How Smart Contracts are Disrupting Traditional Markets – Part 3

Posted on March 16, 2020

By Natalie Lord

We’ve explored the concept of blockchain in general and acknowledged that it has the potential to revolutionise the banking industry. This week we continue to look at the specifics of how and where this could happen with clearance and settlements systems.

Blockchain technology offers an economical yet highly secure method of sending payments that eliminates the need for verification from third parties and beats processing times for traditional bank transfers. The fact that an average bank transfer takes three days to settle has a lot to do with the way our financial infrastructure was built.

It’s not just frustrating for the consumer, moving money around the world is a logistical challenge for the banks themselves. A simple bank transfer from one account to another has to bypass a complicated system of intermediaries, from correspondent banks to custodial services, before it reaches its final destination. The two bank balances have to be reconciled across a global financial system, comprised of a wide network of traders, funds, asset managers and more.

If you want to send money from a UnicaCredit Banca account in Italy to a Wells Fargo account in the US, the transfer will be executed through the Society for Worldwide Interbank Financial Communication (SWIFT), which send 24 million messages a day for 10,000 financial institutions.

Because UnicaCredit Banka and Wells Fargo don’t have an established financial relationship, they have to search the SWIFT network for a correspondent bank that has a relationship with both banks and can settle the transaction for a fee. Each correspondent bank maintains different ledgers, at the originating bank and the receiving bank, which means that these different ledgers have to be reconciled at the end of the day.

The centralized SWIFT protocol doesn’t actually send the funds, it simply sends the payment orders. The actual money is then processed through a system of intermediaries. Each intermediary adds additional cost to the transaction and creates a potential point of failure. Approximately 60% of B2B payments require manual intervention, taking an average of between 15-20 minutes every time.

Blockchain technology, which serves as a decentralized “ledger” of transactions, could disrupt this state of play. Rather than using SWIFT to reconcile each financial institution’s ledger, an interbank blockchain could keep track of all transactions publicly and transparently. That means that instead of having to rely on a network of custodial services and correspondent banks, transactions could be settled directly on a public blockchain.

Further, blockchain technology allows for “atomic” transactions, or transactions that clear and settle when a payment is made. This is in contrast to current banking systems, which clear and settle a transaction days after a payment.

To start with this would help ease the costs of maintaining a global network of correspondent banks, but further, banks have estimated that blockchain innovation could cut at least US$20 billion worth of costs from the financial sector by providing better infrastructure for clearance and settlements.

Ripple, an enterprise blockchain services provider, is the most prominent player working on clearance and settlement. While the company is best known for its associated cryptocurrency XRP; Ripple itself is creating blockchain-based solutions for banks to use for clearance and settlement.

SWIFT messages are one-way, much like emails, which mean that transactions can’t be settled until each party has screened the transaction. By integrating directly with a bank’s existing databases and ledgers, Ripple’s xCurrent product provides banks with a faster, two-way communication protocol that permits real-time messaging and settlement. Ripple currently has over 100 customers signed up to experiment with its blockchain network.

R3 is another major player working on distributed ledger technology for banks. It raised US$107 million in May 2017 from a consortium of banks like Bank of America Merrill Lynch and HSBC.

Blockchain projects are doing more than just making existing processes more efficient, they’re creating entirely new types of financial activity. Next week we’ll look at how this is taking effect in the fundraising space.

 

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ACCESS

Singapore Cryptocurrency and Blockchain Industry Association

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