EXPERT Insight

How Blockchain Will Change the Way We Pay Premium

Banking Disruption

Soley, Jorge

Date: Fourth Quarter 2017

Tags: blockchain, Bitcoin, Ripple, cryptocurrency, Goldman Sachs

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Ten years ago, the term blockchain would have meant little to most readers. Cryptocurrencies like Bitcoin and new payment protocols like Ripple did not even exist yet. Today all that has changed: Most businesspeople have at least heard of these technologies, if not explored them for themselves. Indeed, cryptocurrencies were the highest performing assets of 2017, with Bitcoin experiencing gains of 1,000 percent.

While there is still a great deal of uncertainty about the future of the world's most traded cryptocurrency, a Goldman Sachs report has predicted that the technology on which it is based -- blockchain -- is going to "redefine the way we transact, changing the way we buy and sell, interact with government and verify the authenticity of everything from property titles to organic vegetables. If that sounds incredibly far-reaching, that's because it is."

Growing numbers of academics and practitioners appear to agree. Some even believe that blockchain could end up doing for transactions what the internet did for information. We are, they say, witnessing the birth of "the internet of value" -- a secure, worldwide platform that will allow transactions to be carried out instantaneously across distributed databases.

The impact of a blockchain-based economy will be felt across many business sectors and industries. In Austria, for example, the utility company Wien Energie is taking part in a blockchain pilot to exchange energy, while in New York State, residents are trading solar energy among themselves, using blockchain techniques.

But one industry, in particular, stands to be disrupted the most: banking, whose long-established role as facilitator, guarantor and validator of payment operations would lose much of its relevance. As such, national and international financial intermediaries are busy exploring the possibilities of the new technology. IBM reported that 14 percent of the financial market institutions it surveyed "expect to have blockchain solutions in commercial production, and more critically, at scale in 2017" in four main business areas -- clearing and settlements, wholesale payments, equity and debt issuance, and reference data -- with the first three areas seen as having the most potential to "open up new transformational business models."

This article considers the impact of this financial decentralization on payment methods and, by extension, banking operations and companies. Drawing on my research and experience of financial systems and institutions, I will discuss the benefits and drawbacks not only of blockchain itself but of one of its associated developments, Ripple, an enterprise blockchain solution for making global payments. Despite enthusiasm for this game-changing technology, there are still many questions that need to be answered.

Centralized Trust
Along with credit, the management of payments has always been the primary domain of banking. In 2016, the total value of international transactions was some $300 trillion, generating an estimated $150-$200 billion in revenues for the sector. Thanks to the confidence and sense of security that banks generate as qualified financial intermediaries, they have come to dominate the global payments system -- a system based, above all else, on the centralization of trust.

Put simply, any banking operations involving a payment are exchanged through mechanisms supervised by national central banks. These central banks carry out two main functions:

Compensation: the process by which the payment orders are transmitted, reconciled, confirmed and a definitive settlement position established.

Liquidation: the transfer of funds between the paying entity and the recipient.

A distinction is made between retail payments and larger payments. In the first case, the compensation does not occur by reconciling one payment against another, but by "netting" the positions of one bank with respect to another at the end of each working day. This process involves a degree of uncertainty regarding the settlement of transactions, which is often referred to as the system's liquidation risk. This is the possibility that a failed liquidation could end up triggering a domino effect across the system.

By contrast, for large payments, such as those made in the interbank market, "gross" settlement is used. This means payment orders are processed and liquidated the moment they enter the system -- provided, of course, that the payer has sufficient balance available in its central bank account.

In the case of cross-border payments, the clearance and settlement of transactions take place between international accounts set up in correspondent agreements (one credit institution agrees to provide payment services to another). The system through which they are channeled is the secure communication network known as Swift (Society for Worldwide Interbank Financial Telecommunication). Swift is a cooperative that is owned by its member institutions. It has become a global standard for collections, payments, treasury operations, securities and foreign trade.

Within Europe, and for payments in euros, another mechanism applies. At the initiative of the banking sector, and with the support of the European Central Bank and the European Commission, the Single Euro Payments Area (SEPA) was launched in 2008. It covers 34 states: the 28 member states of the European Union plus Iceland, Liechtenstein, Monaco, Norway, San Marino and Switzerland. SEPA allows companies and individuals to make payments and collections in euros within and across national borders, under equal conditions and with the same rights and obligations, regardless of the member state where they are processed. The SEPA payments market includes transfers, direct debits, and credit and debit cards, but not checks, given their need for physical processing.

This integrated payment market was made possible by five key factors: the single currency; efficient payment processing infrastructures; common technical standards; common commercial practices; and a harmonized legislative framework.

Distributed Trust
Enter blockchain, which upends these traditional systems. Instead of trust residing with central banks, blockchain dispenses with central authorities or third parties altogether. The blockchain technology, on which Bitcoin and other cryptocurrencies work, is a distributed database, meaning it is not centralized at any point. It is also dynamically encrypted, meaning it is updated every 10 minutes with brand new data. Each block that joins the system must be validated in a decentralized manner by the previous blocks. And the data are ordered in time without the possibility of revision or modification.

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