Banking: Blockchain & my chain of thoughts

Bitcoins & underlying Blockchains made me a curious cat when I read Ravi Subramanian's novel 'God is a Gamer' in 2014.  The book is a fast-based thriller, which opens up the world of bitcoin to the readers.  I have researched on bitcoins, TOR, onion network, the underlying blockchain, digital wallets and bitcoin's father, Satoshi Nakamoto(hei.. there's a recent false identity claim again) at that time. I saw bitcoins as an extension of the gaming world in musings after a good read and thought Banking world will not embrace virtual currencies in place of fiat currencies.  Bitcoin had it's fair share of skepticism and assurance in these two years.  But, underlying Blockchains had a remarkable growth to a point that the technology world touts 2016 is a year of Blockchain.  The Blockchain Revolution book sees 'Blockchain as Internet of money or value' similar to internet of information brought by www before few decades. If you see the statement as far-fetched, let me convince you in rest of the article. 

What's Blockchain?

Blockchain is a technology where transactions are recorded permanently based on pre-defined rules which can be amended but cannot be deleted.  All the transactional changes will be tracked as a trail of historical sequences and uses a consensus mechanism to authenticate a change. Sounds complicated?? Let me try elaborating separately for techies and business readers.

Techie version: It's a distributed database which maintains ever-growing records hardened against tampering or destroy(immutable). Visualize it as data structure blocks which store the data and even underlying programs(ex: Ethereum) in some implementations. Each block holds a batch of recent transactions and contains timestamp and information linking to the previous block.  Hope the name blockchain make sense now.

Business version: It's distributed ledger which can be shared(but cannot be altered without consensus) across multiple sites.  All participants have an identical copy of the ledger. Any changes in the ledger are verified and reflected in all copies within a pre-defined time.  All ledger entries can be modified based on predefined rules(one, mutual or all participant's agreement). Key differentiator than a current centralized ledger is that it uses consensus mechanism(ex: proof of work) for trust and reliability rather relying on a centralized authority or third party (ex: clearing house; central bank).

How blockchain works?

Let's try simplifying the working with an example.  Let's assume our infamous Mr.X owes $10 for Mr.Y.  He transfers that money in a blockchain powered system.  All confirmed transactions at that moment is hashed(encrypted) using a robust algorithm(Ex: SHA256 in Bitcoin or ECDSA in Ethereum) and embedded in a blockchain.  The block is signed using the originating institution's private key and ensures that the block is protected against tampering.  This block is confirmed as authentic by the pool of nodes(proof of work) within 10 minutes(Bitcoin) or by the approved validators within few seconds(Ripple).  The nodes receive a small commission as a fee for confirmation, and the process is referred as mining. $ can be a pseudo(Bitcoin) or a fiat currency (USD). 

Key Features:

Permissoned vs. Permissionless ledgers: The blockchain' s shared ledger can be permissioned or permissionless.  Permissionless model(like bitcoin) will have open access to the internet, and anyone can participate.  If there's a majority(more than 51%) the transaction is considered as genuine.  In a forked permissioned model, only approved validating servers will(like Ripple) do the validation of the transaction and will make the transaction quick and less power consuming.  

Transaction synchronization: Transactions in the blockchain are synchronized within the participants based on the standards and rules set-up for data integrity.  This underlying 'proof of work' may be supported by a payment incentive(Ex: Bitcoin for the miners).  In a non-incentive type like Ripple(referred as consensus) there are validating servers which are run by itself or agreed third parties.  Synchronization will ensure that all transactions are validated and immutable.  In the above example, what if Mr.X is an anti-hero and wants to double-spend the 10$.  i.e., he tries paying it to Mr.Y as well as Ms.Z.  If the transaction to Mr.Y is known to the network first, it will automatically reject Ms.Z's transaction.  The underlying rules dismiss the blocks to prevent the appropriate balance going to two separate ends.  

Virtual Currencies: The blockchain networks are built with a pre-defined quantity of virtual currencies which are transferred(bitcoin) and/or spent(XRP - read as ripples) for a transaction. The predefined quantity ensures the history and quantity of every transaction are verifiable as history in the distributed ledger.

Privacy: Stumbling block for a financial institution in using a 'shared ledger' will be fear of exposure.  What if other entities know entity's current position or regulatory warrants for customer privacy?  The blockchain underlying security ensures the individual parties in transactions cannot be identified.  The identity of the user behind an address remains unknown until information is revealed during a purchase.  The public and private key pairs are required to gain access to the details of the transaction.  A miner will only see a scrambled from and to address of a transaction. In a permissioned ledger(Ripple/Corda) the transaction will be seen only by regulatory nodes and not all hooked-in parties.

Smart Contracts: Smart contracts are part of second generation blockchain technology.  It's computer protocols or business rules that facilitate, verify, or enforce the negotiation or performance of a contract.  This advanced blockchain not just does a currency transfer but also store the underlying business rules.  Ethereum is a pioneer in building smart contracts along with the data transferred in the blockchain. A caveat in smart contracts is that it's not yet approved by law and cannot be legally enforceable. 

Did it make sense? I am sorry if it was a monotonous prologue.  Let me quickly jump into some of the use-cases banking has in store.

Banking Use cases:

Cross-currency Payments: Overseas cross-currency payments are with high fees and delay.  A wire transfer in highly traded G10 currencies takes 3-5 business days for settlement in APAC region.  The blockchain enabled payments solution (Ex: Ripple) will settle these transactions in few seconds.  Fees will be lower as the network will be capable of routing transaction through the lowest bid/ask spread of the competing market makers. The case doesn't stop only with customer transactions.  The treasury operations like inter/intra-bank transfers will have reduced settlement time. Banks like Westpac,  ANZ, TDBank, Santander, FIDOR, DBS, Crossriver Bank and SCB have already on-boarded or in the testing phase for using the Ripple product.  

P2P Money Transfer: P2P money transfer and remittances space are crowded with digital wallets and MTS companies.  Remittance services like the Western Union or Moneygram are settled in few hours.  But, the charges are much higher than the wire transfers.  Blockchain enabled money transfer services companies are trying to mitigate the issues like high transfer costs or last mile distribution method.   Bitspark(Hongkong), Coins.ph & Rebit(Philippines), CoinPip(Singapore) are few Asian P2P blockchain products gaining traction.

Financial Inclusion:  Financial inclusion is providing affordable financial services to the underprivileged or disconnected communities to get access to the mainstream economy.   Every emerging economy countries and Central Bank are breaking their heads to bring them into the mainstream(Check this Accenture Whitepaper).  In the recent Singapore's DBS Hackathon Nubank team presented a proposal to bring in Philippines rural unbanked to using financial services.  It's a concept to be deployed in unbanked remote villages and named as Hyperlocal.  Stellar  & Oradian launched a new service to support Nigeria's rural woman for financial inclusion.  

AML & KYC: Money laundering prevention and KYC for transactions are incredibly expensive for financial institutions.   The Compliance solutions expenditure across institutions in 2014 is estimated around $10 Billion in 2014.  Sharing of Customer information as a registry for KYC is in place now in many systems.  For example, SWIFT publishes a KYC registry of 2000 participants periodically.  Use of a distributed ledger system will enable encrypted updates of customer information updated in near real time .  KYC-Chain & Algorythmix are two blockchain entities gaining attention in this space.  Algorythmix's CITAS was announced as winner in CITI Mobile challenge APAC 2015 and  is provided as part of Azure blockchain as a service by Microsoft.

Trade Finance: A trade involves a buyer and seller of goods.  A bank or financial institution in trade finance act as a third party to reduce the risk of both counterparties.  On a trade contract, Buyer's bank supplies a LC(Letter of Credit) to seller's bank, which guarantees seller will be paid when agreed conditions as per contracts are met.  Seller provides the 'bill of lading' to his bank and receives payment.  Buyer receives the 'bill of lading' from his bank and collects the goods.  In a blockchain scenario, the LC rules can be embedded as part of the smart contract  which can be used for payment instructions.  BOA is testing a product with R3 consortium.  Standard Chartered & DBS banks are experimenting with a ripple based solution for trade finance.  

Capital markets: All capital markets have a dream of  t+0 settlement.  Most runs on t+2 settlements or trying to reduce it further.  The settlement risk can be mitigated by moving to instantaneous t+0 settlement which is a dream since 1970's.  Blockchain can aid in achieving this dream.  Nasdaq in late 2015 tested the Linq blockchain by allowing an issuer to complete and record a private securities transaction.  It shortened the settlement cycle and removed the need for paper stock certificates.  Nasdaq also tested the proxy voting using  Estonia's e-Residency platform built on the blockchain. It was a system for shareholders of companies listed on Nasdaq's Tallinn Stock Exchange in February 2016.

Other notable consortiums/products:  R3CEV leads a consortium of 42 financial institutions. A Blockchain product Corda is recently unveiled by R3CEV.  Corda has few key deviations from core blockchain technology like no global sharing of data, and a workflow reaches counterparties without any central authority etc.,  It's a blockchain product developed with the Finaicial Institutions concerns in mind.    Linux Foundation, IBM, SWIFT, Hitachi, Accenture and many other entities are coming together for an initiative called Hyperledger Project.  It is a collaborative effort created to advance blockchain technology by identifying and addressing key features for a cross-industry open standard for distributed ledgers.  Microsoft Azure is leading cloud space by providing blockchain as a service.  Microsoft tied up with different blockchain products and service providers for this initiative.

Is it all rosy and bright?  Not really.  Following are the few issues predicted on Blockchain moving in mainstream by a recent Morgan Stanley report

 Issues: 

1. Cost benefit: Will the incremental expenditure on the new platform and structure provide ROI for the Bank's investments?  

2. Scalability: Network, bandwidth, storage and computing power grows exponentially as the adaption increases.  Bitcoin already showed a delay in latency time for settling the transactions.  Blockchain to become successful needs to provide an efficient, scalable solution on current infrastructure.  

3. Governance & Regulation: Who will be responsible for managing a blockchain? Who admits new participants in the permissioned system. Few of this are more process related rather than technology.  Legal approvals and central bank acceptance are key requirements for blockchain deployment.

Despite the hurdles such as compliance, security governance, and regulatory legislation, it's certain that Blockchain will become an undisputed and omnipotent technology for the Banks in this decade.

Carpe diem friends!!

References: CITI GPS - Digitial Disruption; SWIFT on distributed ledger technologies;2016 Advanced Payment Report; Distributed Ledger Technology: Beyond blockchain; Wikipedia: Blockchain; On public & private blockchains; Banking on blockchain; Blockchain Tech & Applications - Technical report ; Stellar - Financial inclusion in Nigeria ; LTP - Blockchain Technology overview ; Trade Finance - Changing landscape ; Blockchain in banking: Threat or tool