Blockchain and fintech are inextricably linked. Distributed ledger technology (DLT) has been around for a long time, but blockchain was created in 2008 by Satoshi Nakamoto to serve as the infrastructure for the cryptocurrency bitcoin.
Blockchain’s security, immutable transaction record, and near instant transaction speeds are all vast improvements on previous DLT technology. Because of why and how it was created, people have a hard time separating blockchain and cryptocurrency, specifically bitcoin. This is despite the myriad use cases for blockchain, both within and outside the financial services industry, other than cryptocurrency.
Blockchain in financial services
Blockchain has many different applications within financial services, including payment infrastructure, digital currency, audit management, asset tokenization, compliance, credit scoring, and financial inclusion. (The last one is more of a goal than a specific application, but warrants mentioning as there is so much content discussing it.)
Cryptocurrency and blockchain
You can’t talk about blockchain in finance without at least mentioning cryptocurrency. Crypto is the most highly publicized application of blockchain, but is possibly the least useful for a couple of reasons.
One, the volatility of cryptocurrencies is startlingly high, which is a huge problem for anyone wanting to use it to conduct business. Cryptocurrencies are so volatile because they are traded as an asset. Yes, foreign currency markets exist and finance professionals have commoditized money, but above all else, government-issued currency acts as a store of value. Particularly in more politically stable countries, there are not huge day-to-day shifts in value. To prevent volatility—or at least limit it—a single cryptocurrency would have to be ubiquitous. The general public looks at crypto as an investment rather than a medium of exchange, and that holds it back from widespread adoption.
As a concept, cryptocurrency is fantastic—a way to circumvent government or centralized control of currency; a way to democratize money. The reality is murkier, and that prevents the widespread adoption of cryptocurrency as a monetary standard, particularly because there are powerful actors—nation states—with a vested interest in retaining control of the money supply.
The second is the difficulties inherent in scaling the technology. As the number of transactions conducted using a particular blockchain increases, the transaction speed slows. Every new block that is mined contains all of the previous blocks since the inception of the particular chain, so cryptocurrency mining takes more computing capacity and becomes more expensive, driving the cost per transaction up.
Blockchain for digital identity management
One of the most interesting use cases for blockchain technology in financial services is blockchain identity software, which can be used to manage and verify digital identity. Blockchain technology can be used as a tool to promote financial inclusion in underbanked populations by constructing an immutable digital record of individuals. This identity is constructed by compiling payments records from mobile bill payments and microtransactions that an individual using the blockchain conducts. Housed on the blockchain, this data can be used to verify an individual’s identity and extend them financial services. Financial services providers may also use them to automate credit decisioning, allowing financially excluded populations to gain access to credit and other valuable financial products.
|Related: Blockchain and Identity: Best Use Cases and the Future →|
Blockchain for payment infrastructure
Blockchain can be used as the infrastructure through which payments flow, which serves a goal of settling transactions in real time at little cost.
Currently, the payments world is a mad tangle of disparate systems, with layers of intermediaries to facilitate communication between these systems. The result of this confusing web: Those conducting the transactions (vendors and customers) have to pay exorbitant transaction fees. The aim of blockchain payments is to facilitate the free movement of money, regardless of location. An example of blockchain being used as payments infrastructure is JPM Coin.
JPM Coin is a blockchain-based payments solution designed to facilitate instant payments between financial institutions. The coin, which was introduced by J.P. Morgan Chase early in 2019, is a stablecoin, meaning it is tied directly to the value of a fiat currency.
What is Fiat Currency?
Fiat currency is any currency issued by a government not backed by a physical commodity (gold, silver, etc.) This is different than commodity money, which is currency backed by a physical asset. The U.S. dollar is the most widely used fiat currency in the world.
In this case, JPM Coin is tied directly to the value of the U.S. dollar. The goal of the coin is to allow real-time transactions to take place on a blockchain without introducing the volatility of a non-stablecoin digital currency like bitcoin. The value to clients is in the increased transaction speed and the immutable transaction record. From a PR perspective, blockchain project implementation is a boon to J.P. Morgan’s image as a financial services innovator.
J.P. Morgan Chase has been looking into blockchain technology applications since 2015. The company has a huge reserve of trust built up with its clients, and the fact that JPM Coin is backed by USD held by JPM makes housing assets on the blockchain less risky for clients. JPM Coin operates on Quorum, which is J.P. Morgan Chase’s blockchain technology built on ethereum, one of the two main blockchain protocols. JPM Coin is one of the first indications of major bank buy-in to blockchain as payments infrastructure.
Blockchain for asset tokenization
Asset tokenization, at its core, involves recording an asset—a physical asset, like property, or digital assets—on a blockchain. What’s the point? Increased liquidity, faster transaction times, and the ability to split an asset into seemingly infinitesimal portions.
To tokenize an asset, a user must create a smart contract—written on the blockchain—breaking down the various scenarios for trading the asset. The writing of the smart contract is a vital step, because it requires the user to decide how many tokens will exist; that is, how many pieces an asset will be split into. This determines the available number of tokens that can be sold and traded. Any and all assets can be tokenized, which gives this application of blockchain technology the potential for massive impact.
|Read more: What are Smart Contracts? →|
Tokenization is a hot topic among finance professionals discussing the future of the industry, with some believing that all assets in the system will eventually be tokenized and put on a blockchain. However, without widespread adoption, this reality will not occur. The more banks that tokenize their assets and put them on a blockchain, the safer the system becomes and the easier it is to regulate.
Blockchain adoption roadblocks
One of the major issues preventing widespread blockchain adoption stems from the relative lack of public trust in the technology.
The reason for that lack of trust? Blockchain is inextricably linked to cryptocurrency. Fair or not, the fact remains that the general public’s first exposure to blockchain technology was bitcoin. The hysteria that fueled the currency’s explosion in value in late 2018 (and its subsequent fall into relative obscurity) will raise questions about any financial institution looking at widespread blockchain implementation.
The public’s lack of understanding about the technology itself doesn’t help, either. Blockchain, while fairly simple on the surface, is actually quite a difficult concept to grasp. For adoption to take hold in the industry, financial institutions probably need to not only convince internal stakeholders of the benefits of blockchain, but the public as a whole.
However, that fear might be unfounded, as the public may not care about the backend technology—they don’t care to understand how payment rails work, or how many different layers a transaction has to pass through to clear. People just see the end result of increased convenience, and a lot of blockchain platforms are on the back end in financial services. If the technology makes their lives more convenient and their transactions less costly, people might not care about the details.
A drawback to blockchain technology adoption that doesn’t hinge on public opinion is the difficulties inherent in scaling the technology. Blockchains such as ethereum and bitcoin are difficult to scale for a few reasons. The main problem is that as the number of transactions increases, so does both the size of each block in the chain and the entire blockchain itself, which has to be verified in each subsequent block that is added to the chain. This increases the difficulty of the problems that miners have to solve, subsequently slowing the rate at which blocks can get confirmed and jacking up the price per transaction to something untenable for widespread use as infrastructure for payments. This issue is more problematic for public blockchains (e.g., bitcoin), but similar scalability problems could plague private ones—like JPM Coin—if they grow enough.
|Related: The Problematic Entry of Big Tech Into Financial Services →|
Blockchain adoption benefits
Adopting blockchain technology brings with it a host of benefits. The key to eliciting the most value out of blockchain technology is proper implementation and use case selection. Not every situation calls for blockchain, so judicious application of the technology is vital to ensuring success. Blockchain may be the shiny new toy for CEOs to parade in front of their boards and the general public to solidify their status as purveyors of cutting-edge solutions, but it is not the right solution for every situation or every company.
One of the major benefits to blockchain in financial services is the potential for more immediate, less costly transactions. Transactions on the blockchain should be free, or nearly so, and occur in real time. While the average person may see little to no difference between a 20-second transaction time and near real-time transactions, the billions of transactions carried out daily can—and do—slow down the networks on which they are conducted.
At the same time, the increased convenience of digital payments has not equated to better cost to vendors and consumers. People herald services like Square as a vast improvement over credit card machines, but the reality is that the transaction fees are nearly the same for vendors. And while there are a lot of free options for peer-to-peer payments, vendors have no options. If they don’t like the percentage per transaction fee, they can head to a payments provider that does per transaction costs, which isn’t much better for vendors with a low average dollar amount per transaction.
Because of the stasis that payment processing costs seem to have reached, there is massive opportunity for blockchain-based payments infrastructure projects to grab large swaths of market share. Alipay’s overwhelming success in China has been a result of the company charging about a fifth of the typical fees of a payment processor.
Currently, payments go through a complex web of banks, third-party verification, and various other intermediaries. This is especially true of cross-border payments, which often include disparate systems or payment rails that don’t interact easily with each other. Every additional layer included in the process adds complexity and cost.
Blockchain’s immutability is another reason for its use. Transactions on the blockchain are easily tracked because they cannot be changed, making them valuable from an auditing perspective. Maintaining compliance and identifying potentially noncompliant activities are both easier when the record of document changes and transactions is easy to peruse.
The future of blockchain in financial services
What does the future hold for blockchain technology in the financial services world? A vast majority of banks have at least begun exploring potential blockchain use cases in their businesses. (Those that haven’t are likely to miss out, as the potential savings at an investment bank are around 30%.)
Any way you look at it, blockchain warrants exploration and likely implementation—the potential benefits are too great to risk missing out on. Financial services companies can leverage blockchain to save on costs and improve their business, contributing to the democratization of finance in the process.