Blockchain and distributed ledger technology (DLT) have transformed into more paradigm-changing high-techs in the past years. The fundamental nature of these systems is to manage the data digitally, in a decentralized manner – that in turn affects the pattern by which individuals and institutions transact and trade with one another. The technology got its fame, with the development of the world’s first peer-to-peer cryptocurrency’s acclaimed application – bitcoin. The primary function of bitcoin is to assist any individual or entity in carrying out transactions, without the involvement of any third party. Ethereum (a public blockchain), is focused on a similar principle. Regardless of the novel idea of blockchain, the wide adoption of blockchain is still obstructed due to bitcoin’s lack of wider integration with other technological infrastructures and its unresolved place in the existing regulatory frameworks.
Blockchain and DLT
Huge-scale businesses and governments are showing interest in analyzing the latent merits of DLT and blockchain. In the case of enterprise-grade blockchain in financial and other economic sectors, the architecture is not open as in the bitcoin application but is centered on permissioned systems. For smaller businesses or set-ups, few nodes are needed to generate consensus so they do not require high computational power or capacity for greater scalability. In contrast to public blockchains, no requirement to ‘incentivize validators’ is present to clash with hashing power for cryptocurrency rewards, since maintaining network security is a shared interest. These days, the financial sector is prioritizing blockchain models that offer more security and scalability, instead of decentralization, or simply, financial sectors are favoring the permission-based consortium model.
Types of Blockchain System
There are three kinds of blockchain systems present viz., public blockchain, consortium blockchain, and private blockchain. Let’s understand them a little.
For public blockchain, the managing entity is decentralized and is appointed to all participants. It gets relatively tougher to alter the rules once made, concerning governance. The speed of transactions is slow, as well as the network is difficult to expand. Everyone has access to the data in a public blockchain. The identifiability here is pseudo-anonymous. The transaction proof herein cannot be known before-handed and is generally decided by PoW and PoS algorithms. One such example of a public blockchain is bitcoin.
Next is the consortium blockchain, wherein the managing entity is the participant of the consortium. The rules here can be changed easily if the majority of consortium members agree to the same. The transaction speed is faster and the network is easy to expand. The data access is limited to only authorized users. You can get identified here. The transaction proof is known via authentication and verification of the transaction. The block generation is constructed based on the rules accepted earlier. Examples of consortium blockchain include R3, Ethereum, Hyperledger Fabric, etc. While talking about private blockchain, the central institution holds all the authority, and also the same central institution holds the governance of changing the rules, as per the decisions made. It comes with a fast transaction speed and the network is very easy to expand. The access to data herein is limited to only authorized users. You can get identified here. The transaction proof is generated by the central institution. One example of a private blockchain is Linq.
Industries are adopting a more practical approach toward DLT and blockchain. It encompasses focussing on efficiency and cost-saving. Let’s look into more cases:
1. Minimizing risks and maximizing benefits
One core property possessed by blockchain is to maximize the benefits and limit the risk associated with collaboration and co-investment. In case of novel situations, wherein banks and businesses are involved, use cases where blockchain can be applied involve, know-your-customer, trade finance, and primary security issues. Industries recognized five major drawbacks that could be solved using DLT. They are security, speed, transparency and traceability, risk, and cost management. Since single-point failures could come across while dealing with a centralized nature of a legacy financial system, a distributed network of DLT-based systems can be put into execution.
Likewise, a blockchain is a ledger that offers visibility to the complete lifespan of a transaction or value exchange, going all along the bank’s way of operations. Implementing blockchain can minimize time-consuming and expensive third-party verifications in the payment or fund transfer pathway. With the help of DLT platforms, recording of transactions of arbitrary assets or cash, simultaneous, and multiple changes can be made to the ledger. This gives rise to the notion of Delivery vs Payment, where one asset is obtained after the other, due to which two parties can know the status of an invoice at any time, and the payment would be accomplished at the same instant the invoice is signed and paid. In addition, both parties will have the status and its changes visible to themselves. Thereby, DLT transactions when aggregated could be cheaper than all the collected transactions on multiple isolated and discrete accounts. DLT also eliminates credit risk.
2. Greater Return and Cross-border Payment
One convenience provided by blockchain is cross-border payment, due to its decentralized nature. Advantages that DLT over current payment technology embraces, enabling frictionless settlement at any moment, global interoperability, strong security, and faster and cheap transactions. Cross-border payment depends on correspondent banking networks simplified by financial mediators at multiple stages.
Let’s take a look at the correspondent banking model.
- A correspondent banking model will possess a Nostro or Vostro account in another country, with a counterpart bank.
- Nostro refers to the account of a local bank detained by a correspondent account in foreign currency in another country.
- Vostro refers to the account of a foreign correspondent account held by a local bank in its domestic currency.
- Through such mediums, there is a smooth flow of funds and transactions across countries.
Even though cross-border payments are streamlined, there are more inconvenient and extravagant than domestic payment options, the reason for the same being the number of financial intermediaries involved.
3. Shifting to Tokenization
Tokenization essentially refers to shifting from an account-based to a token-based payment system. DLT-induced transactions would enable the authenticity and value of tokens to be verified individually and discretely, preventing the need for messaging, clearing, and settlement systems. It is anticipated that this token-based business service could break out the pre-existing mediators and cause more alternations in the market structures.
4. Banks and Fintech
There is still a tension between innovation and distribution and it is yet to be resolved if financial technology firms would accomplish distribution until the time banks completely innovate themselves. Factors on which the future of banks depends includes, the power of customer insight, advanced analytics, and digital technology.
Talking about the novel and small FinTech companies, there is a slight chance that they’ll come up with a more radical and innovative approach to cross-border payments. For banks, cross-border innovation has solely been restricted to analytics, a digital technology. As banks are concerned, they take to play on the safer side by obliging regulatory customs and setting up boundaries with the tech curve, blockchain applications, etc. This can be reflected as a mere disadvantage as the neo-banks or small FinTech firms are customized to have a light regulatory burden and more maneuverability in trying new solutions. These days some banks even believe in -co-development with fellow FinTech start-ups. Collaborative activities carried out through consortia might assist in bringing about more extensive industry changes in cross-border payment.
There are certain consortia considerations as well. Banks while becoming a member of consortia are either though being a ‘follower’ or a ‘leader’. The decision for the same is taken by the consortium’s governance structure.
The future of banks relies on meeting all the regulatory approvals and needs concerning KYC and AML. One such hindrance faced is the lack of harmonization across jurisdictions and the unavailability of global standards.
Few features of DLT conflict with the existing regulatory approaches in competition, intellectual property, and consumer law. According to the International Telecommunication Union (ITU), there are five major issues: distribution, autonomy, tamper evidence, incentive mechanisms, and transparency. These issues come out largely at domestic levels. For respondents, the crucial problem is the fragmentation of regulation across various borders and jurisdictions.
Internal blockchain governance within a consortium can distribute or allocate liability and stipulate the governing laws, jurisdiction, and resolved dispute mechanism to some degree. Establishing ecosystems consisting of multiple consortia has reduced the hindrance of interoperability, wherein ecosystems serve as ‘super-connectors’.
The only problem which remains is the regulatory divergence. It is relatively tough to achieve regulatory consensus. The most rewarding way to simplify cross-border innovation for financial services is via a bilateral basis between specific regulators.
The regulatory strategies toward DLT in the financial arena contrast pointedly concerning the authorities’ risk tolerance and effort.
- Wait and see approach – Herein regulators take a step back and allow nascent technologies to evolve naturally
- Test and learn strategy – It consists of private solutions devised through a conversation among the innovators and regulators
- Regulatory Sandboxes – This allows innovators to examine and test their products in a small-scale, live environment controlled by the authority. They are more transparent and standardized.
There are two kinds of regional sandboxes viz., private industry sandboxes to sharpen products and public regulatory sandboxes to test a regulatory framework.
Upcoming Drifts in Blockchain and Banking
In the future, regulators are likely to become more innovative in their approach to managing FinTech solutions. They are likely to form their own ‘consortia’ whenever the use case may be implemented. As of now, there are a few early-stage efforts to underline common notions for cross-border convergence in financial solutions.
1. Trade Finance
Since DLT offers remarkable speed, transparency, and freeing up of capital, trade finance becomes a particular area that is likely to experience blockchain integration in the next five years (approx.)
Some examples of the same include:
- We. Trade – a blockchain-based platform developed by nine banks in order to rationalize cross-border trades
- Marco Polo
Both We. Trade and Batavia were constructed on the Hyperledger Fabric platform whereas Marco Polo and Voltron use R3 Corda’s framework, and komgo. Both of them settled on Quorum. The drawback that can incur here is the resolution of both the parties (international trade and client) agree to use it. This does not happen in most cases. The other problem is the smaller parties being warded off by centralized international and scaled trades.
2. Security Insurance
Blockchains could power the insurance of primary security like corporate bonds. The immutable characteristics of blockchain transactions can assist to automate specific steps in the life-cycle of a bond via ore-determined smart contracts.
3. Asset Tokenization
The tokenization of securities will assist banks to minimize global trade costs. An economy built and based on tokenization has the potential to provide a more efficient system having less to nil friction in the creation, trading, buying, and selling of tokens.
Respondents and banks are realizing that DLT can help in clearing and settlement. In the cases where complex multiparty transactions occur frequently, a shared ledger could expedite the clearing and settlement of assets. Stock exchanges and financial bodies inhibiting regular, high-volume, mass exchange of securities and derivatives are examining blockchain for the settling process. Pioneers in this scope consist of Goldman Sachs (SETLcoin) and the Nasdaq stock exchange (Linq). Nevertheless, implementing DLT would permit continuous PvP and delivery vs payment settlement on a worldwide scale.
5. Know-Your-Customer (KYC)
Blockchain would enable greater transparency leading to efficient compliance with KYC obligations. A customary and global need is to verify a customer’s identity to prevent funding into criminal activities or to avoid the illicit flow of funds. KYC prevents this by checking across institutions and jurisdictions for duplication and other information. To help the process, blockchain can be appointed, since it has a unique digital identity for each participant on its network. It’ll lead to a smoother and streamlined authentication process.
Future Implementation and Limitations
Blockchain is still in its evolution phase, and since its beginning, it has experienced a notable jump in its features such as introducing smart contracts, scalability, and integration with other technology. Through this, it is estimated that blockchain’s capacity is likely to expand in the following years to come. The composite, encryption-based, and distributed attributes of blockchain can be very long to process relative to traditional payment and thus need more advances in engineering and processing speeds. Another challenge is scalability. For instance, public blockchains like Bitcoin have given priority to decentralization and security, rather than scalability.
Looking further, apart from implementation, adopting blockchain technology might have a low cost, but the operating cost can outweigh the former.
Working out and resolving these issues is a necessary step towards the sincere global embracing of DLT.
Regulatory and Governance Challenges
Regulatory strategies toward blockchain technology at both domestic and international level requires significant upgrades. One way to do it is the ‘productionalising’ of regulatory sandboxes for better performance. Second is the ‘medium-term improvement’, wherein once the innovations are given to production, it must be easier to move along to other parts of the value chain after the entry. Another area of improvement is developing global standards and clarity in key regulatory arenas. Getting all parties involved in the trade is also an important step. Being focused is essential for the consortium members as well. Collaborations are thus, indeed, needed along to reduce costs through private blockchains.
Blockchain presents the most promising cross-border payments, and efficiency gains and also mitigates pain points. Few considerations for huge global banks to employ DLT includes, understanding the specific use case, joining a consortium, appropriately implementing underlying technologies, gearing towards ‘co-opetition’ rather than competition, and meeting regulatory compliance.
Reference The role of blockchain in banking. (2020). Retrieved from omfif.org