Beyond the Bitcoin Hype: Distributed Ledgers for Payments

Changes to complex payment channels are rare, but when they happen, the impact will be profound. The distributed ledger behind Bitcoin is the technology that brings about this change, and banks' control over customer and commercial payment interfaces will be challenged, and most banks are not yet ready to meet this challenge.

Distributed ledger technology can improve the speed, transparency, and efficiency of payments by eliminating intermediaries, simplifying the connection between contracts, and storing data in tamper-proof blockchains. Bitcoin is not perfect, but it presents an interesting case and has spawned a wave of investment and innovation. Since 2012, there have been hundreds of distributed ledger-related investments, totaling about $1 billion. For example, Ripple Labs, an officially recognized distributed ledger startup, has a seat on the Federal Reserve's Faster Payments Task Force, a payment modernization priority for U.S. regulators.

What does this mean for banks? To answer this question, Bain & Company interviewed more than 50 senior bankers, venture capitalists, technical engineers, international payment union directors and startup CEOs. Through these conversations, the answer gradually became clear: in theory, banks can handle the changes brought about by distributed ledgers very well, but in practice, the situation is more complicated. Regulatory issues and other obstacles will force related startups to cooperate with current banks rather than compete with them. Even so, distributed ledgers will create winners and losers in the banking field.

How Distributed Ledgers Work
Distributed ledgers have a wide range of applications, especially in payments. Traditional payment systems rely on central authorities to transfer value based on different levels of trust, transferring money between participants, usually in the form of digital records in a database, using a central contract to record and supervise the transfer to avoid fraud, and participants bear the costs, which is time-consuming and must be reconciled with their own systems afterwards.

With distributed ledger technology, trust comes from the process itself, not any other participant. The shared database ensures security, and each participant has a backup of the database. Payments are verified by all participants, and the database is updated almost in real time. Robust cryptography ensures that the initiator of the transaction must be the verified party, which ensures the trust issue, and the output of this system is accurate and unchangeable, so it can be trusted to represent value.

Moreover, distributed ledgers can identify participants and automatically execute transactions, thus creating a powerful platform for more advanced functions and automated business logic, also known as "smart contracts." Even in a basic distributed ledger, a multi-signature payment verification can be created to automatically complete third-party functions.

Although distributed ledger is a new technology, it combines existing technologies in a new way:

• Blockchain - securely records historical transactions in blocks, links them in chronological order, and stores them in different nodes to provide a reliable source of records.

• Digital Signature - A unique digital key used to verify and validate transactions, clearly identifying the initiator of the transaction.

• Consensus mechanism - using rules and technology to ensure the validity of participants' recording and processing of transactions.

• Digital currencies - using cryptographic tokens to represent value, Bitcoin is an example, but central banks will eventually create their own digital fiat currencies.

The specific characteristics of distributed ledgers vary from case to case. Some systems, like Bitcoin, allow all participants to verify transactions. Others, like Ripple, are limited to a small group of trusted people. Each choice of system architecture has its own trade-offs. For example, the openness of the Bitcoin system promotes its widespread use, but at the same time brings a lot of consumption because it requires a complex, expensive, energy-consuming consensus mechanism to prevent fraud.

Two waves in the distributed ledger movement
The development of distributed ledgers will not be linear. Instead, we expect it to develop in two waves:

• Wave 1: Focus on the development of international payment systems

• Wave 2: A broader domestic payments system triggered by central bank-issued digital fiat currencies.

In Wave 1, financial institutions will focus on their own opportunities for improvement, reward innovators, and have no central contractor like a global central bank in control. In this case, opportunities will emerge for international payment services, especially correspondent banking and trade finance. (See Figure 2) The existing outdated international payment system is full of friction, takes days to settle, lacks transparency, and often fails due to message errors, so these companies have sufficient incentive to upgrade their services. In contrast, domestic payment systems, such as credit cards and automated clearing houses, generally function effectively, so there is no business case and user demand for change.

However, a spark can eventually start a prairie fire. The spark of Wave 2 has already appeared, and some central banks have begun testing the issuance of national digital currencies in different scenarios, allowing anyone to use real digital legal tender (not just a means of interaction between banks). This has a profound impact on the domestic banking sector. The dominant position of commercial banks in financing and lending will disappear, and they will face more competitors. Ultimately, the credit card and automated clearing house industries will be at risk of disappearing.

Attacking the chaotic international correspondent banking business

Since there is no common central arbitrator to coordinate transactions, international financial institutions set up a workspace for their clients, where banks have bilateral (or agency) relationships and directly conduct transaction clearing and delivery. If two banks lack a direct relationship, they will use another bank as an intermediary to complete the connection, which increases the complexity. (Figure 3)

Compared with the current system, the digital ledger has unique advantages. It eliminates the middleman, allows transactions between contractors to be conducted directly, reduces transaction time, and each user can fully see their account and balance, which is a function that automatic payment tracking and reminder tools can achieve. Customers' needs for more active response and a holistic view of their financial situation will be met.

Digital ledgers can effectively reduce costs and error rates. For example, banks must reserve funds for multiple settlement accounts. Digital ledger transactions are settled directly, which reduces the cost of capital flow. Even foreign exchange fees will be reduced because the profits will be more transparent, which will bring more price-based competition.

However, for international correspondent banking, change is not so simple, and the current market structure has sufficient incentives to maintain the status quo. We estimate that about $300 trillion in cash flows pass through the international correspondent banking network each year, which brings banks about $150 billion to $200 billion in revenue. The network dynamics make it difficult for alternatives to be widely popularized: participants will not participate in a network until it is strong enough, and strong enough comes from more widespread participation.

Some well-known companies are trying to solve such problems. For example, Ripple, a startup in San Francisco, has created a viable system for international payments, and this system can customize protocols and currencies. Since 2012, Ripple has raised $40 million from venture capital and is currently working with 30 banks to test their system in different use cases. Financial institutions are still hesitant because they are worried about the scalability of this technology, privacy issues, especially the leakage of sensitive business information caused by cash flow, and the volatility and management of the system's tokens (Figure 4).

Yet we are seeing signs of startups overcoming these barriers. The wave of investment in Bitcoin and related technologies shows that people are paying attention to payment rails, and the system is ready to change. Competitors are already nibbling at the edges of international payments, changing user expectations. In the consumer market, companies like TransferWise are using existing technology to launch an improved customer service, which is also attracting the attention of corporate customers. According to a survey by the Financial Professionals Union, 60% of corporate finances are dissatisfied with the financial services provided by banks and are re-examining them.

Tough choices for banks

How should banks respond to this rapid development? Their current approach of experimentation, appointing mid-level technical leaders to form a consortium, go to meetings, and conduct limited distributed ledger simulations, makes banks look clumsy. The "wait and see" approach only makes sense if there is a clear strategy that ensures specific plans are taken at specific trigger points. Without such a strategy, banks risk delaying decisions until it is too late. Different types of banks should have different strategies.

For a supra-regional bank , with multinational and global goals, it is possible to replicate the global transaction banking network using digital ledgers to compete with it, and for customers, this network is cheaper and more powerful. The choice of partners is crucial. If there are too few partners, the network will not be able to attract users, and if there are too many partners, it will be too difficult to reach consensus. Therefore, supra-regional banks should form partnerships with alliances that complement their geographical locations.

Supra-regional banks should also build relationships with more complex alliances and organizations. An alternative is to focus on delivering one service—interbank payment transfers or cash pooling—which can quickly and cost-effectively build confidence, experience, and power within the organization.

For the global authority groups , the largest global transaction banks, the outlook for the future is mixed. If they do nothing, they will lose out to new entrants into the market. However, if they can overcome institutional inertia, they will use their scale, trusted partners, and IT experts to strengthen the security of their current networks and improve their efficiency. How these banks deploy their resources will determine the outcome. A more pragmatic approach is to encourage proprietary partnerships with the most well-known third-party platforms to develop systems in-house, lobby regulators to tighten anti-money laundering (AML) and know your customer (KYC) policies, which gives the current banks an advantage over new competitors, and then create a highly trusted distributed ledger and migrate part of the existing payment flows to this platform.

Trade finance: a tougher nut to crack

Although trade finance is smaller than international correspondent banking services, they share the same characteristics. It generates $23 billion in profits from global banking each year, widely supports bank transactions, and endures the friction in the middle. For example, 50% of the fees come from the manual management and verification of bank letters of credit, a process that brings delays, errors and losses. Digital ledgers will significantly improve this situation, although the commercial application of digital ledgers is still in its early stages. Moreover, distributed ledgers are particularly suitable for trade finance because they can ignore the cultural background and management system background of all participants. Use automatic business logic to process trade transactions, and use smart contracts to create a consensus on the business transaction mechanism, making subsequent transaction processing easier.

This improvement can be divided into two categories. The first category is a direct improvement to the current paper-based trade finance archives, including better anti-fraud systems through digital identities and tracking of paper archives. Second, the automation of digital ledgers will speed up settlements, and automatic receipt confirmation and payment will reduce expenses. At this stage, more complex digital ledger elements such as smart contracts will streamline the transaction process. These commercial contracts and agreements will be automatically triggered when participants encounter specific situations, such as contracts for the delivery of goods, thus avoiding the uncertainty risks brought about by lawyers interpreting legal contract terms.

If anything, trade finance is changing more slowly than international correspondent banking. Efforts to create global standards have failed despite the support of major players, and no single bank, no matter how big, can influence the current shift in behavior. Projects such as the EU’s Bolero project and the digital letter of credit system BPO have only achieved a small adoption despite widespread attention. Nonetheless, the pressure on international correspondent banking and trade finance is growing, and banks cannot afford to ignore them. Banks will adopt different strategies depending on their size and ambitions.

Hyper-regional banks using digital ledgers will have the opportunity to establish a beachhead in markets controlled by global power groups. To achieve this goal, hyper-regionals should focus on trade corridors where they are already present and exert influence in the supply chain. Hyper-regionals should work with a small number of like-minded companies, including other banks, ship logistics companies and local port authorities, to solve technical problems and obtain business models more quickly. This will allow them to build their own credibility and experience before expanding to other players.

The outdated manual processing methods used by global authorities in trade finance lead to a lot of losses and risks. In order to improve profits and provide better customer service, global authorities should learn from the past lessons. They should focus on customers and improve the trade finance ecosystem and case files in the right way. Sectors such as textiles and daily necessities, which have integrated their supply chains in complex system platforms and have thin profits, provide fertile ground for the development of new technologies.

Domestic payments have shown signs of

Although the current payment system is very efficient in developed countries, it is still very likely to be disrupted in the long run. Central banks such as the People's Bank of China and the Bank of England are actively exploring the feasibility of issuing national digital legal tender using digital ledgers. Central banks and governments are attracted to digital ledgers for direct control over the implementation of monetary policy, better tracking of financial payments, and automatic taxation.

The devil is in the details, and limited to interbank payments, the impact of digital fiat currencies is limited compared to real-time settlement systems such as the UK's CHAPS. However, payment services that are available to the public and inexpensive can bring about a dramatic change in the financial services sector. If consumers and businesses can use electronic payment methods without cards or ACH systems, then the importance of accounts is reduced. Banks' high-margin cross-selling products will then become a problem, and banks will find a strong competitor in the deposit and loan areas (Figure 5).

The central bank will undoubtedly remain cautious, while commercial banks may speed up their pace and develop their own digital currencies with its alliances or independently. For example, the digital pound issued by commercial banks could be exchanged one-to-one with the real pound and used as cash. Merchants and consumers can conduct transactions directly with each other. If successful, the central bank will follow suit, just like paper bank notes, which were once printed independently by individual banks and finally unified by the central bank.

Whether triggered by a specific event or following a development trajectory, the trend toward digital currencies is reshaping the industry. Regulatory measures like Europe’s new Payment Services Directive (PSD2) break up banks’ monopoly on customer data, and payment wallet services from Apple, Google, and other tech companies threaten the unique relationship between banks and their customers. To deal with such uncertainty, banks should prepare for both short-term disconnection and the eventual arrival of digital currencies. They need to step up to take three actions:

Accelerate investment in digital wallets and payment applications . Currently, banks have a user advantage. They provide free accounts to provide users with basic financial services - safe storage of funds, payment options, etc. In return, banks can easily obtain funding sources, cross-selling platforms and pricing risks, credit and other important data. Digital wallets such as Apple Pay and PayPal are eroding this situation, and digital fiat currencies will accelerate this process. In order to fight this threat and maintain their customer access, banks should urgently invest in payment applications and wallets from new technology companies.

Reinventing compliance as a competitive advantage . If central banks issue digital fiat currencies, they will emphasize the identity of wallet owners and which wallet they keep their money in (unlike Bitcoin, where wallet owners are anonymous). This requires a KYC process, which is also currently implemented by commercial banks. Many banks have spent a lot of effort to implement AML and KYC regulations. These regulations are a barrier to new competitors, and these regulations will give banks a huge advantage.

Invest in startups and services that protect digital identities . Digital keys and strong passwords play an important role regardless of the use case. Banks should transform themselves from trusted and regulated entities to custodians of customer keys and digital signatures. This will strengthen the role of customers as the gateway to financial services. Banks should invest in technology services to protect users' digital signatures, just like a digital shield for keys.

The next stage of the problem
The emergence of distributed ledgers presents attractive options for bank managers. They must anticipate their impact and development early on, make rapid changes in the complex payments industry, anticipate the moves of competitors, and nimbly adjust the ship to mitigate risk and meet regulatory requirements. Given these challenges, it is understandable that they would reluctantly maintain the status quo, but the innovation genie has been released from the bottle and maintaining the status quo is no longer a viable option.

• Banking leaders can begin the journey from experimentation to action by answering these basic questions:

• How can our organizations prepare for the development of digital ledgers and their associated technologies?

• Which system should we invest in? Who are our customers? Where is the team promoting, exploring, and developing digital ledgers?

• Is our strategy to be a leader or a fast follower? How do we understand such technology and its commercial potential?

• What is our stance on wallets? Is it about maintaining control over user payment interfaces and user identities? Is our plan robust in the battle for user wallets and digital identities?

These questions are like litmus tests, and by simply answering them honestly, banks can benefit from new revenue streams and new customer relationships.

How Santander Bank is testing the waters

Over the past few years, Santander has been actively exploring the feasibility of distributed ledgers, including investing in Ripple. Current projects involve short-term and long-term payment projects and related fields.

For international payments, Santander recently launched its first Ripple-based consumer payment application for retail services, and it is also testing multiple cash management products targeting SMEs and large corporate clients. It is also working with other banks, alliances, and technology providers to develop smart contracts for trade finance.

Meanwhile, Santander is speculatively participating in opportunities including tools to simplify and improve the giant banking settlement system and various ways of dealing with final settlement, or cash-on-ledger.

Julio Faura, head of research and development at Santander Bank, noted the importance of deploying a distributed ledger strategy. He said that in order to overcome inertia and develop a way to show results, management must identify relevant and manageable forms to make it work. Faura said,

"If you try to make it easy for everyone as you roll out the whole thing, you're not going to get anywhere. The key is to start with a small, growing, cheap-to-develop rollout that demonstrates the benefits and gets the organization on board with it."