Bitcoin, Blockchain, Distributed Ledgers… What Wisconsin Bankers Need to Know.

Against the backdrop of Bitcoin's volatile market value and deteriorating reputation, the financial services industry has begun taking its first steps into the world of cryptocurrency and the technology that built it: blockchain. But, what do Wisconsin bankers need to know? How will this technology impact the day-to-day business of banking in the Dairy State? The answers may surprise you. 

Blockchain 101

So, what is blockchain? According to the Harvard Business Review, it's "an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way." Bert Ely, a banking consultant based in Alexandria, Va., prefers to use the term "distributed ledger technology" (or "DLT"). "Essentially, DLT is a highly secure, tamperproof database in which transactions, financial or otherwise, can be entered sequentially so that a "claim of title" is created for each discrete item, or token, that is being accounted for within that database," Ely explained. "One of the problems with the DLT concept is that it's made to be more complex and mysterious than it really is."

Girish Ramachandra, senior manager leading fintech and blockchain initiatives at Wipfli, says DLT can also allude to technology which doesn't use the ideas behind blockchain. The world was introduced to "blockchain" as a specific term with the arrival of Bitcoin, the first cryptocurrency to receive significant public attention. "Cryptocurrencies are the case studies that can be used to explain blockchain," Ramachandra explained, and cryptocurrencies have been discussed since 2002 with the invention of PayPal . What made cryptocurrency popular was the release of a whitepaper introducing Bitcoin—published shortly after the collapse of Lehman Brothers in 2008; the timing was ripe for people to be interested in secure electronic currency that existed outside of the traditional banking system. "Cryptocurrency was specifically designed to keep banks out," acknowledged Jeffrey Kurek, IT systems officer at Park Bank, Madison and a member of the 2017-2018 WBA Technology and Operations Committee. 

Today, Bitcoin receives almost as much negative press as banks did in 2008, but that's largely because some investors treat it as though it has inherent value. "When Bitcoin was created, it was designed as a means of value transfer," explained Doug Buan, director of risk management at Wind River Financial. "Now, it's being treated as a commodity in various investment circles, which isn't what it was intended for." In fact, Buan explains, cryptocurrencies like Bitcoin could be value-transfer solutions for countries suffering from terrible inflation and remove barriers for unbanked consumers.

For the financial industry, blockchain technology can be described as an electronic, highly efficient approach to a proxy or arbiter. "From a business standpoint, because each middle entity to a transaction generally takes their cut, the more entities involved the more expensive it is to process the transaction," Buan explained. "The Blockchain Protocol can replace the middle entity or entities with automation and, thereby, lower the cost of the transaction while mathematically helping to ensure legitimacy."

How the technology works is where the math (and some of the mystery) comes in. Each of the individuals participating in the blockchain network are running computers and solving complex, difficult math problems. When one computer solves the current problem, it time-stamps the discovered solution and sends it to the other computers in the network to verify. When a certain number of computers agree, a new blockchain is created. This occurs about once every 10 minutes. "Every blockchain contains every transaction that has ever been done in that chain," Buan explained. "It's the investment in electricity and computing power that secures the transaction. Theoretically, one entity would need to control more computing power than all the rest in order to fake the next block, which makes it essentially impossible."

The good news is: bankers don't need to understand how blockchain works in order to prepare for its impact on the financial services industry. "It's a strategy discussion, not necessarily a technology discussion," said Kurek. "Is it part of your strategy to do international transfers? Do you want to be a digital wallet? Those are things to consider."

Possible Banking Applications

"There are multiple ways the technology of blockchain will impact the financial services industry," said Ramachandra. "For me, it's a question of 'when?' not 'if?'." Two of the most likely financial services applications for blockchain technology are international payments and smart contracts. "To me, the first logical application will be reducing the cost of moving funds around the globe," said Buan. "Blockchain is a de-centralized public ledger, so it's hard to beat the efficiency and security of it." It will also move current technology ahead by leaps and bounds. "The technology that's used for settlements today—such as capital markets and international transfers—only allows the transfer of value to take place over time," Ramachandra explained. "If you were to send money from the U.S. to another country, it takes at least 24 hours. That's a significant amount of time, and a lot of value is lost. Blockchain has the potential to make those transactions settle in real time." 

Blockchain technology could also be used to store smart contracts, bringing automation into what is currently a very manual process. "Smart contracts are an electronic format of physical contracts which can be enforced in a programmatic way," Ramachandra explained. "Most are written so that if certain conditions are met, a certain transaction must take place." Somewhere between 10%-20% of these contracts are very complicated in nature, such as syndicated loans. Since blockchain is immutable and secure, syndicated loans could be executed through smart contracts stored on blockchain. "That has huge potential for impact," said Ramachandra. 

While smart contracts and international transfers are likely to be two early applications of blockchain technology in banking, the long-term possibilities are more wide-ranging. "Although the first financially based application for the Blockchain Protocol was Bitcoin, the same benefits can apply to many applications," said Buan. Loan applications, mortgage loan servicing, and even trust banking could see the development of blockchain technology applications. Self-executing legal contracts, life insurance or other policy-automated payments, trading platforms, document management, customer authentication, and even voting are all possibilities. Eventually, the changes this technology allows for will transform the banking industry. "My sense is the implementation of DLT over time will lead to downstream changes in banking and financial systems to accommodate new flexibilities given to the bank customer," said Ely.

Already "In the Works"

The financial services industry is just beginning to leverage blockchain technology, but the initial experiments are encouraging. In the value transfer arena, cryptocurrency Ripple is starting to gain traction. Unlike Bitcoin, Ripple is designed as a payment settling, currency exchange, and remittance system rather than a digital currency. "In some ways, Ripple uses blockchain principles in that it relies on a decentralized network consensus to validate settlement," Buan explained. In November 2017, American Express partnered with Ripple to speed up its cross-border payments between the U.S. and the U.K., and Ripple (the fintech firm has the same name as its product) wants to expand even further. "They're offering to replace SWIFT, and they have a compelling ability to make wire transfers settle in real time, built on blockchain," said Ramachandra. "There are several large banks testing that right now." However, using Ripple to facilitate international transfers on a global scale could be difficult to implement, he admits, because multiple institutions need to agree on it and the infrastructure must cross international borders. 

In the mortgage lending field, Cook County, Ill. is experimenting with storing property titles on blockchain. In September 2016, the Cook County Recorder of Deeds (CCRD) announced it would participate in a pilot program to study how blockchain technology could be implemented into current law and practice in the state's land records. Through its partnership with California-based velox.RE, a startup focused on blockchain applications in real estate, CCRD became the first government agency in the U.S. with a pilot program to use blockchain in an official capacity. 

What's Next?

So, what should Wisconsin's bankers be doing about all this? First, learning. Buan, Ely, Kurek, and Ramachandra all agreed that learning about this technology is the most important action step for Wisconsin's bankers. "Education is extremely important," Kurek emphasized. "The only reason Bitcoin works is because people want it. We need to listen to that market and figure out how we can be helpful to those consumers." Buan noted that learning about DLT/blockchain is the only way for bank executives to reach the comfort level required in order to invest in eventual product applications as they reach the market. "The key thing is to be open-minded about it," said Ely. However, if the bank wants to explore beyond education, Ramachandra advises caution, particularly related to cryptocurrency. "A lot of activity regarding cryptocurrency is out of bounds due to regulatory concerns, so before getting involved, make sure you communicate with your regulator to be sure you're allowed," he said.

Second, make sure your core provider and technology partners know you're interested. "For community banks, the primary way they'll access this technology is through their core provider," Ely explained. Like most computer applications, the majority of Wisconsin's banks will find it less expensive and more effective to license the software rather than develop it internally. "The disruption is coming at us. Talk to local fintech companies and try to understand the innovations that are happening locally," Ramachandra advised. "There are many fintech companies in Wisconsin who can help small and mid-sized banks get to the next level." In fact, Marquette University has a blockchain lab that hosts regular educational and networking events. Established in 2017, the lab facilitates education, research and innovation, and collaboration in the interest of advancing knowledge and implementation of distributed ledger solutions. It is an interdisciplinary initiative that unites students, faculty, and community partners from across disciplines and industries to create workable blockchain solutions for a wide array of problems.

Finally, don't panic. While distributed ledger/blockchain technology will have a significant impact on the banking industry, it will happen slowly. "DLT is just the next generation of computerized banking activities," said Ely. "It's part of the ongoing progression that started with handwritten ledgers and passbooks. Like previous technological innovations, it won't happen overnight." Blockchain is simply the next step in the evolution of banking technology.

Wipfli LLP is a WBA Silver Associate Member.
Wind River Financial is a WBA Associate Member.