The world of banking as we know for many years is in a fundamental transformation process, triggered by new technologies. The most important is blockchain that is said to fundamentally change the way financial transactions are handled today. It is forecasted that this technology will have significant consequences on how traditional banks do business in the future, enabling new business models, deliver new value propositions and solve longstanding challenges, with the well-needed transparency and security in transactions that nowadays involve multiple parties and large amounts of data.
Though this technology is currently still at a nascent stage, blockchain is proclaimed to be a game-changing, disruptive innovation that holds the capability of completely shaking up the landscape of banking in the coming years. Others even proclaim that blockchain will make banks (entirely) obsolete.
Questions that arise are: how will blockchain technology drive disruption in the banking industry, what are the main areas that will be touched, and how will the banking ecosystem look like in say five to ten years from now.
But what is disruption (not!)?
But before answering these questions, it is important to agree what disruption really means. Since the word disruption was launched in the nineties this term has been used for so many things that it has lost their original meaning. Everything that is ‘new’ is described as disruptive and/or innovative.
It was the US professor Clayton Christensen who introduced the idea of disruptive innovation in 1997. According to him disruption means “any innovation that transforms a complicated, expensive product into one that is easier to use or is more affordable than the one most readily available”.
Disruption has three components: responding to competitors effectively; identifying new growth opportunities; and, improving understanding of what customers want.
“A disruptive business is likely to start by either satisfying the less-demanding customers or creating a market when none existed before. So, when mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred”. Clayton Christensen
It is however very difficult to know in advance what real disruptors are. The process is often very long. It could take years before the true effects of disruption are presenting themselves in the market.
Though the classic examples of disruption involved technological advancements, disruption is not all about technology. Not every successful business or product needs to disrupt. But disruption is any time organizations find a more efficient, better way of doing things that attracts customers.
What makes blockchain (so) disruptive for banks?
What makes blockchain so disruptive for the banking industry? Why is this technology forecasted to revolutionising the way banks are nowadays doing business? The answer to this question lies in the three specific in-build properties of a blockchain: Decentralized, distributed and Immutability. These differ completely from those of banks that are centralised organisations.
Blockchain operates on a decentralized network, that is acting on a peer-to-peer basis. It handles all operations similar to a bank, but without any central authority that monitors all data. So it potentially cuts out the middleman, giving back the power to the owner of the assets (i.e. data or tokens carrying some financial value).
All information is stored across its network via blocks. These blocks, that are time-stamped and linked together with all past and current transactions, are permanently recorded and consistently reconciled and updated in a cryptographically secure way. By storing data across its network, blockchain eliminates the risks that come with data being held centrally.
A second property of blockchain is the distributed ledger, that allows sharing of a ledger of activity – such as arbitrary data or virtually anything of value between multiple parties. What makes blockchain so important is its ability to automate trust and transparency among all parties using it. Because the ledger is distributed among all transaction participants, it exists simultaneously in multiple places. Each of the computers in the distributed network maintains a copy of the ledger to ensure transparency and also prevent a single point of failure and all copies are updated and validated simultaneously. This makes it extremely difficult to manipulate entries or tamper with the data without the other parties noticing.
A third unique property is its immutability. By design, blockchains are inherently resistant to modification of data. All blockchain networks adhere to a certain protocol for validating new blocks. No changes can be made once the system is set with the initial standards. Once recorded, the data in any given block cannot be altered without the alteration of all the subsequent blocks, which requires the consensus of the network majority.
Where will blockchain be most disruptive for banks?
But where will the disruptive impact of blockchain be the most outspoken? Though blockchain is said to have impact on virtually every aspect of the financial system, most disruptive use cases can be found in activities such as cross border payments and remittances, share trading, clearing and settlement, trade finance and supply chain finance, regulatory reporting and compliance, as well as smart contracts. It is however clear that when the technology further evolves there will be many more areas for applying the blockchain technologies emerging.
Let us take a look at the current use cases of blockchain technology in the financial services and what changes they will bring about.
Cross border payments
It is not surprising that payments is emerging as the first and foremost blockchain use case of any banking and/or financial system. Nowadays payments across borders is a time-consuming and expensive process, given the need of correspondent banks or other intermediaries. .
Blockchain offers an easy and secure solution, as it will not require third party authorization. . By cutting out many of the traditional middlemen, the laborious and costly process of cross border payments is simplified, thus significantly speeding up the cross-border payment process and that at a cost much less than with the traditional banking systems.
Using blockchain for buying and selling stocks and shares could also bring a number of significant benefits. Share trading involves many third parties, such as brokers, CCPs, CSDs and exchanges, making this process time consuming.
The decentralised nature of blockchain technology can remove all those intermediaries and enable trading to be run on computers all over the world. Eliminating some of the middlemen from the share trading process speeds up the settlement process and allows for greater trade accuracy. Trading transactions in blockchain thereby reduces the redundancy of information and thus improves performance.
Clearing and settlement
The global cash settlement for fixed income, equity, and derivative products in various currencies is slow, costly, and complicated. Because of the large number of parties involved, It takes several days to settle.
By eliminating a large number of intermediaries, blockchain enables instantaneous settlement leading to substantial lower costs.
Many trade finance activities still involve lots of paperwork, such as bills of lading, invoices, letters of credit etc. All participants in the trade chain must maintain their own database for all transaction-related documents, that must be constantly reconciled against each other. It is as a result a time-consuming activity.
Blockchain-based trade finance can streamline the entire trading processes by getting rid of this time-consuming paperwork and bureaucracy. It eliminates the need for several copies of the same document and can integrate all necessary information in one digital document, which is updated in real time and can be accessed by all network members.
Syndicated lending is also a financial activity where blockchain could be a game-changer. Due to several participants involved, traditional processing of such syndicated loans by banks can take up many days. This given the need to meet the challenges for KYC and AML requirements.
Blockchain can improve this process and make it more transparent. Use of smart contracts for syndicated loans processing can bring the syndicate members a range of advantages. Each participating bank can benefit by exchanging the information through blockchain. This lowers the cost of meeting regulatory requirements for syndicated lending and significantly saves time.
Digital Identity Verification
Another area where customer experience could be significantly improved when using blockchain is in the digital identity verification process. Online financial transactions require a lot of steps to be taken, including face-to-face checking, authentication, authorisation etc. All of these steps need to be taken for each new service provider.
Blockchain makes it possible to securely re-use the identity verification for other services. With blockchain users can choose how they identify themselves and with whom they agree to share their identity. They still need to register their identity on the blockchain, but they do not need to repeat the registration for each service provider if those providers are also powered by blockchain.
Accounting Data Reconciliation
Some financial institutions have outdated, and thus inefficient databases and reporting systems. Distributed ledger technology is set to revolutionize the way financial data is recorded and exchanged within the bank as well as between banks or between banks and corporates. The idea of a semi-manual data reconciliation should become obsolete when blockchain becomes interwoven into banks’ daily operations. This is because blockchains act as a database that is secure and immutable.
Smart contracts are another way to fundamentally change the way business is done nowadays. The functions of a bank such as lending, deposits, treasury, investment advice, business intelligence, regulatory compliance, payments, and remittances will be disrupted by using these contracts.
Through the use of smart contracts, blockchain technology will change the way information and money is exchanged in finance (and in many other industries). Smart contracts enable operating and automating business processes in a fully decentralized fashion, enabling shared rules of engagement, conduct, and business processes to be automated and enforced ecosystem-wide.
Future banking eco-system
The future banking eco-system will look very different from now. Triggered by blockchain technology and its disruptive character, this eco-system will be one of open innovation, collaboration, bank-fintech partnerships and increased competition. While there will be much lesser need of middlemen, there will be a growing need to cooperate between banks and other parties in order to get the most advantage from this and new technologies. On the other hand, there will be more intensive competition from new-comers (at least in the short term).
The blockchain-based bank eco system will be one of intensive collaboration, within an increasingly open banking environment, not only with other banks but also with various third parties in the financial chain. Whether the third party is a payment processor, fintech start up or creative app developer.
Future success will depend on their willingness to co-operate – even with the apparent challengers to their core activities. Banks don’t really have a choice in this – not if they want to survive and prosper. Although it might seem counterintuitive to banks to facilitate new services beyond their immediate control and balance sheets, standing in the way of external creativity and innovation carries the greater risk.
For large financial institutions, open innovation means engaging with “knowledge capital and assets”, opening the organizations’ IP (intellectual property), and organisational transformation to the digital era.
Prompted by open banking, the big established banks may unlock new waves of fintech innovation by allowing a diverse range of external parties to connect securely with their core banking mechanisms. These partnership will be shaped like global networks to enable seamless transactions and get the most out of the use of blockchain.
“Open banking promises to transform financial services – but only if banks drive the changes by making it easier for third parties to connect with their systems.” Marten Nelson of Token
Even as the disruptions continue, the ecosystem will see deeper collaboration between financial institutions and fintech firms and the creation of platform companies to meet the changing needs of their customers. While fintech companies have the advantage of innovation, financial institutions provide a sandbox for proof of concept and scale.
Most fintech start-ups lack a number features for a stand-alone existence, that are well known for traditional banks. Fintech firms need to be wary of product functionality, flexibility, scalability and compliance. Banks have the advantages of greater resources and larger scale. Good partnerships between banks and fintechs could bring the best for both worlds.
On the other hand banks will get intensive competition from new-comers, at least in the shorter term. These new comers may include non-financial service providers, fintech start-ups, other challenger banks and even big retailers, triggered by the blockchain technology that is cheap in terms of developing products and services, quick in launching terms and also highly secure or “trustless”.
Numerous non-bank companies are already attempting to make decentralisation a new mainstream trend in the financial world. A growing number of these upcoming companies are starting to expand their offerings and include some of the features previously only seen in banking, thereby impressing customers and driving new revenue streams. While sending payments is currently the most commonly used feature, soon, numerous other possibilities will open up blockchain use cases. These include things like payments, loans, remittances, investments, and more.
But while the disruption opportunity for Fintech start-ups and other non-bank service providers is massive, they will have to find a way to scale out their business while facing increased regulations, higher costs, and larger infrastructures, if they want really replace traditional banking in the longer term.
Why should banks react?
But if blockchain technology is so disruptive, why are banks worldwide so enthusiastic in their adoption of this technology? Disruption could be seen both as a ‘gift from heaven’ bringing a lot of opportunities, but also as a real threat for banks, especially if they do nothing.
Combat increased competition
One of the answers is to combat increased competition from fintech start-ups and other non- bank financial services providers. New technologies are already bringing unprecedented disruption in the financial services ecosystem, upending the world of finance.
Fintech changes are impacting customers’ access to goods and services in their day-to-day lives. A growing number is turning exclusively to solutions such as Facebook or Amazon for their financial needs.
Notwithstanding their strive for digitalisation, banks are still far away compared to fintech companies, that are focusing on “the innovative use of technology in the design and delivery of financial services”, and are increasingly filling the gaps left by the banks.
Meeting present challenges
Another answer is the many potentials of blockchain itself to improve the way they are now doing business. The traditional banking industry, composed of centralised institutions that are operating on central networks, is plagued with various problems, such as concerns of privacy, heavy regulation, high costs and fees for customers, limited user’s control over their own account and their own funds. This makes banking processes more expensive, time-consuming and inefficient. And if it is breached, all stored information, data and cash become vulnerable to fraud and digital crime.
It is not that strange that, while the real impact is yet to unfold, banks are betting on the big potential for blockchain technology to really shake things up and to see how blockchain will disrupt the industry. The above-mentioned blockchain use cases in banking may bring serious benefits for them. Blockchain may make existing processes more efficient, secure, transparent, and inexpensive. A distributed ledger can thereby take over many of the functions nowadays performed by central third parties, such as share information that is secure and provide for the unalterable transfer of data – ensuring data integrity. This is particularly relevant for the financial services industry.
Provide seamless customer experience
Blockchain may give the opportunity to create secure and safe financial products and bring innovation in the financial sector. It will enable banks to introduce new products and services quicker and in a cost-effective manner. Blockchain technology thereby presents a great opportunity for financial services firms to provide seamless customer experience and transparency.
How should banks react?
As the financial service industry is moving from exploration phase to application phase for blockchain, it is very important for banks to understand the future role of blockchain and their impact on banking services if they want to take advantage of this financial revolution.
Success will depend on how banks quickly respond to opportunities for innovation. Used effectively, disruption is key to driving organizational change and taking the business to the next level.
Disruption can be a valuable way for banks to reinvent their organization by challenging competitors and identifying growth opportunities. In order to be able to work effectively in the new eco-system, banks should identify radically new ways to conduct business. They therefore have to change their old business models and personal skills, and create new, viable models for the blockchain age in order to be able to combat new competitors.
“It’s a very interesting space to watch. It’s clear that blockchain has the potential to make finance more efficient, but the big players are well-established. And establishments don’t tend to favor innovation. I’d keep an eye on the start-ups who want to disrupt, but also know how to play nice with the institutions.” Jeff Koyen
While the process of disruption triggered by blockchain technology has only just begun, many expect it to speed up soon. This and the coming years we will – as a result – see a lot of changes in the banking industry, while new players will enter the market. Blockchain may eliminate some roles in financial services in the short term.
Although the financial industry is thrilled about blockchain, the technology will take a few years to become a mainstream financial model. That means that disruption will happen gradually – but surely. In the meantime banks have the time to prepare and adjust so that they can have a “second live” in a blockchain world.
The way blockchain is driving disruption in the traditional financial services industry is however not straightforward but may occur in both obvious and not so obvious ways. The future of the financial services industry will thereby depend on how the various stakeholders including banks capitalize on this technology and how they interact with each other.
But when financial institutions fully adopt this technology, we should see these gained efficiencies in the form of lower fees for consumers, creating a renewed promising customer experience by banks.
In that case these banks may survive ….