The Impact of Blockchain in the Financial Sector
Contributed by Paolo Tasca
Paolo Tasca is a Digital Economist specialising in P2P financial systems. An adviser on blockchain technologies for different international organisations including the EU Parliament and the United Nations, Paolo is founder and Executive Director of the Centre for Blockchain Technologies (UCL CBT) at University College London. Previously, he was Lead Economist on digital currencies and P2P financial systems at Deutsche Bundesbank, Frankfurt.
It is my view that three blockchain applications in particular are most likely to make a significant difference to the financial sector in the next five to ten years:
1) payment and cross-border transactions;
2) trade finance;
3) real-time regulation and Regtech.
Blockchain enables the near real-time point-to-point transfer of funds. This technology will have a major impact on domestic payments and international money transfers. It is crucial to understand some of the implications of this capability.
It is clear that moving towards near real-time settlement will increase profitability by reducing liquidity, operational costs and by reducing overheads. Moreover, blockchain will enable a direct interaction between sender and beneficiary banks. This has the potential to eliminate the need for correspondent banks. Smart contracts running on top of blockchain-enabled payment systems can capture obligations and drive reporting by minimising operational errors and accelerating outcomes. Blockchain will also lower money transfer costs for certain products, which will in turn become more attractive to large multi-national organisations with high frequent cross-border funding and trade finance demands. Blockchain will also open the door to new payment business models such as micropayments, as well as facilitate seamless Know Your Customer (KYC) by leveraging the digital profiles stored on borderless payment platforms.
2. Trade Finance
In situations where there is lack of trust, blockchain can grant that payments will take place only once goods are exchanged according to certain rules. There are a number of inefficiencies in the current chain for the following reasons:
• Current solutions suffer from a lack of transparency along the chain;
• Paper-based documentation is slow and open to fraud;
• Working capital is tied up from when goods are manufactured to when they are paid for – 30 to 90 days after delivery. A reduction in processing time could result in a USD6 trillion improvement in working capital;
• Taxes and duties need to be accounted for in each country;
• Compliance costs (including KYC) mean only the most profitable customers get banked;
• Messages need to be reconciled and this normally takes place overnight;
• Information is required to be in Roman characters, meaning a significant amount of translation takes place.
Blockchain can solve most of the above problems by optimising the regulatory and operations costs of trade finance. In particular, blockchain can disintermediate third parties (that support transaction verification/validation) and accelerate settlement. Moreover, blockchain can enable real-time multi-party tracking and management of documentation. These functionalities bring about the possibility to automate the letter of credit. Storing financial details on the ledger can automate the creation and management of credit facilities through smart contracts. Blockchain can also improve real-time visibility of the transaction the better to institute regulatory and customs oversight. Officials will be empowered with new real-time tools to enforce AML and customs activities. Finally, blockchain will enable direct interaction between import and export banks.
Trade finance applications of blockchain are currently being explored by a number of incumbent institutions, with a focus on letters of credit encapsulated in smart contracts and electronic invoice ledgers.
Additionally, with financial regulation constantly changing, banks and financial institutions are under continual pressure to keep up with the latest rules. RegTech is thereby emerging as a hybrid of regulation and technology. On one hand, RegTech can help financial intermediaries (not only banks) to be compliant, while on the other it can be conceived as an additional supervisory tool to monitor regulated entities. Such a double-effect mechanism is undoubtedly important for the sound development of the financial sector in the future.
At UCL Centre for Blockchain Technologies, we are currently working on a RegTech project called BARAC (Blockchain technology for Algorithmic Regulation And Compliance). This project is sponsored by the UK Government and is run in collaboration with four Universities, seven departments, two research centres, ten investigators and eleven industry partners. The main idea of BARAC is to reverse current regulation and compliance models and to use distributed ledgers and blockchain technologies to move from post transaction monitoring to on-demand real-time monitoring.
The Future Trajectory of FinTech
FinTech is a long-standing process of innovation in financial markets driven primarily (but indeed not only) by technology. The technological drivers of FinTech date back to the 60s, with the invention of semiconductors and microprocessors. We can continue with other stages of technological innovation: in the 70s the invention of mainframes, in the 80s terminals and PCs, in the 90s the internet, in the 2000s smart devices, and now new technologies such as biometrics, quantum and cognitive computing, blockchain, robotics, and machine learning. As semiconductors and microprocessors allowed the replacement of physical records with digital data, so all these other technologies allowed the creation of new products, services and business models. The internet, for example, saw the advent of electronic trading and digital banking.
Many of the technologies underpinning the current FinTech revolution, including blockchain, are foundational and still in the so-called “era of ferment”. This concept is characterised by technological uncertainty, technological variations, rivalry and competition. With regard to the level of blockchain adoption, we remain in an embryonic phase mainly populated by innovators and early adopters who still have unclear preferences. In this context, there are different types of emerging blockchain technologies, which are characterised by different S-curves of technological performance. If at the beginning we only had digital currencies (internet-based exchange media), now we have also asset-centric technologies (semi-decentralised consensus mechanisms and permissioned blockchains), asset registry technologies (applications that link tokens to real assets), and application stacks (platforms for the development and execution of complete applications).
Therefore, it is likely that both new directions and new technologies will emerge in the near future, as has happened in the past. At the same time, it is to be expected that current trajectories (e.g., cloud-based accounting, alternative lending, new payment rails, and so on) will become more sophisticated because of technological specialisation.
Incumbent Banks and the Challenge of Technological Change
Many of the incumbent banks are not oblivious to the need to change the way they work, but are rather prevented from doing so by entrenched cultures and working practices. The problem is not only typical of banks, but is present in any large entity. It is a basic economic rule that every company has its own life cycle consisting of three stages: early, mature and decline. A company may first grow rapidly and then stagnate for a while before starting its decay. The length of the life cycle largely depends on each company’s ability to adjust its business model in response to changes in the market. Indeed, it is more difficult for big companies to make such adjustments, especially internally, because of the rigidities in their corporate culture and management practices. This rigidity is more amplified for large corporations with long business histories.
Examples of management styles that hinder the creation of innovative cultures include: excessive hierarchy, which limits agile decision-making; a lack of diversity in teams and of cross-departmental collaboration; a lack of experimentation; a too-narrow focus on a particular sector when seeking business opportunities; excessive analysis; and a fear of breaking moulds. A sensible choice for large corporations looking to overcome the problem of promoting an organisational culture with innovation in its DNA is often to accelerate or acquire FinTech start-ups that will serve as pathfinders in new areas. Accordingly, banks have in recent years poured money into accelerators, alliances and innovation labs.
The Challenges of Differing Regulatory Frameworks Worldwide
The differences in regulatory frameworks around the world are more like challenges than they are fetters, as they bring not only limits but also opportunities. On one hand, contradictions between regulations restrict the ability of FinTech start-ups to operate on a global scale, while on the other hand it also provides entrepreneurial opportunities for early stage companies. For example, we may consider the differences in monetary regimes of various countries that forces the development of peer-to-peer cross-border transfers. Moreover, different regulatory frameworks may create arbitrage opportunities. For example, after the recent tout-court ban of ICOs by the Chinese SEC, many entrepreneurs started looking at other jurisdictions and other markets.
Regulatory Compliance Guidance for FinTech Start-ups
What sort of adviser is best placed to help a start-up with regulatory compliance depends on the stage of the company. If the start-up is at an early stage, still conceiving its ideas – with a team consisting of only part-time founder(s), where the company is in discussions with potential customers to determine demand in the market, where the pricing/revenue structure has been developed, but needs market validation, where the company has no revenue – what that company would need most desperately is neither a compliance consultant nor a lawyer. In this case, the most suitable option is a mentor with expertise and experience both in financial and technical areas to help the company in shaping its ideas.
And if the choice for such a company is between a lawyer and a consultant, I would regard a compliance consultant as being more suitable for the role. This is because the best of these consultants will have rich experience in specific financial regulations and reporting. Therefore, compliance consultants should be capable of advising a start-up by making analysis of market demands and of the compliance challenges faced by its business model, and by helping the team to design business models that are compliant with regulation. At the same time, in the presence of new technologies, regulation is generally vague or incomplete. In the initial phase of the introduction of new technologies to a specific sector, new rules and opinions (rather than regulation) are promulgated everyday and both compliance consultants and lawyers need to continuously study to keep up with the latest developments. During these periods, consultants and lawyers may actually collaborate in creating start-ups themselves, rather than playing the role of navigators.
The Role of Venture Capital Investors for FinTech Start-ups
To understand the role of venture capital investment in start-ups, we first need to look at what these investors are doing. Many venture capital (VC) investors are trying to change the ways in which they are used to thinking and investing. An obvious change is that nowadays, VCs pay more attention to investment in tracks, which is to invest in an industry rather than certain start-ups in the industry that are believed to be profitable. For instance, some VC firms, such as Passion Capital and Anthemis, are renowned for their expertise in the FinTech sector. The start-ups selected by those VCs will not only benefit from the adequate financial support provided by the firms, but also by their good connections with governments, regulators and other stakeholders in the FinTech ecosystem. It is their comprehensive incubatory ability that makes investment from those types of VCs more attractive than others.
The Role of Consulting for FinTech Start-ups
In a sector like FinTech, external advisers and consultants play a decisive role for the success of a company. FinTech companies work in complex environments that require complementary expertise in different fields (eg FX, TMT, machine learning, or big data analytics). The consultant has the primary task of guiding the top management of a company in selecting the right team of experts to help that company bring their products and services to market. The consultant has a secondary task of identifying and helping to resolve any anomalies and weaknesses, and facing any threats the company can encounter. In this regard, consultants can provide advice by developing research and technical reports on the industry as a whole, or more specifically on the start-up’s major competitors. These reports give the company an insight into potential opportunities, and the pros and cons associated with them. For example, with the help of SWOT analysis, consultants can effectively advise the company in terms of its future direction and strategy layout. The company – especially in its early stage – can also benefit from the networks and reputation of the consultant and therefore quickly find its standing point in the industry.