Commentary

The whys and hows of banks and the blockchain

The blockchain technology at the heart of the cryptocurrency bitcoin has opened up a number of possibilities for the banking industry. Here's what's in it for financial institutions.

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April 10, 2017

by Natallia Babrovich

Soon after the mysterious Satoshi Nakamoto released Bitcoin: A Peer-to-Peer Electronic Cash System, the term bitcoin became a buzzword making the headlines.

While some bitcoin evangelists argue that it could substitute for financial institutions and allow people to manage their own money with no intermediary, others are not so fascinated and point to the weak points of bitcoin: volatility; price fluctuations; and links with dubious trade activities from anonymous accounts.

Yet despite the criticism, bitcoin has long been under banks' scrutiny and, as it turned out, for good reason. The blockchain technology at the heart of bitcoin opened up a number of possibilities for the whole industry. Let's see what's in there for banks and financial companies.

Top 3 banking challenges

After the well-known fraud of Lehman Brothers with repo transactions, policymakers enacted structural reforms to the U.S. financial system. Regulations as such Basel III and the Dodd-Frank Act significantly increased compliance costs for banks.
The existing cross-border payments system is rather outdated. Most personal and business transactions still happen via bilateral correspondent banking relationships, which is often time-consuming and costly (especially for banks that have no direct relationship with each other). Additionally, using the centralized SWIFT messaging protocol is rather insecure, since the system is not always resistant to hacker attacks. For example, in 2016, the Bangladesh Central Bank lost more than $81 million due to unauthorized transactions routed through the New York Federal Reserve Bank using the SWIFT network.
Numerous cases of so-called "naked short selling" (when an individual short-sells a tradable asset without first borrowing the security or ensuring that the security can be borrowed) led to the problem of double-spending. Though this practice is illegal, , cases of naked short selling still occur due to various loopholes and discrepancies between paper and electronic trading systems.

Searching for a way to solve all these challenges, banks have pinned their hopes on blockchain with its concept of a distributed ledger.

Why blockchain?

Blockchain is not a totally ground-breaking technology, since it combines numerous already existing concepts, such as distributed systems, peer-to-peer networks, asynchronous cryptography and cryptographic signatures.

What makes blockchain unique is its ability to transfer value and verify ownership at any given time.

Using a chained encryption scheme, the system allows all data to be kept in chronological order, which makes it simple to trace any changes made to the ledger and eliminates tampering.

Robert Palatnick, DTCC Managing Director of IT Architecture, highlighted the blockchain potential by aptly calling it "a single indisputable version of the truth."

How banks are unfolding blockchain

Banks looking to retain their competitive edge in the face of fintech innovation went for partnerships with startups, creating proofs of concepts and pilot programs around blockchain. Here are a few examples ...

The Global Payments Steering Group

A group of major banks including Bank of America, Merrill Lynch, Santander, UniCredit, Standard Chartered, Westpac Banking Corp., and Royal Bank of Canada created the Global Payments Steering Group using Ripple's distributed financial technology.

These institutions are working together to address the need for faster cross-border payments while reducing payment costs. The shared goal of GPSG is to establish a common set of standards and protocols to securely manage high-speed money transfers across borders using blockchain.

R3 CEV consortium

R3 CEV also leads a consortium of about 70 of the world's largest financial institutions. Their blockchain-inspired Corda platform is primarily oriented on working with "smart contracts."

Though Corda inherited some principal characteristics of blockchain (for example, the concept of a distributed ledger or consensus mechanisms), it is not a "pure" blockchain platform.

R3 has said that Corda is being adopted specifically for the needs of the banking and financial industry. For example, the Corda platform ensures the privacy of transactions and commercial information by limiting the unnecessary global sharing of data. This feature can be valuable for letter-of-credit transactions or factoring, where only contracting parties will have access to common data.

DTCC distributed ledger

Another initiative came from the Depository Trust & Clearing Corp., which decided to test the effectiveness of distributed ledger technology on the credit derivatives market. On Jan. 9, the corporation announced that it had selected IBM, Axoni and R3 to work on the DTCC Trade Information Warehouse, building a distributed ledger solution for post-trade processing.

The project is being developed in collaboration with major banks including JPMorgan Chase, UBS, Wells Fargo, Barclays, Citigroup and others. After the project goes live, it can be connected to the Hyperledger, which will operate on a global scale.

Blockchain is a contender

Alex Tapscott, founder and CEO of Northwest Passage Ventures and co-author of Blockchain Revolution, named blockchain the second generation of the internet. Nevertheless, banks should not consider blockchain a panacea that will ease all of their pains. After all, the technology is very young and banks still have a lot of work ahead to discover and effectively implement all the possibilities of blockchain.

Natallia Babrovich is a business analyst at ScienceSoft (www.scnsoft.com), a software development and consulting company headquartered in McKinney, Texas.