April 8, 2016

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Threats to BlockChain: Part 1 Correspondent Banking Substitutes

BlockChain technology is in its infancy. There are a very broad set of investigations taking place to find the best use of BlockChain enabled processes and applications. Both the technology and their use cases have significant hurdles to overcome before they become accepted within business and consumer eyes.

However, there are a few things getting in the way of its adoption.

Over the next few posts, I examine those threats and propose ways they can be mitigated to allow the more significant benefits of BlockChain to be enabled.

Correspondent Banking Substitutes

A correspondent bank connects entities with accounts in one country with an entity with a bank account in another country. Usually this means making a payment from a bank account to another bank account.

This 'correspondent' service exists because a bank may not have a license to operate in another country (such as the recipient's) and so relies on a partner to transfer money into an account on their behalf.

Currently this is achieved by a banking infrastructure called Correspondent Banking. This is where an entity instructs its local bank to pay to a bank account in a foreign market. The local bank then instructs a bank with accounts in both countries (the Correspondent Bank) to pay the local bank in the other country.

The local bank and the correspondent bank make money by charging fees roughly grouped into 2 areas: lifting (processing) fees and foreign exchange fees. For example, a local bank in the UK would charge its customer both of these – a processing fee of around 4% and an FX rate of 40 basis points above mid-market.

This established revenue source has been challenged by the rise of consumer-access correspondent organizations. Companies such as TransferWise offer 0.5% and ‘real’ exchange rates by owning accounts in both foreign and domestic markets. This has bypassed bank's services and third party solutions (such as Visa and SWIFT) and so they have become real challengers in the market.

Why does this affect BlockChain?

One of the large use cases for the BlockChain is cross-border payment – the transfer of money from one country to another country between buyer and seller.

BlockChain offers to do this for free as money isn’t stored in one place but exists ‘virtually’ on every computer participating in the BlockChain, regardless of country. It just has to be claimed by the authenticated owner.

This sounds ideal as a consumer solution but there are challenges in convincing consumers to buy into it - given there are competitive facilities and substitutes that already do it at a low cost. This raises the question why consumers would bother with the BlockChain technology when they can already do it using companies such as Transferwise.

For example, although the TransferWise solution can take a few days and charges ‘real’ exchange rates, the consumer is typically already receiving much better service than using a bank. If the consumer is happy with this, then there is not much point in using another solution such as one powered by BlockChain.

How do we solve it?

This problem can only be overcome if the BlockChain technology makes significant improvements over the services offered by the correspondent banking substitutes.

First, if there were no fees associated with using the BlockChain (unlike TransferWise) then the consumer would gravitate towards the companies powered by the technology. Income would need to be found elsewhere, such as through asset investment in money markets or other short term holdings while the transfer took place.

Second, if the consumer understood that the delay in the transfer was actually unnecessary and just a way for the correspondent company to buy the foreign currency at below mid-market rates and then charge the customer the spread from mid-market rates then the unfairness would become apparent.

Third, using a company such as TransferWise is inherently risky; they could go bust. They are not regulated in the same way as banks are and hence utilizing them has significant risk over a bank. BlockChain offers no risk as no single company owns the sender's money.

Summary

There are already major improvements being made by start-ups in the global payments space which is driving a significantly better experience than a consumer's current service. To make the BlockChain successful we've really got to step up our game to show consumers the real improvements the BlockChain technology has to offer.