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 cryptocurrency like Bitcoin in this fashion but imagine the trillions of dollars of payments, advice, account statements moving through the financial world. So like I said blockchain 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 no panic. And see the banks emerged bigger and better than what they were in 2008.
However, with the success of cryptocurrency 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.
A] 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 transfers 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 cryptocurrency 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 blockchains that can be restricted to a particular network and mining can be regulated. Most financial companies are interested in implementing private blockchain. In fact, there is a sort of consortium of financial companies developing a private blockchain 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.
B] How Can Smart Contracts Help Banks and Financial Companies?
Now, this is where things start to get scary for banks. Smart Contracts combined with the 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 a smart contract that can stop the TV if 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.