DBRS considers Blockchain to be promising for improving efficiency and automatisation of banks’ operations. However, the technology is still immature and poses challenges for future applicability in the banking sector, particularly with regards to operational and reputation risks.
Technology based-applications are driving rapid change within the financial sector for varying reasons, including changes in consumer behaviour, technological innovation, evolving regulation and a search for greater efficiency. Innovation in banking is not new, but many changes have contributed to disruption within the banking sector over time, with more recent changes being driven by technology.
Evolution in technology often presents both opportunities and risks for implementers and users. The impact can be significant for banks, market competition and consumer protection. Assessing this impact can be challenging especially for new applications due to the lack of sufficient information and track record.
Blockchain technology has the potential to improve efficiency in executing lengthy and complex processes while also increasing the level of security and transparency. Nevertheless, the technology is still immature. While the current regulatory environment remains unsettled, there remains uncertainty over future benefits and challenges in terms of operational risk. In DBRS´ view, the success of blockchain based activities will largely depend on the results of the testing processes (Proof of Technology and Pilots) and more extensive adoption will likely occur over the longer-term.
Potential benefits and banking applications
The hype around blockchain amongst financial institutions and start-ups (fintechs) is backed by its extensive applicability. It can be implemented as disruptive technology, or as the backbone for market infrastructures of digital assets. It can be used as an enterprise software platform to streamline business processes or as a tool to improve transaction management and record retention. Blockchain, which was first introduced as the underlying technology of “Bitcoin”, is attracting interest from banks due to its potential to improve efficiency, security and speed. Unlike traditional ledgers and database, the potential for blockchain technology is based on its combination of different features including decentralisation, consensus, cryptography mechanism and smart contracts (see definitions below), which can improve the efficiency and speed of transactions.
Blockchain is a distributed ledger technology (DLT) underpinned by a strong consensus process and full transparency for permitted users. DLT has the potential to provide banks with reliable information eliminating the need for trusted intermediaries to reconcile each counterparty record within the same business transaction, therefore shortening the process and reducing costs. The use of smart contracts would increase the level of process automation, thus supporting lower back office costs and administrative burdens. Greater efficiency and speed could also contribute to mitigate counterparty risks and improve capital and liquidity efficiency via shorter settlement times, whilst pricing decisions would benefit from secure data and lower information asymmetries. Additional benefits may emerge in the area of operational risk. DLTs could strengthen the process of record keeping and reduce the risks of duplications and alterations. Streamlined process and audit tracks would ultimately reduce risks associated with meeting compliance and reporting obligations.
DBRS expects financial institutions to increase their budget spending on Blockchain related projects. Most of these applications are still at an early development stage, testing phase or proof of concepts. In many cases, financial institutions and banks, especially the large ones, have joined forces in partnerships and consortiums to achieve economies of scale, develop industry-specific solutions and keep a competitive advantage against potential market disruptors. Trade finance, cross-border payments, clearing and settlement, lending origination and scoring are areas which appear able to benefit the most from the application of blockchain technology. Benefits are also expected in identity verification, customer due-diligence process and know your customer (KYC), as well as audit activities and anti-money laundering (AML), and other record keeping activities such as voting records.
Outstanding challenges and future risks
Although the concept is promising, DBRS considers that Blockchain technology remains immature, posing challenges for banks’ operational risk, reputation and financial strength. IT, legal and regulation are some of the most critical areas and potential sources of risk for blockchain based applications.
The architecture of blockchain is complex and involves several components. The robustness and functionality of the system largely depends on consensus methodology, the number of nodes that are needed to validate a transaction, as well as the mechanism of governance which regulates the access of the participants and their level of reliability. Other than these aspects, questions arise on the interoperability between the systems of different institutions and integration challenges with existing infrastructures.
The complexity of the network and expansion of the entry points could also pose IT risks, including cyber-attacks, especially if one of the systems is weaker. Issues may also emerge from concentration risk and high reliance on third party service providers. Signature frauds such as stolen keys, represent another source of security risk.
DLTs also hints at a trade-off between the level of security and scalability. In the case of permissionless and permissioned networks, the less scalable but more secure and transparent public platforms can be contrasted with more customisable and faster processing but opaquer private DLTs.
Finally, DBRS is of the view that the lack of regulation of blockchain creates uncertainty about systems’ compliance with future legislative frameworks. Uncertainty remains also regarding the validity and enforceability of smart contracts, whilst concerns arise for privacy and data protection.
Press release by DBRS
Publié le 08 octobre 2018