How Blockchain can reshape transparency in Financial Services
“Chancellor on brink of second bailout for banks”. The headline from The London Times in UK encoded in the first bitcoin blockchain transaction on January 03, 2009. The origination of Bitcoin and the development of technology underlining it, the Bitcoin Blockchain, was said to be due to the disenchantment and loss of trust of the founders and its early adopters with the incumbent financial services industry and the havoc the 2008 Global Financial Crisis had caused.
It was a system created to eliminate the middleman from a transaction and reward users for their efforts, while aiming to provide traceability and transparency on transactions. All Bitcoin transactions are meant to be public, traceable, and permanently stored in the Bitcoin network. Bitcoin addresses are the only information used to define where Bitcoins are allocated and where they are sent. These addresses are created privately by each user's wallets.
Though these addresses are meant in a way to act like bank account numbers and therefore provide end user traceability, the lack of KYC and visibility on the details of the owners of these addresses provided an opportunity for nefarious elements to start using Bitcoin, for payments of illegal activities and ransomware. Quite a few users also used Bitcoin as a means to circumvent rules on cross border payments and currency control measures. This led many authorities globally to look at Bitcoin related transactions, and as an extension, all cryptocurrency transactions, as cover for illicit activities. The ICO boom and bust of 2017 to 2019, only further reiterated this view among these regulators.
While this hypothesis does hold good for a number of crypto activities over the last few years, there have been significant efforts made to bring in greater transparency and traceability. With the FATF rules on VASPs (Virtual Asset Service Providers, i.e., cryptocurrency exchanges), we are seeing a lot more transparency being brought into the cryptocurrency world. These rules require VASPs to provide details of every transaction, including names of the sender and receiver. In the recent times, there are much stringent KYC requirements on most of the large and established exchanges, and users can be easily traced. This has now allowed for more licensed institutions globally to start looking to both use as well as facilitate investment into cryptocurrencies as an alternative asset class. In addition, we are also seeing Central Bank Digital Currencies being considered globally, not least in large economies such as China.
Beyond looking at cryptocurrencies as another way of conducting payments, many financial institutions and regulators have focused on the underlying distributed ledger/ blockchain technology as a tool to increase transparency and traceability in the financial world, while reducing inefficiencies in processes such as reconciliations etc., We are seeing many applications of the technology for the KYC process, especially as there is an immutability element to blockchain along with the distributed nature of the ledger. This allows individuals and institutions to share and validate KYC data. Secondly, as an extension, blockchain can be very useful for AML through transaction monitoring and eliminating fraud.
Blockchain is but one example of how emerging technologies under the label of Regulatory Technology or Regtech, are bringing in higher transparency and building trust in financial services, both by the end users as well as regulators. We have also noticed increase use of Artificial Intelligence and data mapping
techniques to determine relation between transactions and find red flags related to AML and fraud detection. All of these are dependent on qualified and verified data to allow for models to be built on top. Financial institutions have a lot of data, but much of this data tends not to be properly classified and structured. Use of technology can help in data structuring and classification to enable data analytics. These technologies can be built either inhouse or by engaging Regtech startup solutions.
The emergency of Fintechs in the last decade happened due to two main reason, (1) Newer technologies, like Appl iPhone which changed customer behavior and (2) inability of incumbents to keep up with technology advancement and leaving a a gap between customers and bank’ services. All in all, by better use of these technology solutions, financial institutions can achieve better transparency and confidence in their processes. Secondly, use of regulatory technology for reporting can help provide regulators and policy makers with higher quality evaluation data points and build their confidence in financial institutions. Lastly, for effective use of technology for risk management across the base helps keep the financial institutions/ balance sheet in gaining investor confidence.
