– By Vrishali Pawaskar – T. A. PAI MANAGEMENT INSTITUTE, MANIPAL
Introduction
The global financial services sector is an epitome of transformation for the other industrial segments to follow suit. Automation and digitalization have caused a paradigm shift in the way in which banks and financial institutions operate. In the words of Barclays’ former CEO Anthony Jenkins, “Banking is headed for an Uber moment”. The latest to join the bandwagon of disruption in the financial sector is the blockchain technology. Originally developed as a DLT (distributed ledger technology) supporting bitcoin transactions, financial institutions are now exploring several use cases apart from payments for application of this technology. They have been developing proof of concepts thus trying to assess the technical, legal and compliance aspects of implementing this technology. The fundamental motivation for most of the potential applications of blockchain technology in the financial services segment is to achieve cost savings and security, increase availability, speed up processes by eliminating the need for intermediaries, middlemen thus reducing effort duplication, easing reconciliation and improving the efficiency of services. This research paper strives to enlist and elaborate upon potential blockchain use cases in the banking and financial markets ecosystem, some of which have already been experimented with and others which are still at the idea level.
Application of Blockchain Technology
The following figure illustrates how most of the blockchain use cases aim to modify the modus operandi of banks and financial institutions.
Source: A joint report by Infosys Consulting and HHL Leipzig Graduate School of Management, titled “Blockchain Technology and the Financial Services Market”, November 2016
Blockchain Use Cases for Banking
Cross-border payments
Current Scenario: Most of the cross-border payments involve bilateral correspondent banking relationships, a network of banks which use SWIFT messaging protocol for execution of transactions. Although there are many benefits of such a process like consistent process standards, guaranteed security and comprehensive global reach but this process also has certain pain points. For instance, pricing and foreign exchange rates are not finalized until funds arrive in the recipient’s account, relying on multiple banks causes uncertainty about the timely and accurate transfer and it becomes difficult for both the sender and the receiver to track the status of transactions. Moreover, this is a fee intensive process with customers having to pay fees for every transaction.
Blockchain potential: Broad peer networks of verified partners such as banks could employ a private blockchain solution equipped with a strong legal framework and appropriate technological requirements, allowing each member to send funds and transact relevant information directly with other members. This would eliminate the need for third parties like clearing houses thus speeding up the processes involved, reducing costs due to 24*7 real-time settlement and simplify the transactions.
Projects underway: One such system developed is that of Ripple Lab’s blockchain Ripple protocol. Ripple is a real-time gross settlement system, currency exchange and remittance network which was released in the year 2012. This protocol supports different tokens such as fiat currency, cryptocurrency, commodity or any other units of value. Ripple provides an open source payments approach to banks thus allowing replacement of other payment intermediaries in the payments industry. Rabobank, a Dutch multinational bank is one such example of a bank partnered with Ripple and experimented blockchain technology in making payments to customers and cross-border transactions. Ripple said that its technology could allow banks 33% reduction in their operating costs during international payment process and allow lenders to move money in seconds. The current concern with Ripple protocol is that it is a proprietary protocol and hence cannot be integrated with other systems. In order to solve this issue, an inter-ledger protocol will have to be developed and implemented.
Smart Contracts
Current scenario: When parties decide to get into a contract, a middleman is required right from contract creation to contract execution and overseeing the execution until contract completion. Of course, there are fees associated with the provision of these services.
Blockchain potential: Smart contracts are computer codes that self-execute the contractual agreements between parties. They help exchange money, property, shares or any other asset in a transparent and conflict-free way. It helps reduce transaction costs and middlemen in the process. Smart contracts on blockchain allow autonomy since you don’t require a lawyer, allows security as your documents are cryptographically encrypted on a shared ledger, it allows backup as data is replicated at all the user nodes, it allows accuracy and reduces manual errors and provides provenance of data. Other application of this solution would be life term insurance. The conditions for a pay-out can be clearly defined in the contract thus allowing self-execution of insurance policy.
Projects underway: The Decentralized Autonomous Organization (DAO) for venture capital funding is one such example of its implementation. Smart contracts are yet to achieve satisfactory levels of maturity in order to handle complex legal contracts. Deutsche bank experimented with one of the use cases with smart contracts and applied it to life cycle management of corporate bonds. This helped them to assess both the technical and legal capabilities of the technology and closely look at the life cycle management events and transfer of ownership of corporate bonds. They concluded that blockchain is capable enough to perform these activities and that they are positive about its future potential for the financial ecosystem at large.
Fraud Reduction
Current scenario: According to Constantin von Altrock, Director of Counter Fraud Management at IBM, payment fraud is a $20 billion-a-year problem. Traditionally, banks maintain their ledgers in the form of a centralized database, processed and secured by legacy IT systems. Since all the information is available at one place, this model is vulnerable to attacks by cyber criminals.
Blockchain potential: The fundamental of blockchain technology is the distributed framework and transparency wherein data is replicated at each node and verified by miners before being added to the blocks of transactions. Thus any attempt of fraud at any one node will not pass through the validation checks and hence will prevent the entire system from security threats. Moreover, once the transaction is posted to the blockchain, it becomes irreversible thus preventing any further changes. But to achieve this, banks need to work in collaboration with regulators and FinTechs to develop a credible solution.
Projects underway: Emirates Islamic Bank, UAE has integrated the blockchain technology to prevent cheque fraud. The bank has registered each cheque to the decentralized ledger of the blockchain with a unique timestamp and cryptographic proof. Chile’s Santiago Exchange plans to introduce blockchain technology across the country’s financial sector to help reduce errors, possible fraud, and transaction processing times in its short-selling system for securities lending.
KYC and Online Identity Management
Current scenario: Financial institutions initiate ‘know your customer’ requests every time a new customer is on-boarded, even though that customer has probably completed a KYC process somewhere else before thus entailing duplication of efforts. The entire procedure may take days at length to be completed satisfactorily, thus affecting the customer experience. Moreover, banks and other financial institutions have to dedicate a vast amount of resources for this purpose. Similarly, online identity management is a time-consuming and costly process wherein customers need to undergo face-to-face checks or need to provide several identity documents and they require a means of authentication and authorization. This process is repeated for every other institution that these customers obtain service from.
Blockchain potential: With blockchain, once the banks have done the KYC for a customer, they can put his/her statement with the summary of documents over the blockchain which can then be used by other banks and institutions. Thus, once a customer’s bank completes the verification, other institutions need not do it all over again, reducing their costs, it also prevents the customer from going through all the hassle again. To handle the privacy and security issues of this solution, it will have to be implemented as a private blockchain which would only contain reference points to the data secured cryptographically, which would link to the relevant client information in a repository maintained separately in addition to the blockchain. Also, levels of access and permissions will help prevent any unauthorized access to the data. According to a Goldman Sachs report, the banking segment can achieve 10% reduction in workforce with the implementation of blockchain in KYC processes. There would be additional cost savings with respect to employee training, there will be 30% reduction in resources assigned for such training. With online identity management moved to the blockchain, customers will have to register on the blockchain once and choose their means of authentication and with whom their identity can be shared. Once done, this process need not be repeated for other financial institutions. A similar concept can be applied to Anti-Money Laundering (AML) compliance.
Projects underway: IBM and Credit Mutuel Arkea have experimented one such project in improving bank’s ability to verify customer identity. Indian blockchain consortium Bankchain’s first project is a permissioned blockchain for integrated and shared KYC and AML/CFT (Anti-Money Laundering and Counter Financing of Terrorism).
Trade Finance
Current scenario: Today 80% to 90% of international trade uses trade finance products as estimated by The International Chamber of Commerce (ICC). Challenges and risks involved in the international trading contracts range from insecurity, mistrust, low trading volumes to different languages, long distances, and unknown solvency of trading partners has led to the creation of fundamentally same kind of products by financial services across the globe. But, the underlying processes are still manual and based largely on paper documentation. For example, letters of credit (L/C), bills of lading (B/L), multi-signature and such other services that banks provide is document heavy with complex information flows. Technological innovations in this area lag behind relative to other areas. This area has seen some digitization in the form of the Bolero platform or the bank payment obligation (BPO) which attempted to reduce latency and costs but it is still to see radical technological disruption.
Blockchain potential: The financial supply chain of trade finance which is currently served by Bank Payment Obligation (BPO) or Bolero can be transferred to the blockchain. The solution will aim at creating a global marketplace and a legal framework thus meeting both financial services and legal requirements. A trade finance solution in blockchain would include carriers issuing B/L and banks issuing L/C on the blockchain as digital assets, asset tracking, multi-signature contracts, and smart contract enabled event based fund release to ensure speed and transparency. An asset with a unique identification code like a serial number available in the blockchain can guarantee the authenticity of goods. The buyer of a good will be able to verify the serial number against the immutable database and thus can prevent risks of having a counterfeit good. Smart contracts will help execute and fulfill the contract between two parties automatically, reducing manual handling of documents and legal conflicts. Once all the conditions of the contract are verified to be fulfilled, a predefined process can be triggered. For example, a payment initiation or a message alert. This could allow replacing the process of sending a paper B/L from one institution to the other. Blockchain in trade finance will help overcome the trade-off between low cost and high security often faced by the standard finance products while at the same time it can allow secure collaboration over long distances at low process costs. Although blockchain would help ease out process and make it flawless, it cannot replace the intermediaries in trade finance completely. In cases of default, banks would still be needed to cover the investments of buyers or sellers.
Projects underway: DBS Bank Singapore in collaboration with Standard Chartered and Infocomm Development Authority of Singapore (IDA) developed a proof of concept (PoC) to reduce double financing (secure invoicing) in trade finance. The Singapore based start-up Open Trade Docs is currently in the PoC phase with financial institutions for digitizing trade documents and securing them in the blockchain. Everledger, a London based company has developed an asset tracking process for diamonds thus providing valuable data for owners, wholesalers & retailers, banks, insurers and other authorities across countries. Skuchain’s product ‘Bracket’ performs asset tracking and automated signal triggered payments and information flow.
Blockchain Use Cases for Capital Markets
Trading platforms & settlement process
Current scenario: An asset is first introduced in the primary market with the initial public offering (IPO) after which it is traded in the secondary market which happens via the exchange. Both the buyers and sellers quote their respective prices based on which the trading platforms try to match their bids. Once the trade is executed on the platform, that is, a seller finds a suitable buyer, the settlement process is what follows next. Settlement process varies across countries depending on their respective regulatory bodies. Some follow T+1/T+2 while others follow T+3 settlement. During this process, the securities are transferred from the seller’s demat account to the buyer’s demat account and funds are transferred from the buyer’s cash account to the seller’s cash account.
Blockchain potential: For the trading platforms, the idea is as follows: for every high-value item created, a corresponding digital token is issued by a trusted central authority which authenticates the asset and then every time the asset is bought or sold, the digital token moves in parallel thus mirroring the real world chain of transactions in the blockchain. This digital token acts as a virtual certificate of authenticity. The recipient of this token would be able to trace back the chain of custody right to the point of creation. These tokens are secured by cryptography thus protecting the trade data and allowing only permissioned access to information. Blockchain technology in case of trading platforms provides advantages in terms of cost savings, reducing fraud and threats, transparency, immutability, assurance, and eliminating the need for intermediaries. Blockchain can be leveraged to improve the efficiency of the settlement process with an aim to achieve T+0 settlement so as to have the instant closing of the trade thus reducing cost and improving the latency involved. This provides an opportunity to eliminate the need for intermediaries like CCPs (central counterparty clearing houses) by the availability of immediate collaterals and immediate settlements thus avoiding the counterparty risks. This apparently is a shift from the traditional hub and spoke model to a bilateral model. This does not elicit complete elimination of intermediaries but forces them to rethink their business models and provide novice low-cost services. They seem to have a change in role in future with both CCPs and banks operating more efficiently.
Projects underway: NASDAQ developed their first blockchain based proof of concept in late 2015 with the help of Chain.com, a blockchain development company. It helped build a distributed ledger based Linq platform. This platform provides for efficient, electronic services for the issuance, transfer, and management of private company securities. This not only improves efficiency and reduces risk but also helps keep track of movements of paper-based certificates. IBM and Mizuho Financial Group have tested one such use case of settlements with virtual currency. Swiss bank UBS is developing a system to enable financial markets to make payments and settle transactions quickly using blockchain technology.
Regulatory compliance and audit
Current scenario: The regulatory bodies require and maintain all the information pertaining to firms listed on the exchange as well as to the stakeholders involved in trading. This calls for the huge amount of data that firms have to provide to the regulators in their regions, countries or across countries and this flow of data is growing exponentially with regulators not having any efficient processes to consume it. A lot of duplication and reconciliation of tasks happens here.
Blockchain potential: Blockchain technology could help these regulatory bodies to track the provenance and availability of these tasks in a distributed form allowing several bodies having access to the data at the same time in an unambiguous and simplified manner. This could lead to a huge amount of savings.
But this solution comes with its own issues and concerns. For instance, concerns about identity, anonymity, what portion of the transaction should be published, what needs to be maintained privately, levels of access, matters of confidentiality, etc. Market commentator, Lee Fulmer states his concern with respect to this solution in terms of the relative immaturity of the blockchain technology itself. He rightly mentions that banks will never open their books completely to the regulators or competitors which they would be required to in case of adopting the technology. Also, the commercial terms of the contract need to be confidential. Hence, there is a need for more innovation and continuous development in this space.
The list above is not exhaustive, there will be new additions to it every time an opportunity is identified to improve the current workflows of financial institutions. Having known about the potential applications, it is important to understand that blockchain will not replace the current systems at banks but will simply be an augmentation to the current business networks providing increased trust, immutability, provenance, auditability, assurance and improved latency. There are certain issues that need to be handled for successful application of blockchain. There is a need to have a standard protocol so that proprietary private blockchains from different institutions are inter operable in a compliant manner. Moreover, there is no established central organization to regulate and monitor blockchain protocols, thus facing regulatory uncertainty. The other issues that need to be looked into are the transaction speed, data limits and the verification process so as to allow wide application of this technology. It will take some more time to have mature models in place ready for go-live, but with increasing number of FinTechs fostering blockchain technology, future seems not too far.
References
- Finextra White Paper in association with IBM. (2016, January). Banking on Blockchain: Charting the progress of Distributed Ledger Technology in Financial Services. Retrieved from: https://www.ingwb.com/media/1609652/banking-on-blockchain.pdf
- Tandulwadikar, A. (2016, April). Blockchain in Banking: A Measured Approach. Retrieved from: https://www.cognizant.com/whitepapers/Blockchain-in-Banking-A-Measured-Approach-codex1809.pdf
- Krause, E. G., Velamuri, V. K., Burghardt T., Nack D., Schmidt M. & Treder T. M. (2016). Blockchain Technology and the Financial Services Market. Retrieved from: https://www.infosys.com/consulting/insights/Documents/blockchain-technology.pdf
- Fintech Network. (2017). Four Blockchain Use Cases for Banks. Retrieved from: http://blockchainapac.fintecnet.com/uploads/2/4/3/8/24384857/fintech_blockchain_report_v3.pdf
- Deloitte Nederland. (2016, November). 5 blockchain use cases in financial services | Deloitte. Retrieved from: https://www2.deloitte.com/nl/nl/pages/financial-services/articles/5-blockchain-use-cases-in-financial-services.html
- IBM Blockchain – Blockchain Applications. Retrieved from: https://www.ibm.com/blockchain/business-use-cases.html
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