How the blockchain could revolutionize banking

When people hear the word ‘bitcoin,’ they may think of shady, anonymous online deals, unreliable exchanges that disappear with all their money and illegal, drug-peddling marketplaces. You’d think that banks would give the digital currency a wide berth, but they’re more interested in the technology underpinning the digital currency.

The real value at the heart of bitcoin is the blockchain. This is a distributed ledger, designed as a record of transactions that can be held, viewed and updated by all participants in a network — and it’s turned existing financial models upside down.

Historically, a group of people making transactions between each other would need a central ledger as a single source of truth. If one of them tried to act fraudulently by paying someone electronically and then claiming they hadn’t, then the central ledger would be the decider. The bank held that ledger, and all transactions ran through it.

The blockchain uses cryptography to ‘seal’ transactions into the ledger, making them immutable. It removes the need for a central ledger, and for a bank to maintain it. This appealed to bitcoin’s designer, Satoshi Nakamoto, who wanted a form of money that could be exchanged without the need for central banks to process the transactions. When he unveiled the concept in 2009, the idea of peer-to-peer financial transactions took shape.

Settlements

Instead of fretting about their exclusion from the financial system, many banks see blockchain technology as a way to fix some of the issues in the financial system, particularly in settlements.

While trades in stocks and other securities are currently negotiated in microseconds, the back-end settlement process typically takes far longer. Clearinghouses must reconcile the trades after the fact, ensuring that all parties have the assets to cover their positions. They must then notify the depositories, which document ownership of the securities involved, such as stocks. This is a complex process that often takes three days after the initial trade, in a model known as T+3.

This model creates a drag on the financial system, locking up money in collateral. Vitalik Buterin, founder of alternative blockchain system Ethereum, said clearinghouses add no value to the system. Banks are hoping to use Ethereum and other new flavours of blockchain to remove those complex bottlenecks and reconcile trades directly, using decentralized ledgers.

Ethereum goes far beyond the original bitcoin blockchain in its support for more complex transactions. Ethereum’s transactions are executable programs known as ‘smart contracts,’ which can check certain conditions and act accordingly. A smart contract running on the Ethereum blockchain could enable a bank to automatically pay dividends to all holders of a particular stock based on that company’s quarterly earnings, for example.

“The reason that blockchains and smart contracts have been gaining lots of interest is because rather than T+3 days it would be instant settlement (T+0 days),” Buterin explained, adding that the blockchain settles transactions almost instantly.

Blockchains used in banks will be different to the bitcoin blockchain in other ways, too. Bitcoin’s blockchain was public, meaning that anyone could participate. Banking blockchains will be private, restricted only to known, identified participants in what experts call a ‘permissioned’ system. This is necessary because of the strict regulatory frameworks in banking, which have strong rules to prevent money laundering.

“The institutions in the financial services markets live under a microscope and they have no ability to make major changes in operations without assuring that they meet regulatory muster,” said Charley Cooper, managing director of R3CEV, which is working with some 40 financial institutions to explore blockchain-based technology.

Dozens of banks are mulling blockchain technology for settlements and other processes. BNP Paribas has been experimenting with it for post-trade processes and recently confirmed its commitment to the technology after holding a ‘bizhackathon.’ JP Morgan is working with Digital Asset Holdings, a blockchain technology company founded by former JP Morgan Chase director Blythe Masters, on addressing liquidity mismatches in loan funds. NASDAQ has already launched a blockchain-based system called Linq for managing private equity (an opaque process hitherto handled by lawyers and spreadsheets).

Some banks are even building their own digital currencies. Citibank announced in 2015 that it had already built three experimental blockchains and had its own currency called ‘Citicoin’ in the labs. Japanese bank Bank of Tokyo-Mitsubishi UFJ (MUFG) is developing ‘MUFG Coin,’ with which it hopes to replicate bitcoin’s instant peer-to-peer payments system.

The blockchain has come a long way since it was first unveiled in 2009. Thanks to its unique combination of decentralization and cryptography, it may finally unshackle some entrenched procedures in finance and unlock millions of dollars in extra capital. The paradox is that the technology could end up bolstering the very financial institutions that bitcoin’s most ardent advocates hoped to topple.

Image courtesy of Free Digital Photos