Blockchain Technology, Digital Assets, and the Future of Finance

Axel Wieandt - September 28, 2021

Tips for practitioners

Blockchains and traditional databases differ significantly in terms of administration, trust, and fault resistance, which gives them advantages and disadvantages depending on their purpose. A traditional database stores data – whether encrypted or not – in rows and columns. It can be modified and controlled by a single user, the so-called administrator, who can optimize its performance and delegate certain roles and permissions to other users. The administrator can recreate the database from a backup if something goes wrong. A traditional database is recursive, meaning that one can always go back and repeat a particular task or record and modify or delete it. The existence of a central administrator constitutes a single point of failure. Even if the database is run in the cloud, the administrator bears responsibility for maintaining data security.

Advantages of blockchain/DLT over traditional databases

In contrast, blockchains store data in cryptographically linked structures called blocks, do not need an administrator, and are permissionless, in the sense that anyone can read or write on it. For example, anyone who has a wallet address can send and receive Bitcoin, and anyone who invests sufficient computing power can run a computing node and participate in the race to “mine” the block and “earn” the mining reward. Critically, blockchains are immutable and transparent, and transactions on a blockchain are non-recursive, meaning they cannot be repeated once validated in a block. Blockchains are highly fault-tolerant because their entire history is kept on many nodes in parallel. Blockchains are also trustless, in that their integrity depends solely on incentives and consensus-mechanisms.

Blockchains have certain drawbacks. First, the mining devices used by miners to solve cryptographic puzzles faster than anyone else also consume a great deal of energy. Second, since block size and timing are fixed, most blockchains are not readily scalable: the bigger, more decentralized, and more secure a blockchain is, the slower and less scalable it becomes. Third, permissionless blockchains need to incentivize node mining with rewards and/or transaction fees. Finally, blockchains are not yet fully interoperable.

When is a blockchain actually better suited than a traditional database or vice versa? Broadly speaking, a traditional database is ideal for data which: needs to be updated continuously, is confidential, requires fast processing, and does not require verification. Blockchains, on the contrary, are ideal for transferring value, implementing smart contracts, and storing procedures with triggers to process transactions.

A functional view of finance – moving the boundaries between markets and organizations

Nobel Prize laureat Robert C. Merton’s functional view of finance pays less attention to financial intermediaries and focuses instead on the core finance functions. Merton identifies six core functions performed by the financial system:

1. payments,
2. pooling of funds,
3. maturity transformation,
4. risk management,
5. coordination of decentralized decision making, and
6. dealing with incentive-based asymmetric-information and incentive problems.

He argues that financial functions are more stable over time and across jurisdictions than institutions, and that competition drives the evolution of institutional structure towards increased efficiency.

Given the importance of finance functions, what potential does blockchain/DLT have to drive change in the structure of financial markets and institutions? Generally, digital identity can be applied broadly to new verticals such as investments and lending. Blockchain/DLT drives simplicity and efficiency by providing a new, foundational technology for next-generation financial services infrastructure with a range of benefits such as trade, settlement and payment processing, on-chain supervision, and transaction monitoring. This infrastructure gives life to radically new processes and rattles the foundational orthodoxies of current business models, such as the need for clearing houses and central counterparties.

A 2016 World Economic Forum industry study on the future of financial infrastructure identifies six value drivers for blockchain:

1. operational simplification,
2. regulatory efficiency improvement,   
3. counterparty risk reduction,
4. clearing and settlement time reduction,
5. liquidity and capital improvement, and
6. fraud minimization.

Similarly, a 2018 CB Insights study identifies areas of finance that could be impacted by blockchain/DLT:

• Payments: By establishing a decentralized ledger for payments, blockchain/DLT could facilitate faster payments at lower fees than banks. These benefits have driven the popularity of stablecoins such as Circle’s USD Coin. J.P. Morgan has even developed its own stablecoin, the JPM Coin, which runs on Quorum, their own public permissionless blockchain.
• Clearing and settlement: Distributed ledgers reduce operational costs and bring us closer to real-time transactions between financial institutions. The Utility Settlement Coin (USC) project, which is known since 2019 as Fnality International and backed by a number of large banks, has the potential to transform cumbersome clearing and settlement processes. It enables Delivery vs. Payment (DvP) in tokenized securities markets and instant settlement on a Payment vs. Payment (PvP) basis in secured funding markets.
• Issuance: Initial Coin Offerings (ICOs) are experimenting with a new model of financing that unbundles access to capital from traditional capital-raising services and firms.
• Securities: By tokenizing traditional securities such as stocks, bonds, and alternative assets — and placing them on public blockchains — blockchain/DLT could create more efficient, interoperable capital markets. Vonovia, the European real estate company, recently issued a 20-million-euro bond on the Stellar blockchain. This occurred after Bitbond, the fintech pioneer, issued the first BAFin-approved debt security on Stellar in 2019. BNY Mellon, a leading custodian, under attack from Coinbase and Anchorage, has recently announced its new crypto-custody-based services.
• Lending: By removing the need for gatekeepers in lending, blockchain/DLT can make it more secure to borrow money and provide lower interest rates. For example, The Maker protocol, a decentralized finance application, allows participants to lend and borrow against crypto-currency collateral.
• Trade Finance: By replacing the cumbersome, paper-heavy bills of landing processes(?) in the trade finance industry, blockchain/DLT can create more globalized transparency, security, and trust among trade parties. In 2017, a number of the largest international banks and a few corporations established the Marco Polo network to launch and develop a distributed, blockchain-powered solution which allows for the seamless and secure transfer of data and assets. It employs the Corda open source blockchain platform developed by R3, another banking consortium.
• KnowYourClient/Anti MoneyLaundering: By storing customer information on decentralized ledgers, blockchain technology can make it easier and safer to share information between financial institutions.

As these examples illustrate, crypto-fintechs and consortia of financial and corporate entities have begun to the explore and exploit the potential economic benefits of blockchain/DLT.

The four phases of blockchain development and financial market transformation

Foundational technologies like blockchain/DLT are adopted in four basic phases, depending on the degree of novelty and the amount of coordination required, as Ianisti and Lakhani already pointed out in 2017:

• In phase 1, blockchain/DLT is adopted in single-use environments, with crypto currencies being sent from one wallet address to another. Crypto-pioneers and their experiments dominate this phase.
• In phase 2, blockchain/DLT is adopted in permissioned networks with known participants. Trade finance and other financial service applications running on R3 Corda, a private enterprise blockchain/DLT software platform connecting a known number of financial institutions and corporates, are recent examples of blockchain/DLT applications in localized, controlled settings. In this phase, the technical challenges of developing and maintaining an open software platform and key issues of enterprise blockchain settings - such as privacy concerns in a coopetition environment are addressed.
• In phase 3, blockchain/DLT empowers new business models on public, permissionless blockchains. The Facebook-led - former Libra - now Diem stablecoin project launched by a consortium of telecommunication, payment, venture capital, and research organizations, could pioneer this phase. Potentially, Diem could facilitate embedded commerce among over 2.5 billion monthly social media users and over 100 million connected merchants, possibly replacing traditional payment channels. In order to succeed where Libra failed, Diem must win the trust of national regulators and decision makers to avoid backlash, such as from the G7 or the Financial Stability Board.
• In phase 4, blockchain/DLT (would) completely transform and decentralize the financial system. Decentralized Finance (DeFi) provides a window into a future in which individuals, organizations, machines, and algorithms transact freely and financial services are fully automated, possibly on multiple interoperable blockchains constituting a resilient infrastructure.

In banking and finance specifically, a 2018 research report by JP Morgan identified four waves of anticipated blockchain/DLT developments in banking/finance. In the first wave, ending in 2019, blockchain were used primarily to communicate data, tested between trusted parties as proof-of concept and in parallel with existing workflows. In the second wave, ending in 2025, market participants are and will continue to incorporate blockchain/DLT solutions to make existing technological solutions more robust and efficient. In the third wave, blockchain/DLT will be integrated into major capital market infrastructure and the tokenization of assets, trading, and settlement on-chain will free up significant amounts of liquidity and capital. The timing of the fourth wave, the full decentralization of the financial system, is uncertain as it requires a legal and regulatory environment that fully supports tokenized asset ownership and transfers directly from issuer to investor and among on-chain counterparts.

In order for blockchain/DLT to truly transform financial markets, greater legal, tax, and regulatory clarity at the national and international level is required. At the G7 level, the Financial Stability Board has devised comprehensive regulations for global stable-coin arrangements such as Diem. The European Union is promoting a comprehensive blockchain agenda and is trying to level the playing field with its latest Markets in Crypto Assets regulation. In the US, the Office of the Comptroller of the Currency has recently paved the way for federal banks to run nodes in blockchain networks. The People´s Bank of China is spear-heading the development of a digital currency. Until legal and regulatory consensus can be achieved internationally, blockchain/DLT-powered financial services will likely co-exist with legacy infrastructure for quite some time.

Literature references

• Tabora, V. (2018): Databases and Blockchains, the difference is in their purpose and design, in: https://hackernoon.com/databases-and-blockchains-the-difference-is-in-their-purpose-and-design-56ba6335778b.
• CertiK (2019): The Blockchain Trilemma: Decentralized, Scalable, and Secure?, in: medium, October 4, 2019, found at: https://medium.com/certik/the-blockchain-trilemma-decentralized-scalable-and-secure-e9d8c41a87b3.
• Merton, Robert C. (1995): Robert C. Merton, 1995: A Functional Perspective of Financial Intermediation, in:  Financial Management, Financial Management Association, vol. 24(2), Summer 1995.
• CB Insights (2018), Research brief: How blockchain could disrupt banking, December 12, 2018, found at: https://www.cbinsights.com/research/blockchain-disrupting-banking/.
• For JPM Coin compare https://www.jpmorgan.com/solutions/cib/news/digital-coin-payments.
• Fnality (2019): Utility Settlement Coin (USC) continues to evolve, Fnality Press Office, June 3, 2019, found at: https://www.fnality.org/news-views/usc-continues-to-evolve.
• Iansiti, Marco, Lakhani, Karim R. (2017): The Truth about Blockchain, January-February 2017, Harvard Business Review, found at: https://hbr.org/2017/01/the-truth-about-blockchain.
• JP Morgan (2018): Decrypting Cryptocurrencies: Technology, Applications and Challenges, in: J.P. Morgan Perspectives, Global Research, February 9, 2018.
• FSB (2020): Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements, October 13, 2020, found at: https://www.fsb.org/2020/10/regulation-supervision-and-oversight-of-global-stablecoin-arrangements/.
• EU COM (2020): Proposal for a Regulation of the European Parliament and the European Councial on Markets in Crypto-assets, September 24, 2020, found at:  https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020PC0593.
• US Office of the Comptroller of the Currency (2021): Federally Chartered Banks and Thrifts May Participate in Independent Node Verification Networks and Use Stableocins for Payment Activities, January 4, 2021, found at: https://www.occ.gov/news-issuances/news-releases/2021/nr-occ-2021-2.html.