• Elvis Yeung

How can Blockchain Technology Transform the Banking Industry Business Model in the Future?

Updated: Aug 23

Blockchain technology has provoked a lot of attention over the past few years, propelling beyond the praise of crypto fanatics and into the mainstream interlocution of financial analysts and banking experts. With the emergence of blockchain technology in various applications, many industries are embarking on transformation from traditional operation to tech-based simplification. Blockchain technology and distributed ledger technology (DLT), as a popular emerging financial vehicle triggering a disruption in the financial system, inevitably raised the consideration in the bank industry.

Blockchain is the first technology that provides a solution to fully manage digital assets in a decentralized, transparent, traceable, and automated way. All the data is immutably stored on the blockchain and distributed on the ledger. Trust has been successfully embedded into the smart contract without any third parties intervening in the procession. It can be used to transfer digital values of all kinds. Admittedly, the transaction with cryptocurrency has also become one of the main use cases on the blockchain, people transfer their money to individuals freely without regulation and supervision. While blockchain and cryptocurrencies are rapidly expanding and gaining popularity, the inherent risks and regulatory challenges daunting the traditional banking industry to adopt the application of these digital assets. Despite the skepticism, the question of whether blockchain and cryptocurrency will overwhelm or revolutionize the operation of the banking system remains. As Bank of England deputy governor, Sir Jon Cunliffe said, this new financial offer could draw away so much capital from current bank accounts to stablecoin in virtual ‘wallets’ provided by non-banks. The banking industry, therefore, should no longer afford to ignore or disregard this innovation in the global financial ecosystem if they do not want to be left behind.

Why banking industry dislike cryptocurrencies?

1. Decentralization in blockchain diminishes the importance of the banking industry

First, we should all acknowledge that decentralization is the principle of blockchain and cryptocurrency. In the traditional financial system, all the money transfers or FX should pass through the banking system to accept or process the transaction. However, digital assets such as crypto pop up as an alternative to the traditional banking infrastructure in which the intermediary is no longer necessary to exist to handle the money flow. DeFi even allows users to loan or borrow cryptocurrencies for any purpose they want without credit checking. The decentralized blockchain nodes, DLT, and smart contracts have replaced the job duties of what a bank is supposed to carry during the remittance and money transaction. The decentralized nature of the currency sabotages the authority of banking, leaving some to believe that banking service is a surplus industry in the future. Meanwhile, the wide use of cryptocurrency highly disrupts the bank revenue from the transactional fees of global remittance.

2. Compliance concerns

As cryptocurrency continues its break-neck rise in popularity and usage, the cybercrime derived from the deregulation of decentralization is becoming more and more serious. The growing menace of ransomware becomes the biggest threat to the adoption of cryptocurrency. Over the last two years, the amount of unique crypto wallets has increased at a rate of 40 million users while the cybercriminals accounted for $11 billion worth of fraud from illicit sources. The anonymity structure on the blockchain is also being exploited to launder criminal cash with a 30% increase in 2021. This kind of pseudonymity operation is different from the operation of traditional banking which must carry on supervision and AML before allowing the transaction.

Without a regulated intermediary to monitor the transaction, peer-to-peer fund transfer with cryptocurrency is very easy and quick, which could also vulnerate to illegal activity and scams on the banking network. By considering the risk and the legal grey area of accepting cryptocurrency, the banking industry will never bear the responsibility of any crypto-related crime. Therefore, instead of facing the challenges in cryptocurrencies, banks just frankly found it easier to say ‘no’ to avoid damaging their reputation.

3. High Volatility

If you were an early adopter of the cryptocurrency market, you must agree that the price of cryptocurrencies is very volatile over a short period of the life cycle. Just recently, Bitcoin, the most popular cryptocurrency, crashed below $18,000 for the first time since November 2020, more than 60% in value was dropped over the last seven months. Although the high volatility and valuation have driven the popularity of cryptos and attracted attention from the public, traders, and the media, this volatility is not acceptable in the traditional payment system. According to the research from Bank of International Settlements, it showed that cryptocurrency investors and users were not motivated by distrust in traditional banking and payment services, thus the entire crypto market is more likely to be dictated by investor sentiments, usage, and user interest. The central bank is an authority to govern the safety and stability of the economy and its systems, such volatility cannot be a candidate to contribute to a sound financial system in a country. If adopting Bitcoin or other cryptocurrencies into the financial system, the control of inflation and the monetary policy will be ceded to those actors and their activities. The unit of BTC used to buy a house today may only be worth purchasing a car tomorrow. The overall national economy will be crushed by such volatility.

An alternative to adopting cryptocurrency and blockchain

When offering products in this fast-developing sector, banks need to protect themselves and their customers against the risks that new technology can bring. This is not to say that the blockchain technology used by cryptos cannot also be used by central banks to provide, regulate or monitor stable digital currencies for the populations and economies they protect. In fact, this destructive technological footprint has been expanded in some commercial banks such as JP Morgan and Morgan Stanley to offer its wealthy clients access to bitcoin funds. As such, banks and the global financial system need to find a way to embrace this technology and treat it as a friend rather than an enemy to avoid being left behind.

1. Stabilize the digital currency with the use of Central Bank Digital Currency

As mentioned, Bitcoin, as the leading cryptocurrency, has very high volatility that cannot be accepted by banking for transactions or tradings. Therefore, instead of selecting a cryptocurrency from the current market to officially adopt in the contemporary financial system, creating an official stable coin backed by substance fiat currency reserve will be a reasonable starting point under the standard of the banking industry and government. In view of the stability of the digital currency, the Central Bank Digital Currency (CBDC) becomes an alternative for many countries to step into the era of digital currency. Digital transactions could then be secured and verified by using blockchain technology. It is a big difference from what we are holding and transferring money in digital form via bank accounts, online transactions, or payment apps. The forms of money used in our daily transactions now are liabilities of private banking and obviously, CBDCs would be a liability of a central bank, like the Federal Reserve, representing a currency that enables the general public to make digital payments like the existing forms of paper money. This can eliminate the risk from any third party like bank failures while the central bank, or the country, is guaranteeing monetary stability. Meanwhile, the importance of backing should not be neglected: one of the main contributors to the high volatility in cryptocurrency is the insufficient actual financial collateral to support the corresponding value of the cryptocurrency. The collapse of LUNA and UST is a typical example to show the importance of liability on digital assets. Tether (USDT), the largest stablecoin in the crypto market, also suffered from panic selling during the crisis of UST, falling as much as 6% from its dollar peg due to the incomplete reserves transparency.

In order to avoid such de-peg, CBDCs are directly tied to a fiat currency. It is just like a stablecoin, their value remains as stable as the fiat currency with clear transparency of national reserves. However, there is a critical concern that CBDCs will violate the principle of decentralization with the control of the central banks to avoid illegal monetary actions. This is the reason why CBDCs should not be considered a cryptocurrency but a digital currency based on blockchain technology to facilitate the transaction. When the central bank and the government implement their monetary or economic policy, we should all admit that decentralization will never be their priority and regulation will be a must. If CBDCs can easily be traced from user to user with the combination of blockchain validation and KYC, they are no longer viable for money laundering, underground economic behaviors, or the financing of other illicit activities. But still, some elements of decentralization need to remain during the digital transaction in order to retain the market sentiment and trust affected by cryptocurrencies and the innovative technology. The crypto stablecoins like USDT and USDC will then play a pivotal role in the decentralization.

In the game of cryptocurrencies, stablecoins are one of the main gates for the general public to buy any other cryptos and exchange them back for their fiat currency. The entire transaction process remains decentralized and solid. For that reason, the CBDCs should act as an auxiliary role to support the operation of digital fiat currency without disrupting the current crypto operation and features. A new possibility is derived from such rationale: the exchange between CBDCs and crypto stablecoins. CBDCs will become a derivative digital currency network from crypto stablecoins, and the crypto stablecoins, such as USDC, will still remain the center of the crypto transaction network. Under this duet stablecoin model, a centralized token will not directly invade decentralized cryptography while the crypto stablecoins can remain their functions and act as a medium to connect various CBDCs. Indeed, a thorough audit on the breakdown of stablecoin reserves holding will be a must before forming such a connection with the digital economy. People still have the freedom of choice to leave their money at the stage of crypto stablecoin and exchange the crypto into paper fiat currency in a regulated market or swap to the centralized digital currency via crypto stablecoins. To legitimate crypto users, the CBDCs will lure their attention and adoption of real-life digital transactions due to the full protection from the central bank and government.

2. Change of Clearance and Settlements

With the continuous development of CBDCs, the digital transaction system will keep evolving with the use of blockchain and Distributed Ledger Technology (DLT), resulting in faster and safer payment options between countries, households, and businesses. Today, trillions of dollars sloshing around the world through an antiquated system of slow payments and surcharges. In the current clearance systems of financial institutions, it takes around 3 days to clear out a transfer. Existing protocols like SWIFT merely send the orders for transactions, and the rest of the process has to bypass a complicated system of intermediaries, including a wide network of traders, funds, asset managers, and more. In fact, 60% of B2B transactions are manually intervened, adding additional cost from each intermediary and creating a potential point of failure.

With the popularity of CBDCs, the application of a decentralized ledger of transactions will be directly motivated and disrupt this complicated ecosystem. Rather than using SWIFT to reconcile each financial institution’s ledger, an interbank blockchain could provide an immutable and secured ledger for banks to keep track of all transactions publicly and transparently. By eliminating the extra workloads from any intermediaries, transactions could be settled directly and immediately on a public blockchain. This stands in contrast to current banking systems, which clear and settles a transaction days after payment. An Accenture survey among 8 global banks found that blockchain technology could bring down the average cost of clearing and settling transactions by $10B annually. By adopting this technology, financial institutions can save money and grant customers more safety, power, and control over the money they entrust to those institutions. In a nutshell, CBDCs and blockchain will replace SWIFT.

3. KYC and Trade Finance Facilitation

Before enjoying the banking services and carrying out day-to-day financial activities, banks need to proceed with a KYC to verify your identity and personal information. This will help avoid malicious transactions, illegal activity, or scams used in banking services, further diminishing clients’ anxieties about the risks that these transactions pose. While estimates vary, banks take an average of 24 days to complete the customer onboarding process. The time cost for the KYC is high enough to lose potential customers. In addition, the annual cost for banks to comply with KYC compliance and customer due diligence has reached $500 million. It turns out that the cost-effectiveness of KYC has not kept pace with the technological advancements.

With the influx of technology in the financial sector, blockchain is gradually becoming a mainstay in the compliance process. With KYC customer information recorded on a private banking blockchain, the decentralized nature would allow all institutions that require KYC information of the customers to access the private chain without manipulating the information. The blockchain DLT application can significantly reduce the manpower and cost involved in KYC compliance, saving up to $160M annually.

Another financial instrument and product where blockchain can help banks is trade finance. Technically, the function of trade finance is to introduce a third-party like banks to transactions to remove the payment and supply risks, ensuring exporters and importers can engage in international trade safely. However, like many traditional operations, the documentation is still dominated by uneconomical manpower with the threat of fraud logistic proofs. This opens up the possibility of the same shipment being repeatedly mortgaged.

By enabling companies to securely and digitally prove country of origin, product, transaction details, and any other documentation under blockchain technology, the fraud of missing or repeated mortgaged shipments will be exposed evidently. Moreover, through the smart contracts setting, CBDCs could become an automatic payment between importers and exporters, dramatically speeding up trade finance. With approximately 80-90% of world trade relying on trade finance, the impacts of blockchain in cross-border trading would be felt globally.

The concerns surrounding the security and stability of cryptocurrency always hold banks back from entering the era of blockchain-based digital assets. However, instead of ignoring those advantages, the banking industry should be committed to formulating compliance guidance and regulation to gain a first-mover advantage. Jamie Dimon, the CEO of JPMorgan Chase, derided Bitcoin as an inferior product worse than tulip bulbs, and stated that it wouldn’t end well. However, five years later, JPMorgan Chase has become one of the leading edges in the banking industry to promote the use of blockchain and cryptocurrency actively. Wisely say, decentralization will never replace the position of banking as long as the sovereignty of the stage remains, so the backing industry should absorb the advantages of this innovative technology but not exclude it. Blockchain is not a magic wand that will solve every bank’s problem, but it has been disruptive enough to revolutionize the entire banking industry.

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