Blockchain: How this technology is going to shuffle the banking industry?

By Nathan Burnel Hauteville and Mevlüt Ozdemir,

Grenoble Ecole de Management,

April 2017.

Do you know Blockchain? This word has probably no meaning for you, but this could be one of the greatest revolutions to the banking industry. According to Vinay Gupta,[1]M.D., Blockchain is” a distributed database that maintains a continuously growing list of ordered records, called blocks.” This technology has the potential to revolutionise the banking industry thanks to Fintech, Banks, and other non-financial protagonists.

The first function of banking is to create money. The creation of money is the consequence of debt which finances prosperity out of the future and economic growth. This debt’s source however, is from junk bonds like CDO (Collateralized Debt Obligation-structured financial product which pool together assets which are repackaged in slices that are sold to investors) and CDS (Credit Default Swap- similar to CDO), which have higher default risks in investment-grade bonds. This financial product was offered by banks until 2009. For decades, debt has been a commodity supported by rating agencies such as Standard & Poor’s and Moody’s. The financial crisis of 2007 – 2009 was linked to high yield corporate bonds rated AAA instead of junk bonds status. For example, when you place your money in savings, 90% could be lent to other people, with 10% staying in the bank’s accounts (Basel III). Consequently, many people have lost faith in the security of placing their money in banks. All these junk bonds had a significant influence on our economy. People now are demanding more transparency. This is exactly what Blockchain offers.

How did this technology emerge?

Conceptualised in 2008 by Satoshi Nakamoto, “Blockchain technology” was really revealed to the public 9 years ago, by Bitcoin, a cryptocurrency based on the blockchain concept.[2].

This technology is based on blocks, which provide a continuously growing list of ordered records. This concept is fundamental to explain the potential of this technology because it is an engine of transparency. Nowadays, for financial transactions, banks use clearing houses like Clearstream or Eurostream to control the evolution of the transaction. In fact, they assure that the buyer receives his goods and the seller receives his money. But with Blockchain, banks would have no need for clearing houses. Anybody could become the “trustworthy” person. And of course, banks will re-assume this role. As a consequence, many companies have started to become interested in this technology with the emergence of Bitcoin during the 2010’s. This technology could be a game changer. Moreover, Blockchain technology could be a great tool against shadow banking because we could keep clear records of transactions.

Blockchain, a technology with many advantages

Many people are assigning certain qualities to Blockchain. But only some of these are really interesting for the banking industry. As proposed in Deloitte’s insight report, here are some potential benefits of this technology[3].

  • First, Data quality. With Blockchain, we will have all the data from previous transactions. This benefit is very evident because it is fundamental to the Blockchain concept.
  • Second, security: With all this data, the banking industry is able to provide a much better security ecosystem.
  • Third, cost: With this high level of security, banks will have no more need to develop other security systems. And in time, the cost of Blockchain will fall due to economies of scale.
  • Fourth, it’s developed by users: The user is the key actor in this technology. They get control of it and assure the decentralization of the system.
  • Fifth, durability: With the decentralization of the system, the technology is less exposed to failure. In fact, it is also less exposed to malicious attack.

Tremendous potential in the banking industry

According to Michael Porter’s theory on value chain, companies need to stay at the cutting edge of technologies. This theory is particularly true in the banking industry and Blockchain represents a key investment issue.

In the next few years, only specific technologies will have an impact on the banking industry. According to Kariappa Bheemaiah, author of “ The Blockchain alternative ”[4], these are called “Skeleton keys”. This term encompasses 5 d (???)

  • Machine learning
  • Neural network or Deep learning
  • Natural language processing
  • Artificial intelligence
  • Blockchain (and related smart contracts)

Some of them are in line for development by famous Silicon Valley companies such as Alphabet, Facebook and Amazon. Blockchain technology is certainly one of them and is already targeted by Banks[5] and Venture Capitalist to become the next security technology used in the banking industry. Over the last decade, investments into Fintech start-ups working on Blockchain grew significantly[6]. A good example of a Fintech concept which is working on accelerating the adoption of the Blockchain is Ledger[7]. This start-up offers cryptocurrency technology based on Blockchain, such as multi-signature, multi-currency, or time locked payments.

The CEO of Ledger, Eric Larchevêque, said “Ledger has seen tremendous growth in the last months, and we are on track to increase our revenues tenfold this year. Our primary objective is to reinforce our position as a global market leader with hardware wallet products, while we accelerate the development of enterprise cryptocurrency solutions through the signature of soon-to-be-announced strategic partnership agreements. We are also actively pursuing research & development on hardware oracle technology, with key industrial customers for smart grid, supply chain and insurance Blockchain use cases.”

 

Only a few protagonists could benefit from this technology

There are only a few actors who are able to benefit from this technology. The biggest entry barrier is funding. The banking industry is generating billions of dollars each year in revenue and is also playing a crucial role in the modern economy. As a consequence, banks have great funding capacities and are using it to protect and assure their dominant position. In fact, many banks are collaborating, incubating, or even buying Fintech[9]. One recent example of this strategy is the acquisition of Compte Nickel by BNP Paribas on April 4, 2017.

Another actor, which has exactly the same strategy, is able to influence the development on Blockchain. We are, of course, talking about GAFA. This famous abbreviation for Google, Apple, Facebook and Amazon is symbolic of the tremendous influence exerted by these companies on our daily life. After transforming our social life, shopping habits, means of communication, and life in general, some of them are planning to disrupt our relationship with money. And these actors themselves definitely have the capacity to benefit from Blockchain. Let’s take the example of Apple Pay. This system is already offered in western countries, and is based on the principle of fast payment and security. Nevertheless, this service still has issues. That is why implementing Blockchain into Apple Pay could be beneficial.

Nevertheless, those which have a high performing and realistic concept are, most of the time, bought by banks or big companies. That is why we think that the actor who is best positioned to benefit from this innovation is the bank. As we previously said, banks have both funds and knowledge to buy and evaluate the viability of a project. You can easily find a good university teaching you the principle of Blockchain. But it is much more difficult to have funding. Some start-ups have been successful with their fund raising, but they were not working on disrupting the banking industry. Most of the time it was InsurTech, startups working in the insurance sector.

From our point of view, banks have the best position to get the most benefits from the Blockchain revolution. According to Teece[10], different actors with different positioning could win. In this case, the owner of assets has the best chances to win. Banks have money and expertise, but they need innovation. Startups have expertise and innovation, but need money. These two actors need each other to collaborate and to expand this technology. Finally, we think that many new startups are going to emerge in the next few years, but no new actor will succeed in disrupting the banking industry because they will be bought by banks and/or other technology actors which have enough funds, such as Apple, Alibaba, or Google.

 

An unknown impact on the banking eco-system (Above graphic: “are they key”)

According to Schumpeter, the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, is incessantly creating a new one”[11]. Technology is evolving and transforming itself, pushing entire sections of economic activity to slacken and then disappear after toppling from dominance. The change is structural before being quantitative.

As you can imagine, the use of Blockchain in the banking industry will cause, in consequence, the creation of jobs linked to this technology. Workers specialized in it have great perspective on banks. If you would like to be one of them, you should know how to code Python and PCA (Principal component analysis).

Nevertheless, a Blockchain transaction requires very little oversight for processing reconciling. As a consequence, jobs in this field will not be relevant anymore[12].  In this period of transformation of the economy, some economists argue that we are going to have reduced human employment caused by robotization. For now, no evaluation has been made on the potential impact of the Blockchain on employment.
To use Blockchain, you need computers, data storage and data centers. These infrastructures need a lot of energy for air conditioning and powering machines. As a consequence, all this energy used has a negative impact on the environment; unfortunately, it is still difficult to evaluate its impact.

A technology with a future

As it is starting to demonstrate, Blockchain is a technology with great potential. Banks are developing projects based on Blockchain, but these projects are still at an early stage[13].  For now, the most advanced concept based in Blockchain is Bitcoin, but this particular initiative doesn’t come from a financial institution. Many people are working on developing projects, but it will take time to implement these. It is exactly the same thing with articles talking about Blockchain. By analysing the hype cycle proposed here, by Gartner, Blockchain is at its peak of inflated expectations, which means lots of people are talking and writing about it, but there is no real application in business. By following this hype cycle, we could forecast disillusionment toward this technology in the next few years.

So as you see, it is hard to know, for now, if all the expectations on Blockchain will materialize. For now, Blockchain technology is only used by a few innovators who have a certain expertise in this technology. In fact, Bitcoin users perfectly embody this idea of competence, expertise, and interest. For now, many Blockchain projects are still not fully developed. Moreover, in the next five years it will require customers to accept significantly increased levels of operational risks.

According to the Rogers Adoption/ Innovation Curve, we can argue that this technology is only used by early adopters. Most of them are working in the banking industry.

Nevertheless, we can still expect great things from Blockchain for one simple reason. As we explained earlier, with Blockchain, banks would have no more need for clearing houses. In fact, financial transactions would be easier and faster. That is why we personally think that Blockchain is “the next big thing” in the banking industry.

As we have begun to explain, Blockchain is a technology with a tremendous potential, and explains why banks have so much invested in Fintechs and related research projects. Nevertheless, the potential benefit for those wise enough to be patient and ready to invest will be tremendous. As a consequence, concrete performance realisation based on Blockchain technology will only appear in five years or so. If we had to summarise Blockchain’s influence, we would say that it has a bright future which actors linked to the finance industry must include in their forecast.

 

[1] Gupta, Vinay. March 2017. “ The promise of blockchain is a world without middlemen ”.

https://hbr.org/2017/03/the-promise-of-blockchain-is-a-world-without-middlemen.

[2] Gupta, Vinay. February 2017. “ A brief history of blockchain ”.

https://hbr.org/2017/02/a-brief-history-of-blockchain.

[3] Deloitte Netherland. 2017. “ Blockchain technology 9 benefits and 7 challenges ”. https://www2.deloitte.com/nl/nl/pages/innovatie/artikelen/blockchain-technology-9-benefits-and-7-challenges.html.

[4] Bheemaiah, Kariappa. 2017, The blockchain alternative

[5] Bloomberg. January 8, 2017. ” Blockchain, fintech transforming Asia ”.

https://www.bloomberg.com/professional/blog/blockchain-fintech-transforming-asia/.

[6] Michael Casey, Paul Vigna. January 23, 2015. “ Bitcoin and the revolutionnary power of digital currency ”. The Wall Street Journal.

[7] Ledger. 2017. “  Ledger raises 7m to accelerate worldwide adoption of security solutions for bitcoin and blockchain ”. https://blog.ledger.co/ledger-raises-7m-to-accelerate-worldwide-adoption-of-security-solutions-for-bitcoin-and-blockchain-214aef1d4ccd.

[9] Mikhailo, January 2017,  “ Applications of blockchain technology in fintech ”.

https://www.romexsoft.com/blog/blockchain-technology-in-fintech/.

[10] Teece, David J, « Profiting from technological innovation: Implications for integration, collaboration, licensing and public policy »

http://www.sciencedirect.com/science/article/pii/0048733386900272?via%3Dihub

[11] Schumpeter Joseph, « Capitalism, Socialism and Democracy », 1942

[12] Monica Eaton-Cardone, 4 January 2017 “ How blockchain will affect financial services employment ” http://news.efinancialcareers.com/us-en/269710/how-Blockchain-will-affect-financial-services-employment

[13]Ninon Renaud Sharon Wajsbrot, 5 juillet 2016, “ Quatre cas d’usage de la Blockchain en finance “, https://www.lesechos.fr/05/07/2016/lesechos.fr/0211100640578_quatre-cas-d-usage-de-la-blockchain-en-finance.htm

 

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