“Change is the only constant in life”
-Heraclitus, Greek philosopherIf you have been following events from around the globe, there is a very good chance that you have heard about blockchain technology. Even though it started its journey to provide an alternative to the regular currencies, viz., cryptocurrencies just 12 years ago, it is already making its mark in almost every industry possible; the biggest transformation is, however, seen by the finance industry. Even though the world is not completely being run by blockchain at the moment, more and more organisations are embracing it as days pass by. The worldwide pandemic has revealed quite a few cracks in every industry, including the finance sector, for which blockchain demonstrates the possibility of a strong solution. So it is highly likely that very soon the financial industry is going to see massive upturn because of this new technology.
What is blockchain?If we explain in very simple terms, “blockchain” is merely a series of time-stamped “blocks” containing digital information, stored in a public database using cryptographic principles or “chain”. This digital information consists of 3 parts – information about a transaction, information about the participant of that transaction, and special information (hash) which distinguishes every single block from one another.
What makes blockchain so special?Blockchain is a revolutionary technology that beats every other transaction technology that we have so far because of its very special features.
The record of data in a blockchain is managed by a cluster of computers instead of one. It has no central authority controlling it – hence, this data is decentralized.
This way, blockchain creates a decentralized network, acting on a peer-to-peer basis. So it cuts off all the middlemen and gives the power back to the owner of the assets.
A “block”, before being added to the “chain”, is verified by potentially millions of computers distributed around the network. So for any transaction to be added to the blockchain, it needs to go through a whole lot of validation process, which makes it more trustworthy than the regular transactions.
Only verified transactions are added to the blockchain; and once data is stored in a blockchain post going through the unique verification protocols of a particular network, it cannot be altered. If data in one block changes, data in all the subsequent blocks change which calls for the consensus of the network majority. This immutability of the data adds an extra layer of reliability and security.
Once data is added to the blockchain, it is available publicly. That is why no one can change the data without leaving their own mark on it. As the ledger is distributed among all the transaction participants, it exists simultaneously in multiple places; and if there is any single point of failure in the process, all the copies on all these computers are updated at the same time. This makes the data incredibly secure.
User Authentication with Cryptographic Security:
Each user with access to a blockchain is issued two cryptographic keys — private and public. The public key is exposed to all users for verifying request details and other work. However, the identity of the user is hidden with a unique obfuscation called “digital signatures”, which is the private key for the users. This cryptographic security of user access makes it almost impossible for identities to be hacked and data to be compromised.
No transaction cost:
Being decentralized, transactions over a blockchain carry no transaction cost, making them much cheaper than other transactions.
Blockchain transactions are programmed through smart contracts that encode all the commercial and regulatory rules that need to be enforced. Transactions between the nodes are only triggered when all the conditions are met. For example, the receipt of a required set of documents confirming the acceptance of credit terms can trigger the release of a loan to a customer.
All this is verified digitally with no human help. This cuts the middleman off which reduces the possibility of corruption as well as human error.
How is blockchain “disrupting” the current financial systemThe word “disruption” has a strong negative connotation attached to it in the common public mind, which is not necessarily true. Before getting into actually what is happening, we need to understand what “disruption” really means. According to the US professor Clayton Christensen who introduced the idea of disruptive innovation in 1997, disruption is – “any innovation that transforms a complicated, expensive product into one that is easier to use or is more affordable than the one most readily available”. Disruption has three components: responding to competitors effectively; identifying new growth opportunities; and, improving the understanding of customers’ requirements and demands. According to Christensen, “A disruptive business is likely to start by either satisfying the less-demanding customers or creating a market when none existed before. So, when mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred”. To build something new, something old always has to be destroyed. With the rise of new blockchain technology, quite a few such disruptive events happened in the financial industry, and few more are going to happen soon. Let us see how blockchain can shake up the financial world:
Cross BORDer paymentsWhen you think about finance, payments are undoubtedly the first thing to pop in your mind. So unsurprisingly, blockchain disrupted the payment system first. In the traditional system, payments to a different country are time-consuming and a very expensive process, given all the collaboration required with corresponding banks and other intermediaries. The major change blockchain brings to any industry is removing the middle-man and replacing it with a security system with zero transaction fee. So the process of cross border payments becomes much simpler, much less costly, and much faster.
STOCK TRADINGShare trading involves many third parties, such as brokers, CCPs, CSDs and exchanges, making this process time-consuming. Using blockchain technology in stock trading will ensure registration of equities, and hence it will also make stock manipulation by voting virtually impossible. This deletes the middle-men who regulate the system from fraud and manipulation and so the complex equation among brokers, regulators, and traders will be eliminated – which, in turn, will give rise to a faster, cheaper, and less risky trade execution.
clearing and settlementCash settlement for fixed income, equity, and derivative products in various currencies is slow, costly, and complicated, all over the world. Because of the large number of parties involved, It takes several days, and in some cases, several months to settle. Eliminating the intermediaries with the help of blockchain and smart contracts will speed up this process, and also will cost substantially less.
trade financeTrade finance participants need to keep a record of bills of lading, invoices, letters of credit etc. as transaction-related documents must be constantly reconciled against each other. This still involves a lot of paperwork which makes the process longer and laborious. Blockchain can integrate all necessary information in one digital document, with clear date and time stamp, eliminating the need for several copies of the same document. These are updated in real-time and can be accessed by all network members.
Syndicated lendingSyndicated lending involves several participants, and also KYC and AML need to be fulfilled at each point. Hence traditional processing of such syndicated loans by banks can take up many days. The use of blockchain will make this process more transparent, less complicated, and inexpensive. Smart contracts can assist in underwriting and credit decisions, and thus the risks of these types of loans can also be mitigated by tracking identities and capitals in real-time.
Digital identity verificationCurrently, online financial transactions involve a lot of steps, including personal verification, authentication, authorisation etc.; that too for each new service provider. With blockchain, users can choose how they want to identify themselves and with whom they agree to share their identity, as well as register all this only once when they are provided with private and public keys. This ledger can be used across banks to authenticate the identities of customers.
record keepingMany businesses, including banks, don’t just do internal financial transactions; they have financial deals with other banks, corporates, vendors, suppliers, and retailers. All of these parts of the supply chain need information from each other. Using blockchain in this procedure will make the records safe from being misused as well as being lost, along with making the record-keeping process much cheaper. Every transaction detail will also be available across this network at all times.
smart contractsAs already mentioned, smart contracts is a revolutionary application of blockchain technology. The functions of a bank such as lending, deposits, treasury, investment advice, business intelligence, regulatory compliance, payments, and remittances – everything will be disrupted by using these contracts. Smart contracts enable operating and automating business processes in a fully decentralized fashion, enabling shared rules of engagement, conduct, and business processes to be automated and enforced throughout the entire ecosystem.
Financial inclusionPeople who want to avoid banks because of their high fees, asset requirements, regular income requirements, and minimum balance requirements to store money will immensely benefit from a blockchain ledger system. Their identities will be stored without the help of a central authority like a bank and they will be able to transact money simply with the help of a mobile device. By keeping costs low and allowing startups to compete against big banks, blockchain thus can promote financial inclusion.
reduced fraudWhenever there is a concept of money involved, the possibility of frauds come automatically. According to a PwC report, 45% of Financial Services organisations have suffered economic crime in its many guises, from fraud and cybercrime to money laundering and bribery and corruption. A centralized database system is vulnerable and highly prone to cyber attacks as a single point of failure in such systems can be exploited by hackers to steal money, or at least valuable information. Blockchain technology can reduce frauds in various financial sectors with its secure record-keeping and transaction methodology, and smart contracts.
- As stated earlier, blockchain technology is resilient against hacking, DDOS attacks, and other forms of fraud, since there is no such single point of failure in the blockchain.
- It can also help banks and others identify individuals quickly and accurately through a blockchain-enabled digital ID.
- As said before, it will significantly reduce stock manipulation by voting.
- Superfast cross-industry data sharing will enable proactive fraud prevention in insurance claims. The review process will also be automated, removing the middlemen, hence making the procedure quicker.
- Blockchain, with its potential for almost real-time transaction settlements, will allow insurers to introduce new risk instruments and exploit capital opportunities in the market.
- Sometimes, in online transactions, there is an element of scamming – you do not receive your product/service even after payment is done, or refunds do not reach you. Blockchain-based payments are quick and irreversible, with every transaction detail recorded. You can easily track and bring the scammers to court.
secure tracking in supply chainThe supply chain is basically transporting goods from one point to a final destination, going through a series of temporary nodes in between. Many businesses like cosmetics, electronics, luxury goods, and pharmaceuticals are subject to theft and counterfeiting. Using blockchain in this system will secure the transactions done in this series by documenting everything in a permanent and decentralized method which will be easy to share as well. This will greatly decrease delays, waste, and human errors as well as track the fair trade status of the products throughout the supply chain.
asset managementTo meet investors’ demands for a global set of products, the asset management industry uses intermediaries, making the process complex and time-consuming. The distributed ledger of blockchain can enable direct trading and settlements across boundaries, which, in turn, reduces costs, increases data accuracy and reduces delays.
investments and crowdfundingIf you have ever tried to open a start-up company, you must have known how hard labour it is to collect investment. The current investing model requires intermediaries such as investment bankers, venture capitalists, brokers, lawyers etc. to create markets by matching investors with entrepreneurs, SMEs and enterprises at every stage of growth from angels to IPOs, which involves a lot of costs. Blockchain’s decentralized peer-to-peer model allows pledges or individual investors to directly connect with creators and entrepreneurs to fund them. New projects can raise funds by releasing their own tokens that represent value and can later be exchanged for products, services, or cash. Blockchain platforms also allow everyday investors to participate and invest at an early stage of the company funding cycle. So if the company makes money, they will be much richer than the ones who started investing at a later stage.
risk managementFinancial institutions’ most basic responsibility is protecting individuals and enterprises from losses or catastrophe, which consumes millions of dollars each year. Blockchain’s secure and transparent feature will save all this money and at the same time, assets will have the highest level of protection, since the procedure will be automated and corruption-free.
improved customer experienceUsing blockchain to share information with clients and vendors may allow companies to serve customers more quickly and even find new sales opportunities.
The world is starting to embrace blockchain alreadyThe financial services industry so far has been highly regulated by the authorities, albeit for good reasons. However, the decentralized nature of blockchain threatens that concept and many countries are not taking it very well as of now, so the pace of blockchain adoption will depend on how the changes are supported by regulatory bodies across the globe. While many countries have been banning the use of blockchain, the good news is, the Australian Securities and Investment Commission regulatory framework allows it. However, the body mandates financial services companies using distributed ledger technology to have proper infrastructure and risk management systems in place in order to operate. By the very definition, blockchain endangers the traditional financial system, but it does not eliminate it. Many financial institutions have already realized the major benefits blockchain can bring to them, and have started to change their outlooks towards it by assimilating the new technology – seeking new areas of applications of it in their field.
- The American multinational investment bank headquartered in New York City has started a new division called the Quorum division specifically for research and implementation of Blockchain technology. It is a distributed ledger and smart contract platform for enterprises that support speedy transactions and throughput; addressing challenges for the finance industry, banks and beyond. It seems that they have already issued a yearly deposit certificate based on a distributed registry with a variable rate.
- Another name in the line is Goldman Sachs, who is actively involved in research and support of distributed registry technology, and has invested in a cryptocurrency project called Circle. It aims to solve the key problem of volatility in the digital currency space thus, making the finance sector more reliable with crypto options.
- Several major banks have partnered with Ripple to improve cross-border money transfers and minimize the exposure to cryptocurrencies.
- Some of the largest stock exchanges in the world like Shanghai stock exchange and Nasdaq have already announced implementing blockchain technology in their businesses.
- The movie BRAID became the first major feature film to be financed through a token “crowd sale” on the Ethereum blockchain through its $1.7M campaign on Weifund.
Risks involved in using blockchainBlockchain certainly is a booming sector to invest right now because of all of its huge advantages. However, like every good thing, blockchain also has its downsides, which you should keep in mind before getting into it.
FraudsSince at the end of the day, blockchain is used by humans themselves, some risk of fraud is always there. So you need to research the company well before investing in it.
- False white papers: In order to raise crypto capital for a start-up all someone needs to do is draw up a detailed white paper document and convince people to invest in the form of ICO (Initial Coin Offering); a structured company is not required. If you do not do your research, you may lose a fortune. However, since there is no authority you can complain to, the money you lose is gone forever.
- Hacking: Hacking poses a similar threat. $1.1 billion in cryptocurrency was stolen by hackers in 2018, and gone for good.
- You might lose assets: Not every start-up ends up becoming Amazon or Netflix. Even if the start-up you invest in is legit, there is no guarantee it will become successful; in fact, a lot of them shut down quickly enough for you to earn anything at all. Virtual ICOs are often less successful than other businesses.
- It is a long-term investment: Once you invest in any blockchain-consulting start-up, you are in it for the long haul. They usually take some time to even start working, and even longer to be really successful – however big ROIs they end up bringing in the future.
- Highly volatile: As for cryptocurrencies, there is no governing body to expand or limit the money supply to meet changing events, and also no mechanism to prevent widespread price manipulation. This makes crypto highly volatile, i.e, the value of them rises and falls in a very disorganized manner. Bitcoin shot up in value from $1,000 per Bitcoin on 1st January 2017, to $19,783.06 in mid-December of that year, and then again the value went down by 80% in between January and September in 2018.
- Storing may not help much: Cryptocurrencies have no store-of-value. If you invest in $1000 of value in crypto today, because of its high volatility, there is absolutely no guarantee that you will get back $1000 worth of crypto in future.
- Cryptocurrency paradox: Being decentralized, the price of a cryptocurrency is only determined by supply and demand and supply differs widely between exchanges. If someone buys a lot of one form of currency on a smaller exchange, investors on other exchanges will notice and buy the same currency, triggering market-wide inflation.