It’s unknown to many what BLOCKCHAIN actually means. Let’s start from the basics.
A blockchain is a so-called Distributed Ledger Technology, a database made of consecutive blocks of data, cryptographically approved and recorded by a network of validators by means of computing power.
Such structure means that a blockchain is:
- Decentralized: the network is validated and updated by its own users, and they retain a copy of the whole blockchain. Central control is not required.
- Immutable:every transaction is recorded in a cryptographically-approved block, which is dependent on the block before it. Editing a data record in a blockchain would change the cryptographic code (or hash) and become a bright anomaly to all validators.
The first-ever product built on this technology is quite famous: the Bitcoin.
Every time a validator computes a block’s hash, he/she can be rewarded with coins, in order to create an economic incentive for this behavior. But again, Bitcoin is just an application of the blockchain technology.
In fact, it has several use cases across different industries. Among these, the Banking sector is safely assumed to experience a blockchain revolution.
There are many innovative, network business models that are coming after traditional financial services and banking organizations, and big banks are beginning to realize they must evolve in response if they want to remain viable in a digitally centric world — whether it comes by acquiring, partnering or developing leading-edge technologies. But what’s less clear is why, exactly, these new entrants are so disruptive and powerful. What enables them to skirt perceived constraints of these once ‘too large to fail’ incumbents and exploit unseen possibilities? In short, it is network-centered thinking with platform-based business models.
Blockchain enthusiasts believe that the application possibilities are endless — improving the way we hold and transfer secure goods from money to deeds to music to intellectual property. In fact, blockchain, as a pure platform technology, may be able to cut out the middlemen.
This technology can radically change many established processes in international finance.
- Payments and remittance: a blockchain can enable peer-to-peer transactions over the internet. Oversea and cross-border payments can therefore become faster and cheaper.
- Issuance, ownership and transfer of financial instruments: the peer-to-peer nature implies that users are able to transfer ownership without intermediaries. This concept can apply to securities markets.
- Servicing of instruments: advanced blockchain platforms (such as Ethereum) support smart contracts, i.e. they can pre-program actions in the blockchain, such as dividend or coupon payments.
- Regulatory reporting: this is straightforward, as the blockchain is not only a database, but also an immutable record. Hence, it allows a transparent and accurate reporting.
- Know-Your-Client and Anti-Money Laundering: every identity can be stored as a permanent ID in a blockchain, which means a much more efficient KYC AML process.
- Reconciliation: this process becomes abruptly redundant, as every user owns a copy of the whole database (one version of truth).
- Clearing and settlement: a programmable blockchain allows for a much safer trade lifecycle.
Of these 7 use cases, we should focus our attention on the last one.
The revolution of a streamlined trade lifecycle
The trade lifecycle in the financial industry is incredibly important, as it is the basis for trillions of financial assets.
In fact, approximately 80 to 90% of world trades happens because of trade finance.
In practice, the most common product is the LoC, “Letter of Credit”, which guarantees a payment from one party to another. How does this letter enable global trade?
In short, trade finance reconciles exporters and importers’ needs by guaranteeing a payment between parties and reducing risk. The first actor, the exporter, maximizes its utility by receiving the payment before shipping goods to the exporter, while the latter does so by paying upon receiving those same goods.
Simply put, this impasse is solved by two banks and one Letter of Credit.
The importer’s bank issues a LoC to the exporter via its bank, essentially guaranteeing payment once proof of shipment of purchased goods is available.
This mechanism has been solving the trust issue between the parties, protecting them and electing banks as money holders, for years. How? Easy guess: paperwork, the only way to reconcile different parties and certify goods movements.
Until the blockchain.
The purchase is first shared with the import bank by using a so-called Smart Contract.
In real-time, the bank can digitally review the agreement, and draft the required documents to send to the export bank.
The latter will review them and generate a Smart Contract to cover terms & conditions and obligations.
Then, everything becomes a matter of digital signatures in the contract.
In fact, the exporter signs the Blockchain-equivalent letter of credit to initiate shipment, which is inspected and digitally approved and signed in every phase by 3rd parties’ audits, recording every step in the smart contract.
Finally, the reception of goods automatically triggers the payment, which is automated, again, via smart contract.
What can we expect in the next future
In the most extreme case, it is possible to assume that the whole trade lifecycle will be managed entirely peer-to-peer in the future.
Importers and exporters will sign the agreement, store funds in a smart contract, certify the logistic process by using dedicated IoT devices connected to the blockchain, and unlock the funds once delivery is proven.
The process of disintermediation from banks is certainly supported by the technology’s characteristics and potentials, but it is yet to be proved as viable and as safe as the current solutions.
In a milder scenario, banks will simply be able to simplify the process by an order of magnitude, creating a win-win disruption where traders enjoy less risks and low-latency payments.
Both cases equally show how the Blockchain can radically change decades-old process and industries.