In this section, we look at the potential impact Blockchain can have on:
- Capital Markets
- Banks – International Payments
- Insurance ecosystem
- Central Banks
Having covered potential use cases, it is important to look at an actual use case which has been around for almost 7 years, Cryptocurrencies.
1.1 The Landscape
In today’s world, buying or selling assets on a stock exchanges requires multiple intermediaries to be involved in the transaction. The parties involved are:
- The exchange
- Clearing house
For most of these, there is a representation from the buyer’s side as well as the seller’s side.
The most immediate use of Blockchain can be in clearing and settling transaction.
The current system of settlement in stock markets across the world range from T+2 to T+3 days. Let us take the example of a T+2 settlement schedule in an Indian stock exchange.
Table 1 : Timeline of Trading, Clearing and Settlement
|Process||Activity||Current System||Blockchain Potential|
|Trading||Rolling Settlement Trading||T||T|
|Clearing||Custodial Confirmation||T+1 working days||T + 10 minutes|
|Delivery Generation||T+1 working days||T + 10 minutes|
|Settlement||Securities and Funds pay in||T+2 working days||T + 10 minutes|
|Securities and Funds pay out||T+2 working days||T + 10 minutes|
Source: National Stock Exchange, India + Author’s Additions
With Blockchain, the same processes can be completed much faster.
1.2 Blockchain in Clearing and Settlement
By using Blockchain in clearing and settlement, the stake holders will be impacted in the following ways:
With shortening of the settlement period to T + 10 minutes, investors can get their money or security much faster. This makes investing in the stock market easier as opposed to holding any other security which can be liquidated immediately such as gold.
By through transaction chaining and with the addition of smart contract, country part risk can be reduced. Given the lower time frame as well as reduced counter party risk, capital costs can be reduced as the requirement to set aside capital could be lowered.
As Blockchain is very transparent, it makes Know Your Customer (KYC) procedures much simpler by making it single point. Once the initial KYC is done, when changing brokers or any other service provider, the procedures need not be repeated as it is already established.
The immediate benefit would be a reduction in middle and back office costs.
With a possible increase in transaction volume, brokers could see increased brokerages. But Blockchain also opens the possibility of rendering the broker redundant in the entire process. As transactions are digitized and matched through electronic bids, the addition of Blockchain could enable direct interaction with the counter party through the exchange without the requirement of a representative such as a broker. The precise impact would depend on the nature of the new structure of trading.
The main function of an exchange is price discovery. While Blockchain, as is, is not equipped to deal with, Blockchain in settlement can make a huge impact on the settlement process there by the system. Blockchain can possibly reduce short deliveries given the process integrity. With the addition of smart contracts, business logic could also be built into transactions. The immediate impact would be seen on the Investor Protection Fund. There would be a substantial reduction on the requirements of the investor protection fund. There would also be efficiencies in middle and back office work, thereby reducing costs. This would have a direct impact on the profitability of the exchange. Other impacts would depend on behavioural change caused by the shorter settlement period as well as the structure of the new system.
The main function of a clearing house is to mitigate counter party risk. With Blockchain, counter party risk is completely eliminated given the way Blockchain functions. Delivery transaction would no longer be required to go through a clearing house. In the case of margin transactions, there would be better over-sight of margin requirements, positions and other information regarding the participants.
Depending on how the system evolves, Depositories may be unaffected in terms of their requirement in the system or be automated with embedded business logic and smart contracts. However, their role will be limited.
With the digitization of the entire process of transacting, there would be less need for traditional asset custody.
While at an aggregate level, the fund transfers would remain the same, Individual banks would see higher rates of money flows due to the reduced time gap. With Delivery vs payment being the mode of settlement, T + 10 minutes would require fund transfers to also happening in a similar time frame. This would require banks to be highly integrated in the entire system. This does pose a security threat to banks.
Given the real time availability of data, the regulator would have better over sight over transactions happening with very little lag. Given the intrinsic nature of Blockchain, there also is an inbuilt audit trail available to the regulator to understand asset movements.
While the benefits of technology will not be evenly distributed to all players, the parties on whom the value chain depends- the buyer and seller, will benefit. The exchange will also benefit. But other players such as custodians, clearing houses and depositories may see their role being limited. The regulator gets an almost real-time view of the entire transaction network as also a history trail of the assets, making it easier to monitor participants. The advantages as a whole to the entire system can be summed up into:
- Faster clearing and settlement
- Reduction in cost
- Ease of transaction
1.3 Challenges to implementation
There are certain challenges to implementing Blockchain in the context of capital markets. There are two broad categories of challenges – Technology and Operational.
The ability to execute Margin Finance/Intra-day transactions on the Blockchain as is, is difficult given the process logic. Blockchain requires the participant to own the asset/cash in order to transact. However, this can be overcome with the help of smart contracts and possibly upgradation in the Blockchain workings.
The scalability of the technology is one of the biggest question. With a limited number of participants, the system is viable. The highest number of transactions seen on the Bitcoin platform in a 24-hour window is 2,34,069. The average number of trades that take place on the National Stock exchange between trading hours (six and a half hours) are 65,95,977 (Market Activity Report NSE – 11/3/16). The question of whether the technology will be able to handle such large transactions in a short time frame is still a question. This also extends to the amount of computing power required to support the miners to enable these transactions.
The current standard of the technology remains behind the levels required to support adoption in capital markets. Apart from the technology itself, there will be demands on other fronts such as security and integration with non-blockchain systems. These are yet to be explored.
There is a limit placed on the size of a block to 1MB, this could be an impediment given the amount of detail that would have to captured and the number of trades occurring in the time frame.
As the ledger size increases with increasing transactions, it becomes increasing unviable for participants to download the entire blockchain. An individual investor who perhaps trades once a year, to be able to download large amounts of data (running into Terabits) would be unviable. Or even a daily participant to be able to download all the trades that are recorded on the blockchain for that particular day, running into Gigabytes is also an impediment.
Given that the technology is new, there are those unknown unknowns which exist. The could be unknown technological risks that this technology carries.
Given the time frame of the transaction life cycle, deeper integration with all parties involved in the transaction such as Banks, Depositories, would be required. This increases their cyber vulnerability.
With the free availability of balances and positions, the credit scoring of the participants would be impacted. While there is pseudo anonymity of the public key, the account wise credit scoring of the participants would be possible. A large part of this data in kept confidential. The impact this would have on the system needs to be studied.
The introduction of Blockchain would require the existing technological infrastructure to be overhauled. This would again require time and resources to be invested. All participants would have to redesign their technological infrastructure to suit Blockchain.
Operational risk of transitioning from the existing infrastructure to the new blockchain infrastructure is a serious risk that needs to be reviewed carefully.
There are privacy issues given the nature of the technology. There exists pseudo anonymity on the system. While the name of the entity may not be discoverable, with enough audit trailing, the various public keys that belong to one private could perhaps be deduced though understanding the purchase and sales patterns from various accounts using data analysis and patterns.
2.1 Current Landscape
The current system of international payments has multiple intermediaries providing different services at different stages of the transaction. This patchwork system creates costs that amount to $1.6 trillion per year absorbed by all of the players in the ecosystem (Ripple). Blockchain is a perfect solution to help cut costs in the banking sector as well as overall costs to the ecosystem. Blockchain can also bring almost real time fund transfer across borders.
The overall transaction scenario is as follows:
Figure 1 : Current Landscape
There are multiple intermediaries involved in sending money across borders. Apart from the Banks and Central banks, there are a network of payment service providers such as SWIFT and forex service providers on whom the exchange rate for the transaction depends. Each of these service providers has a fee for their services, which are additional to the bank’s charges. Given that the forex rate is given to the person sending the amount, there is no scope for seeking a better quote. Hence there can be inefficiencies in the system. There are reports of the payment systems also being inefficient. To add to the list of inefficiencies, time is also an issue. Transferring money to an international destination can be a time consuming affair. Below is the timescale of international payments from the Barclay’s wealth services.
Table 2 : International Payments Timeline
|Where to:||Up to (working days):|
|Rest of the World||8|
Some financial services agencies also go to the extent of saying that “payments to India can take up to 3 months.” (Nationwide, n.d.). There are issues of exchange rate, regulations, banking infrastructure in the two countries, the settlement systems, national/public holidays and many other issues that cause delays apart from the verification, clearing and settlement of these transactions. Given the scale at which transactions are taking place in today’s world, there are thousands of payment orders being placed every day. Sometimes the physical infrastructure many not be in place to handle such volume. Only 18 countries have a Real Time – Retail Payment Systems which are currently in place with another 29 exploring possible systems (SWIFT, 2015).
2.2 A Blockchain Solution
Blockchain can revolutionize the way payments are done by creating the following value chain:
Figure 2 : A Possible Value Chain
The workings of the new system:
“To send an international payment with Ripple Connect, the sending bank requests a quote from the receiving bank. The receiving bank responds with their fees and any PII or other data that the sending bank requested. Then Ripple Connect queries the RCL to get the best available FX rate for the payment and constructs a quote that is presented to the initial sender to accept or reject. After the sender accepts the quote, the sending bank executes an internal book transfer to debit the funds from the sender, then settles the payment through RCL to the receiving bank. Both banks monitor the RCL for the transaction. When the receiving bank sees that the transaction is in a validated ledger on the RCL, the receiving bank executes an internal book transfer to deliver the funds to recipient. Throughout the entire process, either bank can query the state of the payment at any time because each payment is assigned a unique identifier.” (Ripple, 2016)
The advantages that Blockchain brings to such a system are:
- Uniform systems
For real-time interbank payments to take place, all these banks would have to be on the Blockchain. Central bank participation on the network in a market maker capacity would also be needed between payment service providers in different currency jurisdictions. This would ensure uniform systems across countries. This would reduce a lot of hurdles that exist, given the sources of delay which are listed above.
- Cost reduction
Costs can be reduced significantly as Blockchain records and verifies transactions. Hence it is a complete clearing and settlement tool.
A Blockchain network can increase speed significantly.
Given the inbuilt cryptographic security at various stages, the data is secure.
2.3 Banking from the Institutional Economics perspective
Blockchain technology, as a catallaxy, can also take networked business models to a new level by supporting a whole host of breakthrough applications such as creating native payment systems that run without intermediaries and cut cost and reduce time from transactions. “Reputation systems built on social and economic capital and controlled by individuals, rather than by intermediaries like rating agencies and credit rating services, will change the dynamic between consumers and companies” (Tapscott & Tapscott, 2016). Trustless transactions, where two or more people need not know nor trust each other to do business, will be feasible. The implication this has business such as banks that are primarily in the business of trust, are staggering. With the rise of alternate payment system, banking services are being commoditized. With central banks contemplating issuing digital currencies, the rise of alternate trustless organizations which run on cryptoeconomic incentive systems could possible change the way business is done by enabling Peer to peer transactions globally at a scale which has never been seen before.
With the acquisition cost per policy going steadily going up, the insurance industry has been moving towards direct acquisition of customer rather relying solely on agents. As of FY12, 39% of the new business came in from direct business, up from 16% in FY08. Agents’ share in new business has been steadily falling from 72% in FY08 to 47% in FY12 (Dun & Bradstreet, 2012). This has also increased the acquisition cost per policy from Rs. 11250 in FY08 to Rs. 18947 in FY11 (EY). The industry continues to be plagued with fraudulent claims. This put pressure on compliance as well as investigative branches of the firms. Despite resources being spent on the same, fraudsters continue to attack with new and innovative ways both from within the firm as well as the outside. It is estimated that 1 in 10 insurance claims are fraudulent (Shetty, 2015). While there is mounting pressure to process claims thoroughly to mitigate the risk of fraud, settlement times are being delayed. Settlement durations can span between 15 days to 207 days depending on the insurance company and nature of claim (MINTWISE , n.d.).
Given this context, Blockchain can reduce the problem areas with the help of smart contracts. By building a Blockchain platform that could support the automation of insurance products. While insurance products are already standardized (such as flight insurance and life insurance while booking a flight ticket), the claims part could be automated using Blockchain.
Crop insurance is often quoted as an example of hedging mechanism against adverse consequences of bad weather on a farmer’s harvest, which could be automated through a smart contract hosted on a Blockchain protocol and using an oracle, in this case a trusted weather data feed. Crop insurance can be linked to the Indian Meteorological Department’s update + Drone verification (the plot of land can be marked and verification about the status of land can be done). The contract can be auto executed given certain conditions.
While companies will have to do a cost benefit analysis of how such a technology will impact them to reach a conclusion on the adoption as issues such as cash flows, cost of labour in labour surplus countries and so on, such a technology will be beneficial for the sector as a whole.
The emergence of virtual and cryptocurrencies have got regulators worried about monetary policy transmission in the country, as well as capital flows. There are bigger implications with the creation of DAOs where cross border transfer will be almost entirely disintermediated. The central banks may not be able to control such flows. This poses a huge problem for central banks. While some have taken a positive stand on virtual currencies and are planning on issuing their own such as Russia (Das, 2016), there are those who are considering banning it.
This section looks at the threat landscape of Blockchain as a DAO that helps facilitate cross border payments and as a government backed cryptocurrency. The areas of focus will revolve around Monetary Policy, Exchange Rates and National Security.
The rise of DAOs that can facilitate cross border payments could impact the above areas in the following ways:
- Monetary Policy
The creation of digital currencies, be it state sanction or privately created, will make monetary policy transmission more difficult as platforms which facilitate trade can emerge outside its borders making it difficult to control exchanges and capital mobility. “Bitcoin fits the bill perfectly as a conduit to evade capital controls, and as a hedge against depreciation,” said Charles Hayter, the founder of CryptoCompare. With inflation targeting being one of the methods used by central banks, the lack of control on capital could dilute the impact on inflation. The strain of a tightened on monetary policy maybe unevenly felt throughout the economy adding to the other dominant pressures within the economy.
With the creation a digital currency, the transmission of this currency will depend on the accompanying ecosystem. If everything is considered to be the way it is now, there could be a downside to it. For someone to move money outside the country bypassing the central bank, a private cryptocurrency can be used. There are barriers such as conversion, price fluctuation and acceptability that act as strong barriers to heavy outflows. With the issuance of a centralized currency, the problem of conversion into other currencies, be it non state back cryptocurrencies or other paper currencies is made easier. While the system enables the central bank to monitor flows, the system can always be bypassed by converting it into another cryptocurrency and moving the money around. This poses a risk to monetary policy transmission as well as effectiveness. This also leads to issues such as financial stability and macroeconomics stability from the view point of capital flows.
- Exchange Rate Risks
On June 11th 2016, there was a 20% surge in the prices of Bitcoins due to an increased demand from Chinese buyers after a statement issued by the IMF regarding the “systemic threat posed by China’s massive pile of corporate debt”.
While there is an established relation in standard economic theory between capital mobility and exchange rates, the relation between bitcoins and other such virtual currencies and exchange rates are yet to be studied in depth. There could be upward or downward pressures on the exchange rate which could force the central bank to step in and act. Depending on the scales, peg can be broken leading to a larger financial instability. One will have to disaggregate the impact of other issues and look at the change in forex reserves for the time period to understand its exact impact. Such a movement on a larger scale can be used as a tool of economic warfare, state sponsored or otherwise.
There is a cryptocurrency called NuBits which conceptually a pegged cryptocurrency. It has an inbuilt model to regulate the supply to ensure that the currency is pegged at $1. For over a year and half, the currency was successfully pegged close to $1. However, over the past few months the price has fallen to $0.18. The key take away here is that it is possible to regulate the exchange rate in such an environment. However, when issued as a legal tender, there are real ramifications for the economy. To maintain the stability of the peg at a time when there are heavy inflows, the supply can be increased. However, the amount of domestic currency in supply increases dramatically. This can cause inflationary pressures in the economy. Hence, there is a limit to how this can function.
- National Security
While the issuance of such a currency can marginally deter enemies of the state from printing fake currency notes depending the scale of adoption, there are threats to such a system. In an era where cyber warfare is state sponsored and effects have been seen on exchange rates, the creation of a digital currency opens up the issues of cyber-attacks on the system. The risks and eventualities are difficult to control.
A study done by RAND titled “National Security Implications of Virtual Currency: Examining the Potential for Non-State Actor Deployment” where they study the threats posed by non-state actors “to increase their political and/or economic power by deploying a VC as a medium for regular economic transactions”.
While in the above cases, the application of Blockchain has been a “potential use case”, when it comes to Cryptocurrencies, Blockchain has proved itself. Bitcoin is in essence a digital bearer instrument. They have been active since 2009. Today there are over 700 cryptocurrencies. They have been successfully operating without many functional problems relating to Blockchain. Cryptocurrencies stand at a market capitalization of $13.3 Billion with Bitcoin at $10.9 Billion. To put these figures in perspective, Twitter is valued at $9.5 Bilion.
Gartner in its report, Hype Cycle for Emerging Technologies, 2015, positioned Cryptocurrencies in the second half of the peak of expected inflation with an expected time to plateau at 5-10 years.
Figure 3 : Cryptocurrencies on the Hype Cycle
Cryptocurrencies are rated ‘high’ for transformational impact, implying they have the potential to create new ways to save or make businesses money. With research being done in Internet of Things (IoT) based currencies where devices can own currencies and transact, the idea of money is going to change. The concept revolves around devices owning currencies such as a car owning currency which it uses for fuel and repairs or any other expenses it incurs.