Decentralized lending/borrowing protocols, liquidity providers, exchanges, and other blockchain applications carry major improvements over traditional finance’s shortcomings; indeed, the current consensus on blockchain-based decentralized finance (DeFi) preaches the inevitability of how it will supplant traditional finance.
So, why do we believe that two seemingly competing industries can coexist and leverage each other, at least in the medium term? The answer to this question was discussed in a recent blog post [1] and can be found when looking into the human emotion of fear, born from a lack of knowledge. In this instance, lack of knowledge pertains to both sides.
Why fear? Because it is caused by a perception of danger. In the case of financial services, the perceived danger is that institutions will be outpaced by blockchain-based companies. Similarly, retail users are paradoxically skeptical of those same benefits that blockchain introduces in the system; no centralized authorities that can resolve issues, state-of-the-art technology that can’t be easily understood by non-savvy investors, and no centralized regulation to keep ‘fair play,’ among others. These are some of the reasons that prevent blockchain from mass-adoption and winning the ultimate prize: gaining one of the biggest economic sectors on the planet.
Knowing this, what can centralized financial institutions (FI: banks, insurance providers, funds, etc.) do to keep the lion at bay? First, they must have a deep understanding of what their relative strengths are and pinpoint the factors that prevent blockchain from gaining mass adoption. Once they have accomplished that, they may undertake the enterprise of leveraging blockchain technology within a centralized framework. Many believe that blockchain will do to finance what the internet did to the media industry; while it didn’t completely dismantle it, it did grant higher access and cheaper products to users and forced media companies to adapt to a new status-quo.
Competitive strengths and weaknesses of financial institutions.
Spotting some of the main competitive strengths of centralized FI is not a straightforward task. Within them we can find:
- First and foremost, borrowing & financing are the main services that characterize the banking industry, and although it is already being threatened by providers like Aave, Maker, and Compound, they still have the advantage of being renowned institutions that wary investors choose to invest in. Decentralized finance (DeFi) has a total lending value locked of US$ +6B, while the commercial and industrial loans in the United States alone amount to US$ 2.7T.
- Underwriting & decision making are two services that are hard to displace by technology alone, given that there is a high degree of human interaction, experience and intuition within them.
- Another arguable strength is the economic stability that centralized FI provides to societies and ecosystems. We say ‘arguably’ because there are debates taking place about how new cryptocurrencies can take over this role. The consensus is, however, that even if this is a strong future possibility, trust in cryptocurrencies is not a current worldwide reality [2].
- Facilitates the management of risks. Main financial risks include market risk, interest rate risk and credit risk. All of them are directly or indirectly present in the world of cryptocurrency, as well.
- Provides mechanisms for dealing with asymmetric information (centralized FI developed and continues to develop a series of mechanisms to account for what they don’t know). Credit ratings, liquidity and solvency scores, and others are just some of the many that are present in the current financial system.
Similarly, other services that are prone to be highly challenged by decentralized ledger technology (DLT) include some core functions of the financial system:
- Currency safekeeping: Remember the old-days, when money was limited to its physical form, and the best way to keep it safe was handing it to a bank to diminish your exposure to robbery? Nowadays, decentralized currencies are kept secure through cryptography and provide the best alternative for the safekeeping of private funds. A number of custodial and non-custodial wallets in both digital and real (hardware) formats are available for users depending on their preferences on UI, practicality and security [3][4][5].
- Clearing & Settlement are two processes that may not be the most glamorous, but are definitely established for FI’s clients. Moreover, despite being heavily threatened by the simplification of processes by blockchain, it is an area that can be (at least in the short term) heavily empowered with an interest cost reduction. In 2017, Accenture estimated that an average of US$ +10B a year could be saved [6].
- Payment systems for the exchange of goods and services are the distinguished case of the ‘lost battle.’ Explicit in Bitcoin’s whitepaper, ‘peer-to-peer electronic cash systems’ are being constantly improved upon and are ever closer to gaining the payment battle. In the meantime, FI must stand on the regulatory and technological inconsistencies of DLT that prevent growth and universal adoption, and aim to prolong the fight for as long as possible.
- Mechanism for the pooling of funds to undertake large-scale indivisible enterprise, and the transfer of economic resources through time and across locations present two extra categories threatened by DLT.
Centralized institutions and blockchain outlook
Accounting for their relative strengths and the factors that put a stick in the blockchain evolution wheel, banks can evolve by:
- Monitoring, understanding & accepting what they can and can’t change. This is the first step before progressing onto specific transformations. Having a clear understanding of future business models, they can incorporate blockchain technology where it matters, and drop uncompetitive product lines.
- Reducing fees. Almost every service financial institutions provide either is or will be under attack, there is no way around it. Accepting that creates an opportunity for those who take the lead in reducing fees, gaining market share today and hopefully maintaining a larger client base going forward.
- Specializating & downsizing. Offering startup ventures bypass capital markets through blockchain-based offerings, personalizing products, offering guidance, and tokenization opportunities, which are some of the areas financial institutions can specialize in themselves, in order to have a fighting chance. In these same lines, downsizing soon-to-be outdated market segments permits a faster and more fluid opportunity to adapt.
- Using cryptocurrencies as investment vehicles. It’s hard to fathom that the knowledge of institutional investors can be easily surpassed by newly assembled decentralized organizations. Historically, funds had the most capable systems in place and individuals to navigate the volatile nature of most assets. Additionally, given the expected risk-adjusted returns of various cryptocurrencies v return on typical assets (stocks, bonds, etc.), it can provide investors of funds with extraordinary managed returns.
Some recent cases
Let’s take a look at some current projects that provide evidence for our position.
- Payment services provider PayPal announced the launch of a “new service enabling its customers to buy, hold and sell cryptocurrency directly from their PayPal account, and signaled its plans to significantly increase cryptocurrency’s utility by making it available as a funding source for purchases at its 26 million merchants worldwide” [7][8].
- Banks: JPM has been piloting a blockchain-based Interbank Information Network since 2017, involving over 400 participating banks and corporations. A year after the announcement, it has launched its own cryptocurrency (JPM Coin), used primarily for fund transfers and faster transaction settlements among clients [9]. Similarly, other main banks around the globe have been offering blockchain-based investment products or optimizing current processes with it.
- Exchanges: Nasdaq, a historic American exchange, has been a long-time believer and one of the earliest, most prominent blockchain adopters. Since 2015, when it partnered with Chain to power its private securities platform, to its recent association with R3 blockchain solution provider, Nasdaq continues to prove its firm stand on blockchain adoption. Comparably, Swiss digital exchange “SIX” and Australia’s “ASX” are also located in crypto-friendly regulation countries that aim to leverage blockchain benefits for improving their processes.
For more detailed information on blockchain applications in the banking industry please visit Haitham Nobanee survey and Blockchain-works 2017 article [10][11].
Conclusion
Steering the ship in the turbulent waters of what can be considered the fourth industrial revolution is not an unchallengeable mission. An unwavering mindset and strong leadership is key for making the tough decisions that financial institutions are faced with when competing with blockchain technology.
Is it possible to succumb in the face of adversity? Definitely. Is it plausible to adapt and avoid that same route? We believe so. But the absolute condition is to start that path today. Hoping for the best is an alternative that will inevitably result in extinction.
Scalable Solutions can aid institutional clients in applying the best of blockchain technology to their systems, thus taking advantage of financial innovations happening in the industry. Find out more by getting in touch with our team here.
References
[1] Marais, Piers. “Cryptocurrency Is Dead. Long Live Central Bank Digital Currency!” Finextra Research, Finextra, 28 Aug. 2020, www.finextra.com/blogposting/19256/cryptocurrency-is-dead-long-live-central-bank-digital-currency.
[2] For a detailed explanation on digital currency wallets please visit our recent article: “Custodial v Non-custodial wallets”
[3] “Imagine 2030: The Decade Ahead.” Deutsche Bank Research, 4 Dec. 2019.
[4] Danielsson, J. (2019). Cryptocurrencies: Policy, economics and fairness. Systemic Risk Centre Discussion Paper, 86, 2018.
[5] Breckenridge, Garrison. “Crypto and Fiat Currencies Are Worlds Apart, Here Are the Reasons Why.” Cointelegraph, Cointelegraph, 31 May 2020, cointelegraph.com/news/crypto-and-fiat-currencies-are-worlds-apart-here-are-the-reasons-why.
[6] “SERIES: BANKING ON BLOCKCHAIN—A VALUE ANALYSIS FOR INVESTMENT BANKS.” Https://Financialservicesblog.accenture.com/, Oct. 2017, financialservicesblog.accenture.com/series/banking-on-blockchain-a-value-analysis-for-investment-banks.
[7] “PayPal Launches New Service Enabling Users to Buy, Hold and Sell Cryptocurrency.” Https://Newsroom.paypal-Corp.com/, 21 Oct. 2020, newsroom.paypal-corp.com/2020-10-21-PayPal-Launches-New-Service-Enabling-Users-to-Buy-Hold-and-Sell-Cryptocurrency;
[8] Shevchenko, Andrey. “PayPal to Offer Crypto Payments Starting in 2021.” Cointelegraph, Cointelegraph, 21 Oct. 2020, cointelegraph.com/news/paypal-to-offer-crypto-payments-starting-in-2021.
[9] Authors, Guest. “JPMorgan’s Blockchain Products, Explained by Ex-JPM Tech Leads.” Cointelegraph, Cointelegraph, 24 Nov. 2019, cointelegraph.com/news/jpmorgans-blockchain-products-explained-by-ex-jpm-tech-leads?_ga=2.267145614.141223522.1605272677-543740393.1604919522;
https://www.jpmorgan.com/insights/technology/blockchain
[10] Albeshr, S., & Nobanee, H. (2020). Blockchain Applications in Banking Industry: A Mini-Review. Available at SSRN 3539152;
[11] Campbell, Rebecca. “Which Major Banks Have Adopted or Are Adopting the Blockchain?” Blockchain Works, Blockchain Works, 12 Nov. 2020, blockchain.works-hub.com/learn/Which-Major-Banks-Have-Adopted-or-Are-Adopting-the-Blockchain-.
General Sources
Cocco, L., Pinna, A., & Marchesi, M. (2017). Banking on blockchain: Costs savings thanks to the blockchain technology. Future internet, 9(3), 25.
Daisyme, Peter. “The 5 Ways Banks Must Transform to Thrive in an Era of Cryptocurrency.” Due, 24 May 2019, due.com/blog/the-5-ways-banks-must-transform-to-thrive-in-an-era-of-cryptocurrency/.
Mogul, Zubin, et al. “How Banks Can Succeed with Cryptocurrency.” BCG Global, BCG Global, 3 Nov. 2020, www.bcg.com/publications/2020/how-banks-can-succeed-with-cryptocurrency.
Pollock, Darryn. “The Future Of Banking: Is It All Bitcoin And Blockchain?” Forbes, Forbes Magazine, 25 July 2019, www.forbes.com/sites/darrynpollock/2019/07/25/the-future-of-banking-is-it-all-bitcoin-and-blockchain/?sh=381078f131eb.