Blockchain has great potential to change the face of the financial industry. On this 2 part series we’re delving into some examples of different banking services that could be disrupted by blockchain.
On part 1 we talked about the use of blockchain in payments, clearance and settlements systems, and fundraising. In this piece we delve into securities, loans and credit, trade finance and look beyond the hype.
By tokenizing traditional securities such as stocks, bonds, and alternative assets — and placing them on public blockchains — blockchain technology could create more efficient, interoperable capital markets.
- Blockchain removes the middleman in asset rights transfers, lowering asset exchange fees, giving access to wider global markets, and reducing the instability of the traditional securities market
- Moving securities on blockchain could save $17B to $24B per year in global trade processing costs
To buy or sell assets like stocks, debt, and commodities, you need a way to keep track of who owns what. Financial markets today accomplish this through a complex chain of brokers, exchanges, central security depositories, clearinghouses, and custodian banks. These different parties have been built around an outdated system of paper ownership that is not only slow, but can be inaccurate and prone to deception.
Say you want to buy a share of Apple stock. You might place an order through a stock exchange, which matches you with a seller. In the old days, that meant you’d spend cash in exchange for a certificate of ownership for the share.
This grows a lot more complicated when we’re trying to execute this transaction electronically. We don’t want to deal with the day-to-day management of the assets — like exchanging certificates, bookkeeping, or managing dividends. So we outsource the shares to custodian banks for safekeeping. Because buyers and sellers don’t always rely on the same custodian banks, the custodians themselves need to rely on a trusted third party to hold onto all the paper certificates.
To settle and clear an order on an exchange involves multiple intermediaries and points of failure.
In practice, that means that when you buy or sell an asset, that order is relayed through a whole bunch of third parties. Transferring ownership is complicated because each party maintains their own version of the truth in a separate ledger.
Not only is this system inefficient, but it’s also imprecise. Securities transactions take between 1 to 3 days to settle because everyone’s books have to be updated and reconciled at the end of the day. Because there are so many different parties involved, transactions often have to be manually validated. Each party charges a fee.
Blockchain technology promises to revolutionize financial markets by creating a decentralized database of unique, digital assets. With a distributed ledger, it’s possible to transfer the rights to an asset through cryptographic tokens, representing assets “off-chain.” While Bitcoin and Ethereum have accomplished this with purely digital assets, new blockchain companies are working on ways to tokenize real-world assets, from stocks to real estate to gold.
The potential for disruption is massive. The four largest custody banks in the US — State Street, BNY Mellon, Citi, and JP Morgan — each oversees over $15+ trillion worth of assets under custody. While fees are typically lower than .02%, profits come from the sheer volume of assets. Using blockchain technology, tokenized securities have the potential to cut out middlemen such as custodian banks altogether, lowering asset exchange fees.
Further, through smart contracts, tokenized securities can work as programmable equity — paying out dividends or performing stock buybacks through a couple lines of code. Finally, putting real-world assets on blockchain technology has the potential to usher in broader, global access to markets.
Some examples of Securities process through blockchain
Polymath is one of the blockchain technology companies that wants to help migrate trillions of dollars of financial securities to the blockchain. Polymath is building a marketplace and platform that helps people issue security tokens and implement governance mechanisms to help these new tokens meet regulations. So far, Polymath has announced partnerships with SPiCE VC, Corl, and Ethereum Capital to launch security tokens on the platform.
Meanwhile, financial institutions themselves aren’t sitting still. The Australian Stock Exchange announced an effort to replace its system for bookkeeping, clearance, and settlements with a blockchain solution developed by Digital Asset Holdings.
In June 2017, enterprise-focused blockchain company Chain — since incorporated into a new company called Interstellar — successfully orchestrated live transactions between the Nasdaq and Citi’s banking infrastructure via integration. Meanwhile, Overstock’s CEO launched a trading platform called tZero, which wants to create a blockchain-backed dark pool, or private exchange, for securities that might be listed on the Nasdaq.
While tokenized assets are a hugely promising use case for blockchain technology, the biggest hurdle is regulatory. It’s still unclear if ownership blockchain technology is legally binding, while tokens remain an ambiguous term that don’t currently have legal standing. Regulatory and legislative guidance will be key to the success of these nascent projects.
2. Loans and Credit
By removing the need for gatekeepers in the loan and credit industry, blockchain technology can make it more secure to borrow money and provide lower interest rates.
- Blockchain-enabled lending offers a more secure way of offering personal loans to a larger pool of consumers and would make the loan process cheaper, more efficient, and more secure
- The first live securities lending took place in 2018 with a $30.48M transaction between Credit Suisse and ING
The worlds of the consumer, the financial institution, and blockchain are slowly converging. Another space where that convergence has the potential to completely upend the way finance operates today is lending and credit.
Traditional banks and lenders underwrite loans based on a system of credit reporting. Blockchain technology opens up the possibility of peer-to-peer loans, complex programmed loans that can approximate a mortgage or syndicated loan structure, and a faster and more secure loan process in general.
When you fill out an application for a bank loan, the bank has to evaluate the risk that you won’t pay them back. They do this by looking at factors like your credit score, debt-to-income ratio, and home ownership status. To get this information, they have to access your credit report provided by one of three major credit agencies: Experian, TransUnion, and Equifax.
Based on that information, banks price the risk of a default into the fees and interest collected on loans.
This centralized system is often hostile to consumers. The Federal Trade Commission estimates that one in five Americans have a “potentially material error” in their credit score that negatively impacts their ability to get a loan. Further, concentrating this sensitive information within three institutions creates a lot of vulnerability. Last year’s Equifax hack exposed the credit information of over 145 million Americans.
Alternative lending using blockchain technology offers a cheaper, more efficient, and more secure way of making personal loans to a broader pool of consumers. With a cryptographically secure, decentralized registry of historical payments, consumers could apply for loans based on a global credit score.
While blockchain projects in the lending space are still in their infancy, there are a couple of interesting projects out there around P2P loans, credit, and infrastructure.
Example of improved lending through blockchain
One project, EthLend, raised $16.2M via ICO. EthLend wants to build a decentralized peer-to-peer lending application on top of Ethereum. This is how it works: when a borrower issues a loan request, a smart contract is created with the loan amount, interest rate, and time frame. The borrower puts up tokens of EthLend as collateral. If the loan isn’t paid in time, the lender receives tokens as collateral.
Dharma, for example, is a protocol for tokenized debt. It aims to provide developers with the tools and standards necessary for building online debt marketplaces. Meanwhile, Bloom wants to bring credit scoring to the blockchain, and is building a protocol for managing identity, risk, and credit scoring using blockchain technology.
While most of these projects focus on creating liquidity through loans around people’s existing crypto assets, they’re also jumpstarting the infrastructure that will enable bigger disruption in loans via blockchain.
3. Trade Finance
By replacing the cumbersome, paper-heavy bills of lading process in the trade finance industry, blockchain technology can create more transparency, security, and trust among trade parties globally.
- The use of blockchain and distributed ledger technology (DLT) can support cross-border trade transactions that would otherwise be uneconomical because of costs related to trade and documentation processes. It would also shorten delivery times and reduce paper use.
- With approximately 80 to 90% of world trade relying on trade finance, the influence of blockchain on the market would be felt globally throughout all industries that use cross-border trading
Trade finance exists to mitigate risks, extend credit, and ensure that exporters and importers can engage in international trade.
It is a pivotal part of the global financial system, and yet it frequently still operates on antiquated, manual, and written documentation. Blockchain represents the opportunity to streamline and simplify the complex world of trade finance, saving importers, exporters, and their financiers billions of dollars every year.
Like many industries, the trade finance market has suffered from logistical setbacks due to old, outdated, and uneconomical manual documentation processes for years. Physical letters of credit, given by one party’s bank to the other party’s bank, are still often used to ensure that payment will be received.
Blockchain technology, by enabling companies to securely and digitally prove country of origin, product, and transaction details (and any other documentation), could help exporters and importers provide each other with more visibility into the shipments moving through their pipelines and more assurance of delivery.
One of the greatest risks to trade parties is the threat of fraud, which is greater because of a lack of confidentiality and little oversight on the flow of goods and documentation. This opens up the possibility of the same shipment being repeatedly mortgaged, an unfortunate occurrence that happens so often that commodity trade finance banks write it off as a cost of business.
Through blockchain technology, payments between importers and exporters could take place in tokenized form contingent upon delivery or receipt of goods. Through smart contracts, importers and exporters could set up rules that would ensure automatic payments and cut out the possibility of missed, lapsed, or repeatedly mortgaged shipments.
The adoption of blockchain technology in trade finance could mean greater trust between trade parties, increasing global business, while also hiding confidential information such as pricing and trade secrets when necessary.
It would also give buyers better insight into where their goods originate from and when they’ve been shipped. Under traditional systems, this information is often incomplete. But blockchain would enable consumers to be updated at each step of the trade, further increasing trust and transparency.
Examples of trade finance on blockchain
Arguably, the time has come for blockchain in trade finance, with multiple companies and banks weighing in to find a solution that will stick.
Standard Chartered and HSBC are two banks that have joined consortia dedicated to using blockchain technology to fix trade finance.
One of those consortia is Voltron, run by R3 and CryptoBLK, which operates a blockchain platform for digitizing paper letters of credit.
Beyond the Hype
Disruption doesn’t happen overnight. Blockchain technology is still in its infancy, and a lot of the actual technology has yet to be perfected. Die-hard believers in cryptocurrency believe that it will replace banks altogether.
Others think that blockchain technology will supplement traditional financial infrastructure, making it more efficient. With global banking currently a $134T industry, blockchain technology and DLT could disintermediate key banking services.
If you missed part one on blockchain’s potential to disrupt then you can read the banking service examples here.
Excerpt originally published by CB Insights, How Blockchain Could Disrupt Banking.
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