How blockchain could help financial institutions mitigate the effects of a recession
Updated: Mar 9
“It is going to be worse than 2008”, “I’ve never seen something like this in my life, and I’ve seen sh*t”, “brace yourselves, winter is coming”. If you are remotely connected to the financial industry, you must have been hearing this sweet lullaby during the last few days and weeks. I am not one to judge if those comments are justified (yet) or if they are a mere release of the tension accumulated by waiting for “the big one” during the last couple of years… In any case, fears of an upcoming recession are undoubtedly mounting. In the following lines, I will examine why the new coronavirus poses a threat to global financial stability, how this may affect financial institutions and how blockchain could help mitigate negative effects.
The “$19 tn time bomb”
Cassandra is a figure of the Greek mythology cursed with receiving the power of divination just to see her prophecies shun by whomever she tries to warn. This is how bears must have been feeling for the last few years, warning that a recession was overdue. That markets were over-extended. And that the abuse of the money press by central banks was creating a generalised state of “everything bubble”, on the verge of popping. What they could not have predicted is that the initiator of the chain reaction would be a pangolin, the most heavily poached mammal in the world (some say a bat, others say another animal, it is still unclear).
Perfect candidate for the title of a textbook example of Black Swan theory, the SARS-CoV-2 virus could potentially lead to a downturn which would differ from those of 2001 and 2008 by its origins: it would not have been caused by greed (let’s forget about share buybacks). The dot-com and US housing bubbles popped when overvalued supply started outstripping waning demand and the effects of their bursting propagated to the real economy. Currently, we are facing the risk of a serious hit in worldwide demand, directly affecting the welfare of millions of corporations of the real economy. And corporations matter; in fact, after twelve years of cheap money their indebtedness might pose a systemic risk.
“The $19 tn time bomb”: the Guardian came up with this catchy phrase in an article in October last year, citing the International Monetary Fund’s (IMF) biannual Global Financial Stability Report. The report identifies the explosion of corporate debt as one on the major threats to global financial stability in the event of a downturn. The IMF came to this conclusion by running a stress-case scenario for a select number of countries, simulating a GDP decline amounting to half of the decrease seen in 2008–2010. Interest rates paid by firms were simulated to rise to half the level of the last downturn.
The report notes: “Based on the IMF staff corporate bonds valuation model, spreads are projected to widen significantly as corporate fundamentals deteriorate, economic uncertainty rises, and current misalignments disappear. Firms would face lower profits and -given heavy debt loads, valuation pressures, and likely limited market liquidity- would not be able to deleverage quickly”.
The results of the stress-case scenario were not encouraging: the simulated slowdown in GDP created a total of $19 trillion of unserviceable debt (debt with an Interest Coverage Ratio -or ICR- less than 1), representing roughly 40% of the total projected corporate debt (the Institute of International Finance quotes total corporate debt of $75 tn at the end of 2019, 40% of which would rather approximate $30 tn). To make matters worse, the two largest economies in the world, China and the USA, would be amongst the countries the most affected by a downturn. And remember, this is only half the severity of the crisis of 2008–2010.
Economic slowdown and bad debt -seems eerily familiar. Bailout the banks, increase regulation, print money, rinse repeat, right? Not so fast. In the USA, cheap money and negative yields have made corporates favour capital markets (67% of total debt raised by corporates) and financial entities through private issuances (14%) for their borrowing needs. Banks only owned 19% of total corporate debt. Apparently, this has been the theme of the decade.
Yield, yield, yield
Negative-yielding debt peaking at $17tn last year was recorded by market observers as a clear symptom of an excessively dovish monetary policy. They nervously raised the question of how fixed income investors would meet their return targets. Rightly so. The authors of the IMF report observed that “the prolonged period of accommodative financial conditions has pushed investors to search for yield, creating an environment conducive to a build-up of vulnerabilities. Lower yields have prompted institutional investors -for example, those with nominal return targets- to invest in riskier and more illiquid assets, providing a growing source of funding for nonfinancial firms and facilitating borrowing by weaker firms”.
What should we expect?
To summarise: according to the IMF, a slowdown of the world’s economy half as severe as the one of the global financial crisis would, among others, entail the generation of at least $19 tn of bad corporate debt endangering nonbank financial institutions in “advanced economies” and roughly all financial institutions in “emerging market economies”. The world’s largest two economies, the USA and China, are to be counted amongst the most vulnerable.
It would be presumptuous and futile to try to guess the form and shape of the economic policy destined to mitigate the effects of such a situation. However, one could extrapolate and learn from the effects, measures and consequences of the last global financial crisis on the banking sector in “advanced economies”. In January 2018, the Bank for International Settlements — BIS (often referred to as the central bank to central banks) published a paper listing key lessons and trends of the structural changes in banking after the crisis of 2008–2010.
The study notes that the burst of the US housing bubble “exposed the excessive risk-taking […] and acute vulnerability within the global banking industry. Numerous banks in Europe and the United States failed or received government capital injections, and some were nationalised”. This pushed regulators to tighten supervision measures and banks to reshape their business models by abandoning riskier activities, creating a burden on profitability as a result.
This might be the most important conclusion of the report: banks have traded resilience for profitability. The authors of the research stated that:
“Banks and their shareholders must adapt to a persistent reduction in profitability, as pre-crisis levels of profitability proved unsustainably high. It is difficult to predict future profitability, but the impact of some drivers that led to a decline of RoE is likely to persist. […]
Anyone with experience working with or for a major financial institution would be able to confirm: for the most part their IT infrastructure and processes are far from being in line with the latest standard, a real concern in the context of growing competition from rapidly expanding fintechs and established tech giants.
This observation echoes a recent survey carried out by Finextra, identifying the IT priorities of banks for 2019:
“After a decade of bank IT spending being dominated by regulatory compliance (with as much as 80% of banks’ total IT development budget being consumed by mandatory items), market sentiment appears to be that the worst of this is now over. Budgets are now being freed-up to spend on other things such as innovation, measures to improve business efficiency and new products and services. […]
In terms of the highest, and high priority items, digital customer experience (79%), innovation (45%) and cost reduction (46%) were the top three areas of expenditure. The move toward digital is a key strategy of many banks, bringing a range of benefits including enhanced processing efficiency and more automation.
The priority given to innovation would include working with specialist new fintech suppliers […] to provide the bank concerned with a competitive advantage through the launch of a new product or service, or improve operational processes.”
It would not be unreasonable to extrapolate the same kind of effects to the nonbank financial institutions at risk cited above: sluggish market conditions during and post-recession, creating more oversight and lower profitability. In such an environment the optimisation of costs (through digital transformation or otherwise) might become a key strategic priority.
Blockchain and financial institutions
Financial institutions have always demonstrated a keen interest in blockchain, with their first strategic investments taking place as soon as 2014, just 5 years after Bitcoin’s genesis block.
In 2015, a Fintech paper published by Banco Santander estimated that “distributed ledger technology could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15–20 billion per annum by 2022”.
A later study by Accenture, noted that the 8 major investment banks could save up to $12 bn annually, or approximately 50% of their cost base. As the authors of the paper put it:
“Since the 2008 global financial crisis, the capital markets industry has faced a perfect storm of diminished returns, largely due to the rising cost of regulatory compliance, rising capital allocations and liquidity costs, and dwindling revenue. We estimate that investment banks spend around two-thirds of their IT budgets supporting legacy back-office infrastructure, plus $billions more each year on cost reduction initiatives.
In other words, it’s costing too much time, effort, liquidity and capital to support processes that don’t offer a sustainable improvement in profits. Consequently, banks, central banks, exchanges and clearing houses are urgently experimenting with blockchain as a way to tip the cost fundamentals and return to profits that improve Return on Capital.”
Finally, in 2018, a report published by Juniper Research found that “blockchain deployments will enable banks to realise savings on cross-border settlement transactions of more than $27 billion by the end of 2030, reducing costs by more than 11% per on-chain transaction”.
According to Juniper Research, banks that integrate blockchain will “achieve cost reductions not just in payment processing and reconciliation, but in treasury operations and compliance. Indeed, the research argued that in compliance, automation of identity/money-laundering checks, allied to capability of the blockchain to verify the digital identity of an individual, should enable savings of up to 50% of the existing costs base within a few years”.
The road ahead is still long: during the early phases of implementation, the new technologies (either developed in house or in partnership with a fintech) would need to run concurrently with the institutions’ legacy systems and would not immediately translate to lower costs. In addition, the deployment into production of some projects is still challenged by regulatory or technical hurdles. However, the message is clear: blockchain has the potential to help banks save costs. And what is true for banks is essentially true for other financial institutions:
Insurance companies will benefit from automatising claims, modernising their client database with digital IDs or sharing claim information with competitors without revealing it thanks to zero-knowledge proofs;
Funds will benefit from a reduction in administration costs due to a streamlined clearing and settlement process;
Trade finance providers will start tapping into the $1.5 tn financing gap by removing fraud and automating compliance procedures;
Family offices will benefit from being provided with a larger array of fractional investment opportunities thanks to the digitalisation of securities; etc.
For the avoidance of doubt, I am not stating that blockchain will solve all of the problems faced by financial institutions. However, blockchain is a tool perfectly suited for a specific set of use cases destined to increase their operational efficiency.
I truly hope that the impact of the current pandemic will remain limited to a few weeks of closures and that the governmental measures to help corporates will be enough to contain the shock. However, we need to be ready for the eventuality of a deeper recession and act accordingly to support the recovery as much as we possibly can.
I like to take comfort in the fact that financial institutions have at their disposal technological solutions that can help them mitigate the effects of such a downturn and potentially avoid having to resort to more drastic measures such as layoffs or offshoring, which would only cause additional harm to local communities.
At Schema Capital, we are convinced that distributed ledger technologies are the cornerstone of the modernisation of the world’s financial infrastructure and we are committed to support entrepreneurs building businesses that will help financial institutions in hard times and beyond, modernise the world’s financial system and ultimately positively impact society as a whole.
About Schema Capital:
Schema Capital is a venture capital investment and advisory company dedicated to supporting European fintech founders from inception to seed.
We focus on “deep fintech”, where emerging technologies (blockchain, AI, IoT, quantum) are revolutionising the infrastructure of financial services and enabling entirely novel ways of creating and consuming financial products and services.
We also run The Drawing Board, a rolling advisory programme destined to help entrepreneurs hit the ground running and raise an institutional seed round.
The programme offers hands-on assistance with business strategy, product design and development, business development, investor documentation, pitch preparation and all things finance until a CFO steps in. The Drawing Board is open to Fintech startups only.