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Blockchain: unlocking its potential in commercial banking

By Darryl Proctor 13 Oct 2016

Rather than fear blockchain technology commercial banks should engage with it to understand its potential to deliver efficiencies and reduce risks.

The creation of Bitcoin depended from the beginning on its underlying blockchain technology. Essentially, a blockchain is a distributed online database that can be accessed by multiple users simultaneously, updates in near-real time and cannot be altered retrospectively.

The original idea was that by building this distributed, unalterable database, banks could be removed from the payments process altogether, enabling individuals to transact with each other directly.

However, although the intention of Bitcoin's inventors was to remove banks from the picture many financial institutions are now investigating how they could take advantage of this technology to reinforce their position. For example, the recently established Hyperledger project, hosted by the Linux Foundation, brings together more than 80 organisations including banks in a joint project to create an agreed open source blockchain framework that will enable organisations to build their own, industry specific blockchain applications.

But as with other attempts to adapt the principles behind the original Bitcoin blockchain to create practical applications in the commercial world, it is clear that the public Bitcoin blockchain itself is not robust or secure enough to meet the needs of banks or the expectations of their regulators and clients. Instead, banks are leaning towards private distributed ledgers that incorporate an additional feature – smart contracts – including those that are being developed by companies such as Ethereum, Eris, Tendermint and R3, the main banking blockchain consortium.

Smart contracts are self-executing programs embedded in the blockchain that automatically permit the next step in a process to take place once the necessary conditions have been met – "if x, then y" in effect – and set out the penalties that will apply if the conditions are not met. In principle, incorporating these self-executing, condition-based programs into a private blockchain would enable essential steps in a transaction that today have to be validated and actioned by an intermediary to be completely automated.

These could offer much faster processing and settlement in areas that remain cumbersome and largely paper-based, such as international trade finance. Instead of correspondent banks needing to verify and exchange the various pieces of paperwork required to complete each stage of a cross-border trade transaction, the process could be run on a private blockchain that links the multiple parties and uses smart contracts to automate the progression from one stage to the next. This explains why many observers believe that the real game-changer in institutional take-up will involve distributed, private databases based on blockchain technology that are accessible to all member banks and incorporate these smart contracts.

Some banks are already active in this area: in September, Barclays and tech start-up Wave executed the first international trade transaction using an electronic bill of lading transferred digitally via blockchain technology. News that the first blockchain trade transaction has completed also indicates that companies are becoming more focused on the potential of blockchain. In the recent Ovum Corporate Treasurer Survey, two thirds of the respondents globally were "interested in solutions based on blockchain technology to reduce my trading risks".

Equally, blockchain is being suggested as way to streamline and de-risk the factoring business, where banks advance funds to the seller of goods or services before the buyer has paid for them. This is another cumbersome process that involves manual checking and opportunities for fraud, and could be made more efficient by a single, distributed ledger including smart contracts.

For commercial banks looking for more efficient – and therefore cheaper – ways to support high-friction operations such as these, blockchain looks to have great potential. But even these apparently obvious applications of the technology are not fully understood yet, and major questions remain unanswered.

Perhaps the most important is how adoption of this technology will happen in practice. Consortia such as Hyperledger and R3 are working to develop technology frameworks and use cases for blockchain within banking, but we are still some way from agreement on standards and protocols in all sorts of areas such as data security, confidentiality, governance and inter-operability. How will that change? Barclays says it hopes to persuade other banks to use Wave's technology for trade finance in the hope that it will develop into a de facto industry-wide standard, and there is much to be said for pushing ahead rather than waiting for common standards to be agreed. Co-operation between groups of banks is obviously going to be critical because distributed digital technologies such as blockchain benefit heavily from the network effect – they become more powerful, efficient and valuable the more users they attract.

While they await agreement on industry standards, banks may decide instead that the best way forward is to explore internal use cases for blockchain-based systems, for example to increase efficiency in internal workflows such as pre- and post-trade, where collaboration with other institutions is unnecessary. Limited exercises such as these will enable them to be much better prepared when bigger, industry-wide implementations come over the horizon.

Temenos is convinced that in a developing situation such as this, where the final technical standards are not clear, banks that have modern, flexible core banking software that supports open standards will be best placed to adapt to the new environment and move from a SWIFT-based trade finance system to one built on blockchain and smart contracts.

We also believe that for all the potential advantage of a move to distributed ledgers and smart contracts it's also possible they will pose challenges to banks, for example by enabling their disintermediation from certain processes. If smart contracts enable a trade finance transaction to self-execute, is a bank needed to bring trust to the process and service the various parties, or could that role be taken on by another organisation? New technologies frequently bring the threat of disintermediation in financial services, and this is why we believe banks must engage and explore the possible applications of blockchain in order to counter this threat.

As a software provider to financial institutions, Temenos believes blockchain is a technology that could change the industry and it's one that is easy for us to work with because we have modern technology architecture. But although we're clear that blockchain has the potential to take the friction out of cumbersome processes and enable transactions to proceed much more quickly and securely, banks will need to consider its impacts – positive and negative – very carefully. The best way to do that is to start experimenting, understanding possible use cases and gaining early insights.

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