Module 4: Blockchain Applications in Financial Services

What role can blockchain technology play in the financial services sector? In Module 4, we explore the many different use cases and advantages of blockchain in finance.

Introduction

As we have seen so far, blockchain technology is a type of distributed ledger technology (DLT) that is decentralised. It is a "chain of blocks" in which each block contains timestamped digital data and its own unique identity, known as a hash.

The application of blockchain in financial services has been seen as the technology's primary use case since its introduction. When it was employed for the cryptocurrency Bitcoin in 2009, as seen in the previous module, the technology received a lot of traction. Today, the unique and innovative characteristics of blockchain have the potential to overhaul the finance industry.

Our global financial system serves billions of people and moves trillions of dollars every day. However, the system is riddled with flaws, increasing costs through fees and delays, causing friction through onerous record-keeping, and opening the door to fraud and criminality. Because of this, regulatory costs are continuing to rise and remain a significant source of concern for bankers, with banking customers ultimately bearing the burden.

How Can Blockchain Technology Solve the Challenges Faced by the Finance Industry?

The finance industry has faced plenty of challenges. Although significant technological breakthroughs have resulted in the solution of various problems, some new technologies have also resulted in creating new issues.

Blockchain in financial services is extremely promising and can alleviate many of the industry's problems. Let's have a look at how.

1. Better Security: Financial services are still centralised and multi-layered all over the world. Financial data is typically housed in centralised systems and must pass through several intermediaries, including the front office, back office, and other departments. The system severely lacks transparency, with the data's protection exclusively reliant on middlemen and database security. Even if databases are well-protected, there is still a significant risk of data leaks and server hacking.

By implementing blockchain technology, financial institutions will become more secure. Blockchain technology is based on principles of cryptography, decentralisation and consensus, which ensure trust in transactions. Blockchain technology enables decentralisation through the participation of members across a distributed network

2.Payments: By establishing a decentralised ledger for expenses (e.g. Bitcoin), blockchain technology could facilitate faster payments at lower fees than banks.

3.Clearance and Settlement Systems: Distributed ledgers can reduce operational costs and bring us closer to real-time transactions between financial institutions.

4.Fundraising: Initial Coin Offerings (ICOs) are experimenting with a new model of financing that allows access to capital from traditional capital-raising services and firms.

5.Securities: By tokenising traditional securities such as stocks, bonds, and alternative assets, blockchain technology could create more efficient, interoperable capital markets.

6.Loans and Credit: Blockchain technology can make it more secure to borrow money and provide lower interest rates by removing the need for gatekeepers in the loan and credit industry.

7.Trade Finance: By replacing the lading process in the trade finance industry, blockchain technology can create more transparency, security, and trust among trade parties globally.

8. Customer KYC and Fraud Prevention: Blockchain technology can make it easier and safer to share information between financial institutions by storing customer information on decentralised blocks.

Blockchain Use Cases in Finance

There are many uses cases for blockchain in finance, but we shall look at three prominent use cases today.

1. Cross Border Payments

2. Clearance and Settlements in Capital Markets

3. Trade Finance

Cross Border Payments

Transferring goods or payments across borders is expensive and time consuming since banks impose an extra fee for each transaction. For example, if someone wants to send money from the United States to Russia, the transfer must transit through several financial institutions.

The transfer chain is as follows: sender's bank, sender's central bank, receiver's central bank, the receiver's bank before finally reaching the intended recipient.

With blockchain technology, Individuals can send and receive money without third-party intervention. In addition, cross-border payments can also be handled quickly and more cost-effectively with the help of blockchain payment solutions supported by blockchain networks.

According to the World Bank, the global average cost of sending $200 worldwide in the fourth quarter of 2020 was 6.5% of the initial amount sent.

One solution that financial institutions have implemented to mitigate high-cost and slow global transfers is SWIFT.

SWIFT is essentially a financial messaging network that allows banks to connect for global bank transfers. It is important to note that SWIFT is a secure messaging platform that does not handle money or accounts. The purpose of SWIFT is to avoid long-chain intermediaries. However, SWIFT still has limitations such as cost and speed as human intervention to process the transactions.

Blockchain Advantages in Cross Border Payments

Reduced Costs

Intermediation comes at a high cost. Every intermediary charges a transaction fee. Solutions such as SWIFT are still expensive for banks, and expenses are passed to the customers.

Faster Transactions

Blockchain offers an almost real-time transfer rate as compared to intermediate alternatives that can take up to 2-5 days to process.

Higher Security

Blockchain's immutability provides more robust security for monetary transactions of any size. SWIFT network has been susceptible to network attacks leading to the loss of billions of dollars. 

Clearance and Settlements in Capital Markets

As much as capital markets are highly digitalised, the underlying process is still entirely manual and inefficient. Clearinghouses are one of the most prominent players in capital markets transactions and act as the central intermediary for trades and ensure trust between trading parties. However, the processing of transactions at the clearinghouses remains slow.

How Can Blockchain be Applied to the Process?

Smart Contracts

Blockchains allow for the creation of self-executing smart contracts that set out the terms of a transaction. Smart contracts could replace manual guarantees (in the form of emails), allowing for real-time settlement.

Open Source Decentralised Ledger

With an open-source decentralised ledger, intermediaries are eliminated, and the decentralised database is transparent. Instead of relying on a clearinghouse to validate trades, validation is completed by every network participant, and a blockchain consensus pool officiates the process.

Advantages of DLT in Clearing/Settlements

The advantages of DLT in clearing and settlements are as follows:

Transparency

All parties act as validators and have access to the decentralised ledger.

Efficiency

Processing speed is reduced from up to 3 days down to seconds.

Faster Auditing

Auditing is faster and easier as all transactions are recorded in real-time and are easily accessible through a decentralised database.

Trade Finance

In simple terms, trade finance is when an exporter requires an importer to prepay for goods shipped. The importer's bank assists by providing a letter of credit to the exporter (or the exporter's bank), providing for payment upon presentation of certain documents, such as a bill of lading.

With advance payments, payment is made before shipping, and the risk remains with the importer. With open accounts, the payment is made after shipping, and the risk remains with the exporter.

Currently, the solution is to introduce a crediting bank between the importer and exporter. The crediting bank issues a letter of credit guaranteeing that the importer will pay for the goods once the shipping is received as per the agreement. In case of default on behalf of the importer, the bank agrees to payments. However, this is an expensive and time-consuming process.

Blockchain Solution to Trade Finance

The terms of a sales contract can be easily coded onto a Blockchain-based smart contract. The transaction process then becomes peer-to-peer, and payment is automatically executed once the goods are delivered or refunded if the sales contract is breached. Also, since the process involves cross-border payments, peer-to-peer transfers will be less expensive for both parties.

More Blockchain Use Cases in Finance

Lending Platforms

Today, most users rely on intermediaries to establish trust and complete transactions. With blockchain in finance, however, borrowers may negotiate directly with lenders on interest rates, instalments, and transaction duration using immutable smart contracts. Smart contracts allow borrowers and lenders to negotiate terms. If borrowers fail to comply with the requirements, the smart contract adds late payment costs to the total amount due to the lender.

In recent years, there has been a significant increase in loans underwritten by fintechs and alternative lending platforms. With non-bank lending gaining momentum, blockchain-based lending platforms are cropping up, and fintechs are offering an ever-more diverse selection of products. Many banks have attempted to build on their digital capabilities to stay competitive, but this alone is not enough. Banks need to aggressively cut operating costs, pursue partnerships and technologically overhaul current lending processes. 

Credit Score

Before proceeding with a loan application, banks and other financial institutions demand an applicant's credit score. The lack of mobility in credit ratings is one of the present credit management system's flaws. A person's current credit score is not transferable to another country. As a result, a universal credit score is required. The recent hacking event involving the credit agency "Equifax," which exposed the personal information of 143 million Americans, also highlighted the need for a systemic overhaul and is a cautionary tale in relying on centralized entities.

Using blockchain to manage credit scores could offer more transparency to the system. Lenders can examine immutable records of financial transactions on the blockchain to determine a person's creditworthiness. Smart contracts ensure that an applicant's personal information is never compromised or disclosed.

Government Expenses

Governments all over the world are implementing digital ways to update legal processes and improve citizen relations. Technological advancements have made it possible to boost the openness of public finance in order to make the system more reliable.

With the implementation of blockchain technology in this space, citizens could keep track of how and where their money is being spent by the government. Thus, the citizens' fight against corruption can be averted if governments start using public blockchain to store information about expenses spent on development, centralized digital currencies, healthcare, etc.

Conclusion

Blockchain in financial services can offer multiple benefits, which can help transform the finance industry and also benefit consumers. Blockchain in finance is an exciting concept with the potential to overhaul the finance industry completely.

In the last module of section 1, we will share more about Ethereum. Click here to read on!