The banking industry has long been one of the major users of IT; among the first to automate its back-end and front-office processes and to later embrace the Internet and smartphones. However, banking has been relatively less disrupted by digital transformations than other industries. In particular, change has come rather slowly to the world’s banking infrastructure.
“With advances in technology, the relationship that customers have with their bank and with their finances has changed…” notes a recently released Citigroup report, Digital Disruption: How FinTech is Forcing Banking to a Tipping Point. “So far these have been seen more as additive to a customer's banking experience…
Despite all of the investment and continuous speculation about banks facing extinction, only about 1% of North American consumer banking revenue has migrated to new digital models… we have not yet reached the tipping point of digital disruption in either the U.S. or Europe.”
Recently, I discussed some of the highlights of Citi’s excellent FinTech report. Investments in financial technologies have increased by a factor of 10 over the past five years. The majority of these investments have been concentrated in consumer payments, particularly on the user experience at the point of sale, while continuing to rely on the existing legacy payment infrastructures. I’d like to now focus on the potential evolution of the backbone payment infrastructures.
Transforming this highly complex global payment ecosystem has proved to be very difficult. It requires the close collaboration of its various stakeholders, including a variety of financial institutions, merchants of all sizes, government regulators in just about every country, and huge numbers of individuals around the world. All these stakeholders must somehow be incentivized to work together in developing and embracing new payment innovations. Not surprisingly, change comes slowly to such a complex ecosystem.
The Promise of Blockchain
But sometimes, the emergence of an innovative disruptive technology can help propel change forward. The Internet proved to be such a catalyst in the transformation of global supply chain ecosystems. Could blockchain technologies now become the needed catalyst for the evolution of legacy payment ecosystems?
The blockchain first came to light around 2008 as the architecture underpinning bitcoin, the best known and most widely held digital currency. Over the years, blockchain has developed a following of its own as a distributed data base architecture with the ability to handle trust-less transactions where no parties need to know nor trust each other for transactions to complete. Blockchain holds the promise to revolutionize the finance industry and other aspects of the digital economy by bringing one of the most important and oldest concepts, the ledger, to the Internet age.
Ledgers constitute a permanent record of all the economic transactions an institution handles, whether it’s a bank managing deposits, loans and payments; a brokerage house keeping track of stocks and bonds; or a government office recording births and deaths, the ownership and sale of land and houses, or legal identity documents like passports and diver licenses. Over the years, institutions have automated their original paper-based ledgers with sophisticated IT applications and data bases.
But while most ledgers are now digital, their underlying structure has not changed. Each institution continues to own and manage its own ledger, synchronizing its records with those of other institutions as appropriate - a cumbersome process that often takes days. While these legacy systems operate with a high degree of robustness, they’re rather inflexible and inefficient.
“In a world where every business has its own books, payments tend to stop and start between different ledgers. An overseas transfer leaves the ledger of one business, then goes on another ledger at a domestic bank. It then might hit the ledger of a bank in the international transfer system. It travels to another bank in the foreign country, before ending up on the ledger of the company being paid. Each time it moves to a different ledger, the money has a different identity, taking up time and potentially causing confusion. For some companies, it is a nightmare that can’t end soon enough.”
Blockchain-based distributed ledgers could do for global financial systems what the Internet has done for global supply chain systems.
As Citi’s Digital Disruption report notes, blockchain technologies “could replace the current payment rail of centralized clearing with a distributed ledger for many aspects of financial services, especially in the B2B world… But even if Blockchain does not end up replacing the core current financial infrastructure, it may be a catalyst to rethink and re-engineer legacy systems that could work more efficiently.” The report goes on to explain why the blockchain might well prove to be a kind of Next Big Thing.
Decentralized and Disruptive
“Blockchain is a distributed ledger database that uses a cryptographic network to provide a single source of truth. Blockchain allows untrusting parties with common interests to co-create a permanent, unchangeable, and transparent record of exchange and processing without relying on a central authority. In contrast to traditional payment model where a central clearing is required to transfer money between the sender and the recipient, Blockchain relies on a distributed ledger and consensus of the network of processors, i.e. a supermajority is required by the servers for a transfer to take place. If the Internet is a disruptive platform designed to facilitate the dissemination of information, then Blockchain technology is a disruptive platform designed to facilitate the exchange of value.”
The report summarizes some of the blockchain key advantages:
- Disintermediation: Enables direct ownership and transfer of digital assets while significantly reducing the need for intermediary layers.
- Speed & Efficiency: The reengineering - i.e., reduction - of unnecessary intermediate steps will ultimately results in faster settlements, lower overall costs and more efficient business models.
- Automation: Programmability enables automation of capabilities on the ledger (e.g. smart contracts), that can be executed once agreed upon conditions are met.
- Certainty: System-wide audit trails make it possible to track the ownership history of an asset, providing irrefutable proof of existence, proof of process and proof of provenance.
But much, much work remains to be done. Blockchain is still at the bleeding edge, lacking the robustness of legacy payment systems. Distributed ledger systems have only been around for less than a decade, and are thus quite immature compared to the existing, decades-old financial infrastructures. While legacy payment infrastructures are complicated, inefficient and inflexible, they actually work quite well, being both safe and fast. Replacing them will be a tough and lengthy undertaking, no matter how innovative and exciting the new technologies might be.
It’s too early to know if the blockchain will join the pantheon of Next Big Things and become a major transformational innovation. As we’ve seen with other such successful innovations - e.g., the Internet, the Web, Linux - collaborations between universities, research labs, companies and government agencies are absolutely essential. So are close collaborations among technology developers and users in order to get the architecture right, agree on open standards, develop open source platforms and set up governance processes embraced by all.
In a short number of years, blockchain technologies have made a lot of progresshttp://blog.irvingwb.com/blog/2014/02/reflections-on-bitcoin.html. We might well be close to an ecosystem-wide FinTech tipping point. It will be fascinating to see how it all plays out in the years to come.
The complete blog was first posted April 18 here.