KPMG outlines blockchain technology impacts and countermeasures for banks in China

Big Four accounting firm KPMG recently published its third quarterly report on China’s banking sector. Among a variety of topics is the implications and countermeasures for commercial banks, “under the rise of blockchain technology.”

“Under the sweeping effects of continued technological innovation, commercial banks should prepare themselves to adapt to and even thrive on an upcoming age of blockchain-based finance.”
— – KPMG

KPMG’s report, China’s banking sector: Performance of listed banks and hot topics, was authored by Zhou Guangyou of Fudan University School of Economics. Guangyou provides analysis of important topics and key performance indicators in China’s banking industry, including financial data analysis of listed banks. The series tracks ongoing developments in the sector, providing commentary on future affects in banking industry.

“Overall, China’s economy has grown steadily since 2016,” the firm states. During the third quarter net profits of listed banks increased compared to the previous year, but at a slower rate. However, interest rate cuts by China’s central bank have narrowed interest rate spreads, resulting in operating difficulties.

Blockchain technology can potentially lower costs as well as improve services. A June 2015 report, jointly authored by Santander InnoVentures, Oliver Wyman and Anthemis Group, states that blockchain technology could reduce banking infrastructure costs relating to cross-border payments, securities trading and regulatory compliance. Saving could amount to $15-20 billion per annum by 2022.

While blockchain technology’s benefits are recognized in Western countries, KPMG questioned "how practical are they in China? Will the Chinese Government allow this new technology to flourish in an immature financial system?" Alongside regulatory uncertainty, China’s commercial banks also face competitive and security pressures, the firm noted.

KPMG identified two areas in the Chinese banking sector poised for blockchain disruption, real-time fund transfers and the creation of credit. Both are major sources of income for commercial banks, states KPMG, and incumbents should accept the idea of decentralization and potential replacement.

KPMG also stated that traditional cross-border fund transfers are "complex, high cost, time-consuming and error-prone." Global information services group Experian estimates that the average error rate for bank account data is 12.7%, 7.0% of which is related to incorrect bank codes.

An analysis by Ripple, published in February, shows that global cross-border funds settlement is also slow, often takes three to five days, is error-prone, and costs approximately $1.6 trillion in systemwide costs.

Blockchains can offer real-time transfers, lower cost and accuracy of identity checks. In addition, small or mid-sized banks have to pre-fund accounts or establish lines of credit with correspondent banks to service international payments.

With blockchain technology, KPMG said the need for banks to reserve funds in their current accounts for the transfers will also be removed, freeing up capital which results in increased liquidity and eliminating opportunity costs.

The creation of credit may also be reshaped by blockchain disruption, providing financial institutions with reliable and detailed information, KPMG explained. “Traditional commercial banks that live and thrive on information asymmetry may lose their hard-earned competitive advantage under the rise of blockchain technology.”

“Theoretically, blockchain technology can allow the two parties involved in a transaction to carry out economic activities in the absence of a trusted third-party intermediary. This can simplify banks’ business, but on the other hand, it will put an end to many lucrative businesses of commercial banks, such as the Letter of Credit (L/C) business.”
— – KPMG

Blockchains can also help the Chinese government combat criminal activities and maintain fairness and stability in the financial market, KPMG states, “As China’s financial system may lack effective and mature regulation, offenders can take advantage of legal and institutional loopholes to carry out illegal acts that harm China’s national interest.”

The government can use blockchains to monitor asset conditions and potential financial risks in real-time, in an attempt to prevent stock market fraud as well as cross-border money-laundering. KPMG pointed out that varied data sources and collection methods make it difficult for banks to submit reports to regulators.

The Chinese government is already aware of the potential benefits of the technology. In October, the Chinese government released a blockchain whitepaper, summarizing developments at home and abroad, while providing analyses of the technology’s applications.

“Whether China can play an important role in the process of international standardization and how to improve its participation and influence depends largely on whether it can react quickly and rationally.”
— – China Block Chain Technology and Application Development White Paper

China’s central bank can also benefit from blockchains in several ways. KPMG asserted that the technology can, “greatly facilitate the regulation of commercial banks” due to its immutability, which results in data authenticity. Benedicte Nolens, the head of risk and strategy for the Hong Kong Securities and Futures Commission, reportedly said that using blockchain technology to comply with Know Your Customer (KYC) regulations could reduce errors through automation, remove duplication and create a record of all checks carried out for each client.

Citing KYC and Anti-Money Laundering (AML) as, “a pretty significant inefficiency and problem case,” Nolens stated at the MIT Technology Review Emtech conference, “If you start tallying up the fines, that banks have been subjected to globally for this field, you’re into the 10 billions or more of US dollars.”

The People’s Bank of China (PBC) has also already committed to using the technology. Governor Zhou Xiaochuan revealed in February that the PBC has been studying digital currency for “a long time,” having spent “a lot” of time and energy researching applications. He has subsequently announced that the Bank will launch its own digital currency as soon as possible. The Bank posted a job advertisement looking to hire blockchain experts to help develop its digital currency last month.

“Strong decentralisation that lies at the core of a blockchain poses a great challenge to centralised regulators’ efforts to execute administrative interventions. Overcoming such a challenge requires regulators to be more adaptive to the development of new technology and change their regulatory methodology accordingly.”
— – KPMG

KPMG proposed two key countermeasures for banks to consider. “Commercial banks should be technically prepared for globally accepted technical standards for blockchain technology to be developed in the future,” was the firm’s first suggestion. KPMG found that commercial banks in China have fallen behind international efforts to research blockchain technology and digital currencies.

For example, while most major banks globally have joined the R3 CEV consortium which was founded in September 2015, Chinese banks were absent until the second half of this year. In May, after more than 40 banks have joined, China’s second-biggest insurance company, Ping An Group, became the first Chinese member to join the R3 consortium. Since then, China Merchants Bank, Minsheng Bank, and China Foreign Exchange Trade System (CFETS) have all joined the consortium.

Instead of participating in international efforts, most Chinese financial services firms have opted to form their own blockchain consortiums, such as the China Ledger Alliance established in April, and the Shenzhen Blockchain Finance Alliance established in May.

Emphasizing the benefits of international collaboration, KPMG advised China’s banks to stay informed of their international counterparts’ activities in the space. They should “make early efforts to study and develop blockchain products and adjust their development strategies in a timely manner,” the firm’s report states. Ultimately, KPMG believes that banks in China “should actively participate in the formulation of international standards and protocols to seek more say in the matter and avoid simply becoming a passive follower.”

To achieve this goal, banks can either set up their own R&D laboratories or work with fintech companies, the firm proposed. It also noted that developing a variety of blockchain application scenarios as well as “innovate the fusion of blockchain technology and inclusive finance to serve China’s specific needs.”

“Efforts can be made on studying how to leverage blockchain technology to achieve low-cost transfers and payments in China’s underdeveloped regions to provide them with more accessible and better financial services.”
— – KPMG

The second countermeasure KPMG proposes involves the new digital currency, ZCash, which can completely anonymize select financial data, “ZCash, an emerging new technology, can encrypt transaction source data in a blockchain.”

An October launch saw Zcash reach record high prices among cryptocurrencies, but the aspect of the altcoin that KPMG appreciated is the opaque nature, which can help banks protect customer privacy, as well as help keep secrets from each other.

“Theoretically, encrypted blockchains based on zero-knowledge proofs can improve blockchain technology flawed by complete and uncontrollable exposure of transaction records,” the paper explained, “and help commercial banks ensure the security and authenticity of transactions while protecting their business secrets and allowing privacy management.”

KPMG also looked closer at bitcoin’s blockchain, explaining why such openness isn’t ideal for banks. “Although bitcoin and other digital currencies are known for their ability to conceal Transactions,” they noted, “it is quite common to access information about the sender and transaction location of bitcoin by tracking transactions recorded on the blockchains of bitcoin.”

Without going into detail why anonymity is a useful countermeasure, KPMG explained how Zcash could bring more anonymous transactions to banking. “Unlike bitcoin, which makes transaction data available to the public, ZCash applies encryption to the source data of a transaction,” the paper stated.

“With its advantage of total anonymity that places unremitting insistence on the protection of privacy, ZCash is poised to have enormous value in the financial industry.”
— – KPMG

KPMG isn’t the only big-four firm to recognize the attraction of anonymity. PwC Transformation & Assurance Director, Patrick Spens, told the UK House of Lords that collaboration stands in the way of rapid blockchain adoption in the financial services industry. "Banks don’t need to share information," he said. In contrast, "If you are an airline or a travel agent, you must share information."