The banking system has learned how to make money in the most elaborate ways over its centuries of existence. Take subprime loans as one example. This complicated financial instrument helped American banks sweep the risks of mortgage loans under the rug in the early 21st century which resulted in unsecured mortgages being issued en masse and eventually a global financial crisis whose effects can still be felt to this day.
The modern banking system is inefficient
The banking system’s inefficiency can be seen in the simplest transactions. If you want to give your friend $5 through a bank where he does not have an account, then you’ll have to pay a commission of $20 to $40. If you send a recipient a million dollars, you’ll have to pay for the bank’s services — between 1 and 5% of the total transfer, or $10,000 to $50,000 if there are no ceilings for fees. The transfer will take several business days.
The banking system also creates fertile ground for abusing their system of accounting, thanks to which banks regularly are stripped of their licenses, and depositors’ money disappears into offshore cesspools.
Yet another problem with banks are their administrative costs. Keeping business records and facilitating transactions mean that banks have to maintain a cumbersome back office, and the large number of employees makes it necessary to have a slew of administrative personnel. Banks also still have a lot of paperwork. All of these expenses are rolled into fees, and that’s why bank services are so expensive.
What’s more is that banks maintain mainframes — an outdated type of server which is where banks’ software runs (which is also usually very old and extremely expensive to maintain). Banks’ IT divisions are one of the most expensive, opaque, and technically complicated lines of business out there.
Neither is the international system of bank transfers a shining example of perfection. The SWIFT network has been hacked several times over the last several years. One of the largest hacker attacks on SWIFT took place in Bangladesh in 2016, in which over 80 million dollars were stolen from their Central Bank.
In spite of all of these drawbacks, there has simply been no alternative to banks until recent times. And the situation changed with the advent of blockchain technology.
Financial operations using blockchain technology can be affordable and inexpensive
Cryptocurrency platforms enable users to transfer any sums — from $0.01 up to billions of dollars — almost instantly and very inexpensively, with the commission independent of how much the transaction is. On April 19th, 2018, Litecoin’s network conducted a transaction worth 700,000 litecoins (around $100 million at the current exchange rate) which took only 2.5 minutes and cost $0.40. This was made possible thanks to blockchain technology, which underpins cryptocurrencies. Transferring $5 or $1 million dollars on the blockchain takes only several minutes and costs only several cents.
Moreover, blockchain is totally transparent. As soon as you send money through the blockchain system, you can see the payment’s status at any moment. You don’t need to call a bank hotline and sit on the phone waiting for an answer. Cryptocurrency wallets are usually anonymous, but if you know the ID number of the wallet you need, you can track the money transfer to or from it.
Distributed ledger technology can eliminate the cumbersome document flow process. You can easily track any operation recorded by blockchain, and all you have to do to establish the chain of transactions is look at the program viewer. Moreover, the fact that it is impossible to retroactively edit records means that you don’t need any middlemen to conduct multi‐step transactions. Banks have already started to introduce blockchain for commercial financing and issuing corporate bonds.
Getting rid of hard copies and the manual labor required to check and verify documents means that banks can downsize their workforce, and in tandem with that, unnecessary costs. According to a report from Accenture and McLagan, the western banking system could save 8 billion dollars per year by introducing blockchain into their traditional business processes. Western banks spend a total of approximately 30 billion dollars per year.
Blockchain can also eliminate the problem of people using the same collateral to receive loans from different banks — also known as cross collateralization. This is one of the most common kinds of fraud in the banking sector.
Fraudsters simultaneously pledge the same property with different banks and take out several loans at the same time. Banks are trying to solve this by creating notary registries, but since there is usually some lag time with entering information into ordinary databases, fraudsters have a window of opportunity to take advantage of. With blockchain, information immediately enters the database after the transaction is complete. So the human factor is excluded: as soon as the requisite number of transactions are gathered into one block, the information is immediately recorded in the blockchain. This makes it impossible for fraudsters to take out a loan at 9 a.m. using the same collateral they intend to use at 3 p.m. at a different bank.
There are already examples of blockchain being used to issue loans secured by property or real estate. On July 31st 2018, the Agricultural Bank of China (ABC), one of the largest banks in the world, made the news for being the first to issue a loan of $300,000 secured by land using blockchain technology. Blockchain is being tested to eradicate fraudulent operations which have prevailed for a long time in the agricultural sector. Currently, ABC aims to expand their use of blockchain in issuing loans secured by land or real estate. According to the bank, distributed ledger technology has simplified the process of loan approval by increasing trust between both parties, and it has also eliminated the risk of document falsification.
Blockchain is simplifying client identification and the process of “KYC” — know your client. Crédit Mutuel Arkéa and IBM have already launched a project to tackle that. Using blockchain, banks identify a client to confirm transactions: copies of their personal documents are recorded on the distributed ledger, and then there is no more need to reverify the documents of clients who use the various services of companies and banks under the aegis of Crédit Mutuel Arkéa.
Automation of processes on a blockchain can be easier and smarter
One of blockchain’s unique features are smart contracts: electronic algorithms with pre‐determined conditions that automatically execute after a previously agreed on event takes place. When a smart contract is recorded on blockchain, it is impossible to change or prevent it from being executed. Participants in a deal can be confident that the deal will take place on the exact terms and conditions that were spelled out in the original contract when the key event takes place. For example, real estate ownership rights could be reliably transferred only after a signal is received that money has entered the seller’s account.
Georgia has introduced a cadastral registry on blockchain. Estonia is transferring electronic medical records to blockchain as well. At the same time, blockchain is being integrated into “Electronic Estonia.” Georgia and Estonia are already running notaries using blockchain. And although we are still a long way off from entirely automated deals, new technology is breaking ground toward them.
Another sector blockchain can be used in is corporate financing deals. In business processes such as settlement of account by letter of credit, factoring, and insurance, deals can last from several days to several weeks. And corporate financing can take several months to organize.
If a company seeking financing could have their accounting records and business plans written into the blockchain, checking them out would take hours, not days or weeks. Red tape would also decrease if each side saw the documents and actions written into blockchain.
But despite its advantages, blockchain is not a panacea for the banking sector. The technology continues to be difficult and expensive, and therefore the majority of banks have decided to wait and see for now. Blockchain is unregulated, but the decisions approved by blockchain still need to be approved by regulators.
Cryptocurrencies are more and more competitive with SWIFT
The finance sector started taking an active interest in introducing blockchain technology in 2014 – 2015. That was when the finance and tech company R3 CEV LLC was formed along with a consortium of 70 finance companies under R3, which are engaged in developing blockchain technology to be used in the finance sector.
Many countries are actively studying this field. The bank of England, for example, is even developing a road map to modernize the country’s financial infrastructure using blockchain technology.
One example of the successful application of blockchain in the banking sector is Ripple, a cryptocurrency for interbank settlements. Ripple intends to create an alternative system to the SWIFT Network. Ripple started cooperating with banks back in 2014, and today around 200 banks across the world support transactions with Ripple.
SWIFT is not lagging behind, and they are introducing the Global Payments Innovation system, which uses cloud computing in place of blockchain. But if servers turn off, the GPI will stop working, whereas Ripple will continue to work so long as even only one bank supports its platform. Ripple’s CEO Brad Garlinghouse compared the competition between GPI and blockchain to a race between a horse and a car.
In July 2018, a consortium of state banks from BRICS countries announced their intention to research blockchain technology for international transactions.
Introducing blockchain will require a unified network and the interest of bank managers
On the global level, as many banks as possible, ideally the entire banking system, need to be transitioned to the blockchain. There is no value in establishing channels to transfer money between two banks: in the field of monetary transfers, all banks should use blockchain. If banks are not prepared to work with each other, a global blockchain network could never emerge. The fragmented usage of this new technology will not provide the necessary positive feedback loop: fees will not decrease, and transfers will not become more speedy.
Regardless of who creates the network, without a unified reliable network blockchain has few chances of success.
Aside from interbank coöperation, there’s also the problem with staff: banks need to teach employees the new technology. And finally, they need decisions from regulators that will confirm the security and legitimacy of blockchain technology.
There is yet another setback that no one talks about directly: using blockchain can be unprofitable for bank managers because it makes it impossible to manipulate accounting records. For that reason, banks may yet drag their feet for a long time before they introduce blockchain technology. We wrote about that in our article why banks are afraid of blockchain.
In our opinion, the fundamental difficulty of introducing blockchain into the banking sector lies in the contradictory nature of the two systems. In essence, blockchain decentralizes while the banking sector makes decisions strictly from the top down. Uniting them is like mixing oil and water. Ripple, for instance, is often criticized for their pseudo‐centralization: the system’s functionality is supported by terminals that have been certified by Ripple Lab. It seems that the partial loss of decentralisation is a reasonable compromise which fervent supporters of the technology should allow in order to get it introduced in the banking sector.
Despite the fact that Accenture surveys showed that back in 2016 the majority of American and British bank managers were interested in using decentralized ledgers, few have yet moved past studying the technology. Conservative bankers believe that transitioning all transactions to blockchain is impossible, but that it can be used part of the time. However, there is another opinion: that blockchain in the banking sector will work only if absolutely all banks transition to it.
What brings the future
On one hand, banks are concerned with threats that decentralized systems create in their line of business. In February 2018, Bank of America released a statement saying that extensively introducing new technologies in financial services “could require significant expenditures” to adapt it to changing industry standards and consumer preferences. On the other hand, banks have the opportunity to earn money here. The very same Bank of America has more than 50 registered patents for blockchain technology. In July 2018, Bank of America applied for yet another patent to create a blockchain system authorizing third‐party verification of data.
Bank of China has 11 patent applications for blockchain technology. Moreover, the bank is using blockchain in 12 pilot projects including decisions on trans‐border payments, electronic currencies and accounts, and also data exchange.
The new technology will help banks decrease the cost of operations and also create new products and services. Banks are certainly using it to earn new sources of income. But it would be fantastic if, instead of banks starting to use blockchain, blockchain forever squeezed banks out of the financial sector.