Banks are researching blockchain technology to reduce costs.
The modern banking system dates back to the 13th century in Italy where the most famous bank across Europe was the Medici Bank. Their main innovation was the combination of banking and accounting systems, writing double entry data inside a general ledger. A bankers job was to track debits and credits or handle deposits and withdrawals for clients. They had to make sure entries were placed in a safe place and funds were secured.
Trust and talent were one of the biggest components for a banks success back then and for decades to follow.
For centuries, some of the biggest companies and salaries around the world came from the banking industry. However, during the 2008 financial crisis, this trust between banks and clients took a hit. Many banks had mismanaged their clients' funds and it was time for something new. Many startups jumped into the scene and offered mobile-first banking solutions, UI/UX friendly etc but the problem was still there. Human error, corruption, pen and paper records, and mismanagement of transactions would not go away with the current system.
It was during this time that a new technology was being introduced to the world. This technology allowed third parties to track transactions in a public ledger, transfer value around the world at a faster pace, and manage pseudonymous identities online all without the need of a central entity. This technology was called bitcoin, introduced by Satoshi Nakamoto. Bitcoin unknowingly introduced a triple-way accounting system that banks could leverage to evolve their current infrastructure.
Banks research blockchain technology
Now, bitcoin might have been created to decentralized the current banking system, but this won't stop banks to research and try to leverage this infrastructure and evolve their systems. Managing a personal bank account might not be for everyone even though bitcoin facilitates the tools of doing so, even for the 2.2 global Billion global unbanked population. Blockchain reduces the infrastructural cost of running a bank. This may help banks (or other startups) to onboard this large unbanked population.
According to Mike Bodson, CEO of DTCC (check out his interview for The Blocks podcast):
“U.S. markets let’s say it’s about 65 billion dollars for equity markets. Their belief is that within five to seven years, I think, that’s 65 is going to go down to 48 billion dollars. So you’ve got this massive pressure on costs. Right. And all the Wall Street firms have done the same things over the last few years, you know. They’ve all tried to modernize but we all sit off old legacy technology. You’ve outsourced, you’ve sent things overseas. You’ve done all sorts of things to try to drive that cost base down but at the same time you’ve got the pressure of compliance and regulation, which is making your costs go back up.”.
Note: DTCC spends $1.4 billion each year, and 50% in tech ($700 Million) and handles $1.8 quadrillion of trades every year.
Long term opportunity
Every bank is focusing on reducing costs, and blockchain technology might just help them achieve part of it. They can transition key operational, risk and finance systems to blockchain platforms.
Accenture made a report on what areas could benefit blockchain the most.
Some of these areas could see a 70% disruption impact due to their easily automative nature. Imagine having all trades within one database where anyone can audit its history, and current trades are updated live. Since all trades are digitized, there are no more worries that if a storm comes it could damage the place they are stored and lose valuable time to re-inform the network. Also, since a blockchain stores trades in a distributed network, no one can hack it, tamper it, or corrupt past information (unless they own 51% of the computing power which is another story).
Accenture finalized the report saying blockchain can help save ~$8 Billion if systems are upgraded.
Current blockchain solutions for central banks
Since 2014, central banks have been investigating the applicability of digital ledger technology for various banking obligations, with some 40 central banks doing so today. While blockchain, like any new technology, is full of unknowns, experiment and research points to significant advantages from central bank adoption of CBDCs (Commercial Banking Digital Currencies) and DLT (Distributed Ledger Technology). In this World Economic Forum white paper, ten use cases are put forward:
- Retail CBDC for consumer use similar to physical cash or alternative bank deposits.
- Wholesale CBDCs for interbank settlement on the commercial level.
- Interbank securities settlement to allow simultaneous, peer-to-peer asset trades.
- A primary or back-up domestic payment system in case of emergencies.
- Sovereign bonds issued and managed by states who act as nodes.
- Financial tracking of AML/KYC information as a unified information outlet.
- An information sharing site between public and private entities for financial data flows.
- Trade finance issued on a distributed ledger to increase domestic and global efficiency.
- Cash flow supply train to track and analyze large cash flows between commercial and central banks.
- Blockchain database for the EU’s SEPA credit system to increase overall efficiency between member nations.
Retail CBDC for consumer use similar to physical cash.
In a future where consumers use less cash, it is vital for a country to introduce a good CBDC. Especially in countries where commercial banks are unstable and deposit insurance is not offered. CBDC can be the answer for financial inclusion, especially with a 52% mobile penetration rate.(Statista).
Wholesale CBDCs for interbank settlement on the commercial level.
Central banks coming from emerging countries can beneficiate the most to settle an instant transaction. Central banks with already efficient systems (such as the Bank of Denmark) can create a primary or back-up domestic payment system in case of emergencies.
The intersection of emerging countries and developed banks can create the necessity of everyone being on the same page. So if say the Bank of Denmark is using blockchain as a backup, and the Bank of Argentina as primary, it might be necessary for them to use the same technology to settle transactions.
Blockchain-based issued bonds issued.
French banking group Societe Generale has issued a 100 million euro covered bond on the Ethereum ($ETH) blockchain as a security token dubbed “obligations de financement de l’habitat” or OFH. The bond is rated Aaa/AAA by Moody’s and Fitch and was part of an internal startup program for fintech experiments. Blockchain allows Societe Generale to explore a more efficient process for bond issuances in real time. The blockchain bond reduces time to market, increases transparency, and faster transportability, and settlement. A smart contract automated the whole process.
Afghanistan, Tunisia, and Uzbekistan have been testing sovereign blockchain bonds to help out critical sectors of the economy and increase trust in their markets. Afghanistan is interested in issuing a bond tied to metals. specifically the country’s $3 trillion lithium industry. Uzbekistan was interested in issuing blockchain bonds for its cotton industry. Tunisia would issue a bitcoin-based sovereign bond. (Asia Times).
Financial tracking of AML/KYC information as a unified information outlet.
According to Banque Centrale de Tunisie governor Marouane El Abassi, Blockchain based bonds can combat money-laundering, manage remittances, fight cross-border terrorism and limit grey economies. (Asia Times).
Banks already testing or using blockchain technology
BNY Mellon- Blockchain based US Treasury bond settlement
The Bank of New York Mellon, is an American worldwide banking and financial services holding company headquartered in New York City with $1.8 Trillion in assets under management. They focus on providing a suite of foreign exchange, securities finance, collateral management and segregation, capital markets and prime brokerage services as well as custody and wealth management. They launched the US treasury bond settlement- BDS360 with blockchain technology back in 2016 as a backup record to their system. This blockchain can reduce the three-five days settlement of bonds to 1–10 minutes in a secure, transparent, more affordable, and instant manner. The backend is bypassing intermediaries that do not trust each other and antiquated infrastructure by clearing and verifying a bonds authenticity within a blockchain.
Banco Santander- Cross-border transactions
Banco Santander is a Spanish multinational commercial bank and financial services company founded and based in Santander, Spain raking $54 Billion in revenue in 2017. With services all around the world, Banco Santander and blockchain technology are a match made in heaven due to the instant cross-border transaction this technology offers. Together with Ripple’s service Xcurrent, Santander launched One pay FX in 2018 to roll out a distributed app (Dapp) offering same day International transactions for customers in Brazil, Spain, U.K, and Poland. The traditional system takes three-five day and charges an average of $25 fee + 3–7% to its customers depending on the bank to finalize an international transaction.
ING- Zero knowledge proof set membership
The ING Group is a Dutch multinational banking and financial services corporation headquartered in Amsterdam. Its primary businesses are retail banking, direct banking, commercial banking, investment banking, asset management, and insurance service with 37 million clients worldwide. They have tested blockchain technology to increase confidentiality in a public ledger using Zero-Knowledge Range Proof (ZKRP) solutions. Developed in-house, the team’s test has demonstrated significant efficiency improvement to protect clientele private information. ‘Zero-Knowledge Proof’ allows a party to verify the accuracy of a statement without conveying the actual information in the statement. Zcash is one of the biggest cryptocurrencies that uses the ZKRP modeling.
A public blockchain (Permissionless blockchain) allows anyone to interact with the network and run a node. Blockchain networks such as Bitcoin, Ethereum, Litecoin, and EOS are permissionless. The benefits of a permissionless blockchain is the basic components of more decentralization, transparency, and immutability.
A bank might not be so interested in allowing everyone to partake in the network. Permissionless blockchain such as Monero, Zcash, and Grin are focusing their technology on more private components using Zero Knowledge Proof algorithms.
- The Aztec protocol provides privacy components built on top of the Ethereum blockchain.
Private blockchain (permissioned blockchain) only allows parties with access to the blockchain to participate in the network, check transactions, and audit the information flow. Consortiums are being created to bring all banks together and work on private blockchains without revealing critical data that shouldn’t be seen in public.
- Ripple, Stellar, Quorum, and R3 are some of the biggest private blockchains or set of consortiums.
There are many use cases for banks to look into blockchain technology aside from opening cryptocurrency trading desks. Blockchain is beyond the testing phase for the banking world now. They want to know how blockchain will work for them.