Digital currencies and distributed ledger technology will have huge and unpredictable implications for banks, increasing efficiency in some business segments and inviting competition in others. Eventually it could completely transform their relationships with clients.
Banks were not the first to spot the potential of the blockchain, but they are now among its greatest enthusiasts. Having allocated considerable time and capital into researching and developing the underlying distributed ledger technology (DLT), they clearly recognise its long term significance.
Digital currencies mainly exist as a way to represent cash on a ledger. But since banks also deal with other forms of data it is DLT itself which interests them most, as a way to increase efficiency, potentially right across the business.
Distributed ledger technology could increase banks’ efficiency right across business.
In engaging with DLT banks have had to change their mindsets, opening themselves up to the creative destruction this technology will surely unleash. But they have also worked hard to modify the technology itself. To be useful for them, DLT needs a greater level of centralisation than the blockchain offers. They will require gatekeepers – potentially a bank, or a collectively owned utility like the R3 consortium – to manage access to the system.
Christophe Van Cauwenberghe, head of payment innovation at Société Générale, says: “Blockchain developers and banks have begun to adapt the blockchain to make it more applicable to their commercial realities, for example adding a layer of privacy so that not everything can be seen by everyone. The emerging DLT is more like the other systems they use and does not seem as complex to integrate at this stage.”
Replacing third parties
Banks are therefore deep in the experimentation phase. In the coming months and years they will learn as much about what does not need to be “blockchainized” as what does. But it is starting to become clear which parts of the business will benefit: generally those where it is possible to replace a third party from a process with the ledger.
Van Cauwenberghe says the four DLT use cases with the most obvious potential for banks are payments, syndicated loans, trade finance and know your customer (KYC) compliance.
The four DLT use cases with the most obvious potential for banks are payments, syndicated loans, trade finance and know your customer compliance.
Trade finance is perhaps the most obvious area in need of a technological makeover. It remains painfully low-tech and involves numerous counterparties spread over considerable distances. There are still technical challenges to overcome, but there is little doubt DLT has the potential to make international trade considerably more efficient. This is excellent news for the global economy.
Syndicated loans is similarly well suited for DLT given the involvement of different institutions, and presents similar challenges around data privacy and access.
Harnessing DLT to increase efficiency in the cumbersome and costly business of KYC compliance presents a slightly different challenge, especially given it is exclusively data, not currency, that would be shared on the ledger.
KYC and anti-money laundering (AML) regulations create a huge headache for banks and a KYC register on a blockchain could be among banks’ most cherished possible outcomes from their experiments with DLT. Significant technical challenges remain, especially around who would be liable for the accuracy of the information shared on the database, but it seems likely these can be overcome in due course.
The future of payments
So far attention has largely focused on payments settlement. Digital currencies that settle in or close to real time significantly reduce counterparty risk. This in turn reduces the system’s reliance on correspondent banking, where banks provide services on behalf of other banks, the system that facilitates international payments and allows people to use ATMs around the world.
Many banks have been experimenting in this area. Mizuho Financial Group is developing its own coin, which it hopes will improve the bank’s offerings in services relating to exchanging foreign currencies.
Meanwhile UBS, Deutsche Bank, Bank of New York Mellon, Santander and Icap have been developing the Utility Settlement Coin (USC), which they believe will reduce costs and speed up settlement.
Typically, notes Kirill Timofeev, senior developer in the blockchain team at DataArt, a technology consultancy, settlement includes three parts: analogue/digital representation of something, a legal contract and fund movements. It is the last of these that presents the real challenge, because DLT has not yet seen broad enough adoption. “Until that moment it is hard to fix this process,” he says.
A particular challenge will be ensuring banks collaborate during the period of mass adoption, ensuring system interoperability and connectivity between banks.
A particular challenge will be ensuring banks collaborate during this period of mass adoption, ensuring system interoperability and connectivity between banks.
While all this will feel seismic for the institutions adopting DLT and the businesses involved, and will no doubt make a difference to the service offered to clients, it does not necessarily look transformational from a customer experience point of view. This may change when banks are further along in the process of adoption.
“Right now, banks are mainly looking for opportunities to reduce their operational costs,” Timofeev says. “However, when the technology matures enough, there are bigger advantages for a consumer market as well. When money is digitised in a shared ledger, it opens a doorway to another dimension, unlocks new markets and makes it possible to transform legacy processes by automation.”
It’s a view shared by Mizuho. According to a company spokesperson, “banks, including ourselves, are studying the possibility of whether it will improve customers’ convenience, and what we can do with it for customers”.
Mizuho does not rule out using its digital currency as a means of transacting with its clients, for example allowing the currency to be earned and then spent on bank services, rather like a loyalty card. However, such developments are a long way off, it stresses.
“DLT is unlikely to cause a revolution in finance,” comments Timofeev. Rather, distributed ledger technology will have a long adoption cycle and change will be incremental, happening in three stages: point solutions first, followed by process solutions, and only then market-wide solutions. “Markets are always resistant to change, processes can’t be substituted overnight, no matter how promising new technologies are.”
For now it is next to impossible to say specifically how things will change. One thing that does seem clear is that DLT will not make banks redundant. As trusted third parties, they will continue to play a crucial role in finance in the foreseeable future.
Still, Van Cauwenberghe of Société Générale admits banks remain nervous about where this road ends, even if they have been converted to the DLT cause. “If central banks issue cryptocurrencies and distribute money directly, without intermediaries, meaning no banknotes, cash registers or ATMs, that would lead to disruption on a different level. It is impossible to predict where it would lead.”
But, he adds, central banks are in no hurry to do that, and “are happy to let commercial banks lead the way”. Experience shows, no matter how disruptive a technology is, it is always better to embrace it and adapt than pretend it isn’t happening. This is exactly what financial institutions are doing.