In the banking industry, blockchain is viewed by some as the ultimate disrupter, set to wholly transform the industry as we know it. However, recent efforts by traditional banking institutions to assimilate the technology into their current operations, and realise its real-world value, may require this view to be recast. An indicator of this alternative argument is the adoption of blockchain within existing processes, already under way in areas such as clearing and settlement, digital identity and trade finance.
Ultimately, in our view, blockchain will have the most impact on processes and services which are outdated, time and resource intensive, and which require collaboration from parties who currently work in relative isolation. Many of these processes evolved when technology was less advanced and are hence now ripe for reform. They are also particularly receptive to transformation via blockchain because many of their requisites – such as verifiability and record-keeping – can be fulfilled by the technology.
In the middle of a chain reaction
Many banks are currently facing the dual challenge of rising operating costs – caused largely by a wave of new regulation – and suppressed profits, resulting from the low or negative interest rates which have narrowed the gap between the interest paid on deposits and charged on loans. Technologies which can therefore automate processes are widely sought after, with blockchain leading the pack amongst those with the potential to transform crucial functions, along with the push to implement robotic technologies. Added to this is the rising challenge posed by more savvy and customer-focused start-ups and challenger banks, which is generating further incentives for traditional banks to adopt an innovative and consumer-centric approach.
Time to settle up
The clearing and settling of trades, where records on both sides are verified and funds exchanged, is both costly and lengthy. Trades often take several days to settle because details are recorded separately by each party in the transaction and are then reconciled and rectified post-execution. An example of how complex this can be is found in the collapse of Lehman Brothers and the subsequent unwinding of its positions – which reminded the industry just how critical clearing houses are to the financial system, despite for years complaining about the costs.
The underlying complexity and costs have led many institutions to explore the potential for blockchain to enhance clearing and settlement functions. Most recently, six multinational banks joined forces to work on a so-called ‘utility settlement coin’, which would allow firms to pay for trades via blockchain using digital coins which could then be converted back into traditional fiat money. The bypassing of cash to pay for securities allows the time and resources required to settle trades to be reduced dramatically.
In practice, blockchain can support a cut in settlement latency, the time between trade execution and settlement, by providing transacting parties with near-instant access to immutable trade data post-execution. Doing this would greatly reduce the time spent checking and reconciling trade details and would speed up the exchange of funds. Furthermore, as the trade record in the blockchain would be permanent, the requirement for an intermediary to maintain a record would no longer exist, thus also creating a cost saving.
Nevertheless, it is very unlikely, in our view, that blockchain can provide a full alternative to the role currently played by clearing houses. Clearing houses will likely continue to be required to secure the stability of financial markets, particularly with regard to futures transactions, by holding margin on client accounts in case of counterparty default. Additionally, from a regulatory respective, the central clearing of some derivatives is mandated by both the EMIR and Dodd-Frank regulations, which itself requires some form of centralised governance.
The use of blockchain to maintain digital records of individuals’ identities is already being pursued as part of a UN-backed project to provide identity verification to the 1.1 billion of the world’s population currently without it. In one sense, blockchain is a tool for opening-up access to financial services to the unbanked – but it also creates benefits for existing customers through its impact on ‘Know Your Customer’ (KYC) processes. KYC is currently an unnecessarily prolonged process, with the time spent by analysts requesting information from clients often outstripping that spent reviewing them. For customers, the experience is equally frustrating, due to the need to provide identical information to multiple institutions asking for exactly the same information.
In investment banking, there is the possibility that investors could establish a permanent and unalterable record of their structure and ownership which could be provided, through a private blockchain, to the institutions they wish to deal with. Such a mechanism removes the exchange of documentation from the process, and frees up time for analysis. This principle can also be transferred to the high street to benefit retail banking customers, with individuals maintaining a personal record which could then be made available to their banks. Implementing such a process would save both time and money and would quicken the rate at which new relationships could be formalised and approved.
The possibilities for digital identity show that whilst banks’ primary motivations for adopting blockchain may be cost reduction and process optimisation, there is also a significant benefit to be had for the customer and improving the customer experience. Allowing consumers to maintain a digital record of their identity, which can be shared with multiple institutions, as required, would reduce both the number of contacts customers are required to make with banks as well as the amount of paperwork involved. This would create a superior user experience and would provide traditional banks with a key weapon to counteract the rise of start-ups.
The trade finance services provided by banks to companies wishing to export goods or services across borders are another area where significant blockchain developments are already occurring. Indeed, the first blockchain-enabled cross-border trade transaction took place in 2016, facilitated by Barclays and involving a platform designed by Wave.
Traditionally, trade finance has been a manual and paper-laden process. Transactions frequently involve numerous parties, including the exporter, importer, banks and third parties, who must maintain, update and verify key documentation. This helps to ensure that the transaction progresses and that there is sufficient protection for the goods and payment of the trading parties, but it also creates a process which is costly and slow.
There are, therefore, two key ways for blockchain to positively impact trade finance. The first is through increasing the connectedness of the transaction participants, and removing the need for multiple versions of documents to be maintained and verified. The second, closely linked to the first, is to provide a platform where records can be updated in real time and made accessible to all parties simultaneously, which can then trigger the automatic release of payment.
Moving key documentation on to a blockchain platform negates the need for individual parties to maintain their own records, along with the task of reconciling them – resulting in a significant cost reduction. Added to this, because it is possible for the progress of transactions to be provided to all parties in real time, via blockchain, smart contracts can be used to trigger payment once confirmation is received that specific conditions have been fulfilled. This allows funds to be transferred much faster and transactions to settle quicker – providing huge benefits to companies engaged in international trade. Overall, the potential for blockchain to transform trade finance is in our view vast; by engendering improvements in the flow of documentation and payment between different parties, blockchain can help reduce both the cost and duration of transactions.
That is the question
We may be some way from understanding the full potential of blockchain – and even further from a complete overhaul of the current banking system – but it is clear that blockchain will make a big dent in the industry.
Through the lens of settlement, digital identity and trade finance, we believe there is potential for blockchain to transform existing processes which are overly manual and time consuming. It can transform these areas, in large part, because its inherent qualities fit neatly with the characteristics and functions these processes require. Several institutions have already identified these opportunities and are forging ahead with new blockchain-centred initiatives, in what is a rare case of intra-industry collaboration within the financial services sector.
Whilst blockchain has largely been viewed as a tool with which banks can tackle their costs, and hold back the onslaught of technology companies, it should also be emphasised that the technology will generate a superior experience for both high street customers and investment clients. Faster and cheaper settlement, less burdensome identity verification, and swifter payment for exported goods are all outcomes desired by retail and investment consumers alike. Delivering them via blockchain can therefore help traditional banks stem the flow of customers moving to more agile firms.
In banking, there are many questions. For some of these questions, blockchain could be the answer.
To find out more about how blockchain can impact the banking sector, please contact Oliver Maskell.