Blockchain and operational risk: opportunities and challenges

  • 13 July 2018

In the midst of the buzz and excitement of the Blockchain Summit in London, it was clear that blockchain, the new method for exchanging value, is an influential and potentially revolutionary technology. ORX News examines the opportunities and challenges for operational risk managers.

What caught our attention was the fact that all industries were working collaboratively to find new ways of enhancing customer experience using blockchain. Industries at the event included not only the financial and insurance sectors, but also art, sports, gaming, construction, and healthcare to name a few. Innovative industry leaders were keen to highlight that blockchain is not a solution looking for a problem, but it has the potential to solve real world business problems.

In finance, for example, banks are currently experimenting with a number of applications such as trade finance, know your customer (KYC) checks, cross border payments, and syndicated loans. In insurance, the applications include underwriting, processing of claims, and also KYC checks.

Basics of blockchain

Let’s take a closer look at how blockchain can reinvent trade finance.

Global trade is a complex process involving a number of third parties alongside exporters and importers, including shipping companies, banks, customs agents, and regulators. For transactions to be completed they must pass through all intermediaries, typically using manual paper-based processes.

Blockchain offers a shared platform enabling all parties to interoperate in an efficient, transparent, and secure way. Paper-based systems can be eliminated and replaced by a digitised, automated process which is entirely transparent to all parties in the transaction. Transparency and the immutable properties of the blockchain reduce the potential for fraud, while smart contracts can be programmed to execute parts of the transaction, automatically reducing the time and errors introduced by manual human processing. Businesses pioneering trade finance on the blockchain are hoping that these features will significantly reduce the time, cost and risk associated in conducting global trade.

During the summit, it was apparent that while blockchain is evolving, the financial and insurance industries are not trying to reinvent the wheel but rather collaborating with blockchain providers such as IBM, R3 and B3i. In this way, the blockchain may increasingly be seen as a commodity software product that companies can purchase to creatively apply to solve their business problems. A general theme also apparent was that in order for blockchain to operate at its full potential, it needs to work in combination with other technologies.

Managing the challenges and risks

The mood for blockchain was optimistic, but also realistic. Summit participants discussed the challenges and barriers preventing the technology from going mainstream. These challenges centre on issues of trust resulting from uncertainties in its liability, security and scalability, given that blockchain is at its infancy.

For example, who is liable if the blockchain system fails, who can be held accountable, and what laws are in place to award damages? Although blockchain is designed to be secure, security can only be determined after time in use. One initial concern is how blockchain users can keep their private keys secure, as evidenced by multiple high profile thefts reported in the media. Due to its distributed nature, it can take time for all versions to be updated in contrast to a centralised ledger where only one update is required.

Overall, the summit was a great opportunity to see how participant industries are reinventing themselves with blockchain. Alongside developing the opportunities of blockchain, financial services firms need to manage the risks. ORX News will continue to monitor and include operational risk events that impact firms that are currently using blockchain technology to deliver financial services. At this stage, these early adopter firms are often providing exchange services around digital currencies such as bitcoin. These events, such as the hack on South Korean cryptocurrency exchange Bithumb, provide valuable case studies for operational risk managers to learn about some of the potential risks associated with blockchain.

This is part of the work of ORX News to develop coverage of cyber-related events. As well as covering cryptocurrency events, this also means providing information about significant cyber events outside of the financial services industry. These are important as they can provide valuable lessons across industry sectors. This is especially important in managing cyber risk, where firms may have limited internal data, and where ORX News provides a comprehensive data set, recently used in an IMF working paper on quantifying cyber risk.

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