Traditional methods of performing transactions
The conventional way of moving money across borders is to use financial intermediaries. To secure the process of transactions, most financial institutions use the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system. The SWIFT system is a messaging system used by financial intermediaries to perform a transaction.
It is usually paired with the International Banking Account Number (IBAN), which allows financial institutions to identify which counterpart the transaction is being made to and from. This payment system is a complicated and expensive process, where many financial intermediaries take part in verification. The average cost of transferring money across borders within G7 countries for ordinary households averages 2%. These fees rise when moving money to or between countries outside of the G7 categorization, resulting in remittances averaging 7% fees (The Economist, 2019).
The SWIFT system was never intended to be political but has succumbed to playing a geopolitical role. Most recently, Donald Trump has threatened to issue sanctions against any financial intermediary using SWIFT that does not ban transactions with Iran. Moreover, the SWIFT system allows for US Intelligence agencies unrestricted access to information about European companies, causing the current German Foreign Minister, Heiko Maas, to state his disagreement publicly (Nasdaq, 2018).
At the center of the SWIFT system lies the banks and other financial intermediaries, and the SWIFT system only works when financial institutions uphold specific standards required of them. However, this is not always the case.
Recent examples of financial fraud
In 2006, Danske Bank bought Finnish Sampo Bank. Apart from Sampo Bank being the third-largest bank in Finland, its presence in high-growth areas such as Lithuania and Estonia were deemed lucrative. From the period 2007 to 2015, suspicious transactions from non-resident clients, connected to corruption and tax evasion, passed through the Estonian branch. Despite several internal whistleblower reports, the transactions were not further investigated. Following an official investigation, the former CEO of Danske Bank, Thomas Borgen, resigned. This is mainly due to his responsibility for international banking from 2009 to 2012, before being appointed CEO, which included responsibility for the Estonian branch. The transactions in this money-laundering scandal amount to an estimated $200 billion (Financial Times, 2018).
A well-known jeweler, Nirav Modi, and others were alleged to have defrauded the Punjab National Bank (PNB) in India for $43 million by conspiring with employees of the bank. The conspiracy with the bank employees involved fraudulently obtaining Letters of Undertaking (LoUs) from PNB, which act as a guarantee by the issuing bank, often used in international banking transactions. The LoUs were issued using the SWIFT system without proper authorization, and the transactions were not stated in the records of PNB. The Central Bureau of Investigation (CBI) found that the estimated money lost was closer to $2 billion. Nirav Modi fled the country and is still currently a fugitive, while the bank employees were arrested and tried (Fraud Magazine, 2018).
The two examples above are among many in both recent and more historical periods.
As previously mentioned, using financial intermediaries to perform transactions is a complicated and expensive process. Each financial intermediary takes a small fee for verifying the transaction. Besides, performing operations through traditional ways of financial intermediaries poses several risks, including corruption and money laundering, as well as specific and systemic risk factors. Systemic risk factors are seen in the fractional reserve banking model by many commercial banks. For example, European banks are required to hold a percentage of the bank’s funds as a reserve within the European Central Bank. In Europe, this reserve amountwas lowered to 1% of the banks current account in January 2012 (ECB, 2016).
The fractional banking model enables the banks to issue deposits of one client to be distributed amongst other clients, often leading to additional risk. Most recently, during the financial crisis in 2009, we have seen that this banking model poses severe threats to economic and political landscapes as well as the socioeconomic welfare of citizens worldwide.
The rise of cryptocurrencies and blockchain technology — is this the solution?
To accommodate the rising dissatisfaction with financial intermediaries we have, in recent years, seen the rise of cryptocurrencies. The independent and privately-owned digital cash entities, sometimes seen as an uproar to the traditional banking methods, create a decentralized framework with limited public intervention and immediate fiscal policy changes. Retail banks have also considered the use of digital cash. The aim for the retail banks is to reduce the amount of fiat money circulating the economy, which is the primary source of financing for purchases on the black market, terror funding, and other disruptive agents.
Cryptocurrencies and blockchain technology:
The main goal of cryptocurrencies is to alleviate the issue of double-spending between users. In traditional banking methods, the accounts, balances, and transactions are controlled by a centralized server. When creating a decentralized authority, this server is, of course, not present. If users disagree on any element of a transaction, the whole payment network breaks down, and there is, therefore, need for consensus and transparency among users without a central authority.
Users perform transactions, which must be confirmed by the so-called “miners.” Once the transaction is verified, it cannot be reversed or forged, and the transaction is broadcasted among the user network. In other words, the transaction is recorded in the blockchain (Blockchain Technologies, 2019).
If we take Bitcoin as an example, then these miners create bitcoins by solving a cryptographic puzzle or “hash,” which connects the new block with its predecessor. Once the hash is found, the miner can build a block and add it to the blockchain while being rewarded in a certain number of bitcoins. The consensus-process is therefore not nested in people or a trust, but cryptography (ibid.).
Blockchain systems like Bitcoin, for example, makes the use of monetary policy, such as inflation and deflation, obsolete. These were the reasons for the popularity of cryptocurrencies.
The drawbacks of these cryptocurrencies are that they are relatively volatile and are susceptible to cyber-hacks and black-market purchases. Bitcoin prices were roughly $800 in start-December of 2016. The following year in December 2017, Bitcoin prices reached an all-time high of approximately $17,000. While in December of 2018, the price of Bitcoin fell to roughly $3,300.
Concerning Central Banks, they have considered using Central Bank-issued Digital Currencies (CBDC) based on distributed ledger and blockchain technologies. Arguably, this initiative enables the central banks to take the role of a retail bank and therefore, does not mitigate the issues of monetary and fiscal policy.
A solution between the two?
The complexity, cost, and susceptibility to risk of the traditional financial system have paved the way for the rise of the cryptocurrencies and blockchain technology. Although, volatility and illegal payments, as well as monetary and fiscal policy changes, are somewhat of a concern when dealing with independent cryptocurrencies and CBDC, respectively.
However, one could argue that the current transaction systems have similar concerns. There needs to be a balance between legacy financial systems and modern technology. Companies like ARYZE are seeking to bring the global payments systems into the digital age with an improved method for transferring ownership of value. They do so by utilizing regulated and stable cryptocurrencies.
These stable cryptocurrencies are commonly referred to as stablecoins. By using distributed ledger technology, which reduces the reliance on financial intermediaries in a cost-efficient manner, digital representations of fiat currencies can live on the blockchain. A stablecoin is a digital asset with a market value pegged to the value of a fiat currency, like USD or EUR, or to a basket of underlying assets. The upside of using stablecoins is that users receive the benefits of blockchain technology, namely programmability, while maintaining familiarity to the current fiat currencies that are used in financial systems across the globe.
We have begun to see a number of tech companies and financial institutions make investments into building stablecoins for a variety of purposes. Perhaps the most famous of these, Facebook’s Libra, highlights the fact that even social media giants, with a history of privacy breaches, could enter the race for a global reserve currency. A scary thought, to be sure.
However, deciding not to replace current dominant currencies, but instead innovating upon the format in which they are transferred, may be a valid argument for stable digital currencies. ARYZE has chosen to approach this issue by creating an accurate and stable digital representation of sovereign cash. Digital Cash, as it is referred to in their white paper, is a series of stablecoins that have the same value as cash notes would have, as issued by central banks.
The deposited money is stored in a low-risk ecosystem, and the aim is to stabilize the volatility by placing user deposits back into the central banks which issued the relevant currency to begin with. In order to do this, and control risks associated with KYC/AML, ARYZE will acquire infrastructure to create a full-reserve banking model for user deposits. It gets a bit technical at that point. However, by following this model, ARYZE can facilitate transactions at near zero cost.
Given that the deposit is stored in central bank, the volatility caused by the implementation of decentralized authorities, as previously exemplified with Bitcoin, is significantly reduced. This is portrayed by allowing the use of monetary and fiscal policies from central banks as well as using the global reserve currency, and later other dominant currencies, as the stabilizer. The plan is to gradually increase the degree of decentralization of the system towards a Decentralized Autonomous Organization. This DAO will have automated processes for solvency and auditing, becoming an ultimate network of trusted payments.
Concluding remarks
We have noted the severe challenges the traditional banking system and current blockchain technologies face. The examples given are a few of many but should illustrate the challenges of financial fraud, corruption, and funding for disruptive agents, and a solution to dissuade them. Today, households and businesses face volatile, expensive, complicated, and insecure payments systems. Stablecoins, given that the model takes credit-risk and regulation into consideration, are likely to have an enormous and innovative role to play in the future. Combining security, trust, and programmability on the blockchain to improve the way we pay will be necessary for the next generation of financial technology improvements.