To shape or to let the digital banking system be shaped
We are probably at the dawn of a new era for the banking industry, as happened in the 1970s with the advent of information technology. The three main driving forces of the change are (i) the social pressure and increasing regulatory requirements on bank transparency (after the financial crisis), (ii) new market entrants and the utilisation of the existing banking infrastructure by third parties (e-money entities or third party bank transfers / payments) and (iii) the development of new digital technologies that enable new business models (like crowd funding) or more efficient banking processes (like peer-to-peer banking or cryptographic payments).
Increasing regulation and the entrance of new digital competitors are creating a perfect storm, under which banks have two alternatives, either start working under the new paradigms of this environment, as new entrants have already done, or fight and lobby against it as other industries have done under similar situations (media and entertainment industries for instance, although with little success). In the view of this author, banks must adopt an early bird strategy, and combine the new digital technologies with the existing bricks and mortar infrastructures and services to protect their business, instead of starting legal and political fights that were so unproductive for other industries in the past.
Embracing digital disruption
There is little consensus on what digital banking or digital disruption means for banking. But we can define digital as business models and processes born and designed for the digital ecosystem, without the limitations coming from the current bricks and mortar models and infrastructures. In the article, entitled ‘Strategic choices for banks in the digital age’ (see ‘related links’ below), Henk Broeders and Somesh Khanna claim that, by 2018, 40 percent of banking revenues in Western Europe will come from digital products and services, so embracing digital disruption is a must. This requires more than just deploying new technology: it is about using this technology to achieve three main goals; (i) a simpler and fairer customer experience by designing customer-centric business models and processes, (ii) personalisation by taking advantage of big data and advanced analytics, and (iii) automation and optimisation of business processes by redefining them for the digital world. Eventually, this should lead to a portfolio of products and services designed under the above mentioned paradigms.
The advantage of competitors exclusively active in the digital domain is that their customer experience has been designed for the digital world from scratch, which means that processes are customer-centric, making them simple and quick, with a high level of personalisation. To make this leap in the delivery of customer experience, banks need to act quickly to acquire capabilities in user experience and interfaces.
At the same time, banks are amongst those organisations that can bridge the physical and virtual identity of customers. This is a key advantage, since many banking products and services have know-your-customer (KYC) restrictions, and banks have strong on boarding processes to guarantee the actual identity of customers. Therefore, banks should combine the strength of their time-tested KYC processes with the simple and quick digital experience.
Customer personalisation is routinely done in the digital ecosystem, where landing pages are customised depending on your history of navigation or purchases. For the very first time, information about the financial life of a customer can be analysed in an economically and timely manner by using big data analytics. Moreover, it can be enriched with external information about preferences and behaviours, so the customer experience and product offering can be personalised as never before.
What is blockchain and the distributed ledger technology?
Technology also facilitates the design of digital products and services that are more efficient and cheaper thanks to the automation of processes and the removal of intermediaries. One example is the blockchain technology that has emerged in the Bitcoin landscape.
To recap: Bitcoins exist as computer code based on cryptography and are stored on electronic wallets. Bitcoin does not require a central clearing house or financial institution clearing transactions. Users must have an internet connection and Bitcoin software to make payments to another public account/address. The user can send payments within a decentralised, peer-to-peer network, can purchase and sell Bitcoins through online exchanges and trade Bitcoins for traditional currencies.2
The article, entitled “Bitcoin: How its core technology will change the world”, published in New Scientist in 2014 (see ‘related links’ below), outlines that “beyond creating the web’s first native currency, the true innovation of Bitcoin’s mysterious designer, Satoshi Nakamoto, is its underlying technology, the ‘blockchain’. That fundamental concept is being used to transform Bitcoin – and could even replace it altogether. It is a ledger of transactions that keeps Bitcoin secure and allows all users to agree on exactly who owns how many bitcoins. Each new block requires a record of recent transactions along with a string of letters and numbers, known as a hash, which is based on the previous block and produced using a cryptographic algorithm.”
Investopedia defines blockchain as follows (see ‘related links’ below): “A blockchain is a public ledger of all Bitcoin transactions that have ever been executed. It is constantly growing as ‘completed’ blocks are added to it with a new set of recordings. The blocks are added to the blockchain in a linear, chronological order. Each node (computer connected to the Bitcoin network using a client that performs the task of validating and relaying transactions) gets a copy of the blockchain, which gets downloaded automatically upon joining the Bitcoin network. The blockchain has complete information about the addresses and their balances right from the genesis block to the most recently completed block.”
Investopedia further explains: “The blockchain is seen as the main technological innovation of Bitcoin, since it stands as proof of all the transactions on the network. A block is the ‘current’ part of a blockchain which records some or all of the recent transactions, and once completed goes into the blockchain as permanent database. Each time a block gets completed, a new block is generated. There is a countless number of such blocks in the blockchain. So are the blocks randomly placed in a blockchain? No, they are linked to each other (like a chain) in proper linear, chronological order with every block containing a hash of the previous block.”
“To use conventional banking as an analogy,” Investopedia adds, “the blockchain is like a full history of banking transactions. Bitcoin transactions are entered chronologically in a blockchain just the way bank transactions are. Blocks, meanwhile, are like individual bank statements. (…) The full copy of the blockchain has records of every Bitcoin transaction ever executed. It can thus provide insight about facts like how much value belonged a particular address at any point in the past.”
New Scientist points out that “ordinary Bitcoin users needn’t know the details of how the blockchain works, just as people with a credit card don’t bother learning banking network jargon. But those who do understand the power of the blockchain are realising how Nakamoto’s technology for mass agreement can be adapted. “You can replace that agreement with all sorts of different things and now you have a really powerful building block for any kind of distributed system,” says Jeremy Clark of Concordia University in Montreal, Canada.”
New Scientist provides this example: “One of the more advanced concepts being touted for a next-generation Bitcoin is the idea of decentralised autonomous corporations (DAC) – companies with no directors. These would follow a pre-programmed business model and are managed entirely by the blockchain. In this case the blockchain acts as a way for the DAC to store financial accounts and record shareholder votes. In a way, Bitcoin is actually the first DAC, says Daniel Larimer, a developer in Blacksburg, Virginia. People who own bitcoins are shareholders in the company, which offers financial services, earns revenue through transaction fees and pays a salary to its employees, the miners. But no one is in charge. Larimer has started his own DAC, called BitSharesX, which he says can perform the actions of a bank, lending other currencies to customers, who can provide BitShares as collateral.”
Based on Bitcoin's open source code, other crypto currencies started to emerge in 2011. Since then, not only other currencies, but also many companies, functionalities, features and services have been developed to create a full environment of crypto technology based on the distributed ledger.
Distributed ledger as a breakthrough banking technology
Blockchain is also a concept which allows the development of faster and cheaper inter-banking infrastructures. The distributed ledger used by technologies like Bitcoin or Ripple could provide banks with a competitive technological advantage, if adopted quickly, i.e. it could trigger the next breakthrough in terms of efficiency. This would entail replacing current inter-banking infrastructures based on bricks and mortar models with those based on central nodes in charge of operations such as authorisation, clearing, fraud prevention, dispute resolution and execution of payments and contracts. If payment systems migrate to models deploying a distributed ledger, it would impact the role of clearing houses and centralised authorising systems (eg card systems).
Applying the distributed ledger to payments and beyond: the smart contract
Payments are just the first area where the distributed ledger is being used. It could however, also be applied to support any kind of other transaction, since the essence of this protocol is to be a proof of record of agreed transactions and contracts. Technically speaking, any banking entry (not only payments), banking contract or capital market sale/purchase could potentially be registered in publicly distributed ledgers, backed by all participants in the banking system. Under this scenario, banking databases could even be open and accessible to all players, secured by a cryptographic protocol shared between the customer and the bank.
One of the most innovative applications of this type of technology is what is called ‘smart contracts’. Smart contracts are computer programs that can automatically execute the terms of a contract (penalties and outcomes) i.e. when a programmed condition is triggered, the smart contract executes the corresponding contractual clause.
These trust-based agreements utilise web-based data – such as currency prices, web search figures, global positioning system (GPS) signals or internet protocol (IP) sensors – as proof that a condition required to trigger the agreed contractual event has been met. The key element is who will certify that the event has actually happened.
Smart contracts systems rely on host entities who hold the contract (platforms with modular smart contracts where contractual parties can set up the contract) and cryptographic signatures submitted by trusted entities which sign claims about the state of the contract.
Banks are currently offering similar services in the bricks and mortar world with products like letters of credit, since banks are trustworthy actors who host, and verify that the conditions of the agreement were met. What blockchain adds is the possibility of having multiple banks certifying that the condition has been met, so contracting parties don’t need to trust in one specific bank. In fact, the distributed ledger allows the hosting bank to use unknown certifiers, under the assumption that the chances of a set of unrelated certifiers colluding are negligible as the cost is overwhelmingly impractical.
One basic example which can help with understanding the application in banking is online shopping: the purchase made at one online store can be registered as a smart contract in the blockchain that looks for the courier tracking data, making sure the package the customer ordered has been delivered before releasing the payment to the seller.
In addition, banks could hold contracts that monitor the performance of digital or non-digital assets as futures, forwards, swaps or options.
To summarise, trust, security and risk management are core values of the regulated banking industry. Adding to those values the simplicity, fairness and personalisation power of digital technologies should lead the way for banks to transform their business and the rails on top of which they operate, and improve the service they offer to their clients.
Roberto Garcia is project manager at Isban (Santander Group).
Related articles in this issue:
Related articles in previous issues:
The Future of Payments: European Commission Invited Exchange of Views at its Conference on Emerging Challenges in Retail Finance and Consumer Policy. Participants discussed latest developments, and ones to come, in terms of consumers' safety, accessibility and convenience ( Newsletter, Issue 25, January 2015)
Virtual Currencies: a House of Cards or a Mass Market Trend? The Answer to that Question Remains Pending. A commentary on the latest developments in the emerging virtual currencies landscape ( Newsletter, Issue 25, January 2015)
The Concept of an Open Standard Interface for Controlled Access to Payment Services (CAPS). A commentary: “Access to accounts – why banks should embrace an open future.” ( Newsletter, Issue 21, January 2014)
The Future of Payments: Markers for Success. The six markers which payments incumbents and newcomers alike can use to define positioning and strategies for successful innovation ( Newsletter, Issue 17, January 2013)
1 The expression “distributed ledger” is used in this article in a loose interchangeable manner with “blockchain”, especially when referring to the banking operations field, although they are not strict equivalents.
2 Edith Rigler: “Virtual Currencies: a House of Cards or a Mass Market Trend? The Answer to that Question Remains Pending”. Newsletter, January 2015. (The link to this article is included in the ‘related links’ at the end of this article.)
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