August 24, 2017    4 minute read

Blockchain: What It Means for the Banking Industry

A New Dimension?    August 24, 2017    4 minute read

Blockchain: What It Means for the Banking Industry

The principal problem with today’s financial transactions is that each requires a ledger – defined as a collection of financial accounts for recording the history of transactions whose separation inevitably makes them prone to fraud or error. Moreover, the system’s reliance on intermediaries leads to less efficiency and involves a lot of paperwork.

The Solution

Blockchain solves this problem by operating as a single shared ledger which cannot be altered once information is stored. Referred to as the ‘Internet of Value’, it extends the notion that in addition to information, Digital Assets can also be shared and exchanged through a centralised system or cloud.

There are 3 principal advantages of the technology. The first is found within is its distributed nature, meaning that data embedded into the network is shared among participants, reconciliation of disparate ledgers is reduced, and no member has more control over others.

Furthermore, it is given permission, which provides each member access rights allowing confidential information to be stored on a need-to-know basis, and the ill-intentioned altering of any unit becomes almost impossible. Lastly, it is secured, as a consensus for a transaction is required from all network members and all validated transactions are permanently recorded.

Welcoming a Blockchain Banking Industry

While its emergence in 2014 seemed to initially spell the end for the future of the industry, sentiment has gradually shifted to investment banks embracing the technology due to its potential to support and streamline several of their business areas. Investment banks’ infrastructure costs are estimated to be reduced by $8 to $12bn a year by 2025 as the technology helps in eliminating the process of clearing and settling securities as well as unifying data to meet demands on trade reporting.

The world’s largest exchange company, NASDAQ, has been leading the way with its blockchain initiative Linq whose goal is to reduce settlement risk by more than 99% for private market trading pre-IPO. More recently, NASDAQ and Citi Treasury Trade Solutions announced an integrated payment solution in May 2017 enabling straight through payment processing and automating reconciliation through a distributed ledger.

On the other hand, following the credit crisis, regulators have been reluctant to materially reduce clearing and settlement infrastructure, so it will be some time until blockchain networks have been approved for this purpose as a fully safe, secure, and resilient solution.

Technological Advancement

The rise of smart contracts spurred by the Ethereum platform allows its users to code a customized financial solution, which could be seen as a threat to the derivatives expertise present in banks if Blockchain takes over. The technology is advancing quickly, having already been applied to trading, matching, and the settlement of US Treasury bonds. UBS and Goldman Sachs have recently investigated the use of a regulated decentralised information and value ledger for issuing and trading bonds capturing their entire life. This technology can also be used to structure more complex products such as options.

Concerns and Problems

There are concerns that manipulations of prices like those causing the Ethereum ‘flash’ crash from $319 to $0.10 after a multimillion dollar sell order may occur again due to the limited size of the market currently and the difficulty to scale any single cryptocurrency.

Another problem with implementing a Blockchain-based trade system is that its immutable nature increases the possibility that ‘fat-finger’ trades cannot be reversed, resulting in the potential for unintentional losses.

A good compromise to resolve these risks, and possible further development of Blockchain’s evolution, may consist of allowing counterparties, regulators and other appropriate parties to view the details of a given trade- but, crucially, not third parties.

Given its undeniable future impact, well-known financial companies and banks have been heavily investing in early-stage companies developing these technologies, amounting to over $200m in 2017.

Conclusion

Almost 700 cryptocurrencies are actively used around the globe, and with the value of crypto-token markets having doubled according to the Smith+Crown Index in the second quarter of 2017, Financial Services will have to deal with trading being carried out through cryptocurrencies.

Whether blockchain’s growth can eventually lead to a regulatory and economic system where central banks and investment banks are not required anymore is hard to predict, but the technology is likely to become integral to banks’ business models instead of disrupting them entirely in the short and medium term.

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