Distributed Ledger Technology Utilization in Regulated Financial Industries
Adopting blockchain technology offers compliance cost and filing time savings for financial institutions serving high risk industries. Distributed ledger technology (DLT) helps to reduce friction while increasing the transparency of shared data in systems that rely on verifying identities to create trusted relationships when disseminating information between traditionally trust-less industries.
There exists various uses for DLT in modern financial industries including pathways for providing banking services to traditionally restricted capital markets as we have seen with remittances. Another optimization based on current standards of modern financial services is the ability of distributed ledger technology to create a new universal business language around shared financial information which is the proposed solution for limiting costs associated with compliance.
A universal standard to communicate metadata associated with transactions between global financial institutions is one of the larger macroeconomic challenges facing rapidly globalizing data systems around the world. As we see more transactions move across borders at a faster rate, the speed as to which the information attached to those transactions must match or exceed the speed of the transaction.
Financial Industry Opportunities Utilizing Blockchain
Blockchain as a technological solution in high risk industries becomes more important as the relationship between money and attached information continue to grow more complex. This relationship will be explained further, but first let's briefly describe the concept of a blockchain.
Blockchain technology is based on a cryptographically secure distributed ledger containing information stored in peer to peer network. Copies of interactions between each participant on the network is kept on the ledger in a near immutable way to limit any single point of failure. The proposed system relies on a validation protocol called a proof which guarantees individual transactions, and the meta data contained about them based on existing records on the ledger are correct and can be shared effectively.
Multiple areas of blockchain technology has seen exposure in the current financial system around the world. The economics of global remittances, Know Your Customer protocols (KYC), and Counter Terror Funding (CTF) or Anti Money Laundering (AML) processes are seeing the impact of utilizing distributed ledgers to store information.
Let’s look at remittances over the last few years as an indicator of the kinds of problems banks are running into in regards to adequately tracking information associated with transactions in a modern globalized economy. Worldwide, an estimated $625 billion (USD) was sent by migrants to individuals in their home countries in 2017. Tracking remittance payments worldwide is difficult because many countries do not track funds that are sent or received.
There are many reasons why the process of tracking money is a complex problem for modern governments. In the scope of this research, the focus on the cost of compliance in tracking financial information and reporting it to each jurisdiction that requires regulatory reporting is the major friction mechanic of any transaction. The process of building a regulatory report is time consuming and expensive because it relies on traditional financial compliance solutions to track the movement of complex digital transactions which are becoming more popular across the globe.
Human capital costs are a large portion of the expenses needed to accurately run compliance checks on money moving through international systems. Managing the flow of liquidity needed to facilitate these types of transfers offers a new set of challenges for financial institutions who attempt to do business overseas in developing markets through remittances and international wire transfers. This stems from the various forms of regulation that overlap and intersect when the process transferring funds begins.
The wording of such regulation might be insufficiently clear or difficult for firms to understand. Sometimes this reflects the challenge of writing a set of instructions that can be understood and implemented by multiple types of public and private firms operating under separate jurisdictions and regulatory structures. This is where KYC and AML information become regulatory requirements so that financial institutions know who is involved in the process. Banks are required by law to process and record data associated with the identities handling the transactions so they can monitor the internal compliance teams to ensure that the information is validated before funds are settled.
The systems that currently act as the compliance layer for banks are built on the utilization of archaic human-capital rich resources and rely on transcribing information across non-standardized databases that can be changed and edited at will by financial institutions who must revisit certain transactions over time to ensure compliance information is maintained for regulators.
Immediately one can see how the prototype blockchain systems being proposed today may offer significant efficiencies in sending information about transactions without centralizing complex processes that commercial firms currently carry out locally. One such feature is being able to understand and interpret regulatory instructions for digital identities and producing logic to generate regulatory reports and distribute information to all financial firms via a DLT platform.
For instance, blockchain can act as a distributed set of technical standards. These rules are agreed upon protocols in which the coded language of regulation will communicate with financial systems. Language standards will be required for how financial firms organize their data before providing it to any proposed blockchain system. The system must also provide an environment for data to be reused across multiple regulatory systems, built to differing standards based on regulatory requirements that they operate in as per existing obligations or limitations associated with existing practices.
However, as previously noted, ensuring regulatory reporting is done correctly has major financial and legal implications for banking firms who must comply with Bank Secrecy Act regulations. Ensuring that correct regulatory reporting can be translated across borders with the money that is moving simultaneously is one of the processes that should be migrated to a DLT platform which may act as significant cost saving tool as these markets continue to scale.
Financial institutions currently have security standards built out to prevent data being accessed or used inappropriately by any one single entity that may have access to a distributed network. Similar universal business language standards can be applied to blockchain without the same costs in head-count and expertise when maintaining information on a distributed ledger can be simplified to a point of near automation if a universal language is used in mind with current financial messaging standards.
One of these standards, ISO 20022 was developed by SWIFT to ease the burden of sharing information around transactions, ISO 20022, “allows communities of users and message development organizations to define message sets according to an internationally agreed approach using internationally agreed business semantics and, whenever desirable, to migrate to the use of a common XML or ASN.1-based syntax.”
Developing modern financial compliance frameworks built on the concept of interoperability and transparency without increasing friction when sharing such information can save time and money when dealing with high risk industries. This concept of universal business language or (UBL) lays the foundation for distributed ledger technology to define new messaging standards in a decentralized way.
Blockchain Enhancing Current Regulatory Processes
In this section the various aspects of digital object tracking are explored within the context of blockchain solutions applied to their unique financial markets. These corporate entities are experimenting with DLT in ways that allows their financial information to help lower friction and access new high risk markets, ultimately lowering costs for their services.
Digital Identity With DLT
Blockchain technology is currently being tested for identity fraud detection through the creation of distributed digital identity networks maintained by the financial ecosystem they service. This is because DLT offers the ability to streamline communication between partitioned databases that can rely on digital signatures to validate interactions between participants on the same ledger.
Bluzelle Networks, a blockchain-based data storage start-up, in 2017 worked with a consortium of three banks in Singapore—HSBC, OCBC, and Mitsubishi UFJ Financial Group—to test a blockchain platform for Know-your-Customer (KYC) and its effects on internal costs of compliance. The project showed that a blockchain platform would improve efficiency, cut the risk of financial crime opportunities, and increase the interoperability of existing datasets all pointing towards the optimization of information sharing for data rich financial institutions utilizing DLT solutions.
Elsewhere, Norbloc, a Swedish start-up that builds regulatory applications on blockchain platforms, is working with Belgium-based infrastructure provider Isabel Group to build a platform to simplify identity management. Both examples show a continued demand for technology that makes sharing sensitive information over digital channels more effective in increasingly digitized financial systems.
Meanwhile in payments, Mastercard has patented a system for identity and credential protection and verification via blockchain. What does this mean? In the past, financial institutions were often required to make risk management decisions based on limited data, obtainable from a few brokerages and agencies. But in a future built on blockchain, information can be accessed in a compliant way when standardized business communications attached to transactions are the norm.
Digital identities are a great way to build the digital banking future consumers want, while leveraging the payment and identity information already in use by high risk industries.
In the current financial system, digital identity validation is a service provided by a third-party authority that utilizes public information based on previous interactions within a corporations technology stack, for instance an existing database that tracks the money services attached to social media platforms digital identities.
A large social networking company like Facebook may want to connect their platforms private user information with their own proprietary payment processing data to create a living KYC compliance engine. The recent development of the Libra project run from Facebook’s need to optimize their money services business practices when it comes to dealing with their users information in light of Europeans GDPR regulations is one aspect of digital identity experimentation that is creating discussions at every level of government.
Thanks to a combination of technological advances, including the increasing sophistication of smartphones, advances in cryptography, and the advent of the blockchain, it is now possible to build new systems around exchanging identity information such as social media, and existing payment datasets.
Blockchain technology offers the potential for pooling large volumes of data that can be anonymized and protected by the ledger’s encryption protocols. Data carried on a distributed ledger could be accessed without explicit at-the- time permission (customer consent can be granted via pre-programed smart contracts). Information partners theoretically, could view data that has been uploaded by any bank in the financial network without worrying about the accuracy or regulatory parity of such data. The result should be faster decisions, more efficient processes, and the potential for a more informed credit allocation process.
Blockchain Enabled Augmented Data Reporting
The common thread between all of the above mentioned projects is that every regulated financial firm is required to submit data to regulators through regulatory reports. Governments provide the instructions for how financial compliance reports should be built and delivered.
The amount of money services business regulation and regulatory reporting has increased significantly in the decade since the financial crisis. Given this increase in reporting and regulation, the complexity and time it takes firms to manage regulatory reporting has also grown.
Financial firms provide regulators with reports defined in regulation, but regulators also make ad hoc data requests for financial data in the form of audits. FinCEN requires united states based financial institutions to run independent audits to ensure data accuracy over time. A prototype DLT system may reduce duplicate data storage and associated costs for running audits on historical transaction data potentially reducing some data security risks by eliminating erroneous data transfers between firms and regulators when it comes to archived information.
Any KYC data used to generate the compliance reports or fiscal audits would remain with the firms while a trust-less record of transactions could be linked to the banks historical transaction ledger with ease. This means that not only the augmented compliance report would be shared with the regulator, but the information attached to each interaction with the dataset as well.
By making financial data available on demand, fiscal regulators may also store less data in their own digital systems, helping regulatory IT budgets reduce strain on the departments who are tasked with maintaining financial trust, but are restricted to the amount of data they can securely process due to human capital costs. Finally, by executing standardized UBL code within financial firms own digital infrastructures, the fluidity of data, as well as the transparency, is potentially increased while reducing the friction of sharing financial information associated with past processes.
More than a few retail banks are dipping their toes in the blockchain pool based on those proposed savings. Santander, a major EU financial entity for example, worked with California-based Fintech Ripple in 2018 to launch the first blockchain-based money transfer service focused in the global remittance market. This ties to one of the proposed use cases of digital assets, helping reduce the friction associated with cash moving around global markets, while promoting the use of digital applications to track the customer information associated with the movement of those funds.Still, for the retail banking industry to move forward at scale, further proof of value will likely be required.
More validations of distributed ledger technology are seen with each passing day. While we have passively identified three major pain points when it comes to dealing with high risk financial marketplaces— know-your-customer/ID fraud, internal costs of financial compliance, and risk management scoring— more proof in the cost saving potential of all Know-your-customer protocols are critical tools in the battle against fraud, which is a significant and growing challenge. Currently banks lose $15 billion to $20 billion annually from identity fraud alone.
A related issue is money laundering. A report estimates that global anti-money laundering (AML) spending alone exceeded $8 billion in 2017, up 36 percent from 2013. AML headcount increased as much as tenfold at major US banks over the past five years.
Retail banks have made significant efforts to combat fraud, protect data, and prevent money laundering, investing in automation and standardization, introducing real-time information sharing, and building predictive models. Blockchain enables these systems in new and exciting ways.
These distributed ledger technology initiatives have increased efficiency do have significant upside potential but have also led to longer on-boarding times for clients interested in the technology as government regulatory clarification lags behind.
Between that and higher costs, reflecting the significant operating model changes and manual effort required to adjust to new methods around blockchain. Automation and machine learning may be a potential solution. For example, on-boarding or account opening can be done by referencing image based identification, cell-phones can help to physically or digitally sign transactions across the world.
Blockchain-based technology enables physical and digital customers to have their interactions with a financial network securely tracked and near immutably recorded in the form of a digital identity which may be attached to the financial engagement they perform. Similar to how an actual physical fingerprint can be used as a unique identifier to see what a person has touched in the physical world, a digital fingerprint should be established to see how entities touch digital information, especially when it comes to digital transactions.
This data can be safely stored on a distributed ledger and have a verifiable receipt of any reference by any bank in the network. The owner of the digital fingerprint can use it to submit new account applications and prove her identity universally. They could decide which entities can access their data similar to a license model.
In this new system the decentralized blockchain structure eliminates overlapping KYC and AML compliance checks by helping standardize the language in which banks share digital identity authentication information. The on-boarding of a customer need only be done once by use of existing technologies such as mobile phones, fingerprint scanners, and facial recognition technology.
Augmenting Compliance Auditing
We’ve discussed how distributed ledger technology can help augment the way financial institutions access data already stored on their own ledgers, and how standardizing how that data is communicated can act as an additional form of due diligence in future filings or audits.
An additional benefit of blockchain is its basis in encryption which ensures that an entity on the network has access only to the information to which it is entitled. Even if a customer’s file is meant to be transparent, a log should be kept both as to when the change was made and by whom which can be referenced by validators on that network. Transaction audits and compliance surveillance can also be automated more fully when a standardized methodology is agreed upon.
Benefits of the distributed ledger architecture included the ability to provide a secure channel to send codified regulations to multiple firms, to provide a single source of truth for a shared set of facts and a consistent environment that ensured the code ran successfully.
Blockchain technology could bring value in core parts of the digital and retail banking business models. However, retail banks have been slow to engage new firms to build open source and shared solutions, opting for more traditional, internally optimized traditional software solutions. The future of distributed ledger technology faces challenges in terms of scaling, the volatility of digital assets which currently are used to track engagements with distributed systems , and trusting the framework in which information can be shared without giving up competitive advantage.
A blockchain-based universal business language standard around transactions and digital identities may create a new method to communicate financial metadata associated with physical or digital transactions between money services businesses (MSB) and other financial institutions. Eventually, banks and other MSBs can establish a framework for optimized global data sharing systems around the world.
Another optimization based on current standards of modern financial services is the ability of distributed ledger technology to create a new universal business language around shared financial information which is the proposed solution for limiting costs associated with compliance.
Distributed ledger technology (DLT) helps to lower friction while increasing the transparency of shared data in a system that must rely on verifying identities to create trusted relationships when sharing information between traditionally trust-less industries.