October 28, 2016    6 minute read

A Wake-Up Call For Banks: Blockchain Is Here

Are Banks Digging Their Own Grave?    October 28, 2016    6 minute read

A Wake-Up Call For Banks: Blockchain Is Here

Back in 2008, in the wake of the financial crisis, a group of developers set out to create a secure and verifiable transaction service that eliminated the middle man – banks. They came up with bitcoin, the world’s first blockchain technology, now infamous for its role in the dark web. Eight years and millions of dollars later, blockchain is making its first steps into the mainstream.

The First Steps

On Monday, the first cross-border transaction between major banks using this revolutionary technology took place. The Commonwealth Bank of Australia and Wells Fargo & Co. used multiple blockchain applications to exchange funds corresponding to a shipment of cotton from the United States to China. Australian trader Brighann Cotton Marketing purchased a shipment of 88 bales at $35,000.

If everyone kept their records of transactions, the system would be highly corruptible. Banks try to solve this problem by acting as arbitrators. Bitcoin has a less human-dependent solution to this problem. All the relevant information to a transaction, called blocks, are kept in a continuously growing distributed database that acts as a public ledger, the blockchain. New blocks are added through a collaborative process called mining.

The metadata about each specific data point are highly encrypted and distributed amongst all electronic agents related to the network. These structural elements make it practically impossible to alter any single block.

Big Money

The potential of this technology was observed many years ago. It promises to cut transaction costs and time, minimise fraud, eliminate agency and coordination costs.

According to Accenture, blockchain-focused fintech firms secured $613m in investments between 2010 and 2015, the bulk of which came last year. In September 2015, nine of the world’s heavyweights in finance, such as J.P. Morgan, Credit Suisse and Barclays came together to form R3, a company developing blockchain technology. As of August 31st, the consortium counts 70 members.

HSBC, Bank of America, the Bank of Tokyo-Mitsubishi, Siam Commercial Bank and much more have invested in projects trying to implement some application of blockchain technology. Goldman Sachs launched its version of bitcoin very recently.

China published a 70-page report identifying key milestones in the development of the technology, encouraging firms to follow them. While the Chinese dominate the bitcoin economy regarding exchanges and mining, they have had little influence on the application’s core protocol.

It Goes Further Than Finance

Finance was not the first industry to take note of the revolutionary capacity of the blockchain. Back in 2014, Vitalik Buterin founded Ethereum, a decentralised public blockchain platform that executes peer-to-peer contracts, trading on a cryptocurrency called ether.

In the same year, a small startup called Ascribe popped up in Berlin that secures attribution of intellectual property and tracks the spread of a given piece through blockchain technology. Within 12 months they had raised $2million in investments.

British singer and composer Imogen Heaps was “fed up of hearing herself complain” about the emaciated reward that reaches artists after she heard the news about Ethereum. This is because what the consumer pays goes through distribution agents and record labels. She launched Mycelia, a company that allows artists to sell directly to consumers through intelligent songs with built-in smart contracts.

The Last Test

The applicability of this technology is to be determined when the final part of the cotton transaction takes place in November. As the staff unload the bales, they will be scanning a barcode on each. This will update the electronic contract to transfer the ownership of the goods from one party to another, which in turn will automatically authorise the release of payment.

Smart contracts, complex pieces of software that automatically execute instructions, are the second tier of software technology and they will drastically reduce the human element necessary for business. The trajectory culminates with autonomous agents, bundles of smart contracts that operate as highly distributed enterprises.

Because every blockchain transaction is public, the data about it cannot be tampered with. The same applies to the corresponding smart contracts. It establishes integrity and trust through mass collaboration and code.

Are Banks Digging Their Own Grave?

The music industry is not the same since consumers found an alternative to buying physical records. The advent of piracy could have meant the end of record labels, were it not for the monetising solution Spotify came up with. As blockchain platforms render distribution platforms redundant, they stand to win or lose depending on if and how quickly they embrace this new technology.

It is nothing short of common sense for banks to invest in blockchain technology. If they do not head its progress, they will be left behind by it. They will also be rewarded in decreased costs of transactions and management. In a 200 banks study by IBM, all forecasted commercial applications by 2020.

The public ledger, however, threatens to shake the foundations of the economy. Currently, trust is established by third parties. This applies to contract enforcement between agents guaranteed by banks and banks’ ability to pay back debt certified by rating agencies. It also applies to sharing economy companies, like Uber, which run on the aggregated willingness of suppliers to sell to and through a centralised platform.

The Implications

Everything Uber, Spotify and Airbnb do, can be done by an independent association built on a blockchain since the trust protocol ensures integrity amongst strangers. Even exchanges of physical products can happen, as the Wells Fargo deal shows. Walmart is already using blockchain in the manufacturing of pork products in China, tracking shipping information, storage temperatures and other variants. It brings users closer to the Internet of Things.

The trust protocol of blockchain is decentralised and distributed amongst everyone on the network. This shifts control of reputation to individuals, who judge it based on public records, social and economic capital. Two people will need not know or trust each other to conduct business. The reason why is quite complicated and lies in the coding elements of the process of mining.

The implications of this are far-reaching. The middleman gradually moves out of the picture, while the dynamic between consumers and companies is changed to empower the latter. As the technology strides towards implementation, the question is how far it will go. Banks may find themselves outdated and obsolete in many of the services they offer.

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