An analysis of the potential future impact of blockchain on corporates and the financial industry by the World Economic Forum concludes the technology promises to help fundamentally redraw processes ranging clearing and settlement to proxy voting and, more broadly, challenge orthodoxies underpinning traditional business models.
The potential of blockchain to revolutionise financial services is being increasingly appreciated by the industry and policymakers, says the WEF report. On the basis of latest data it reckons more than 24 countries are actively investing in blockchain – more generally referred to as digital ledger technology (DLT). More than 90 corporations have joined blockchain consortia while venture capitalists have invested $1.4bn in the technology over the last three years. Nearly a hundred central banks are investigating the technology with the WEF study, The Future of Financial Infrastructure, predicting that more than 80% of banks will have initiated blockchain projects by 2017.
The Forum believes DLT has “great potential to drive simplicity and efficiency through the establishment of new financial services infrastructure and processes”. As well as simplifying operations and generating greater transparency, the technology promises to improve regulatory efficiency; reduce counterparty risk; reduce clearing and settlement times and minimise fraud.
But while DLT in itself holds massive potential to revolutionise financial services the WEF says its integration with digital identity and digital fiat (legal virtual tender) will be “critical” for amplifying its benefits to the industry. DLT infrastructure that boasts such integration would result in, for example, faster and far more accurate AML and KYC processes; seamless customer onboarding and the elimination of the need for an inefficient bridge between cash and the new financial infrastructure.
Global remittance revamp
To highlight the real world potential of DLT the study highlights nine plausible use cases, most of which are already in the early stages of being attacked by the fintech industry. They include global remittance where volume is increasing by 5% yearly worldwide and will reach an estimated $600bn in 2016. Revenue across this segment is growing in all regions, especially in Asia where China will likely surpass Brazil as the third largest payment area after the United States and the Eurozone. Profit margins for remittance services providers are high, with the average cost to the money sender running at 7.68% of the amount transferred.
While new generation, digital only remittance newcomers like WorldRemit, Transferwise and Currency Cloud are beginning to disrupt the industry they still account for just 10% of the total payments volume, indicating the still vast potential for a big shakeup of the sector. The study says real-time settlement of international money transfers by financial institutions can increase profitability by reducing liquidity and operational costs as well as generate value for payees. It imagines this could be actioned by the use of DLT incorporating smart contracts to enable direct interaction between sender and beneficiary banks, eliminating the role of correspondents. Such a system would also provide institutions and regulators with much more accurate AML and KYC information in real time.
Key elements that need to be in place for a DLT-driven remittance industry include standardisation of KYC processes and regulators, central banks and legal participants collaborating from different countries to reach a valid legal framework for global payments. There would also be the need for a significant number of institutions to reach agreement on the choice of DLT platform and so allow economies of scale and higher return on investment.
Insurance, specifically the commercial property and casualty (P&C), is another industry where DLT could be transformative. After life and death insurance, P&C is the second largest segment of the industry worldwide, generating earned premiums in 2014 of $729bn – growing at 5.1% since 2010 – and set to reach $895bnn by 2018. Claim and loss processing, however, is a major source of friction for the sector, accounting for an average of 11% of the overall written premium (revenue).
The WEF imagines a future where claims can be submitted either by via the insuree or technologically enabled “smart asset”, triggering an automated claim application. Insurance policies could be issued via smart contracts, with due diligence automatically carried out using business rules embedded within the smart contract. The DLT can then interrogate other data sources to automatically assess the claim and calculate the loss amount. Depending on the insurance policy, a smart contract can automate the liability calculation for each carrier where a syndicate (or insurers or reinsurers) exists. If the claim is approved, payment to the insuree is initiated via a smart contract.
As well as being operationally simpler and faster, the use of DLT and smart contracts for P&C claim processing would ensure a much enhanced customer experience and reduction in fraudulent claims as insurers would be able to seamlessly access historical claims and asset provenance details, enabling them to spot suspicious behaviour more quickly and effectively.
The WEF’s attractive scenario for P&C claims processing, however, would require a number of “critical conditions” to be met over and above the infrastructure. Asset records, for instance, would need migrating to the DLT to allow smart contracts to interrogate reliable, up to date data directly over the ledger in case of a claim. Insurers, regulators and other stakeholders will have join forces to develop and adopt data standards for all information as well as a legal and regulatory framework governing the smart contracts.
The application of DLT within insurance is still in infancy but fintech activity is picking up. According to US-based venture capital database CB Insights global funding to insurance technology start-ups topped $1bn over the first half of 2016. At more than 80, the deal volume over the first two quarters combined puts the year to date on track to top 2015?s total by over 42%.
Removing uncertainty from CoCos
Another interesting use case highlighted by WEF focuses on capital raising instruments, specifically contingent convertible (CoCo) bonds. A key pillar of the post-crisis regulatory regime, CoCo bonds were drawn up to strengthen banks’ capital levels and prevent taxpayer bailouts. They are a kind of hybrid between debt and equity, issued as debt by banks but converting automatically into equity or even forcing a cancellation of the debt if it gets into hot water. Their aim is increase financial stability by enabling banks to increase their capital ratio in case it falls below a predefined threshold.
But there are concerns over CoCos. The WEF report points out that after experiencing continued double-digit market growth since 2013, CoCo bond issuance flatlined in European markets in 2015. A primary concern has been the uncertainty associated with them: what happens for instance when a bank tries to convert a CoCo? No one really knows as none have required conversion to equity yet, making the market largely untested in the real world so far.
Another key concern is the extreme volatility of CoCos. Earlier this year, for instance, the market for the instruments seized up on fears over Deutsche Bank’s ability to pay bond coupons triggered wider market concerns that other issuers would also struggle to service interest payments.
The report says current “pain points” for the CoCo market include limited rating information, which restricts participation from large institutional investors, and regulators having to rely on point-in-time stress tests to assess the health of the banks and the CoCo bonds market. At the same time, bank equities are susceptible to extreme volatility as investors exercise extreme wariness ahead stress test results.
The WEF believes that DLT having the potential via smart contracts to embed and automate regulation into business processes could help reduce volatility and uncertainty of CoCos, even maybe help with their issuance in the future. Tokenising bond instruments when soliciting capital from investors can enable them to make informed, data-driven decisions. Smart contracts could alert regulators when loan absorption needs to be activated, minimising the need for their point-in-time stress tests. And providing investors with transparency into loan absorption could reduce uncertainty currently associated with the hybrid bonds.
Proxy voting for the 21st century
Corporate governance failures globally are widely regarded as having played a key role in development of the financial crisis. The WEF believes DLT could help here too by supporting efforts by governments to ensure shareholders, especially retail investors, have a bigger say in corporate decision making. Ledger technology could be particularly helpful in boosting participation in proxy voting, which facilitates remote investor voting during annual corporate shareholder meetings without requiring attendance.
Under the current regime, corporates are responsible for distributing proxy statements to ensure investors get the chance to make an informed decision. Typically a third party is employed to deliver these statements to investors in partnership with intermediaries that track order execution. Investors can then conduct a manual analysis of the potential voting impact before casting their own vote directly to the third party.
It has long been a source of concern that retail investor participation in proxy voting globally is low compared institutional investors. For instance, according to ProxyPulse, a shareholder voting database covering North American companies, institutions on average voted 83% of their shares versus just 28% for retail investors during the 2015 “mini-season” covering the period July 1 to December 31. As a result of such turnout performance significant shareholder participation in elections is lacking each year, with billions of shares remaining un-voted every year.
The WEF says key drawbacks of the current proxy voting regime include a costly distribution process for proxy statement distribution and summaries within proxy statements providing a misleading view into a corporation’s health. Voting discrepancies are another problem.
The use of DLT for proxy voting would force disintermediation, killing off the need for third party involvement as all investment records would be stored on the blockchain. A smart contract can notify regulators of proxy statement availability and ensure distribution to investors. The streamlining of the distribution process would result in cost savings and improve accessibility and participation. Smart contracts would ensure voting is aligned to share ownership at the time of the vote while transparency is assured through voting data being made available to the corporation and voters in real time.
A DLT-driven proxy voting system would require three key elements to be in place. Firstly, companies and exchanges would have to store all investment records on a distributed ledger in order to identify beneficial investors without the need for intermediaries. Secondly, to ensure proxy voting is available to investors across all demographics, systems will need to be developed to automatically convert votes cast via mail or phone into tokens that can be stored on the distributed ledger. The report also cautions that if corporations develop voting solutions unilaterally, investors will not be able to standardise analysis across investments. It therefore suggests companies form partnerships with each other exchanges to minimize parallel development.
Nasdaq is one exchange actively exploring the use of ledger technology to better manage and streamline the proxy voting process. Earlier this year it announced it is trialling blockchain for proxy voting by shareholders of companies listed on its exchange in Tallinn, Estonia.
Other DLT use cases highlighted by the WEF cover trade finance; automated compliance; asset rehypothecation; equity post-trade processes and syndicated loans.
While DLT hold enormous potential for the financial industry the WEF cautions “it is not a panacea and should be viewed as one of many technologies that will form the foundation of next-generation financial services infrastructure”. It adds that “the most impactful DLT applications will require deep collaboration between incumbents, innovators and regulators”, though this may add to the complexity of the infrastructure and so delay its implementation.
The WEF analysis involved engaging with more than 200 leading financial industry players, innovators, academics, policymakers and regulators via five workshops held at global financial hubs including London, New York and Singapore.