Blockchain or Distributed Ledger technology is still evolving so there is a lot to be done before it starts really disrupting the financial services and banking world. The banking world is paranoid about security and data privacy. I mean imagine a scenario where my transactions are stored on any public node in the blockchain – I know it can’t be altered but how do I prevent everyone from seeing my transactions. In the financial world frauds can happen even when someone can just see data they are not supposed to or authorized to see. It makes things complicated. It is one thing to move a single crypto currency like Bitcoin in this fashion but imagine the trillions of dollars of payments, advices, account statements moving through the financial world. So like I said blockhchain needs to evolve to start really meeting the needs of the financial world.
However, there is no mistaking the potential cost and labour savings it could create for the global financial market. And more importantly the potential disruption could change the way the market works – as such many financial institutions are investing millions – of dollars in finding out how to exactly implement this technology. I believe blockchain is an innovation or disruption that threatens the very root of the financial world. The financial world is based upon the concept of a middle-man someone who will either guard your money, invest your money or manage your money, move your money etc.. The big claim most experts are making is that if implemented correctly blockchain or distributed ledger coupled with smart contracts can potentially replace the middle man. Now I have worked closely with bankers all my life, I have seen them during the dot.com crash of 2001 – they were relaxed and looking to make more money. They ended up being bigger and better than before. I worked closely with senior bankers during the mortgage crisis of 2008 – and the same- there was not panic. And see the banks emerged bigger and better than what they were in 2008. However with the success of crypto currency and the potential of blockchain, I do sense some panic when talking to senior bankers. They are genuinely worried. And when bankers are worried about blockchain – it’s time to start investing in blockchain.
What is blockchain?
Unless you are living under a rock or in a cave – by now you have heard of Bitcoin which is a type of a digital cryptocurrency. The allure of Bitcoin is that it operates without the need for any central bank or regulatory authority. The entire administration of the ledger i.e. books of accounts of transaction history is done publicly by the technology which is now known as blockchain (or which I like to call distributed ledger). Each transaction is added to a block – now each transaction itself happens when a user transfer part of their value store to someone else for example user X pays user Y 0.001 BitCoin – to understand how this happens we need to understand why it is called a crypto currency in the first place. All transactions have to be digital and done when the user is online i.e. through some kind of wallet software either on your computer or your mobile. Once you configure your wallet you get your private key which is used to sign all your transactions. This ensures that you can write a transaction to the block. Now a block that is a set of such transactions needs to be made irrefutable so that’s where the miners will come in. I won’t go into the details of how mining works but there are people out there who will verify that the block is genuine and confirm it. Once confirmed a transaction cannot be reversed. And this block is replicated on all public nodes in the bitcoin network.
This is an example of a public blockchain where anyone can send value anywhere in the world where the blockchain file can be accessed. However there are private block chains which can be restricted to a particular network and mining can be regulated. Most financial companies are interested in implementing a private block chain. Infact there is a sort of consortium of financial companies developing a private block chain standard called CORDA.
A recent World Economic Forum report predicts that by 2025 10% of GDP will be stored on blockchains or blockchain-related technology.
All that’s okay – but how are we really going to change the financial industry
Let’s get down to brass tacks, what areas of the financial world will be early adopters of blockchain and how will the impact spread.
Most banks run on something called as a core banking software , now core banking today is built on a centralized database concept. Core banking is like the heart of a bank – any change to it is really tough to manage and if the system is experiencing problems it impacts almost everyone. Blockchain is like the opposite of what todays core banking systems are. I am sure some one is out there in the open source world developing a version of core banking that uses a distributed ledger. Once a proof of concept is executed we will understand a bit more on how soon everyone needs to change their core banking. But if the answer is yes then this change will be bigger than the Y2K change.
One of the most important parts of lending is Know your Customer or KYC as it is called in the IT circles. It is estimated that banks and lending companies spend anywhere between 300 to 600 Million dollars per year on their KYC software. Now KYC is really necessary especially in today’s world to prevent or reduce money laundering and terrorism activities. Blockchain inherently has a mechanism of independent verification of transactions – with some tweaking this could easily be moulded into a framework that will allow the independent verification of clients by banks to be done in shared manner like mining. Spoiler this will not result in cost savings but IT teams can rejoice for this will surely spice up KYC budgets for the coming years.
Now this is where things start to get scary for banks. Smart Contracts combined with Internet of Things – can really change the game in consumer lending. Today if you want to buy a TV a finance company lends you the money – because the manufacturer does not want the headache of managing the financials. Now imagine a scenario where there is smart contract which can stop the TV if a payment is not made or delayed. In this case no middle man is really necessary. Because this is so scary – I believe banks and finance companies will first start experimenting with and implementing smart contracts. They can extend to Letter of Credits, Letter of Undertakings (most Indians will remember the big Fraud in the news because of fraudulent Letters of Undertaking) and also invoice factoring. My view is that this is the most exciting part of the blockchain technology. However, we are in the infancy stage a lot of work needs to be done. But the potential is there, and lenders are right to be worried.
Collections and Payments.
The Payments world is very complex. It gets even more complex when talk of moving money across countries. I have worked extensively in SWIFT payments for some really large banks – and I actually don’t see how blockchain will impact international funds transfer. But I do hear a lot talk that Blockchain will potentially disrupt the payments world. Let’s wait and see.
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