Money transfer is one of the core competencies of traditional banks, usually between parties via bank-to-bank transfers. Of course transferring and receiving money is not the only service banks perform but it is at the core of the bank’s reason for being since most other services depend or are connected to the fact that banks can move money from point A to point B.
In the old days before computers or telegraphs banks had to transfer money physically between them. They did create notes (essentially IOUs) which could be exchanged on a short-term basis but eventually a physical transfer of funds was necessary. Since gold was the currency du jour this transfer took the form of horseman loaded up with saddle bags of gold or an armored stage-coach escorted by armed people.
Banks kept track of who owned what money in a ledger. Of course these ledgers were tied to the local bank so you had to physically go to that bank to know what money was where and owned by whom. This type of localized “ledgering” made it a challenge to prevent fraud from occurring.
With the invention of the telegraph money could be “wired”. With these wire transfers money stayed in the bank. What was wired was the details of the ledger changes (what amount of money was taken from A and given to B).
Two of the major ways bank-to-bank money transfers occur today are through the Automated Clearing House (ACH) electronic network and by wire transfer.
Automated Clearing House Transfer
“Automated Clearing House (ACH) is an electronic network for financial transactions in the United States. ACH processes large volumes of credit and debit transactions in batches. ACH credit transfers include direct deposit, payroll and vendor payments. ACH direct debit transfers include consumer payments on insurance premiums, mortgage loans, and other kinds of bills. Debit transfers also include new applications such as the point-of-purchase (POP) check conversion pilot program sponsored by the National Automated Clearing House Association (NACHA). Both the government and the commercial sectors use ACH payments. Businesses increasingly use ACH online to have customers pay, rather than via credit or debit cards”.[1]
ACH transfers are a centralized process as all financial transactions have to go through the ACH. For example, suppose several customers deposit checks into Bank A:
- Customers deposits checks into Bank A
- Bank A enters the deposits in its ledger as pending transactions
- Bank A aggregates the customer transactions into batches
- The “batched” transactions are transmitted electronically at regular predetermined intervals over the ACH network
- The ACH Operator receives batches of ACH entries from Bank A. The ACH transactions are sorted and made available by the ACH Operator to Bank B
- Bank B checks to make sure funds are available to payout the checks in the received ACH transactions and updates it’s ledger
- Bank B sends notification to Bank A that the deposited checks have cleared. Bank A changes the associated transactions from the pending state to complete. This notification can take from 1 to 3 days or more from the time Bank A submits the deposited check transactions over the ACH network. This delay is necessary to ensure the integrity of the transaction (i.e., to make sure the money is not spent multiple times).
Wire Transfers
Electronic Funds Transfer (EFT) is the technology used today to “wire” money. On-line banking, direct deposit, and paypal are all examples of EFT. Though EFT is used for both direct wire transfers and ACH transfers, the difference is that straight wire transfers are peer-to-peer while ACH transfers are processed through a central body.
Western Union is one of the biggest operators of wire transfers (online money transfer). Western Union started off as a telegraph company “with the goal of creating one great telegraph system with unified and efficient operations”. With an extensive telegraph network system they were in a great position to be the leader in the wire transfer of money, i.e., the transfer of electronic data documenting the details of the money transaction.
There are three significant problems with the above money transfer processes (ACH and Wire):
- High cost to transfer
- Time to transfer
- Localized bank ledgers which are hidden and can be compromised
Most banks charge a fee to transfer money to another bank and the transfer does not happen instantaneously:
The above table provides some examples of the type of fees which may be charged to transfer money the traditional way.
When banks maintain local ledgers the security of that ledger is totally dependent on the local bank as the ledger can’t be seen by outsiders. One example of this problem is the recent discovery that Wells Fargo bank employees were creating unauthorized accounts for some bank customers.
Blockchain Explained
Blockchain is a decentralized electronic technology which allows for the transfer of secure digital transactions outside the control of banks and the government. This technology is used to transfer a digital currency (crypto-currency) called Bitcoin. Bitcoin is a form of currency which is built on the Blockchain architecture. Since Bitcoin is “currency” it has value relative to other forms of currency and that value varies just like other currencies. For example, as of October 8, 2017 one Bitcoin was worth about $$4,562 US Dollars.
The advantages Blockchain/Bitcoin has over the traditional ways of transferring money are:
- It’s cheap. Whereas you can pay a few dollars for an ACH money transfer and over $20 for a wire transfer, Bitcoin transaction fees can be just a few cents.
- It’s quick. It can take seconds for a Bitcoin transaction to complete but one source states the average confirmation time is 43 minutes. The time can vary based on the transaction fee paid. Currently the amount of this fee is up to the sender.
- It uses decentralized ledgers. The Blockchain technology uses a shared (distributed) public ledger. This means that people do not have to rely on or trust a local bank to keep track of the transactions. The Blockchain ledger is “out in the open” so if a fraudulent transaction is added to one copy of the ledger, other copies will catch it and throw it out.
Rather than use a “trusted” middleman such as a bank or ACH operator to make a transaction, with the Blockchain people can transfer money directly (peer-to-peer) without the need for a bank or other third party.
Here’s how the process works in simplified terms:
- Persons T and Y open Bitcoin accounts with a Bitcoin exchange company. There are a number of these companies in the USA as well as international locations. To open an account they would need to attach it to their traditional bank. Bitcoins are purchased by transferring money from their bank to the Bitcoin exchange company. The amount of Bitcoins received is based on the exchange rate at the time of the transfer
- Person T requests the transfer of one Bitcoin to Person Y. Bitcoin Exchange A validates that Person T has the money in their digital wallet and initiates the transaction
- The transaction is submitted to the network for validation
- The transaction is monitored and validated by a decentralized network of volunteer-run nodes called Miners. There are thousands of these nodes in the Bitcoin network and each one has a copy of the open Blockchain digital ledger. These Miners are incentivized to take part in the network because the Blockchain technology randomly rewards one node with a fixed fee every time a new block is settled and committed to the chain.
- Once a majority of Miners (at least 51%) reaches consensus that all transactions in the recent past are unique they are cryptographically sealed into a block and that block is linked to the previously sealed blocks to create a chain of accepted history which results in a verified record of every transaction.
- Once the transaction is validated notification is sent to Bitcoin Exchange B that One bitcoin is ready to be deposited into Person’s Y digital wallet
- Person Y’s digital wallet is credited and Person T’s digital wallet is debited by the amount of the transaction and all copies of the digital ledger are updated with Persons T and Y new Bitcoin balance.
Blockchain Issues
There are several potential issues with the Blockchain:
- Complexity
- Network Size
- Scalability
- Security
Complexity
Blockchain technology depends upon a complex architecture utilizing cryptography, hashing algorithms and other high-level mathematical techniques; and since it is an unregulated technology there is a chance of system flaws. Thus, for it to grow larger in the future there needs to be some type of government regulation along with an independent regulating body to ensure its integrity.
Network Size
This technology requires a very large network of independent distributed users and nodes to work effectively. So rules and regulations have to be defined to make sure this happens.
Scalability
Transaction costs seem to be increasing as more users enter the system. That is somewhat caused by the increase of transactions in the system. The Blockchain can only process around seven transactions per second as all copies of the digital ledger have to be updated before the transaction is complete. This problem should be minimized to some degree as time goes because of increases in digital network speeds and decreasing costs of cloud storage of the data.
Security
If 51% or more of the Miners on the network agree that a “bad” transaction is “good”, the bad transaction becomes true and it is added to the network as a valid transaction. That’s why it is so important that the implementation of the network is robust and that the number of nodes on the network remains above a critical mass.
The Future
So what’s the conclusion? Will traditional banks go the way of the dinosaur? Well, as Mark Twain once said when a newspaper prematurely reported his death: “The report of my death was an exaggeration.” Traditional banks will be viable for some time, but, if they don’t jump on the bandwagon of some of the new technologies like Blockchain, their future relevance will diminish.
The technological limitations of the Blockchain should be overcome with time:
- Complexity – You don’t have to understand what’s under the hood to drive a car and get around successfully. The same goes for the Blockchain. Consumers will become more and more familiar with executing money transactions utilizing the Blockchain or some similar technology. There will be added levels of regulation of the technology and smart people will make sure transactions keep humming down the road with minimum problems.
- Network Size/Scalability – Technological advances in data storage capacity and network speed have continued to increase at a blistering pace since the days of the U.S. Defense Department’s Advanced Research Projects Agency Network (ARPANET) and the Commodore 64 with its measly 64 kilobytes of Random Access Memory (RAM). The ongoing exponential increase in network speed should allow the Blockchain to process many more transactions per second as time goes on.
- Security – Improved and robust computer/network security has to be a core foundation of any future data network, whether we are talking about the Blockchain or traditional networks. In this area the Blockchain may be a little ahead of ACH and other traditional networks because of the transparency of the Blockchain ledger and checks & balances.
So what can traditional banks do to be a part of the Blockchain revolution?
One thing they can do is to get involved in participating in Blockchain transactions. They would need to manage these transactions in parallel but separate from their traditional transactions to not introduce any more security issues.
The second thing they can do is to work with Blockchain technology companies, Blockchain as a Service companies, and/or Blockchain architecture companies to help make sure the architecture accounts for the unique requirements of the banking industry.
The third thing they can do is to partner with or buy one the Bitcoin Exchange companies. This allows them to bring Blockchain/Bitcoin Subject Matter Experts (SMEs) in-house where that type of knowledge doesn’t current exist inside the bank.
In all the above ways banks can play a role in shaping the future in a way that will be most helpful to their future relevance.
History is littered with companies who were once dominate but went the way of the dinosaur or lost their edge because they didn’t innovate or change with technology (i.e., Prodigy ISP, AOL Instant Messenger, Kmart, etc.). Banks would be wise to not become part of that history.