Infusing Blockchain into Banking

For over three years, we’ve discussed banking and blockchain as two separate spheres under the umbrella of financial technology (FinTech). Current technology enhancements in banking improve activity only within existing infrastructure and payment networks. These structures and networks were built by entities with licensing, regulation, and gatekeeping relationships in financial services for 50+ years. Near-term changes are slowly taking place towards open banking and leveraging customer data, but still running on a legacy system.

Blockchain provides new infrastructure and network capabilities, and removes the need for third parties. Having gained a global presence over the last decade and rising in demand (from crypto), its more than a technology that powers bitcoin. The inherent traits of security, authentication, and decentralization help build trust in transaction processing and record-keeping.

As the industry looks ahead in terms of long-term impact, banking enhanced by blockchain is a viable driver this decade. What Bill Gates alluded to in 1994 about banks makes sense — administering financial services between two parties without an intermediary (bank) should be examined closely.

The next generation of neobanks and challenger banks can be built with blockchain instead of the payment rails and network relationships that exist today — enabling transfers, settlement, user onboarding and validation, and lending.

BLOCKCHAIN adoption in banking

At a broad level, the technology and structure in blockchain networks enables two distinct parties to conduct a transaction (after a consensus is formed by network participants, or nodes) without an intermediary. A majority of nodes (in agreement on posting a transfer) builds a layer of trust programmatically. The driver of these types of transactions is most often related to a transfer of currency (or ownership rights as highlighted in last week’s discussion on NFTs).

At its core, banks act as 3rd parties (between a sender and recipient) enabling similar transfers (i.e. payments) in financial services. Banks and other financial institutions are trusted by consumers due to strict compliance and oversight (montiored by regulators) to protect against criminal activity, fraud, and losses.

The consensus and security protocols of blockchain remove the need for governing entities. However, banks (in some form) will still retain some role in the financial lives of consumers to identify and screen the users conducting transactions, and offer customer support. The bridge between banks and blockchain lies in Distributed Ledger Technology (DLT). As a branch from blockchain, DLT modernizes existing processes and standards that financial institutions use today (especially with external access of a client’s banking data).

The critical banking components enhanced by blockchain over the next decade:

Payments, Settlement, and Know Your Customer (KYC).

banking Payments on blockchain

The capability of quickly, securely (and cheaply) sending payments between two parties (especially cross-border) provides the largest impact from blockchain-based banking. Current global structures for wire transfers are fragmented and involve correspondent banks, lengthy processing times, and potential foreign currency losses (from FX risk). Consortia and payment groups widely agree that blockchain will influence this industry sector within the next 5 years.

Part of the resistance to change from banks is attributed to the annual fees collected in performing transfers — in 2019, there was estimated $200B generated in revenue. The sending bank, intermediary bank, SWIFT network, and receiving bank all collect a fee or some revenue in foreign currency margins.

In contrast, blockchains can be viewable to the public and allow all users to send / receive funds in minutes or days (instead of weeks) to other countries for a minimal cost. Enhancements are being made to lower the cost further and increase settlement times through alternative coins and tokens. Eliminating third parties reduces the overall cost and speeds up the transaction. Banks would be able to communicate and transfer directly (e.g in the graphic above a US-based bank processes a transaction with the bank in Japan).

The risk with blockchain-based payments comes from its decentralized, crypto transactions being anonymously conducted — users are outside the scope of government regulators, which allows fraudsters or criminals to operate within the financial system. It’s this lack of identity verification against current standards in anti-money laundering that represents one of the largest blockers in banking adoption.

Top payment use cases in banking:

• Remittances and B2B payments: Countries in emerging markets struggle with the cost of transfers both domestically and across borders. In areas like sub-Saharan Africa that lack banking infrastructure, payments via blockchain eliminate over 8% of fees. BitPesa (serving Nigeria and Kenya) processed over $1M and continues to increase monthly volume at a 20% rate;

• Merchant payments: top eCommerce platforms (such as Shopify) have integrated with crypto payment providers to allow acceptance of bitcoin and other tokens. Mastercard and Visa started to form partnerships with crypto platforms to accept these payments globally. Merchant groups have also formed their own networks aligned with payments startups and apps for consumers to pay with crypto at point-of-sale.

• Micropayments: High volumes of sub-dollar transactions can be more expensive to process at scale for some payment providers. Blockchain allows these small amounts to be processed seamlessly without a per-transaction loss in merchant costs;

For retailers, peer-to-peer (P2P) transfers, and individuals sending/receiving remittances — the security, cost ,and speed of payment methods are all critical. Well-known money transmitters (MoneyGram and Western Union) have led this category for decades, especially among unbanked. New startups are launching to disrupt and gain market share in payments and they’re using blockchain as a competitive advantage.

upgrading Clearance and Settlement

As much revenue as banks gain in processing payments, the monitoring and oversight is painful to manage. Orders must be reconciled at two banks in a fragmented global system of intermediaries, traders, and foreign currency managers. The SWIFT network, the world’s primary path for international transfers, handles over 30M requests daily across more than 10K banks and institutions. When a transaction order gets lost or delayed, a tracking inquiry must be sent to the network to trace the funds in transit — about 60% of payment requests require some level of manual processing.

The best case is for a transfer to settle in 3 days and the worst case is that the funds can’t be traced and never reach the destination. Once an order is processed, the money movement takes place through 3rd parties (custodial services and correspondent banks), who each charge a fee for their part of the process.

The ability to settle transactions directly and provide transparent ledgering would be a welcomed advance for banks concerned about clearance and settlements. There would be an open and transparent view of transactions as they’re processed. Payments would made as soon as the transaction clears — no need to hold funds. Removing middle layers and uncertainty in the overall process provides tremendous improvement over the legacy infrastructure we have today.

Established banks and industry groups managing this current process need to rally efforts to bring efficiency in processing transfers through blockchain and DLT. The potential annual savings in using blockchain by global banks can be up to $1B in costs.

Top clearance and settlement use case:

• Cross-border, enterprise-level transfers: the well-known blockchain settlement provider (Ripple) provides multiple features to banks for clearance and settlement. It’s product suite contains xCurrent (integration with a bank’s ledgering system for real-time messaging towards settlement), and xRapid (cross-border transaction processing by using XRP for conversion with near-instant settlement). More than 300 banks and enterprises in 40+ countries work with Ripple.

• Fundraising: Startups, charities, political campaigns, government groups, investment and crowdfunding platforms all have a need raise funds and provide detailed transaction records. Both needs can be solved through a blockchain-based platform with a public ledger, which gathers and converts various fiat currencies into one crypto fund for disbursment;

Other players have similarly launched DLT solutions for banks in order to settle high volume transactions through cryptocurrency. JPMorgan Chase has even launched its own token and incubated its own network, Onyx, to help them and other banks in the US keep pace with the latest technology. Overall, there’s industry-wide efficiency by connecting all financial institutions on a unified ledger.

Customer KYC and Fraud Prevention

Outside of payments and settlement, there are other applications to boost financial services through blockchain. The initial onboarding of users for banks and fintechs can be a cause of friction — users must enter personal info (name, address, date, of birth, social security number) and provide a government ID (if applicable). These requirements are part of anti-money laundering guidelines and Know Your Customer (KYC) standards in identifying users and screening against watchlist or sanctions list. The actual review process by banks can also be lengthy, especially if manual review of documents is required. Over $500M is spent annually in the banking industry towards KYC.

For customers applying for an account or card with an unknown platform, providing this level of personal data is uncomfortable and risky. Platforms must protect the transfer and storage of this data against privacy breaches and takeover attempts.

Blockchain can store customer information and protect against compromises. This method reduces the time and staffing required to monitor programs, and enables faster access to data.

Top KYC improvements through blockchain:

• Customer Profiles: Each individual or business user has their KYC captured once and securely stored on a blockchain network. From the graphic above, this network allows access to specific third parties authorized by a user, and also continuously monitors against watchlists (to meet regulatory requirements). Additional services can include monthly reviews on behalf of the user to ensure their personal data hasn’t been compromised. Ripple (through its xCurrent product) and other institutions (partnering with IBM) are piloting services in this space.

As the cost of compliance and fraud prevention increases, these initiatives will be in high demand across financial institutions and at the regulator level. If the rate of data breaches rises, consumers will add further to the demand.

Futurist Outlook on Banking on the Blockchain

The status quo in banking is firmly embedded in our financial system. The requirements for licensing, capital, insurance, and compliance place huge barriers to entry for new entrants and disruptors. For emerging companies that apply to be a bank, the application process is lengthy and approval isn’t guaranteed.

Multiple entities and agencies provide governance within banking and financial services. Any industry changes would wipe out existing payment facilitators, such as the ACH network, correspondent banks, SWIFT network, and clearing houses. These groups would be the first to object to changes in infrastructure.

The best avenue for blockchain in banking is an internal (dual) champion — the combination of a financial institution AND government-level regulator. Banks such as JP Morgan Chase and institutions utilizing Ripple’s platform already exist. What we haven’t seen is regulatory leadership in support of this movement.

Cryptocurrency as a broad sector is just starting to gain consideration and visibility at the end of last year. 2021 should offer more definition in the government’s stance toward crypto’s place in financial services. Positive synergy in banks adopting this tech is necessary to remain competitive with other countries’ payment systems

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