Blockchain offers an alternative to many record-based transactions, from money transfers and asset custody to ‘know your client’ checks, healthcare records and music downloading. It would release huge cost savings and create additional value, but could negatively impact employment levels. Otherwise, transaction times are likely to be reduced.
Jakov Agbaba, Risk Analyst at Rathbones, co-authored with Julian Chillingworth, Chief Investment Officer
Risk of disruption = medium/high
You might have read or heard about it; ‘blockchain’ is the financial disruption buzzword of the moment. Intended initially as the platform for storing and transferring the Bitcoin currency, blockchain has become the building template for what is referred to by some as the biggest change since the internet.
Blockchain is promising to do for value what the internet has done for information: decentralise control, remove asymmetries, and change the way we transact and interact with everything. From money transfers and asset trading, through healthcare provision and music downloading to collaborating and sharing of resources, blockchain promises to enable, empower and revolutionise. And disrupt.
A huge public ledger of transactions
Blockchain is a platform for transacting without an intermediary, from one individual or peer directly to another. In electronic payment terms this means that one person can make a payment to another person without using a bank or any other intermediary. All aspects of the transaction are performed by a computer or, as is actually the case, by a database. Figure 8 shows how this differs from current intermediated transactions.
The first defining feature of this new and nascent technology is that it is distributed or shared. Rather than located on one computer, blockchain is a database spread across multiple machines. Everyone can access blockchain, view its contents and add new transactions.
Another defining feature of blockchain is that it is decentralised. In the context of databases, this simply means that no single party has control. The update and maintenance of blockchain database is carried out by many parties. In Bitcoin blockchain, these parties are known as miners. Their job is to validate transactions and keep the database up to date.
Cross-border payments
Recent estimates from McKinsey & Co suggest that blockchain could generate $80 to $110 billion of value in the financial services industry alone (McKinsey, 2017). Most of this impact, McKinsey says, would be felt in the payments segment, where cross-border business-to-business payments could see new value creation of $50 to $60 billion. This would be created from additional activity, cost reduction, and capital release from the current cumbersome process.
A report published in 2015 by Santander InnoVentures claimed that blockchain could generate cost savings in cross-border payments of $15—20 billion per year by 2022 (Santander InnoVentures, 2015). The report went on to say that the immediate impact would be felt by the cross-border payments segment of the financial sector. Blockchain would achieve those savings, the authors argued, by bypassing the existing international payment networks, which are slow and expensive.
The disruption of cross-border payments has already started. Transferring money from one country to another today costs significantly less than it used to. There are many online providers of this service, which has put significant competitive pressure on the traditional providers, such as banks and money transfer companies.
Chris Mager of BNY Mellon describes the current state of affairs in banking as an “unprecedented period of change and transformation” and goes on to say that there is a potential role for blockchain in payments (FinTech Network, 2017). Existing payment systems are outdated, slow and inefficient; they were not designed for the world we live in today. Blockchain could help by eliminating these inefficiencies and, through this, reducing banks’ costs and their charges to the consumer.
Blockchain technology has the potential to make the cost of transferring £1 equivalent to the cost of transferring £10,000. At present, the costs associated with processing a transaction make the £1 transfer disproportionately costly. The human effort required to process both transactions is identical, yet the value of each is vastly different. Remove human involvement and replace it with a machine and the cost falls to the point where both transactions are viable.
Application of blockchain technology to payments would also deal with the disproportionate amount of time it takes to process cross-border transactions: between four and seven days. Blockchain could enable the almost instantaneous execution of payments, both domestically and globally (FinTech Network, 2017). The delay between sending and receiving the payment would be equal to the amount of time it took for the sender to sign off the transaction, the recipient to confirm and the miner to validate it. On average, this is somewhere between 10 minutes and an hour (Dr. Joseph Bonneau, 2015).
It is important to note the impact of these changes is not limited to the cost savings and convenience for consumers. The changes can have a significant impact on global trade too. Exporters and importers are heavily burdened by the cost and time it takes to pay for goods and services. As an aside, global shipping companies can experience significant delays when crucial customs paperwork gets lost, delaying the loading or unloading of containers. Blockchain could allow such paperwork to be seen by all necessary parties in real time without the risk of it becoming lost. The cost-savings could be huge.
Know your customer
The impact of this technology on the financial sector is not limited to payments. Blockchain database could be used to store other data. In its recent white paper, the FinTech Network (a blockchain consortium of about 70 banks) cites four potential areas of banking where blockchain could reduce inefficiencies, generate savings, increase security and reduce fraud (FinTech Network, 2017).
Know your customer (KYC) is a procedure mandated by regulators through which banks and other financial institutions carry out checks on customers in order to prevent fraud, particularly money-laundering. According to a recent survey by Thomson Reuters, banks on average spend $60 million per year to carry out these checks. For the largest banks, however, expenditure on KYC and due diligence can be closer to $500 million (Thomson Reuters, 2016).
KYC procedures can be costly, demanding and cumbersome for both the financial institution and their customers. Although there are attempts to centralise KYC information and make it available to participating banks, 84% of banks in the SWIFT network still do not participate in information sharing (FinTech Network, 2017).
Each time a customer — retail or corporate — switches banks or approaches another bank for additional services, a new KYC procedure must be carried out. The information the new bank is required to gather is already there, but just isn’t shared. So the task is duplicated, the cost replicated, the customer inconvenienced by having to once again prove their identity and cover at least a part of the cost of this repeated activity. If the information were held on a blockchain, it could be readily used by other financial institutions.
It is important to make clear that this or any other information does not need to be shared with the whole of blockchain. Using private blockchains, the information can be secured and distributed only to those who need to view it. These can be either private sections of a public blockchain or separate and closely-held blockchains. These are like an intranet; it is similar to the internet, except accessible only to the employees of a particular organisation.
Chris Huls, a blockchain specialist at Rabobank who investigates different types of blockchain and the opportunities they offer to the financial sector, has proposed that KYC data be stored on the blockchain (FinTech Network, 2017). Once a bank has carried out its KYC process on a customer, it could confirm this with a statement on the blockchain and a summary of the documentation that has been collected from the customer. This information could then be used by other banks, insurance companies and other financial institutions — after all, much of the underlying information belongs to the customer, not the bank.
In a recent report, Goldman Sachs estimated that application of blockchain in customer onboarding and transaction monitoring, as well as the technology and training required for these functions, would generate $2.5 billion of cost savings for banks, or 25% of the overall operational costs. Key savings would be seen in transaction monitoring (that is, the monitoring of existing clients), where blockchain would lead to a 30% reduction in headcount or cost savings of $1.4 billion (Goldman Sachs, 2016).
Figure 8: Embedding distributed ledger technology
A distributed ledger is a network that records ownership through a shared registry.
Cryptocurrencies and cryptosecurities
Global custody is another key area of potential disruption. Custodians are the safe-keepers of assets. Their role is to safeguard the financial assets of individuals and financial institutions. Custodians hold stocks, bonds and commodities; they handle settlements of asset purchases and sales, recording changes in ownership; they collect and store information on assets, record and monitor dividends as well as coupon payments on bonds; administer corporate actions; manage bank accounts and handle foreign exchange transactions.
All of these roles could be performed automatically through blockchain. They can be written into what is known as a smart contract. This is an automated and self-executing agreement stored on blockchain in the form of computer code or a program consisting of pre-written logic in the form a statement: “if this happens, then do that”. The execution of a smart contract is performed by a computer. It can be viewed by everybody, replicated and used as a template for new contracts and arrangements (Antony Lewis, 2015).
Blockchain’s recording and data storing capability will deal with the register of ownership, while smart contracts will facilitate everything that needs to happen in the life of an asset, such as dividend and coupon payments, corporate actions and so on. Goldman Sachs estimates that the automation of custodial services will save the financial industry $11 billion to $12 billion per year in overhead costs (Goldman Sachs, 2016). It will also speed the settlement of assets from the current period of three days to potentially one hour, which is inconceivable in the current labour-intensive systems of settlements and custody (FinTech Network, 2017).
Blockchain can allow parties to enter into any transaction, irrespective of size, without drawing up a new contract every time this transaction occurs. For example, a musician might decide to post his or her music on a blockchain music platform, including, for example, one free play of the song. But, if another party wanted to download the song for future listening, use it as a ring tone or put it into a movie, the artist could stipulate the costs and terms governing such use.
This same contract could be applied to an infinite number of transactions. The artist wouldn’t need an agent to sell his or her music, neither would a new legal contract be needed for each transaction. The artist would be able to keep a larger proportion of the value they have created and the consumer would benefit from lower costs.
Smart bonds
Such an automated world could sound like pie in the sky to anyone who is familiar with the labyrinthine workings of financial institutions’ middle and back offices, as well as the global settlements and custodian processes for every asset, but the future is surprisingly near.
In 2015, UBS reported it was working on smart contracts in the form of self-servicing bonds (Sarah Jenn, 2015). These instruments, also known as smart bonds, are automated contracts in which all aspects of servicing are executed by a computer. UBS has created a blockchain-based application that can deal with a bond’s issuance, interest calculation, coupon payments and maturation process. There is no need for pre- or post-trade intermediaries, usually the back and middle offices in an organisation.
Other uses of blockchain
Although the initial wave of significant blockchain innovation and disruption is likely to happen in the financial industry, the technology has potential to change other areas of life.
Imagine a healthcare system with the data and other tools required to make treatment fully targeted, less expensive, more effective and, above all, make certain conditions preventable. From clinical trials and patient records to patient compliance with treatment, blockchain could be the first medium of healthcare collaboration between patients, physicians, medical researchers and regulators.
At present, medicine still largely has a ‘one-size-fits-all’ approach, which means that adverse drug reactions are commonplace. Often, a simple test and immediate access to a patient’s records, could prevent such reactions. Sharing patient data between physicians using one secure database source could mean that treatment could be given more effectively, at a lower cost, and without sometimes fatal errors.
Data from clinical trials is rarely shared between different medical researchers. Sometimes, this cannot be done for competitive reasons, but there are situations and stages of medical development which would warrant greater collaboration between medical researchers. While looking for one particular molecule, researchers will often come across other molecules that do not fall into their area of research or expertise. These molecules are usually not shared, but sharing them with other researchers, the World Health Organisation and other organisations could potentially lead to ground-breaking discoveries (Deloitte, 2017; Tierion, 2016; and Helen Disney, 2017).
We have mentioned the effect blockchain may have on healthcare, but there are other industries as well as parts of our daily lives that could be significantly changed with the advent of this technology. We discussed custodial services earlier, but similar effect could be seen in the land registry. Some countries are already transferring their land registries to blockchain. Other areas of innovation and disruption include:
- instantaneous smart card payments
- corporate supply chains
- tracking of government finances
- online voting
- cloud storage
- music payment and licensing
- further decentralisation of the sharing economy.
Conclusion: disruption or innovation?
In 2015 and 2016, venture capitalists invested around $1 billion in the development of blockchain (McKinsey, 2017). The banking industry is expected to spend around $400 million by 2019 (McKinsey, 2017). Wide-ranging uses of blockchain are being developed and tested in many other industries.
Blockchain is coming, that’s for sure. What is not certain is what shape it will take, the kind of change it will eventually lead to and when this will happen. It will be some time before these questions can be answered.
Proponents of blockchain argue that the technology is not as much about disruption as it is about innovation. And to some extent they are right. For example, with cross-border payments, blockchain might offer banks a get-out-of-jail-free card — a way to compete against their online counterparts and ultimately hold on to their market share. In terms of healthcare, blockchain may offer a less costly, more effective and secure way of collecting, storing, sharing and analysing data. It could lead to significant improvements in healthcare provision.
But some companies will inevitably suffer disruption. In these cases, blockchain may prove impossible to adopt, conflicting with every part of their service offering and presenting a threat rather than opportunity. Those businesses will either have to readjust and change, which can take both time and resources, or face closure when other providers gain critical mass and offer similar services at far lower cost.
Box 6: Blockchain: how it works
Blockchain is a digital public ledger of all transactions that have ever been executed. Each block in the chain represents a group of transactions.
A new transaction is carried out using a private key. Using a public digital signature, the same transaction is then signed by the sender at one end and the recipient at the other. Once the transactions in a block have been validated (by so-called ‘miners’ in the case of Bitcoin), the block is added to the chain and forms a permanent part of the database.
Think of it as pages in a book. A book is a chain of pages. Each page in this blockchain book is a mini-statement of transactions. The entire blockchain book represents all the transactions ever executed. Every time a block is filled and added to the chain, a new block is generated. Blocks are linked to each other in a clear linear and chronological order, with every block containing a hash or link to the previous one. The entire chain is akin to a chronologically ordered book of all transactions that can be read and added to by everyone — an open book for all.
Unless it has been disputed, which normally happens very early on, the transaction cannot be erased or altered retroactively. This is the third key feature of blockchain: it is protected from revision and tampering. Once entered, a transaction is permanent.
The database is secured using complex and powerful cryptography. There are private keys we mentioned earlier, but there are also public keys. Owners are linked to their cryptocurrency using private keys. Provided they are stored securely, these private keys are not accessible to anybody else. The public and private keys are then linked together, so that the information necessary for a transaction to take place can be relayed publicly. All other information remains accessible to the holder of the private key only. Giving your private key to somebody else means giving them access to your cryptocurrency — losing your private key means losing your cryptocurrency forever.
Hacking into and taking control of the database would be prohibitively expensive. It is said that the power behind the Bitcoin blockchain is equal to 500 of the world’s most powerful supercomputers multiplied by 13,000 (The Economist Explains, 2015).
