Blockchain – Part 2 – Applications
This is the second in a three part series on blockchain, focusing on some of its potential applications. Of course, it’s impossible to talk about this subject without mentioning the original: Bitcoin. However, there is plenty written about this on the Internet so suffice to say that this is a digital currency where all transactions ever carried out are stored on a blockchain. Besides Bitcoin, there is now a plethora of so-called ‘cryptocurrencies’ of varying degrees of popularity.
In this article, we look at three other applications of blockchain (or distributed ledger technology in general) that have been of interest to Sinara’s clients: trade financing, capital markets, and cross-border payments. These are areas in which, as a software development firm catering to the financial industry, we certainly expect to be working on in 2018 and beyond as the technology matures.
A typical trade financing process still tends to involve multiple paper-based contracts (letter of credit, bills of lading, etc) with settlement often taking days if not weeks. Many parts of this process are dependent upon individual steps by many different participants (producers, ports/warehouses, buyers, customs agencies, inspection agencies, insurers, banks, etc) without any individual participant necessarily having full visibility into the entire supply chain. The time-consuming and complex nature of the process often results in significant cost for all participants.
There is therefore plenty of interest in replacing these paper-based processes with secure digitised operations. Of course this doesn’t necessarily have to be via a distributed ledger, but the nature of the technology lends itself well to this application, especially given the particular issues of trust in trade financing. Imagine the letter of credit, bill of lading, invoice, quality control certificates, photos and other documentation all stored on a blockchain. Anyone inspecting it would be able to verify when the entries were added and by whom, and be guaranteed that they are valid.
The increased transparency, consensus and traceability provided by this system on a fundamental level could help mitigate the risk of mistakes and fraud, simplify reconciliation needs, and offer increased guarantees as to the quality and origin of the products in the supply chain. The read-only, or immutable nature of blockchain technology also allows for a secure transfer of value.
All this adds up to cost reductions. Having a distributed ledger shared among banks could also further reduce costs and the chance of fraud, as it would show every recorded transaction between the ledger’s participants. Once entered onto the system, a transaction could not be erased, which would prevent, for example, the same collateral being pledged to multiple banks for loans.
It wasn’t that long ago that equities markets largely operated around paper-based tickets, certificates and ledgers. Since these had to physically be sent between counterparties, it would routinely take five days or more to settle trades. Following the ‘Big Bang’ in the London financial markets, 31 years ago this month, there was a major shift towards electronic trading, and gradually many (though certainly not all!) of these processes were digitised. However, clearing and settlement processes still tend to replicate the original paper-based processes, whereas trading has embraced the potential of new technologies to a far greater extent.
This has resulted in three major inefficiencies: the need to reconcile books and records between participants, the need for centralised providers to manage risk and facilitate communications, and the 2-3 day delay between trade and settlement. As each transaction often passes through several intermediaries, there can be duplication of data entry, inefficient use of capital, delays to settlement, and reconciliation errors.
All this increases cost and hence requires capital to cover the risk that is inevitably incurred–counterparty risk, principal risk, and others. This includes the cost of requiring a central counterparty to manage that risk, the cost of depositories to keep records of ownership, and the cost of intermediaries and multiple back offices interconnected by complex digital messaging protocols, but each with their own “version of the truth”.
Distributed ledger technology, if it succeeds in reducing or eliminating the need for a central counterparty, has the potential to be able to reduce the settlement timeframe to trade day (T0) or even real-time. Hence, risk, and therefore cost, is reduced. Furthermore, by removing intermediaries and providing a trusted and shared view of permissioned data, a distributed ledger could help reduce costs by, for example, having fewer reconciliation errors, speeding up settlement (faster validation), increasing resilience by not having a single point of failure, and improving transparency (easier to monitor and regulate).
Putting reference data such as market and client/counterparty data onto a distributed ledger would also make it easier to reconcile and disseminate the data. By reducing settlement times and enabling this asset information to be shared in a trusted manner, distributed ledgers could allow investors to more easily exploit underused assets, enable new collateral requirements, increase flexibility, and simplify operations in general.
Cross-border payments have become one the most proven applications of blockchain, and there was plenty of discussion about this at the last Blockchain Summit in London, with a number of products and companies on display.
At present, there are several issues associated with cross-border payments: they usually take more than a day (and are restricted to business hours). The exchange rate and any transaction fees can often be unknown when the transaction is initiated. The funds can move through many correspondent banks before reaching their destination, at the risk of incurring delays and additional fees. In managing these payments, customers have to take into account these delays and fees, and all of the resulting uncertainty. Banks have to track and manage these transactions, check payment details, ensure liquidity, respond to enquiries, and fix problems. This all adds to cost.
The way that some fintech startups are solving these problems is to bypass the network of correspondent banks completely by using a ‘cryptocurrency’ such as Bitcoin as a global ‘payment rail’ to transfer funds from one country to another. As mentioned previously, Bitcoin is the most widely known application of blockchain technology, and is a purely digital currency that uses a blockchain to record transactions and track the funds that each participant has access to.
Users can still enter and use products through familiar channels such as cash and credit/debit cards. Companies will exchange the local currency to Bitcoin, move Bitcoin, then transfer local currency back to users. Whether it relates to micropayments, remittances, or international business wires, customers don’t need to know anything about Bitcoin nor need to know that it is being used at all! Bitcoin is used as the store of value and payment processing, whilst customers can still interact with their own national currency.
Of course, converting Bitcoin to a currency still means that some means of currency exchange must be provided in each country, but costs will still tend to be significantly lower than traditional banks. In fact, the increasing use of the Bitcoin network by financial institutions, businesses, and individual consumers as a global payment rail has corresponded to a steady increase in Bitcoin price.