Blockchain Applications in Financial Services

Blockchain Technology in FinTech and Capital Markets

Blockchain Technology (also called Distributed Ledger Technology (DLT)) allows for the entire financial services industry to dramatically optimize business processes by sharing data in an efficient, secure, and transparent manner.

As the key mechanism for digital cash transactions, blockchain technologies are reshaping the financial services landscape. Existing inefficient business models and profit pools are beginning to face the risk of complete disruption by upstart, highly efficient blockchain-based financial platforms. Substantial benefits are to be gained from using blockchain technologies, especially in back-office operations as the distributed ledger works to improve transparency and security. This is very favorable from an auditing and regulatory perspective. Those harnessing these advancements early on are set to have key competitive advantages in the financial services industry for years to come.

The existing capital markets infrastructure is slow, expensive, and often requires several intermediaries. The bureaucratic nature makes performing and receiving financial services difficult. Many new blockchain capital market inventions are entering the market and improving work flow and helping to cut overhead dramatically, while allowing entities to deliver better, more secure and private services to businesses and individuals.

How the Centralized Banking System Works

To understand the concept of decentralized financial services, we first must understand the current dominant framework for money management—centralized banking.

If you have a bank account, which nearly all of us do, then you are a part of the centralized banking system. The structure for centralized banking is quite straightforward, you give your fiat funds to the bank and they store them for you. People all over the world store their money in a central location managed by a third-party. Bank and bank personnel serve as a managing intermediary layer between you and your funds. Within this system there are fees you have to pay to the centralized bank in order to access and manage your money.

The global banking industry as it stands today is a $134 trillion shrine to our dependency on these centralized financial services. Living without a bank account in a modern day developed country would be extremely difficult, if not impossible. From this vantage point it is easy to feel helpless and absolutely at the whim of these banks. There have to be some benefits beyond conformity that we are garnering from their use? Right?

Here are the main reasons why we use the centralized banking system:

1. Efficiency

Up until this point, centralized banking has been the most efficient way for us to store our money. Banks have provided convenient branch locations where we can receive in-person assistance in managing our funds. There are also easy-to-use web portals and mobiles apps now that allow us to bank from anywhere in the world (or right from our couch). Banks can approve us for loans, debit cards, and credit lines. There are now additional centralized payment platforms too, like PayPal or Venmo, that make daily micro transactions fast and easy.

2. Security

Storing cash on your person or in the home has been a popularly considered a bad idea for some time now. If you get robbed or the house catches fire, there goes all of your hard-earned money. Also, it is against Federal Law and in many cases if you are not claiming these funds it is considered tax evasion or money laundering. Now with direct deposit and the previously mentioned micro payment platforms, we are rarely required to handle cash. Storing funds in a centralized bank insures the funds against theft and fraud and has been the most secure way to keep your funds.

3. Interest

Despite interest rates being generally low at central banks for savings accounts, some interest is better than no interest. We get rewarded for allowing the bank to safeguard our funds.

Banks were the most efficient way of storing funds, and now with blockchain technology, we are able to harness that new efficiency and decentralize the power away from a central source. While banks seem all powerful and we feel in part obligated to them, the banks are actually the ones dependent on us. Without our money they are just a name or a place. Banks need us as much as we have needed them. The less we deposit, borrow, and transact within the central banking system, the less power the centralized system has and the more power will be shifted to peer-to-peer financial services. The competition will also pressure banks to deliver services on par with their new decentralized counterparts.

How Blockchain-Based Financial Services Are Better

 Decentralized financial services are theoretically a vast improvement on the centralized banking system, and many believe that distributed ledger technology will work to disrupt these institutions as we know them. Before Satoshi Nakamoto created digital currency that can only be spent once, solving the double-spend issue that long stood as an obstacle to digital banking, there was no way to avoid centralized banking without storing cash under your mattress.

Now blockchain technology is used to convert fiat to digital currency using a peer-to-peer verification protocol. Rather than having a bank authenticating your financial activity, with decentralized banking the distributed network supports and verifies each transaction through mining (like with Bitcoin) or another protocol.

Blockchain explained in the simplest terms, converts fiat into a digital currency through a peer-to-peer electronic cash system. With blockchain banking, every peer on the network has a list with all transactions and can validate transaction via consensus rather than by a single institution like a bank. How does this competing method of money management eliminate overhead and ramp up efficiency?

Here is how decentralized banking improves upon the centralized banking model:

1. More efficient

Blockchain technology enables faster global trade across time zones. As we move towards a more globalized economy we will need more effective protocol to deal with increasing cross border transactions. Traditionally, these transactions can take days or even weeks to process. Blockchain is faster because it works to automate the verification process, eliminating the need for multiple parties to confirm manually. Blockchain technology will continue to increase in speed as its scale increases.

2. More secure

Blockchain technology allows liability for funds to be distributed throughout the network. Distribution as a strategy has been a historically logical approach to one’s storing assets. If just one singular, centralized institution controls access to funds, when faced with market volatility, you could potentially be denied by an all-powerful gatekeeper. Centralized systems are more vulnerable because there is one point of entry and one point of exit. Conversely, a large peer-to-peer network with automated verification has no single proprietor and risk is dispersed accordingly.

3. Higher potential for increased value on digital assets

While high interest rates are attractive to banking customers for savings accounts, they are rarely more than one or two percent. While crypto markets might fluctuate, the potential return on investment for owning digital assets is infinitely higher. Cryptocurrency value is determined by how many peers are using that currency and network. The more efficient and widely used coin platform, the more likely the digital asset will increase in value.

4. Lower associated costs

There are little to no associated costs with smart contract-based transactions. No more domestic or international wire fees or overdrafts. There are, however, many hidden fees associated with centralized banking that exist to support the enormous overhead operating a central bank requires. With decentralized financial services overhead is at a complete minimum. The tamper-proof ledger also helps prevent fraud, identity theft, and the costly legal services that follow.

How a Transaction is Verified on the Blockchain

Blockchain-based transactions can seem pretty mythological at first. To understand how a transaction is verified in an anonymous and automated fashion, first imagine actual, real-life building blocks. For every transaction there is one block. On one side of that block is a private key and on the opposite side a public key, these two together create a digital signature that is unrelated to personal identity, meaning your name or information is not associated at all with the block that gets sent out to the node network, which represents your transaction on the public ledger.

Every block also has a timestamp and a 10-digit hash of that previous block, verifying the transaction before that one. This is what puts the “chain” in blockchain. The leap frogging hashes link together all the transactions in a long line of verified transactions.

Verification systems vary from blockchain to blockchain and developers are only just starting to really experiment with verification processes and ways to incentivize the peer-to-peer network to authenticate transactions in more energy efficient ways.

This peer-to-peer verification system is the mechanism for all blockchain applications in financial services that we are going to discuss below.

Blockchain Technology Financial Services Use Cases

Blockchain technology can be applied to financial services in countless ways. Smart contracts can execute events independent of a third-party, and they have the capacity to automatically take on managing stocks, bonds, deeds, claims, and settlements. In this section we will talk about some top ten major use cases for blockchain technology that have the potential to majorly disrupt centralized financial institutions as we know them today.

Cross-Broder Transactions

• This use case we have already discussed pretty thoroughly, but it is worth repeating as it is the one of the most important use cases for blockchain. It could enormously benefit not just a stand-alone industry, but the entire global economy. Transferring funds has been a notoriously slow and expensive process within the centralized banking system. With the use of peer-to-peer networks to verify transactions, millions can be processed across several time zones in seconds.

Smart Bonds

• Instead of using traditional bonds, using smart contract technology investors can hold Smart Bonds instead. Smart Bonds are automated bond contracts that use blockchain technology to automate bond registry services. The use of smart contracts in this case also allows for instant settlement.

Point of Sales Systems

• Decentralized POS systems allow businesses to accept and process cryptocurrency as payment. This eliminates their dependency on costly merchant service programs and credit card transaction fee overhead. The ledger system can also assist with cash flow management and analysis.

Lending and Borrowing

• Before the days of big banking, lending and borrowing was an activity regularly handled within communities on a…you guessed it… peer-to-peer basis. Now you don’t have to trust that your neighbor will pay you back or pay interest to a big bank, you can borrow trustless-ly on the blockchain. This is also known as syndicated lending.

Trading Platforms

• Blockchain can reduce the cost of trading and offers a new way to exchange digital assets without a third-party. Stock exchange processes (similar to cross-border payments) are not always instantaneous. Smart contracts can be used to trigger buying and selling on behalf of investors dictated by events without any intermediary lag. Current trading processes demand documents, copies, databases that require reconciling, and navigating bureaucracy. Blockchain works to eliminate all of those present trade finance issues.

Clearing and Settlements

• This is one of the biggest use cases for blockchain technology as there is a reported $20 billion lost annually in associated costs. The typical three-day clearing and settlement cycle can be revolutionized with the use of blockchain. The cycle is currently extremely complex and requires that all counterparty balances are matched, reconciled, and resolved across the global trading system. Blockchain can make these processes automated and frictionless.

Bookkeeping and Auditing

• Standardization with the help of blockchain would allow auditors to automatically verify the most important data behind financial statements and thus decrease the costs and save time. Blockchain makes it possible to easily prove the integrity of electronic files. One of the approaches is to build a hash string of a file representing the digital fingerprint of that file and then create a timestamp for it by writing into blockchain. To prove the integrity of files, an auditor can generate the fingerprint again and compare it with the one that is stored in the blockchain. Identical fingerprints prove that the file has not been changed. As a result, audits can be conducted in real time and not last for days or weeks.

Hedge Funds

• Hedge funds consist of a group of investors partnering with a fund manager to maximize their potential returns and mitigate the risks associated with “playing” the stock market. Now hedge funds trade in cryptocurrencies, some investing centrally and others with a decentralized hedge fund. Decentralized cryptocurrency hedge finds give investors a better way to invest without a fund manager or single entity in control. This new take on the hedge find offers investors an open platform to usher in more investors and further minimizing investment risk.

Digital Identity Verification

• While identity verification might not seem related to financial services, it is actually the crux for every transaction you’ve ever made with your debit card or at your local bank branch. Your identity is inextricably linked to your assets. Blockchain’s ability to verifiy identity while still separating identity from transaction using the public-private key system allows for anonymous transaction verification. With some financial services applications on the blockchain you can verify your identity once and never have to repeat the process even at multiple different providers. This puts the user in control of revealing identity, not a centralized entity.

Credit Reports

• In order to make large purchases one needs to establish credit and prove a credit score. Blockchain credit reports save time and money and store data on the immutable ledger, while protecting user identity as described above. Now this information is no longer stored centrally where it can be hacked, bought, or sold. Blockchain based credit reports open a new avenue for small businesses or first-time loan applicants to get approved in an accurate and secure way.

The Decentralized Financial System

What will the banking industry look like with decentralized financial services available?

The landscape for financial services will not only shift dramatically and become more efficient, it will be extraordinarily diversified in comparison to 2012 or 2015 even. We all use financial services daily and will have more choice than ever before.

Decentralized trading platforms and financial decentralized applications aren’t going to eliminate centralized banks (fortunately or unfortunately). Instead, the introduction of blockchain technology and imminent widespread adoption forces banks to adopt distributed ledger technology themselves. To be able to compete with decentralized alternatives to financial services, banks will need to use blockchain to facilitate things like faster cross-border payments, lower fees, and automated clearing and settlements.

Decentralized technology applications in financial services are not objectively working to “disrupt” as in “stop” the centralized banking industry as much as they are pushing big banks to integrate peer-to-peer backed networks to facilitate trustless, more affordable, and faster services. Those looking to use digital assets and currency to divorce themselves from dependency on centralized banks will have a wide variety of options for alterative services. For the rest of the population who is not concerned with the political or ideological ramifications of banking at Bank of America or U.S. Bank, they will likely enjoy improved centralized banking brought to them in part by blockchain technology.