In this article, we will analyze which areas of financial institutions will be mainly impacted by blockchain technologies. We believe that in the near future, blockchain technology will have the same effects on our financial organization, than the internet did on the Information industry. It will totally reorganize it.
Decentralised Ledger Technologies have created the “internet of value” by enabling peer to peer, easy, immediate and almost free exchanges of value over the internet. This role was until now banks monopoly. We will analyze how this nascent technology will challenge banks on their field and give birth to formidable competitors. On the other side banks and financial institutions in general, have always been at the forefront of technologies evolution and it is also very interesting to describe how they are currently preparing for battle.
We will separate this study into two different articles. One dedicated to retail banks, i.e the banks that are dealing with our day to day operations (I) and the other to investment banks involved in capital markets and corporate banking (II).
I – THE IMPACT ON RETAIL BANKS
Banks as we know they are involved in very diversified activities. From money supply to real estate management, banks are present in every step of our economy. But it has not always been the case. At the beginning, banks were only storing gold on behalf of their customers for security reasons. In exchange, customers were receiving a receipt that was a proof of ownership for a given amount of gold. For obvious convenience reasons, these receipts were then progressively exchanged for goods and services because they were backed by gold. Fiat currencies were born.
But then, since peoples were only exchanging these receipts, banks realized that all the gold that was sleeping in their safes could be loaned and this is how began the history which evolved up to the exotics derivatives products that most of the population discovered in 2008.
This (very) brief history of banks reminds us that the core functions of a bank are to update a ledger in order to organize payments and incidentally to offer loans. And this is still the case today. When you buy something with your credit card, your bank updates its ledger by removing the spent amount from your account and adds it to the account of the seller (through the seller’s bank if needed). So your account is just a number on the ledger of the bank showing the amount that you have deposited and that the bank owes you. In the same way, when a bank grants you a loan, a line is created on the debit side of your account and diminished every time you make a repayment.
So in the current economic system, banks are playing the role of trusted intermediaries, because peoples are not able to exchange value with each other without these intermediaries. Will blockchain change this? After all, a blockchain is also a ledger, but the difference relies on the fact that no trusted intermediaries are needed since all the members of the network update it in a decentralized manner. In theory, the blockchain could connect each participant to an economic system so that they could interact with each other directly using a blockchain to record all transactions.
Banks are trusted intermediaries
According to a report issued by Credit Suisse, market leaders of the payment card industry such as Visa and MasterCard, are not directly concerned by the technological evolution based Decentralized Ledger Technologies because of the significant investments made in this area. The achievement of domestic payments (in the same country) is generally regarded as efficient and fast by the users due to the significant number of terminals of payments and points of cash withdrawals.
The crypto purist would say that it is not more difficult to pay by scanning a QR code or send coin from a Ledger Nano S. The only difference relies on the massive investments that have been raised to equip every single shop with card payment machines and replacing them with secured bitcoin payments terminals will take time.
Direct payment with bitcoins or any cryptocurrencies should not be mixed-up with crypto-cards such as the one proposed by Xapo, TenX, CryptoPay, Bitpay, Bitwala, and Wirex which are debit cards prepaid with cryptocurrencies. We cannot consider them as bitcoin/cryptocurrencies payments since Credit Card companies still control their right to issue debit cards.
However, there are still areas where the payment system as we know it is far from being efficient and where crypto payments will surely prove to be formidable competitors: internet payments (1), international transfers (2) and providing financial services to the unbanked (3).
1 – Internet payments
We generally forget that credit cards were created before internet appeared. So they have been tailored for physical payments and not internet payments. Credit cards present three main issues. First, they require high processing fees. This is the way credit cards operators are remunerated and these fees can be composed of a fixed rate (typically 0.30 euros) and of a variable. These fees are manageable for day to day transactions on e-commerce platforms but certainly not for the micropayment world we are entering where machines are completing billions of microtransactions with each other. Fraud is the second main weakness of credit cards payments. Despite all the efforts of banks and credit cards operators to protect these transactions, fraud resulted in losses amounting to $21billion in 2015. Last but not least, security is a major concern with credit card payments over the internet.
At the same time, Alfred Kelly, CEO of VISA the world largest credit card issuer, mentioned during an interview to CNBC, “I don’t view bitcoin as a payment system player”. In the current state of the Bitcoin protocol, he might be right. As we already mentioned in our article on the Internet of Things, Bitcoins are a very safe medium of value transfer over the internet, but it is also very limited, for several reasons:
- The Bitcoin protocol is slow: the Bitcoin protocol is programmed to add a block every 10 minutes. The difficulty of Proof of Work is indeed always adjusted to the number of miners acting on the network (i.e the amount of hashing power used on the network) so the time frame between two blocks will always be 10 minutes. It is also generally considered that 6 more blocks should be added to the blockchain for a transaction to be considered irrevocable. In practice, it means that we need to wait 60 minutes to confirm a transaction, which is far too long for commercial applications.
- Bitcoin does not scale: Due to the limited number of transactions that can be added to the blockchain, it is actually difficult to apply the blockchain to a network with an exponential increase where transactions made among members of the network (either physical persons or not) will also increase exponentially. The size of each blockchain blocks is 1MB and it is not sufficient to process all the transactions made on the bitcoin network. It is indeed considered that 250,000 transactions are permanently waiting to be processed.
- Bitcoins fees are very high: A direct consequence of the previous point is that at the moment, the demand for adding transactions to the blockchain is so important in comparison to the space available, that fees charged by minors to users can reach peaks of up to 25 dollars. Here again, these fees are not suitable for commercial uses of the bitcoin.
A way to solve these issue (temporarily), would be to extend the block size in order to procede more transactions at the same time and reduce the fees charged by minors. This was the purpose of the implementation of SEGWIT 2X. The cancellation of the SEGWIT fork clearly states that Bitcoin protocol developers have opted for another solution.
The Lightning Network (described in details in our article “Internet of Things: Blockchain, Lightning Network and Tangle“) seems to have been chosen as an alternative because it proposes a very promising architecture. It allows the creation of off-chain channels in which users can realize as many transactions as they want without having to add them to the blockchain every time but still benefiting from the security of a decentralized ledger network. In other words, transactions are instantly confirmed and fees are spread among all transactions of the channel when this one is closed and the last transaction (the result of the netting of what parties owe each other) is added to the blockchain.
The only problem this that channels are only set between two persons. In order to reach a person with which you do not share a channel, you will have to use intermediaries nodes or “hubs”. However, these nodes and hubs might be considered by regulators as “money transmitters” and be subject to heavy requirements such as minimum capitalization, Know you consumers (KYC checks) (…) which cannot be completed by any given person.
“FinCEN’s regulations define the term “money transmitter” as a person that provides money transmission services, or any other person engaged in the transfer of funds. The term “money transmission services” means “the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.””
This is where banks and major corporations such as credit card companies, might come into play and start managing the bitcoin network, but only the future will confirm this scenario. This video sums-up the issue pretty well:
Tangle, an alternative to Lightning Network
Tangle is the second example of innovation that could dramatically increase the speed and security of payments online. This a new type of network based on a DAG (Directed Acyclic Graph) which has been designed with the Internet of Things in mind. Tangle is no longer really a blockchain properly speaking since there is no longer a “block” or a “chain”. Tangle is actually a second generation blockchain that does not rely on an architecture of blocks connected to each other by cryptographic hashes, but retains some of the fundamentals of the current blockchain:
– A peer-to-peer network
– A decentralized database
– A consensus mechanism to validate transactions
The transactions are directly stored in the DAG which means that every single node is a miner and there are no fees. For these reasons, systems based on Tangle should scale very well, be very fast and cheap.
The system of value transfer on the Internet is 20 years late in comparison to the information systems. The system of international payments is currently very similar to what was the system of communication by e-mail in the 80s: a closed and compartmentalized system. If you were a user of the Genie messaging system, you could only send e-mails to users of GEnie, but not to users of CompuServe or AOL. SMTP is the protocol that linked all these independent networks and quickly became the reference protocol.
The consequences of these divisions are multiple. The international payments generally take more than a day, can be achieved only during the opening hours of banking agencies and generate significant costs. The reason is that before reaching its destination your funds will likely transit through several banks that have their own processes and systems.
All these steps significantly increase the work of cross-checking data which increase the duration of the transfer, costs and the risk of mistakes.
The remarks of Chris Larsen, Chairman, and co-founder of ripple, required during a session of Q&A on Quora on 1 December 2016, summarize the situation very well: “Global transactional demands are changing, and the current financial system is woefully inadequate to meet tomorrow’s payment needs and opportunities. This is especially true with regards to low-value payments, which are unprofitable for banks and too costly for customers. Companies of all sizes are increasingly global from day one and need to provide on-demand delivery of services. From the Fortune 500 to the tech industry and beyond, we call these the “new corporates,” and includes companies like Uber, which needs to pay its drivers in over 70 countries, and Amazon, which ships around 1 billion items behalf of merchants in 100+ countries to customers in 185 countries. New corporates want their bank to enable them to send low-value payments instantly and with full transaction visibility. Banks of all sizes want to serve these customers and offer new products like micro-payments to businesses as well as consumers for retail remittances.”
We mentioned earlier that credit card companies might not be impacted by the development of cryptocurrencies in the short to middle term, but it might go differently for the companies organizing international transfers of funds, such as SWIFT or Western Union. The services proposed by these companies are slow, expensive and generally relying on outdated technological systems. As we have already mentioned, it is possible today thanks to blockchain technology to transfer large sums to the other end of the world, instantly and for a ridiculous price. The World Economic Forum goes further and says that the power is disturbing for DLT comes from the simple fact that “The technology is available and this fact makes it superfluous the banks, providers of payments and the credit card companies”.
Ripple: banks answer to the threat
Ripple is an Internet protocol which purpose is to facilitate funds supply among its members (a growing community only composed of banks and corporations). In the same way as Simple Mail Transfer Protocol (SMTP) has defined the rules organizing e-mails exchanges, RTXP (ripple Transaction Protocol) defined a set of rules to perform transactions on the Internet instantly and free of charge, in any currency, cryptocurrency, material (gold for example) or any other unity of value.
Ripple’s goal is to link all the existent and incompatible banking systems in order to make international funds transfers among institutions immediate and almost free. For more information on Ripple’s functioning you can read our article “Ripple: the protocol that connects banks”
PROVIDING FINANCIAL SERVICES TO THE UNBANKED
Decentralized Ledger Technologies will give the opportunity to the person who cannot open a bank account, to have access to banking services from their smartphone. According to a report issued by McKinsey, nearly 2.5 billion adults (almost half of the world adult population) have no access to banking services for borrow, store or transfer money.
However, a significant part of these adults is now equipped with a smartphone that could grant them direct access to microcredit or receive payments from relatives working abroad without using expensive intermediaries. According to the Overseas Development Institute (ODI), “these excessive fees cost the African continent $1.8 billion per year, enough money to pay for education in the primary school of 14 million children in this region. It is because the workers paid on average 12% in fees for transferring money to their relatives based in sub-Saharan Africa. To give you an idea, a worker sending $200 for the education of his family would bear a $25 fee.”
BitPesa is a start-up based in Kenya that provides services of payments by allowing its users to exchange bitcoins for Kenyan shillings and send them directly to their mobile phone portfolios.
Having a portfolio on his mobile phone and use it to make payments is more and more common in Africa and this service existed in Kenya before the arrival of BitPesa. Safaricom holds M-Pesa, the undisputed leader of the transfers and payments by mobile phone (a tier of the GDP of the country would go through its system). BitPesa initially relied on Safaricom networks to ensure its development.
But in offering the same service than M-Pesa at a much lower cost, BitPesa was actually in direct competition with Safaricom and the latter decided to terminate its contract and therefore become unable to propose its services on the African continent.
A new agreement with Airtel money has subsequently helped BitPesa to return and to ensure a high growth in the last two years.
We also wanted to mention Abra, a start-up founded in 2014 and which object is to organize free and instant international currency transfers. This application also uses the Bitcoin protocol to achieve the transfers, but the difference with Bitpesa is that users do not buy the bitcoins themselves. As the said Bill Barhydt, the founder and CEO of Abra, during the conference “American Banker’s Blockchain and digital currencies” in July 2016, “Users do not even realize that they have a bitcoin portfolio. From their point of view, they hold the local money“. This application is interesting because it proposes to manage the important risk of volatility of the bitcoin.
According to Bill Barhydt, putting in place smart contracts with institutional bitcoin investors who constantly hold significant quantities of bitcoin carries out the stability of portfolios. These contracts operate a little as “Contracts for Difference” (“CFD”), i.e a contract by which the parties agree on the value of a property in the future (here the bitcoin) and conduct of bilateral payments according to that the fluctuation of this value at the end of the contract.
We can imagine that Abra manages to balance its portfolios by performing a combination of opposite CFD so that the gains generated by a contract would compensate for the loss of the other contract.
Stellar proposes a framework of payment based on a decentralized ledger which operates in the same way that the system developed by Ripple. The founders of stellar, Jed McCaleb (also creator of the famous MtGox) and Joyce Kim, were also among the founders of Ripple before leaving the project to create Stellar. The idea of the founders of stellar is to offer to people who do not have access to banking services, mainly the inhabitants of developing countries, payments facility from their mobile phones as well as solutions of immediate and almost free international transfers.
Concretely, Stellar provides the platform to develop applications from its API (“Horizon”) and to interact with the entire network by the intermediary of “stellar core” whose function is to validate the transactions through the system of consensus that we have described above. Once connected to the network, so it is easy, immediate and almost free to exchange any value from one end of the planet to the other.
LOAN GRANTED BY THE NETWORK AND STORED ON THE BLOCKCHAIN
Fintech start-ups relying on blockchain technology are also very active in the loan industry. Two players could be mentioned as the solution they propose are really promising: SALT and Jibrel Network.
Both startups use the same mechanism. Users will record some of their assets on the blockchain as collateral of the loan they will receive from other users of the network. For each assets registered, a token is issued and transferred to the lender until he received the full repayment of his loan. During the life of the loan lenders are allowed to exchange these tokens and obtain interests.
The loan granted by these cryptolenders are very flexible because no pre-payments are requested from borrowers, interests are mutually agreed and the credit checks are replaced with cryptocurrencies and real assets collateral.
We could obviously question the legal validity of the assets recording and their acceleration by the lender if the borrower does not repay the full amount, but when you see that French regulator recently recognized the legal value of titles recorded on a blockchain, you can really feel the wind of change.
Even if the technology is still at a very early stage, it is obvious that the trend is here to stay and change the financial industry as Internet did to the information industry. Bank a fully aware of this threat and are almost all financing fintech startups incubator to remain on top of this disruptive technology.
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