Big Banks Embracing Blockchain

By Howard Yu — The Mark News —

The world’s biggest banks are investing in blockchain, the same tech that powers bitcoin. This move could lead to faster, more convenient international money transfers, while saving banks billions of dollars per year.

Four of the world’s biggest banks — UBS, Deutsche Bank, Santander and BNY Mellon — announced team efforts aimed at pitching central banks to use blockchain to settle financial trades. And this group isn’t the first. Earlier this year, Goldman Sachs and Barclays had similarly invested in another blockchain venture, aiming to make real-time money transfers possible. Even JPMorgan Chase, an initial blockchain skeptic, joined Citigroup, Bank of America and Credit Suisse to test out applications in credit derivative markets. Blockchain, a record-keeping technology that powers bitcoin — the first digital currency — has irrevocably gone mainstream.

Until recently, bitcoin has been infamously associated with drug dealers, pornography and illicit weapons trade. To invoke the kind of eagerness of big banks to experiment with blockchain as an emerging technology that might one day revolutionize the financial industry has seemed a bit farfetched. The situation is much like imagining Sony Music or Warner Music dabbling in peer-to-peer music sharing when Napster was at its height back in the late ’90s — it just didn’t happen. Music labels ignored, shunned and deplored such initiatives.

So what’s different this time? Why would pinstripe suit–wearing bankers suddenly turn into adventurous entrepreneurs?

Anyone who sends money abroad knows how inconvenient it is. Banks take days, sometimes weeks, to clear payments, and they take a hefty fee in between. And, yes, it can happen, when errors occur, money vanishes into thin air. “Banking now is like sending a letter; you send it and you don’t know if it reached” observed Chris Larsen, CEO and cofounder of Ripple, a San Francisco-based startup.

It turns out not much has changed in the way payments are settled among financial institutions when compared to the original banking system invented more than a century ago. Let’s look at a simple example.

Mary, a mother living in New York, wants to wire $1,000 to her son David, who is studying abroad in Madrid. Upon order, Mary’s U.S. bank immediately debits her account and puts the money on hold at the Federal Reserve. The Reserve then sits on it, waiting to aggregate hundreds of thousands of daily transactions before sending them in a batch to The European Central Bank. The ECB then dispatches the bundle and schedules the distribution of individual transactions to different local banks. After two to four days, David finds the equivalent of around $900 in his local account after the deduction of about 10 percent in administrative and exchange fees charged by every intermediary in the chain. The intricacy of this modern banking has been a series of work-arounds to get strangers to trust one another. The inevitable result is a maddeningly long chain.

Now imagine a world where the identity of the account holder is masked by encryption, but everyone can see the money in every account. In other words, everyone owns the same ledger and thus it can’t be altered unless you can gain control of the majority of all the computing resources. When Mary’s money is deducted and David’s is added, the movement is completely transparent — no reconciliations or double-checking are needed between multiple parties. Such is the basic logic of bitcoin, and its technology, blockchain, which effectively cuts out central banking oversight.

So why are big banks so enamored by such a prospect? The regulatory pressure to record everything from stock trades to money transfer has caused compliance costs to spiral astronomically in recent years. From Basel III (of 509 pages including 78 calculus equations) to the Dodd-Frank Act (2,300 pages), our centralized system reeks of Soviet-style command and control. Just by eliminating the manual processes around reconciliation with customers, trading partners and securities exchanges, it has been estimated that blockchain would deliver savings of $15 to $20 billion per year by 2022 — a net profit straight to the bottom line. For auditors, blockchain could eliminate the need to manually sample financial transactions; regulators can instead focus on identifying trends and exceptions that require further scrutiny.

Framed in this way, blockchain — a decentralized monetary system enabled by distributed ledgers — has little to do with new services or offerings that cannibalize existing businesses. Breakthrough innovation notwithstanding, blockchain is posed to support big banks in handling their voluminous transactions in years to come; it helps big banks take costs out of a bulging baseline. In other words, financial companies care less about the brave new digital currency; they are interested in better ways to move their existing assets around.

Though blockchain is now embraced by Wall Street, the biggest payoff may well lie outside it. The applications of a tamper-proof public database are practically endless, given the ubiquitous need for trustworthy records required by our modern economy. Think land registry, property deeds, proof of ownership for expensive art work, personal health records or academic transcripts, just to name a few. In fact, in theory any documents currently required to be formally notarized or vouched for by professionals can be eliminated by blockchain. Given the pioneering efforts on blockchain conducted by big banks, one should expect Wall Street to successfully capitalize future payoffs across different sectors of the economy. Alas, that scenario would defy the weight of business history that stacks against it, such as seen with the internet.

When the online world first took off, early pioneers focused on building infrastructure to navigate it. Major players were Sun Microsystems, IBM, AOL, AT&T, Microsoft, Cisco and the likes. It wasn’t until the information highway became so established that the commercial applications quickened, and with that, the coming of e-commerce: from Amazon to Google, and  Facebook to Uber. The brutal reality remains that the first wave of asset builders lacked the imagination and capacity to capitalize the very business opportunities that they doggedly created.

If history were to repeat in the evolution of blockchain technologies, big banks may one day find themselves being lauded for their pioneering spirit in building the trust machine that will take our economic connectivity to the next level. Even if Wall Street fails to ride on the future waves of a blockchain revolution, recognition that big banks are creating values for society at large that go beyond the narrow interest of shareholders would, ironically, be a worthwhile cause.

Howard Yu is a professor of strategy and innovation at IMD in Switzerland. In 2015, Yu was featured in Poets & Quants as one of the World’s Best 40 Under 40 Business School Professors. He received his doctoral degree at Harvard Business School. (@howardhyu)