How can Blockchain revolutionize the Finance Sector?
Blockchain technology is a decentralized ledger and is a form of distributed ledger technology (DLT). It is a “chain of blocks” where each block holds timestamped digital data and its own along with its previous blocks’ unique identity known as a hash. Since its inception, blockchain in financial services has been considered as the technology’s primary use case. The technology gained a lot of traction back in 2009 when it was used for the cryptocurrency Bitcoin. The unique features of blockchain have the potential to benefit the finance industry significantly.
The financial services industry is estimated to reach USD 2.6 Trillion by 2022. The global financial system deals with trillions of dollars a day and serves billions of individuals. With such great heights come many challenges that the finance industry has been facing for a long time. Ranging from the high cost of multiple stakeholders to delays, excessive paperwork, and data breaches, these challenges have been the root cause of massive amounts of losses the industry faces every year. As per a PWC report, 45% of the financial intermediaries like stock exchanges, money transfer services, and payment networks face economic crimes every year. Blockchain technology can be a possible solution to the challenges of the global financial system.
Blockchain in Finance refers to the implementation of blockchain technology in the finance industry. The development of blockchain solutions for financial services can lead to several benefits for the industry. Blockchain in financial services has also led to the introduction of decentralized finance,more commonly known as DeFi. DeFi is a form of finance powered by blockchain technology that aims at removing intermediaries from financial services by using smart contracts. You can learn more about DeFi here.
In this article, we will discuss about blockchain in financial services by answering the following questions:
- How can blockchain technology solve the challenges faced by the finance industry?
- What are the use cases of blockchain in finance?
Let’s begin by understanding the financial industry’s challenges and how blockchain in finance can help solve them.
How can blockchain technology solve the challenges faced by the finance industry?
The finance industry has been facing many challenges for a very long time. The incredible advancements in technology have led to solving numerous problems, but some new technologies have created new issues in the process. There are multiple fintech solutions available today, making it very confusing for financial service providers to decide which solution will suit them best. Hence, they look for an all-in-one solution that can help solve all of the major challenges being faced.
Blockchain in financial services is highly promising and can solve significant challenges faced by the industry. Let’s see how.
Security and Transparency
Financial services all across the globe are still centralized and multi-layered. Financial data is mostly stored in centralized databases, and it has to go through multiple intermediaries such as the front office, back office, etc. There is a severe lack of transparency in the system, with the safety of the data being solely dependent on the intermediaries and database security. Even if the databases have maximum protection, there are still very high chances of data breaches and servers’ hacking.
The lack of transparency in the system fosters security threats as nobody can know what is happening until things go wrong or data gets breached. Though understandably, everyone does not want their financial records to be transparent, having a certain degree of transparency in the system is beneficial and essential for both financial service providers and their clients.
Solution: With blockchain in financial services, transparency and security can be ensured simultaneously.
- Immutability: As blockchain is immutable, no data can be altered. It ensures that all data is secure, authentic and correct.
- Privacy:There are two security keys – a public key and a private key. The public key is available to all users in the network. The private key, however, is only shared between the stakeholders of the transaction. Hence, the transaction will be visible to all users in the network with the public key’s help, whereas the stakeholders’ and transaction details will only be visible to those who have the private key. It ensures that transparency is maintained in the system while securing the confidential financial information of the stakeholders.
- Zero-Knowledge Proof Technology: Several blockchain networks support the zeroknowledge proof technology as a privacy solution for their blockchains. It allows verification of the financial data without disclosure.
Given that the financial sector is mostly centralized, it invests a lot of money in:
- purchasing central databases
- maintenance of databases
- labor costs
- security of databases
- intermediaries’ commissions
- value transfer systems
These costs are recurring, which means money has to be invested in them at regular time intervals. All these additional costs make the system more expensive without the guarantee that data breaches won’t occur.
Solution: With blockchain in finance, many costs can be reduced. According to a study, DLT can reduce the cost of financial services infrastructure up to USD 15 Billion – USD 20 Billion per annum by 2022. Blockchain technology is a form of DLT, which can help increase transparency and reduce costs while ensuring security. Financial service providers like banks can also implement smart contracts in their systems to reduce the costs of:
- value transfers
Hence, blockchain in financial services can substantially save costs.
Effectively Control Risks
Financial service providers face a lot of risk in providing services like loans, such as:
- the counterparty not being able to meet its obligations.
- credit risk due to information asymmetry.
- trusting intermediaries.
In the case of commercial banks, emphasizing on the monitoring and tracking of the loan usage is also not very reliable and effective as the trust has to be ultimately placed in an intermediary. Hence, the risk is significant as the providers will face substantial expenses if anything goes wrong.
Solution: With blockchain in financial services, every stakeholder is treated as a node. Hence:
- peer-to-peer (P2P) transactions can be enabled, which eliminates the need for intermediaries.
- fund management risks and credit risks are reduced as all transactions are recorded on the network.
- smart contracts help to settle transactions quickly.
- data immutability improves reliability.
Blockchain in finance makes it easier for financial service providers to handle all risks.
In the current financial system, some payments can take up to a week to finally settle. The reason behind it is mainly the presence of multiple intermediaries in the system. Our current financial system is multi-layered, which means that every transaction has to go through at least a couple of intermediaries in order to settle. Sometimes these intermediaries are front and back offices of a bank, while other times, these are third parties like currency exchangers in case of cross-border payments. The presence of numerous intermediaries is a way to ensure security and authenticity in a centralized system, but it leads to multiple problems like long settlement times and increased costs.
Solution: With blockchain in finance, peer-to-peer (P2P) transactions are possible. It implies the elimination of intermediaries as smart contracts will be able to manage transactions successfully. As the “layers” of the system will be reduced, instant settlements of payments will be facilitated. Blockchain payment systems can also be implemented so that cross-border payments can also occur instantaneously.
Hence, blockchain in financial services can facilitate instant settlements.
Auditing is a very long and expensive process. In the present centralized system, there is no transparency. Hence, accountants and compliance officials working for financial service providers have the freedom to show specific pieces of information at the time of audits. It facilitates unethical behavior, dishonesty, irregular compliance and long auditing time periods.
Solution: With blockchain in financial services, the auditing process can be streamlined. Blockchain records are immutable, so the auditors can check them to ensure if the compliances are being correctly met and what is exactly going on in that finance organization.
Transparency will be maintained with blockchain, which will ensure that financial service providers are honest and ethical. Any suspicious transaction activity can be easily tracked. As all information will be quickly available, the time required for auditing procedures will also be reduced.
Hence, blockchain in finance can also lead to better auditing.
Now that you understand how blockchain technology can solve the challenges faced by the finance industry, let’s take a look at some of its use cases in financial services.
What are the use cases of blockchain in finance?
Some use cases of blockchain in financial services are:
- Cross Border Payments
- Lending Platforms
- Credit Score
- Invoice Management and Billing Solution
- Fund Investment
- Government Expenses
- Political Funds
- Financial Record Keeping
- Stock Exchange
- Initial Public Offering (IPO)
Let’s discuss them in detail.
1. Cross-Border Payments
Since banks charge an additional cost for every transfer, transferring goods or payments across borders becomes expensive and slow. For example, if someone has to transfer money from the USA to Russia, the transfer process must go through one or more financial institutions before it reaches the receiver.
Blockchain allows individuals to send and receive money with minimum involvement from different entities. Also, with the help of blockchain payment systems supported by blockchain networks like Stellar and Ripple, cross-border payments can be settled quickly and cost-effectively.
2. Lending Platforms
Before blockchain came into existence, people required intermediaries to create trust and make a transaction happen. However, with blockchain in finance, borrowers can directly deal with the lenders on the rate of interest, installments, and duration of the transaction with the help of immutable smart contracts.
Borrowers and lenders can negotiate terms on the smart contracts. If borrowers are not able to abide by the terms, then the smart contract adds late payment fees to the actual amount to be paid to the lender.
Reputed banks like ING and Credit Suisse have successfully swapped high-quality EUR 25 million liquid assets with a blockchain based lending application. Blockchain can add trust to the system without the need for an intermediary, making the entire process seamless.
3. Credit Score
Banks and other financial institutes require an applicant’s credit score before proceeding with a loan application. One limitation of the current credit management system is the credit ratings’ lack of mobility. The current credit score of a person does not remain valid in a different country. Therefore, a universal credit score is needed. The hacking incident of the credit agency “Equifax,” which compromised the sensitive information of 143 million American consumers, also demonstrates the need for an innovative change to the system.
Managing credit score using blockchain could bring transparency to the system. Blockchain allows lenders to access the immutable records of financial transactions to understand the creditworthiness of a person. Smart contracts ensure the personal information of an applicant is never compromised or revealed.
4. Invoice Management and Billing Solution
Companies are adopting electronic invoicing, but they lack the standards required to execute invoicebacked financing in a streamlined manner.
With blockchain in finance, companies can upload the invoices on the blockchain through smart contracts. Information like payment due date, amount to be paid, and the client’s details can be saved on the blockchain. Once the individual pays the bill, the smart contract will update the invoice status as “paid” and will notify the companies that the client has made the payment.
Blockchain in financial services can help to decide if the client is safe to trade with or not.
5. Fund Investment
Currently, investing in funds is time-consuming and expensive. The current procedure involves manual processes using multiple databases.
With blockchain in finance, providers can store the user’s legal, personal, and public information on a blockchain. It could:
- reduce the possibility of errors and frauds
- bring transparency
- make access to data easier.
With an immutable smart contract, the fund investment companies can retrieve the user’s information quickly. If a user denies sharing the data, access would not be granted. The users can also keep track of who uses the information and for what purpose.
So, blockchain in financial services can make the fund investment process more transparent.
6. Government Expenses
Governments around the world are adopting digital methods to modernize legal processes and build good relations with citizens. Advancements in technologies have made it possible to increase the transparency of public financing to make the system trustworthy.
Imagine citizens can track how many dollars are spent on the construction of the road. If the governments start using public blockchain to store the information related to expenses spent on cities’ development, the citizens’ fight against corruption can be avoided.
Hence, blockchain in financial services for the government would enhance the system’s efficiency.
7. Political Funds
Capturing the information related to public funds received and paid by a political party on a blockchain can offer transparency to voters. Using blockchain, voters can make better decisions about political parties.
8. Financial Record-Keeping
Companies are planning to use blockchain to store the immutable records of finance-related information like:
- financial history
- Money on Money Multiple (MoM)
- profits earned
- dividend distribution
The smart contract allows different shareholders to get access to the relevant information. For example, shareholders should be able to access confidential information while interested parties should only gain access to public information.
Therefore, blockchain in financial services helps companies to bring transparency to the financial systems.
9. Stock Exchange
The current stock market involves entities like regulators, brokers, and the stock exchange that add more cost to the system. A decentralized approach to manage the stock exchange can make the system highly efficient.
Blockchain can eliminate the need for third-party regulators as regulations can be built on smart contracts.
10. Initial Public Offering (IPO)
High fees for the bureaucracy of venture capitalists, private investment firms, and banks make the entire IPO process expensive.
Therefore, equity markets are planning to move towards decentralization. Blockchain allows the complete range of investor-company interaction to be carried out securely without middlemen to cut down the cost.
Blockchain in financial services can offer multiple benefits, which can help transform the finance industry. According to KPMG, blockchain can reduce errors by up to 95%, increase efficiency by 40% and reduce capital consumption by up to 75%. Blockchain in finance is an exciting concept with the potential to transform the finance industry.
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