Blockchain is transforming everything in banking: from cross-border payments, settlements and clearances, to even fundraising. However, beyond all the hype around blockchain, how will it really shape the traditional finance industry?
Clearance and Settlements Systems
The fact that an average bank transfer takes three days to settle has a lot to do with the way our financial infrastructure was built.
It’s not just a pain for the consumer. Moving money around the world is a logistical nightmare for the banks themselves.
Today, a simple bank transfer — from one account to another — has to bypass a complicated system of intermediaries, from correspondent banks to custodial services, before it reaches its final destination. The two bank balances have to be reconciled across a global financial system, comprised of a wide network of traders, funds, asset managers and more.
If you want to send money from a UnicaCredit Banca account in Italy to a Wells Fargo account in the US, the transfer will be executed through the Society for Worldwide Interbank Financial Communication (SWIFT), which sends 24 million messages a day for 10,000 financial institutions.
Because UnicaCredit Banka and Wells Fargo don’t have an established financial relationship, they have to search the SWIFT network for a correspondent bank that has a relationship with both banks and can settle the transaction — for a fee. Each correspondent bank maintains different ledgers, at the originating bank and the receiving bank, which means that these different ledgers have to be reconciled at the end of the day.
The centralised SWIFT protocol doesn’t actually send the funds, it simply sends the payment orders. The actual money is then processed through a system of intermediaries. Each intermediary adds additional cost to the transaction and creates a potential point of failure — 60 per cent of B2B payments require manual intervention, each taking between 15–20 minutes.
The blockchain, which serves as a decentralized “ledger” of transactions, can completely disrupt this state of play. Rather than using SWIFT to reconcile each financial institution’s ledger, an interbank blockchain could keep track of all transactions publicly and transparently. Instead of having to rely on a network of custodial services and correspondent banks, transactions could be settled directly on the blockchain. That would help alleviate the high costs of maintaining a global network of correspondent banks.
According to Deutsche Börse, the Australian Stock Exchange and Depository Trust & Clearing Corporation [DTCC], he said: “Today it is managed through a myriad of messages and manual reconciliation. There is a big opportunity for blockchain to seriously restructure that industry.”
Loans and Credit
Traditional banks and lenders underwrite loans based on an inaccurate and insecure system of credit reporting.
When you fill out an application for a bank loan, the bank has to evaluate the risk that you won’t pay them back. They do this by looking at factors like your credit score, debt-to-income ratio, and home ownership status. To get this information, they have to access your credit report provided by one of three major credit agencies: Experian, TransUnion, and Equifax. Based on that information, banks price the risk of a default into the fees and interest collected on loans.
This centralised system is often hostile to consumers and small businesses. The Federal Trade Commission estimates that one in five Americans has a “potentially material error” in their credit score that negatively impacts their ability to get a loan. Furthermore, concentrating this sensitive information within three institutions creates a lot of vulnerability. Last year’s Equifax hack exposed the credit information of 143 million Americans.
Alternative lending on the blockchain offers a cheaper, more efficient, and more secure way of making personal loans to a broader pool of consumers. With a cryptographically secure, decentralized registry of historical payments, consumers could apply for loans based on a global credit score.
The benefits, particularly for individuals and small-to-medium-enterprises (SMEs) are significant, as access to credit can often be difficult, with many hoops to jump through.
Blockchain lending essentially builds on the timeless peer-to-peer model, making the entire process more seamless and reducing the amount of time the process takes. The middleman (a bank) is cast aside, and individual borrowers or businesses are connected directly to willing lenders. The great value of such decentralised lending is that with a single request, a borrower can access very competitive financing, as geography is no constraint on a blockchain platform, lenders from all over the world can bid to provide the loan.
Thanks to smart contracts, lenders are able to validate transactions, verify the legitimacy of counterparties, and perform routine account administration tasks almost momentarily, reducing costs and accelerating the process.
Importantly, there is no need to rely on a third party for background checks or “proprietary ratings”. Since all transactions are open and audit-able, every address can be assigned a credit rating, almost trivially. The transactions of a given address can be analysed in detail. For an example of how powerful a tool this can be, just go to Trivial and enter an Ethereum address, to see incoming and outgoing transactions. If there is any suspicious or unusual activity that raises the eyebrow of the loan provider, they can simply refuse to extend their services.
While most of these projects focus on creating liquidity through loans around people’s existing crypto assets, they’re also jumpstarting the infrastructure that will enable bigger disruption in loans via blockchain.
To buy or sell assets like stocks, debt, and commodities, you need a way to keep track of who owns what. Financial markets today accomplish this through a complex chain of brokers, exchanges, central security depositories, clearing houses, and custodian banks. These different parties have been built around an outdated system of paper ownership.
Say you want to buy a share of Apple stock. You might place an order through a stock exchange, which matches you with a seller. In the old days, that meant you’d spend cash in exchange for a certificate of ownership for the share.
This grows a lot more complicated when we’re trying to execute this transaction electronically. We don’t want to deal with the day-to-day management of the assets — like exchanging certificates, bookkeeping, or managing dividends. So we outsource the shares to custodian banks for safekeeping. Because buyers and sellers don’t always rely on the same custodian banks, the custodians themselves need to rely on a trusted third party to hold onto all the paper certificates.
In practice, that means that when you buy or sell an asset, that order is relayed through a whole bunch of third parties. Transferring ownership is complicated because each party maintains their own version of the truth in a separate ledger.
Not only is this system inefficient, but it’s also imprecise. Security transactions take between 1 to 3 days to settle because everyone’s books have to be updated and reconciled at the end of the day. Because there are so many different parties involved, transactions often have to be manually validated. Each party charges a fee.
Blockchain technology promises to revolutionize financial markets by creating a decentralized database of unique, digital assets. While still in its infancy, continued efforts to educate adopters and investors alike will ultimately ensure a more efficient, transparent, and secure financial ecosystem.
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