Blockchain and the end of the role of Banking?
“We but mirror the world. (…) If we could change ourselves, the tendencies in the world would also change.”
Humanitarian crises require the cooperation of different national and international stakeholders. Banks have always intermediated the necessary transactions to deliver humanitarian aid by recording them in their “centralized” database. With technological innovation over the years, banking has been improving its financial processes and products, progressively adapting even now to digital transformation and fintech business models.
Notwithstanding, there is a technology that not only is digital, fast and secure, but also has a “distributed” database that records visible transactions by all of the stakeholders that participate in its network across international borders, which means the potential of provide full transparency to aid delivery operations and, for that reason, perhaps no longer having to need the banks.
Blockchain has come, and along with it, the opportunity to make the necessary changes in trust between stakeholders to deliver aid in the right place, in the right way and at the right time: the beginning of a new age of disintermediation seems to be the future of the humanitarian system.
Whit this in mind, in the following paragraphs, we will see the possible effects of blockchain against the role of the financial services industry in humanitarian crises, especially considering the regulatory challenges facing the characteristics of blockchain.
For this purpose, part II considers the relationship among humanitarian crises, financial services and blockchain; part III explains financial services for crises and their problems; part IV describes how blockchain works in delivering humanitarian aid and its implications in current regulations; and finally, part V shows the conclusion about these concerns.
II. Starting with the basis: The advent of blockchain in financial services and humanitarian crises
For hundreds of years, the financial services industry has played a key role in addressing core social needs, serving as trusted middlemen that connect surplus and deficit agents. Even when financial crises have taken place due to certain weaknesses in the financial system, generating the loss of public trust and complex discussion about the industry’s adequate infrastructure and regulation, it had never proposed to sidestep traditional banking. On the contrary, some financial institutions were deemed “too big to fail” and rescued by governments to avoid disastrous systemic consequences on the economies.
However, it was not possible until the context of the 2008 financial crisis and the Information Age to unfold a movement that, through technological innovation, would raise a new debate that does not revolve around how to improve banking and its regulations, but rather the question of whether these companies are actually necessary for providing financial services, which involves what is known today as fintech (financial technology).
As part of this phenomenon, blockchain -a type of distributed ledger created to drive the first cryptocurrency in the world– is perhaps the most revolutionary innovation. This is because, in essence, its structure challenges the paradigms of the established economic and legal systems, while proposing a change in the basis of social organization for making economic exchanges between two parties (peer-to-peer) without the need for a “trusted third party”, recording transactions in a distributed, transparent and immutable way like never before.
Sidestepping the intermediaries, blockchain promises to reduce transaction costs dramatically, which represents a huge potential to boost economic and social wellbeing. Hence, in recent years, we have witnessed a large wave of interest in the implementation of this technology and the regulatory framework it should have.
The main actors are governments, regulators, financial institutions, technology firms, entrepreneurs, venture capitalists, consultants and academics from around the world, whose focus ranges from the entire financial services industry (payments, deposits, lending, capital markets, insurance, etc.) to any other sector and activity that traditionally requires an intermediary to validate its transactions (such as supply chains, transportation, health, identity, property, democracy and sharing economy).
Nevertheless, among the many applications that blockchain could have in the pursuit of economic and social wellbeing, its use in humanitarian crises could make a real change and impact the livelihoods and resilience of millions of people globally in dire need due to conflicts, violence and natural disasters — a task that, as has been pointed out, “is too important to fail”.
However, surprising as it may seem in the 21st century, we are facing the worst humanitarian crises since the end of the Second World War with a persistent funding gap. Thus, humanitarian needs continue to grow, reaching new peaks every year, and the available resources to supply are still insufficient and unable to effectively promote the resilience or development of people in need.
Although the resilience economy requires several fronts, the cooperation of the financial industry services has been — and still is — fundamental before, during and after crises. Following their nature, financial institutions provide financial services to channel donor funds to people in need, minimize risk exposure and stimulate the economy in crisis regions. Thus, together with humanitarian institutions in the last few years, they have worked with new types of innovative financing mechanisms to deliver financial support efficiently, making increasing use of technology.
In this context, we are seeing the first blockchain projects to achieve the urgent change in delivering humanitarian aid to connect donors and people in need, by means of a cheap and transparent mechanism which automates the trust that was traditionally provided by banking and other intermediaries.
III. Financial services in crises: the problem
As noted, the role of financial services is fundamental to the value chain of humanitarian aid delivery. Thus, in addition to payment services, there is a complex range of financial products that can be used in crisis settings, from the most sophisticated financial products for investment into risk reduction (to tackle various aspects and stages of crises, e.g. climate change, disasters, conflict and refugee contexts) to those that allow financial inclusion for the resilience and development of people affected by crises.
For instance, banking and international lending institutions provide concessional loans or contingent credit to governments as a risk-finance tool to ensure that adequate funds are directly available to meet financial needs in the event a disaster occur, with more generous terms than market loans. On the other hand, the financial services industry (including capital markets and insurance and reinsurance institutions) shifts the cost of risks for investors who provide compensation when a disaster occurs as a risk-transfer tool, in exchange for a premium (e.g. catastrophe bonds), and also transfers the risk of the implementation of social programmes to investors (social impact bonds).
All of these instruments, and other innovative mechanisms (e.g. trust and pooled funds), are just a fraction of the total resources, in contrast to short-term grant-based allocations. For this reason, one of the approaches of the international humanitarian community is to “shift from funding to financing”. Therefore, to face the persistent funding gap indicated above, it is necessary to activate the potential of financial services, making more use of risk-finance and risk-transfer tools to obtain more funds available for assistance. In this regard, crowdfunding, a sharing economy tool where intermediaries are web platforms (marketplaces) that connect donors and humanitarian projects, is gaining relevance.
Regarding the financial services provided to people affected by the crises, remittances, savings, insurance, credits and cash transfers are tools that support livelihoods and stimulate economic activity after crises.
These financial services face barriers to delivering, since policy and regulatory environments are especially limiting in crisis regions: problems of compliance exist with know your customer (KYC) regulations, due to the lack of identity documents (national identification or passports, which may have been destroyed or lost after a sudden disaster or displacement due to conflict.), and with anti-money laundering (AML), for which additional documents, such as a proof of address (e.g. a utility bill), may be needed to process a financial transaction.
To solve identification problems, there have been cases in which humanitarian agencies have collected the beneficiaries’ data (such as fingerprints and iris scans) and issued identity cards that can be recognized by the financial entities. Nonetheless, these technologies have generated some rejection of the beneficiaries due to the risks of privacy, inappropriate use and lack of accuracy. This is because, in crisis situations, there is a special sensitivity to the risk that criminals or some kind of cyber-groups can get access to the centralized databases and may harm the registered beneficiaries.
This conflict of compliance with the regulations of KYC / AML and Data Protection is due to the fact that KYC / AML do not consider special contexts such as crises. Humanitarian agencies are still making efforts to keep the information of beneficiaries protected, following the humanitarian principle of “no harm”. Without ignoring the purpose is to prevent the financial system from being used to channel illicit resources, it is necessary to promote the implementation of mechanisms in which the data of the beneficiaries are not exposed.
Moreover, another limitation of financial services is that local financial entities are vulnerable to operational interruptions and destroyed physical and financial infrastructure in crisis scenarios (for instance, roads, telecommunications networks, power grids, bank branches, automated teller machines [ATMs], and agents).
Recently, we can see digital cash transfers using mobile distribution (using cell phones, card-reading point-of sale [POS] devices, text message platforms, and cloud-based data management platforms)and cash-out for card-based programs (by agent banking), where the beneficiaries can access to mobile wallets or to bank accounts; however, despite their benefits due to the multiplier effect in the economy and reaching areas where the financial infrastructure did not allow them, their operations are still a small portion of the humanitarian response. The use of digital cash transfers must be expanded, but for an adequate implementation of its objectives it is important to highlight that, according to various case studies, where these programs have been implemented, improvements are needed to achieve that beneficiaries can trust and rely to electronic money.
With all the above said, it is remarkable that there is a big task to expand financial services for the financial services providers, which is not only the banking, but also fintech companies that can reduce costs and be more effective (e.g. crowdfunding, mobile money).
Finally, if we consider the reduction of costs of financing humanitarian aid, it is necessary to highlight that in addition to the costs of financial intermediaries providing the financial services described, the delivery of humanitarian aid has other costs (costs of coordination and sharing information, costs of fraud, corruption, audit, etc.), due to: i) the diversity of stakeholders (all kinds of government offices, local and international non-government organizations, multilateral organizations, suppliers, financial services providers, etc.); and ii) the lack of mechanisms that offer adequate transparency to trace the delivery of aid, which does not allow a full picture of the range of resources that reach crisis-affected populations.
IV. Blockchain: the potential
In brief, heretofore I have only mentioned that blockchain is a distributed ledger that is characterized by transparency, immutability and security, offering a main benefit: cost transaction reduction due to the automation trust. How is it possible to have these characteristics and automate trust? In simple terms, a distributed ledger technology (DLT), unlike a traditional ledger, is not stored by a trusted administrator, but is stored simultaneously by all the participants of a synchronized network (called “nodes”) and together they make a common ledger. As long as the stored data is replicated at the same time in the nodes of the network, it is considered that there is less risk of manipulation. This is why the DLT brings by definition more security than banks and other intermediaries: if a node is destroyed, it will not affect the database since it is replicated in all points of the network (“nodes”).
Also, there is no trusted administrator that knows the content of the information and validates the transactions but, through a mathematical consensus mechanism of the nodes (“hashing”) — which use to be Proof-of-work (PoW) and Proof of Stake (PoS) — , they are incentivized to validate the transactions, whose information is encrypted.
It is this characteristic that represents the automation of trust. In this way, to validate a transaction, a bank or a notary that has the confidence of the parties will no longer be needed. Instead, a network of nodes, properly incentive to tell the truth, will validate the transaction. This feature also implies greater security, while hacking the system would require hacking more than half of the network’s nodes.
In addition, the other characteristic to highlight is that all the information of the blocks is encrypted. So, with cryptography, while all the nodes can see each chain, as only those that are authorized by the private key can access the information, blockchain represents a solution for the privacy of the beneficiaries whose data can be registered.
Finally, blockchain is made of a chain of blocks, where each block contains any kind of information of the transactions (from the data record of the identity, assets, properties, money, even smart contracts, until the previous transactions made with these contained in previous blocks). If someone tries to modify the data contained in a block, the entire network of the nodes can know this.
Hence, blockchain is characterized by immutability and transparency, being able to be the effective tool for the delivery of humanitarian aid as long as it is possible to have the full picture that it has indicated previously, tracking the information from the donor to the beneficiary, and reducing the costs of corruption, fraud and audit.
The use cases of blockchain in the humanitarian system come from protected data sharing, supply chain, donor financing, cash programmes, to crowdfunding, using even cryptocurrencies. In all these cases, due to the described characteristics above, the blockchain operates expanding the provision of the financial services, making transactions simpler, faster, and safer, but mostly transparent, reaching more donors who can trust in the humanitarian system, and cutting many traditional intermediaries out on the way.
Indeed, the scope of risk-finance and risk-transfer tools to obtain funds for humanitarian aid can increase if they are placed in the blockchain, since the instruments can be fractionated and reach more investors, what has been seen in the first cases of catastrophe and social impact bonds.
Likewise, in relation to the compliance of AML and KYC regulations, blockchain can allow financial institutions to simultaneously have all the client’s data and, therefore, the efforts to verify the information should only be made once. At the same time, this logic is also applicable to humanitarian agencies that constantly need to share information between themselves and with banks, benefiting from the cost reduction that blockchain brings and protecting at the same the data of the beneficiaries. However, precisely these both features (immutability and transparency) have raised concerns about compliance with data protection standards.
The solution to these concerns could change if blockchain is a permissionless DLT (e.g. Bitcoin) or permissioned DLT (e.g. Hyperledger). In the first case, there are all kinds of legal concerns due to the unprecedented model of governance, where anyone could access the network and be a node (civil law, torts, etc.).
For the second case, it depends on those responsible for the development of technology adopting policies to comply with the standards: the appropriate treatment of the data becomes adopting compliance policies at the level of development of security and encryption of information (public key, private key, “off” information). Even when there is a clear conflict between immutability and the “right to be forgotten”, in addition to the great sensitivity of the information collected from the beneficiaries; it must be considered that for this aspect it is also possible to reconcile technology with law. For example, mechanisms can be developed not to “eliminate” the information but to restrict its access in a definitive way. Thus, when concerns arise about going against a certain “law”, it is necessary to go beyond the literality of a legal text and think about the principles and interests that are intended to protect in a peaceful social coexistence.
With all these features, blockchain seems ideal to share information and transfer digital assets in a fast, tracked and secure way, having the potential to provide substantial benefits in the humanitarian sector.
It is evident that if more efficient and effective alternatives arise than those offered by banks, they must be taken into account. But clearly, blockchain is not a panacea, behind the use of this technology there are still people who interact in different ways with different interests. There is no system 100% safe or reliable: errors, manipulations can come from outside the blockchain and affect the confidence of its participants. This is where there is a complex task of the law to try not to discourage technology and at the same time seek the protection of rights and principles.
As highlighted, blockchain is most valuable when it is used to track ownership of complex things over time; there are multiple groups or actors involved, there is no well-established or effective central authority in place; groups or actors involved need to work collaboratively; and, a record or proof of transactions is desired. Considering everything described so far, I cannot think of another sector that could value the blockchain more than the humanitarian system.
In the end, humanitarian system operates on trust. It is clear that the blockchain will take an important role in the improvement of this sector. However, the division of labor will not cause banks to be totally displaced. Their knowledge of risk management is important as we have seen. But the time may come when blockchain expands so much that the financial institutions and its costs are really reduced.