Bitcoin was going to disrupt the world’s big banks. Instead, its technology is poised to save them billions of dollars.
When bitcoin first appeared a little over eight years ago, early adopters saw the potential to disrupt the big banks of the world.
It’s all there in the very first line of the abstract to the paper that introduced the cryptographically powered currency. “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution,” wrote bitcoin’s mysterious creator, Satoshi Nakamoto.
The new form of digital money attracted attention from fans of Occupy Wall Street and contrarian businesspeople alike, including Overstock CEO Patrick Byrne, who is perhaps known as much for his battles with Wall Street brokers as for his online retail success; in 2007, Overstock sued Morgan Stanley and Goldman Sachs over alleged stock market manipulation that Byrne claimed caused his company’s shares to drop.
But while big banks have generally avoided dealing in bitcoin and other cryptocurrencies, many have become quite taken with the underlying technology behind these alternative monetary systems: the digitally shared ledgers known as blockchains. In fact, within the past year or so, a Who’s Who list of the world’s largest banks—from Goldman Sachs and BNY Mellon to Deutsche Bank and Mitsubishi UFJ—have all very publicly announced plans to explore blockchain technology.
“This kind of feels like when the Internet started,” says Suresh Kumar, BNY Mellon’s chief information officer. “There is an expectation that, okay, this is something new and different, so there is some value to leveraging it, and the question is: Okay, what are the implications of that for the traditional services, and what kind of services can be enabled that were not practical before?”
While it can be implemented in a number of different ways, the core idea of the blockchain is that it’s a transaction database, similar to an accountant’s traditional ledger, but one that is digitally synced between market participants with built-in cryptographic safeguards to keep anyone from altering data that’s already been recorded. These digital ledgers are designed to ensure that everyone involved in a transaction has the same record of what’s taken place without the need to periodically reconcile records. In some cases, blockchains can also give trading partners who don’t particularly trust each other a way to do business without a mutually reliable intermediary.
“Each transaction in the ledger is openly verified by a community of networked users rather than by a central authority, making the distributed ledger tamper-resistant; and each transaction is automatically administered in such a way as to render the transaction history difficult to reverse,” states a report issued last year by Santander InnoVentures, the Spanish bank’s financial tech venture capital arm, in conjunction with finance tech investment firm Oliver Wyman.
Financial institutions are exploring the possibility of using blockchain technology to record everything from stock trades to regulatory compliance data. The answer why is simple: It could save financial institutions tremendous amounts of money and time. A widely quoted estimate from that report predicts that the blockchain could save banks $15 to $20 billion per year by 2022.
Those savings, says Oliver Wyman partner Ben Shepherd, would stem from the blockchain’s ability to enable banks to streamline processes around reconciliation—that is, the labor-intensive procedure banks go through with their customers, trading partners, and securities exchanges to verify everyone agrees on who’s paid how much for what. “That function is typically one of the biggest headcount areas on the bank operations team,” says Shepherd.
Banks hope that by automatically sharing a trusted record of each transaction, they’ll reduce the need for human intervention and the potential for error, because they will know their trading partners are looking at the same records in the same format. The goal is to shift more transaction types toward so-called straight-through processing (STP), which allows transactions to be handled from beginning to end by automated processes with no need for human intervention.
“If a process has a high STP rate, then there’s not that much more that blockchain can do,” says Kumar.
One negative side effect is that by cutting human intervention, this will almost certainly lead to cutting jobs. “I think generally it would be mean a lot less staff, particularly in the sort of transactional control area,” says Shepherd.
Employment at top financial institutions peaked in 2010, The Wall Street Journal reported last year, and employees from analysts to bank tellers are facing growing competition from increasingly smarter banking bots. A March study released by Citigroup found that bank employment could fall by another 30% by 2025, mostly thanks to automation.
Ironically, the technology that just a few years ago bitcoin enthusiasts thought might unseat Wall Street’s banking titans could end up helping the “1%” cut jobs.
But if the technology is widely adopted, the blockchain may have effects on the financial system beyond simply replacing bank workers with robots.
In areas from the $2 trillion repo market, which lets banks and hedge funds extend one another short-term loans using securities as collateral, to the syndicated loan market, where institutions team up to fund big deals like corporate buyouts, banks are planning to test whether shared ledgers will enable deals to settle faster. That could potentially mean less risk that transactions will fall through and less capital that banks have to set aside while deals are waiting to clear. The exact financial savings, however, remain to be seen.
“We believe that the capital release is beneficial but not game changing,” the authors of the Citigroup report write. “We do see some small benefit from reduced operational risk thanks to fewer trade fails and reduced counter party risk from shorter exposure.”
A move to the blockchain also brings the promise of smart contracts—agreements written in code, rather than legalese—that can automatically execute programs to shift money and other assets from account to account when certain conditions are met. The technology’s been in the news lately after a smart contract-based organization called The DAO raised $130 million through Ethereum, a recently developed cryptocurrency, with a promise to fund projects democratically selected by investors.
But traditional financial institutions and their tech firm partners are looking at smart contracts as well: just as they hope shared blockchain ledgers will help them streamline data sharing and keep information about what transactions have already taken place in sync, banks expect that mathematically encoded contracts could help them agree on the next steps in complex, multiphase transactions like derivatives deals or so-called corporate actions like share buybacks.
“Examples include removing much of the cost of corporate actions for custodian banks that manage security holdings on the part of the investors, for the automation of fund portfolio allocations following trades executed on behalf of asset managers, or in the context of international trade finance or domestic invoice financing,” states a report released earlier this month by the SWIFT Institute, the research arm of the international banking network.
But even the biggest blockchain boosters acknowledge that some of these developments are still years away. Industry standards for blockchain structures have yet to be solidified, and, as the SWIFT Institute authors point out, neither have the legal standards for smart contracts. There’s also a need to adapt the kind of contracts presently used by lawyers and judges to resolve disputes to this new technological framework.
In the meantime, though, banks are testing out blockchain technology with smaller-scale experiments, says Jerry Cuomo, IBM’s vice president of blockchain technologies. If blockchain is a “moonshot” technology for the financial industry, he likens current projects to NASA’s individual Apollo missions in the 1960s, which grew in ambition until they finally put men on the surface of the moon.
“While everyone still has their eye on the big ones, those big game-changing use cases, there are more incremental use cases that we’re starting to talk to financial institutions about that are quite interesting but more incremental,” Cuomo says.
In some cases, he adds, companies are setting up “shadow chains” which replicate existing business records on shared blockchains. That could let companies doing business together confirm that they agree on particular data points without having to change how their internal systems store information. One potential benefit of shadow chains would be in resolving accounting discrepancies in complicated transactions, because it makes it faster for companies to see where their understandings diverged.
“[Companies can say] the dispute happened after this point, but up until this point, everyone was in complete agreement,” Cuomo says. “This is where something went awry—some piece of information was captured incorrectly, or whatever.”
As smaller blockchain projects prove successful, they give companies confidence in the technology itself and, presumably, in software and cloud-computing vendors like IBM who are lining up to provide the underlying tools of the blockchain.
“It’s doing these projects that give you more conviction in going after the big projects,” Cuomo says. “I think there’s more conviction after some successful, more humble projects that the big projects are doable, and now we know how to go after them.”
So while cryptocurrencies like bitcoin arguably still search for their killer applications, their core algorithms might turn out to be pretty useful to the financial institutions they were once thought to be in line to disrupt.
“Sometimes people ask me, is blockchain a friend or foe, and to me, why would I think of that as a foe?” says BNY Mellon’s Kumar. “It’s another piece of technology that could help us and our clients and remove friction from the system.”