www.ifc.org/ThoughtLeadership Note 38 | May 2017 Can Blockchain Technology Address De-Risking in Emerging Markets? Blockchain, or distributed ledger technology, has the potential to address many problems in emerging markets. In this note we consider whether blockchain can be used to mitigate the problem of de-risking by financial institutions, which affects receivers of remittances, businesses that need correspondent banking relationships, and charities working in conflict countries. Blockchain is an evolving technology, and understanding its scope and limitations will be critical to employing it to address these and related issues. At its simplest, blockchain is an online database for the Shared: Traditionally, computing services run on centralized exchange of information that takes place on a digital network to networks in which a central server distributes information to form a secure, transparent, and easy-to-use platform. This computers (clients) on a network. A digital ledger is different— technology can be used to send money between countries, it is replicated and distributed across nodes—several computers verify land ownership, share electricity across grids, and reduce around the world that compete to verify transactions in a peer- the cost to banks of verifying customers and transactions. to-peer network—where information is shared by all parties engaged with the transaction. Blockchain allows data to be stored securely and accessed by multiple users without recourse to a trusted third party such as Unlike a centralized network where there is one hub or server a bank. Instead, a network of users verifies and stores the and every other node is a client, blockchain has smaller mini- information. hubs where a peer-to-peer network, consisting of equal peer nodes, functions as both client and server. Each peer on the What is blockchain or distributed ledger technology? blockchain provides computing power and stores a replicated The term ‘blockchain’ refers to the way that data are stored. version of the ledger, thereby creating consensus and sharing Transactions are recorded in time-stamped “blocks” and each the responsibility of governance. block is connected to previous blocks, forming a chain of Recorded and verified: Transactions on the blockchain are transactions. This chain is stored by all users on a network; confirmed by all participants on the network, and once they are every time a new block is verified and added, the entire chain is recorded they become secure from revision and tampering. updated simultaneously across users. Banks spend significant resources to reconcile records with counterparties. By contrast, blockchain technology updates and Currently, when buying, selling, or verifying the ownership of stores information in real time, and has the potential to vastly an asset, individuals must rely on institutions such as banks, reduce the costs of reconciliation. credit card companies, or governments. Blockchain technology provides an alternative to that method by making use of The problem of de-risking in the financial sector cryptography and computer code to generate the trust that would otherwise be provided by an institution. De-risking is a common response to regulations related to anti- money laundering or combating the financing of terror (AML/CFT).1 Although financial crimes such as money Blockchain is a shared digital ledger laundering, terrorism financing, and tax evasion are serious Let us now consider a more technical definition. A ledger is a offenses which may have negative repercussions for both book or computer file that records transactions. Blockchain wealthy and poor nations, anti-money laundering regulations technology is a shared digital ledger wherein transactions can intended to counter these types of financial crimes may be recorded and verified without recourse to a central sometimes serve to hinder capital flows, especially to authority to oversee the transaction. individuals in poorer countries. They may also reduce the transparency of financial flows. Tougher banking regulations require banks to assess the risks How can blockchain help? of doing business in countries with weak anti-money laundering Blockchain technology can help with de-risking by reducing regimes or customers who might be engaged in illicit activity. regulatory compliance costs while increasing the transparency Failure to do so could cost banks heavy penalties. However, of transactions. In particular, blockchain has the potential to regulatory guidance on how to manage these risks is often reduce compliance costs associated with “Know Your vague and contradictory. As a result, to reduce their own risks Customer” requirements. banks have become more conservative and less discretionary when evaluating customers. Lower customer verification costs and greater transparency can mitigate de-risking by financial institutions while also Available evidence suggests that some banks are denying benefiting senders and recipients of remittances, businesses services to firms, market segments, and entire countries that needing trade finance, and charities operating in conflict areas.3 appear to have higher risk and lower profit, and that could cause costly future fines or legal issues. In short, banks are engaging Financial institutions dedicate a significant amount of resources in de-risking entire segments of customers rather than judging to complying with Know Your Customer requirements. They the risk levels of clients on a discretionary basis.2 must meet these requirements when taking on a new customer even if the customer’s identity and credentials have already Who loses from de-risking? been verified by another financial institution. A Thompson The poor and economically vulnerable—and organizations that Reuters survey found that Know Your Customer costs are, on serve them—stand to lose the most from this type of de-risking. average, $60 million per year for financial institutions. 4 Some They include: institutions spend up to $500 million a year on procedures to verify customers that can take several months.  Migrants who remit money across borders to their families and therefore require a healthy money transfer sector. Blockchain has the potential to improve this situation. As Money transfer organizations that are denied services by discussed earlier, each block of information contains a record banks are often forced to use services that carry higher of valid transactions with time stamps, and carries the history transactional fees or that are based in less transparent of all transactions on the network by including a reference to jurisdictions. the previous block. And while the blockchain can replace a centralized authority or trusted third party, its multiple users can In 2013, Barclays Bank informed over 140 United also ensure that any data stored is extremely difficult to change Kingdom-based remittance companies that their accounts or tamper with. This feature, combined with biometric would be closed. Following this and similar de-banking identification or Know Your Customer utilities, can be an episodes in the United States and Australia, only larger effective, inexpensive way to verify customers and their money transfer organizations have had access to bank transactions. accounts. Reports from industry associations indicate that several smaller players in the money service sector have Blockchain is not a perfect technology; nor is it impervious to had to close, become agents of larger businesses, or even hackers. While it enables the protection of confidential disguise the true nature of their operations in order to information, the level of anonymity it allows can be obtain or keep a bank account. De-banking of money problematic, leaving it open for bad actors to conceal their service businesses can impact global remittances, a vital identities and making the tracking of individual payments source of finance for poorer countries that totals some $440 difficult. billion a year—over three times the amount of foreign aid Yet blockchain could also bolster anti-money laundering disbursed. efforts, according to the Bipartisan Policy Center. “Blockchain  Nongovernmental organizations (NGOs) delivering could give banks and regulators access to far more detailed humanitarian assistance to vulnerable individuals in post- transactional and cross-institutional data than is currently disaster or conflict situations. These organizations are available, allowing them to peer deeper into financial networks affected by de-risking because they can fall outside of a to identify bad actors. Furthermore, the distributed nature of bank’s narrowed risk appetite. blockchain technology makes it difficult for criminals to falsify transactional data to cover their tracks. All of this could take  Small to medium-sized firms in poor countries. Their place in real-time, giving law enforcement the precious time ability to apply for credit often depends on the rating of they need to identify terrorist plots before they happen. local banks vis-a-vis larger international financial However, this additional speed would need to be balanced institutions and the global financial system. Rich-country against privacy concerns that could arise depending on how banks increasingly report withdrawing correspondent such a system were implemented.” 5 banking services from banks in high-risk jurisdictions, including those in poor countries. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Given the technology’s enormous potential, regulators should BitBond, a German firm that offers peer-to-peer loans using fully explore how blockchain can improve the current anti- bitcoin blockchain, announced that it is teaming up with money laundering system. There should also be room for BitPesa to provide financing for small businesses in Kenya, experimentation. For example, the UK Financial Conduct Nigeria, Uganda, and Tanzania. New borrowers can have Authority’s Project Innovate has created a “regulatory financing from BitBond paid into a local currency mobile sandbox”6 to allow institutions to test new products and money account or bank account in as little as 20 minutes. services.7 A new report from the United Nations Economic Commission on Latin America and the Caribbean argues that, The use of blockchain for trade finance with the appropriate enabling environment, there are While many financial institutions are embracing blockchain, blockchain-based solutions that might be used to address the others remain skeptical. Some are opposed to making large problem of de-risking in Caribbean countries.8 investments in a technology that they argue may not be profitable.10 Others are making significant investments in The use of blockchain for remittances building blockchain-based networks. Hyperledger, an open Blockchain might also be used to conduct transactions between source collaborative effort created to advance cross-industry two fiat currencies. A local currency can be converted to bitcoin blockchain technologies, is an example. Hosted by The Linux and transferred between customers across countries in a manner Foundation, it includes ABN-AMRO, ANZ Bank, Deutsche that is cheaper and more secure than traditional methods of Borse Group, BNP Paribas, BNY Mellon, State Street Bank, sending and receiving remittances. Wells Fargo, and other financial institutions. Seamus Cantillon of Marino Software Insights argues that In October 2016 the Commonwealth Bank of Australia, Wells blockchain combined with biometric ID can lower Know Your Fargo, and international cotton producer Brighann Cotton Customer costs. He outlines six steps by which financial announced the first global trade transaction between two institutions can identify customers and/or transactions: 9 independent banks combining blockchain with smart contracts 1. A customer is onboarded to the blockchain and the Internet of Things. The transaction involved financing 2. A customer’s personal information, Know Your a shipment of cotton from Texas, in the United States, to Customer documents and biometric data is added to Qingdao, China, using a distributed ledger algorithm known as the blockchain with appropriate encryption the Skuchain’s Brackets system. 3. A customer’s biometric data along with a PIN would Table 1: Traditional process vs blockchain proof of concept act as a key for transactions 4. A customers’ transaction is recorded and validated by a consensus algorithm on the peer-to-peer network 5. With customer authorization, a financial institution can access a customer’s record for verification 6. Further changes to the record would be validated by the network Cantillon paints an optimistic picture, yet there are concerns about storing personal identification information on a blockchain. Nonetheless, blockchain-based businesses are emerging, including Kenya’s BitPesa, a remittance service that allows customers to send money across countries using the cryptocurrency bitcoin. Customers can send money in a fiat currency (such as Kenyan shillings) to BitPesa, which converts it to bitcoin and transfers it to designated mobile money accounts, to then be converted Source: Commonwealth Bank of Australia back into another fiat currency. BitPesa charges a 3 percent remittance fee for this service. By contrast, BitPesa’s main According to the Commonwealth Bank’s press release, this competitor M-Pesa charges fees up to 30 percent for registered trade “involved an open account transaction, mirroring a letter users and 66 percent for unregistered users. BitPesa’s website of credit, executed through a collaborative workflow on a says that it can now transfer money from Nigeria, Tanzania, and private distributed ledger between the seller (Brighann Cotton Uganda to any bank in China. US); the buyer (Brighann Cotton Marketing Australia) and their respective banks (Wells Fargo and Commonwealth Bank).”11 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. The parties involved in this transaction introduced a physical Barclays Bank provides an additional example. In 2016 it supply-chain trigger to confirm the geographic location of enlisted Wave, an Israel-based fintech, to develop a blockchain- goods in transit before a notification was sent to allow for based system for settling trades. A letter of credit was generated release of payment. This tracking feature provided all parties between Seychelles Trading Company, a food distributor, and with greater certainty compared with traditional open account Ornua, an Irish agriculture co-operative, through Wave’s and trade instruments such as letters of credit, which focus on blockchain platform, guaranteeing the shipment of dairy documents and data.12 products worth nearly $100,000 from the Seychelles to Ireland. The transaction was settled using smart contracts.13 According to the Commonwealth Bank, the use of blockchain Traditional trade finance requires an enormous amount of technology created transparency between buyer and seller, a paperwork—in bills of lading, insurance certificates, higher level of security, and the ability to track a shipment in certificates of origin, letters of credit, bills of exchange, and real time. Advancing from paper ledgers and manual processes invoices—to transport goods around the world (see Figure 1 to electronic tracking on a distributed ledger reduced errors and below for an example of a traditional transaction between transaction times from several days to a few minutes. institutions located in Tanzania and Germany). Commonwealth Bank and Wells Fargo indicate that they will The most inefficient step, according to Jeremy Wilson, vice- continue to collaborate with trade finance clients, financial chairman of corporate banking at Barclay’s Bank, is the bill of institutions, fintech companies and consortiums, and businesses lading, which he notes “can take weeks to get to the other side in the insurance and shipping industries to explore the potential of the planet.”14 A standard bill of lading (of which there are of distributed ledger technology. Table 1 above shows a over 12 common types), includes the description of goods, schematic of costs and benefits of traditional processes versus quantity, weight, freight details, port of loading and discharge, blockchain, as seen from the perspective of the two banks. final destination, shipper name, and so on. If issued incorrectly, the forwarder could lose the shipment. Figure 1: Traditional Model of Trade Finance Source: Susan Starnes, A review of IFC’s trade solutions - impactful, strategic, profitable, learning from experience, capacity to grow. IFC 2016 (internal document) A blockchain system allows individuals to undertake instant Many banks are considering the potential of blockchain and transparent global transactions, and quickly correct technology. Natixis, HSBC, KBC, Société Générale, UniCredit, documentation errors, while avoiding delays for the importer Rabobank, and Deutsche Bank have signed a memorandum of receiving the original bill of lading. understanding to develop a Digital Trade Chain, a new product based on a prototype tool that allows cross-border trade for This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. small businesses using blockchain.15 Alfa Bank and S7 Airlines networks—appears to be underway. As discussed above, some have also tested blockchain technology by recording a letter of banks are testing blockchain technology as a new way to credit on a blockchain platform and settling the transaction process transactions in trade finance and cross border using a smart contract.16 settlements. Although examples of NGOs using blockchain to transfer But other applications, such as self-executing smart contracts, money are not readily available, it is not difficult to see the may take a while—perhaps decades—to gain wide use. Iansiti potential of a platform such as BitPesa. There remains, and Lakahni caution that as the scale and impact of blockchain however, the problem of ensuring transparency when the transactions increase, adoption of the technology will require cryptocurrency is converted to fiat currency. But in the interim significant institutional change and will pose very real there is scope for business-to-business transactions in the NGO challenges to governments, regulators, and financial sector. Blockchain-based applications are currently being tested institutions. by NGOs for purposes other than financial transactions. Conclusion Can blockchain be truly transformational? Blockchain is an exciting new technology that has the potential Blockchain and distributed ledger technology have tremendous to reduce the costs of verifying customer transactions, thereby potential in various sectors. There are several examples of widening access to financial services in emerging markets. The blockchain technology being used in the electricity sector, examples discussed in this note describe significant changes in including a startup called Grid Singularity, which explores "pay the way transactions are made and recorded. It is likely that the as you go" solar power with financial transactions recorded on major players in the financial sector will continue to make a blockchain. investments in blockchain technology. We do not yet know whether blockchain will become a technology that is widely It is still too early to tell if blockchain will become a widely used. At the very least, this will take time and will involve used technology. Marco Iansiti and Karim Lakhani at Harvard significant changes to the regulatory regimes and institutions Business School argue that blockchain is a foundational that govern economic activity. technology, similar to TCP/IP technology that was introduced in 1972 and powers the Internet as we know it today. 17 They Vijaya Ramachandran, Senior Fellow, Center for Global argue that “single use” applications that are low in novelty and Development (vramachandran@cgdev.org) complexity, such as payments made with bitcoin or blockchain- Thomas Rehermann, Senior Economist, Thought Leadership, based Know Your Customer credentials, are already appearing Economics and Private Sector Development, IFC in the financial sector and will likely spread across at least some (trehermann@ifc.org) parts of the sector. Innovation that is quite novel but needs only a few users—such as private distributed ledgers or peer-to-peer 1 9 Center for Global Development Working Group Report, The Unintended Seamus Cantillon, Blockchain and Identity: Revolutionising KYC for Consequences of Anti-Money Laundering Policies for Poor Countries, Financial Institutions. Marino Software Insights, November 3, 2016. 10 Center for Global Development, Washington DC 2015. Bain & Company/ Broadridge. Blockchain in financial markets: how to 2 Ramachandran, Vijaya, Mitigating the Effects of De-Risking in Emerging gain an edge. 2017. 11 Markets to Preserve Remittance Flows, IFC, EM Compass Note 22, Commonwealth Bank of Australia. Media Release: Commonwealth Bank, November 2016. Wells Fargo and Brighann Cotton pioneer landmark blockchain trade 3 Neocapita, Blockchain use cases in international development, Medium, transaction. October 24, 2016. 12 March 14 2017. Commonwealth Bank of Australia. Media Release: Commonwealth Bank, 4 Thomson Reuters, Thomson Reuters 2016 Know Your Customer Surveys Wells Fargo and Brighann Cotton pioneer landmark blockchain trade Reveal Escalating Costs and Complexity, ThomsonReuters.com, May 9, transaction. October 24, 2016. 13 2016; Carlo R.W. de Meijer, Blockchain: accelerated activity in trade finance, https://www.thomsonreuters.com/en/press-releases/2016/may/thomson- Finextra.com, January 26, 2017. 14 reuters-2016-know-your-customer-surveys.html Richard Kastelein, Blockchain could be a new operating system for the 5 Readling, Kristofer and Justin Schardin, Why Blockchain Could Bolster planet says Jeremy Wilson, Vice Chairman of Barclays Corporate Anti-Money Laundering Efforts, Bipartisan Policy Center, June 2, 2016. Banking, Blockchain News, February 20, 2017. 6 15 Financial Conduct Authority, Regulatory sandbox, November 2015. Oscar Williams-Grut, Deutsche Bank, HSBC and five other big banks https://www.fca.org.uk/publication/research/regulatory-sandbox.pdf are collaborating on a blockchain project, UK Business Insider, January 7 Readling, Kristofer and Justin Schardin, Why Blockchain Could Bolster 16, 2017. 16 Anti-Money Laundering Efforts, Bipartisan Policy Center, June 2, 2016. Oscar Williams-Grut, Deutsche Bank, HSBC and five other big banks 8 Robert Crane Williams, Prospects for blockchain-based settlement are collaborating on a blockchain project, UK Business Insider, January frameworks as a resolution to the threat of de-risking to Caribbean 16, 2017. 17 financial systems. United Nations Economic Commission for Latin Iansiti, Marco and Karim R. Lakhani, The truth about blockchain, America and the Caribbean, April 2017. Harvard Business Review, January-February 2017. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.