A Blockchain is a digital, immutable (unable to be changed), distributed ledger that chronologically records transactions in near real-time. That is, Blockchain is a distributed ledger technology (DLT), in which the transactions can be shared amongst a distributed network of computers. The prerequisite for each subsequent transaction to be added to the ledger is the respective consensus of the network participants (called nodes), thereby creating a continuous mechanism of control regarding manipulation, errors, and data quality.
Thus, Blockchain, as the name suggests, is a chain of blocks – each being a repository that stores information pertaining to a transaction and also links to the previous block in the same transaction. These connected blocks form a chronological chain providing a trail of the underlying transaction. Blocks created are cryptographically sealed in the chain. This means that it is impossible to delete, edit or copy already created blocks and put it on the network, thereby creating true digital assets and ensuring a high level of robustness and trust.
Blockchain uses cryptography to allow each participant on the network to manipulate the ledger in a secure way without the need for a central authority. Once a block of data is recorded on the Blockchain ledger, it is extremely difficult to change or remove it. When someone wants to add to it, participants in the network (called miners) — all of which have copies of the existing blockchain — run algorithms to evaluate and verify the proposed transaction.
Hence, at its core, Blockchain is a novel system to digitally manage data in a decentralised manner, transforming how individuals, companies and businesses can transact and trade with each other.
Banking and Blockchain
The interest in Blockchain technology arose after the 2008 economic meltdown. Its best-known application is “Bitcoin”, the cryptocurrency developed by a pseudonymous individual (or group), under the name Satoshi Nakamoto in 2008. Bitcoin employs Blockchain technology to allow, in principle, any anonymous individual or entity to perform transactions without a trusted third party. Unfortunately, many of the banking regulators (including Reserve Bank of India) banned the use of bitcoin and this has hampered the mass adoption of Blockchain technology. According to a 2017 study by Deloitte, the US consulting firm, while the interest by banks and financial institutions on Blockchain technology is huge, challenges remain for large scale adoption of the same.
Blockchain and Indian Banks
As early as the beginning of 2017, Reserve Bank of India (RBI), through its research arm Institute for Development and Research in Banking Technology (IDRBT), tested Blockchain technology. This was done in collaboration with MonetaGo, a New York-based cryptocurrency firm, Indian banks, financial institutions and clearing houses. RBI’s Blockchain research followed a partnership between one of the Indian banking majors, ICICI Bank and Stellar. ICICI Bank had announced its plans to develop a Stellar-based blockchain application for transactions within closed groups.
Reserve Bank of India’s experiment involved the use of blockchain in a trade application and the results are now available in a white paper titled “Applications of blockchain technology in banking and financial sector in India”. The whitepaper was developed in collaboration with State Bank of India, Punjab National Bank, Bank of Baroda, ICICI Bank, HDFC Bank, Axis Bank, Citibank, Deutsche Bank, Infosys, IBM Research, Deloitte and other partners.
R. Gandhi, the then Deputy Governor of Reserve Bank of India and Chairman, IDRBT, said in the whitepaper that “Blockchain technology (BCT) provides a tamper-evident recording of the linked transaction history in a distributed network, and has the potential to disrupt the financial business applications”. The whitepaper stressed on banks adopting internal experiments and pilot projects first and then moving on to interbank applications such as centralized KYC (Know Your Customer), cross-border payments, syndication of loans, capital markets, supply chain finance etc.
Individual banks like ICICI Bank, Axis Bank and Yes Bank have since made considerable strides in developing Proofs of Concept (POC) in different areas like trade finance, remittance and cross border payments with the collaboration of partners such as Infosys, Stellar and Ripple. State Bank of India had taken the initiative to form India’s first Blockchain exploration consortium called Bank-Chain.
In 2018, IBM and Mahindra announced a partnership to create a POC for supply chain financing. Bajaj Electricals and Yes Bank employed blockchain technology to design a vendor financing solution that cut down bill discounting time from 4-5 days to a real-time transaction. National Stock Exchange (NSE), along with banks like ICICI Bank, IDFC First Bank, Kotak Mahindra Bank, RBL Bank collaborated on a Know Your Customer (KYC) POC involving blockchain.
Blockchain: Areas of application in banking
Fraud Reduction: With most banking systems throughout the world built on centralized databases, they are extremely vulnerable to cyber-attacks, which have been increasing over the years. Using blockchain technology, banks would be able to protect themselves from many of the online cybercrimes being committed today, thus protecting valuable customer databases from being hacked.
Know Your Customer (KYC) Regulations: According to a Thomson Reuters 2017 Global KYC Survey, financial institutions spend about USD 60 million to USD 500 million per year to keep up with Know Your Customer (KYC) and customer due diligence regulations. Blockchain technology would allow a bank to access the verification details of a client by another bank, thus avoiding repetition of the KYC process. The reduction in administrative costs for compliance departments would be significant.
Trade Finance: Trade finance is another area where blockchain technology offers significant benefits of speed, transparency and the freeing up of capital. Trade finance is still mostly based on paper, such as Bills of lading or Letters of credit, being sent by fax or courier around the world. Blockchain technology is the obvious solution especially as numerous parties need access to the same set of information. Under the blockchain technology, all the documents such as LCs, Bills of lading/ Shipping bills, Tax invoices can be recorded in a centralized repository where all the parties involved can access real-time data. This will, in turn, improve the efficiency tremendously and will also allow the parties required to track the transactions with ease.
In May 2018, Infosys, along with seven Indian banks, set up the India Trade Connect, a blockchain-based trade network with the aim of increasing transparency and to manage risks in trade finance operations better, while cutting time to deliver supply-chain financing.
Vendor Financing: Bank’s vendor financing programs provide credit facilities such as Letter of credit, Bill discounting and financing against purchase orders and invoices. Banks also provide structured financing services against confirmed purchase orders from their customers. The system currently in vogue has several drawbacks such as manual documentation and time-consuming manual process which adversely impact the working capital cycle of the vendors, lack of mechanism to track the status of invoice throughout the process and huge potential for fraud. All these can be overcome by using blockchain technology by using automated documentation, real-time tracking and settlement of transactions and fraud-proof systems in place.
Cross Border Payments: Cross border payments are riddled with several pain points like inefficiencies, costs and risk to daily operations by way of cyber-attacks etc. Blockchain technology can help in facilitating near-frictionless settlement at any time, thus facilitating global interoperability, high security, and ultimately, quicker and lower-cost transactions. In September 2019, J.P. Morgan, a leading US Bank brought in seven Indian Banks namely ICICI Bank, Axis Bank, Yes Bank, Union Bank of India, Federal Bank and Canara Bank to its blockchain platform that would enable payments to reach beneficiaries faster with fewer steps in cross-border payments. IIN (Interbank Information Network), as it is known, is the first live blockchain service by JP Morgan and represents the largest number of banks to join a live application of blockchain technology. INN is aimed at providing a secure exchange of information to banks associated with cross-border payments. It aims to reduce costs and mitigate the risks involved in the cross-border transactions.
Monitoring end-use of funds disbursed: Banks have been facing many issues in terms of recoverability of loans granted by them due to diversion of funds by big borrowers. Using blockchain technology, all the transactions right from the disbursal till its end-use can be recorded, which will help the banks in tracing the diversion of the loaned funds, if any.
Tackling the NPA menace: To tackle the problems of bad debts and defaulters, eleven Indian banks including ICICI Bank, HDFC Bank, Axis and Yes Bank came together to launch India’s first blockchain-linked funding initiative for Micro, small and medium enterprises (MSMEs). This is also expected to remove the information asymmetry between large corporates and MSME lenders.
The above are some of the areas in which Blockchain technology can be used in banking.
Applications of Blockchain technology in other financial institutions
While many of the applications pertain to the banking sector, blockchain technology has applications in other financial institutions as well.
Capital Markets: Issuance of securities, sales and trading, clearing and settlement, post-trade services and infrastructure, asset servicing and custody are some of the areas in which blockchain technology can be used. Facilitation of capital market activities, streamlining processes, reducing costs and decreasing settlement times can be some of the applications of the technology.
Asset Management by Mutual Funds: Similarly, Fund launch, Fund Administration and Transfer Agency in Asset Management are some of the areas of application in respect of Mutual Funds.
Insurance: Property and casualty insurance claims are prone to fraud and claim assessments can extend over long periods of time. Blockchain technology can securely streamline data verification, claims processing, and disbursement, thus reducing processing time significantly.
Claims processing and disbursement, parameterized contracts and Reinsurance markets are some of the areas where blockchain technology can be used effectively in the insurance industry.
Other Financial Institutions: About 77% of Fintech is expected to adopt blockchain in their production system by 2020, according to Global Fintech Report 2017. Blockchain will be a boon for the financial services sector as it seeks to bridge the existing gap that prevails between the regulators, financial institutions and the consumers.
Concluding Remarks: While Blockchain technology offers a host of benefits to financial institutions, it is to be understood that banks and fintech firms are still grappling with many technological issues. This being a new technology, banks and other financial institutions will have to adopt a trial-and-error approach. Also, the complex, encryption-based and distributed nature of blockchain transactions can be lengthy to process vis-à-vis traditional payment systems, and hence require more advances in engineering and processing speeds. Hopefully, blockchain’s capacities would expand in the ensuing years.
Apart from implementation, another important issue is whether cost reductions from adopting blockchain technology can outweigh its operating costs, as otherwise financial institutions may not be willing to adopt the technology. Further, regulatory and governance challenges to remain. Also, safekeeping of crypto-assets, the method for storing, controlling, and handling of private keys are important questions that would clarify the definition of digital custodial services.
About the Author
Rajan Sundaram is a banker with more than 3 decades of experience with Canara Bank. Earlier, he was a faculty with Canara Bank, specializing in the area of Credit, Risk Management and Legal & Recovery. He has also been AVP (Credit Analyst) with Wells Fargo.
A holder of MBA (Finance) and PG Diploma in Human Resources Management from IGNOU, Rajan Sundaram has been Academic counsellor for the MBA Program at IGNOU and guided students for their MBA projects. He has taught papers on Statistics for Management and HR for IGNOU. Sundaram has also taught papers on Trade Finance and Quality Management at B Schools. Apart from academic teachings, he is a freelance trainer on credit and soft skills programs.
Furthermore, he contributed articles to Canara Bank House Magazine and Vinimaya a publication from NIBM Pune. He has presented research papers at Management Development Institute (MDI), Gurgaon and other colleges. Currently, he is serving as a faculty of Banking in Manipal Global Academy of BFSI.