Dawn of the Blockchain

Will Banks keep up?

Bastiaan Krowinkel, Reinout van der Meer, Olivier Thieme Groen

February 2017

In a time where the entire world is digitalizing, the most important new technology in finance is the blockchain. It is independent, decentralized, quick and secure. The use of physical money is declining as NFC chips and IBAN numbers have made their entry into the financial market. The impact of this digitalization will reach far into the financial system. How should banks handle this change? Can the financial sector even be merged with the blockchain? This raises the following question:

"How will the Blockchain change our current banking system?"

Exploration of this question is structured as follows: First, we will explain the conventional banking business model and its shortcomings. Secondly, we briefly introduce the inner workings of blockchain technology. Finally, we discuss its impact on the future of several core functions that banks currently have in our society.

Traditional banking under siege

Traditionally, a bank’s business model consists of acquiring funds by taking on deposits and then lending these deposits out again, or using these funds to buy assets that provide an income. This core business model has changed over the past years: banks are shifting from their traditional function as financial intermediary to a role as financial advisors. Additionally, banks started providing risk management solutions for their clients. Ultimately, banks have been trusted institutions where people feel comfortable storing their money. This unblemished reputation has been seriously harmed during the 2008 financial crisis and until this date it has not recovered completely. To illustrate this: 4 out of 10 consumer bank customers have expressed that they feel less confident that their bank will be their primary financial service provider in the near future (EY Global Consumer Banking Survey, 2016). These developments show signs of general distrust of consumers towards the financial services industry. As is the case in any market, customers will ultimately look for new solutions when banks remain unable to satisfy their changing financial needs. With the dawn of the blockchain technology such a solution might have been found.

Dawn of the blockchain

The blockchain might be the biggest technological innovation of this century. It functions as a control system that uses a network of independent computers to make a secured transaction system that mitigates any counterparty risk by simply controlling the validity of the identity of both parties in the transaction. The blockchain is composed as a chain of “blocks”, where each block contains records of transactions that appear between individual parties on a network. The technology is based on a Peer-to-Peer network. This data-transfer technology is known from download software applications such as Napster and Bittorrent. The blockchain transactions are linked to the previous transaction through a system of cryptographic hashes, which can be considered as a trustworthy, secured signature. A strong characteristic of the blockchain technology is the traceability and visibility of the transactions. All the parties on the network can follow the history of transactions and are thus able to verify identities rapidly (Pilkington, 2015).

Another feature of the blockchain is the fact that neither a centralized location nor a controlling function by any entity is required. Every participating party is able to create their own copy of the blockchain by adding new blocks that are broadcasted on the network. To secure the network at all times, so called “miners” validate a set of transactions. This “proof of work” procedure theoretically makes the blockchain the most secure digitalized data transaction technology ever created (Joshi, 2016). The arrival of the blockchain has shown the world that several core functions in the financial services industry show to be ripe for disruption. We discuss these functions subsequently in the following paragraphs.

Moving value

The financial system executes financial transactions across the globe on a daily basis. Each time money is moved, the financial sector has to make sure no penny is spent twice: from the seventy-five cents package of gum purchased in a small town grocery store to the transfer of nine-digit figured intercompany transactions. The blockchain technology has the potential to become the common carrier for the movement of anything representing value – currencies, stocks, bonds, properties, lands, patents, licenses, trademarks or titles – clustered in any given volume, covering the shortest to the longest distance, connecting counterparties both familiar and unfamiliar to one another. Therefore, the blockchain has the ability to disrupt the transfer of value over the same lines and at the same magnitude as the standard shipping container disrupted the transfer of goods. It will drastically decrease costs, increase pace, trim friction, and stimulate economic growth and prosperity (Lotus, 2015).

Storing value

Companies, governments and individuals traditionally use banks as a safe haven for the storage of value. With the emergence of the blockchain; companies, governments and individuals are no longer bound to use banks as primary depots of value storage because the blockchain technology is capable to store value in a more efficient and secured way. The value storage is more efficient because it is less labor intensive and thereby reduces costs. Additionally, it is more secure because of the cryptographic character of the technology (Lotus, 2015).

Lending value

From household mortgages to Treasury bills, the financial sector accommodates the issuance of credit. The lending enterprise has paved the way for several secondary industries that execute credit checks, credit scores, and credit ratings. Blockchain technology directly enables anyone to facilitate the issuance, trade and settlement of conventional debt instruments, resulting in higher transparency and processing speed for all parties involved. Moreover, peers will be directly linked, giving people looking for credit immediate access to parties that pursue investment opportunities. This theoretically removes the middleman’s markup and will have a significant impact on the way our lending system is organized. Thereby, blockchain poses a serious threat to the current banking business model.

Exchanging value

Every day, trillions worth of financial assets are traded on the global stock markets. Blockchain technology has the potential to reduce the time to settle a trade from a month to a second. This abridgement opens up new opportunities for currently unbanked and underbanked individuals to allocate funds, however small, and engage in the creation of wealth on financial markets (Trautman, 2016).

Investing value

The convergence of cash in assets, firms, and business opportunities enables investors to receive a return. The financial sector is the market maker: matching investors to investment opportunities at every stage of growth in the business life-cycle. Whether an angel investor or an IPO is considered, the financial intermediary comes in at some point because raising money requires the assistance of investment bankers, venture capitalists and lawyers amongst others. The peer-to-peer design of the blockchain holds the power to automate many of these costly, labor intensive processes that are monopolized by highly specialized professionals (Tapscott & Tapscott, 2016).

Responding to the new reality

As the blockchain is a major breakthrough in data storage and transmission, it might fundamentally transform conventional financial and economic models in the banking sector. A growing number of financial institutions and banks are investing in the new technology hoping to find a way to participate and not lose their function as intermediary (Kaiser, 2017). If they are unable to adapt to these changing market circumstances their services will, in time, become obsolete. Banks will need to radically change their business model if they want to survive the blockchain revolution.

In 2016, the United Nations and the International Monetary Fund have paid close attention to the development of the Blockchain technology. Multiple blockchain technology consortiums have emerged in order to promote the development of blockchain technology and its applications. One of the most dominant blockchain consortiums is the R3 (Higgins, 2015). The R3 is an initiative of the 40 world’s leading financial institutions, including big banks such as Bank of America, Deutsche Bank, Barclays, BNP Paribas, and Banco Santander to deepen their knowledge of the blockchain technology (Martin, 2016). Although the technology will lead to considerable changes in the contemporary banking models, the majority of the banks is positive about the new technology. The blockchain will bring strong improvements in the back-end processing efficiency and will speed up transactions. This results in security and quality improvements and substantial cost reduction (Shen, 2016).

While the upcoming rush to revolutionize banking is gaining strength, new markets arise. Recently, some big banks such as Goldman Sachs and Bank of America have patented innovative blockchain technologies. This potentially brings a costly implication to light; the use of blockchain applications by banks may belong to other entities that patented the technology. Blockchain software startups emerge and big banks are starting to buy them, hoping to secure their monopoly: the war of blockchain patents has begun. In the coming years, banks will need to invest heavily in the blockchain technology to keep up with the competition. Since the R3 consortium is comprised of major international banks, it is doubtful at best that the smaller banks, lacking sufficient funds to patent their own technology, will be able to keep up with the blockchain revolution (Kharif, 2016).

The role of regulators

In the pursuit of a new banking business model, central banks and other financial authorities will also have to adapt to the new technology. Existing regulations must be aligned to a new financial environment. Although the Blockchain system has not been hacked since its establishment, the possibility of such an event will continue to pose a threat to its public acceptance. At this moment, the R3 blockchain consortium studies how to form industry standards for interbank applications. The main characteristic of the blockchain technology is its authenticity. When a particular piece of information is added to the blockchain, it cannot be modified afterwards. In terms of regulation, this feature will end fraud. However, as a result, the preliminary inspection of information should be treated with extra care, demanding stricter information access mechanisms. Once a blockchain transaction is initiated, it is irreversible. Hence, the authenticity and reliability of the transactions should be verified to avoid accidental losses (Krigsman, 2016). In our view, regulators hold responsibility to design a frame that overcomes these obstacles.

Banking in the blockchain era

The blockchain could revolutionize the underlying technology of the payment clearing and credit information systems in banks, thus upgrading and transforming them. It appears that big banks have identified the threats as well as the opportunities the blockchain offers, and have found a way to keep up with the technological revolution. “Divide and conquer” seems to be the credo as big bank conglomerates, like the R3, emerge. For the smaller banks however, the new reality seems to be a lot bleaker; the high investments needed to remain competitive in the new age will likely stay out of reach.

The way in which value is moved, stored, lent, exchanged and invested will encompass the largest turnaround to our current financial system, as blockchain technology holds the power to fundamentally reshape these core processes. On the other hand, there has been widespread optimism regarding the application of blockchain in the banking industry. Last year, a global banking executives survey, found that around fifty percent of the executives believe that blockchain will have a substantial impact within 3 years. Another survey predicted that, in 2018, blockchain technology will be extensively implemented by 15% of all banks (Guo & Liang, 2016). This clearly points out that an increasing number of banks emphasizes the importance the blockchain. Further, the blockchain advertises the construction of decentralized, no intermediary involved networks that will improve the overall cost effectiveness of banking. It is worth mentioning that regulatory and security issues have always provoked controversy along the way of any financial innovation. History however, was never stopped by these type of obstacles. As always, the technical and regulatory concerns dominating the current debate on the blockchain will ultimately be resolved. For this reason, the prospect of an integrated banking blockchain network will happen sooner rather than later. The dawn of the blockchain revolution is upon us.




Bastiaan Krowinkel

MSc Finance at VU Amsterdam

Reinout van der Meer

MSc Finance at VU Amsterdam

Olivier Thieme Groen

MSc Finance at VU Amsterdam