Blockchain in Banking (Part 1)
The rising popularity of Blockchain, especially within the industry application itself – has enabled it to evolve and become the backbone of a whole new type of Internet service where digital information is to be distributed, instead of being copied or duplicated. Despite being well-known, few people understand what blockchain really is, and how blockchain disrupts their internet activities on a real time basis. Blockchain was originally a technique that was described and intended by a group of researchers in 1991 to timestamp digital documents so that it is not possible to backdate them or even to tamper with them, which is quite similar to a notary. However, it went by mostly unused until it was adopted by Satoshi Nakamoto in 2009 to create the digital cryptocurrency – Bitcoin, where the technology mainly serves as the public ledger for all sorts of transactions on the network. From here, it is safe to judge that a blockchain is essentially a decentralized, distributed and public digital ledger used to record transactions across many other computers or devices, in order to avoid any involved record being altered retroactively, without the alteration of all subsequent blocks, that later allows the users to verify and audit transactions independently, relatively and inexpensively.
Like the term indicates itself, a blockchain is a chain of “blocks” that contains information, specifically information about the transactions (date, time and amount), information about the participants in a particular transaction (digital signature and username), as well as key information that distinguishes one block from many other blocks (unique code / hash). It is an ingenious invention with each of these blocks of data to be secured and bound to each other using cryptographic principles. For instance, asymmetric cryptography with public keys ensures high level of safety and security when it comes to data protection. Quoted from the authors of Blockchain Revolution (2016), Don and Alex Tapscott, “The blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.” In other words, by using blockchain technology, not only are all transactions virtually recorded, persisted and protected, but it can also be used to disrupt and transform traditional operations or transactions in the entire supply chain. Speaking of disruption, blockchain is often termed as a disruptive technology and an approach to market or industry competition – it addresses the needs of a market or industry that was previously neglected, by offering a simpler, cheaper, and more convenient alternative to existing solutions, products, or services. As an example, Google had actually disrupted online advertising services and not by its much-advanced search algorithms, but through AdWords – a self-service ad product with cost as little as USD$1. Therefore, AdWords enables Google to serve a whole new audience to advertise online, and from time-to-time with significant capabilities added onto the advertising services, Google Ads becomes a low-end disruption in the industry.
Given its extended capabilities and benefits, you may wonder how blockchain is essentially formed. First of all, a transaction must occur between both parties, involving any asset that can be described in digital format, such as cash or contracts. The transaction must then be verified after making purchases, in order to be recorded into a new block containing transaction details provided such as a unique hash code, and also references to the previous block’s hash code. The verification will be done and checked by a network of computers or devices, often called “nodes” to make sure the transaction happens in the way it was described. Once hashed, the block can be added into the entire chain in a specific order, by forming a sequence of linked and secured hashes between the blocks. However, for a new block to be added into the chain, an agreed “consensus mechanism” between the involved parties must be achieved to validate such action. Once the block has been validated and added into the chain, the transaction is recorded on a real-time basis without any monitoring from a third party and is held in a distributed ledger that could not be altered.
Before the introduction of various blockchain platforms such as bitcoin, banks monopolized how transactions were made, leaving consumers with no choice but to use the services provided by the banks to perform transactions. The banking system was considered outdated, cumbersome, and flawed when consumers were first introduced to blockchain platforms as the blockchain technology provided consumers with the distributed ledger in which users can enjoy a faster, safer, and more transparent platform for them to transact in. When consumers utilize banks to perform transactions, consumers have to bear bank charges and/or commissions for their transactions while also enduring long waiting times for the banks to clear or access a transaction. Today, trillions of dollars are sloshed around the world via an antiquated system of slow payments and added fees. For example, if you work in San Francisco and want to send part of your paycheck back to your family in London, you might have to pay a $25 flat fee for a wire transfer, and additional fees adding up to 7%. Your bank gets a cut, the receiving bank gets a cut, and you’re charged exchange rate fees. Your family’s bank might not even register the transaction until a week later. Besides, the clearance and settlement systems used by banks are inefficient and cumbersome to operate. The fact that an average bank transfer — as described above — takes 3 days to settle has a lot to do with the way our financial infrastructure was built. It’s not just a pain for the consumer. Moving money around the world is a logistical nightmare for the banks themselves. Today, a simple bank transfer — from one account to another — has to bypass a complicated system of intermediaries, from correspondent banks to custodial services, before it ever reaches any kind of destination. The two bank balances have to be reconciled across a global financial system, comprised of a wide network of traders, funds, asset managers and more.
When we zoom into the loans and credit services provided by banks, traditional banks and lenders underwrite loans based on a system of credit reporting. When you fill out an application for a bank loan, the bank has to evaluate the risk that you won’t pay them back. They do this by looking at factors like your credit score, debt-to-income ratio, and home ownership status. Based on that information, banks price the risk of a default into the fees and interest collected on loans. This centralized system is often hostile to consumers. The Federal Trade Commission estimates that one in five Americans have a “potentially material error” in their credit score that negatively impacts their ability to get a loan. In conclusion, it is evident that the current banking systems are outdated and are burdening the consumers in various aspects. The introduction of blockchain as a substitute or value-driver for banks will definitely transform and revolutionize how transactions are performed.
There are four main pillars and properties that have helped blockchain technology gaining its widespread popularity, especially within the context of disrupting the banking industry, which include decentralization, transparency, immutability (security) and privacy.
Blockchain consists of a number of decentralized networks, which means the information is not stored by one single entity in the entire system, but in fact, everyone in the network owns that particular information. In simpler words, if a hacker in a decentralized database like blockchain intends to retrieve information from one block, he or she has to break into every block in the chain. Hence, all the nodes in this decentralized network can access the information stored and compete to be the next to add onto the database chain. Since blockchain is somehow publicly viewable and accessible to anyone, “consensus mechanism” or “consensus model” are often deployed as tests on blockchain to those who attempt to join and add records to the chain. Reaching a consensus requires users to ‘prove’ themselves, usually through “Proof of Stake” or “Proof of Work”; for example, in “Proof of Stake”, users buy tokens that allow them to join the network, and the more tokens they have, the more they can mine; while in “Proof of Work”, nodes must demonstrate that they have done ‘work’ by solving an increasingly difficult computational puzzle like data mining etc. Decentralization network of blockchain provides banking operations higher level of safety and security, especially in terms of exchanging information, data and other digital assets
Transparency is a rather complicated context to discuss under the blockchain technology, because it actually takes more of a neutral stand. Even though decentralized network of blockchain allows all the nodes to view and access the blocks of information, meaning the information of a user’s identity could be revealed, in contrast, the identity is actually well-protected via hidden, complex cryptography and represented only by the public address. For example, when the banking industry deploys blockchain technology into its transaction operations, its real identity will be secured but a series of public addresses will be shown, and thus it is still possible to learn the transaction details by which party engaged in.
The hash codes on a blockchain keep the records and data stored safe.
A hash code is generically created by a combination of math functions and algorithms that takes digital information from the blocks and generates a string of letters and numbers from it. Regardless of the size of the original file or information, the hash code will always be generated of the same length, but any change to the original input will generate a new hash code. The changed hash will thus break the entire chain, but the next block in the chain will still keep the old hash, and the hacker who tends to access the information in these blocks will have to recalculate the hash codes to restore the chain. However, recalculating the hash codes would take an enormous amount of time and computing power.
In a decentralized network, blockchain technology allows the information and data stored in each block readily, publicly viewable, and accessible, if the nodes are given both the public and private keys. Nodes can choose to connect their computers or devices to the blockchain network itself too, in order to receive automatically updated information about the blocks whether a new block is added. However, a decentralized network means all transactions would be held on a peer-to-peer basis, where intermediaries in areas like human resources and software providers can be eliminated. For instance, with the application of blockchain technology in the banking industry, they will be able to reduce the operation costs, since the need for third party tools to aggregate data would be eliminated, as information would be stored in a blockchain.
Blockchain is a complicated concept to understand and implement, but the banking industry has adopted it in several ways, such as applying it in multi-step transaction where traceability and visibility is required. From a macro perspective, banks often serve as the critical storehouses and transfer hubs of digital asset or value, and blockchain serves as a digitized, secured, and tamper-proof ledger, in which it can inject enhanced accuracy and information-sharing efficiency into the entire financial services ecosystem. For example, JP Morgan Chase has started a new division called the Quorum, specifically for research and implementation of the blockchain technology, such as issuing a yearly deposit certificate based on a distributed registry with a variable rate. Blockchain technology possesses all these attractive characteristics of being decentralized, transparent, secure, and private, as well as relatively cheaper, it thus serves as the best fit of a reliable, promising and in-demand solution for the banking industry.
When blockchain technology was introduced a few years back, most of the biggest industries in the world were worried due to the degree of digital disruption it might have on their scope of business, more specifically the financial industry. It was previously perceived that these two distinct forms of mediums would not be able to coexist with one another. On the contrary, there is a need for both of these entities to be integrated with one another due to the fact that blockchain technology will be able to be fully utilized.
The outcome of the integration between the blockchain technology and the banking industry is that it will enhance the speed, security, and productivity an enterprise or business. For instance, if banks and blockchain technology exchanges, like crypto exchanges worked hand-in-hand together, it will benefit the banking industry in regard to the provision of insight into potential inflows and outflows from the exchanges. According to BlockTelegraph (2018), the cost-savings for banks would be estimated at a range of $8 – $12 billion USD per annum if they utilized the blockchain technology. Japan has launched the world’s first bank-owned crypto exchange and it has been yielding a heap of advantages.
However, there are also an array of challenges involved during the implementation process of blockchain technology within the banking or financial industry.
Keep in mind that the blockchain technology system is a decentralized system, which means it has no central authority. Regardless of the amount of security advantages it provides, there will always be a drawback such as the amount of mining power an individual or a group could possess, which has to be above 50% which leads to a 51% attack, which means that this specific attack inhibits other miners from creating blocks or making transactions altogether. In order to avert or minimize the probability of this occurrence, the mining pool within the blockchain system has to be frequently monitored.
Cost and Efficiency:
It is known that the blockchain technology provides large cost-savings overall. However, the initial cost of implementation bears a large cost and companies within the financial industry, such as banks are not keen on investing their capital in a system that holds an uncertain future.
The blockchain technology is not yet equipped with the handling of transactions on a large scale that occur on a daily basis, reason being is that multiple nodes within the system are required to validate each transaction and with the high and ever increasing volume of transactions coming through the system each day can reduce the transaction speed and increase the fee charged per transaction, hence, leading to expensive maintenance costs as well.