Blockchain for Central Banks
Banking is being disrupted in quite a few ways: there are innovations in fintech, for example, the Kenyan M-Pesa (Pesa is Swahili for money, so it translates as “mobile money”) which is transferred by mobile phone. People are accessing credit via crowd-funding and P2P lending, rather than bank loans. The banks have antiquated legacy systems which are costly and ponderous. The comparison with swift, small mammals running rings round powerful but outdated dinosaurs is hackneyed but perhaps correct in this case.
Many conventional banks have noticed this phenomenon, and are attempting to get on board the roller-coaster. Technology advances, but it does not emerge without casualties: think about all the blacksmiths and vets who were made redundant by the emergence of motor vehicles in the early 20th century. They protested and lobbied against the new form of transport. They were unsuccessful but slowed the emergence of automobile technology. It will be the same with blockchain (distributed ledger) technologies (DLT): there are powerful groups that will lose out in the market. So this will be opposed. They have the ear of governments so they can have legislation passed, but other groups will benefit so – sooner or later – the vested interests will have to concede.
César A. Del Río says, in a paper about blockchain and finance, “There are three major factors behind the push for DLT in the finance industry:
Cost savings and efficiency. Banks are dealing with rising costs for maintaining or replacing their aging infrastructure and ensuring compliance with heavy regulatory burdens. Furthermore, banks must deal with increasing economic instability. To that end, DLT-based solutions could generate cost savings of up to $20 billion per year, according to Banco Santander (Belinky, Rennick, & Veitch, 2015).
Competing with start-ups. Financial technology companies (FinTechs) are using DLT to offer services (such as remittances and international payments) at reduced costs, with greater speed, and with more user-friendly interfaces than major banks. As a result, banks have started to construct their own DLT-based solutions to better compete with these up-and-comers.
New business models. Banks can use DLT-based systems to circumvent central bodies or legacy infrastructure. Banks could potentially develop these systems to create brand new business models that disrupt the current financial ecosystem.”
However, Central Banks are normally cautious and risk-averse. They see cryptocurrencies and blockchain as the “Wild West”, filled with bandits and crazy dreamers. However, some banks like the Royal Bank of Scotland and the Monetary Authority of Singapore (Project Ubin) have experimented with DLT prototypes. No doubt that the recent announcement that Venezuela is embarking on a cryptocurrency called the Petro, backed by its oil reserves, will make some bankers start to take notice.
Banking Problems that Blockchain can address
1 - KYC/AML
Now that banks are no longer small local operations, and with the availability of large amounts of money from illegal organizations such as drug traffickers and terrorists, banks have to take a lot of care over whom they transact with. KYC/AML procedures are long, labor-intensive, and costly – some estimates suggest 20% of a bank's overheads may be involved with this area of their business.
A blockchain-based verification system could mean that once a person or company was verified (possibly via biometrics) then they could give access to anybody who wanted to verify their identity. This would be a swift process. There are privacy implications, although most people never bother about what social media companies or supermarkets are doing with their data, so perhaps this is not an issue for significant numbers of citizens.
“Specifically, DLT enables the creation of a chronological, decentralized, interbank ledger in which financial institutions that need to conduct the same KYC verification tasks for that customer can verify the result of the process that has already been conducted for that customer, thus avoiding conducting duplicated KYC verification tasks.” Jose´ Parra Moyano, Omri Ross; KYC Optimization Using Distributed Ledger Technology
2 - Speed of transactions
Although the scalability of some coins like bitcoin and etherium is in dispute, this is because they are early developments. There is no reason why more mature blockchain technologies cannot reach the intensity of Visa transactions (thousands per second). Bitcoin can only max out at 7 transactions per second and takes ten minutes to verify them. Visa confirms a credit card transaction within seconds, and processes 2000 transactions per second on average, with a peak rate of 56,000 transactions per second. Clearly, there is a way to go yet.
There are fundamental problems in scaling cryptocurrencies to meet global banking demands of the intensity necessary. However the technical community is strong, and similar, but not quite identical challenges in other spheres like cable TV networks or broadband have been overcome.
3 - Verifiability of transactions
This is where cryptocurrencies score over earlier technologies. DLT contains a certain and verifiable record of every single transaction ever made. This mitigates the risk of double-spending, fraud, abuse, and manipulation of transactions. The blockchain itself has complete integrity. It is “human error” where things go wrong. It is expected that the next generation of wallets will incorporate AI to ensure that they verify transactions carefully before sending/receiving funds.
Central Banking DLT Examples
Project Ubin – Monetary Authority of Singapore (MAS)
“A group of banks in Singapore, with the support of MAS, Singapore’s central bank and financial regulatory authority, have also been developing a payment system prototype using DLT in which
bank users can exchange currency with one another without lengthy processing times, expensive processing fees, or intermediaries. R3 – a consortium specializing in DLT – has partnered with the
group on the initiative, known as Project Ubin. This project represents a significant opportunity for Singapore’s ecosystem to establish leadership in the area of DLT research and development, in line with Singapore’s broader goal of becoming a Smart Financial Centre.” Project Ubin Report 2017
The project uses a cryptocurrency token for the Singapore Dollar (SGD). It was a six-week experiment to see how a DL would function in reality. The first phase was to offer real-time transactions, and the next two phases will involve securities, in internal Singapore transfers, then cross-border ones. The prototype was tested for the ability to transact 24/7, resilience against single points of failure, and timeliness of settlements. The MAS announced that Phase One was successfully concluded on 9th March 2017. Currently, in Phase Two, the lessons learned are feeding into the ongoing project, which is using Microsoft Azure as its cloud platform.
UAE Takes a Leadership Position
Dubai launched its “Blockchain Strategy” in 2016 with the ambition to become the first blockchain-enabled government by 2020. Utilizing paperless blockchain transactions the city authority plans to save 25 million work hours annually through DLT transactions. In October 2017 the Dubai Land Department became the world’s first government entity to adopt blockchain. It records all real estate contracts, including lease registrations, and links them with the Dubai Electricity and Water Authority, the telecommunications system and various property-related bills.
Dubai is also preparing to issue its own official state cryptocurrency emCash, to make Dubai the world’s first blockchain city. Similarly, the regulators of the UAE’s financial centers – ADGM and DIFC – are embracing fintech and its underlying technologies. ADGM’s Regulatory Laboratory (RegLab), is providing a light-regulation sandbox environment for regional start-ups, one of the first programmes of its kind in the region. Both centers have held global competitions to identify and support innovators in fintech.
Use cases for DLT in the Banking and Finance Sector
International Money Transfers
Conducting international money transfers through DLT could provide real‐time settlement and reduce costs, enabling new business models (e.g. micro-payments), and institute more transparent methods of regulatory oversight. This would need an internationally-agreed blockchain protocol, equivalent to the current SWIFT system.
Property and Casualty Insurance (P & C)
Facilitating claims management for property and casualty (P&C) insurers on DLT can automate processing through smart contracts, improve assessment through historical claims information and reduce the potential for fraudulent claims.
Again this is an area where international standards would be required, and the insurance sector tends towards innovating slowly. New legal procedures and regulators would be required.
Deposits and Lending
For syndicated loans, utilizing blockchain to automate syndicate formation, underwriting and the disbursement of funds (e.g. principal and interest payments) can reduce loan issuance time and operational risk.
Trade finance: DLT can store financial details to facilitate the real‐time approval of financial documents, create new financing structures, reduce counterparty risk and enable faster settlement.
For historical reasons, Islamic finance has a greater complexity and need for religiously compliant documentation. So the potential gains in terms of lower bureaucracy and greater speed of implementation will be of great benefit to most Islamic countries. Several locations, particularly Dubai (see above), have picked up on the potential of this and are moving to position themselves as leaders in this field.
Utilizing DLT to store financial information can eliminate errors associated with manual auditing, improve efficiency, reduce reporting costs and, potentially, support deeper regulatory oversight in the future.
Here again, this will depend on how responsive governments and their regulators are too disruptive technologies.
Transacting Equities and other Securities
Utilizing DLT and smart contracts to facilitate post‐trade activities can dis-intermediate processes, reduce counterparty and operational risk and, potentially, pave the way for reduced settlement time, and limit error and fraud.
Like the motor car in the 20th Century, the rise of cryptocurrencies and blockchain is probably unstoppable. In 2017 it went from a strange nerdy pastime to a phenomenon that governments and major newspapers had to take seriously. There is going to be a lot of resistance from institutions and vested interests. The banking, insurance and broking sectors have got a huge amount of capital tied up in legacy systems, and there is always resistance to change from people who have a done well out of the existing system.
However, the emergence of globalized, digitized networks over the past thirty years or so has completely changed the structure and operations of many industries, dis-intermediating them and creating whole new forms, which couldn't be conceived of previously. Once, to be a media star, you had to overcome intense competition to work for a major media organisation like the BBC or the New York Times, Forbes, you couldn't just blog from your bedroom, let alone become a trendsetting financial success when barely out of your teens, like fashion blogger Zoella, who has over 12 million YouTube followers.
The risk-averse central banks will probably need some kind of shock like the financial collapse of 2008 to jolt them out of their complacency, but clearly, challenges from new fintech industries will be nipping at their heels. Although Dubai and Singapore are significant financial centers, they do not have the global importance of New York or London, but this makes them less resistant to change and more able to adopt new technologies, as they have less to lose by doing things differently. Over the past few years, we have seen the re-emergence of powers like Russia and China, as political power moves towards a multi-polar world. So it looks likely that the banking blockchain developments to watch will come from Russia, China or the developing world, rather than existing leaders, who are too embedded in the current paradigm to make a major shift in their methods of operation.
Ali H. Askar, CTO - ThalerTech.io