How Blockchain Could Disrupt Banking
As blockchain picks up momentum, will the traditional banking industry embrace this new technology or be replaced by it?
This explainer is excerpted from a long-form overview of how blockchain technology could disrupt — or supplant — traditional banking. See the full post on our Research Portal.
Last September, JPMorgan Chase CEO Jamie Dimon took a stab at Bitcoin: “It’s worse than tulip bulbs. It won’t end well. Someone is going to get killed.”
Lloyd Blankfein, head of Goldman Sachs echoed that thought, saying, “Something that moves 20% [overnight] does not feel like a currency. It is a vehicle to perpetrate fraud.”
Yet at the same time, according to a survey by The International Securities Association, 55% of companies polled are monitoring, researching, or developing solutions on top of blockchain.
But this very loud and public backlash against cryptocurrencies from banks begs the question: What do banks have to be afraid of?
The short answer is “a lot.”
Blockchain technology provides a cryptographically secure way of sending digital assets, without the need for trusted third parties — such as banks. Further, tools such as smart contracts promise to automate many of the tedious processes within the banking industry, from compliance and claims processing, to distributing the contents of a will.
Global banking is currently a $134 trillion industry. Banks help intermediate payments, make loans, and provide credit. The promise of blockchain as a trustless, disintermediated technology is to disrupt all of that, including these top areas:
- Payments: By eliminating the need to rely on intermediaries to approve transactions between consumers, blockchain technology could facilitate faster payments at lower fees than banks.
- Clearance and Settlement Systems: Blockchain technology and distributed ledgers can reduce operational costs and bring us closer to real-time transactions between financial institutions.
- Fundraising: By providing blockchain companies with immediate access to liquidity through initial coin offerings (ICOs), the blockchain is creating a new, cryptoeconomic model of funding that unbundles access to capital from traditional financial services.
In the full report, we’ll also explore:
- Securities: By tokenizing traditional securities such as stocks, bonds, and alternative assets, the blockchain is upending the structure of capital markets.
- Loans and Credit: By removing the need for gatekeepers in the loan and credit industry, the blockchain can make it more secure to borrow money and provide lower interest rates.
Read on for a deep dive into the top 3 ways that the blockchain could turn the traditional banking industry on its head while enabling new business models through technology.
1. Payments
Today, trillions of dollars slosh around the world via an antiquated system of slow payments and added fees.
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 the wire, and additional fees adding up to 7%. Your bank gets a cut, the receiving bank gets a cut, and you’re charged hidden exchange rate fees. Your family’s bank won’t even register the transaction until a week later.
The typical cost per transaction for a money sender averages to 7.68%, which come from per-transaction fees associated with payments, like wire fees or hidden exchange rate markups. Facilitating payments is highly profitable for banks, providing them with little incentive to lower fees. Cross-border transactions, from payments to letters of credit generated 40% of global payments transactional revenues during 2016.
Blockchain is disrupting this system by offering a higher-security and lower-cost way to send peer-to-peer (P2P) payments — one that requires no intermediary. Because cryptocurrencies like Bitcoin and Ethereum are built around a public, decentralized ledger that anyone can use to send and receive money, it cuts down on the need for trusted third parties to verify transactions.
In doing so, blockchain technology is giving people around the world access to fast, cheap, and borderless payments.
Bitcoin transactions can take 30 minutes or up to 16 hours — in extreme cases — to settle. That’s still not perfect, but it represents a leg up from the average 3-day processing time for bank transfers.
Meanwhile, as transaction fees can be high, developers are actively working on scaling cheaper solutions for cryptocurrencies like Bitcoin and Ethereum. Other cryptocurrencies, like Bitcoin Cash, already have low-priced transactions. Currently, transaction fees on Bitcoin Cash are hovering at around 20 cents per transaction.
One company, TenX, is approaching the payments problem slightly differently. It has built a wallet that’s attached to a debit card, making it easy to spend cryptocurrency everywhere you normally use plastic. The company is building a distributed network to trade between different cryptocurrencies and working to integrate that network with physical cards.
While cryptocurrencies are a long way from completely replacing fiat when it comes to payments, the last couple of years have seen exponential growth in transaction volume for cryptocurrencies like Bitcoin and Ethereum. Bitcoin transaction volume grew by 118% in 2016 alone, although much of this was a function of speculative trading (and not P2P payments).
In developing countries today, blockchain promises to give billions of people around the world access to financial services. One example of this is BitPesa, a blockchain company focused on facilitating B2B payments in countries like Kenya, Nigeria, and Uganda. BitPesa handles monthly trade volumes of $10M. Compared to a whopping 9.2% fee charged on the average cross-border payment to Kenya, BitPesa is able to slash fees to 3% through the blockchain.
Another example is BitPay, a Bitcoin payment service provider that helps merchants accept and store Bitcoin payments. BitPay has grown its payments volume 328% in the past year, with merchants receiving north of $110M per month. Compared to the 2%-3% fee associated with credit card transactions, BitPay charges 1% per transaction.
One big reason behind the coming disruption of the payments industry is the fact that the creaky infrastructure supporting it is just as liable to disruption — the world of clearance and settlements.
2. Clearance and Settlements Systems
The fact that an average bank transfer — as described above — takes three 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.
If you want to send money from a UnicaCredit Banca account in Italy to a Wells Fargo account in the US, the transfer will be executed through the Society for Worldwide Interbank Financial Communication (SWIFT), which send 24 million messages a day for 10,000 financial institutions.
Because UnicaCredit Banka and Wells Fargo don’t have an established financial relationship, they have to search the SWIFT network for a correspondent bank that has a relationship with both banks and can settle the transaction — for a fee. Each correspondent bank maintains different ledgers, at the originating bank and the receiving bank, which means that these different ledgers have to be reconciled at the end of the day.
The centralized SWIFT protocol doesn’t actually send the funds, it simply sends the payment orders. The actual money is then processed through a system of intermediaries. Each intermediary adds additional cost to the transaction, and creates a potential point of failure — 60% of B2B payments require manual intervention, each taking between 15–20 minutes.
The blockchain, which serves as a decentralized “ledger” of transactions, can completely disrupt this state of play. Rather than using SWIFT to reconcile each financial institution’s ledger, an interbank blockchain could keep track of all transactions publicly and transparently. That means that instead of having to rely on a network of custodial services and correspondent banks, transactions could be settled directly on the blockchain. That would help alleviate the high costs of maintaining a global network of correspondent banks.
Banks have estimated that blockchain innovation could cut at least $20B worth of costs from the financial sector by providing better infrastructure for clearance and settlements.
Ripple, an enterprise blockchain services provider, is the most prominent player attempting to replace SWIFT. While the company is best known for its associated cryptocurrency, XRP, this is separate from Ripple’s banking products.
SWIFT messages are one-way, much like emails, which mean that transactions can’t be settled until each party has screened the transaction. By integrating directly with a bank’s existing ledgers, Ripple’s xCurrent product provides banks with a faster, two-way communication protocol that permits real-time messaging and settlement. Ripple currently has over 100 customers signed up to experiment with its blockchain network.
R3 is another major enterprise blockchain player catering to banks, and wants to be the “new operating system for financial markets.” It raised $107M from a consortium of banks like Bank of America Merrill Lynch and HSBC. It’s also lost some key members, such as Goldman Sachs, which departed because it wanted more operational control over R3.
While projects like Ripple and R3 threaten to disrupt players within the broader financial services ecosystem — like SWIFT or custodian banks — they’re also working with traditional banks to bring greater efficiency to the sector. Ripple and R3 seek to decentralize systems on a smaller scale than public blockchains by connecting financial institutions to the same ledger in order to increase efficiency of transactions.
Blockchain projects are doing more than just making existing processes more efficient, however. They’re creating entirely new types of financial activity. The fundraising space is perhaps the best example of this.
3. Fundraising
Raising money through venture capital is an arduous process. Entrepreneurs put together decks, sit through countless meetings with partners, and endure long negotiations over equity and valuation in the hopes of exchanging some chunk of their company for a check.
On the blockchain, you don’t need a platform to raise money. You don’t need venture capitalists. You don’t have negotiations. Anyone is free to raise money from anyone at any time, and anyone can invest in projects they find interesting. In the parlance of Naval Ravikant, it is “open, distributed, and liquid all the way.”
On the blockchain, fundraising takes the form of an initial coin offering (ICO). It’s the blockchain version of an IPO. Projects sell tokens, or coins, in exchange for a cryptocurrency like Bitcoin and Ethereum. The value of the token is — at least in theory — tied to the success of its implementation in the future. Investing in tokens is a way for investors to bet directly on usage and value. Through ICOs, blockchain companies can short-circuit the conventional fundraising process by selling tokens directly to the public.
Over the course of 2017, a whopping $5.6B was raised through ICOs.
There are a couple immediate benefits to ICOs for blockchain companies.
First, ICOs occur globally and online, giving companies access to an exponentially larger pool of investors. You’re no longer limited to high-net-worth individuals, institutions, and others who are able to show the government that they’re credible investors.
Second, ICOs give companies immediate access to liquidity. The moment you sell a token, it’s priced on a 24-hour global market. Compare that to ten years for venture-backed startups. As Earn CEO Balaji Srinivasan says, “the ratio between 10 years and 10 minutes to get the option of liquidity is up to a 500,000x speedup in time.”
We’re already seeing the impact of ICOs on the fundraising market. In Q3’17, the deal size of ICOs totaled $1.3M — close to the deal size of all tech angel and seed deals that quarter at $1.4M.
Venture capital is taking notice, with VC firms like Sequoia, Andreessen Horowitz, and Union Square Ventures all directly investing in ICOs, as well as gaining exposure by investing in cryptocurrency hedge funds. David Pakman, a partner at Venrock, says, “There’s no question that crypto will disrupt the business of venture capital. And I hope it does. The democratization of everything is what has excited me about technology from the beginning.”
As the ICO boom is well underway, we’re simultaneously seeing a broader decline in the market for IPOs, from 7,322 in 1996 to 3,671 in 2017. In 2016, total funds raised from US IPOs dropped to a low of $18.5B, compared to $74.4B in 2014. It’s still not table stakes — fees to investment bankers per IPO can range from 3.5% — 7%. With greater access to private capital and alternative fundraising methods such as ICOs, we can expect to see this profitable market for investment banks decline even further.
The amount of money raised by ICOs in 2017 was already over 6% of the funds raised by IPOs in the US during the same period. Low interest rates and higher regulation have made private funding more attractive to many startups than the public markets.
While the majority of ICOs thus far have been for pre-revenue blockchain projects, we’re seeing more and more technology companies build around a paradigm of decentralization. Telegram, the messaging app, for example recently announced that it’s trying to raise $2B via ICO. Telegram offers a free service with high user growth — but its lack of revenue makes it unlikely to succeed in the public markets. The idea behind the ICO is to sell tokens to users and bootstrap a payment platform on top of the messaging network.
If, as blockchain advocates predict, the next Facebook, Google, and Amazon are built around decentralized protocols and launched via ICO, it will eat directly into investment banking margins.
Several promising blockchain companies have emerged around this space.
Companies like CoinList, which began as a collaboration between Protocol Labs and AngelList, are helping bring digital assets to the mainstream by helping blockchain companies structure legal and compliant ICOs. CoinList has helped blockchain companies raise over $850M via ICOs.
It has developed a bank-grade compliance process that blockchain companies can access through a streamlined API, helping projects ensure everything from due diligence to investor accreditation. While CoinList’s platform is designed for blockchain projects, its focus on reducing the logistical and regulatory load around fundraising is being mirrored in the public markets. Investment banks today are experimenting with automation to help eliminate the thousands of work hours that go into an IPO.
And CoinList is just the start. A number of companies are emerging around the new ICO ecosystem, from Waves, a platform for storing, managing, and issuing digital assets, to Republic.co’s crypto initiative, which is aimed at helping people invest in ICOs for as little as $10.
While the majority of ICOs thus far have been for pre-revenue blockchain projects, they have the potential to expand much further and become a viable alternative to traditional funding.
We’re still in the early stages of the blockchain, and likely in a bubble. There’s no doubt that many of these projects will fail altogether. What’s interesting is that they’re testing out uses for the blockchain that replace functions of traditional banks. That’s not just limited to company fundraising, but also to the underlying fabric of securities.
Beyond the hype
Disruption doesn’t happen overnight. Blockchain technology is still in its infancy, and a lot of the actual technology has yet to be perfected. Die-hard believers in cryptocurrency believe that it will replace banks altogether. Others think that blockchain technology will supplement traditional financial infrastructure, making it more efficient. One thing is clear, however: blockchain will indeed transform the banking industry.
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