Blockchain Technology and the Financial Services MarketState-of-the-Art Analysis
For several years, the hype surrounding the distributed ledger approach and blockchain technology has grown steadily, fostering discussions and research activities on potential areas of application throughout the financial services industry. Current research and several use cases reflect the first feasible implementations of the technology, bringing major changes for segments and processes within the industry. An increasing number of banks are realizing the urgency of the topic and are exploring ways of using blockchain technology. A differentiated approach is necessary to elaborate on the potential impacts on industry segments and financial institutions, as blockchain technology is characterized by complexity and several limitations.
Drawing from a broad range of statements from experts from both Infosys Consulting and institutions from various sectors of the industry, this paper provides a high-level business-case viewpoint on the potentials and limitations of the blockchain technology.
Blockchain has promising potential in several financial services areas.
Investment banking and transaction services are the most promising fields of blockchain application in the near future.
Other promising areas for blockchain applications include lending business, insurance, real estate and factoring.
Distributed ledger and blockchain are not one-size-fits-all solutions.
Blockchain technology is currently not sufficiently regulated and future success will depend on clarifying legal aspects.
Collaboration between FinTechs and banks is key for broad implementation.
How blockchain technology works
Since a decentralized network of computers conducts intermediary tasks over the internet, the distributed ledger approach eliminates the need for a trusted third party. All transactions are recorded into a digital ledger, which is publicly available and fully distributed to all members of the network (so-called nodes). As each network member holds a valid copy of the ledger, the network itself is able to certify asset ownership and clear transactions, providing a mechanism that offers higher security than the current central ledger approach. Transactions are visible to all network participants and are immutable once they are recorded in the ledger. Moreover, the distributed ledger approach could increase transaction speed and decrease transaction costs, because operations are performed peer-to-peer between the corresponding parties rather than indirectly through trusted third parties.
No magic potion for everything.
Although the distributed ledger technology has the potential to change and improve the current financial services industry, it does not constitute a one-size-fits-all solution. Potential business cases need to fit to the technology’s specific characteristics, which are:
All transactions recorded in the blockchain are immutable and transparent. Therefore, the application of the technology is appropriate for use cases in which security plays a major role.
Decentralization enables business models that replace any trusted third party or intermediary because a trust relationship between unknown parties is established.
Any asset possible
Tokens used by the network allow the exchange of any physical or non-physical asset so that the blockchain can be used for different kinds of transactions.
Internet as basis
The blockchain uses the internet as the underlying infrastructure to process transactions. This enables business cases to provide banking services without the need for a banking infrastructure.
Lower costs, higher speed
In some cases, the blockchain could reduce transaction costs and increase transaction speed. This feature depends mainly on the number of transactions and the network size.
Besides these characteristics, some possible obstacles or limitations have to be mentioned: Since the blockchain technology is a network approach, a certain number of members is required to participate in the network to offset the costs of setting up the blockchain infrastructure. Furthermore, severe consequences of IT instability or human error can interfere with blockchain business use.
Despite technological characteristics and requirements, the application of blockchain technology to business cases requires a solid legal framework that regulates the rights and obligations of all participants and also takes into account the rules, laws and taxes imposed by public authorities. At the moment, legal bodies have just begun to take notice of the technology and are far away from releasing a legal framework. In light of the above, the distributed ledger technology can develop its full potential only if the mentioned criteria are fulfilled.
The blockchain technology shows a huge potential for various products, processes and areas within the industry. Three main fields of application are:
- Payment transactions
- Trade finance
- Over the Counter (OTC) market.
Within the field of payment transactions, the technology could be used to overcome current problems of the correspondent banking system and international money transfers. The fee-intensive and fragmented processes of cross-border, non-cash transactions could be eliminated by the exclusion of third parties, direct money transfers and efficient interbank settlements. The possibility to create a competitive marketplace of liquidity providers potentially ensures the best exchange rates for international exchange and payment transactions.
Trade finance is one of the segments in financial services that could not keep up with technological developments and digital evolution, blockchain technology could induce a needed transformation. The current legal situation in trade finance could be transferred to the blockchain, which would create strong legal certainty. The technological capabilities of delivering trust, security, risk mitigation and fast processes at low cost offer true innovation potential.
Blockchain technology could redesign the OTC market infrastructure and lead to elimination of obsolete market participants. Huge costs savings might be possible by using smart contracts that could automate the execution of OTC agreements. Direct trade without trusted third parties could be executed, whereby customers no longer need to depend on their brokers. The technology has the potential to reduce settlement risks by enabling almost instant settlements and avoiding latencies of about T+3 days to settle.
About the author
Dr. Eric G. Krause
Smart Data Transformation
Surfing the Big Data Wave
The Coming Paradigm Shift in European Banking Payment Services