Digital Banking is on everyone’s mind — it’s about automating end-to-end banking processes and offering a digital experience to end clients. The focus on Digital Banking is understandable — we are all witnessing increasing cost pressures, regulatory pressures and a low-interest rate environment. Digital Banking is the answer by the traditional banking system to these pressures. However, Digital Banking per se causes little changes to the banking ecosystem: in principle banks continue as they are, just operate more effectively.
Most of us witnessed the emergence of the Internet and World Wide Web 2.0 and the new network-based business models that were born. Could the same happen with Digital Banking? Could we anticipate the emergence of Digital Banking 2.0? Would it result in widespread changes in the banking landscape and business models in the same way as Web 2.0 did?
I represent the thesis that Bitcoin and its underlying conceptual technology — Blockchain — may enable revolutionary changes to the banking landscape and the emergence of Digital Banking 2.0.
Bitcoin is a digital currency which enables instant payments to anyone, anywhere in the world. It is based on private-public key cryptography, where the owner of the private key can do transactions with his Bitcoins and where a public key allows anyone to see the amount of Bitcoins on a specific address or to send Bitcoins to this address.
The Bitcoin system is based on the Blockchain technology, which is in essence a cryptographically secured, distributed ledger. Old transactions cannot be changed and new transactions are added to the end of the distributed ledger in an unchangeable way. The integrity of the ledger is ensured by a computationally heavy process known as proof of work, which verifies transactions and is executed by a network of anonymous computer owners known as Bitcoin-miners. The Bitcoin Blockchain distributed ledger is available to anyone who participates in the Bitcoin system.
The Bitcoin Blockchain is used to track ownership and transactions between Bitcoin holders, but the Blockchain technology is not limited only to Bitcoins — any transaction with digital assets could be represented with this same Blockchain approach.
Most financial assets have digital representation and hence they could be stored in Blockchain. The transactions between the holders (addresses in Blockchain terminology) could be modelled in Blockchain, and they could be available to anyone using Blockchain technology.
Blockchain represents an innovation that could be compared in its impact to the invention of the double-entry bookkeeping system or of the legal form of doing business, a corporation. These last two innovations shaped the way we do business today. Will Blockchain be the next big invention?
Most of the financial industry is based on ledgers which record who owns which assets, who receives payments from these assets, and how to transfer ownership of these assets from one participant to another. But these ledgers are all private to banking institutions. This creates the need for a new ecosystem of participants whose core business is transferring ownership between asset owners.
For example: If client A sells 10 shares of IBM to client B, we see the following transactions: Client A’s custodian transfers shares and receives money, and Client B’s custodian receives shares and transfers money. The process can take up to 3 banking days and there is a middleman (clearinghouse) validating that all runs properly. The middleman will charge a fee for this service.
However, Blockchain technology allows the creation of distributed ledgers between all market participants. This results in new business models that exclude middlemen. Client A and Client B may interact directly with each other using a public distributed ledger. It is obvious that this public ledger-based approach increases the efficiency, transparency and quality of the transaction execution, and at the same time reduces its total cost.
Uses of Blockchain in traditional services
Digital Asset Registries
As I said before, most financial assets can be represented digitally: publicly traded instruments will have ISIN codes, and similar codes are being created for OTC instruments too (UTI from ISDA for example). Digitally represented assets can be stored into Blockchains, including information about who owns how much of which asset. Buy and sell transactions would be as simple as moving a specified number of digital assets from one owner to another in a cryptographically secured way. The transferor of the asset has a private key for the authorization of the transaction; the receiver of the asset has to use his private key for payment authorization. Settlement and clearing of trading transactions would be significantly simplified and speeded up by such an approach.
If all assets of a banking client can be represented digitally, his portfolio can be completely represented by digital asset registry. A client portfolio could contain digitally represented assets and digital money (Bitcoin, Litecoin, Ethereum, etc.). The client could be able to access his portfolio from any place with his private key; he could execute transactions in his digital assets or digital money with his private key; or he can delegate management of his assets to a professional asset manager by assigning him his private key or by using a multi-signature approach in which specific transactions have to be signed by two or more private keys.
In today’s custody business model, the asset manager either has his own custody (if he is a bank) or uses the custody services of another bank. However, by using public ledger-based asset registries, the client will be the real owner of his assets. The client will not run the risk of bank failures. He will not face situations where part of his assets may be converted into bank equity (based on too big to fail provisions, when bank capital ratios are sinking below regulatory targets) or be lent out by the bank — with Blockchain, the client will be the real owner of his assets.
Another business case for distributed ledgers can be collateral management in the lending process. By registering collateral in a distributed ledger and by specifying for whom and how long the collateral is allocated, we create an effective means of collateral management. The speed of collateral management will be increased, the traceability will be available and transparency for regulatory reporting will be created. Additionally, collateral margin calculation would be simplified as it would become transparent how many times specific collateral is already lent out.
These were some examples of the potential uses of distributed ledgers. One can assume that there will be as many new potential uses of distributed ledgers as there are ledgers today.
New applications for the new technology
Blockchain technology also allows for the implementation of “Smart Contracts” where assets are exchanged on certain conditions against payments. Let’s look again at the example “asset in exchange of payment”. If we have a digital asset which represents an IBM share and if we have a digital means of payment (Bitcoin), then the exchange between Client A and Client B can be executed in one transaction. This new transaction will be added to the Blockchain, it will be cryptographically signed and there will be no way to change it after that. There will be no need for complex 3-banking-days long business processes — everything can be completed within 10 minutes.
This is an example of a basic smart contract. The business logic of a smart contract can be extended in arbitrary ways: there can be multiple participants, there can be escrow services, multiple payment terms, etc. These will be digitally executable contracts between digital assets and digital money. All derivative, future or bond contracts could be represented as smart contracts so that their processing can be 100% automated.
Private and Public Ledgers
Bitcoin Blockchain is a public ledger and thus is available to any member of a Bitcoin system. Asset registries and transactions between holders of these assets on Bitcoin Blockchain are visible to anyone too. Public ledgers do not have any gatekeepers defining who can or cannot participate.
At the same time, there are several technology providers offering Private Blockchains. These are “mini-Bitcoin” systems, where only the participants of the private blockchains can transact with each other. These Private Blockchains can be use-case specific or participant specific — for example private collateral management blockchains for big banks. Private Blockchains would work on the basis of permission, namely there would still be a central instance which will grant or remove memberships to respective blockchains. These gatekeepers would thus have a potential revenue source or even provide new business models.
Emergence of New Service Providers
Every bank has either built or bought their “ledger” systems for managing huge numbers of standardized digital transactions. Middlemen are facilitating the ownership and flows of funds between banks. Both these bank “ledger” systems and middlemen are becoming obsolete.
Both services can be taken over by public or private Blockchain ledgers from new service providers. One bank probably does not want to become a member of another bank’s private Blockchain ledger, where the other bank is gatekeeper to the service. However, the same bank could be ready to become a member of a private Blockchain of an independent service provider. The private Blockchain would have a higher utility as more participants join, which would attract new participants and so on. It’s the same network effect which is core for e-Bay or Facebook business models.
This creates room for new market participants whose core business will be running today’s diverse banking ledgers. The businesses of these new service providers will benefit strongly from network effects however, which will likely lead to the consolidation of these new service providers.
Investments into Bitcoin / Blockchain Sphere
By September 2015 venture capital investments into Bitcoins were USD 921 mio; the number of venture capital-backed startups was 119 and the Bitcoin sector became the fastest growing startup sector. Investments into Bitcoin companies in 2014 and 2015 match investments into early internet companies in 1994 and 1995. Blockchain and Hybrid startups have received USD 285 mio in investments, representing 22% of startups in the Bitcoin sphere.
Additionally, there are a number of big banks experimenting with Blockchain technologies, whose main focus is how to use decentralized ledgers in banking business processes.
Bitcoin may have caused people to overlook the potential of its underlying technology, but based on venture capital investments and on experiments in the major banks, we can say for sure that the Blockchain technology is here to stay.
Digital Banking 2.0, based on Bitcoin and Blockchain technology, will result in revolutionary changes in banking. The role of current players in the ecosystem will change and new players will emerge. Many current services will be provided at a much lower cost basis. Middlemen will lose their positions in value chains in the same way it happened in the music industry about 15 years ago. This will translate into changes in banks’ revenue models, which, together with the entrance of new participants to the market, will trigger changes in business models, and result in complete banking ecosystem changes.
The transactional part of the banking business will change as well. Many of the complexities of ledgers, asset transfers and collateral management will be simplified, and banks will be able to decrease headcount. Transaction management will become a commodity in the banking business.
However, the advisory process, portfolio management, credit management and risk management — the know-how intensive disciplines of modern banking — will stay. Banks will simply focus more on their core competencies and less on transaction processing. This will result in an increased focus on know-how intensive areas, which at the end means real value creation for clients.
(This article was first published in Swiss CFA Society Magazine 2015 November Edition)
· Venture capital investments into Bitcoin technologies: http://www.coindesk.com/bitcoin-venture-capital/
· State of Bitcoin and Blockchain Q3 2015: http://www.coindesk.com/research/state-of-bitcoin-q3-2015/
· Bitcoin Wiki: https://en.bitcoin.it/wiki/Main_Page
· 8 Banking Giants Embracing Bitcoin and Blockchain Tech: http://www.coindesk.com/8-banking-giants-bitcoin-blockchain/
· Meet the 25 Banks Working With Distributed Ledger Startup R3: http://www.coindesk.com/meet-the-25-banks-working-with-distributed-ledger-startup-r3/
· Bitcoin in the Headlines: Blockchain Scores Economist Cover: http://www.coindesk.com/bitcoin-in-the-headlines-blockchain-scores-economist-cover/
Web Site: https://smartcredit.io
Blog (first article from Jan 2014): https://smartcredit.io/blog