Executive summary
In the last six months blockchain technology has gone from a complex and arcane topic to increasingly mainstream, as the technology evolves from concept to use. In July 2020 the OCC allowed banks to provide custody services for digital currencies. In late 2020 Federal Reserve Chair Jerome Powell spoke at an IMF conference on digital currency, saying that given the dollar's important role globally it is essential the Fed remain on the frontier of research and policy development. A month later Brian Brooks was appointed acting Comptroller of the Currency, and a month after that the OCC approved banks' use of digital currencies in payment activities. While blockchain has been around for a few decades, these developments move it into the mainstream.
What is blockchain? It is a distributed public ledger stored in a shared database, a system of recording entries in a manner where all parties can confirm them. No entries can be changed to reverse transactions, which makes data stored in the blockchain as trustworthy as a wire confirmation from the Federal Reserve. The technology enables new payment rails that do not flow through central banks.
Blockchain has four key attributes: security, transparency, decentralization, and efficiency. By virtue of its architecture it is secure, so currency recorded in a blockchain is as surely money as a dollar bill. The technology stands in place of the Federal Reserve in providing the trust needed for the financial system to function. All entries sit in a public ledger. Perhaps the biggest difference from the Fed is that blockchain is robust because it is decentralized, whereas the Fed's authority comes from its role as a centralized clearinghouse. Finally, and perhaps most important, blockchain is designed to enable financial transactions to be recorded in real time at low cost. That efficiency is likely to be the attribute that drives adoption in the United States.
Digital currencies are the most prevalent application, but banking uses also include know-your-customer and anti-money-laundering programs, payment systems and transaction settlement, maintenance of loan files, and ownership ledgers.
Digital currency
Digital currencies like Bitcoin were the first application of blockchain. The technology is secure enough that it can stand in the place of an institution like the Federal Reserve to create money. That said, money is used as a medium of exchange, a means of payment that enabled mankind to move beyond barter. Bitcoin is different. It is a fiat investment, created out of thin air, that can be used to hedge other investments. For digital currencies to be money they need to be stable, like the next generation of digital currency, stablecoin. There are about a dozen dollar-based stablecoins and almost as many backed by other currencies or commodities. Eventually these will be used for everyday purchases.
Unlike Bitcoin, stablecoin is designed to minimize volatility. Stablecoins solve a key problem for digital investments by providing a medium of exchange for the period between the trade and settlement. An investor seeking Bitcoin exposure can deposit dollars in a bank, take back stablecoin, and use it to buy Bitcoin, with the sale process running in the opposite direction. Many stablecoins are backed by dollar deposits, ensuring stability. At the beginning of 2021 the OCC issued guidance formally approving banks serving as depositories backing stablecoins.
As bankers we often ignore near money and focus on money controlled by the Fed. Near money includes numerous other assets that can be monetized, and many of these offer clear business opportunities to banks. Prepaid debit cards are functionally equivalent to debit cards linked to checking accounts without overdraft privileges. A balance on a retailer's stored-value card is no less money than the same amount in a checking account. Balances held with online payment providers and marketplaces are also near money. By allowing banks to back stablecoin balances, regulators are maintaining some influence over this form of near money.
It has been nearly 50 years since deregulation of financial services ushered in the concept of cash management accounts holding both long-term investments and more liquid cash equivalents. In that environment all investments are near money. Fixed income securities are nearer than equities, public nearer than private, securities nearer than real property. But all bear attributes of money, and banks can profit by servicing debit cards, providing lockboxes, and contracting with investment advisors. Banks need to work with money and near money in order to remain relevant to customers.
It is natural for banks to manage digital currency accounts. If a customer chooses to be paid in Bitcoin and then shops using Bitcoin, someone will need to balance all of the debits and credits. Banks are well positioned to provide that service.
Customer identity, know your customer, and anti-money laundering
Blockchain can create a decentralized database of known customers, which directly addresses the still widely held belief that digital currencies are only used for nefarious purposes.
With blockchain technology it is possible for participating institutions to differentiate known customers from others. That status could be portable, so when a customer attempts to transact with another bank, that bank need only check the registry. FinCEN rules allow banks to rely on information gathered by third parties. Such a process would avoid the duplication of effort now required as every bank gathers the same photocopies of a driver's license and other personal information. More importantly, the attestations central to the concept of a known customer are best maintained by banks. No one else has a greater or deeper web of trusted information to verify customer identity.
Know-your-customer protocols can be burdensome for community banks, especially relative to the benefit of reducing illicit activity. Participation in a blockchain-supported network sharing this data may be the best way to ensure compliance at the lowest possible cost. Digital currency companies face similar regulatory requirements to banks, and financial regulators will not allow near money or digital currency to bypass know-your-customer and anti-money-laundering regulation.
Payment systems and transaction settlement
Blockchain technology is able to disintermediate the Federal Reserve's wire system. Trust is the lynchpin of the financial system, and wire transfers are the most trusted transaction: no bounced checks, no returned ACH debits. Blockchain provides a similar level of trust. Most importantly it maintains a trusted record of all transactions submitted in any currency, whether dollars, foreign currency, or digital currency. For banks this provides the possibility of real-time, low-cost transfers.
Federal Reserve technology has not kept pace with innovation in financial services. As a result numerous services have stepped up to provide payment services that do not go through the Fed. Same-day ACH and internal payment processing are examples of institutions using technology to cross transactions, leaving only the net amount to clear through the Fed. By paying federal funds on the net balance, such a platform can operate without the Fed at all.
Maintenance of loan files
Blockchain's public ledger need not include personally identifying information about customers. Because it is decentralized, many believe customer data would be at risk on those distributed computers. In fact the ledger records the existence of the information but not the information itself. This architecture is critical. Blockchain is efficient because the ledger is public but the customer data is not. Ledger information is tiny and easily stored in multiple decentralized databases, while customer data is often cumbersome, running to scanned images of hundreds of pages, and need not be transferred between parties at all.
Mortgage loan files are the most obvious application. In the mortgage business, origination is often separated from servicing, and servicing is often separated from ownership of the loan, so it is critical for many parties to share information and certify that the file is complete. Shipping the physical file risks loss in transit, and shipping the digital file can be time consuming. A $100 million servicing transfer can include as many as 50,000 loans, and file transfer can take days even with multiple simultaneous uploads. With blockchain the file can be encrypted and stored in a single location, and a transfer requires only the encryption key.
Verifiable consumer credit report data can disintermediate the credit bureaus and give consumers greater control over their credit scores. The profile could include confirmed payment histories for all debts, reconciled with bank account transactions, and could be locked down to assure lenders the consumer has not incurred additional debt that does not appear on the report. Blockchain also enables peer-to-peer lending with encrypted loan files and verified credit reports, where requests can be posted to exchanges without revealing personally identifying information until the winning lender is identified.
Ownership ledgers
Blockchain can be used to record the creation and ownership of digital currencies. Ironically, many digital currency investors hold balances in online accounts that are not protected by the technology, and there have been several high-profile thefts as a result. With a blockchain ownership ledger it would be possible to track ownership of an asset, whether digital currency or another investment, to eliminate or at least reduce theft and fraud losses. One such application would be the recording of real estate mortgages and ownership, where the current process is not standardized.
Summary
Blockchain is a powerful technological tool with numerous financial applications, ranging from digital currencies to normal banking activities like payment processing, file transfers, and ownership ledgers. It also offers an alternative to centralized government control of financial transactions. Institutions like the OCC and the Federal Reserve are not designed to lead change; they prefer to opine on the innovations of other market participants. With the traction blockchain established in 2020, it is critical for most banks to be positioned as either leaders or fast followers to avoid customer attrition as these technologies are implemented.
