Digital Currency and Blockchain: How are Financial Institutions Responding?


A survey of the early stages of a financial revolution

Beyond the hype around Bitcoin, there is a quieter revolution taking place as various governments and industries explore the potential uses of digital currencies and their underlying blockchain technologies. Governments as diverse as Russia, Japan, China and Dubai are developing state cryptocurrencies to supplement (and maybe even eventually replace?) their more tangible fiat currencies. Meanwhile, a whole range of industries from banking and finance to insurance and big tech are looking to streamline systems, lower costs, and explore new revenue streams by leveraging tokenized systems and public and private blockchain platforms.

As with any emerging and disruptive technologies, there are those industries and companies which sense new opportunities and want to get ahead of the game through early exploration and adoption, while others wait to see how things will shake out.

In the bitcoin and blockchain worlds the hyperbole of innovators and haters gets most of the press, but we don’t often hear about how specific industries and companies directly threatened by the bit-block revolution are responding.

Let’s take a peek.

Perhaps the industry most obviously threatened by blockchain is banking and financial services. Digital currencies and blockchain platforms are by nature in the business of putting financial overlords out of business. If individuals and institutions can transact directly at a significantly lower cost due to the removal of exchange middlemen, then there is less of a need for traditional banks and other controllers of the money game. Says Lewis Farrell, head of the Silicon Valley Insurance Accelerator, regardless of the industry, “anyone in the middle should be scared.” For example, transaction intermediaries (e.g., card networks like Mastercard) — five or more of which are currently required to complete the end-to-end processing of, say, your coffee purchase at Starbucks — are potentially put at risk.

The responses by financial institutions are varied. Some, like Morgan Stanley and BNY Mellon, are co-opting the technology through the development of blockchain systems to maintain secure backup records and to more efficiently process transactions. Customized digital currency creation by financial institutions are also in the works, such as Switzerland-based UBS bank’s experiment with a “utility settlement coin,” for clearing and settling transactions over blockchain. According to a report from banking giant Santander, these types of blockchain investments could eventually save banks $20 billion a year.

A number of financial institutions are sharing the exploratory heavy lifting by funding or joining partnerships to chase and deploy opportunities for individual and joint cost savings, such as with lower inter-bank settlement fees. Over 40 industry consortiums, mostly in the financial arena, are actively exploring blockchain use cases, developing rules and standards, and creating platforms for a range of financial activities including cross-border payments, asset management, and trading. One such collaborative, the Global Payments Steering Group (GPSG), brings together a diverse group of financial players such as Bank of America, Merrill Lynch, the Canadian Imperial Bank of Commerce, Mitsubishi Financial Group, the Royal Bank of Canada, Santander, Standard Chartered, and others. The group is collaborating on an effort for financial institutions to try real-time blockchain settlements across borders, which could directly challenge SWIFT, the current global system for processing international settlements between banks.

Many of these consortiums serve as a kind of financial international space station. All participants know that there are advantages to joint exploration and shared costs, but there is also competition at play in a still unexplored environment.

On the institutional investment front, hedge fund managers everywhere are racing to get into the digital currency game (At last count over 100 hedge funds were active in the space). Specialized crypto hedge funds now allow investors to put their money into a pool of existing and new cryptocurrencies. Hedge funds are likely to continue their lead in digital currency investments, because of their “light regulatory touch, speed to market, and the chance for fund managers to make outsized profits.”

Digital currency futures trading is just now launching through exchanges like the Chicago Board Options Exchange (CBOE), enabling investors to bet against price fluctuations in digital currencies, and it may not be long before crypto-specific Exchange Traded Funds join the party — assuming regulatory frameworks go their way.

Other lesser-known areas within the financial world could also be significantly affected, such as stock loans (where borrowers can take out loans against the stock they own), a $954 billion market. Blockchain innovations like Overstock’s tZero, a new, streamlined tool to allow companies to directly issue and borrow securities, could directly challenge leading agent lenders like State Street Bank.

In the highly lucrative business of money transfers, global leader Western Union does not appear to be overly concerned about blockchain-based cryptocurrency money movement competitors. Upstarts in the crypto money transfer space like Abra advertise lower money transfer fees using bitcoin, but Western Union counters that the ease of use and ubiquity of their existing systems, and lack of customer demand for crypto-based systems, do not offer enough of an incentive to change course (yet). Says Khalid Fellahi, SVP and General Manager at Western Union Digital, “We are always looking for blind spots…but we do not feel threatened.” Still, they are exploring opportunities to utilize the technologies and have already conducted an experiment with Ripple, a blockchain payment protocol provider, and invested in the recently formed Digital Currency Group.

While most financial institutions have expressed an interest in further experimentation with blockchain, some have attacked bitcoin specifically. Much was made of JP Morgan Chase’s CEO Jamie Dimon’s September 2017 assault on Bitcoin, who called the currency a fraud. Ironically JP Morgan Chase is said to have filed a patent for what some have called a “Bitcoin killer,” called webcash, back in 2013. Apparently the patent was eventually rejected. In another twist, JP Morgan was found to be purchasing exchange-traded-notes that track the price of Bitcoin and has now made statements validating Bitcoin as an emerging asset class. According to the company’s CFO, Marianne Lake “We are very open-minded to the potential use cases in future for digital currencies that are properly controlled and regulated. We’ll have to see, it’s quite nascent.”

Larry Fink, CEO of BlackRock, the world’s largest asset manager, has called Bitcoin an “index of money laundering,” and in a November 2017 interview with Bloomberg, Citigroup CEO Michael Corbat predicted that Bitcoin’s threat to the financial system will cause governments to fight back. Citi’s chief global economist went one step further in dismissing Bitcoin and other cryptocurrencies, claiming they will meet the same fate in other countries as they did in China, where cryptocurrency exchanges were recently banned. Paradoxically, Citi is in the process of developing its own digital currency, called Citicash. The currency is intended to reduce or eliminate issues in cross-border foreign exchange transactions.

Although major financial firms like JP Morgan Chase, Blackrock, and Citigroup resort to scare tactics or pursue what some might call two-faced strategies, others are seemingly looking to slow things down. As reported in Barron’s, a banking executive interviewed for a Bain report on blockchain told an interviewer that, in one banking consortium, “half of the people in the group are looking for a solution; the other half are there uniquely to obstruct progress.”

According to Austin Trombley, CTO of Vaultbank, developer of a debit MasterCard for cryptocurrency transactions, “Some companies like Visa are trying to stifle any crypto transaction services to stave off the existential threat to their business.” At the same time Visa has approved a small number of card programs that enable consumers to convert cryptocurrency to fiat currency, linked to a Visa debit or prepaid card. According to a Visa spokesperson, “cryptocurrency is an innovative technology, but the regulatory landscape around the world is not yet fully developed.”

No doubt some legacy institutions are hesitant to try the new technologies at a time when existing systems still work and are profitable. They understandably want to see how other large companies and startups fare before making major investments of their own. But the writing is on the wall, especially since startups in the fintech world are nipping at their heels and driving the development of new, innovative solutions. Bain surveyed executives at financial firms and found that about 80% expected the blockchain technology to be transformative and see their firms using it in some form by 2020.

The bottom line on blockchain in the financial sector is perhaps best summarized by Don and Alex Tapscott, the authors of Blockchain Revolution: How the Technology Behind Bitcoin is Changing Money, Business and the World. “Blockchain is not an existential threat to those who embrace the new technology paradigm and disrupt from within. The question is, who in the financial services industry will lead the revolution?”

Another sector facing a real threat from cryptocurrencies and the new funding model they have spawned is venture capital. Says Jamie Burke of Outlier Ventures, “ I can honestly say my industry is being disrupted beyond belief right now.” Initial Coin Offerings (ICOs), the token-based funding mechanism for most blockchain startups, have raised more money than venture capital in Q1 of this year — a trend which directly challenges the venture capital funding model. If issuing a token through an ICO can generate millions of dollars in only hours after a new token is offered for public purchase (a situation which is not uncommon), startups don’t need to jump through the hoops typically required to get VC funding. Furthermore, in the crypto-capital universe, blockchain startups don’t need to relinquish full ownership of their companies or worry about eventual shareholders bossing them around. Instead of demanding business plans, VCs may eventually need to develop a business plan of their own in order to stay competitive.

Then again, as corporate and finance attorney and faculty member of the Blockchain Research Institute, Joel Tepner, points out, “What happens when they (ICO funded companies) need additional capital moving forward? If they have raised enough tokens to keep them running, then there is no need for VCs, but what will happen is that more traditional funders will need to support those with real business needs.”

How are VCs reacting? Some, like Burke, are jumping in with both feet. “The funny thing is, I like it,” he said in Wired. Other VC firms are investing in outside hedge funds as a way to test the waters. Polychain Capital, a firm that invests in cryptocurrencies and ICOs through a $250m hedge fund, has raised money from top venture capital firms like Andreessen Horowitz, Union Square, Sequoia Capital, Founders Fund, and Bessemer Venture Partners. The venture capital firm Union Square Ventures (USV) apparently changed its investment strategy so that it could buy ICOs directly.

Not surprisingly, there is also pushback. Venture capitalist Chamath Palihapitiya has said he thinks that “99 percent of I.C.O.s are a scam.” According to the New York Times, this is a feeling that other leading venture capitalists share. Mark Suster of Upfront Ventures has stated that, “People are raising obscene amounts of money for companies that are not yet at the stage where they are good stewards of that much money or would know how to deploy it.”

To be fair, many venture firms have prohibitions in their fund documents that don’t allow them to invest directly in tokens or bitcoin, the corporate structures of crypto-funded companies is unclear, and the crypto world is largely unregulated. But for an industry that prides itself in supporting disruption, the current lack of involvement suggests that there is real concern, or at least an unusual uncertainty, on Sand Hill Road.

For the many industries which are potentially threatened by the rise of cryptocurrency and blockchain it is still early days. It’s hard to know how to react to potential threats when the technology and business opportunities are not fully understood. As the fog clears, it will be interesting to see how industries across the board continue to respond to real and perceived challenges. Will traditional sectors and companies keep their heads in the sand, or will they cry foul to regulators and the public and attempt to put up roadblocks? Will larger companies swallow up startups in the crypto-blockchain space, or will they figure out ways to utilize the the technologies to their advantage and to develop new and competitive platforms and services? As the revolution marches on, the answer is likely “all of the above.”

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