The term creative destruction by Joseph Schumpeter describes the process of creating net economic growth in a capitalist system. The entrepreneur creates greater economic value from his radical ideas and innovations than is destroyed by the replacement of established ways. This radical destruction is seemingly a positive news for the financial services industry.
What is Blockchain?
Blockchain can be seen as a registry, for example, a land charges registry – that is, the records kept of charges on a property’s history, such as e.g. ownership disputes, outstanding unpaid loans and restrictions to the deeds of the property. In May 2015, the application of the technology to land title tracking began to gather momentum after a US technology company revealed it had agreed to build a blockchain-based land-title registry system for the Honduran government. The country’s land registry, which currently operates using a centralized ledger, has been regularly vulnerable to fraud, particularly at the hands of bureaucrats who have hacked into databases to jump the queue and secure luxury beachfront properties. A blockchain-driven decentralized system, in contrast, will be immutable and transparent, so that the transactional record for a specific property is available for all relevant network users to verify. Moreover, the creation of such a land registry system would result in more secure mortgages, contracts and mineral rights, as well as incentivising the owners of nearly 60% of unregistered Honduran land to officially and inexpensively register their properties.
Ghana has also been making strides in this area. A few start-ups and NGOs are in the process of developing a system for entering land title records underpinned by blockchain’s technology, after numerous government attempts to develop a fair and efficient land administration system resulted in a myriad of legal land dispute cases. It is hoped that once the new registry system is in place, buyers can easily discover the last owner of property rights and land ownership disputes, while the disputes themselves can be made visible – and thus more easy to resolve before such cases are escalated to court – and ensuring more security for property owners. However, as with Honduras, the progress of this project is still in the early stages, indicating that much work is yet to be done.
Creative Destruction within Banks
With the ability to transfer several kinds of values cheaply and transparently, blockchain is expected to comprehensively disrupt the finance industry, among others. The flow of funds between parties is expected to benefit from greater market visibility under blockchain, which would enhance market transparency and liquidity, and improve regulatory oversight within financial markets. At the same time, the possible eventuality of numerous distributed ledgers being available and competing for users is bound to generate desirable outcomes for overall market efficiency. Money-laundering and fraud could also be dramatically reduced.
Banks, meanwhile, are now starting to catch on to blockchain’s potential to improve overall business performance. Major banks have already published research papers investigating blockchain’s disruptive capabilities, and has highlighted the concerted effort by stock exchanges, credit card firms, clearing houses and insurers to shift their focus onto the technology’s potential. The publications asserts that the technology is one of the first truly disruptive ideas from the Fintech sector and that a paradigm shift in the financial sector is a likely possibility, as many intermediary services could be replaced by a P2P network. The establishment of innovation labs, strategic board appointments, as well as the collaborations between major institutions and relevant Fintech start-ups, all provide further evidence that banks are seriously considering using distributed ledgers to replace their costly, inefficient proprietary systems.
Furthermore, collaborative work on an industry-wide scale has already begun. By the spring of 2016 already forty-two financial services firms have united to develop its shared ledger initiative which hopes to develop commercial applications and consistent operating standards across the finance industry for such technology. As with other Fintech areas, however, much work is still to be done before the emerging technology can be implemented confidently by financial markets.
Creative Innovation in the insurance industry
Given that the technology facilitates the creation of publically verifiable, trusted contracts, the implications could also be sizeable for the insurance industry. A report published in December 2014 studied the potential effects of blockchain on personal insurance. More specifically, two roles of a trusted third party may well be displaced, namely the prevention of duplicate transactions and the provision of a verifiable public record of all transactions. For insurances, especially smart contracts powered by the blockchain can provide customers and insurers with the the means to manage claims in a more transparent, a more responsive and irrefutable manner.
Blockchain-based contracts could also allow policyholders to begin self-administering their own insurance products, which would indicate a shift away from the current risk pooling model of risk management which currently prevails within the industry. Furthermore, identity ledgers could be used by the insurance industry to better manage entitlements. A family insurance policy could contain a finite list, or identity ledger, of members which can’t be altered, for instance. On the whole, the report heaps praise on blockchain’s potential for the insurance industry, concluding that it expects to see a proliferation of blockchain applications in financial services, including insurance.
One of the biggest international insurance market, London, recently announced that plans to modernize its market infrastructure are very likely to include recommendations to use blockchain technology in order to improve operating efficiency. The blockchain’s potential to improve the way insurers record risk, increasing the speed, accuracy and transparency of our processes. An example of such improvement in the form of a blockchain-powered innovation could be a digital deal rooms, whereby documents could be shared securely across the blockchain. This would ostensibly eliminate the need for an independent third-party, and would be in stark contrast to the present situation, where deals are done on the basis of personal relationships and paper documents.
A Blockchain-type ledger could end up overhauling banks’ operational systems and ultimately save them millions. Blockchain presents a solution to reduce banks’ and insurances’ costs for cross-border payments, securities trading and international compliance. While major challenges over how exactly such technology should be incorporated remains, it could be the case that markets ranging from derivatives to private equity could adopt private blockchains within a matter of a few months.
According to the EU regulators and EU banking commission, there will be two separate waves of disruption to financial services from such distributed ledger technology. First, it will pertain to the improvement of existing processes, via efficiency, security, transparency and cost. The second, will involve new innovations based on the application of the exclusive features of cryptotechnologies, which presumably will involve the creation of new products.
Blockchain technology could influence processes from the front-end through to the back office within the next three to five years, across all stages of the trade cycle. I see especially potential in the reduction of operational costs, counterparty risks, settlement risks as well as overall transparency within the market. Additionally, I see this disruptive innovation of the blockchain within the financial services industry to provide a powerful force for making markets more transparent, more efficient and use scarce resources more productive as they flow from the least to the most efficient sectors – a creative destruction.
- Regulatory Competence Center
- Article: The many faces of Fintech
- Article: Is Fintech an enabler or a disruptor?
- Report: The Pulse of Fintech