The financial services industry has been the slowest to adopt any change given its sensitive nature. While at a retail level, consumers are becoming more demanding and banks are being forced to adapt and innovate, the Banking sector as a whole, given their fiduciary responsibility, still remain conservative when it comes to innovation at a large scale as the stakes are very high. While the rate of change in “front end” transactions have been increasing at a significant speed, settlement schedules have been the same for decades. In an age where people have access to new information across the globe at almost real time speed, customer are demanding banks to increase the speed of their services. While e-commerce sites deliver products in less than 24 hours, cheques still take three days to clear despite transaction volumes increasing and technology being integrated into operations. However, we have come a long way from early 2000s. Markets are highly integrated and money enters and exits markets are lightning speed.
In this context of increasingly digitized and high speed financial system, operational resilience is extremely critical. But financial institutions today are tasked with processing, recording, reporting, reconciling and auditing sensitive transaction information. The infrastructure used in this process has been the same for years. The whole infrastructure is built like a hub and spoke model. The functioning is centralized. The system is protected by perimeter security which has repeatedly proven itself to be vulnerable to security breach. The data stored is generally unencrypted and is available for inference, once the perimeter security has been breached.
To understand why Blockchain is a good solution to the problems facing the financial services industry, it is important to understand the current landscape.
- Paid Third Party Payment Services
Currently, paid third party institutions provide centralized payment processing and settlement services.
- Reconciliation Math
Reconciliation is a huge cost centre. A report by the Everest Group estimates that global asset managers alone spend roughly $12 billion on reconciliation services each year. This data is unencrypted and reconciled in different places at different times and stored in different locations around the world for different uses.
- Counter Party Risks
There is always a chance that come settlement day, the counter party may default. This default costs time and resources. Regulations require institutions to set aside capital for counter party risks. This increases the cost of capital for participants in financial markets. On the National Stock Exchange, 0.14% of all delivery trades are short deliveries. Given that the delivery windows are T+x days, capital is required to be held for this duration.
- Burgeoning Transactions
Number of trades and volatility in the capital markets have been increasing consistently with no change in settlement schedules. Number of trades increased 28.62% from 2013-14 to 2014-15 on NSE.
- Idle Funds
While money kept aside to meet counter party risks, stock exchanges have substantial amounts of money locked up in Investor Protection/ Settlement Guarantee Funds. The National Stock Exchange has $100 million as on March 31, 2015 set aside in its Fund. At an aggregate level, a huge amount of money is idle.
- Cyber Security
Financial institutions are subject to persistent cyber security threats. While data security and integrity is one side of the issue, denial of service attacks are also an increasing threat. In a world where are moving towards a digital economy, essential services such as banking being disrupted can cause shocks to the system.
Early 2016 HSBC was the victim of a cyber-attack causing its personal banking website and mobile application to shut down. This led to thousands of customers being without any access to digital services. In 2016, banks in Greece, Bangladesh, Qatar, Ecuador and Vietnam were the victims of large scale attacks involving data theft as well as cash amounting to millions of dollars.
As the world moves towards becoming more technologically integrated, the risks such attacks pose to the entire economy increases.
In such a landscape where transaction costs are increased due to third party payment service providers, constant reconciliation, cyber security and funds being set aside due to regulatory requirements given the inherent risks in the system, there is scope to reduce inefficiencies in the system. Barclays believes Blockchain provides an “elegant solution” (Barclays, 2015). The next section looks at the how the Blockchain can solve the bottlenecks in the current landscape.
Given the above landscape, there are standalone technologies that can address specific issues. Blockchain, however, can address multiple issues together. The benefits Blockchain provides are:
Disintermediation & Trusted exchange
Third parties primarily perform three functions
These functions primarily revolve around assessing and reducing counterparty risk and establishing trust.
Credit is the basis of all human interactions. The word credit comes from the Latin word “credere” which means to believe or trust. It is trust that enables any human interaction. When a taxi driver agrees to drive a passenger to a certain destination, it is the underlying trust that enables that transaction to occur. Information plays a very critical role while establishing trust. There are times when this credit maybe exploited. Hence there are various kinds of intermediaries that come in at various levels right from the regulator to the intermediary at the micro level. One of the reasons intermediaries such as banks exist is to solve problems associated with asymmetric information or agency problems such as adverse selection, which is a problem of credit or trust.
Technology in today’s world is delivering trust in a new way. With Blockchain, two parties are able to transact without the necessity of a third party, almost eliminating counterparty risk. By ensuring transparency and immutability of records with inbuilt transaction chaining and Blockchaining, Blockchain shifts the incidence of trust from the individual to the system as a whole. This process integrity enables two parties to transact without worrying about trust. If in case of doubt, balances of the other party can be checked as it is publicly available. But to be able to make a transaction, transaction chaining ensures that the transaction has a valid basis (either the asset being sold or the cash to purchase it).
In today’s financial system, companies have a centralized data base where transactions are reconciled on a daily basis. There are huge back end teams deployed to work solely on this. These transactions are then backed up and stored at multiple locations to ensure safety in the case of a network attack. By having one single version of events and its distributed nature, Blockchain reduces the need for parties and intermediaries involved in a transaction to reconcile their transactions and accounts. Given the context and requirements, certain reconciliation maybe required. However, by and large, the current system of reconciliation will be rendered obsolete.
As transaction cannot be reversed, once a transaction has been added to the Blockchain and the block is far off, there is no need to worry about the validity of the exchange. There is no scope for chargebacks or any other future claims to this transaction from the sender. While this is beneficial to the “seller”, it is not a losing proposition for the buyer. This insulates sellers from the current system of transactions where a buyer can file a fraudulent claim or chargeback weeks after the transaction is completed.
Every step has enough security measures, either based on logic or cryptography. Transaction chaining, based on logic, ensure the logic of the transaction. Blockchain cryptographically ensures the security of the entire transaction history. The availability of the transaction history or ledger, ensure the safety of the entire system. In the case of an external attack, the copy of the ledger can be obtained from the other participants who have a copy. In the event of an internal attack, the system requires the participant to have more than 50% of the computing power, which given the nature of the system (public/private/permissioned/un-permissioned) can be monitored. In the case of a public system, such as the Bitcoin Blockchain, the global computing power is so large, that it is statistically almost improbable (see the appendix for the math).
Changes to public Blockchains are immutable, meaning they cannot be altered or deleted. Given the chaining of Blocks, it is impossible to alter the Blockchain.
While transaction matching may not be the best use, Blockchain is the perfect solution to post trade clearing and settlement. The settlement time essentially is reduced to the amount of time it takes to solve the crypto problem and, depending on the nature of participants and their computing power, the time is takes for the block to get “far” enough in the Blockchain. Settlement time can be drastically reduced from weeks in the case of insurance and days in the case of financial assets to minutes.
Lower transaction costs
By enabling two parties to transact directly and making available a global copy of all transactions, costs incurred on third parties and back end reconciliation operations can be significantly reduced. Santander estimates distributed ledger technology could reduce banks’ infrastructure costs by $15-20 billion per annum by 2022.
In the current Blockchain landscape, the entities can broadly be classified into two categories – user groups and service providers.
This category comprises of institutions who are exploring Blockchain applications for their own use. The category is largely composed of banks who are exploring Blockchain for fund transfers as also stock exchanges for post trade settlement. Stock exchanges have also been exploring the use of Blockchain in post trade settlement. The main factor driving banks is potential savings as also the fierce competition from FinTech companies such as Mobile Wallets.
My institutions are coming together to form consortiums and working groups to explore the application of Blockchain. “Post Trade Distributed Ledger Working Group” is a working group formed by CME Group, Euroclear, LCH.Clearnet, London Stock Exchange, Société Générale and UBS to discuss how Blockchain technology maybe used to settle transactions.
A lot of existing as well as new companies have emerged as customized Blockchain service providers. Established tech players such as TCS, IBM and Microsoft are developing Blockchain solution to various industries ranging from shipping to financial services. There are new companies that have emerged which are more focused on developing Blockchain applications to certain specific areas.
Everledger is a company that specializes in creating unique digital finger prints for diamonds and storing this on the Blockchain. This has a wide variety of application from verifying the authenticity of a diamond and its point of origin, thereby discouraging blood diamonds to verification in the event of theft or sale.
The main players in the financial services space are Digital Assets Holdings, Chain, Symbiont, Ripple Labs. These firms specialize in developing customized Application Programming Interfaces (APIs) for their clients in the financial world.
There is another way of looking at the Blockchain landscape, a more technical perspective. I came across an image while doing my research. For those interested in understanding more about the tech ecosystem, this would be of use.
 Rs. 691 crores at the prevailing exchange rate of Rs. 67.89.