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Banking unchained: The blockchain reaction

9 Feb 2016
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Imagine a system in which traditionally lengthy transactions are processed and cleared within minutes instead of days, on both sides of the ledger, regardless of geography. Going even further, imagine that this can be done in the absence of authorisation from a central authority, without legacy infrastructural issues where the transactions are automatically secured via a digital signature that can be traced from execution. Well, that’s blockchain technology / the blockchain.

Banks believe that blockchain technology could potentially save them billions in unnecessary costs. According to recent research by Santander InnoVentures, blockchain technology could reduce banks’ infrastructural costs by $15-20bn a year.

The industry is particularly enamoured by the promise of blockchain technology processing transactions at near-instantaneous speed and in a more secure fashion.

It solves the problems that banks experience with the existing infrastructure, a system that is more and more prone to data breaches.

While the speed of processing a transaction is key to banking, it is of paramount importance that any proposed change to existing banking infrastructure takes security into account. Blockchain addresses both of the requirements of speed and security. The banking industry believes that the blockchain can help it transition from the existing journey of ‘payment request > authentication > authorisation > confirmation response > settlement’ process to one that could end up saving them billions of dollars in revenue, that’s billions every year, bypassing slow and expensive payment networks.

Think about this, if you make a payment, particularly a cross-border one, it still takes days to clear, if you purchase shares it takes the best part of a week for the exchange of shares to finalise. This time all accumulates for the financial services industry. It adds up in terms of operating the IT infrastructure supporting this system of checks and balances, and in supervising this system with the qualified resources. But if the blockchain can address the issue of speed in a way that does not compromise security, it could save banks the billions they anticipate.

Now, imagine a system in which these transfers are processed and cleared within minutes, not days, on both sides of the ledger and in multiple locations without the need for authorization from a central authority; no legacy infrastructural issues, and the transactions are automatically secured via a digital signature that can be traced from day one. Well, that’s the blockchain.

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First, a blockchain 101

The blockchain is a permissionless distributed ledger that records every transaction on a network. The transactions are verified and validated by every user, or nodes, of the network. Each block is also digitally signed by a signature number making it virtually tamper-proof. This process of verification and validation removes the need for a central authority, such as a clearing house or central bank, to authorise transactions.

Dr Catherine Mulligan, of the Imperial College London, speaking in a UK Government Office for Science YouTube video provides more context as to why blockchain technology is so interesting, “Blockchain is a new way to store and record transactions. It is very much like a traditional database but the blocks are linked together cryptographically in order to make sure that they are tamper-proof.”

The blocks are interlinked, or chained, via a digital signature. The blockchain contains data that can, for example, contain proof of a financial transaction. It is this ability to verify and validate a transaction that has banks all a fluster. The blockchain provides an audit trail of every transaction that will ever happen. It is a glimpse into the future for the banking industry, but plans for the blockchain in banking circles are already well advanced.

Cheaper and faster transactions

The banking industry believes that the blockchain will allow banks to process payments faster and more economically.

In a recent Fintech 2.0 paper Santander cited the introduction of a distributed ledger technology, like blockchain, as having the potential to result in substantial savings. “Our analysis suggests that distributed ledger technology could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15-20 billion per annum by 2022.”

The blockchain potentially offers the financial services industry an opportunity to:

  • Overhaul banking infrastructure with supervision and IT infrastructure no longer required.
  • Execute speedier settlements, becoming almost instantaneous.
  • Streamline stock exchanges.

The banking industry, however, differs from the creators of Bitcoin in that it does not want an open-source, decentralised system with no points of control. Their idea is a private blockchain that includes permissions rather than a permissionless system. This has, obviously, caused controversy with the banking industry plan going against the whole ethos of Nakamoto’s original idea of a decentralised virtual currency.

In his April 2015 paper Consensus-as-a-service: a brief report on the emergence of permissioned, distributed ledger systems, Tim Swanson – research fellow at Singapore Management University – explains how the permissioned system could work but also how the system cannot be altered to suit one’s own needs:

“But if a company or organisation can effectively approve or deny nodes, can’t they also control consensus?” asks Swanson. “It is true that an authenticated validator set-up can deny any transactions that it disagrees with. That is an implication of the thesis that blockchains can either minimize censorship or reversal, but not both. What is untrue is that the authenticator (let’s call him “the witness”) thereby controls the consensus and can arbitrarily change the rules in its favor.”

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So, what is the banking industry’s endgame?

In September 2015 it was announced that nine of the world’s largest investment banks (Goldman Sachs, JPMorgan, Credit Suisse, Barclays, Commonwealth Bank of Australia, State Street, RBS, BBVA and UBS) have already set in motion a plan to standardise blockchain technology. This band of nine was seeking this blockchain standard via a start-up called R3CEV. The number of banks involved in R3CEV has since swelled to 42.

“If you’re looking to introduce applications with distributed ledger technologies to improve the financial markets, you can’t have each participant working to a different pattern,” said Christopher Murphy, global co-head of FX, rates and credit at UBS. “What R3 are doing is bringing a consensus which could establish common standards.”

This testing was ramped up in mid-January when R3CEV revealed that 11 banks had completed a ‘modest’ blockchain test between January 11-15. According to one of the participants the test proved that in a private, controlled environment, the banks can collaborate.

The R3 blog also revealed that the test involved the transfer of tokens passed between nodes set up by the participating banks and R3. Murphy added “The test returned with no problems. The data about the tokens was intact and the validity of each transaction verified ‘instantaneously’ by all nodes.”

Of course, the issue of trust between banks – who in many cases do not want to share information with counterparts – remains a major issue. This is why recent experiments or tests have to be taken as just that: the industry is still in the experimentation phase with blockchain.

Many banks are also performing experiments unilaterally. Take Bank of America, for example,

Catherine Bessant, Bank of America’s Chief Operations and Technology Officer, in an interview with CNBC at Davos 2016 enthused about blockchain technology: “As a technologist, the technology is fascinating. We have tried to stay on the forefront. I think we have somewhere around 15 patents, most people would be surprised at Bank of America with patents in the blockchain, or cryptocurrency, space.”

By December 2015 Bank of America had filed ten patents related to cryptocurrencies and blockchain technology. The NASDAQ is already using blockchain technology to track the changing value of private companies before they go public on its exchange. Another use is secure messaging and payments with Facebook, Snapchat, and Twitter all using various forms of blockchain technology.

The endgame? Blockchain technology promises so much. It is new, therefore comes without legacy issues creating implementation difficulties in trying to shoehorn it into the existing banking infrastructure. It is secure, digital signatures attached to every transaction, and it has the potential to save the banking industry quite a lot of money when they can significantly reduce the lag in a payment finalising transaction.

Why wouldn’t the banking industry experiment, given these potential results?…

Fexco Transaction Services in association with Business Information Systems at Cork University Business School have partnered to develop the Payments Innovation challenge, which this year will focus on blockchain. Entrants have been invited to submit ideas that focus on the potential disruptive role of blockchain in financial services and retail. We look forward to sharing their submissions in the coming weeks and months.

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