The technology likely to have a significant impact on the financial services industry and the world of business has arrived. Not peer-to-peer lending, artificial intelligence, big data, robo-advisers or Apple Pay – but rather blockchain, the technology behind digital currencies such as bitcoin. Blockchain technology represents nothing less than the second generation of the Internet and will spark a series of profound changes to virtually every corporation and institution in the world, from banks to insurers, manufacturers and retailers, even governments.
Because the first generation of the Internet was built for moving and storing information, not value, it has done little to change how we do business or access financial services. When you send someone information, such as an email, you’re really sending a copy, not the original. When it comes to most forms of information, that’s sufficient. In fact, it’s one of the biggest advantages of the internet – ie that we have a publishing platform for information. However, when it comes to moving, storing and managing value, being able to copy an asset is a bad idea. After all, it’s acceptable to have a printing press for information – but not for money.
The role of intermediaries
We rely on powerful intermediaries, such as banks, to establish trust, verify identity of parties to a transaction, and perform the critical business logic of commerce, from clearing and settling to record keeping. Financial intermediaries do a good job, but with some limitations. They use centralised servers, which can be hacked. They add cost, time and friction to transactions and business. When was the last time you sent a cross-border email? The very idea is absurd, yet fees for cross-border remittance payments can run as high as 10-20% and can take days to clear and settle.
Intermediaries also capture our data, preventing businesses and individuals from using that data to manage their affairs. They can potentially compromise privacy, expose sensitive information and undermine trust in corporations. Moreover, they run on outdated technology and many of the regulations are just as antiquated. These intermediaries also exclude two billion unbanked people who can’t prove identity or don’t have enough money to justify a bank account. In sum, intermediaries capture a lopsided share of the benefits of the digital economy, just as they did in the pre-digital economy.
Blockchain’s promise: moving, storing and managing value
Enter blockchain, a vast, global and distributed ledger running on millions of devices and open to anyone, where not just information but anything of value – money, equities, bonds and other financial assets, titles, deeds, music, art, scientific discoveries, intellectual property, even votes – can be moved and stored securely and privately, and where trust is established not by powerful intermediaries, but through mass collaboration and clever code.
If the Internet was the first native digital format for information, then blockchain is the first native digital format for value – a new medium for money. It acts as a ledger of accounts, or a database, notary, sentry and clearing house, all by consensus. Though the technology is still nascent, it has sparked a Cambrian explosion of innovation in financial services. Consider smart contracts, essentially codes that mimic the logic of paper-based contracts with guaranteed execution, enforcement and payments – and where trust can be established by consensus and not by banks, escrow agents, lawyers and courts. Contracting is the foundation of the financial services industry. Every financial asset is, in a sense, a contract entitling the holder to some economic right, like a sliver of equity in a company or the series of cash flows from a bond. The same principle holds for many other kinds of assets and transactions, from insurance contracts to real estate purchases, initial public offerings (IPOs), and everything in between. The industry can harness this technology to make financial markets radically more efficient, secure, inclusive and transparent.
How Blockchain could impact financial intermediaries
Financial intermediaries perform ten essential functions in our global economy: authenticating identity and reputation, moving value, storing value, providing access to credit, exchanging value, funding and investing, insurance, risk management, audit and tax and of course, central banking- from monetary policy to regulations. Each can be transformed through blockchain.
1. Authentication of identity and reputation: Today we rely on rating agencies, financial data analytics firms, retail and wholesale banks to establish trust, verify identity in a transaction, and decide who merits access to the system. In contrast, reputation accrues on the blockchain itself. On blockchain, you are your credit score. Blockchain technology lowers and sometimes eliminates the need for trust altogether in certain transactions.
2. Payment system: Payment card networks and money transfer services solve the double-spend problem, making sure that no dollar is spent twice as it moves from one person to another. The blockchain can do this by consensus for the movement of anything of value – currencies, stocks, bonds, and titles – of any size or distance, dramatically reducing friction and democratising economic growth and prosperity.
3. Savings: Retail and investment banks, brokerage houses, and asset management firms are the repositories of value. The average person uses a safety deposit box or a savings or checking account. Large institutions use so-called risk-free investments, such as money market funds or Treasury bills (T-bills). The blockchain technology is designed to replicate all these instruments peer to peer.
4. Loans: Retail, commercial, and mercantile banks, along with credit scoring and rating firms, facilitate the issuance of credit card debt, mortgages, corporate and municipal bonds, T-bills, and asset-backed securities. On the blockchain, anyone could check credit worthiness before issuing, trading, and settling traditional debt instruments directly, thereby reducing friction and increasing transparency. Individuals as well as businesses will use rich data about themselves – verified by the blockchain – to attest to their creditworthiness. This is not just big data, but bigger, better and smaller data, with informed consent. The unbanked and entrepreneurs everywhere could access loans from peers.
5. Exchanges: Trading is the exchange of financial instruments for the purpose of investing, speculating, hedging, and arbitraging. It includes post-trade clearing and settling. Blockchain cuts settlement times on transactions from days or weeks to minutes or seconds. This will reduce settlement, counterparty and systemic risk. Moreover, this efficiency creates opportunities for the unbanked to participate in wealth creation.
6. Venture capital and investment: Investing in an asset or enterprise gives individuals the opportunity to earn a return, be it capital appreciation, dividends, interest, or rent. Raising money normally requires investment bankers, venture capitalists, and lawyers to name a few. Blockchain makes raising money peer-to-peer through global distributed IPOs easier. Ethereum, the public blockchain, built around smart-contracting technology, raised USD 18 million in the first ever ‘blockchain IPO’ and is now worth over USD 1 billion. It is used by dozens of fortune 500 companies. The Distributed Autonomous Organization, or DAO, made an even bigger splash, raising USD 165 million in a distributed peer-to-peer global crowdsale in the summer of 2016. By automating the match-making and scaling fundraising globally, it enables more efficient, transparent, and secure models for peer-to-peer financing, and eventually the recording of dividends, and the payment of coupons.
7. Risk Management: Risk managers attempt to protect individuals and companies from uncertain loss or catastrophes not just through insurance but through myriad derivatives meant to hedge against unpredictable or uncontrollable events. With digital derivatives trading on a blockchain, counterparties and other stakeholders such as regulators will have a much clearer picture of risk being concentrated in the system.
8. Accounting: Accounting is the systematic recording and reporting of financial transactions. It is a multibillion-dollar industry controlled by four massive audit firms. Yet traditional accounting practices are not keeping pace with the velocity and complexity of modern finance. The blockchain’s distributed ledger is designed to make auditing transparent and in real time and enable regulators to more easily scrutinise financial actions within a corporation.
9. Central Banking
Consider the roles of Central banks: First, they manage monetary policy by setting interest rates and controlling the money supply. Second, they attempt to maintain financial stability by injecting capital into the system and acting as the lender of last resort. Finally, they help to regulate and monitor the system, particularly consumer savings and loans. For each of these critical functions, blockchain could be a game-changer. Killing cash would reduce crime, because digital money is more traceable and harder to forge than printed versions. Financial regulators would now have a window into the inner workings of the world’s largest financial intermediaries, from banks to accountancies. Imagine a fully-digital fiat currency, running on a blockchain, enabling central bankers to manage monetary policy and monitor risk in the financial system. The upside would be commerce with less fraud, friction, and leakage.
The expected impact on insurance
The applications for the insurance industry are significant and throw into stark relief both the promise and peril blockchain poses to incumbents. Consider the possible benefits: Equipped with vast troves of cryptographically secure and authentic data, insurers can make far more accurate actuarial calculations about policyholders. In the healthcare industry, where data liquidity concerns continue to hinder business logic (for insurers but also providers, patients and doctors), this could be a boon to the industry. Reconciling databases between insurers, reinsurers and other industry participants will become faster and more accurate. Smart contracts will not only enable frictionless payments between parties, cutting down on tedious paper-based work and thus cutting cost, they will also enable insurers to program parameters into specific policies, making them truly “smart policies”: if two parties are in an accident and both have insurance on the blockchain, Internet of Things (IoT) sensors on each car can calculate the required payment and execute it peer-to-peer. Or, policies for floods or earthquake could be tied programmatically to rising water levels or the Richter Scale, triggering at pre-defined levels based on a trusted third party measurement from the NOAA, for example.
However, with great opportunity comes great risk. Blockchain also catalyses cooperative models for organising capability—ie autonomous associations formed and controlled by people who collaborate to meet common needs. Groups of individuals, small businesses and corporations can translate their willingness to cooperate into reliable accounting for risk, assets, skills, and work product that displaces platforms like Uber, Airbnb, and TaskRabbit, but that could also challenge traditional models of insurance. Individuals could self-organise to provide capital and begin writing policies through self-executing smart contracts. Because blockchain technology makes platform building cheaper and manageable, it provides a standard common database and standard common contracts, which increase data transparency and portability, reducing the need for traditional companies. However, incumbents can learn to love mass collaboration and open source. Indeed, just as IBM embraced Linux, insurers too can tap into self-organising networks to co-create or peer-produce value.
Today, virtually every major player in the financial services industry – from banks to insurers to audit and professional service firms – are investing significant resources into blockchain. By one estimate, nearly USD 1.4 billion has been invested in blockchain technology in 2016 alone. Whereas in years past, venture funding was coming from venture capitalists, today you’re as likely to see the likes of Goldman Sachs, Alibaba, Barclays, or Tencent in the mix. This also explains why more than 45 leading banks, including Credit Suisse, JP Morgan and UBS, have joined the R3CEV Consortium to develop blockchain infrastructure for banking and why IBM launched the Hyperledger project, counting Deutsche Bank, DTCC, the London Stock Exchange Group, Wells Fargo and State Street as members. Recently, Munich Re, Swiss Re, Aegon, Allianz and Zurich joined forces to launch the Blockchain Insurance Industry Initiative (B3i), the first of its kind in the industry. NASDAQ, NYSE, LSE and other exchanges are in the game as well.
It is clear that this rush of money into the ecosystem is driven as much by fear as greed. Blockchain may enable incumbents to do more with less, expand their services, reduce risk and cut costs. But it also radically lower barriers for new entrants to create alternatives to the conventional banking industry, challenging incumbents in virtually every market where they operate.
Blockchain is not an existential threat to the companies who embrace this new technology paradigm and disrupt from within. The question is, who in the financial services industry will lead this revolution in a positive way? Throughout history, leaders of old paradigms have had difficulty embracing new technologies. Why didn’t AT&T launch Skype, or Visa create PayPal? CNN could have built Twitter, as it is all about the sound bite, no? General Motors or Hertz could have launched Uber, and Marriott could have created Airbnb.
As with major paradigm shifts that preceded it, blockchain will create winners and losers. Though opportunities abound, the risks of disruption and dislocation must not be ignored. Still, we are hopeful today’s leaders will not become tomorrow’s losers because so much is at stake. The unstoppable force of blockchain technology is barrelling down on the infrastructure of modern finance. We would like the inevitable collision to transform the old money machine into a prosperity platform for all.