A Primer on Blockchain for Banking
The advent of bitcoin in 2009, and rise of other cryptocurrencies since, then gave birth to the idea of a blockchain. An oft repeated buzzword today, blockchain is simply a shared database controlled by a decentralised community. It combines three key aspects:
- Private keys to confirm one’s identity
- Person to person networks for mutual data confirmation and storage
- A protocol for all the members to apply the same rules
The emergence of blockchain creates opportunities to build new solutions and disrupt a variety of traditional industries. Santander Bank estimates that blockchain applications in the banking industry could result in a total savings of USD 15–20 billion per year. While it might be high on the hype cycle, the actual applications of blockhain are in their infancy; companies are still exploring several use cases in search of the proverbial “killer application”.
There are however some key blockchain use cases which have the potential to disrupt banking services:
Cross-border money transfers
International payments across multiple currencies are most often processed through correspondent banking relationships (using the SWIFT network). This allows banks to have global reach for payments with just a few banking relationships. However, with multiple parties involved, money transfers are costly, slow, and opaque in terms of pricing and fee charged.
Using a private blockchain as the backbone allows banks to create direct links with each other, using a common database to track and process payments. This circumvents correspondent banking relationships and real time gross settlement systems (RTGS), creating a faster and more transparent payment system. McKinsey predicts that blockchain could save a total of USD 3–5 billion in fees for cross-border payments.
One example of a blockchain based cross border payments system is Ripple. It enables banks to instantly settle cross-border transfers with end-to-end tracking of the payment. The network allows banks to message each other in real time to confirm payment details, initiate transactions and confirm delivery once settled. Ripple claims to achieve about 60% operational cost savings to banks for international payments. Ripple currently has over 100 member banks worldwide.
Trade finance has inherently been a time consuming process, owing to the manual, paper-based processing involved. Given the verification requirements banks have, and the presence of multiple parties, the entire process takes around 10–14 days. To obtain a letter of credit at present, a trader must send the bill of lading to their bank, which in turn sends it to the partner bank of the end client. This typically takes multiple days to process throughout the chain. Paper bills are also vulnerable to fraud, with high operational and credit risk costs to both banks and traders.
Blockchain offers the ability to digitise paper bills into smart contracts which execute payments automatically. The bill of lading can be verified automatically by all nodes in the blockchain, which provides ‘a single version of the truth’. This can significantly speed up processing times to less than a day, reduce fraud losses, working capital needs, and lower operational cost for banks. In addition, the blockchain stores the full transaction history which can enable easier tracking of the source of trades, and better traceability in supply chains.
We.trade, for example, offers a one-stop trade finance platform to connect banks and traders internationally. Using a private hyperledger, the platform provides a single interface for trusted parties to create trade proposals, sign trade contracts, send invoices and request payments. The consortium already includes some of the largest European banks.
Trading teams in financial markets are often considered to be early adopters of new technologies. The mid- and back-office functions of banks, however, have not kept pace with technological changes; they are more reliant on manual processes to confirm and settle trades. This means that while trades can happen within a fraction of a second, settlement may take several days.
Smart contracts have the ability to incorporate trade agreements as collateral, swaps, and margin agreements onto the blockchain. Smart contracts enable a system that can automatically compute market exposure, calculate the required margin and automatically debit the counterparty. This significantly reduces the manual workflow in mid- and back-office functions and significantly reduces time for settlement. Accenture estimates that global investments in blockchain solutions for capital markets may grow to over USD 400 million per year in 2019.
Lending to corporates can be a time consuming process for all parties involved. The loan applicant is required to provide a large amount of information, and the financial institution in turn has to process this information and conduct due diligence to arrive at a lending decision on the applicant. This process can take many weeks, which creates uncertainty for the client, with little transparency on the status of his/her application.
Using a distributed ledger, banks can speed up and simplify loan transactions. The blockchain nodes can also be made immediately visible to the parties involved, providing high transparency to clients. This is especially relevant in complex loan syndicates where multiple parties are involved. CapGemini, for instance, has estimated that settlement cycles of syndicated loans could be reduced from 20+ days down to 6–10 days with smart contracts and blockchain. This could drive an additional USD 150 billion of loan demand globally.
The Spanish bank BBVA has recently completed a pilot to issue a loan using distributed ledger technology. It carried out the entire process of a EUR 75 million corporate loan on a mutually distributed ledger, that enables both the banks and borrower to stay up to date on the process.
Person to Person (P2P) payments
The ongoing digitisation of economies worldwide has brought us closer to a cashless society. Consumers are increasingly looking for low cost and easy to use solutions to pay other individuals. Existing solutions are susceptible to fraud risk, require a large number of intermediaries to process such transactions, and often leave the consumer vulnerable to hackers as personal information is required for such transactions.
Blockchain offers immutability of transactions, high confidence on counterparty identity, fast processing and settlement, and by circumventing intermediary parties, it could also potentially lower the cost of payments.
Circle, for example, allows users to send money anywhere in the world in any currency, without the delay of traditional bank systems. Circle uses the bitcoin blockchain rails, where users can fund payments with their payment card in their own currency (e.g., USD).
While speculation on the value of blockchain is rife, the technology is still not mature and a clear recipe for success has not yet emerged. However the core function of payment and banking is verifying and transferring financial information and assets – this aligns very closely with blockchain’s core transformative impact. Whether blockchain will have an impact on the use cases enumerated above is a question of ‘when’ and not ‘if’.
Penser is a specialist consulting firm focused on payments and fintech. To learn more about our work visit www.penser.co.uk