Financial players are slowly taking an interest in blockchain technology. Sofia Lotto Persio goes down the innovation road, one that is wise to follow regardless of uncertainties about where it will lead.
Two of the major factors shaping the future of banking are regulation and technology. Efforts to comply with new regulatory measures introduced after the 2008 financial crisis might have delayed financial institutions’ interest in innovation and digitisation – but as new technologies develop, it is time to get back in the game. Of course, just as Rome was not built in a day, a bank’s digital strategy will not be planned overnight. With an abundance of start-ups focusing on specific elements of the value chain to rival banks’ verticals, banks need to get their heads around what is happening, what is working, what has value and, ultimately, where to invest.
A good place to start is blockchain, the fundamental infrastructure underpinning bitcoin transactions. Blockchain has recently come out of the bitcoin’s shadow, increasingly attracting the interest of the tech, fintech and financial communities because of its potential to disrupt financial services.
Describing what the blockchain looks like is no easy task, as it is a fairly abstract concept. Blockchain is usually defined as a distributed public ledger, a peer-to-peer system enabling the immutable and verifiable transfer of digital assets. Transactions are listed on what could be considered an Excel sheet that anyone can access, but no one can edit. Each transaction is verified and enacted almost instantaneously through a series of computers performing mathematical algorithms.
The innovation presented by blockchain affects payments, contracts, identity verification and more. Its potential for use in finance – including trade finance – and other areas of life is huge, which justifies the hype around its development. Developers and innovators are experimenting with different use-cases, with projects looking into applying blockchain technology for purposes ranging from voting to digital identification. For people in financial services, the question is not whether blockchain will disrupt the market – it already has – but to what extent it will force financial institutions to change and upgrade the way they operate.
Trade finance potential
Blockchain and trade finance seem like a match made in heaven. “[Trade finance] has traditionally been a paper-intensive process but it is possible to use blockchain technology to digitise and authenticate records. This can result in trade transactions that are secure with digital records of related data visible to various participants in the trade transaction,” explains Anju Patwardhan, group chief innovation officer at Standard Chartered in a LinkedIn post that went viral in the online trade finance community, suggesting strong interest in digital and innovative solutions for what is known to be a conservative sector.
“Trade finance is not the kind of business or the kind of people who spend a lot of time thinking about the next digital technology,” says Edan Yago, CEO of Epiphyte, a start-up that uses trade finance instruments to ensure payments for digital good transactions happening on the blockchain. “Swift and the ICC have been trying to push the BPO for I don’t know how many years, but they can still count on two hands the amount of transactions they have actually performed. Companies like Bolero and a few small others have a difficult time actually grabbing any substantial piece of these industries,” he adds.
Perhaps due to their resistance to change, certain areas of trade finance, such as documentary and commodity finance, are ripe for disruption. What is unclear is whether the banks are ready to step up to the innovation challenge: “It is more a question of getting a couple of meaningful institutions involved, starting to develop and seeing how far you can take it,” says Mariano Belinky, managing principal at Santander Innoventures, a fund established by the bank to identify fintech start-ups with which to partner.
Paul Szurek, who is responsible for strategy and partnership at Blockchain.info, a popular bitcoin website and wallet, agrees: “The big corporates need to make a decision regarding using that technology for their transactions; the infrastructure is in place to accommodate them, whether they want exposure to bitcoin risk or not. It is also our industry’s job to market ourselves and explain the products we have because the opportunities are already there.”
It is not just the big companies that would benefit from the advantages of a distributed ledger technology, but the small and medium enterprises (SMEs), too.
“It has huge opportunity for small businesses as it allows you to see the collaboration between the buyer and the supplier, which is absolutely where supply chain is going. With blockchain you can see all sides
of a transaction and all the spectrum of the transaction as well, which makes it much more bankable. Potentially it opens up the world of finance,” says Bob Blower, non-executive chairman and co-founder of SCF Solutions.
Until recently, digital transactions through the bitcoin protocol had a reputation as the stuff of drug traffickers and paedophiles. But now the development of blockchain is contributing to shedding light on an otherwise obscure payment network.
“The distributed ledger is actually the most auditable form of trade that has ever been available. It can be downloaded by anyone; it can be searched by anyone. In the end, this is the most powerful audit trail that has been deployed at scale, so maybe you have to disregard the early headlines and early cases for bitcoins, which involved a lot of bad actors. The industry in many ways is evolving totally in the opposite direction, in which it could become a great tool for intelligence and security,” says Szurek.
A major misconception is that transactions on the blockchain are anonymous. They are, in fact, pseudonymous: users are given a cryptographic identity for which it is up to them to either declare their personal details or keep the transaction private. “This infrastructure could be adopted to make financial transactions more secure and traceable for customers, banks and regulators,” writes Patwardhan. While the blockchain shows exactly what transaction has taken place and between whom, the personal details of the parties involved can remain hidden. Whereas any credit card details can be stolen – as multiple cyber-crime episodes have shown – blockchain users are shielded from having personal details pilfered. “It’s very difficult to secure personal information digitally, eventually it can be compromised, especially if the information is centralised. The best way to design a security service with privacy in mind is to have a zero-trust service, to not allow the service to take any personal information from you whatsoever,” says Blockchain co-founder Nicolas Cary.
He continues: “If you’re a criminal, using bitcoin would be one of the dumbest ideas you could have. As soon as an IP address is attached to a transaction you make, they will be able to digitally graph every transaction you ever made, including where the money came from, and who it went to. Bitcoin is probably the least anonymous payment network out there. Once major financial institution realise that, they will get more and more excited about it, and we’ve seen the conversation changing in the last 18 months.”
This changes a lot for banks, whose role as trusted transaction intermediary would become marginalised. “Up until now the banks have had a database with corporate names, checking accounts, and all those products – all based on identification. Now traders can identify themselves to the bank, and not vice versa,” says Rodolfo Barros, managing director at Viking Import & Export. It does not stop there: due to blockchain’s immutable retention and public accessibility of the transaction, the creditworthiness of the users is also immediately available, reducing the need for third-party credit rating. “It’s the Uber model applied to trade finance,” as Barros describes it.
Banking professionals are more cautious about the marginalisation of banks. “We all like the thought of a perfect peer-to-peer humanistic approach, but reality shows that control mechanisms are needed and banks have an important role to play in actually providing that,” says Cian Murchu, director, trade finance and cash management, corporates, global transaction banking at Deutsche Bank. “Our view is that you will always need a trusted intermediary. We as banks need to prevent illicit money travelling between illicit parties, we need controls that people can trust and I think that can be applied to blockchain from a currency perspective,” he says.
Santander’s Belinky agrees: “We’ve all seen a good share of financial institutions failing in trust, but there is still something about the relationship with the client and the trust the client has in a bank that won’t be substituted that easily by a handful of apps that offer this or that product.”
Friends or foes
While banks may well remain relevant players in transactions, the need for co-operation with fintech companies seems inevitable. “Many of these new technologies started off seeking to disintermediate banks, but the trend is now shifting towards collaboration. Partnerships between banks, technology companies and regulators will bring benefits to consumers and the financial system,” reflects Patwardhan in her post.
“We see fintech as partners and clients – they still need access to banking. As an organisation, one of the elements we need to better understand is where we are best placed to create value in the new digital environment and what we are good at: are we good at designing user interfaces or are we good at providing robust controls, checks, KYC, anti-money laundering and local access to clearing facilities? Partnerships with fintechs, I would argue, will make us quicker in reacting. There is no point in reinventing what already exists out there,” explains Murchu.
For Belinky, the key is to understand the technology and make the best use of it, one that makes commercial sense too. “There’s a lot of people around the blockchain treating it as the end of every single problem we have in computer science and the internet. For us it will solve specific problems and we will focus on those problems,” he says.
The interest is certainly brewing: the Bank of England has conducted studies on the utilisation of digital currencies and blockchain technology; Estonian Bank LHV has developed a crypto-wallet app that works on blockchain; and Citigroup is experimenting with its own blockchain and cryptocurrency Citicoin.
To make the most of the technology, banks will have to accept that they should not try to take control of it: “When you try to centralise the ledgers you expose yourself to the security risks,” advises Szurek. “It is positive that these financial institutions are at least interested in the conversation and seeing what the applications of blockchain are for them. It is just a matter of us working together to figure out what solutions are actually deployable and take advantage of the inherent benefits of the technology,” he adds. Barros’ perspective is more radical: “Those banks are realising the writing is on the wall, but ultimately the question is where do we make our money – and they’ll find out that in a true peer-to-peer world they won’t make any money; the money is to be made in a different way.”
“If we were able to address the administrative pain that clients perceive in some of the processes, if we could figure out ways to improve that, we’d be able to do business faster and more easily with clients,” says Murchu.
Banks could save a great amount of money too. Santander Innoventures co-authored a paper with Oliver Wyman and Anthemis Group, suggesting that the distributed ledger technology could cut banks’ costs related to cross-border payments, securities trading and regulatory compliance by between US$15bn and US$20bn per year by 2022.
Banks can exploit the opportunities given by new technologies to upgrade and improve their product offers, letting go of what can no longer be monetised, such as payment transactions, and finding different ways to compete in the market. Deutsche Bank is looking at advisory services, says Murchu: “Rather than being very specifically focused on product sales, you look across the spectrum and instead of just talking about payments, talk with a client about their treasury facility, working capital, and for instance, uniting the cash and the trade element. It’s a very different service because it is not just about a product, but about holistic solutions.”
According to Yago, trade finance is not going to change because of blockchain, but there will be more opportunities in terms of the application of
trade finance law to new types of industries. His company is one of the first using trade finance for blockchain, creating digital letters of credit and BPOs to ensure trading. This way, the lender can see instantaneously that a transaction has been performed: a computer reads the contract, performs the transaction and completes the process. That’s the way banks should go too, he suggests: “Banks can create entirely new markets for themselves by providing letters of credit or trade finance instruments for the movement of digital goods, in addition to physical goods – we see how it can work for physical goods, but we don’t focus on that because it would take too long. It’s more than a possibility, it’s going to happen, but I’ll be grey-haired by the time it does.”
The adoption of blockchain technology is slow because, according to Belinky, it comes with regulatory and compliance challenges, as well as some uncertainty: “No one really knows if the technology will scale up to a billion transactions; no one knows if it will be able to handle the data volumes that banks move around the world every day, so some banks are being more aggressive and inquisitive than others, which are taking more of a wait-and-see approach,” he says.
Murchu thinks that ultimately, the innovation has to be demand-driven, but acknowledges that the relative inaction over blockchain’s opportunities is not going to last: “At the moment banks are trying to absorb and assess the changes and to make a decision on where to invest. This is the calm before the storm.”
Digital currencies and co.
The ‘blockchain: good’, ‘bitcoin: bad’ dichotomy has been a popular, yet short-sighted one. While banks may be more interested in blockchain’s application, cryptocurrencies remain a relevant development in the payment space – despite all the naysayers that have announced the bitcoin’s death – as many as 72 times according to the website bitcoinobituaries.com, at the time of writing.
The idea of using alternative currencies in the supply chain cycle is not new. Going back to the early 2000s, Citigroup, British research and development company DCE and SAP came together to form joint venture Orbian, with the aim to launch a payment system for online business purchases. Orbian created an electronic payment obligation system wherein a buyer could pay a supplier with an Orbian Credit, which could then be used by the supplier to pay its own suppliers, and so on – with no need for actual currency. At the time it did not really work, as people grew suspicious about not receiving real dollars and having their assets linked to a company. Yet it was a glaring example of how cross-border transactions could occur with little need for banking infrastructure.
Following the 2008 crisis, and the distrust in the financial system which ensued, cryptocurrencies started being developed as a means to trade that would not be controlled by governments. They also represent a way for all those considered “unbankable” and who therefore have no access to the traditional banking system, to get credit and perform financial transactions.
More than 500 cryptocurrencies are in use today, but bitcoin is the most used, the most debated, and perhaps the most misunderstood. For Edan Yago, CEO of Epiphyte, the idea of bitcoin as a currency is a misconception: bitcoin is to coin what hamburger is to ham. “Bitcoin is a digital commodity, which is something you can trade on blockchain […] Bitcoin is what gives you the right to write on the ledger. It is a piece of the ledger, as well as being an asset on the ledger – it’s both.”
Regardless of the definitions, bitcoin is the perfect asset for the digital age, one that can be sent anywhere in the world at nearly zero cost; it is nearly impossible to counterfeit; and it is practical, as it can be divided into smaller parts than a cent. And it is already being used for trade. Traders like Rodolfo Barros, managing director at Viking Import & Export, are using it experimentally to trade with countries with high currency volatility, such as Argentina, and in general to bypass the high costs of cross-border transactions.
Yet, despite Visa looking into blockchain and bitcoin and Citibank developing its own cryptocurrency, some banks are cautious in expressing enthusiasm for bitcoin. “It’s not a revolution. It is a disruptive technology that can help us change certain processes to make them more efficient and less costly to our clients. Cryptocurrencies do not materially change the way we do our business,” says Mariano Belinky, managing principal at Santander Innoventures. Others do not exclude cryptocurrencies becoming more mainstream: “It is not impossible to imagine a scenario where even the central banks themselves might look at issuing digital currencies. No bank can afford to ignore what it augurs for the ongoing avalanche of digital innovations to come,” writes Anju Patwardhan, group chief innovation officer at Standard Chartered, in a post published on LinkedIn.
The central banks, such as the US Federal Reserve, are already lending a listening ear: “I am sitting on this US task force that the federal reserve has set up to look at the future of the US dollar settlement system, and cryptocurrencies and blockchain are very much in the minds of all the people sitting around the table,” says Bob Blower, non-executive chairman and co-founder of SCF Solutions. “What the Fed is trying to do is to
say to people: we want to speed up the dollar settlement cycle, to move it to real time and make it 24/7, but it does not necessarily mean we have to do it in the same way as we have done it in the past. We can actually use new technologies to make it happen in a new way. It’s fantastic that the Fed has taken a lead in that,” he says. Whereas bitcoin itself may not ever represent a threat to the dollar, the digitisation of currency is nonetheless a likely development. Watch this space.