RiskTech Forum

A Risk-Based View of Why Banks are Experimenting with Bitcoin and the Blockchain

Posted: 18 September 2015  |  Author: Joram Borenstein   |  Source: NICE Actimize

An increasing number of large well-known banks, stock exchanges, and other financial services organizations are tinkering with cryptocurrencies and the underlying blockchain protocol much more strategically than they were even six months ago. While most financial services firms perceive there to be more value in the blockchain’s resiliency, transparency, and de-centralized ledger model than in the notion of an actual cryptocurrency itself, it makes sense to pause and reflect on the inherent risks posed by this technology, some technical and some related more to perception and competitiveness.

The Search for Operational Efficiency: Financial institutions are beginning to more clearly understand the potential that these technologies hold for improving operational efficiencies that have to do with reducing risk.  Examples of these potential improvements include faster settlement and clearing, stronger identity validation, and time-stamping for compliance purposes. The removal of the human factor in settlement, for instance, may result in lower costs, better quality, and improved customer service, all of which lead to reduced revenue losses and customer attrition.

Positive Implications of Transparency: The blockchain’s transparency and decentralized ledger have the potential to hold positive reputational aspects for financial institutions, such as a scenario in which a bank or other financial provider wishes to provide transparency to someone on the other side of a trade, to a regulator, or to a prospective partner or client. Identity validation is one risk-reducing application of this transparency scenario. Sharing basic identity information with a specific party would not disclose one’s identity (the process for which can peruse the entire blockchain’s transactional history as it wishes) but can instill confidence in a specific party or individual who might otherwise not trust a given financial provider or counterparty.

In Search of New Services: Traditional financial providers know that even partial adoption of cryptocurrencies will put pressure on the banks’ existing fee structures. Familiarity with how this infrastructure works and transacts is key, in case the banks need to offer new services, lower current fees for existing services, or possibly even cannibalize existing revenue streams. Adoption of crypto-currency based or blockchain-based services (think of anything requiring a decentralized way to share elements of value), may push banks to embark on new adventures in offering financial services and products. One such scenario might see banks scale fees higher for customers using less efficient transactional payment mechanisms such as cash or paper checks.

Reducing Competitive Threats: Banks are constantly comparing and learning from one another. Cryptocurrencies and the underlying blockchain protocol represent worrisome competitive risk to the banks. Even though adoption remains small - and regulatory guidance is only partially known in some jurisdictions - banks recognize that by making initial forays into this new world, they can hope to establish a slight competitive and reputational advantage. They realize that a small investment in time and manpower is sufficient to reduce the risk that the competition will surge ahead of them.

Innovation & Talent Seeking: Traditional financial services providers are fighting for talent against the perceived innovators. One key way that banks are pushing back against this perception is to launch “Innovation Labs” and “Centers of Excellence,” particularly in cities with highly educated workforces. Combine the desire to compete for talent along with the knowledge that working with new technologies is a “must” to avoid risks associated with recruitment and retention of key personnel. It therefore makes perfect sense that longstanding financial institutions take a high profile when it comes to displaying innovation.

Regulatory Risk: Regulators in the major economies have begun to weigh in with direction on how these technologies will be regulated, taxed, and monitored. Banks and other financial services companies have concluded that the regulators are often more advanced in their knowledge of cryptocurrencies than the banks themselves are. While banks recognize that regulatory requirements and mandates may change as adoption of these technologies occurs, but they also fully understand that the regulatory environment is something they must monitor closely so as to avoid running afoul of new rules and legislation.

The technical underpinnings of both cryptocurrencies and the blockchain infrastructure protocol represent a potential watershed change in how financial services products and technologies are used, distributed, monitored, and regulated - possibly in ways that reduce risk to the overall institution. While the changes that these technologies bring will not happen overnight, it is entirely possible that the way consumers transact, how their identities are verified, and how financial institutions themselves interact, charge fees, and more will undergo dramatic changes before the end of the next decade.

Traditional financial services organizations recognize the potential of these technologies and know they cannot be caught off guard. Those institutions which grasp these changes, speculate intelligently about how to work with them, and ultimately turn these ideas into profitable new business models, will be the ones who ultimately reduce risk and identify new sources of growth for their institutions.