Bain Research Report: What does blockchain bring to the payment industry?

According to a white paper report by consulting management firm Bain, banks are not well prepared to control payment interfaces for customers and merchants when it comes to blockchain and distributed ledger technology.

Such technology eliminates middlemen, simplifies connections between contracting parties, and records data in a tamper-proof manner. It also provides faster speed, better transparency and greater efficiency for payments.

Despite its shortcomings, bitcoin has attracted a lot of investment, and blockchain startup Ripple Labs holds a seat on the Federal Reserve's faster payments task force.

Financial consultancy Bain interviewed more than 50 venture capitalists, bankers, payments industry executives and startup CEOs. The interviews show that banks want to address the changes brought about by distributed ledger technology, but the situation is more complicated.

The white paper seeks to clarify the gap between banks’ feedback on distributed ledger technologies and the opportunities they can offer.

The white paper also states that distributed ledger technology will determine the success or failure of the banking industry.

Distributed ledger leveraging existing systems

The white paper provides an overview of distributed ledger technology. It says that distributed ledger technology combines existing technologies in innovative ways. It includes:

• The blockchain securely writes transactions into blocks in chronological order and provides reliable provenance through different distributed servers.

• A digital signature is a digital key used to authorize and confirm transactions and to identify the initiator of a program.

• Consensus mechanisms consist of techniques that ensure that participants processing a transaction reach a valid agreement.

• In some implementations, digital currencies are cryptographic tokens of value. Central banks can create digital currencies.

Changes in distributed ledgers

The functionality of distributed ledgers varies. Some, like Bitcoin, allow any participant to verify transactions. Others, like Ripple, restrict it to a group of trusted parties.

Distributed ledgers will follow two paths. One is to work on the development of a global payment system. The other is to subvert large-scale domestic payments through digital fiat currencies backed by central banks.

In the first path, financial institutions will seek improvement opportunities and provide rewards to innovators, without the leadership of a centralized central bank.

International payment services offer the most promising starting point, particularly in relation to trade finance and banking. Currently global payments take many days to clear. They also lack transparency and often fail due to misinformation.

In contrast, domestic payment services, such as the Automated Clearing House and credit cards, work well enough that there is no strong need to change.

Disruption is coming

Large-scale disruption will eventually occur. Signals are already emerging in the second path mentioned above. Central banks have begun to consider issuing national digital currencies. If central banks issue digital currencies for public use rather than internal use, it will have a huge impact on the domestic banking industry.

In this scenario, retail banks will lose their privileged position and face competition in fund and loan products. Automated clearing houses and the credit card industry will also be left behind.

Global financial institutions without middlemen have created a solution for their customers. Banks have bilateral relationships and can clear transactions directly. Two banks should have a direct relationship without other banks acting as middlemen.

Significant benefits of digital ledgers

Digital ledgers offer significant benefits by cutting out middlemen and allowing parties to transact directly with each other. They speed up transactions and ensure that participants have complete customer account information. This is what creates the blockchain for automated payment notification and tracking.

These benefits meet the needs of customers from an overall financial perspective.

Digital ledgers cut costs and eliminate errors. Banks need to pre-fund clearing accounts. In contrast, distributed ledger transactions can be processed in near real time and limit liquidity costs.

The costs of foreign exchange transactions have also been reduced due to improved transparency of foreign exchange trading margins.

The existing system is entrenched

The existing market structure provides incentives for existing players to maintain the status quo. An estimated $300 trillion in transactions are conducted annually through the global correspondent banking network, generating $150 billion to $200 billion in revenue.

Until blockchain technology has widespread enough participation, participants will not join the network.

The most prominent company attempting this feat is Ripple, which has created an international payments protocol and currency. Ripple has raised $40 million in funding and is working with more than 30 banks to test its software.

Why banks are cautious

Financial institutions have been hesitant about distributed ledgers, citing concerns about the technology’s scalability, privacy of sensitive information, regulation and the volatility of tokens.

In the consumer market report, companies like TransferWise are using existing technology to provide improved services. Corporate customers are also taking notice.

Shortcomings of the existing system

According to an industry survey, 60% of corporate accountants are dissatisfied with banks' existing payment services.

Banks appoint mid-level technical executives to industry consortiums to sit in on meetings and run limited distributed ledger simulations. But this may not be enough. Without a clear strategic plan, banks risk delaying important decisions by failing to react effectively and in a timely manner.

Digital ledgers offer a way for supra-regional banks to compete with global transaction banks by replicating their networks at lower costs and with more robust customer offerings.

What banks should do

Banks need to choose the right partners and number of partners. Without these, the network cannot serve customers. Hyper-regional banks should build relationships with partners with complementary geographic coverage.

They also need to build more complex campaigns and alliances. They can focus on specific products, such as intra-bank payment services, so that they can quickly gain confidence, momentum and experience.

Global banks also have opportunities, but they too need to act. If they do nothing, they will lose out to new competitors. By overcoming institutional inertia, they can use their scale, IT experience, and their relationships to improve current networks.

Trade finance opportunities

Trade finance is a slightly smaller industry than global correspondent banking, but with similar characteristics. It supports a wide range of transaction banking relationships, which also have friction. Almost half of the cost of bank letters of credit comes from manual document management, creation errors, overhead and delays. Therefore, digital ledgers offer potential opportunities for improvement.

Trade finance is particularly well suited to distributed ledger solutions as it involves commitments by unrelated parties subject to different legal systems.

Digital identification offers real-time improvements to financial trade, including better fraud management.

Digital ledgers will also speed up settlements and reduce costs by mechanizing information and receipts. Smart contracts will accelerate transaction flows.

Trade finance will change more slowly than global correspondent banking. Previous efforts to develop global standards for trade finance have failed, demonstrating that no single bank has enough influence to change existing practices.

Opportunity requires action

Pressure is growing in both international correspondent banking and trade finance. Banks need to adopt new strategies.

For super-regional banks, digital ledgers offer a way to establish a head start in markets currently controlled by global banks. Super-regional banks need to focus on trade channels where they already have a presence. They can work with logistics companies, customs and port authorities to solve technical problems and build credibility and experience.

Domestic payment systems face disruption

In developing countries, domestic payment systems operate very efficiently and have the potential for long-term disruption.

Central banks are exploring issuing national digital currencies based on digital ledgers. More attractive to central banks are direct control over monetary policy implementation, improved tracking of financial payments, and automated taxation.

If businesses and consumers can transact electronically without the ACH system, current reconciliations will become unnecessary. Banks will find themselves competing for deposits and loans.

Central banks will be more cautious. Commercial banks can create their own private digital currencies.

Change is coming

Whatever the drivers, digital currencies will accelerate a trend that is already reshaping the banking industry.

In Europe, new laws are removing banks’ hold on customer data. Payment wallets from Google, Apple, and other tech companies are also disrupting banks’ relationships with their customers. To address this, banks need to find ways to provide customers with short-term dislocation and eventually use digital currencies.

Banks can accelerate investments in digital wallets and payment apps. They can reframe regulatory compliance as a competitive advantage. They can also invest in services and startups related to keeping digital identities secure.

Issues to consider

Banks need to ask the following questions:

• How can banks prepare for digital ledgers and the technologies that surround them?

• Which systems do banks need to worry about and invest in? Which clients do banks need to work with, and on what terms, to develop digital ledgers?

• Is it an innovator strategy or a fast follower strategy? What is the understanding of the technology and its business significance?

• What is the bank’s position in the wallet? Retaining control over the payment interface and customer identity? How to win the battle for customer wallets and digital identities?