Nascent blockchain technology could have a profound impact on how your community bank manages growing regulatory compliance demands.
By Karen Epper Hoffman
While most people still equate blockchain technology with the cryptocurrencies it underpins, like the seemingly ubiquitous bitcoin, enterprises are recognizing that this infrastructure technology could serve an even more important and expansive role well outside online payments.
As many innovative financial institutions are discovering through early pilots and testing, the essential blockchain technology framework boasts several qualities that make it well-suited to support a number of different operational efforts in banking, from risk-rating system development to sales (see sidebars). But one area where blockchain may eventually make its most pointed and powerful impact on financial services systems—and where, arguably, community banks need the most help right now—is in regulatory compliance technology.
Blockchain was initially created to be fully digital, decentralized and public to provide the most accurate and immutable chronological record of cryptocurrency transactions. Because of that, the technology infrastructure provides an ideal framework for other types of records, transactions and communications that may be drawing from various data streams, and require an open and unassailable means of tracking. So, it’s of little surprise that many prominent financial companies, including Mastercard and Nasdaq, have publicly announced the widespread piloting and use of blockchain even in core operational areas.
According to researcher CB Insights, the term “blockchain” was used nearly 300 times in company earnings calls in the first quarter of 2018 alone.
However, given blockchain’s skyrocketing popularity and widespread use cases, along with the need to simplify and add efficiency to the compliance space, forward-looking bankers and blockchain experts alike believe that is likely to change quickly. In the era of increasingly steep regulatory reporting demands and standards from regulators—and increasingly tough penalties and fines for banks that do not meet these requirements—community banks must find new ways to deliver more with less.
Pei-Han Chuang is CEO of Morpheus Labs, which creates blockchain-based “platforms” as a service for enterprises. He says banks in general “are carefully balancing their need to innovate using blockchain technology [with] the existing regulatory environment.” He believes that successful blockchain implementations in the ﬁnancial industry depend on overcoming some of the technological downsides, including throughput and latency.
Kathy Strasser, executive vice president and chief operating officer for $1.26 billion-asset River Valley Bank in Wausau, Wis., says blockchain technology would benefit her bank’s management of its anti-money laundering (AML) program. “Today we are accumulating customer information and creating a record of our customer and what we know of them,” Strasser explains. “Blockchain could help by enhancing our systematic capabilities of gathering the data, tracking the data and alerting us when it differs for our review. The customer file would then be updated with these new behaviors.”
Sam Penfield is advisory product manager for SAS, a software and services provider to the banking industry. He says he has seen “many blockchain projects going on within the banking space, with limited implementations in a production environment.”
Most of these projects, Penfield says, are focused on ledger-type environments, such as payments, transfers and exchanging value in a peer-to-peer environment.
But while it is still in its early days, blockchain offers much promise for regulatory technology, since “banks are embracing the disruptive nature of blockchain technologies from a cost-reduction perspective,” Penfield says.
He points out that introducing smart contracts via blockchain technologies could allow for specific rules, models, data, transactions and analytics to be introduced into compliance implementations in a secure, chronological environment offering a history of events specific to compliance.
Community banks could also use blockchain to help execute their “know-your-customer” (KYC) process, where customer background information, AML checks, Interpol check results and the like could be stored as immutable records on the blockchain, according to Keith Lim, CEO for Hearti, which works with insurance companies and health care companies on blockchain platforms. “Taking it a step further, this information could be combined with biographic data, such as name, age, gender and address, and biometric data, such as fingerprints, iris scans and handprints, to form the digital identity of the customer on the blockchain that can be interpolated across different parts of the organization or across different organizations,” Lim says. “Smart contracts on the blockchain can also automatically generate regulatory reports on banking transactions.”
A chip off the old blockchain?
SAS has worked with community banks (and larger financial institutions) on a number of regulatory fronts. Penfield believes “blockchain technologies will be very disruptive from many business process perspectives, information access, technology knowledge and implementation. Eventually, there may be multiple disparate blockchains that will need to work together in inter- and intra-bank environments [so that] analytics [can] be utilized to track operational and business data.”
Indeed, Strasser points out that blockchain could specifically meet the need of helping community banks develop better risk-rating systems within their existing AML systems, so that institutions like River Valley Bank could create individualized checklists based on each customer for customer identification programs or KYC protocols. “KYC/AML blockchain data files could be used for marketing opportunities to existing customers,” Strasser says. “Or by sales people out in the field for selling products and services that would enhance their business and their life.”
Under section 314(b) of the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN), financial institutions are permitted and encouraged to share information with the Treasury Department and other financial institutions on potential money laundering and terrorist financial acts (as part of the USA Patriot Act). “A blockchain file would make this sharing quicker and more accurate,” Strasser says.
Blockchain could also serve a purpose in helping banks manage their Bank Secrecy Act (BSA) requirements, since the distributed ledger could allow banks to share their information on a publicly accessible but secure and immutable platform.
The R3 consortium of banks is already working on this application. The consortium includes 40 bank and technology vendor participants, including Deutsche Bank, Microsoft Azure and Synechron. It’s already tested more than 300 regulatory-related applications over 19 markets, allowing bank participants to see when customers approved or updated their identity information.
“Traditional KYC processes are complex and often duplicative,” said R3 in its announcement of the pilot. “This self-sovereign model allows corporate customers to create and manage their own identities, including relevant documentation, and then grant permission to multiple participants to access this data.” Blockchain could enable banks to maintain KYC compliance without having to individually maintain and update KYC records, according to R3.
Chuang agrees that blockchain could be used to improve regulatory reporting in terms of transparency, data quality and governance, and identity management and authentication, as well as KYC and suspicious activity reporting. “This is a time-consuming process, which requires a lot of paperwork [and] involves a lot of entities, resulting in high costs,” he points out. Typically, since customers must provide documents issued by government institutions or trusted companies to banks to verify their identity, banks can increase their eﬃciency by using blockchain as an identity registry, Chuang adds.
“The customer could have a single cryptographic identity, even if it has accounts or assets in multiple legal entities, or banks could record the customers’ documents’ hashes on blockchain, rather than digital ﬁles,” Chuang says. “Furthermore, in a more disruptive scenario, the customers’ identities could be almost completely managed using blockchains.”
Lack of off-the-shelf options and the overall newness of the technology aside, blockchain faces other challenges to broader adoption by community banks for their regulatory needs. Perhaps the most notable is trying to tie cutting-edge blockchain systems to stalwart core-banking systems. As Chuang points out, banks rely heavily on their multiplicity of legacy systems, many of which are still tied to mainframe servers.
“Changing some of these mission-critical processes to include new technologies as nascent as blockchain is not only imprudent but also unwise,” he says, adding that pilot projects should always start with a small test. “There is no need to overhaul all the operations in banks. Banks will do well to pilot a use case involving simple processes, like ensuring documents are tamperproof.” For example, he says banks with digitized documents could then have their hashes stored onto blockchains, where it is sufficient proof that it is original and unchanged.
Despite the potential challenges, Strasser points out that “blockchain efforts in our core systems would offer quicker and more efficient auditing or monitoring of changes to customer data.
“This would allow for better compliance with some regulations like the FACT Act, USA Patriot Act and Truth in Savings with notice requirements,” Strasser says. “It would also allow our sales force to have the most up-to-date customer information with every interaction.”
Remind me: What’s “blockchain”?
To paraphrase Linda Richman, the classic Mike Myers Saturday Night Live character, “A blockchain is neither a block, nor a chain. Discuss!”
Simply put, a blockchain is a decentralized digital ledger. Satoshi Nakamoto, the famously unknown creator of bitcoin, developed blockchain technology as a technological framework to allow users of that cryptocurrency (and, eventually, other online currencies) to record their transactions in a decentralized, guaranteed and unchangeable format. It’s like a spreadsheet duplicated thousands of times across a wide network of computers that is continually being reconciled but is not centralized. Hence, no one enterprise or person can control it, and it has no single point of failure or compromise.
In the decade since bitcoin’s (and blockchain’s) emergence, companies have been seeking new ways to use blockchain technology to provide a more efficient, secure and simple means of recording and sharing information. Keith Lim, CEO of Hearti, says that “transaction histories are becoming more transparent through the use of blockchain technology. Because blockchain is a type of distributed ledger, all network participants share the same documentation as opposed to individual copies.
“This shared version can only be updated through consensus, which means everyone must agree on it,” Lim says. “One benefit of this is that it allows faster processing and easier submission of compliance reports to regulators.”
As experts point out, blockchain technology’s benefits include:
- Enhanced security. Transactions must be agreed upon before they are recorded. After a transaction is approved, it is encrypted and linked to the previous transaction. Lim says this means sensitive records such as compliance records and documents can be securely stored on the blockchain.
- Improved traceability. Historical transaction data can help to verify the authenticity of assets and prevent fraud, which is important for anti-money laundering checks and risk-management controls.
- Immutability. This is a key feature of blockchain, according to Pei-Han Chuang, CEO of Morpheus Labs. “Immutability means inability to be changed or modified,” Chuang says. “Data kept in central databases are prone to hacks and tampering. With blockchain, financial data such as trading history could be stored securely in a ledger that is tamper-proof. Should bad actors seek to erase or modify data, it is almost impossible to do so.”
A true industry game-changer
The phrase “disruptive technology” gets tossed around a lot these days. It’s a way to describe emerging technologies that could change the way that businesses operate internally and with their customers. But blockchain may actually be living up to the hype.
In financial services, as in other industries, blockchain technology has been promised to offer better efficiency, transparency and security. Banks and their vendors have taken note and are cautiously optimistic in their testing and trials of this technology. In an interview with Pymnts.com in June 2018, Esther Pigg, senior vice president for FIS product strategy, discussed numerous internal proofs-of-concept and pilots that the banking service provider has been working on.
Overseas, blockchain has been used in the Republic of Georgia to develop a land ownership registry to verify ownership of property. In a similar way, U.S. banks could close real estate loans more quickly, and real estate holdings could be verified immediately and with certainty. The role of the title agent would be minimized, as the time taken to verify title would be eliminated. More importantly, the cost associated with confirming a title interest through title insurance would be dramatically reduced. All of these results would improve the closing process both from an efficiency standpoint for banks and from a cost standpoint for the customer.
Karen Epper Hoffman is a writer in Washington state.