Blockchain, Banks, and the Innovator’s Dilemma
Blockchain is disrupting banks. What banks execs can do about it.
The tools we use to organize and facilitate the very functioning of human societies, along with the bureaucracies that manage them, have failed to keep pace with the rate of digital transformation. The contracts we set up, the records we keep, and the transactions we make are currently being thought of and crafted in new digital formats. At the heart of this digital recreation of human society is blockchain technology. (1) (For a non-technical read on blockchain click here)
Many believe blockchain will have its most profound effect on financial services — our banks, insurance companies and other large financial institutions. Trillions of dollars flow through the global financial systems on a daily basis. By design and definition these banks perform a number of critical functions that impact our daily lives and play a key role in the stability of our communities, countries, and continents.
This article briefly explores the relationship between blockchain, the world’s next disruptive technology, and banks, the conservative stewards of the world’s riches. This unique relationship is viewed through the lens of insights gleaned from The Innovator’s Dilemma — a research driven exploration and analysis of the reasons why time and time again large, successful, and well managed market leading companies fail to hold on to their positions of market dominance when new disruptive technologies are brought to market (4).
Disruptive Innovation
What is disruptive technology? As it relates to innovation, the concept was originally penned by Dr. Clayton Christensen in the Innovator’s Dilemma, in 1997.
Disruptive innovation refers to a technological or market advance that fundamentally transforms or creates entirely new markets. Disruptive technologies aim to identify and meet customers’ future needs. (5)
Wikipedia and Uber are great examples of disruptive innovation. Uber has globally disrupted the age old taxi industry, and Wikipedia has completely eliminated the encyclopedia industry.
To more easily recognize disruptive technologies Dr. Christensen identified the following distinguishing characteristics:
1. Fundamentally change the value proposition in the market.
2. Initially offer poorer performance than existing solutions and have less capacities.
3. Have functions that only a few fringe customers in niche markets want.
4. Are often dismissed outright or evaluated as not worthy of concern by market leading companies.
5. Advance rapidly, and ultimately deliver sufficient performance and better functionality than existing products. (6)
The effect disruptive technologies have on products or markets can be sudden or gradual. Through the lens of hindsight, however, disruption is unmistakable.
A notable example is Blockbuster Video. In 2004, Blockbuster had 9000 retail stores around the world. They were the undisputed king of video rental. Investors flocked to them because of their strong cash flows. In 2008 Blockbuster generated $5.5 Billion in sales (7). That same year CEO Jim Keyes was famously heard to be highly dismissive of Netflix:
“Neither RedBox nor Netflix are even on the radar screen in terms of competition. It’s more Wal-Mart and Apple.”
Blockbuster filed for bankruptcy in 2010. Netflix is now valued at $68.6 billion. (8)
Steve Balmer, former CEO of Microsoft commented on the first iPhone:
“Five hundred dollars? Fully subsidized? With a plan? I said that is the most expensive phone in the world, And it doesn’t appeal to business customers because it doesn’t have a keyboard. Which makes it not a very good email machine.” (9)
Thomas Watson, president of IBM in the earliest days of computers, made similar comments about computers.
Blockbuster, Microsoft, and IBM were widely considered to be among the best and most well managed companies. Why is it that their executive and managers misunderstood the advent of video delivery/streaming, the smartphone, and computers themselves?
In researching examples like the above-mentioned, Dr. Christensen uncovered four dynamics that lead to disruption. They are often referred to as the Four Principles of Disruptive Innovation.
The Four Principles of Disruptive Innovation
Principle 1: Companies Depend on Customers and Investors for Resources and profits in order to survive. The best performing and best managed companies are particularly skilled at listening to their customers and investors, as well as providing products they want and the profits they expect. They become highly adept at killing ideas their customers don’t want and as a result don’t invest in disruptive products until it is too late.
Principle 2: Small Markets Don’t Solve the Needs of Large Companies. Large companies need to grow. Investors require increasing profits and stock prices, employees require increasing salaries and benefits. As companies grow larger they need more capital to keep up the growth rate. Small markets do not produce big revenue and profits to meet these needs.
Principle 3: Markets that Don’t Exist Can’t Be Analyzed. Reliance on market research and the ability to forecast are qualities of great management. In new markets there is an absence of market data. As a result managers are unable to make informed analyses or predictions. They are therefore afraid to take risks in the absence of sufficient information.
Principle 4: Technology Supply May Not Equal Demand — Disrupters start small but eventually appeal to mainstream markets. The pace of technological progress often exceeds the rate of improvement. So mainstream products often overshoot customer needs allowing disruptive technologies to eventually become direct competitors.(10)
It is these principles that have repeatedly been responsible for managements’ inability to recognize disruptive innovation.
Is blockchain one of these disruptive technologies? If so, are executives and managers in industries like banking and financial services at risk of falling into the same trap as Blockbuster, Microsoft, or IBM? The answer is yes.
Blockchain
In the same way that the internet facilitates the transfer of information, blockchain facilitates the digital transfer of value.
Blockchain is a decentralized shared ledger that allows transactions to take place between willing participants without the need of a trusted third party intermediary, such as banks. It allows for transactions to be transparent and visible to all concerned parties, offering anonymity when needed. Similarly, it reduces the risk of fraud, as records are unalterable after accounts have been settled. It also contains the capacity to be programmable. (Jamie Skella , wrote This article on blockchain, super easy to understand.)
Blockchain — A Foundational Technology
Harvard researchers Marco Iansiti and Karim Lakhani suggest that blockchain should be more accurately thought of not as a disruptive technology, but rather as foundational. The primary difference between the two is the depth of transformation that will take place and the time that it will take to do so.
Foundational technologies recreate the foundations of our economy and social reality.
An example of a foundational technology is the Transmission Control Protocol/Internet Protocol or TCP/IP. In the same way that blockchain technology was created to facilitate the transfer of Bitcoin from one peer to another, TCP/IP was created for the single use case of sending an email from one researcher to another at ARPANET in 1972. Over the course of 30 years TCP/IP moved through successive phases of development until the internet it serves has transformed our social and economic reality.
“Today more than half of the world’s most valuable companies have internet-driven, platform based business models. The very foundations of our economy and society have changed.” (11)
TCP/IP is only one example of a foundational technology. Others examples include the steam engine, the telephone, the computer, and interchangeable parts.
If TCP/IP took 30 years to mature, how long will blockchain take and where are we in that cycle?
Blockchain’s Current Stage of Development
The article, Blockchain Technology in the Insurance Sector offers a historical and projected future timeline of the development and maturation of blockchain technologies.
The period from 2009–2016 is referred to as the The Dark Age of Bitcoin, consisting primarily of Bitcoin-related market solutions. The period extending from 2016–2021 is called The New Era and consists of 3 sub-periods:
- 2016–2018 — Momentum and Hype Building & The Exploration of Use Cases
- 2018–2020 — The Expansion of Proofs of Concepts (POCs)
- 2019–2021 — Commercial Deployment at Scale. (12)
At present most banks and financial companies have begun the process of working on blockchain technologies at some level. The landscape is primarily divided between internal efforts at in house labs, partnerships, or consortiums. While some are still at the conceptual level, others are working on initial proof of concepts. Those at the vanguard have moved from concept, to pilot, and into the production environment.
Banks
Today’s banking cultures and systems have been patched together over the course of decades, and in some cases centuries. The Bank of New York, for example, was founded in 1784, Citibank was founded in 1812, and Wells Fargo in 1854, to name a few.
The need to be conservative in caring for the world’s wealth combined with the lengthy histories of technologies laid on top of one another, has created a bureaucratic and slow-moving system that is expensive to operate. These conditions, coupled with global economic concerns make banks well suited to benefit from blockchain technology, and simultaneously the most at risk of disruption by it.
Before examining the global banking reality and some of its key issues, it is useful to get a better sense of what banks actually do.
There are three different types of banks: Central Banks supervise the monetary system for nations or groups of nations; Investment or Wholesale Banks issue securities, provide services to corporations and financial institutions; and Commercial Banks primarily focus on providing the general public with traditional banking services like checking, savings, and credit cards.
Banks provide four primary services (Figure 1.)
- Value Transfer — Payments
- Value Storage — Deposits
- Value Provision — Lending/Investing
- Value Protection — Derivatives/Insurance
Providing advisory services related to each of the above mentioned is often thought of as a fifth function that banks provide.(13) The next section looks at the global banking landscape and the pressures they are under in the immediate future.
The New World Of Banking
At present the global banking and financial services industry are under pressure from three forces: an uncertain regulatory environment; historically low interest rates; and digitization or digital disruption.
As a result of these three factors, banks and other financial companies could lose over $300 Billion dollars in profits by 2021. (14)
While low interest rates may be the primary concern, changing regulation and disruptive technologies are compounding and exacerbating their effects.
Changing regulations, for example, are opening the door to Fin-tech companies to begin offering products and services to banking clients, entering markets that have been reserved for banks until now. An example of this is SOFI, a US based marketplace lending platform that has raised more than $1.88 Billion from investors. In June, SOFI applied for a new bank charter for the purpose of offering FDIC insured products to its customers. (15)
McKinsey & Co. projects the impact of digital disruption, of which blockchain is a key contributor, will vary across a wide spectrum. For some countries and regions there is cause for concern. For others the next five years could see $100’s of billions in profits disappear.
To meet the challenges ahead banks will need to undergo an “unprecedented transformation.” This transformation will consist of new business models and technology, supported by new visions and values needed to implement and sustain these changes. (16)
Blockchain, Banks and Disruption
Blockchain was created to allow transactions to take place online without the need of banks. It was designed to disrupt banks. (17) The question then is how does blockchain disrupt the four functions that banks serve?
Value Transfer — Payments: An estimated $150-$300 trillions dollars are conducted annually in cross-border payments, generating in excess of $200 billion in revenue. Fees can average 10% and transfers can take between 2–5 business days or more. Payment cards generate an additional $200 billion in revenue. Both are slow and expensive.
Blockchain can digitize any asset or currency, reducing friction and making transfers and settlement almost instantaneous. Ripple, and Abra are start-ups addressing these issues. (18)
Value Storage — Deposits: Commercial banks, investment banks, and brokerages function as holders of deposits/savings. Most people and businesses use a combination of these services.
Blockchain has the ability to perform all of these functions in a peer-to-peer fashion without the need for banks or intermediaries. Bitcoin, Ethereum, and other digital currencies along with some ICO’s are blockchain based tools that can be used as a value storage tool.
Value Provision — Lending and Investing:
The costs associated with lending are generally associated with assessing credit-worthiness, underwriting loans, operations, collections, etc. With blockchain and smart-contracts, the data available for decision-making is more reliable and readily available. Many manual processes are being automated and reducing costs. Blockchain can also open new markets by providing to groups that have been excluded from credit in the past.
As for investing — ICOs (initial coin offerings) are a new model for raising money that increases speed and reduces fees. Additionally, the functions of lawyers, accountants, bankers, and others can be automated by using smart contracts.
Value Protection — Derivatives and Insurance: Risk management protects parties from losses and catastrophe using insurance, derivatives and other tools. Blockchain makes derivatives more transparent, reduces settlement times, and the fees associated with brokers, agents, lawyers, and others.
Blockchain records provide insurers with accurate historical data that allows for better pricing and prediction. R3CEV and Axioni, Etherisc, and Safeshare are blockchain companies tackling this issue. (19)
The Present Reality
At present most banks and financial companies have begun the process of working on blockchain technologies at some level. Use cases and products are being developed at internal technology labs, through partnerships with blockchain product and service providers, and as members of consortiums. While some are at the conceptual level, others are drafting relevant use cases. Still others, are working on initial proof of concepts. Those at the vanguard however, have moved from concept, to pilot, and into the production environment.
The current landscape of enterprise level blockchains that are proven to be capable of handling the scale, interoperability, and smart contract functionality required by large banks and financial institutions are R3CEV’s Corda, the Linux Foundation’s Hyperledger, Chain’s — Chain Core, and the Ripple Protocol.
Recommendations
Blockchain technology is digitally recreating the tools humanity uses to facilitate its functioning and the institutions that organize its collective affairs. As the designated stewards of humanities wealth, banks perform a central function in both regards.
Below are recommendations I have made, adding additional context to suggestions from the Innovator’s Dilemma. These recommendations are for the consideration of executives and managers at banks and financial institutions.
- Adopt a Market Leading Posture: For market leading companies that wish not to fall victim to disruption, adopting the posture of a market leader is crucial. This requires executives to avoid the tendency to take a “wait and see” approach, or doing just enough to say we are working on blockchain. Urgency is needed. Commitment is needed. Resources, both human and otherwise, are needed. Teams will need to move from proofs of concept, to pilot, to production, to scale as quickly as possible.
- Operate in a Learning Mode: Banks are required to make an unprecedented transformation in the years ahead. Teams will be required to create new technologies, new business models, alongside the new visions and strategies needed to implement and sustain them. Operating in a learning mode facilitates the growth of a culture of innovation. It highlights areas in which new capacities are needed, and creates an environment in which gaps in technical and market knowledge can filled with experience gained first-hand and in the field of action.
- View Blockchain as a Marketing Challenge: This particular recommendation may in fact be the most important. Disruptive technologies like blockchain should be viewed as a marketing challenge and not a technology challenge. Blockchain should not be approached as a new product to sell to existing clients. Find new markets and new customer groups. As the new market reaches maturity and your teams will be prepared to operate at scale and meet the needs of new and existing customers.
- Create A Separate Entity. The exact management tactics, processes and cultural traits that paved the way for success in large market-leading banks, will have the opposite effect when trying to address disruptive technologies internally. Banks should give serious consideration to creating a separate entity or funding partner organizations that are free to innovate, able get excited by small but important gains, and remain unencumbered by cultural practices that are inconsistent with developing a disruptive technology.
Over the next few decades humanity has a front row seat to witness the unfoldment of the next disruptive and foundational technology. While it is difficult to predict the future, it feels safe to say, blockchain will play a meaningful role in transforming our economies and societies. In some way we will all be impacted. For banks and financial institutions that time is now.
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Big Thank You’s to all who helped with edits and thoughts — Nasim Mullen, Nikhil Ravi, Jill Pfund, and Taylor Higashi. Also thanks to all who whose work was referenced in this article!!
