Blockchain technology in lending

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WATCH RELATED VIDEO: How blockchain technologies and open banking data enable easy access to finance for SMEs

Expert Q&A on Blockchain Technology in Banking and Financial Services | Practical Law

While blockchain technology is commonly considered potentially disruptive in various regards, there is a lack of understanding where and how blockchain technology is effectively applicable and where it has remarkable practical effects [ 1 ].

Against this background, we present and discuss a case study at length on the impact of this technology in the concrete setting of small short-term loans in retail banking.

We propose to banks a robust and scalable blockchain technology with proof of stake and limited energy consumption used to streamline their processes, resulting in lower transaction and administration costs. This is made possible by smart contracts. Thereby, we facilitate small scale lending at high frequencies and short-term duration as well as an easier and more efficient way to connect small borrowers and lenders.

In , the Satoshi Nakamoto alias introduced the Bitcoin digital currency to the world with the intent of enabling electronic cash payments directly between individuals without the need for third-party intermediaries. Since then, blockchain, the technology behind Bitcoin, has captured a substantial amount of interest from researchers and practitioners. While research on some forms has rapidly developed, particularly in connection with cryptocurrencies, many experts have realized that blockchain technology holds disruptive potential beyond its use in cryptocurrencies [ 2 , 3 , 4 ].

Yet, a profound understanding regarding terms of application and use-cases is generally missing [ 1 ]. In other words, to dismiss the concern that blockchain is an innovative technology in search of use cases [ 5 ] or that few blockchain centric projects have gone beyond their white paper or proofs-of-concept [ 6 ] , more knowledge has to be gained regarding which combinations of features are relevant for particular industries or business processes and how they need to be designed.

These types of questions need to be addressed in order to influentially deploy the technology to business cases [ 1 ]. Following [1], we argue that research can help overcome this paucity by comprehensively understanding the relevance and effects of unique blockchain properties e. The use case we sketch in the subsequent case study is about lending practices at high frequencies but very low in volume.

Retail banks usually do not offer such loans. Friends, family and fools might feel uncomfortable or make the lender feel uncomfortable.

Credit cards are too expensive and loan sharks or private loan businesses all too often follow predatory lending practices. To address this problem, we design a blockchain- and smart contract-based solution for retail banks which can be made available in a cost-effective, safe and scalable manner, unlike the currently existing and oftentimes unlawful payday loans [ 7 , 8 , 9 ]. The contribution of this study to existing research is threefold: First, it presents a concrete use and potential business case by introducing a built-in mechanism to reduce transaction and administrative costs resulting from an obsolete lending practice at banks.

Second, it replaces a trust-based, centralized, and bureaucratic register with a tamper-free and autonomous transactional database system that comprises a secure registration and transaction process. The remainder of this paper is structured as follows. Subsequently, in Section 2 , we first elaborate on the problems that come with micro lending in retail banking, mainly high costs and information asymmetries.

Section 3 clarifies that this work follows a design science research approach to guide the implementation of a blockchain-based prototype. Section 4 briefly analyses the blockchain landscape in financial services, thereby emphasizing on the energy problem as well as the proof of work vs.

We propose and design a workable application for a blockchain-based microlending platform in Section 5. It is discussed thereafter at length, including a market description and a Business Model Canvas. Section 6 evaluates the proposal on the basis of a SWOT analysis. Section 7 concludes and derives lessons for research and practice. Microfinance has been a buzzword in the realm of economic development ever since Dr. Muhammad Yunus was awarded the Nobel Peace Prize , in homage to his efforts in improving the life of the poorest of the poor by the provision of micro-loans.

With the further expansion of microfinance institutions around the globe, the model started having multiple mutations that have brought a mix of positive and negative outcomes, raising questions about the feasibility and effectiveness of microfinance as an economic development tool [ 10 , 11 ].

In contrast to this known and established, but also controversial application of microfinance, we propose to embed it in general retail banking. Yet, in both forms, be it as a development aid tool or a product in classical retail banking, microfinance comes with some peculiarities that have hindered financial institutions from adopting it. Transaction, loan, mortgage and payment services comprise the core of the banking repertoire but often rely on outdated, legacy processes of execution.

Information verification, credit scoring, loan processing, and the distribution of funds are all services that take time [ 12 ]. Clients asking for small, short-term loans have historically been excluded due to the high fixed-costs associated with transaction fees and administrative costs. The cost of acquiring clients compared to the size of the loan is drastically higher in microfinance compared to regular commercial loans [ 13 ].

A survey performed by Lascelles and Mendelson spotted 20 risk factors that could deter the growth in the microfinance sector. Among these factors, cost control is ranked as the fourth most relevant.

This indicates that efficiency in operations is vital for retail banks and microfinance institutes [ 14 ]. Hence, the absence of microlending in retail banking as well as the high interest rates for micro-loans in the developing world. Therefore, an efficient and safe way to manage these transactions could significantly aid both the lenders, with higher benefits by eliminating or transforming the nature of the middle men, and the loan holders, by having access to small, short-term loans with less interests to pay and mechanisms that can prevent over-leveraging [ 13 ].

An important cost driver in the setting of microfinance are information asymmetries, and thus their reduction would bear a positive impact in costs reduction [ 16 ]. Generally, information asymmetry means that one party lacks crucial information about another party, impacting decision-making. We usually discuss this problem along two fronts: Adverse selection and moral hazard.

Adverse selection describes a situation in which interacting parties attach value to the quality of a transacted object but at the same time possess different levels of information about it [ 18 ]. The varied ownership structure and diversity of stakeholders in microfinance render the information asymmetry the main source of risk for microfinance institutes [ 19 ]. Arguably, the economic and regulatory environments in developing countries are more likely to give rise to deeper asymmetries with negative pervasive effects [ 16 ].

In this regard of information asymmetries, the deployment of blockchain can bring relief too. There is emerging recognition of design research in Information Systems as a natural evolution of our field as it matures [ 20 ]. Like others before [ 21 ] , this work follows design science research to guide the implementation of a block chain-based business concept. In terms of design science, microlending in retail banking is a typical "wicked problem" since 1 it may only be possible to find a solution to the problems of high costs and information asymmetries in micro-lending that is "good enough", rather than solving them completely; 2 the solution to the problem will be good-or-bad rather than true-or-false; 3 testing the solution is complicated and depends on several contributing actors; 4 the possibility to learn by trial-and-error is limited as every attempt at testing the solution is complicated and resource-intensive; and 5 the problem does not have an exhaustively describable set of potential solutions or a set of well-described permissible operations.

We therefore chose the ad hoc development approach by first learning more about the twofold problem in the previous section and then designing a draft in Section 5 , which we concurrently and conclusively evaluated Section 6. In our case, the research entry point was context initiated by my Master course on blockchain at the University of Zurich in the spring term of During the course of that class, we reviewed literature from various sources such as academic papers, industry leader reports, and other publications see Section 8 to construct a landscape of current digitalization trends in the financial industry in general and specifically with regard to blockchain technology applications.

We researched the most pressing technical issues that need to be addressed to make sure our solutions could be applied in practice. We interviewed blockchain experts at Trust Square in Zurich and banks directly to validate our approach. When formulating ideas, we focused on solutions that would leverage the existing financial institutions and structures, enhanced by blockchain technology, to provide more value to the clients on the lower-end of the income spectrum in the developed world in the short-term and underbanked in the developing world in the long-run.

Next, different ideas were researched and tested in student groups who prepared a preliminary business plan for each one, finally narrowing down the number of solutions to just the one we pursue in this paper.

We then conducted a market analysis and attempted to position our lending solution for maximum market penetration, the results of which are presented in the following. Our discussion centers around blockchain technology in retail banking. It is independent though of cryptocurrencies and their value as a portfolio asset which is currently also a prominent topic in the financial services industry see [ 23 ] for an overview.

There are many ways in which blockchain can improve upon the current financial system, with the most important being security, transparency, trust, and cost reductions [ 25 ]. Firstly, blockchain offers the possibility of making the system more secure through its consensus-based architecture, which eliminates single points of failure and reduces the need for intermediaries.

Secondly, it can decrease information asymmetries, increase transparency and reliability in the system, acting as a single, immutable shared data source for all participants. Thirdly, it has the potential to significantly reduce costs by allowing financial institutions to eliminate a large number of intermediaries. As a result, many people who were previously barred from participating in financial services due to the high barrier of entry fees, can now participate and reap the benefits.

In particular, with regard to our use case, blockchain technology can be employed to streamline loan processes by enabling, for example, real-time verification of documents, streamlined credit prediction and automated disbursement of funds through smart contracts [ 25 ].

In its generic form, blockchain technology refers to a fully distributed system for cryptographically capturing and storing a consistent, immutable, linear event log of transactions between networked actors [ 1 ]. It creates a decentralized record of transactions, known as the distributed ledger, that allows the current proprietary databases to be substituted by a single, immutable master database.

Essentially, it means that any party can trust the data stored on a blockchain. As current blockchain technology can not only process monetary transactions but can also ensure that transactions comply with programmable rules in the form of "smart contracts" [ 26 ] , it allows even parties who do not fully trust each other like in our context of microlending to conduct and reliably control mutual transactions without relying on the services of any trusted middlemen.

A smart contract is a computer protocol which can verify and execute the provisions of a contract without the need for trusted third-party intermediaries. The terms of the agreement are written directly into the code and once the requirements are fulfilled, the contract is executed.

All transactions performed by means of a smart contract are trackable and irreversible. They are the key ingredient for the performance speed and trustlessness of blockchain lending applications as we envision it. All of these applications, however, require the blockchain technology behind them to be robust, energy efficient, and capable of processing thousands of transactions per day. In theory, blockchain solutions ought to rival and overtake the processing capabilities of credit cards.

Visa, for example, processes around 1, transactions per second, but claims to have the capacity to process more than 65, per second as of March, 31st [ 27 ]. Blockchains currently fall short of that by a significant margin. In the next section, we look at the energy issue of blockchain technology that is responsible for this shortfall and how it can be addressed. Blockchain technology still faces a plethora of issues that hinder its large-scale adoption in the financial services industry.

Arguably, one of the larger hurdles right now is scalability due to the prohibitive amounts of energy needed to add new blocks of information to the blockchain see Figure 2. At this point in time, blockchain technology is not available to most retail clients. Exactly how much is not a simple question to answer.

Key data about blockchains is hard to come by. Their activities can, however, be proxied by the necessary coin needed to run them. The largest blockchain is the one running on bitcoin [1] and bitcoin mining the process of writing transactions on the blockchain is energy expensive. Approximations place the energy consumption of Bitcoin at around 75 TWh annually [ 30 ]. As can be seen in Figure 2 , electricity consumption of Bitcoin has overtaken most of Africa and only 38 countries remain that definitely consume more in electricity [ 31 ].

This is due to the fact that the electricity needed to run the bitcoin blockchain has become a significant cost factor in the implementation of blockchain solutions in the financial industry, slowing down the spread of large-scale blockchain solutions. And most importantly, the proof of work PoW mechanism [ 28 ]. Points 1 and 2 are supply and demand interactions that are unlikely to change.

The proof of work mechanism in point 3, however, is the real energy [2] culprit [ 32 , 33 ]. Simply put, PoW is the game-theoretical mechanism by which blockchains guarantee the security and workability of the "chain". To work, it requires miners. Miners are machines competing to contribute to the blockchain by solving complex prime number factorisation puzzles. These puzzles require a brute force, energy intensive approach, but the real issue is in the duplication of work [ 28 , 29 , 30 , 31 , 32 , 33 ].

As the mining process is a winner takes all scenario, thousands compete for the same reward every minute of every day. By this duplication, the energy consumed to confirm a simple transaction on blockchains can be hundred to ten-thousand times higher than needed.

How loan providers will be using blockchain

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blockchain technology in lending

In the aftermath of a drought in North Horr, Kenya, people who are unbanked and without credit like Arbay, above, have been forced to sell their livestock to buy food. Credit cards. Bank accounts. These are simple tools that many of us take for granted.

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By Anna Irrera. NEW YORK Reuters - Lending startup Figure Technologies is hoping an animated character named Blockchain will give it a competitive edge against big banks that dominate the businesses it wants to disrupt. In a video ad campaign set to launch on Tuesday, Blockchain the character explains blockchain the technology. The company did not disclose how much it is spending on the ads, which will be broadcast online and on television. He interacts with a bearded guy eating instant noodles so he can pay off student debt and a couple applying for a home loan at a bank branch. Cagney left SoFi after employees said the work environment was hostile to women and enabled senior executives to harass female employees.

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Log In. Follow Us In Real Time twitter facebook linkedin. Opinion How to close the servicing-to-originations loop for consumers. A continuous servicing-to-originations loop keeps and grows customer relationships while increasing MSR values and lowering origination cost. But as with all things mortgage, executing on this is harder than it looks, writes Sagent's CEO and President. November Dan Sogorka. New York Community boss makes another bold move with Figure deal.

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Blockchain is transforming everything from payments transactions to how money is raised in the private market. Will the traditional banking industry embrace this technology or be replaced by it? Blockchain technology has received a lot of attention over the last decade, propelling beyond the praise of niche Bitcoin fanatics and into the mainstream conversation of banking experts and investors. Someone is going to get killed.

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With an initial purpose of a mechanism behind cryptocurrencies, today the blockchain technology has stepped far beyond just powering the bitcoin or ether transactions. Blockchain is a powerful and secure technology that is getting into almost every industry, from banking and medicine to the government sector. According to Forbes , blockchain brings the following benefits:. The most popular domain of blockchain use is the banking sector because security is of utmost importance for the financial domain.

The concept of blockchain is still very alien to many, but this innovative technology has the potential to replace and disrupt our traditional bank systems and borrowing and lending money as we know it.

Using extended complexity theory to test SMEs’ adoption of Blockchain-based loan system

Nowak of Pepper Hamilton, LLP on blockchain technology and its implications for the banking and financial services industries. Related Content. What is a Blockchain? A blockchain is a type of database. At a basic level, it is as simple as that.

Decentralized finance

It exposes real-time credit agreements, accrual balances, position information and detailed transaction data to lenders directly from agent bank loan servicing platforms such as Fusion Loan IQ. It empowers lenders with a self-service platform designed to remove administratively heavy queries that burden agent banks — helping drive down operating costs — and provides secure, real-time data and a golden source of truth between agent banks and lenders. FinTech Breakthrough is an independent organization with an awards platform covering a range of categories across lending, payments, personal finance, wealth management and more.

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