Systems powered by blockchain technology are no longer seen as shiny solutions looking for a problem. Their potential is recognized more widely as the next step in answering today’s demand for instant gratification while not compromising on security. In the banking & financial services industry, blockchain technology is becoming increasingly relevant in the payments space, specifically to manage transactions.
Let’s start with the relatively simple area of credit card transactions. The credit card industry is dominated by a handful of credit card providers that process billions of transactions monthly. Visa alone handles 150 million transactions daily. Regardless of whether a credit card is used physically at a point-of-sale (POS) terminal or as a card-not-present (CNP) transaction (online, mobile wallet), the basic steps to complete the transaction are the same:
Merchants pay up to 3.5% in the transaction fees listed above. In addition, they’re subject to flat fees for POS terminal usage, network fees, etc., as well as incidental fees like chargebacks in case of fraud or disputes. Chargebacks are a niche industry in themselves, with many small players acting as intermediaries to resolve disputes between credit card companies and merchants for fraudulent charges.
Disputes may arise even months after the transaction date and may require legal arbitration. The latest Nilson report estimates that in 2017, worldwide credit card losses topped $24.26 billion. All these factors add to the overhead on merchants and pass-through cost to consumers.
So, the main pain points here are:
- Multi-step process.
- Multiple versions of the same transaction maintained by different institutions in varying formats.
- Multiple, ambiguous fees to intermediaries.
- 24-hour reconciliation time across the settlement chain.
- The need for fraud protection.
Credit Card Transactions with Blockchain
Technologies and assets derived from blockchain, such as distributed ledger technology (DLT), smart contracts and embedded cryptography, are leading the way in improving how payments are processed. Blockchain has the ability to modernize a payment’s fundamental imperative of transferring value between multiple parties, securely and with minimal operational or technical friction. In this emerging world, payments could potentially be real-time, transparent and any-to-any. (See our Perspectives series on blockchain in trade finance for more insights on DLT’s potential for optimizing the multi-party payment process.)
This is what a streamlined transaction could look like:
You now have a single record of the transaction, allowing for immediate reconciliation and settlement. The chain of transactions is immutable and cannot be reversed or manipulated in any way once it is formed, thereby addressing the need for security, fraud prevention and a transparent audit trail. Without middlemen, transaction overhead would be greatly reduced and even facilitate what is known as “micro-transactions” — small transactions conducted with near-zero charges and instant verification. Chargebacks would also become obsolete.
Real-life examples are available from payments industry leaders like MasterCard and Visa. The Mastercard blockchain service, which is in use on a limited basis by MasterCard partners, can be used to clear credit card transactions and eliminate administration tasks using smart contract rules. This speeds transaction settlement and enables access by the 22,000 financial institutions in the organization’s payment network.
Moving Up in Complexity, to Cross-Border Payments
Now let’s look at the slightly more complex world of cross-border payments. Imagine a sender would like to transfer money to a recipient in another country. The basic steps are:
- Sender initiates transaction at his local bank (Bank A).
- Bank A may use a correspondent bank (Bank B) in case it doesn’t have a relationship with the recipient’s bank (Bank C) or a presence in the recipient’s country.
- Bank B holds the funds (typically in USD) in a nostro account while doing due diligence.
- Bank B then transfers the funds (in USD) to a USD account at Bank C.
- Bank C converts this to the local currency and passes it to the recipient.
Information about the transaction is shared between the banks through SWIFT messages. Bank B and Bank C have to manage liquidity levels and settle with their central bank. These transactions are slow, manual and error-prone. Additionally, each of these banks manages its own ledgers, so there are multiple versions of the transaction available in multiple formats. And as always, the overhead of fraud prevention looms.
Blockchain technologies could streamline this process with the use of smart contracts that not only transfer monetary value but also contain rules that govern the sender, recipient and other factors of the transaction.
This process would provide a single ledger, with a single immutable copy of the transaction (all aiding in transparent audit trails and fraud prevention), as well as remove:
- Messaging, reconciliation and information sharing across the players, thereby eliminating errors from unclear instructions or human comprehension.
- Delays while waiting for consensus across the players.
- Issues with regulatory compliance across banks and borders.
For large transaction to be near real-time, nostro accounts need to be pre-funded, and a fast process would ideally rebalance and settle through central banks. By adding digitized tokens, even this goal could be met. These tokens would not only include a monetary value (cryptocurrencies) but also encourage token-based secondary markets for liquidity exchange. By making these tokens universal, institutions could move tokens across geographies on a need basis to facilitate near-real-time international transfers.
The Future Emerges
Project Ubin in Singapore and Project Khokha in South Africa recently implemented real-time gross settlement (RTGS) accounts on smart contracts, proving this process’s feasibility. Using BitPesa’s website, users in Kenya, Uganda, Tanzania, Nigeria and the Democratic Republic of Congo can send money directly to bank accounts in China.
The new blockchain-based cross-border payments system provides a future path for near-real-time, secure, transparent payments in a frictionless environment. Like any emerging technology, there will be a range of opinions on its viability. But it also engenders the hope of a world with real-time settlement and neutral decision making – transparent, automated utopia.
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