Imagine a world without cash where you can transfer money overseas and do complex financial trades quickly and securely without the need for banks and other financial intermediaries.
These are just some of the predictions being made for blockchain technology − an online database that keeps an encrypted digital ledger of transactions and shares it among multiple users across a network of computers.
Some experts have even claimed that blockchain, the technology underpinning digital currency Bitcoin, could eventually lead to the end of banks.
Banks are certainly taking the new technology seriously.
The industry will spend $1 billion on blockchain technology by 2017, Magister Advisors has predicted. About 20 blockchain projects are currently underway, with banks often working with start-ups.
Barclays said that its technology combined legal agreements with business logic to create financial trades that run as smart contracts, meaning self-executing technology which automatically verifies that contract terms have been met and then authorises actions such as payments or ownership changes.
Meanwhile, Santander is attempting to become the first UK bank to use blockchain to enable customers to make faster and cheaper international payments, the Financial Times reported in May.
To counter competition from digital payment businesses such as TransferWise, the bank is piloting an app-based service among staff, before rolling it out to customers, the FT reported.
But are reports of banks’ demise premature? And could blockchain be more of an opportunity than a threat for banks if they respond wisely? Yes and yes.
As we note in our report on blockchain (‘Can the financial services industry master cryptofinance?’), blockchain could save banks an estimated €13bn-€18bn per year in banking infrastructure costs by 2022 (by improving cross-border payments, securities trading and regulatory compliance) and €4bn per year in management costs.
Many of these potential benefits will depend on automation, or ‘smart contracts’ , computer protocols that trigger actions following an automated validation of the underlying contractual terms.
Developing instructions for these smart contracts is expected to be easiest in e.g. foreign exchange and listed securities trading, a business already highly standardised today. This said, the case for OTC derivatives may be even more appealing. Despite the fact that implementation will be not just as easy for OTC products, smart contracts could accommodate the vast variety of non-standard OTC contract terms and help avoid a great deal of manual work.
In contrast, it’ll be harder for trade finance. Say you’re shipping gold from Tanzania to Argentina, you will have to navigate an array of companies not listed on stock exchanges and various one-off types of financial transactions, supply chains and regulations in different jurisdictions.
Banks are often facing a typical 'make or buy' dilemma for using blockchain. One option is to build an own technology, as an individual player or as part of a bank consortium. The other option is to collaborate with a blockchain software vendor, which has already built use cases around financial transactions.
Given the head start many of the blockchain technology providers have had, bank chief information officers may rather want to draft in someone from a blockchain supplier to advise them than inventing an own blockchain solution.
Blockchain is still a new technology and it’s hard to predict exactly how it will be used in two years let alone five. But ignoring it could be a very expensive mistake for banks.