Banking on Blockchain

Banking on Blockchain

One of the most transformational technology to shake up the financial world has been blockchain. Right from cryptocurrencies to distributed ledgers to record transactions in a secure and transparent manner, and all things in between. But are Banks, which have been laggards at adopting technology, ready to embrace Blockchain? And if so what use cases do Banks wish to solve for using Blockchain technology ?

But hold on, Banks have always held the ?“Don’t fix that which isn’t broken” attitude. Several Banks, especially Indian biggies, are yet to embrace Cloud fully, and here we are taking a leap of faith with Blockchain? What is going on?

Before we jump into today’s topic, I wanted to thank all of you reading, for energizing me to do Kam Questions every week! Not only that, but for all the questions you all ask in my Live events. Those are the inputs that fuel my content, so keep joining me and ask those questions that keep my thinking caps on !

What is blockchain?

In layman’s terms, blockchain is simply a network of computes that act as nodes in a distributed database. The information in these distributed database is collected together to form what is known as a block. And every node or compute in the network works to verify the integrity and veracity of the data, before adding that block of information to the database. Like it did with every block that came in?before it, thereby forming the chain!

The image below, from Investopedia, mentions it for Bitcoin, but just about every blockchain protocol works the same way

Why is this revolutionary ? Ask any one and they’d say that blockchain is the next best invention ?after the internet. One reason is for the decentralized management, which is a significant change from the internet as it operates today. Because no one node controls it, and because the information is updated across the network, every participant in the network has unrestricted access to it in real time. This potentially allows for faster, less costly for unknown parties to reach a consensus.

It also ups the game in terms of security, because blockchain encrypts information in the digital ledger and makes the transaction history immutable. Almost like a unique digital fingerprint capable to telling the evolution of each ring present!

I am sure by now a lot of you would’ve seen the overlaps with what a financial institution like a bank does, and with the problems that blockchain solves. So its time to look under the hood of banking tech.

Evolution of Banking Tech

The 11th century central France with the Medici Family, probably marks the beginning of banking transactions, what with them using the assets the Pope and the Vatican had parked with them, to get credit from others and put it into developmental activities. From there we have come a long way to AI based banking, haven’t we?

In the Pic : Evolution of Banking. ATM , telebanking, Netbanking, Mobile Banking, SMAC, IoT, AI, RPA, Open Banking ending with Blockchain

The first steps to digitizing was probably was when bank tellers could enter their credit and debit transactions into a spreadsheet program, speeding up the recompilation process at the day. Next was in digitizing the assets with a bank. And this helped figuring balance sheet of each individual branch, which meant for audit and financial practices one needed to theoretically collate the sheets from all the branches.

The drawback here was that information was maintained in silos, so if a customer walked into a wrong branch of the bank, it would be like he never existed. Or worse, the branch would have to request information from the central branch which would take a few weeks for it to arrive. This was also a reason why you could only withdraw money from your home branch’s ATM. Because the books didn’t exists out of the home branch.

So obviously the next step was to build a flow of information between branches in an encrypted format. Remember this was in the early 90s, where information transfer was still an expensive affair, and adding the overhead of securing that transaction more so. Which was why, if you ask your parents they’ll remember, how every ATM transaction outside of the home branch was kind of expensive. But at least you wouldn’t be stranded in the middle of nowhere without access to your bank.

While this was happening in parallel was the ability for Banks to talk amongst themselves. In India, we’d identify the familiar NEFT & RTGS protocols. This was because each bank had their own internal format for transferring information. And if it had to be scaled across banks, the chaos was like 10 different nationals, all shouting in their own native language at the same time. And even though they each had the answers to each other questions, they left without a resolution simple because no one could understand the other person. Until that is an interpreter was introduced into the room. This was what NEFT/RTGS and other such protocols aimed to do. And from there they evolved to real time payments with IMPS protocol and now UPI, which is platform independent.

Armed with data generated from their branches, collated by core banking software, banks could now start predicting which consumers would act in good faith and which could turn out to be the bad apples. And this analytics helped power their credit engines, helping the scale their books with lesser risks. Then came AI and robotics to help automate that which humans were doing, and at the same time improve accuracy.

The same problem with payments existed when it came to transacting between banks in different countries. In this case the Interpreter who was introduced was the Society for Worldwide Interbank Financial Telecommunication. In short, SWIFT. This was the collective effort of 239 banks from across 15 countries, with the collective aim of simplifying cross border payments.

So now that you have had a brief history lesson on the evolution of banking tech, what inferences can you draw ? That financial institutions innovate incrementally, yes ! That most innovations have been from the inside rather than looking at what problems consumers wanted solved, Yes!

Which only means, financial institutions left their flanks un-guarded for technology to strike at them.

Threat of Blockchain to Banks

And this is exactly what happened with the advent of Blockchain and decentralized Finance, and the promise that all banking ops can becomes faster, cheaper, more secure and transparent through blockchain based smart contract.

In the Pic : Cost, Time and Effort difference in Centralized DB versus Blockchain

The disruptions to payments are obvious to most, especially cross border payments. Banks and intermediaries which charges a hefty fee for facilitating cross border payments, which takes days to process are the first to be disrupted.

Next, we have the services where banks provide the “Trust” factor for 2 untrusting parties to transact, while charging a fee on both sides. Big ticket services like Letter of Credit or Bank Guarantees. The consensus based blockchain protocol can do exactly that, in a matter of few clicks that too.

Then we have an operational task that is a regulatory mandate for banks to complete. I am talking about KYC. Blockchain can provide an immutable and secure way to authenticate the identity of an entity, at considerable less costs than it takes banks at present.

In the Pic : KYC using Blockchain

Credit scoring models too can benefit from using the information available on blockchains, especially where the credit bureau fail to record behavioral data to score customers. And in monitoring risky behavior of existing customers too.

What we are saying is, every dimension of banking from operational to risk, assets to liabilities, blockchain is already making in roads into banking.

Use cases for Blockchain in Banks

Payments : Cross border and RTP

One major use case for blockchain when it comes to payments is the ease with which it facilitates real time cross border payments. In fact that was one of the reason why El Salvador made bitcoin a legal tender. Now point to note here is that, El Salvador never really had their own currency, US Dollars was the official currency, so policymakers had gotten used to managing their fiscal policies in the lack of monetary steering wheel.

But an interesting area where in my opinion Blockchain has a huge potential is in RTP. Or Request to Pay.

People who’ve worked in the invoice and payments team of any corporate will tell you how much of their time is spent raising invoice and following up with vendors. Imagine if instead upon completion of a service or delivery of a product, a smart contract could execute a “request to pay” action to the other party, which would get auto-approved after a 90 days period. ?In essence giving the other party 90 days (or how many ever days necessary) to test the product/service and raise a refund/chargeback request.

All of this automatically done, via Smart Contracts on the blockchain!

Credit: Lending and Staking

Lets assume you require short term cash of ?5,000. Say you have crypto coins to the tune of ?10,000. You could potentially collateralize some of these coins to take out a loan with an annualized percentage rate as low as 5% to as as high as 15% depending on the volatility of the coin.

And another party with ?5,000 with them would be willing to lend to you, because

1.??????Peer consensus says you’re a reasonable person to lend to, so I can trust you

2.??????In case of a default they can sell off your cryptocoins and recover their outstanding amount from it

One question could be that if you had digital assets, why not liquidate it instead of borrowing? Well try telling that to the HODLers (HODL stands for Hold on to Dear Life)

But another reason is the possibility of earning a passive income through your cryptocurrencies, which is staking.

Because blockchain is a consensus based system, and each information block needs to be peer validated before being added to the chain, it can be energy intensive and not scalable. There is another Blockchain protocol called staking, where by you tell the network that your node is ready to verify transactions that are equivalent or lesser than the amount you’re willing to stake. And for your services, you shall be rewarded, in terms of new cryptocurrencies being minted.

Loan Syndication

That was for retail credit, what about corporate credit especially the large ticket size ones with inherently more risk ? These kind of loans often require a group of banks coming together to lend to the corporate. Payouts are generally basis the phase of project completion

Now often some projects which banks deem too risky may not get the green signal. But what if the public could actually benefit from them, and hence would be interested in funding it. This was the promise of crowdfunding too, but because the system could not establish trust amongst the different players, it didn’t become as big as it could’ve.

Blockchain can help there. Not only in building a consensus based trustless system but also by providing transparency and avoiding information asymmetry. Add to it, if you could also introduce a DAO (decentralized autonomous organization) giving investors voting rights into the project, hence preventing fringe players from taking decisions that are against the collective interest of the public.

Also, you could solve for the repayments basis phase of project compelted, using smart contracts which are fed information using an array of IOT devices and sensors.

Capital Markets and fractional ownership

REIT did it for Real estate, and now crypto currency is trying?the same for other assets. Fractional ownership opens the gates to common woman/man into wealth creation instruments that were out of her/his reach due to the restriction in amount of money available to invest. But crypto currencies can be infinitesimally small, and yet provide ownership and authentic way to verify the same.

StableCoins

?Central Bank Digital Currencies are possibly the biggest existential threat to a commercial bank.

Banks have been the intermediaries in distributing money to the people. But with CBDCs the central bank can directly reach the end consumers cheaper, faster and more easily. And because bank deposits have been the cheapest funds available to them, this would mean lesser money with banks to lend, and hence earn money from.

But some banks are trying to pre-empt that from happening, by working on pilots to mint their own stablecoins. In fact ANZ bank in Australia was the first to mint their own stablecoin just last week.

And with stablecoins comes the ability to implement all the benefits we just mentioned above ! Win-Win all the way around isn’t it ?

In the Pic : Headline of ANZ'ss A$DC stablecoin, the first bank to ever mint a stablecoin, by CoinHead correspondent- Derek Rose

Challenges with Blockchain (and what Banks can avoid)

Privacy and security

Pick any report on banking, and the one thing they’d say is though consumers feel their banks could do more digitally, they still prefer transacting with their banks because of the “TRUST” they have in their banks. And for blockchain to reach that level they’d have to first fix some teething issues on that front.

The first being the transparency which erodes away at the privacy of a person. Imagine if tomorrow potentially all your co-workers, neighbors, knew exactly how much you spent on your last vacation , Or that big purchase you made for your spouse/partner becomes public knowledge ? Not only is that embarrassing but it also opens you up to potential thefts and burglaries. That is one potential problem with complete transparency.

That is one reason why I feel a mix of blockchain with Open Banking like protocols is necessary so only select members have visibility on the information, and that only if authorized by the concerned party in the first place. But would a semi-public blockchain be accepted by the true crypto-enthusiasts ?

Regulation and Governance

Regulations and Governance are two areas in the Financial services space where there isn’t any scope for a grey area. Its all just Black and White.

Now if something is decentralized what happens when there are bad actors in the system.

One argument is that, once such infringement happens the bad apples are denied access to the system. But that is post-facto. After damage to reputation is already done!

Which is why governments and central banks have so many regulations in place that prevent them from happening in the first place.

And more importantly on whose books do these loses sit on ? Who will be held accountable for ensuring that good governance and regulatory norms are followed by all ?

P.S : If you liked this, then do subscribe to my newsletter,?Kam Questions, where I look under the hood of popular (mis)conceptions to decipher what is actually happening.?Also do consider hitting the bell on?my profile?in case you want to be notified the next time I go live to discuss the latest happenings from the business world. While my niche is the?Fintech?space, I also attempt to discuss about other?Digital Businesses?and their?Strategies?too. And tomorrow at 8PM IST I am discussing War & Inflation. And on Friday I am talking about Careers in Fintech, AMA style.