Blockchains: Recent Applications of Distributed Ledger Technology in the Banking Industry
Blockchain technology has been around for more than ten years. When introduced in 2008 for the purpose of bitcoin trading, it did not gain immediate attention from the mainstream media, because Bitcoin was a relatively new term, and the technology behind it, blockchain, was even newer.
Since then, blockchain has become a revelation that is destined to become the backbone of the financial industry in the near future. The rise of spam and fraudulent activities on the Internet has also forced experts to consider blockchain as a safe, transparent, and efficient means of transferring critical data from one place to another.
Blockchain’s inherent framework, which values decentralized ownership and transparency, is one of the main reasons why banks and other industry players are keen to implement this technology. According to World Economic Forum, more than 90 central banks are actively engaged in implementing blockchain for their global transactions. In fact, more than 2,500 patents were filed related to the technology by the end of 2017.
To understand why many financial institutions are so interested in this technology, we need to briefly study the concept blockchain technology applications and distributed ledger technology.
Blockchain and Distributed Ledger
A blockchain is a type of distributed ledger that records information chronologically in a block. Oftentimes, “blockchain” and “distributed ledger” are used interchangeably, which incorrectly indicates that blockchain and distributed ledger are similar. In fact, blockchain is just one type of technology based on a distributed ledger model.
Distributed ledger technology (DLT) was introduced in 1991. In DLT, the data is spread across different nodes and computers. Each of these nodes operates independently from the other node, making data processing a decentralized and independent process without a central authority.
After the data is independently constructed at each node, each node communicates with the other nodes in the network to reach consensus on the best version of the data. After a consensus is reached, the distributed ledger updates itself by storing the “agreed-upon” version of the data at each node.
The blockchain version of distributed ledger technology was introduced in 2008. As its name implies, it consists of “blocks” and “chains”. The data is stored in the form of blocks, which are connected with each other in an “append-only” chainlike structure. blockchain became extremely popular, when used in a digital currency format such as bitcoin, because it solved the double-spending problem faced by digital cash.
Why Banks and Financial Institutions are Early Adopters of Blockchain Technology?
Banks and financial institutions are racing to adapt DLT due to the secure environment of blockchain, which makes it difficult for hackers to hack the data. In blockchain systems, data is stored and processed in multiple computers around the world. For the hacker to decode the information, they will need to reconstruct every block in the blockchain, which takes enormous time, effort, and, most importantly, cash.
Besides security, decentralization is also a huge attraction of DLT, making it easier for financial players to adapt the technology. For instance, the financial world is full of intermediaries. As a result, when a typical borrower asks for a car loan from a supplier, there are at least two or three financial institutions involved in the process. On a broader scale, the chain of command ends at the Central Bank, who is the ultimate decision maker for everything that consumers do, financially.
Blockchain, as a form of DLT, can help create trust among lenders, borrowers, and financial institutions by decentralizing the chain of command. Instead of a single financial authority in charge of the transaction, intermediaries would feel more comfortable in trusting a "neutral" authority by eliminating central control. This system lowers the financial cost of the transaction and takes back control from the powerful influencers.
Looking from the perspective of both the small and large participants in the industry, it’s a win-win situation for everyone. On one hand, confidence of small players will increase as they are no longer controlled by a central authority, who may manipulate proceedings according to its liking. On the other hand, powerful entities such as central banks will be happy to lower the huge transaction costs that are usually the result of too many intermediaries involved in the financial process.
3. Confidence & Trust
When it comes to gaining confidence of the public, distributed ledgers can also prove effective in restoring the dwindling trust of citizens who don't believe their governments and banks. The case of cryptocurrency is a good example where people investing in crypto don't have to fear enormous devaluation of their currencies such as recent problems with Turkish Lira and Venezuelan Bolivar. At least, cryptocurrencies are not tied to any central bank, which can enforce strict regulations on how and where the currency can be used.
Experts at the University of Delaware, a leading institution involved in the research of DLT, suggest that blockchain can help streamline mistrust among the public on how interest rates are managed. They point to the example of LIBOR and controversies involving the manipulation of benchmark values. Many industry players blamed the Bank of England for not doing enough to provide transparency in the market.
Accordingly, the decentralized nature of DLT, and implementation of "smart contracts" can help reduce mistrust. As more players are involved in creating a reference price and benchmark of LIBOR, greater consensus would mean a more transparent market for industry players.
4. Improved Regulation
Despite the decentralized mechanism of DLT, there is no doubt in the minds of experts that blockchain can be very fruitful to financial institutions based on a private network model. In a private network, the central banks can allow only particular financial institutions and partners to participate. These private networks are different from the public networks used for trading bitcoin price.
The use of private networks will allow the government to regulate the financial industry according to set laws without interfering with the core strengths of DLT, transparency and safety. Some financial institutions are already looking into providing self-execution "smart contracts", which will help take transparency to a new level. Basically, these smart contracts will be available to any public entity if they meet certain standards. It will also help governments keep everything in check while providing exceptional transparency and lot of opportunities for other players to participate.
5. Efficiency & Productivity
Another attractive proposition of distributed ledger to financial sector is tackling the mess associated with duplication of content. As large numbers of financial intermediaries are involved in the process, duplication of data across different industry players makes it extremely difficult to increase accuracy. When different participants are involved in providing loan, they all have different sets of data, which increases the chance of misinformation.
If implemented correctly, DLT will make it possible for financial institutions to share uniform data across modern financial platforms and blockchain technology applications. As verification of data among different nodes is one of the core principles of distributed ledger technology, all financial players would be able to access the same information ledger. Similarly, international payments, corporate stock records, and broker data will be available to everyone without discrepancies.
Business Use: Distributed Ledger Technology Beyond Blockchain
Considering DLT, business use cases in banking and financial sector can be classified into three broad categories based on the type of information stored in a ledger. These three types of ledger are classified as business ledger, information ledger, and time-stamp ledger.
• Value Ledger. It is a ledger described by components involving storage and transfer of valuable assets such as when traders buy bitcoin with credit card and undertake financial settlements as in bitcoin wallet.
• Information Ledger. The ledger contains details of a business process and relevant information. Examples include trade finance and proxy voting.
• Time-Stamp Ledger. As its name suggests, time-stamp ledger contains information of who, what and when the record was created.
The implementation of a value ledger may be the next big thing after the Internet. Traditionally, banks and financial institutions have used soiled ledgers to complete financial transactions. The drawback of these soiled ledgers is the spread of data across institutions, which makes it difficult for banks and other players to transfer financial assets quickly even when all of the information is readily available in digital format.
Verification can often take more than 2 or 3 days to complete because all the data concerning a financial asset needs to be checked and cross-verified by multiple players. In fact, large players can dictate their own terms by charging fees for their role in the movement of data. SWIFT is a prime example of a financial transfer method that consumes time and money because it involves banks.
DLT will eliminate traditional barriers associated with soiled ledgers by storing the data in a place that is accessible by blockchain technology companies, and does not require verification. As such, the financial asset can be moved instantaneously across the globe without any delay.
Information ledgers will play an instrumental role in shaping the industry as various players become involved in creating such information. For particular business process such as trade finance and proxy voting, information ledgers in a DLT environment are able to support multiple service providers catering to several customers, which ultimately reduce cost of processing.
Most importantly, information ledgers will support digital signature that does not require authentication. Nowadays, wet signatures and handling of enormous amount of papers offer limited security to participants. Digital signatures using DLT would eliminate regulatory requirements for physical documents over a period of time. This is particularly useful for financial and banking sector that are notorious for using huge amounts of paper.
These ledgers are used to capture an event and associated timestamps. As every block in a blockchain has its distinguished timestamp, financial institution can use the technology to sign contracts, settle payments, announce events, and assign contracts even when the message is not received directly from the custodian.
These ledgers are also important because it allows market participants to trust the sender without validating mode of distribution. As these ledgers capture the hash of source ledger, it is also difficult to tamper with the source due to the massive amount of re-structuring required by the hacker. As of now, businesses are experimenting with low volume, less automated, and less regulated business areas before expanding its use.
Case Studies in the Banking Industry
The promise of blockchain to offer a safe, secure, and transparent environment for the processing of data is moving the banking industry to attempt applying the technology to their services. Only time will tell if their projects steer the blockchain revolution to their favor or if the decentralized nature of blockchain technology ends up upending the banks themselves.
JP Morgan Chase has already started a new division, Quorum, which is dedicated to the research and implementation of blockchain technology applications. Quorum is a smart platform built on the distributed ledger model, which offers blockchain technology benefits and services to financial intermediaries and other players who require speedy financial transactions based on blockchain. In 2018, it issued a yearly deposit certificate offered at variable rates to the public allowing participants to enjoy decentralized transparent environment.
Major U.S. banks such as Bank of America have filed for patents related to blockchain technology. Bank of America’s patent talks about a customized version of blockchain technology where only authorized personnel are allowed to access the data. Based on the concept of a private network, the patent claims to offer the idea of a secure single network, which will help reduce storage locations around the world.
Goldman Sachs is yet another U.S. based institution that has introduced crypto options. When the majority of industry players were hooked to trading crypto currency, Goldman Sachs has introduced "crypto-options,” claiming to offer a more reliable form of cryptocurrency. Under the Circle project, Goldman Sachs also opened a trading desk exclusive for digital trading.
A number of other industry players are also trying to understand the technology by collaborating with technology partners. By sharing resources, banks and other institutions not only decrease their financial costs of processing data, but also abide by ever-changing global regulations. Post trade Distributed Ledger Working Group and R3rev are types of collaborative projects that are initiated to take advantage of one-step verification offered by blockchain.
There are more than 50 banks in R3rev project who are working together to access the customer profile as a single source. Regarding cost savings, it is estimated that a single large bank spends anywhere from $60 million to $500 million on KYC and theft protection. The money is spent on uploading customer's profile to a centralized registry and updating its content on a regular basis, whenever a customer opens a new account or leaves the bank.
Independent verification by each of these banks, using disruptive ledger technology, will allow the banks to access updated data instantaneously. The end result will be huge cost and time savings.
Blockchain Beyond Banking
Blockchain technology benefits are not restricted to the banking and financial sectors, only. It's proving a potential goldmine as other industries are also exploring its disruptive nature. For instance, the technology has huge implications for non-profits and charities because it can increase transparency by holding charities accountable for the work they do.
For the academic community, distributed ledger can offer verification for academic degrees without the possibility of fraud. Similarly, QV codes on resumes are also able to provide instant verification of credentials.
Retailers can use the technology to offer instant verification of the quality of a product; whereas, the music industry can find solutions to problems regarding royalties.
For governments, DLT can offer data on homeless and illegal migrants, who are otherwise difficult to track. Accessing pertinent information about the group will enable authorities to deal with the problem that is mutually beneficial to each stakeholder.
Overall, DLT is a potential game changer for blockchain technology companies requiring credibility and efficiency in data transfer. By giving network participants a secure space to access data, it offers an even playing field for everyone without any monopolies. DLT networks are created to eliminate false entries and hacking attempts, which is yet another significant reason for its future success.
Perhaps, it has even greater ramifications for a developing world. Imagine a world where citizens of developing nations could vote using the Internet without blaming anyone for interfering in polls. Such developments are sure to impact us in a way we could only imagine a few years earlier. If used wisely, DLT is here to stay, and change our world for good.