The Blockchain revolution, no more third parties involved?

Koen van den Houdt, Thijs Jahae, Gijs van Keulen

February 2017

Blockchain and how it will impact the current banking system

Just like we have seen the internet emerge, blockchain technology has the same potential to disrupt multiple industries and make processes more democratic, secure, transparent, and efficient. Most people will know blockchain as the technology behind the crypto currency Bitcoin. In finance, to send assets through the internet we need to have intermediaries such as banks to establish identity and record-keeping between two parties in the transaction. Blockchain technology facilitates peer-to-peer transactions without any intermediary such as a bank or governing body. It is a large database that is public and shared by all the parties in the network. Every transaction that takes place in the network is recorded and stored. This will create an irrevocable and auditable transaction history. The database is not centralized on one computer but on many across the world. It is continuously synchronised to keep transactions up-to-date. To make it hack proof, all of this is secured by cryptograph securitization. We need to make a note here, since hacks still occur, despite this securitization. During the most recent one, in August 2016, 120,000 bitcoins were stolen from Bitfinex, one of the world’s largest cryptocurrency exchanges, with a value of nearly 68 million dollars. Details of how the hack happened have not been revealed by Bitfinex. This proves that the security infrastructure around the bitcoin can still be improved.

Blockchain is also possible to impact the process efficiency of the clearing and settlement of financial assets after transactions. It can be sharply increased by the blockchain technology, reducing cost at the same time. Hence, it resolves several existing problems in the banking industry to a large extent, which can be easily seen in Table 1 (Guo & Liang, 2016).

To show the possible impact of blockchain on the banking system we highlight/identify two applications in the financial services industry that can be adapted in the coming 5 to 10 years.

First, trade finance is one of the most frequently suggested examples of blockchain application. The financial supply chain involves an extensive amount of manual inspections and paper-based

Table 1: Comparison of traditional banking businesses, Internet finance businesses, and blockchain + banking businesses. Source: (Guo & Liang, 2016)

transactions – for example letters of credit. Manual interventions can be reduced and smart contracts – whereby business rules implied by a contract are embedded in the blockchain (encoded in programming language) and executed with the transaction – can be employed using blockchain technology. This will lead to an improvement in efficiency and reduce manual operations risks. Even if only a few participants use a blockchain solution this would generate significant advantages (Harel, 2016).

Second, interbank payments can thrive on the technology of blockchain. The settlement of international payments involve a series of complicated processes, currently taking a relatively long amount of time and being costly. In cross-border payments, since clearing procedures for each country are different, a remittance requires nearly 3 days to arrive. This is a demonstration of the low efficiency and immense volume of occupied funds involved (Guo & Liang, 2016). With blockchain technology, these transactions can be provided a lot less costly and also a lot faster. An estimation showing that the cost of each transaction in Cross-Border business can be reduced due to the application of blockchain is made by McKinsey and can be seen in Figure 1.

The impact on the financial industry in the foreseeable future is mainly on efficiency and cost reduction. Time can be saved in supply chain finance by the increase in speed of international settlements, where costs can be lowered by the reduction of manual interventions.

Figure 1: Application of blockchain in Cross-Border Payments. Source: McKinsey (Report by McKinsey: Blockchain - Disrupting the Rules of the Baking Industry, 2016-05.)

Internet of things

Blockchain has the potential to be the missing link to settle reliability, scalability, and privacy concerns in the Internet-of-Things (IoT). It’s expected that by 2020 more than 50 billion devices are connected by the internet. This means that tremendous amounts of data will be sent every second. One of the issues is how we manage and track all these devices, storing the data, and how this will be done securely and reliable. Blockchain could be the silver bullet to solve these upcoming issues of the IoT. It enables the coordination and processing of transactions between all the billions of devices, which will reduce costs significantly. Due to the decentralization of blockchain there will be a more resilient ecosystem for devices to run on. And the data of consumer will be more private due to the cryptographic algorithms of blockchain (Nash, 2017).

Trust issues and regulations

Privacy issues play a key role for the potential of future users of the blockchain technology. The blockchain system as used by Bitcoin provides anonymity for all its users. By contrast, within the most recent financial regulations financial intermediaries require more information about their counterparties than ever before. For instance, tracking the default probabilities of counterparties for banks requires a lot of information and the new Basel agreement obliges banks to use this information. The developers of the blockchain system argue that ‘smart contracts’ are developed to provide these possibilities in the new market. There is a possibility for everyone to choose an appropriate blockchain, in which the users can choose which sort and amount of information they want to share.

Still, questions arise on the perception of the future users in accepting this release of private information. To quote Beth Shah, Head of Business Development at blockchain start-up Digital Asset Holdings: “As much as the idea of an intermediary-free financial market might appeal to purists, in reality it is likely that regulators – and customers – will prefer the idea of orderly markets managed by one or a group of trusted parties, at least for the foreseeable future” (Finextra, 2016).

This implies that banks will probably not lose their task of providing customer liquidity in the foreseeable future. However, more and more information and transaction managers at large banks acknowledge the potential engagement of the blockchain system and are already preparing steps to be able to ensure a smooth transition of all the activities (Finextra, 2016). There are also examples of major banks that are starting with the creation of their own blockchains and virtual money (Jon Southurst, 2015). The question seems not to be if the system is going to change, but what kind of customers (retail, businesses, governances, etc.), and how many customers it is going to attract in which amount of time.

This implies that governances all over the world will need to come up with proper regulations, possibly in a very short time period. Although purists probably would like to see as few regulations as possible, the blockchain could have a major impact on the tax system and general safety issues for countries. (McConnel, 2017) argues that especially the IT objective will be so monstrous that governments have the obligation to ensure a safe financial system. What will happen for instance in the case of a big bank failure? Who will get their money back and will smart contracts alone be able to ensure the proper deviation of collateral? These kind of issues are of great importance for a smooth implementation of the blockchain system as a major player in the financial world.

In conclusion, many players in the field believe in the large possibilities of blockchain and that it will have a major impact, but the great uncertainty on the proper workings of the system will probably lead to many delays and complex regulations. Right now the system is still for connoisseurs and a quick implication of a wide used network has not to be expected in the near future.

Opportunities and risks for banks

Blockchain has the potential to have a significant impact on the current way of banking. Schubber (2016) mentioned potential opportunities for banks. First, due to operations improvements, banks will have the opportunity to decrease their operational costs and improve their liquidity. Due to blockchain the transactions will speed up, increase visibility and decrease the number of personnel necessary. Second, blockchain will improve the security of current banks. The decentralizing effect of blockchain decreases the vulnerability to attack, failures and fraud. For instance, it will be harder for corruption to be kept unnoticed. This makes banks more safe and reliable. Third, due to the greater visibility, transactions can be monitored real-time. This increase in information can create value for banks and regulators.

Additionally, currently billions of people are still struggling to open a bank account due to a lack of identification or necessary funds. Blockchain has the potential to counter these distortive effects on the economy which could increase the potential market for banks (Shin, 2016).

When there are opportunities there are also risks. The decentralized open system of blockchain gives rivalling banks the opportunity to monitor each other’s activities. Also, blockchain has an irreversible factor, this is risky because errors that are made for instance by an individual are not reversible in the database. This could result in unexpected losses or gains. Third, the scalability of blockchain, if the data between all the banks is replicated due to the use of a shared settlement system it potentially become too cumbersome (Schubber, 2016). Finally, if the blockchain technology wants to work optimal the current IT systems needed to be renewed. History shows that IT projects have a high failure rate ranging between 50% - 90%. Knowing that all the banks need to implement the blockchain, the chance of success will decrease drastically (McConnel 2017).

Conclusion

Banks will be largely affected by the introduction of blockchain and this will lead to several risks and opportunities. The majority of banks is still in the phase of testing the blockchain technology and how to apply the technology to their services and products. When they act swiftly and create a proper work flow they can create value in terms of operations and security improvements. Banks will probably lose some business due to the transaction automation in the form of their 'third party' function, but the same automation gives opportunities in the forms of supervision, consultation and market increase. In the foreseeable future main tasks for important transactions will survive since trust issues play an important role in the treacly implementation of blockchain. The role of the government will be crucial as well since they will determine the rules surrounding the new playing field for banks.

Altogether, in the coming years a change can be expected in the ways banks will operate and it is advised for banks to act with great care on these issues.


References

  • Fanning, K., Centers, P.D. (2016). Blockchain and its coming impact on Financial Services. The Journal of Corporate Accounting & Finance.
  • Shin, L. (2016). How the blockchain will transform everything from banking to government to our identities. Forbes Personal Finance.
  • Schubber (2016). Banks find blockchain hard to put into practice. Financial Times
  • McConnel, P. (2017). When will regulators wake up to the dangers of blockchain
  • Finextra (2016). Banking on Finance: Charting the progress of distributed ledger technology in financial services
  • Southurst, J. (2015). Four big banks to create a new bitcoin alternative
  • Guo, Y., & Liang, C. (2016). Blockchain application and outlook in the banking industry. Financial Innovation.
  • Harel, A. (2016). Israel: A Hotspot for Blockchain Innovation. Deloitte.
  • McLean, J. (2016). Banking on blockchain: charting the progress of distributed ledger technology in financial services. London: Finextra Research.

a

A