puzzle presented by the Blockchain revolution: How can they benefit from the rise of digital and avoid obsolescence.
Fintech — financial technology is an umbrella term describing disruptive technologies in financial services. Fintech has transformed the way money is managed. It affects almost every financial activity, from banking to payments to wealth management. The banking and financial industry is facing very different challenges. Banks are investing more heavily in innovation. However, they haven't yet fully diffused their innovation strategies throughout their organizations and navigate the regulatory landscape.
Banks will have to find a way to develop new platforms while overcoming legacy infrastructure. Startups will have to find a way to scale out their business while facing increased regulations, higher costs, and more extensive infrastructures that will be more difficult to manage. The Blockchain is a wild card that completely overhauls financial services. Both major banks and startups worldwide are exploring the technology behind the Blockchain, which stores and records Bitcoin transactions.
This technology could lower the cost of many financial activities to near-zero. This would have a dramatic effect on big banks, which currently face high operating costs. It's also disruptive in that it could disintermediate many financial processes. Blockchain technology is poised to transform the financial sector by increasing efficiency, transparency, and security, reducing costs, and unleashing an unprecedented wave of innovation. Blockchain, the technology behind the cryptocurrency Bitcoin, is one of the hottest topics in the financial sector. Dozens of large financial institutions, including many of the world's major banks, have already launched initiatives to explore Blockchain's potential.
As applied in the Bitcoin context, Blockchain is a decentralized, public ledger that contains the details of every Bitcoin transaction that has ever been completed. Due to several innovative technical protocols, the ledger has proven to be exceptionally accurate and secure. Interest in the technology exploded when it became clear that Blockchain can be used to document the transfer of any digital asset, record the ownership of physical and intellectual property, and establish rights through smart contracts, among other applications.
By reordering and automating complex, labor-intensive processes, the technology can enable organizations to operate faster and cheaply.
Blockchain could reduce banks' infrastructure costs by US$15 – $20 billion per year by 2022. Institutions are exploring a variety of opportunities to use Blockchain, including applications to improve and enhance currency exchange, supply chain management, trade execution and settlement, remittance, peer-to-peer transfers, micro-payments, asset registration, correspondent banking, and regulatory reporting (including applications related to "know your customer" and anti-money-laundering rules). Highlighting the potential for banks, Santander issued a report in 2015 estimating that blockchain "could reduce banks' infrastructure costs attributable to cross-border payments, securities trading, and regulatory compliance by between US$15 – 20 billion per financial year by 2022." And there is reason to believe the actual figure may be higher. For most large financial institutions exploring blockchain opportunities, 2017 will be a year of continued innovation and experimentation. But these activities are only a prelude to profound changes throughout the financial sector.
ABCs of Blockchain
Blockchain is a technology that was initially developed for Bitcoin, the cryptocurrency. It is a distributed ledger or database operated by a peer-to-peer network of unaffiliated participants using computers running sophisticated algorithms. These participants, Bitcoin "miners," process transactions according to strict protocols that ensure a very high degree of accuracy and security.
Anyone can participate—the Blockchain is fully transparent and available to all—but only the miners that are the first to process an individual transaction are compensated. As individual transactions are processed and verified by other miners on the network, they are bundled into groups called blocks; blocks of transactions are linked together to make the Blockchain. Every Bitcoin transaction is permanently recorded in the Bitcoin blockchain for all to see, creating an ever-growing historical record of activity. The mining process begins continuous, decentralized monitoring by every computer on the network and ensures the blockchain record's accuracy and security.
Blockchain has the potential to transform how business and government work in a wide variety of contexts. Blockchain technology revolutionizes the transaction process by dispersing control and providing total transparency, obviating the need for the type of intermediaries or centralized authorities that traditionally conduct, authorize, or verify transactions. The use of Blockchain is not limited to Bitcoin or other cryptocurrencies. Blockchain has the potential to transform how business and government work in a wide variety of contexts. Blockchain can be used to record and track the details of any transaction or ownership of any asset, including tangible assets such as real estate and intangible assets such as intellectual property.
It can also be used to automate contracts, dramatically simplifying the process of creating and executing them. (Importantly, companies can choose to develop public or private blockchains, depending on their objectives; see the sidebar "Public vs. Private Blockchains" for more detail.) The perception of Blockchain's potential is reflected in investment trends. According to Goldman Sachs, venture capital (VC) firms invested almost a billion dollars in the technology over the last three years, with about half of that amount invested in 2015.
As we will see, financial institutions are among the biggest investors in Blockchain, reflecting a growing belief that the technology may have its most significant impact in the financial services sector.
Public vs. Private Blockchain
To understand the difference between public and private blockchains, consider the difference between the Internet, which is public and available to everyone, and intranets created by specific entities and only available to certain individuals with permission.
Public blockchains are decentralized and accessible to anyone, regardless of their affiliation. Transactions are publicly verified and remain in the public domain. To ensure the system's integrity and validate transactions, financial-incentive and consensus mechanisms are built into the system to the advantage of public blockchains outside the control of any private or governmental entity. Because a public blockchain is available to anyone, Crowdsourcing improvements are made by consensus of the participants. Open access encourages greater participation and makes it more likely for public blockchain networks to be employed in a broader variety of applications. Notably, public blockchains offer the potential for reducing transaction fees.
For example, in the Bitcoin network, the average processing fee for a Bitcoin transaction is .04 cents, compared to more than .35 cents for a typical credit card transaction. Private blockchains are set up and maintained by a private entity. Security protocols control and limit access to authorized parties. Transactions are verified within the private Blockchain and can potentially be altered within that private network, enabling operators to correct errors.
This feature is not permitted in public blockchains, in part because it can create security risks. There are two types of private blockchains: consortium, which includes preselected participants from various organizations, and entirely private blockchains limited to participants from one organization. Private blockchains can authenticate transactions more quickly— generally within seconds—because they operate on more centralized networks and are made up of fewer computers.
In contrast, it can take as long as two hours to authenticate a Bitcoin transaction, which happens on a globally distributed, public Blockchain involving thousands of unaffiliated computers.
Blockchain Applications in Financial Services
An array of major financial institutions already has launched efforts to explore the potential opportunities Blockchain holds for their businesses. Some, such as USAA Bank and BBVA, have invested millions of dollars in Bitcoin service providers such as Coinbase and Circle to study blockchain applications. Others, such as Barclays and Fidelity, have created accelerators or sponsored hackathons to provide space for and learn from Startup’s. Others, such as Citi and Nasdaq, are beta-testing systems built on top of the blockchain technology to explore its potential. Goldman Sachs applied for a patent on a settlement system for securities markets that would employ its cryptographic currency, the SETLcoin.
Goldman is also one of 42 financial institutions (half of which rank among the 100 most extensive globally, by revenue) that joined a blockchain consortium launched in 2015 by R3 CEV, a financial technology firm. This consortium, one of the first cooperative efforts among significant institutions in the financial services sector, is exploring opportunities to deploy Blockchain in new financial products and services and their ongoing operations. Indeed, financial institutions invested US$75 million in blockchain technology in 2015, according to the Aite Group, a financial services research firm. That is more than double the amount invested in 2014, and Aite estimates that financial institutions will be investing five times that amount annually by 2019.
The following are some of the areas and applications getting the most attention in Blockchain from financial services companies and regulators.
Trade execution and settlement
Blockchain will enable faster settlement at lower costs while simultaneously lowering the risk of fraud. Some companies will develop unique and powerful trade and settlement offerings.
One example is Nasdaq's private Link blockchain network, which enables private companies that have not yet been subjected to the record-keeping demands of the public listing to keep track of changes in the ownership of shares issued to founders, early investors, and employees. Similarly, Ripple has established a robust value exchange platform over which financial institutions can exchange, in real-time, currency, cryptocurrency, commodities, and other tokens of value, without relying on traditional intermediaries of the international monetary system, such as the Society for Worldwide Interbank Financial Telecommunication (SWIFT).
Overstock.com has issued private bonds via a blockchain mechanism in a different context, and the US Securities and Exchange Commission approved Overstock's proposal to issue and record company stock using Blockchain. In each case, a record of the change in ownership is immediately inscribed on the Blockchain, and payment and settlement of the trade occur simultaneously.
Asset exchange Blockchain will enable the development of new exchanges that facilitate the trade of various assets, not only financial instruments. This would typically involve exchanging virtual tokens that represent underlying assets, which could include physical or intellectual property.
In early 2016, the technology company R3 CEV conducted a test that involved exchanging tokens that represented theoretical assets through a private blockchain application. The test, which used Ethereum, an open-source blockchain platform, was executed over five days among bank offices in North America, Asia, and Europe. Banks participating in the test included Barclays, BMO Financial Group, Credit Suisse, Commonwealth Bank of Australia, HSBC, Natixis, Royal Bank of Scotland, TD Bank, UBS, UniCredit, and Wells Fargo. Physical asset registration Blockchain will streamline the process of registering assets, including real property. In real estate, Blockchain eliminates the need for title insurance to confirm a local government's property registry's accuracy.
Instead of the currently expensive and lengthy title review and registration process, a public blockchain can be used to create an accessible ledger of property ownership, dramatically reducing the time it takes to transfer real estate ownership while reducing the associated costs. Blockchain will also facilitate more rapid price comparison and enable the tracking of escrow payments on contracts. Several Startup’s, including Ubitquity, LLC, and Factom, are building platforms designed to track property ownership via notarization functionality.
Supply chain management by enabling accurate tracking of the movement of goods, Blockchain will provide a highly secure supply chain management system that is resistant to fraud. Ever-ledger, a London-based startup, focuses on registering and tracking individual diamonds to document their provenance, track their ownership, and combat insurance fraud.
The company captures the serial number inscribed on individual stones. It effectively digitizes each diamond, placing all collected data on a blockchain ledger and expanding this application of blockchain technology to other luxury goods, such as high-end watches, artwork, and designer handbags, to provide a robust system to track ownership transfers. Cash reserve management's current system of multiple intermediaries drags out settlement time, increases costs, and risks financial institution intermediaries.
Blockchain offers the potential to drastically cut settlement time, which in turn will reduce the amount of cash and collateral that financial institutions will need to hold to mitigate settlement risks.
This will be particularly significant for international transactions, which currently take days to complete but can be completed in hours using blockchain technology. Smart contracts use digital technology to embed business rules into a deal, including automated contract terms. Using Blockchain, smart contracts can be customized on a contract by- contract basis, streamlining transactions by cutting out counterparties and intermediaries.
Smart contracts will also be of interest to regulators because of their more robust security features and reduced internal hacking risks. IBM is investing in a proprietary blockchain to facilitate digital contracts, but it also plans to release an open-source version that anyone can use.
Smart contracts using Blockchain can empower artists, allowing musicians and authors to license and track the use of their works themselves without intermediaries. Algorithmic regulation Blockchain is not only transforming banking. It will also change bank regulation and supervision. For example, financial institutions could leverage existing applications to develop algorithms that identify abuse patterns related to fraud and money laundering.
Blockchain technology will enable banks to track every transaction's progressive history on their systems to ensure that the origin, ultimate destination, and use of funds is clear and traceable. This will improve the ability of banks to identify suspicious customers and networks.
Private entities already use algorithmic approaches that do not rely on Blockchain to monitor and manage compliance for example, Google's automated Content ID system automatically disables YouTube videos that potentially violate copyright laws.
Similarly, government agencies will implement Blockchain in courses such as Fedwire to enable bank supervisors to identify systemic payment risks. What to expect Blockchain is leading the way for a wave of tech-based financial innovation that is already disrupting the banking and financial sectors. It is tempting to analogize this transformation to the computer processing revolution of the 1980's., but that would understate the extent of the coming changes.
When computers replaced paper in the back offices of financial institutions, the underlying processes remained unchanged. For example, the steps required to complete a securities trade are essentially the same today as 50 years ago; computers only increased the trading speed. By contrast, Blockchain fundamentally reorders the mechanics of financial transactions in ways we did not envision just a few years ago.
It will take time for institutions to fully account for the benefits and risks that Blockchain has in store. But few can afford to sit on the sidelines waiting for total clarity as the technology evolves and is deployed by competitors. The pace of innovation will accelerate as technology, and financial services continue to converge, and success will often depend on the ability to take reasonable action based on informed experience.
Thus, it is critical for institutions to actively participate in this cycle of innovation and disruption to ensure that they understand how technology shapes the sector and that they are positioned to identify and pursue opportunities as the landscape evolves.
Similarly, it will be essential to understand that working to develop a perfect solution will be futile if the problem itself changes before the solution can be implemented. We stand when we can predict with reasonable certainty a multitude of changes and developments from blockchain-based solutions.
At the advent of the blockchain revolution, the challenge that lies ahead for financial services and fintech firms may not be so much fashioning solutions as it is identifying the problems that will require new and innovative thinking. The most successful firms will take advantage of these opportunities to harness fintech and the blockchain revolution.