Among the many potential use cases for blockchain, finance is arguably the most prominent one. The technology’s inception, in the form of Bitcoin, was prompted by the 2008 financial crisis, which had devastated the global economy. The traditional financial system had crashed, forcing governments to issue huge stimulus packages to prop up economies and bail out failing banks.
Blockchain aims to address many of the weaknesses that were exposed during the global financial crisis. In this piece, we’ll examine what are the use cases for blockchain in banking and why this nascent technology can help alleviate the sector’s biggest pains.
Advantages of blockchain in banking
The banking industry has been around for centuries serving as a facilitator for a variety of financial and economic activities, including trading, lending and borrowing, transaction processing and settlement, underwriting, and so on. However, this longevity has led to stagnation, with the sector becoming over time slow to adapt to the rapidly changing realities of the digital age.
Implementing new technologies can help modernize the sector. Here’s what blockchain brings to the table:
Banks today still rely on outdated and inefficient systems to facilitate communication and coordination across large networks of counterparties. Various banking activities, clearing, and settlement, for example, are in need of solutions that can improve speed and efficiency.
Applying blockchain technology can provide such a solution. As a secure and efficient peer-to-peer method for data distribution, blockchain technology can eliminate inefficiencies across an organization, reduce the reliance on intermediaries, and deliver significant cost savings for the industry as a whole. A 2017 report by Accenture found that big investment banks could save $10 billion by utilizing blockchain to improve the efficiency of their clearing and settlement operations.
In recent years banks have been scrambling to strengthen their security systems and safety procedures following a number of high-profile data breaches. Cyber attacks, technical glitches, and human error have hit the industry hard, exposing the financial data of thousands of customers. Faced with these challenges, some lenders have in recent years been trying to unlock blockchain’s potential to improve their security systems.
Blockchain can bolster bank security in a number of ways. Firstly, the technology can be used to develop robust know-your-customer (KYC) solutions, as the cryptographic protection it offers guarantees that the identities of all members of a blockchain network are verified. In addition, the information can be easily shared among all members of the network, while also reducing the need for intermediaries to handle data distribution.
The decentralized nature of blockchain also eliminates single points of failure, which reduces the risk of data breaches considerably.
Some blockchain protocols offer an additional layer of protection in the form of smart contracts that enable automatic transactions when certain requirements are met.
Instant payments and money transfers
Blockchain protocols are already starting to challenge the banking industry in terms of payments and other money transfers, so it’s not surprising that many lenders are examining closely what the technology has to offer. For cross-border payments, in particular, adopting blockchain could be a real boon for the sector.
To process payments across borders, banks today rely primarily on the Society for Worldwide Interbank Financial Telecommunications (SWIFT), a vast messaging network that handles the transfer of information between member banks. But with blockchain, lenders are connected directly to each other, thus removing the need for such intermediaries. It should also be noted that SWIFT has seen its share of hacks in the past few years, which further bolsters the case for adopting blockchain.
Mathew McDermott, head of digital assets at Goldman Sachs, told CNBC in August that in the next five to 10 years, “you could see a financial system where all assets and liabilities are native to a blockchain, with all transactions natively happening on-chain”.
One intriguing application of blockchain in banking comes from its ability to digitize physical assets. This means that blockchains can host, among other things, a large variety of digital currencies.
We’re already familiar with traditional cryptocurrencies like Bitcoin, as well as stablecoins that are pegged to a fiat currency/asset or a basket of currencies/assets. These types of projects typically exist outside the traditional banking and finance sector. In recent years, however, a number of commercial and central banks have been working on their own digital currency projects.
Perhaps most prominent is the effort by the People’s Bank of China (PBoC), which is working on launching its own Central Bank Digital Currency (CBDC). The DC/EP (Digital Currency/Electronic Payments), as the CBDC is called, is currently being piloted in several large Chinese cities.
In the commercial banking space, US banking giant J.P. Morgan Chase last week launched its own digital currency dubbed JPM Coin. The coin runs on J.P Morgan’s proprietary blockchain Quorum, with the bank having plans to extend it to other platforms in the future.
As already mentioned, smart contracts can be used to automatically handle money exchange between counterparties. Among the benefits of this approach are minimizing the element of trust needed to reach an agreement, as well as reducing the risk of errors.
How can blockchain be used in banking?
Accounting and audit
Blockchain’s ability to store immutable records can have a profound effect on how accounting, bookkeeping, and audit is done across the banking sector. The technology can help in this domain by reducing paperwork, streamlining traditional bookkeeping methods, and ensuring that records are readily available for audit. Regulatory compliance across the sector will likely improve significantly as a result.
So far, the four major auditors – PwC, KPMG, Ernst & Young and Deloitte have shown interest in blockchain.
Borrowing and lending
One of the hottest blockchain trends in recent years, DeFi (decentralized finance), aims to transform many aspects of traditional finance, including borrowing and lending. DeFi’s goal is not to improve the banking industry, but rather to challenge it head-on by making financial services more accessible to retail consumers. To learn more about how DeFi is enabling the development of innovative services like peer-to-peer lending and borrowing apps, we recommend reading our piece on decentralized finance.
However, blockchain can also be used to boost lending and borrowing activities facilitated by banks. The technology’s robust verification capabilities could reduce the risk of bad loans. In addition, blockchain can make sure that borrowers are not criminals or bad actors, which will boost banks’ know-your-customer (KYC) and anti-money-laundering (AML) capabilities.
Another area where blockchain can help is syndicated loans. Large loans to corporate clients are typically provided by a group of banks. This is a complicated process that requires coordination between the lenders and can take up to 19 days. One big hurdle here is compliance with KYC and AML regulatory requirements. The traditional method necessitates all banks involved in the processing of a syndicated loan to ensure KYC and AML compliance independently. However, blockchain technology allows for a bank that has already completed the compliance procedures to securely share that information with the other participants in a loan, thus simplifying the process considerably.
In 2016, Credit Suisse, Ipreo, Symbiont, and R3 formed a consortium to work on enabling syndicated loans on blockchain systems. Using solutions from Synaps Loans, the consortium successfully completed a proof of concept in 2017.
Blockchain is well suited to improve one area where modernization has been well overdue. Even today, trade finance relies mostly on paperwork, which is distributed by fax or mail across the world. Blockchain could be the technology to finally put an end to this and usher in an era of rapid digitalization across space.
DeFi has already demonstrated that there is a growing interest in decentralized marketplaces and exchanges. While at the moment those are happening outside the banking industry, lenders could be tempted to embrace the concept. As discussed earlier, blockchain could completely transform clearing and settlement operations, which are a key component of a trading business.
Banks have traditionally managed most forms of fundraising such as initial public offerings. The advent of initial coin offerings (ICOs) a few years ago sought to challenge the traditional models, by allowing start-ups to issue and sell crypto tokens to investors. While highly controversial, the ICO trend sparked a new way of thinking about fundraising and eventually led to the birth of security token offerings (STOs), a much more mature version of the original concept.
If the trend continues to grow, it is not unreasonable to expect that banks might start looking for ways to tap into space.
While blockchain was initially designed to offer an alternative to traditional finance, it is now drawing interest from the financial institutions it was meant to rival. After years of downplaying and ever ridiculing the technology, banks are now realizing that the benefits of blockchain can no longer be ignored. Many applications of blockchain in banking offer ways to improve the sector’s existing operations and procedures. However, it is also likely that in the future banks would be implementing blockchain solutions designed to exist outside the traditional system. If that happens, the blockchain challenge to the sector will have been successful.
At LimeChain, we want to help make this a reality. We recently did a two-day workshop for Raiffeisen Bank, advising them how blockchain technology could be best utilized for the benefit of the sector. If you want to draw from our expertise on the blockchain in banking, please drop us a line at [email protected].