Why do banks care more about blockchain than Cryptocurrencies?

“I could care less about bitcoin. I don’t know why I said anything about it. The blockchain is a technology which is a good technology. We actually use it. It will be useful in a lot of different things. God bless the blockchain.” – Jaime Dimon, CEO of JP Morgan.

Dimon’s numerous disparaging comments about Bitcoin has drawn much ire from proponents of the world’s leading cryptocurrency. But one thing he says is unequivocally true – that banks are significantly more excited about the technology underlying Bitcoin – the blockchain – than with Bitcoin itself.

Cryptocurrency is just one of a myriad of applications that can be powered by blockchain. The crypto world is gaining the most attention at the moment simply because of the stratospheric gains that investors are realizing from Bitcoin, Ethereum et al.

But the reality is that blockchain has a set of characteristics that make the technology highly useful in improving the speed, efficiency, cost, transparency, security and verification of banking processes. Indeed, soon after such advantages began to be discovered, many of the biggest banks promptly followed up by establishing research labs to explore its disruptive potential. And importantly, banks continue to anticipate huge transformative and beneficial possibilities by adopting this technology…

The immense, wide-ranging potential of blockchain in banking

Blockchain solves more problems for the banking industry than Bitcoin. Here are five of the most anticipated applications of distributed ledger technology for banks:

• Trade finance – the process by which banks provide credit to business customers in order to guarantee exchange of goods. This process is very antiquated, with much of it being paper-based; for example, bills of lading or letters of credit that are sent by fax or post around the world. Blockchain can “drive efficiencies, reduce cost base and open up new revenue opportunities, like newer models of credit and funding guarantees backing the trade”
• Payments – Cross border payments currently remain slow, expensive and possess a distinct lack of transparency. The noted FinTech firm R3 is currently working with a consortium of many of the world’s biggest banks to put in place an international payments system “that would allow existing central bank currencies and any new digital ones to be transacted via the blockchain”. IBM is also designing a new blockchain to enable banks to speed up cross-border payments, with the technology now expected to process up to 60% of all foreign currency transactions in the South Pacific’s retail foreign exchange corridors, including Australia, New Zealand, Fiji, Samoa and Tonga by early-2018. Back in 2015, a renowned paper from Santander, in collaboration with Oliver Wyman and Anthemis Group, forecasted that distributed ledger technology could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15-20 billion per annum by 2022.
• Clearing and Settlement – Accenture estimates that the world’s biggest investment banks could save $10bn by using blockchain technology to improve the efficiency of the clearing and settlement process. For instance, the Australian Securities Exchange has partnered with renowned blockchain start-up Digital Asset Holdings – and purchased a 5% equity stake in the company – to develop a new blockchain solution for the clearing and settlement of trades. The technology is expected to both simplify and speed-up post-trade processing.
• Regulation and Compliance – It is worth remembering the kind of climate banks have been operating in since the 2007-09 financial crisis – namely one of risk management and/or aversion, regulation. The combination of a backlash against perceived banking recklessness, low interest rates, strict regulations, government control and low consumer trust made banks shift focus away from prioritizing money-making, to ensuring customers and taxpayers are protected. Blockchain is now playing a major role in the RegTech revolution. As the Institute of International Finance acknowledged, “blockchain is transparent by design and could be a mechanism to give regulators direct, instant and full transparency of information in financial institutions. Since all transactions are documented on the distributed ledger, a comprehensive, secure, precise, irreversible, and permanent financial audit trail could exist for regulators. Reporting could be replaced by regulators’ participating in an appropriately permissioned transaction-related distributed ledger”.
• Syndicated loans – it takes an average of 19 days for banks to settle money raised via a syndicated loan in the US. Much of the communication is also fax/paper-based. Seven banks, including BNP Paribas, HSBC, ING, BNY Mellon and State Street, are now jointly developing a block-chain powered marketplace for syndicated loans.

And there are several more uses, including identity/KYC improvements, digitizing corporate bonds using smart contract technology, and fraud prevention.

There is also the issue of competition. Whether banks like it or not, FinTech start-ups are offering blockchain-based services (for example, in remittances and payments) that are more cost-effective, faster, simpler and more accessible than what was previously on offer in the banking sector. Banks have had to innovate and offer similar services simply to ensure they don’t lose customers and can maintain market share.

The problems banks have with Bitcoin

Despite being less than ten years old, Bitcoin’s short history is already littered with major controversies:

• Gox– bankruptcy of the world’s biggest Bitcoin exchange after $460 million was reportedly stolen by hackers.
• The feature of anonymity when trading Bitcoin has meant that cross border transaction business inevitably attracted illegal activity, including drug dealing, money laundering and even terrorism financing. Such activity led to the shutdown of infamous online black-market venue Silk Road in 2014. Banks are doing their best to improve their AML credentials at the moment – exposure to Bitcoin would not help this cause.
• While the blockchain itself is immutable, the exchanges that are hosting crypto trading are not decentralized. This has led to numerous incidents of exchanges being hacked and millions of dollars of Bitcoin and other digital currencies being stolen; for example, Bithumb. Clearly such poor security on exchanges would be a no-go for banks.
• Volatility – Bitcoin topped $10,000 earlier this year, meaning that it has surged by a barely believable 850% last year. That’s four times more than dot-com stocks were returning during their most frenzied period in the late 1990s. Is Bitcoin a bubble? Will it eventually crash? Difficult to say, but with the lack of any clear certainty surrounding this issue, banks are clearly erring on the side of caution during this post-crisis period.

It should be mentioned that banks are not completely dead on the idea of using cryptocurrencies. On the contrary, Ripple in particular is garnering much interest from big-name banks such as Santander, UniCredit, UBS and Standard Chartered. The San Francisco-based firm aims to be a “SWIFT-killer” by creating a singular global settlement network for the transfer of any currency to anyone in the world in a matter of seconds. By providing a network for other currencies, therefore, Ripple is not just another cryptocurrency like Bitcoin.

What’s more, lightning-fast settlement speeds (less than 4 seconds), scalability (can handle “1,500 transactions per second, 24×7, and can scale to handle the same throughput as Visa”) and relative price stability have also allowed Ripple to court banks’ interest, while they largely continue to ignore Bitcoin.

That’s not to say that banks are completely against Bitcoin; indeed, Goldman Sachs is weighing up the possibility of setting up a new Bitcoin trading operation – such a move would mark Wall Street’s first major foray into the cryptocurrency market. But at the same time, the bank stresses the importance of traditional asset classes such as gold, suggesting any steps into the Bitcoin trading world will be tentative.

And with the gradual development of the Bitcoin futures/options markets, banks may warm to Bitcoin more if they believe they can manage/hedge the price risk effectively with the derivative tools becoming increasingly available.