Over the past 5 years, much has been documented about disruptive technology and the impact on banking. Since 2015, the momentum has increased and disruption has spread to all facets of the industry. There are two recent trends to note:
First, advanced technology is no longer the privilege of a few and nor is it centralised within elite corporations. Technology is now both cheaper and more accessible with recent innovations such as cloud computing and mobile technology. It is interesting that non-banks have been the first to move to take advantage of such disruptive technology by offering alternative streams of banking services at lower prices directly to end users thereby creating an industry phenomenon termed as as ‘disintermediation’. The key question then arises: do we still need to rely on banks for banking services?
On another note, post the Financial Crisis of 2008, the banking system is increasingly complex challenged with pressures from market regulations, the high cost of capital and shrinking margins on business lines. As a result, the Return on Equity (ROE) for most global banks has fallen from an average of ~20% to around 7-10%. Poor returns along with the threat of disruptive technology and disintermediation, are forcing banks to revise their strategies and implement leaner models using smarter and faster technologies.
These two broad based trends in banking have led to the rise in interest in blockchain technology. Deriv Asia has spoken with banks across the region and have compiled some key questions the banks are asking.
What is the relationship between Bitcoin and Blockchain?
Blockchain technology and Bitcoin are not one and the same. Bitcoin is a cryptocurrency and the first of its kind to be developed in a market that now has competing cryptocurrencies. The initial popularity of Bitcoin stemmed from its decentralised concept along with the ability to generate peer-to-peer transactions. It did not require a centralised authority e.g. a central bank to monitor flows nor have any control on the creation or supply of bitcoins.
Blockchain is the technology and infrastructure behind Bitcoin. This provides users with a distributed ledger through which to send, receive and store Bitcoins. A recent trend has emerged in financial markets where users are demanding less of cryptocurrencies and instead focusing on investing in low-cost and efficient infrastructures. This is the precise reason blockchain which was previously used for bitcoin has now been replicated by some companies for alternative banking needs.
How can Blockchain disrupt banking?
Many areas of banking are open to disruption by Blockchain. These include payments; settlements; financing activities; repo markets IPOs and OTC Markets. Take the example of a treasury department within a bank trading derivatives. Activity is supported by a trading desk, a back office settlement infrastructure and a custody network for the respective services of trading, settlement and safekeeping. A purpose-built Blockchain can act as trading instruments, storage instruments and settlement instruments respectively. In addition, this has advantages for audit purposes as the blockchain network keeps a record of all transactions ever done, making it both transparent to all participants.
The fact that Blockchain can replicate a trading, settlement and custody infrastructure at lower costs, significantly faster transfer of assets, and a safe and transparent ownership structure that does not involve expensive intermediaries could have a significant impact on the global financial markets. One of the primary attractions is that it allows smaller funds or buy-side participants to trade market instruments without necessarily paying the high minimal fees that is required when accessing a prime brokerage platform.
Effective implementation of blockchain technology across financial services should result in a disintermediation of the market. This means the end client will no longer need brokers who charge hefty spreads, to access the market.
“Blockchain presents a huge opportunity for banks and financial institutions who embrace Blockchain early and are quick to understand it and leverage its full potential. Likewise those who don’t invest in Blockchain may experience a significant loss in revenue and market share.” Marcelo Garcia Casil, CEO of DXMarkets
How are financial instruments created on Blockchain?
Any asset can be replicated on the Blockchain platform in a reliable and transparent manner and then issued. This is termed as the “tokenisation of assets”. Once issued, these assets can be traded freely between parties in a secondary market. Wealth is transferred from the asset holders to investors via the issuance of a token representing the underlying asset. These tokens issued using blockchain technology can be traded electronically on any venue, either via exchange or over the counter, at very low costs and in a transparent way since every blockchain transaction is recorded and made publicly available in real-time to all participants.
Blockchain will also disrupt the primary issuance markets as it can replicate IPO financing by issuing a token that can be backed by its own assets and can be represented by a debt instrument on their balance sheet. The end game of Blockchain is to be able to match investors and issuers directly without the need for a broker or investment bank and hence reduce the cost of funding dramatically.
Is it right for blockchain technology to enter the banking industry given there is so much regulation and compliance today?
The introduction of regulation and compliance controls around surveillance and monitoring are driving costs higher. Much of the compliance monitoring today in banks is still manual thus consuming a significant amount of human resources. Blockchain technology has many features, which are complementary to compliance monitoring and, if applied correctly, could replace the high cost of human capital. Some of the features of Blockchain such as:
(1) A ledger that publicly records the movement of every funds/assets
(2) Proof of ownership and authenticity of assets protected by a coded secure cryptographic framework
(3) A comprehensive audit trail that allows any movement of assets to be traced back to its origin
(4) Confirmations of new trades identifiable by its unique crypto stamp, without the need of elaborate legal documentation, are just some of benefits of adopting this technology for compliance and regulatory use.
Does Blockchain itself require regulation?
Blockchain is a new, cost-effective and smart technology entering a highly-regulated banking industry. Attempts to apply stringent regulations on Blockchain, at this stage of infancy, could result in its progress being stifled. Take the analogy of the Internet bubble in the late 90s and the benefits it accrued from unfettered growth and innovation.
There are some regulators calling for the creation of an independent body to oversee and align blockchain activities to the regulatory compliant guidelines of the banking industry. Unlike banking, where there is a clear division of responsibility between producers (e.g. trading and sales) and support teams (e.g. risk, compliance, audit etc.), for Blockchain, the users themselves are both mining (generating revenue) and authenticating. There may be call for segregation.
How are banks reacting to Blockchain?
Whilst focus in 2013-14 was squarely on the rise of cryptocurrencies, the dominant theme today is blockchain technology. The priority for banks is to develop financial infrastructures that can reduce the cost of support activities ranging from execution to settlement and custody. While banks have already invested in payment infrastructures such as SWIFT or tri-party platforms such as Clearstream or Euroclear, there is room for improvement in the timing of settlements, which currently still sit at T+2 or T+3 across asset classes. This could become instant through Blockchain. Other areas of priority include enhancing security measures and having a foolproof validation method based on sophisticated computer algorithms, which make it extremely challenging for fraud or counterfeit activities.
The leading global banks have, in some form or other, already started initiating and implementing blockchain technology projects. For some, this is at a preliminary stage including feasibility studies and impact analysis. For others, e.g. Santander, UBS and Goldman Sachs, separate divisions have been established to work on developing the technology.
Non banks & infrastructures are also active in the blockchain space. Kevin Johnson Manager of Innotribe Startup Challenge at SWIFT in Singapore mentioned that Blockchain technology will also have a focus in the upcoming SIBOS conference in the fall of 2015: “Blockchain technology is an area that is attracting significant interest from the financial community. Innotribe @ Sibos in Singapore will take delegates on a journey beyond the current conversation. We will bring together banks and startups in the Innotribe space, for an interactive session to understand potential use cases for distributed ledger solutions, for the financial community.”
A report by Santander in June 2015 made a compelling statement announcing that blockchain technology could potential save the bank USD 20 billion a year on infrastructure and operational costs.
“We don’t really need a coalition of 50 banks to make it work. We have ten major geographies. Just us connecting our ten major geographies will allow 100 million customers to make instant payments worldwide. If we partner with two or three banks similar to us we’ve got pretty much global coverage.” says Mariano Belinkey, Head of Santander InnoVentures
In Asian, most of the larger regional banks are at initial stages of trying to understand the blockchain concept and how they can apply it to their various work streams. DBS, the largest bank in Singapore, and no stranger to financial technology is watching this space carefully. “Banks need to spend more time really understanding the technology mega-trends that are affecting the way customers work, play and do banking. Taking a pro-active stance, we at DBS future-cast how the important trends around blockchain, machine intelligence and internet of things will change the way we interact with our consumer and corporate customers.” states DBS’ Chief Technology Officer, Neal Cross.
What are the current challenges with Blockchain?
Blockchain is still in its infancy and there is competition from other companies trying to lead the way. Disagreements on standard industry implementation has created a fragmented environment, normal to technologies in the early stages of development. Over the next 12 months, the industry will see players in the space converging consequently leading to unification and consolidation of blockchain platforms.
Blockchain also suffers from a gap in industry expertise. Being new to the banking industry, knowledge about blockchain resides mainly with startup companies responsible for developing the technology. A recent trend has shown banks and startups beginning to work together to embed the technology within various banking services.
“The Financial Industry, is a conservative one, particularly when it comes to disruptive but immature technologies. Initially, I foresee us collaborating with the Blockchain community in evolving this technology and piloting it in small-scale applications. If successful then Blockchain can, indeed, open a new chapter in the evolution of financial services.” mentions George Papp Technology Director for Financial Services at a leading global bank in Singapore.
The greatest challenge will be one of credibility. Initially, there will be two parallel worlds: the blockchain world and the ‘real world’. Skeptics will still wish to execute, settle and safeguard in the ‘real world’. However, in time, as Blockchain is able to iron out shortcomings and replicate faster and more efficient versions of real world movements, in the same way as the Internet and mobile banking, there will be an exodus of migration onto blockchain platforms and the alternative will become a reality.
Sam Ahmed is the Managing Director of Deriv Asia, a Management Consultancy based in Singapore and London
– See more at: http://www.regulationasia.com/article/why-blockchain-will-disrupt-banking-7-questions-banks-asia-are-asking#sthash.VLYj4FtT.dpuf
The above article was written jointly by Deriv Asia and DX Markets who have collaborated together to answer questions asked by banking clients following the Blockchain event at Jens Hotel Singapore
For further information on developing blockchain technology for banking solutions please contact Sam Ahmed (MD, Deriv Asia) firstname.lastname@example.org and Marcelo Garcia Casil (CEO, DX Markets) email@example.com