Blockchain Technology in Financial Services
Blockchain: a decentralized system that maintains a shared ledger among many parties and that allows us to securely process, record and store transactions between all parties in a distributed network. You end up with an immutable ledger and a transaction history up until the first transaction that was ever made.
Distributed ledger technology (DLT) or Blockchain technology (BT) is currently a very active research field and most applications remain to be built. The financial sector is the most likely to be revolutionized by this technology within those few years.
[I mainly focus on blockchain 2.0, which is an umbrella term to refer to all the applications going beyond Bitcoin.]
Financial institutions were among the first to notice the potential of distributed ledger technology for running their business more efficiently and to solve real financial problems that include cost avoidance, capital reduction, risk reduction, regulatory compliance…
Blockchain’s Innovative Aspects
Blockchain technology can bring innovation in, amongst other, 3 aspects:
- Transfer of value: blockchains are good at telling you “who owns what” without needing a third party to enforce it. As Bitcoin showed it over the past few years, blockchain allows us to create decentralized currency systems for the transfer of value. Whether it is a digital currency or any other type of asset, it can be digitally represented by an ownership title (a so-called “token”) that can sit on such system backed by a peer-to-peer network and secured by distributed protocols
- Identity management: This technology is powerful in terms of managing the verification of users’ identities due to the use of cryptographic hash functions that allows for digital signature
- Contract management: smart contracts could play a pivotal role in bringing down the cost of engaging in a contract by reducing contracting, enforcement, and compliance costs.
The Financial System Today
The financial system is built on this slow fulfillment of trades due to the multiplication of middlemen in the way charging fees on all of these transactions that often take 2 to 3 days to settle.
People can hold a near real-time video call from anywhere around the world, but sending $10 overseas using the traditional banking system can sometimes take a week. Today’s worldwide financial system is old and inefficient in lots of aspects.
The system is siloed into fractions. Most financial institutions have their databases, their accounting system, their payment system, etc. They are all operating within their ecosystem that requires complex API developments to enable connectivity, which makes it challenging for those institutions to operate with one another. This translates into increased latencies and frictions inside financial networks.
Bringing Efficiencies to Financial Processes
Blockchain Technology can bring efficiencies to the financial processes by reducing the intervention of the middleman in the transfer of value, as well as by inter-connecting various entities on a single network to guarantee a single source of truth.
It provides a mechanism to share infrastructure among independent entities where those entities can reliably refer back to a common source of the truth related to transactions that took place between them.
Such infrastructure can bring advantages like capital efficiency gains, reduced latency of transaction processing, efficient auditability of transaction history and transparency along with business processes.
The financial services or processes that will more likely be impacted and benefit from this technology, are those showing these common attributes:
- Multiple writers: when multiple parties are involved as they need to transfer information between each other
- Common information: when these different parties have to update data and to agree on the shared data
- Intermediaries: when there is general mistrust between parties, hence justifying the intervention of one or more middlemen to enforce trust
I will go through 4 services: International Payments, Remittances, Capital Markets, and Compliances.
International Payments
With globalization, a business that once was local became international and firms started to operate worldwide. This comes hand in hand with the process of facilitating communication, delivery, and payment. Though communication and delivery dramatically improved over the years, payment systems have remained roughly equivalent.
The banking system relies on bilateral relationships, in other words, if banks don’t have any direct link with one another, they would have to operate through other banks. Why is it so? Interoperability between two banks can be cumbersome because it requires the development of APIs enabling secure communication.
For instance, if a Nepalese farmer intends to acquire farming equipment from a Kenyan manufacturer, the payment process would be as follows. The farmer goes to a local banking agency and pays in Nepalese rupee (NPR), then the banking agency will send the money to a central counterpart that will then send the NPRs to a correspondent bank. The NPRs are exchanged for Indian rupees (INR) and sent to a receiving correspondent bank. Once again, the receiving correspondent will send the INRs to a central counterpart that iterates the same process.
SWIFT is responsible for communication between centralized databases of different financial institutions. With blockchain, the need for reconciliation of data disappears as parties are working on the same distributed ledger. Therefore, the role of SWIFT becomes redundant.
There exist blockchain-based solutions that simplify the whole process by getting rid of all the intermediaries and assembling both parties on a shared ledger. Blockchain provides a math-based currency and a standard messaging protocol to connect every single user on one network.
Remittances
We learn from the World Bank report that an increase in the number of migrants goes hand in hand with an increase of remittances. This report highlights the fact that migrants are sending money back to their families in developing countries at levels above USD 441 billion a year. This represents one of the largest flows of money from developed countries to emerging nations.
People are leaving their birth country in the hope of making a better living in countries offering more employment opportunities. Once established, many send money to their families back home. What is wrong? The remittance system is highly inefficient and costly. On average, it will cost someone 8 percent to send remittances.
ps: remittances in Sub-Saharan Africa and the Pacific Island countries amount for 20 percent
This system is highly inefficient because a large proportion of the money is reduced due to the high transaction costs of sending money internationally. Indeed, many intermediaries are required along the way and they all take their part of the pie.
Similarly to international payments, remittances would be better off on a blockchain. This would translate into fewer frictions, fewer latencies, and lower costs.
Capital Markets
Capital markets are essentially places where companies can raise capital (primary markets) and investors can trade securities (secondary markets). Those markets play a pivotal role in the allocation of capital to organizations that need it for productive use, resulting in the more effective functioning of the economy overall.
In such markets, it happens that a counterparty defaults, this is called the counterparty risk. This is why intermediaries come into play to reduce this risk. On the other hand, intermediaries slow down the fulfillment of trades and charge fees. The idea is to disrupt the current system by introducing a decentralized business model built on distributed ledger technology.
Blockchain can be useful for eliminating counterparty risk (the risk that the counterparty would default), due to instant collateralization and instant settlement. There could also be an opportunity to reduce intermediary steps in the process. Capital markets based on blockchain would bring an efficient structural change regarding interactions between participants of the capital market and the integrity of the data.
Regulatory compliance
Financial markets are becoming more and more regulated and complying with those regulations can quickly be cumbersome. Issues arise from both sides, on the one hand, banks, funds, exchanges… have to do a lot of reporting, and on the other hand, regulators don’t have an efficient way to process this data.
Transparency is key. Relying on infrastructure like blockchain would contribute to facilitating much of the reporting work for both financial institutions and regulators. Let me illustrate this with the Basel regulations and the MiFID.
Basel III
Basel III aims at maintaining financial stability through more resilient banks’ funding structure to financial chocs. It mainly focuses on raising capital adequacy ratios and reducing banks’ dependence on short term wholesale funding.
It should guarantee that each bank allocates the appropriate volume of own funds and eligible liabilities to, in the first place, absorb any eventual losses, and also to ensure it can recapitalize without the need of public funds.
Banks could use blockchain technology on top of their accounting system to facilitate the reporting of their funding structure. Banks have to compute their risk-weighted assets (RWA) to determine the equity they have to hold in their balance sheet. Verification of RWA computation would become easier for regulators with blockchain-based solutions.
MiFID (Markets in Financial Instruments Directive)
The MiFID is a regulatory framework affecting banks, funds, exchanges, traders…, it affects most financial actors. It forces those institutions to prove that they have acted honestly in the exercise of their profession. This framework aims at protecting the investors and restoring their confidence in the financial system.
The upcoming MiFID II makes it tougher for those institutions to comply with the requirements. In response, the Swiss banking giant UBS is decided with Barclays, Credit Suisse, KBC, SIX and Thomson Reuters, to test a blockchain-based solution on Ethereum that would ease the impact of MiFID II.
Conclusion
Is there an opportunity for financial institutions? At this stage, it is not sure if the blockchain technology will disrupt the entire financial industry but it becomes clear it can enhance the efficiency of a multitude of financial processes.
As mentioned, blockchain technology has many advantages and institutions should care about it. According to Gartner’s latest strategy trends for 2017, blockchain technology counts among the technologies that leaders will need to start focusing on over the years.
Drop me a message if something is not clear!
