Most of the talk in the distributed ledger space has been centered around how to implement this technology in regards to cost cutting activities for incumbents (banks & financial services). As the distributed ledger architecture gets implemented the conversation should begin to turn towards ways to produce revenue-generating activities. These will be things built on top of the DL technology stack (in the application layer). This blog will look at cost cutting activities versus revenue generating activities for banks and financial services companies when it comes to using distributed ledgers. It will also look at potential use cases for revenue generation.
Banks have had a rough time in recent years and are finding it harder and harder to discover additional revenue sources at a time when their regulatory and compliance costs have skyrocketed and forced them to exit some core businesses and reduce their global footprint. They have also repeatedly settled lawsuits in the billions of dollars. One answer to these problems for banks is distributed ledger technology. As has been written in my other blog posts, distributed ledger technology has many benefits for banks:
· cost avoidance (getting rid of middlemen as well as back office/employees; going paperless)
· reducing capital ratios & improving liquidity ratios
· reducing risk
· improving regulatory compliance
· reducing redundancies and getting rid of operational and functional silos
In the initial phases of the rollout of distributed ledger technology it will not be revenue producing for banks but cost reducing. There are two ways to improve your balance sheet: 1) by increasing revenues or 2) reducing your cost . Banks are in desperate need of improving their balance sheet, hence the value of this technology is extremely valuable to them for achieving these goals.
Regulatory oversight (which has led to non-stop fines) has dramatically increased the cost of service while it has depressed revenue growth. Here are a few of the new regulations banks must follow:
This has put massive pressure on banks to shed core businesses (market making, remittance etc.) and raise their compliance costs and teams exponentially. Money Laundering (ML), Terrorist Funding (TF) and Know Your Customer (KYC), have caused financial institutions to stop servicing certain areas and people whom are deemed extremely high risk. Not only must you Know Your Customer (KYC) but you must Know Your Customer Customers (KYCC). This has had a dramatic impact on trade finance and correspondent banking. The costs and fines associated with AML/CTF/KYC have grown dramatically in recent years as the charts below show. Compliance has become a major cost center for banks and financial institutions so de-risking and de-banking has been an easy approach to take in order to ensure that they do not fall afoul of the regulatory authorities.
It is no wonder that traditional banks are on the defense and buying into the promise of distributed ledgers. In fact an Oliver Wyman report estimates that banks can save $15-$20 billion per year by implementing this technology just by cutting costs alone. So assuming distributed ledger technology becomes one of the underlying technology platforms in banks and cost cutting is achieved in all of the areas mentioned above, the next steps will involve building products off the distributed ledger stack (the application layer) which are revenue generating. IT implementations are really expensive so the cost savings generated by distributed ledgers will need to be justified versus what the world currently looks like within the technology layer of a bank.
The Next Steps: Revenue Generation
While there is clear evidence banks have been weakened in recent years, they still have clear competitive advantages which will bode well for their future once they have a handle on their costs, compliance and regulatory strategy in this new environment as well as become more digital. These competitive advantages are 1) the regulatory moat around them and 2) customers, a lot of customers. One strategy (which is out of the scope of this article) is to partner with startups in the distributed ledger and fintech space to give services to their customers. The area I'm focusing on for new revenue generating opportunities would come to from selling new services to their customers that are built on top of this distributed ledger technology stack in the application layer. Enter smart contracts.
Smart Contracts Are Revenue Generating For Banks
Smart contracts, as described below have the ability to be revenue generating for banks . First, a quick definition, I think Antony Lewis in his blog does a great job of describing a smart contract:
"What are people talking about when they talk about smart contracts?
In the context of blockchains and cryptocurrencies, smart contracts are:
– pre-written logic (computer code),
– stored and replicated on a distributed storage platform (eg a blockchain),
– executed/run by a network of computers (usually the same ones running the blockchain),
– and can result in ledger updates (cryptocurrency payments, etc).
… In other words, they are little programs that execute “if this happens then do that”, run and verified by many computers to ensure trustworthiness.
If blockchains give us distributed trustworthy storage, then smart contracts give us distributed trustworthy calculations."
In the context of this article a private network (distributed ledger) will be how these contracts are executed, since it has been well established banks aren't willing to work in a censorship resistant, decentralized world. Banks need to deal with trusted parties who will make good once a smart contract is entered and if not, the dispute will need to be settled in a reasonable manner. Kathleen Breitbart of R3CEV, in her article entitled ""The Problem with "The Problem With Oracles"", hits the nail on the head in her conclusion:
"Within "permissioned" or known-participant systems, issues such as fraud and malicious attacks become much easier to police. Both parties to an agreement would agree upon the integrity of an oracle, which we imagine to be from a reputable institution such as Bloomberg or Reuters in a capital markets context, with an understanding that mass fraud would be easily detectable and swiftly punished by the law. Smart contracts cannot mitigate the collusion of major financial actors (see also: the latest LIBOR scandal), but to conflate the risk of introducing oracles in decentralized systems with oracles in permissioned systems is to fundamentally misunderstand their purpose.
There have been many estimates about the potential cost savings from "blockchain" and/or distributed ledger technology in capital markets. Many of these figures are driven by the assumption that ledger integration will automate or obviate the need for many back office processes. At present, the use of smart contract-enabled distributed ledgers are the best way to introduce this automation, making them an attractive area of focus for financial institutions."
It is clear that smart contracts will bring about cost savings by lowering the legal costs of disputes from two parties who are reading, agreeing and signing the same exact document then executing it at some predetermined point in the future. This is not to say it will get rid of disputes entirely since humans are involved. However, it will get rid of lexical ambiguity (words can have many meanings), textual ambiguity (This is two people reading the same text in different ways and having different interpretations) and factual ambiguity (This is when two parties are looking at the same facts but those facts can be ambiguous depending on a party's point of view). Obviously this will decrease legal costs and teams (both in-house and out-house).
But Where Do the Revenues Come From?
Banks need to start off with simple use cases for revenue generation in the new distributed ledger world. Simple smart contract use cases are a win for generating revenue for a bank as opposed to complex items such as clearing and settlement and payments as mentioned in my most recent blog post.
Before we talk about how banks will make money from smart contracts a few assumptions need to be made:
1) Banks have a fairly sticky product, making it difficult for customers to leave. Moving your finances to another bank is a giant hassle that people want to avoid at most costs.
2) Banks are gatekeepers and charge certain fees for transactions as well as to protect and insure money. Banks charge fees for the services they provide because there is a significant cost to comply with financial regulations.
3) A zero transaction fee world is not viable in the long run for businesses, including fintechs.
With the assumptions above it's easy to see how banks can make revenue from smart contracts. If you have two parties who want to execute a smart contract for payment, those two parties draw up a contract to be executed in which money moves out of one party's bank account into the other party's bank account. The contract stipulates " Take money from Party A's account at Bank X to pay Party B's account at Bank X (or Bank Y). Easy right? Well not so fast. Those smart contracts need to connect to something to settle this transaction. That is a connection to a distributed ledger which connects to the real world banking system and allows the parties to enter this permissioned network and execute the transaction. In other words, integration is needed with the banks API and this is where a transaction fee can be charged by banks for fulfilling the stipulations of the smart contract.
While this sounds simple, think of all the types of contracts that can be executed that need to enter and leave a bank. This could be a big revenue generating activity in the first phase of smart contract rollout. Further out, I see bigger opportunities for data and internet of things, but that will be left for a different post.