Examination

Numbers: B070146, B070439, B065002

Title of Course: Applications of Finance
Course Organisers name: Alistair Haig
Date of Submission: 21/03/2016
Word Count: 4181

Disruptive Business Models in Finance: Bitcoin (and Blockchain
Technology)
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Introduction

This report focuses on disruptive business models and finance, with particular focus on the

introduction of Blockchain technology, and more specifically the software Bitcoin. Bitcoin currently

has greatest proportion of the market (Shown in Figure 1). A disruptive innovation is something that

introduces a different set of features, performance and price attributes relative to an existing

product (Halaburda & Sarvary, 2015), thus essential acts as any form of change to the status quo of

a financial industry, whether that be positive or negative. Although this is a global issue, the US will

be the main focal point. In order to summarise Blockchain technology specifically as a disruption to

financial markets, the following issues must be addressed; what exactly Blockchain technology is,

who it is affecting, the current and future disruptions posed, and finally the strategies and

recommendations for markets to deal with these disruptions.

FIGURE 1: MARKET CAPITALISATION OF INTERNET BASED CURRENCIES
SOURCE: WWW.COINMARKETCAP
.COM (IIF)

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Nature of the Disruption

In order to fully explain the nature of the disruption caused by Blockchain technology, the

areas surrounding it must be fully understood. Therefore, a summarisation of Blockchain as a

technology, cryptocurrency and Bitcoin is required to explain what they are and how they all work

together.

Blockchain technology is a publicly shared transaction database or distributed ledger that

maintains a continuously growing list of transactions or data records. Nodes or servers maintain the

entries (blocks) and every node sees the transaction data stored in the blocks when created.

(Burgess & Colangelo, 2015) There is no centralised authority required to approve transactions

because each block is created when multiple nodes agree and validate the transactions. Blockchain

solves two major challenges for digital transactions, avoiding duplication and controlling the

information. Blockchain eliminates the need for a trusted third party and centralised record when

making payments or financial transactions, which makes transactions faster, cheaper and easier to

access while maintaining security (Wright & De Filippi, 2015). However, financial transactions and

payments might just be one field of application of this technology. The most widely known

application of Blockchain technology is the public ledger of transactions for Bitcoin.

Cryptocurrency is a decentralised medium of exchange which uses cryptography to regulate

the creation of new units and secure the currency on the distributed ledger (Burgess & Colangelo,

2015). The original Bitcoin protocol was designed in 2008 by a person or group of people under the

alias of Satoshi Nakamoto. In 2009, Bitcoin became the first decentralised cryptocurrency (Davis,

2011). Bitcoin is a digital token and a payment system that relies on Blockchain technology and

enables peer-to-peer transactions. Bitcoin can also be used to buy commodities electronically. In

that sense, it is like conventional currency. However, since Bitcoin is decentralised as no single

financial institution controls the network, it is different from conventional currency.

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Bitcoin is an open source software and the tokens are created digitally by miners as they are

paid for devoting computing power to the network. Copies of transaction records (ledgers) are kept

on multiple computers in the network and visible to anyone. The transaction is settled by a

multitude of individual nodes (miners), providing computing resources to the network (He, et al.,

2016). Miners solve a cryptographic puzzle as part of the validation process. Miners need to show

proof of doing this work to the network (called a proof-of-work system), which is costly as it uses a

considerable amount of computing and energy resources. Only the miner who finds the solution

faster than any others receives newly minted Bitcoins as a reward for their service (He, et al., 2016).

Blockchain technology is an innovation that creates a new value and market network and

disrupts the original paradigm in the financial services industry. In the financial sector, Blockchain

offers a potential to replace complex processes and obscure payments and settlements systems

which would eliminate as much as $20 billion of costs (Banking Technology, 2015). R3, a Blockchain

technology company, headquartered in New York, leads a consortium of 42 financial companies in

research and development of Blockchain technology usage in the financial system (del Castillo,

2015). Some of the financial companies who are part of this consortium are Barclays, J.P Morgan,

Royal Bank of Scotland, HSBC and Deutsche Bank (Willms, 2015).

Wedbush Securities published a report in 2014 in which they estimate that 20 per cent of US

GDP (approximately around $3.6 trillion) are generated by industries that could be disrupted by

Blockchain technology (Luria & Turner, 2014). In the report, Wedbush Securities believes that in

addition to the reduction of payment transaction fees, the use of Bitcoin protocol and Blockchain

asset ledger could also challenge financial services fees such as deposit fees, escrow, foreign

exchange fees and collection fees (Luria & Turner, 2014). Apart from the banks, companies like

Nasdaq, Visa, Citi Ventures, CapitalOne and Orange have invested in Chain Inc., a Blockchain

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technology start-up, which is working on a product that will use a new Blockchain to trade stocks in

private companies (Alinikoff, 2015). It aims to reduce the substantial time spent managing the share

certificate process and replace paper share certificates. (Banking Technology, 2015)

It is difficult to predict where Blockchain technology is going and whether it will realise its

full potential. However, the above-mentioned examples (illustrated in Figure 2 below) do indicate

the growing popularity of Blockchain technology and how it has caused disruption in financial

markets.

FIGURE 2: TIMELINE SHOWING WHEN MAJOR COMPANIES GAINING INVOLVEMENT IN BLOCKCHAIN START-UPS
SOURCE: CB INSIGHTS (HTTPS://WWW .CBINSIGHTS.COM/BLOG/FINANCIAL-SERVICES-CORPORATE-BLOCKCHAIN-
INVESTMENTS/)

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Current disruptions

The invention of Blockchain technology changes the spending behaviour of millions of

people around the world. It also creates opportunities and risks to governments, financial services,

each of which is considered below. These in turn then have an impact on both firms and individuals.

Governments

Governments are beginning to employ Distributed Ledger Technology (DLT) for daily

operations such as collecting taxes, issuing passports and delivering benefits. A Distributed ledger is

an asset database based on Blockchain technology which anybody can possess an identical copy of

the database (Government Office for Science, 2016). DLT has now been experimented with by the

Estonian government for years. Estonian citizens could validate the integrity of their personal

information on the government database, which allows the government to introduce digital services

including e-Business Register and e-Tax (Government Office for Science, 2016). DLT is extremely

efficient since any changes in the ledgers are synced to all copies immediately. Likewise, DLT is highly

secure to prevent fraud. Hackers would have to infiltrate into all the computers with the copy of the

distributed ledger simultaneously to change exactly the same piece of information in order to apply

any unauthorised changes.

DLT creates extensive advantages for governments. For instance, transactions between

governments and their citizens become transparent due to the publication of ledgers. In terms of

governments daily operations, DLT could be used to deliver social benefits to the underprivileged.

Digital identities could be confirmed by distributed ledgers, benefits could then be directly

transferred to the recipients without involving banks so transaction cost could be reduced. Risk of

fraud could also be cut as it would be more difficult to forge identities compare with hacking bank

accounts (Government Office for Science, 2016). Moving to national defence, risk of cyber-attacks

towards civil infrastructures could be diminished because servers could be easily monitored with DLT

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being applied. A distributed ledger could be used to oversee the software systems for any illegal

changes which could potentially cause breakdowns of infrastructure systems (Government Office for

Science, 2016).

The further integration of Blockchain technology into the global economy would also cause

disruptions to taxes, especially in the UK since the legislation for dealing with cryptocurrencies is

currently so unclear. Currently HMRC state that no tax liability will be incurred providing profits are

not being turned into regular cash (Stevenson, 2013). However this would need to be further

clarified if disruptions continue to grow.

With the successful trial in Estonia, Distributed Ledger Technology will undoubtedly become

more broadly used by governments. Although the general public requires further education on the

technology, the technology is mature enough to be applied on different occasions. The Distributed

Ledger Technology therefore creates limitless opportunities to governments.

Financial Services

Payment processors such as Visa and MasterCard have started investigating the potential

opportunity by investing in Blockchain technology. Visa claims that Blockchain could be used as a

mean to transfer non-traditional currencies such as gift cards or loyalty points (Roberts, 2015). In

the meanwhile, banks are also looking to update their traditional transfer system with Blockchain

technology. Banks including HSBC and RBS are experimenting Blockchain to complete transactions

spontaneously across their private network. Transactions will be updated instantaneously on the

distributed ledger (Blockchain.info, 2016). It allows banks to complete transactions more efficiently.

On the other hand, cryptocurrencies such as Bitcoin allows users to transfer assets securely without

any third party needing to be involved. The traditional payment process is centralised, where the

virtual currency payment method is distributed. This in turn means that it no longer relies on

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financial services such as banks to transfer payments from givers to receivers unlike PayPal.

Cryptocurrencies charge a lower transaction fee compare with banks and transactions are

completed immediately while banks typically take a few days to complete the transaction. On

average there are over 200,000 Bitcoins being transferred per day which is equivalent to

approximately 83 million USD (Allison, 2016). Suppose banks charge 2 percent fee of the transfer,

they are losing over 1.6 million USD revenue per day. Major cryptocurrencies are also accepted on

online shops such as Microsoft and Expedia. If major online retail stores such as Amazon and eBay

also start accepting cryptocurrencies, usage of virtual currencies will grow enormously and could

eventually surpass credit cards in the future, creating even more significant disruptions.

FIGURE 3: DAILY NUMBER OF BITCOIN TRANSACTIONS

SOURCE: COINDESK HTTP://WWW.COINDESK.COM/DATA/BITCOIN-DAILY-TRANSACTIONS/

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Fraudulent transactions

Blockchain technology allows for peer-to-peer transactions without any intermediary. This

exposes the market to a greater risk of fraudulent transactions.

Criminals can easily use Blockchain technology to transfer, pay, and receive payment from

illegal operations. This is attributed to the lack of transparency, as the identities of both principals

and beneficiaries are not recorded. (Unlike the traditional banking where both parties identities are

recorded.) Other platforms that offer peer-to-peer transaction are PayPal and Apple Pay, but the

transactions stem from traditional banking, as PayPal accounts are linked directly with the

customer's bank account.

Traditional banking follow Anti-Money-Laundering (AML) regulations. These regulations

provide a system to reduce financial crimes (Burgess & Colangelo, 2015). Banks are required to

monitor transactions in accordance with the Proceeds of Crime Act 2002. Since Bitcoin is

decentralized the Crown cannot go directly to the intermediary to seize the asset (Gerhman, 2013).

Instead they must have access to the private key which hold the Bitcoin. (In the heavily published

Silk Road case, the FBI were only able to seize the suspects Bitcoin with his express cooperation.)

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Future Disruptions

Although the current disruptions are the essential, the potential future disruptions cannot

be ignored. The three key areas to be analysed are the future threats of disruption to banks, the

exchange market, online markets and on a broader scope- remittances.

Banks

There is no doubt that one of the main the advantages of Bitcoin helping to continue the

disruption are the significant reduction of transaction costs compared to traditional transaction

methods by cutting out physical intermediaries. This is currently creating concern for banks, and is

only going to be accentuated if Blockchain technology continues to increase as the current global

phenomenon (Janssen, et al., 2015) that it is proving to be. As of December 2015, Bitcoin had a

market capitalisation of around 4 billion USD (Forte, et al., 2015) compared to Americas largest bank

Wells Fargo & Co alone with a market cap of 263.60 billion USD as of 2015 (Relbanks, 2016).

Therefore the relative size of companies using Blockchain technology is unlikely to be a current

worry, but continued growth is increasingly going to cause concern. Furthermore, many executives

in the banking industry are highly cautious of the potential of a completely decentralised system

(Institute of International Finance, 2015). However the future threats of disruption is still prominent,

after creating an opportunity to re-engineer financial industry infrastructure to their advantage

(Institute of International Finance, 2015).

One of the main aims of Bitcoin is to allow those around the world without access to banks

(making up 53 percent of the world population (Swan, 2015)) to be able to maintain their own

independence and have some form of system to allow a more global trade. Although the

introduction of Bitcoin still requires an internet connection and access to smart technology, the

relative simplicity of Blockchain technology for users will allow introduction to be more practical

than that of an entire banking system. This potential installation is in the hopes of increasing

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opportunities for these individuals, since for unbanked customers, generating substantial savings is

virtually impossible and means they are restricted to cash transactions only (Vigna & Casey, 2015).

This would in turn then reduce the impact of dangers associated with carrying/storing potentially

large sums of money in physical cash. For third world countries, the introduction of a system with

lower/non-existent transaction costs could be vital to aid the growth of the worlds poorest

population.

For example, currently in Afghanistan- it is relatively uncommon for women to have a

personal bank account, with any income being put directly into the bank account of a male member

of the family (Vigna & Casey, 2015). This can cause issues in non-harmonious families as the risk can

be, and therefore, Bitcoin would provide independence for such women, and therefore greater

opportunities for their future.

However it is important to note that is it not just emerging markets that make up the

unbanked population, as in America 7.7 percent are completely unbanked and 20 percent are

underbanked (Ratcliffe, et al., 2015). This is for a number of reasons; lack of profit-making potential

from poorer customers; lack of infrastructure and poor legal systems in place that lacks

documentation standards (Vigna & Casey, 2015) all of which are much less vital using

cryptocurrencies compared to a traditional transaction system.

As stated earlier, banks have recently increasingly been getting involved with Blockchain

technology recently, with Barclays admitting that it could revolutionise finance due to the

undeniable advantages (Taylor, 2015). This would once again heighten the impacts of the current

disruptions taking place.

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Remittances

Closely connected to banking, the remittance market is also a financial service which is

threatened with significant future disruptions. Remittance is broadly defined as the transaction of

money from one location to another (Vaccani, 2010), and therefore impacts the world on a global

scale, including both developed and undeveloped countries. Thanks to the pure velocity and

capability of Blockchain technology, the World Bank estimates that the global flow of remittances

will reach a total of $610 billion (EVRY Financial Services, 2015). Remittance makes up monumental

contributions to some countries, especially Mexico where roughly 10 percent of the Mexican GDP is

made up of people working in America sending money home (Frisby, 2014), meaning it could have

huge disruption implications of remittances if it comes more widely accepted.

Transaction costs are an immense cause for the potential future disruptions in terms of

Blockchain technology for both firms and the public as a whole, with remittance fees ranging from 8-

9 percent as of 2014, compared to a mere 0.01-0.05 percent using Bitcoin transactions (Franco,

2014). Lower transaction fees is a result of the decentralised nature of Bitcoin, with no authorisation

being required (Kuo Chuen, 2015), meaning transactions take a fraction of the time required when

using a centralised banking system. The approach to allow anyone access is taken, meaning there is

no restrictions which would slow the process down, thus keeping costs low. In turn, by reducing the

cost of transaction costs, it can be inferred that this may allow companies to adjust their pricing and

marketing to benefit from Bitcoins advantages (Deloitte, 2015)

However, one of the greatest setbacks for Blockchain technology to be used in the

remittances market, is that the bulk of remittances are to developing countries (Lo & Wang, 2014)

thus posing the similar delay in disruption as for the banking sector.

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Exchange markets

Since relatively few companies allow goods and services to be purchased using Bitcoins as a

currency, the greatest current use for exchange markets is a conversion from Bitcoin to fiat currency

required and back again (CGAP, 2014). However in the future, it has been stipulated that if a greater

amount of regulation is enforced, then it is likely it could disrupt the exchange market further if

there is an increase in financial institutions and merchants that are willing to accept cryptocurrencies

such as Bitcoins from one another (Deloitte, 2015).

Further evidence of increasing future disruptions in the industry is provided by the purchase

of a Bitcoin wallet firm by the New York Stock as security in case stock exchanges suddenly surge

into using Blockchain technology (The SWIFT Institute, 2015). The benefits that could be reaped and

significant changes from exchange markets can be found at both each stage of a trade (i.e. pre-

trade, during trade and post-trade), and for all members involved, especially; client, dealers, CCPs

and private trading companies (Oliver Wyman & Euroclear, 2016). Therefore the possibility of these

future disruptions becoming material is anticipated by many.

It can be argued that the stock exchanges are preparing for the inevitability of Blockchain

creating huge disruptions in the exchanges if current setbacks are dealt with, since the Australian

Stock Exchange is contemplating buildings its next generation CSD using Blockchain technology

(Oliver Wyman & Euroclear, 2016) and the price of Bitcoin is now being reported by Bloomberg

(Frisby, 2014).

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Online Market

Blockchain allows stores (or retailers) to accept a different method of payment, thus

attracting new consumers. Currently Bitcoin is accepted at many major retailers such as Dell,

Expedia, Microsoft and overstock, which offer a wide range of items from home furniture to

jewellery.

Nevertheless none of the mentioned companies directly accept Bitcoin. Instead it requires a

third party application such as CoinBase, which converts customers Bitcoin into cash for the retailer

(Davidson, 2015). Therefore all revenue from Bitcoin is converted into cash then transferred to the

retailer. Similar to credit card transactions the merchant is charged a fee for the transaction,

CoinBase charges a flat rate of 0.2 percent (CoinDesk, 2015). Currently the infrastructure needed to

cause a disruption is present, however, actual disruption is far from being realized. For example,

overstock; the principal supporter of Bitcoin has stated that Bitcoin payments account for less than

0.25 percent (Burgess & Colangelo, 2015). The volatility of Bitcoin poses a problem for retailers and

their shareholders. Since there is a fixed amount of Bitcoins (21 million), any inflation rates cannot

be controlled by any governing agency.

A comparison between Blockchain technology (used by software such as Bitcoin) with the

current electronic money is also beneficial in order to explain why cryptocurrencies could be a

greater benefit to online users. Despite their similarity of being an online method of payment, the

two are extremely different to one another. While Bitcoin allows its users to be anonymous and

uses a single form of Bitcoin currency, PayPal is simply a mechanism by which to interact with the

fiat currency (CGAP, 2014) and therefore a credit or debit card is still required to set it up- rendering

it useless to unbanked and underbanked populations.

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Recommendations and Strategies to Firms, Individuals and Regulators

In order to deal with the negative disruptions potentially involved in the introduction of Blockchain

technology, there are many options for minimising them, however the main focus will be on; greater

regulation; government intervention and banks potentially creating their own cryptocurrency

alternative.

Greater Regulation

It has been argued that the traditional internet regulation will need to be reconsidered

(Wright & De Filippi, 2015) and potentially completely redeveloped to ensure it is strong enough to

withhold the demands of cryptocurrencies as they continue to become more established. To a

certain degree, this is already taking place as regulation groups are gradually being set up, and

individuals who use Bitcoin are being increasingly encouraged to actively participate with authorities

to make the regulations as effective as possible (Oliver Wyman & Euroclear, 2016).

The government needs to work with the industry and academia to ensure that standards are set for

the security, integrity and privacy of distributed ledgers and their contents. These standards need to

be reflected in both software and regulatory code (Government Office for Science, 2016).

There has also been suggestions in various white papers about creating a reserve, as this

would then allow the cryptocurrency to be more stable as currently there has been trends of

impressive fluctuations which would benefit from some control (Alcorn, et al., 2015).

Greater transparency and awareness

Although it can be argued that cryptocurrencies are already transparent, the level of

anonymity that provides the opportunity for illegal trades and fraudulent behaviour to occur is still a

major setback for many, since they do not have enough trust in the software to use it effectively. If

developers of software such as Bitcoin were to utilise the potential transparency that is available

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(since the data is already readily available, but just currently hidden behind the unique feature of

anonymity) it could create new opportunities for the technology to excel and create a more

accepted form of currency. If a new software which was created without anonymity for the benefit

of those who do not wish to be anonymous (or Bitcoin gave the option to remove anonymity), were

able to show each transaction more clearly, it could potentially revolutionise the way in which global

transactions occur.

This would be most beneficial for charities in particular if they were to incorporate

Blockchain technologies, as it would allow donors to see more clearly where their money is going,

inducing it would encourage them to donate more (Allison, 2015) and it can be inferred that it would

provide opportunities for new ways for people to give and would create new ways to address social

problems. However it must also be noted that they could also lead to other issues that would need

to be addressed as they arose.

Government Intervention

By ensuring that Blockchain technology forms a stable part of the world economy, it would

be important for the government to create a more airtight legislation to aid protection of users, as

this will increase the trust of those using it (Alcorn, et al., 2015). This could be achieved by explicit

legislation being written to continue the work started in the Criminals Act (2002). Even Malmi Martti

(Finnish Bitcoin developer) has stated that Bitcoins legal status is still a mystery (Stevenson, 2013).

There has also been suggestion creating a filter service which would allow users to generate

a random Message Authentication Code and share it with a filtering service (Barber, et al.,

2012).This would aid regulators tackling the issue of fraud as a disruptive factor for firms and

individuals.

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Financial Intervention

Blockchain technology has the current infrastructure for banks to change their current

system of remittance. Banks could make use of block chain technology to reduce transaction time.

This would lead to staff hours involved in the transaction process being reduced, which could

potentially reduce cost for banks and customers. This would subsequently allow banks to compete

more successfully with Bitcoins low transaction fees, reducing the impact of the disruption.

There is no doubt that cryptocurrencies create competition for credit card companies. To

minimise such threat, the credit card industry should make use of its leading position. For instance,

they could offer lower transaction fees to shops so cryptocurrencies become less competitive. Also

they could also reduce interest rate to attract credit card users to spend more on credit cards.

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Conclusion

Overall, it is clear that the highly complex cryptocurrency is paving the way for an ever

increasing disruption within not only financial markets, but an industry-wide basis as well. There

have been a number of opportunities and challenges created for firms, with particular attention

being drawn to the positive and negative impacts cryptocurrencies have had on banks, financial

exchange markets and services, the various global governments, remittances and perhaps most

importantly on individuals (through online markets). However there is no doubt that there is great

potential for disruptions in these areas if the technology is continued to be developed, especially in

terms of positive disruptions. As shown by the number of strategies and recommendations that

academics have promoted, this possibly revolutionary transaction process is currently in its early-

stages. But with an introduction of intervention (whether this be from banks or governing bodies),

and with perseverance of Blockchain advocates to generate greater awareness and understanding,

this may well lead to enough trust from the wider population to create a disruption on a global level.

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