From A Bank Run, to the rise of Smart Accounts

Over the last few weeks, the media has been filled with rumors and images of people queuing in front of bank doors and ATMs in an attempt to withdraw their funds. These are images we saw back in 2008 and more recently in European countries like Greece. While the causes of these events are known, solutions for consumers have not yet been determined, and blockchain technology may have the potential to be a part of the solution.

After Silver Bank, First Republic Bank, Silicon Valley Bank, Credit Suisse, and others, we are witnessing the failure of a model that has been in place, and successful, for the past 40 years. American banks are falling victim to a large bank run caused by a loss of confidence from their clients. However, it all started with bankers being poorly prepared for the major rise in core inflation rates set by the authorities and a lack of protection against interest rate risk. As consumers rushed to withdraw their funds, the banks had no choice but to convert long-term, unhedged bonds at a major loss. This was the case with the Silicon Valley Bank, which suffered a loss of $1.8 billion during the sale of a bond portfolio in a context of tightening monetary policy.

According to a report from economists working for a set of American universities, around 186 banks in the US ‘may be exposed to the same kind of deposit run that Silicon Valley Bank faced.

Is it the end of the collapse? Probably not. This may only be the beginning of a more significant problem, which requires urgent attention. As US Federal Reserve made it clear that it will continue to deploy its policy in the coming month: “The U.S. banking system is sound and resilient”.

The lineage of banking can be traced back to ancient times, such as the Babylonians who utilized paper notes and receipts as transactional mediums during 1800 BCE. However, the origins of modern banking as we recognize it today can be attributed to Renaissance Italy, particularly to the city of Florence, where merchants introduced bills instructing bankers to pay specific sums of money to designated parties. Since then, banks have played a critical role in the growth of civilizations, contributing to the expansion of local and global economies.

As the world continues to evolve, marked by new technologies, changing regulations, shifts in consumer behavior and the consequences of the successive crisis, the resilience of banks to crisis remains steadfast.

Nevertheless, they may encounter significant challenges during severe and unexpected events, resulting in some banks’ failure while others triumph. One thing remains clear, though, and that is the difficulty in regaining consumer trust following such failures, a challenge that must not be underestimated.

Although banks are actually exploring and experimenting with blockchain technology, there might be several factors that are slowing down its adoption.

Regulatory uncertainty: as blockchain technology and cryptocurrencies are still relatively new and untested at a large scale, regulators are cautious about their impact on the financial system and are taking a careful approach to their adoption.

This regulatory uncertainty can make it difficult for banks to fully embrace blockchain technology. The recent “crackdown on crypto”, including crypto-friendly banks, are signs that regulators are somewhat not at ease with the way banking and crypto are evolving one with the other. The adoption of MiCA in the European countries (planned early 2024) could be a catalyst for banks to embrace this technology, including crypto asset based products and services.

Technology education: we need to ensure a broader acculturation and understanding of the technology, and this within the industry professional. An interesting study conducted by the Institute of Management Technology in India, is looking at blockchain adoption in the banking industry and the criteria that contribute to it. It is not a surprise to find that bankers in the country expect (on top of the technology performance) to have a broader and stronger support from governing bodies and authorities “it is recommended that the senior bank authorities and technical support team organize workshops, conferences, and peer-peer discussions, regarding the usage and benefits of different applications to enhance the bankers’ initial trust and usage intention”.

Need for interoperability: banks operate on different systems and networks, and there is a need for interoperability between these systems to enable seamless and secure transactions.

Achieving interoperability between different blockchain networks can be challenging and may require significant coordination and standardization efforts, although solutions are now available and demonstrating their capacity (i.e. Cosmos Inter-Blockchain Communication protocol).

The history of payment scheme giants like VISA and MasterCard is self-demonstrating when we look at how those companies achieved the creation of a unique worldwide interoperable payment network, with the help of banks and payment service providers.

Technical challenges related to scalability, privacy, and security: Current blockchain networks have limitations in terms of the number of transactions they can process per second, and the public nature of blockchain can raise concerns about privacy and sensitive data protection. While permissioned and private solutions exist, those will have drawbacks, like censorship protection, resistance to hack and fraud, as well as the difficult to scale globally.

At the time of writing only few solutions have demonstrated their ability to scale, either in an autonomous way, or through a third party. The Lightening network is a great exemple of scaling Bitcoin peer-to-peer payment network.

Despite these challenges, we can expect major increase in blockchain technology investment by banks as they explore its potential to improve efficiency, reduce costs, and enhance security in financial transactions. As the technology matures and standards are established, we may see wider adoption of blockchain in the banking industry in the future.

In the retail and commercial banking world, current accounts (also referred as deposit accounts) play a vital role in the functioning of the bank and the wider economy. They provide a source of funds, generate revenue, build customer relationships, facilitate inter-bank transactions, and help banks manage their own cash reserves. Therefore, it seems that current accounts should be the main focus for banks to regain customer trust and confidence, as well as enhance their operations.

A recent trend shows that traditional banks are losing customers to neobanks and fintechs that have entered the banking field. By the end of 2022, an astonishing 68 million US consumers had declared having a bank account with these actors (e.g., Chime, Sofy), with 30 million of them even using it as their primary bank. It is not surprising to see such a battle around this product, as it is the catalyst of customer relationship management and a great customer data aggregator (e.g., card payment data, account operations, loan payments).

When it comes to customers, they are choosing neobanks and fintechs to gain easier access to their accounts, instant payment solutions, pay fewer fees (or zero fees), and manage their account data in real-time. If there is one thing blockchain is great at, it is securing operations, enhancing payment experience, and allowing for transparent data and transaction management.

In order to regain customer trust, as well as improving its experience we can imagine a bank account that is fully managed on a blockchain. All operations would be managed through the distributed data ledger, while transactions and deposits would be secured through smart contracts.

A smart contract is a computer program that is designed to automatically execute the terms of a contract when certain conditions are met. It is a self-executing contract built on code stored on the blockchain, making it immutable and tamper-proof.

Considering that the “Smart Account” is owned by the consumer, we are in an intermediary stage where those smart accounts are held in custody by the bank. While this solution is still centralized, it would allow more people to gain access to it, while allowing them to get benefits from blockchain-based solutions and products.

1. Creating the Smart Account: This process is very similar to the opening of a digital bank account. However, the data will be stored and saved on a smart contract that manages autonomously all conditions required to open the account. During the process, a decentralized digital ID, a on fungible token or any other digital asset could be used to simplify the KYC requirements at the bank operations level.

As part of the process, the customer will select their currencies for deposits and transactions from the following choices: fiat (i.e. Euro or Dollar), cryptocurrency (i.e. Bitcoin or Ethereum), or stablecoin (i.e. USDT, EUROC).

Thanks to the smart contract, the customer is autonomous in managing the account, including account closure. The smart contract is able to manage closure conditions, including holding it if there are payments in process.

2. Managing Smart Deposits: Assuming the registration is complete, the customer is entitled through their banking app to manage their funds and deposits. The consumer could opt for a fixed-term deposit in their account. The bank would then create a smart contract linked to the smart account that defines the terms and conditions of the deposit, such as the interest rate, fixed deposit amount, and maturity date.

The customer could select how those funds could be used by the bank in the financing of the real economy (by sector, industry, risk level,…). Regarding the fund’s currency, the customer should be able to choose based on their smart account options (fiat, crypto, or stablecoin).

If the funding conditions are met, the smart contract starts the interest accrual. Until the conditions for closing the contract are met, neither the bank nor the customer can interrupt the process. At maturity date, the smart contract will release the initial funds and the accrued interests.

3. Extending services: The smart account being tied to a blockchain, the bank could easily extend the area of services provided, including decentralized finance and staking. While this is not the purpose of this paper, those services could provide consumers with additional revenue streams, as well as the bank. There are hundreds of solutions already in place which can be plugged easily to a blockchain based Smart Account.

The same way, smart lending and borrowing could be offered next to the smart account, secured by the smart contract and under the control of the client. The Smart Account deposits could be used by the bank to lend to businesses, under conditions set by the customer on a smart contract. For example, a customer could agree to have 10% of their deposit used for supporting the development of small businesses in their city.

As described above the Smart Account is a solution that could bring more transparency, security and control to the customers, deciding how the funds are being held and managed by the banker. We see also a lot of potential bridging this solution with decentralized finance, lending and borrowing, products and services which are already available on the market.

There are two major drawbacks. One being the regulatory uncertainty on the treatment of this solution from a regulatory standepoint, as well as the centralization of the solution, which at the end allows the banks to “interfere” with the data and transactions related to the Smart Account. While the second one is easy to solve by deploying on a decentralized blockchain, the first one if more problematic as banks are usually reluctant to issue and develop products in an uncertain environment.

« From A Bank Run to the Rise of Smart Accounts » is an essay that explores solutions to the trust and confidence crisis faced by traditional banks using blockchain and its technologies. The use of Smart Accounts could provide several benefits, including increased security, full transparency, better control and management, automation in banking processes, reduction of operational costs and administrative frictions, and new revenue streams.

However, this solution is far from being fully implemented, and there are many questions that need to be answered before it can become a solid alternative to regulated bank accounts. Nevertheless, given the unlimited potential for evolution and creativity of blockchain specialists, we can trust that this solution will find its way.

Un projet ? Une problématique ?

This article is intended for informational purposes only and should not be considered as professional or legal advice. The information contained in this report is based on publicly available sources and our own analysis, which may not be exhaustive or accurate. Any reliance on the information provided in this report is solely at the reader’s own risk. The authors of this report do not guarantee the accuracy, completeness, timeliness, reliability, suitability, or availability of the information presented. The report is not meant to endorse or promote any particular product or service, and any references to specific products, services, or companies should not be interpreted as an endorsement. The authors of this report disclaim any liability for any direct, indirect, incidental, consequential, or punitive damages arising out of or in connection with the use or reliance on any information contained in this report. The reader should conduct their own research and consult with a professional before making any financial or investment decisions.

Hassan El Bakkali, Directeur Associé chez Ceres Advisory