Financial institutions worldwide are exploring the benefits promised by blockchain technology. The research is moving beyond the hypothetical stage to proof of concept and planning.
The Institute for Development and Research in Banking Technology (IDRBT) established by the Reserve Bank of India – India’s central bank – recently explored blockchain applicability to the Indian banking and financial industry by conducting a workshop with bankers, academicians, regulators and technology partners. The participants produced a white paper [PDF] detailing the areas of adoption in the financial sector in India. The Institute also attempted a proof-of-concept (PoC) on applying blockchain technology to trade finance with the participation of banks, National Payments Corporation of India (NPCI) and a solution provider.
Blockchain technology can allow all participants in a business network to share a system of records that provides consensus, immutability, provenance and finality around the transfer of assets within the network. The distributed ledgers can lead to new business models.
In banking and financial services, key transactions in the processes underpin asset ownership and value transfer. In order to settle a transaction, data is exchanged among the institutions, sometimes including “trusted” intermediaries.
Where existing financial processes can be inefficient, costly and vulnerable, blockchain technology can bring cost savings, transparency and efficiency.
Cost savings materialize in the form of fraud protection, reduced forex volatility and faster settlement.
Efficiency emerges from resilience through redundancy, reduced processing time, faster settlements and faster decision making.
Transparency comes in the forms of immutable transactions and provenance (ensuring finality of asset ownership).
A key blockchain application that delivers these benefits are smart contracts; pieces of software that extend a blockchains’ utility from recording financial transaction entries to automatically deploying terms of multi-party agreements. The contracts are applications that encode complex business workflows and enhance efficiency through event triggered mechanisms. The contracts are executed by a computer network using consensus protocols.
Use cases can be categorized into applications with and without native currency. The advantages of cryptocurrency include control and security, transaction transparency and low transaction costs. Disadvantages are volatility and risk.
Despite the disadvantages, central banks worldwide have increasingly developed digital versions of fiat currencies to gain the benefits of blockchain technology. Examples include the Central Bank of Canada and the Dutch Central Bank. In addition, LHV Pank, the largest independent Estonian bank, experimented with programmable, cryptographic certificates of deposits.
Blockchain technology applications without native currency include trade finance. Because letters of credit and bills of lading have complex information flows, a blockchain solution can generate significant advantages.
Barclays and an Israel-based start-up executed a trade transaction using blockchain technology, reducing a process that normally takes between seven and 10 days to less than four hours. The transaction guaranteed the export of around $100,000 worth of cheese and butter from an agricultural food co-operative to a trading company.
Other financial institutions have claimed success using distributed ledgers to replace paper-based letters of credit in trade finance transactions.
Other blockchain applications include cross-border transactions, forex trading, capital markets trading, custody and securities servicing, pre-IPO shares allotment, loan syndication, bond trading and supply chain financing.
An innovative use of blockchain technology is the monitoring of financial transactions of a borrower financed by a consortium of banks. This can prevent “diversion of funds,” a major concern for banks. A borrower moves funds from one bank to another and the end-usage is not known to the lenders. Without a central entity, it is not operationally feasible to reliably track the movement of funds among accounts maintained across multiple institutions.
A collaboration-based approach, on the other hand, can allow the parties to monitor the movement of funds and perform the analytics to detect anomalies according to agreed-upon rules.
A blockchain-based registry could remove the duplication of effort in carrying out know your customer (KYC) checks. The ledger can enable encrypted updates to client details to be distributed to all banks in near real-time.
The KYC ledger can provide a historical record of all documents shared and compliance activities taken on behalf of each client. This will form the evidence to be given to the regulators.
SWIFT is exploring the use of BCT for the SWIFT KYC Registry, which includes more than 2,000 banks.
Blockchain platforms can solve weaknesses in existing financial technology, but concerns exist around security, privacy and scalability.
A major advantage of blockchain technology is integration of data processing, consistency and security into an algorithmically enforced protocol.
With appropriate use of cryptographic keys, confidentiality of transactions can also be addressed, making blockchain systems robust from an information security perspective.
Security, however, has to be multi-level and must encompass all components and entry points in the system. Blockchain systems have to consider security from the perspectives of ledger level security, network level security, transaction level security, associated surround system security and smart contract security.
Other security considerations include handling server corruption and outages.
In blockchain systems that have a native token associated with the ledger, the native token has value in the external world, necessitating the need to consider the impact of volatility of the value with regards to the ledger’s functioning. A crash or spike in the value of the token could affect business models. Malicious events in the external world can impact the functioning of the ledger in such a case.
Privacy concerns present an important challenge in executing blockchain technology. The overriding concern is to determine the minimum amount of disseminated information needed to run the blockchain without losing the advantages of verifiability that blockchain provides and without compromising participants’ privacy.
While maintaining transaction privacy and unlinkability, the system has to make sure some specific parties, such as auditors or a regulatory body, can access specific data to the level needed to perform their functions.
This might mean that they need to access everything, but most of the time it will be ad hoc, such as using a request-response mechanism of some kind. The system should be able to implement access with the required granularity, as well as provide keys to an authorized entity to process the audit function.
The scalability of a commercial blockchain can be limited by multiple factors. Blockchain platforms face different constraints on scalability which depend on the specific use cases addressed by the platform
Oftentimes, a compromise exists between security, privacy, functionality, risk and scalability that must be taken into consideration when designing the platform.
The paper presented a roadmap for the adoption of blockchain technology into the Indian banking system.
Banks can set up a private blockchain for internal use. This helps them to train human resources in the technology and enables efficient asset management, opportunities for cross-selling and more.
Proof-of-concept implementation and testing can be carried out in an order of increasing application complexity. These include centralized KYC, cross-border payments, syndication of loans, trade finance and capital markets settlement.
The project’s PoC provided a useful overview of the workings of the blockchain ecosystem showing the following aspects: complete transparency of various events triggered by counterparties, immutability, and automated flow triggered by specific events.
The focus was only on validating the business workflow and ease of use. Security and scalability aspects must be studied in greater detail.
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