By Prof. K. S. Ranjani and Prof. Mukundan
Blockchain has become the buzzword in both academic research and application solutions. It seems to be the magic wand that can cure, well almost anything. Investment in blockchain based prototypes, projects and deployment crossed $1.4 Billion in the years 2015 to 2017 and more than 2500 patents filed in distributed ledger and associated technology. Does this mean, we are on to something interesting and game changing? Or is this a case of much ado about nothing? To describe blockchain in simple terms, one can look at it as a smart contract that lays out the data into the open and attempts to ensure complete information availability. A blockchain’s three main characteristics are: security, transparency and process efficiency. Its architecture has four essential components – use of consensus algorithm, data anonymity, security and in turn, trust of the chain participants. Consensus algorithm uses serious mathematics, thus ensuring the blockchain implementation to be perceived as unbiased by all participants. Consensus can occur only when trust and transfer of complete information are present. Security algorithms known as cryptography ensure trust in the transaction. The architecture of blockchain is thus to convert (reduce) the indeterminism (variability) in the system.
In this article, we attempt to explore the possible disruptive effects of deploying blockchain in fintech applications, with special reference to financial inclusion. It aims to address three fundamental issues-
- What makes banking and financial services the most used case for blockchain applications?
- How can fintech solutions focusing on financial inclusion be integrated into blockchain?
- Will this really be beneficial, financial or otherwise?
To answer the first question, we need to look at fundamental characteristics of blockchain which make it most suitable for banking and financial applications. Immutability, Equal rights, Integrity, Transparency and Non-repudiation are considered to be the five fundamental properties of a blockchain. What do these fundamental properties mean in simple English? A committed transaction is immutable. A chain of such transactions with relevant security would make it a nonrepudiation data – i.e., no one can disclaim their transactions. Now, how do we ensure the veracity of the chain? Cryptography or encryption provides the integrity of the block data. Further, will it be good if the data is made available for everyone? Hypothetically yes, as one then needs to disprove n-1 participants in the chain hence ensuring transparency. The final piece of the jigsaw is the absence of hierarchy in the chain – every participant has equal right on the data. However, modifications are automatically visible to the rest of the participants. All these properties are fundamental to a blockchain since it is designed to work in a trust less system. We have the option to either make the system trustworthy or apply enhanced algorithms to derive virtual trust. Transactions through the chain possess traceability, provenance, document management, all characteristics that are considered desirable and essential in the banking and financial domain.
While the characteristics of a blockchain make it highly desirable, there are concerns that cannot be wished away easily. Consider this- while blockchains can handle on average 3-20 transactions per second, the traditional banking and settlement infrastructure like VISA can handle 1700 transactions per second. These real time numbers bring to the fore the major challenges of a wide scale blockchain deployment. Blockchain deployment would involve huge investment into computing and network infrastructure, database infrastructure, long latency, scalability in terms of numbers and network size and an ability to game the protocol. The obvious question, then, is whether blockchain could really be as feasible as it is desirable? The answer to this question may be more complex than a straight jacketed yes or no.
Any new technological innovation is usually
a response to a need and in the case of financial transactions, security and data integrity could be that need. We cannot emphasise enough that every financial transaction must be immutable, have integrity and be repudiation free. These are inherently present in a blockchain, giving us a clear head start. However, it may be a challenge to design a block chain that could keep the speed of processing while simultaneously granting equal rights and transparency. Now, if we have a system that can ensure that most of the fundamental properties, the benefits would be immense. To summarise the answer to the first question raised – as to what makes banking and financial services the most used case for blockchain applications – the transactions are cash based, requires identification of the end user, and require security, if possible, through encryption. All of these seem immensely possible in blockchain technology.
The next question that needs an answer is the methodology. Assuming that blockchain can provide near ideal solutions in the financial realm, how can it be operationalized? A necessary pre-condition to host solutions in a blockchain is the ability to digitize the business processes. We can discuss an example of a small or a micro loan, typically lent to the marginalized sections. The basic documentation required for any banking is popularly known as Know Your Customer (KYC). These documents validate the identity, residence and income generation capability of the customer. While the personal identification has been addressed by many countries by using biometric identification systems (Aadhar being a case in point in the Indian context), the income generation capability remains a challenge. Small value transactions are still carried out in cash, thus making it difficult for credit score assignment to the poor. If small, repetitive and replicable transactions can be traced, such transaction trails will lend us a better picture of identifying the end user and modify the lending style. Blockchain through its fundamental properties of immutability and non-repudiation is one such equivalent technology intervention.
We provide a simple blockchain framework for the financial inclusion system in the given Figure. This is a work in progress. We identify four levels – service level, blockchain, component and contract. At the service level, we have the integration of users with the service provider. The component level are the various subsystems required for a financial inclusion solution that digitizes the business process. We have the smart contract level, which captures the credit score, loan details all linked. The final level is the blockchain level wherein all the details are captured as a series of secure blocks.
The last issue that is raised- Will such painstaking movement towards an alternate technology really result in any substantial benefits? Servicing small loans generally involve the following steps:
- Onboarding of customers which involves the time and cost of verification of KYC
- Loan disbursement and servicing
- Loan collection
Financial inclusion can happen only when large volumes of unbanked poor can be reached and currently, it is an operation intensive activity. The cost of servicing a small loan ranges from 10-12%, which means a whopping 100 to 120 basis points. Any savings in this cost could translate into enormous savings when considered on a large base of customers. Record maintenance, verification and data security will become far easier and quicker on a blockchain hence reducing cycle time. The National Payment Corporation of India (NPCI) framework (whose popular mobile application is BHIM) that uses the mobile phone number as a Virtual Payment Address (VPA) simplifies the verification and disbursement aspect. Further, the Aadhar Enabled Payment System (AEPS) is another example. The blockchain system can provide the smart contract system for the financial inclusion business model.
Of all the operational challenges involved in administering small loans, collection is the most difficult to surmount. If settlement tokens can be created, hence obviating the need for cash settlements, it could be the biggest reform that the microfinance industry is waiting for!! An integrated digital solution that would fulfil the end to end needs of a small customer by leveraging available solutions and integrating them into a larger blockchain certainly seems exciting and worthwhile.
(The authors are currently Assistant Professor, NITIE)