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Blockchain is the latest technology to create an impact on the fintech landscape and has already brought disruption to the financial industry.
Despite historically having been one of the most immune sectors to technological disruption, banking is now more focused on the introduction of technology to re-establish trust with their clients, following events such as the global financial crisis.
Blockchain has become critical for banks to provide faster settlement to clients through efficient banking systems and processes. One of fintech's main advantages, apart from its ability to be far more agile than its billion-dollar counterparts, is its ability to tackle highly regulated areas where banks fear to tread due to the possibility of billion-dollar fines. In the future, fintech companies and banks will be able to offer services with much less friction. Hence, processes such as equity settlements to cross-country payments will be made easier being facilitated by new technologies such as blockchain. The big challenge will be how regulators respond to this ever-changing environment.
Blockchain's components - such as cryptographic hashes, distributed databases and consensus building - are not new. But when combined, they create a very powerful new form of data sharing and asset transfer, capable of eliminating intermediaries, central third parties and expensive reconciliation processes. Since the 2008 global financial crisis, the financial institutions and capital markets have faced a perfect storm of diminished returns, largely due to the rising cost of regulatory compliance, rising capital allocations, liquidity costs and declining revenue. It is estimated that world's leading financial institutions spend around two-thirds of their IT budgets supporting legacy back-office infrastructure, plus billions of dollar more each year on cost reduction initiatives. In other words, it's costing too much time, effort, liquidity and capital to support processes that don't offer a sustainable improvement in profits. Consequently, banks, central banks, exchanges and clearing houses are urgently experimenting with blockchain to tip the cost fundamentals and return to profits that improve Return on Capital (ROC).
To be clear, blockchain is not the only solution to remedy all the ills of banking. For many use cases, conventional database structures or processes will achieve a similar outcome without the costs and challenges of a blockchain solution. Examples include internal automation, staff reduction and outsourcing/offshoring. There is compelling evidence that blockchain could radically reduce, if not eliminate, many existing clearing and settlement processes. It has enormous implications for trade confirmations, reconciliation, cash management, asset optimisation and other business logic processes that cost billion of dollars a year. In addition, depending on the underlying asset(s) and counterparty requirements, it also promises to optimise settlement by greatly reducing the time or even eliminating windows for delivery versus payment, while supporting the needs of market makers.
Over the past year or so, major banks across the world have begun investigating what blockchain technology can offer to their business, with many use cases now being piloted. It started out as the rails for cryptocurrencies like Bitcoin, but has evolved as a technology that can transform many legacy business paradigms in the banking sector.
So far financial institutions are exploring blockchain for its potential to reduce costs and streamline processes. But beyond this, there's excitement about the technology's ability to create new ways of doing business. Blockchain can unleash innovation across top line applications like loyalty and rewards, Internet of Things, marketplaces, and more - essentially any application where there is an exchange of digital assets, in addition to serving the bottom line. Forecasts about medium-term cost savings of key operations are promising.
One study conducted by Accenture, a global management consulting and professional services firm, looking at eight of the world's ten largest investment banks found that it could help reduce the costs of infrastructure to support their operations by as much as 30 per cent. This equates to saving between $8.0 billion and $12 billion a year, with benefits to be found in areas such as regulatory compliance, financial reporting and KYC (know your customer) activities.
A study conducted by Business Insider Intelligence found that the most common reasons that financial services firms in Europe, the Middle East, and Africa (EMEA) region are investing in blockchain is to create new business models or launch start-ups. Nearly four out of ten firms (37 per cent) highlighted this as a reason for their interest in the technology. This was followed by the promise of cost and efficiency savings (20 per cent) and a desire to better understand the hype surrounding blockchain (16 per cent). Smaller numbers also cited a fear of disruption and worries they will be left behind by competitors as driving forces behind their investments.
As understanding grows, banks are starting to narrow their focus and are looking for more targeted, tangible use cases for blockchain that aim to solve real problems faced by their businesses. For example, cross-border payments is one key area where financial institutions have a clear line of sight to create value. For payments processing, in a speech made in April 2017, the governor of the Bank of England Mark Carney suggested it could save "tens of billions of pounds" by improving the "accuracy, efficiency and security" of payments, clearing and settlement processes. Historically, settlement chains have involved many intermediaries, which makes them comparatively slow, as well as leaving them exposed to greater operational risk and a higher potential for fraud. Adopting blockchain technology in this area could not only reduce costs but enhance security and efficiency.
Economic theory predicts that a low-cost competitor enjoys cost advantage only when high-cost competitors are still involved in the market. Once a number of banks have adopted blockchain, the market competition will pressure all banks to pass on the initial profit made back to individuals. Blockchain technology can be utilised towards much more than just digital currencies such as Bitcoin or developing new financial technologies. This smart contract can be used for other areas, such as documents provenance, ownership rights, digital or physical assets or to stop fraud.
To use conventional banking as an analogy, the blockchain is like a full history of a financial institution's transactions, and each block is like an individual bank statement. But because it's a distributed database system, serving as an open electronic ledger, a blockchain can simplify business operations for all parties. For these reasons, the technology is attracting not only financial institutions and stock exchanges, but many others in the fields of music, diamonds, insurance, and Internet of Things (IOT) devices. Advocates have also suggested that this kind of electronic ledger system could be usefully applied to voting systems or vehicle registrations by governments, medical records.
There is a danger, however, of expecting too much too soon from the blockchain; like the infrastructure behind the internet, the blockchain is a foundational technology. This brings genuine economic uproar, but can take decades: for example, it took about 30 years for the likes of Google and Amazon to emerge from the technological developments that made the internet possible. Even when the long-term benefits of the blockchain are considered properly, the uprooting brought about by foundational technologies is often met with resistance. If 2015 was the year of the blockchain hype cycle and 2016 the year for experimentation and proof of concepts to learn which use cases had legs, then 2017 is the year financial institutions have started pilot programmes with real customers with an eye toward production-ready releases.
The challenge is to overcome some of the regulatory issues that will need to be addressed if blockchain is to become a mainstream banking technology. These include issues such as jurisdiction and liability if something goes wrong, as distributed ledgers are, by definition, not constrained to any one location. Legal frameworks also need to be developed to establish blockchain systems as "unique and trusted sources of identity" and to be recognised as tamper-proof. The open nature of publicly distributed ledgers means that privacy is a key issue, particularly when it comes to ensuring the security of customer data. FinTech Network observed this challenge is one of the inherent difficulties of the technology.
Despite these challenges, interest in blockchain shows no signs of abating. Blockchain is really a platform for disruptive innovation, its potential extending far beyond reshaping financial services. The World Economic Forum (WEF) has written extensively on the applications of blockchain in the financial sector and beyond and declared that "Blockchain's ability to generate unprecedented opportunities to create and trade value in society will lead to a generational shift in the Internet's evolution, from an Internet of Information to a new generation Internet of Value".
The writer works for Commonwealth Bank of Australia.