Future of Finance


What a Blockchain Economy Will Look Like

A summary of the webinar of 30th September 2021 entitled What a Blockchain Economy Will Look Like

 It is easy to portray blockchain technologies as a study in failure. The original vision of a financial system free of costly and centralised intermediaries has proved harder to realise in practice than the keenest evangelists imagined. Yet the technology has undoubtedly proved seminal. The largest financial institutions have modified the public blockchain into a private permissioned version which is finding multiple applications. Central banks are digitising fiat currencies. Bonds, equities and funds are being tokenised. Digital identity has emerged as the cheap and effective alternative to failing customer due diligence procedures. Law and regulation are changing to accommodate the blockchain revolution. Developers all over the planet are working to eliminate the shortcomings of blockchain technology in speed and scalability. Obstacles to inter-operability between blockchain protocols and between blockchain protocols and traditional marketplaces are being cleared. But nothing signals widespread adoption of blockchain technologies, and their gradual convergence with established ways of doing things more clearly than their growing invisibility behind an array of products, services and apps for consumers and corporates. 

Has the original vision of blockchain proved illusory?

The original vision of the blockchain economy was a trustless transparent financial economy in which centralised and intermediating agents such as governments, corporations, banks and financial market infrastructures would be replaced by leaderless, non-hierarchical, decentralised autonomous organisations (DAOs). Capital would be raised directly from investors by issuers, and all transactions would be priced, invoiced, and settled in non-state currencies.

So far, trustlessness has proved elusive. DAOs developed unstable governance structures and were found to be open to manipulation and even hacking. Cryptocurrency markets have acquired a reputation – whether it is justified or not – for scams and thefts, many of which were inside jobs. Transparency has also proved an obstacle to adoption, particularly by institutions. Most financial institutions and institutional clients of financial institutions, have proved reluctant to share private information. 

This has resulted in a marked preference, in institutional business, for closed networks: private, permissioned blockchains rather than public blockchains on the classic Bitcoin model, in which participants see only what they need to see, rather than all transactions on the blockchain ledger. In addition, as a transaction processing mechanism, blockchain technology has proved slow and hard to scale unless alternatives to the classic Proof of Work model (such as Proof of Stake) are used and transactions are shifted (or, rather “sharded”) off the ledger.

Last but not least, far from replacing state-owned fiat currencies, crypto-currencies such as Bitcoin are not being used for payments at all except in obscure jurisdictions and peculiar pockets of the global economy – indeed, sometimes dark corners, as well as nation-states such as El Salvador. Instead, it looks as if blockchain has inspired the full digitisation of fiat currencies, in the form of the Central Bank Digital Currencies (CBDCs) that dozens of central banks are designing, and some have launched already. 

On the other hand, the original vision of blockchain was no more than a vision: it was not a detailed implementation plan. It is as vulnerable as any financial technology to exploitation by bad actors, and cannot be blamed for their actions. Blockchain technology can also point to significant achievements, especially in payments but increasingly in capital markets. Financial crime associated with blockchain is also declining.

In terms of speed and scalability, the performance of blockchain is also improving, and will continue to improve in the way that digital technologies always have. While classic blockchain protocols such as Bitcoin manage only seven or eight transactions a second, enhanced blockchain technologies using Proof of Stake and “sharding” can support the processing of several thousand transactions per second. Besides, not all markets need throughputs as high as thousands of transactions a second. An added benefit is a reduction in the energy consumption needed to complete the transactions.

The most significant impact of blockchain is a reduction in transaction costs. The benefits of that feed through not just to service providers but to retail consumers and investors, enabling them to spend more on other activities in the same way as any improvement in productivity does. That is how blockchain technology is actually transforming economies.

To what extent is lack of suitable laws and regulations a barrier to adoption of blockchain?

The fact that laws and regulations vary between jurisdictions is a problem for firms operating on a global scale. If there was a degree of convergence between countries on the regulation of blockchain-based  service providers and asset classes, it would help the markets grow. There is an expectation that international regulatory bodies can make this happen, in the same way that the Committee on Payments and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO) promulgated the Principles for Financial Market Infrastructures (PFMIs) and the Financial Action Task Force (FATF) promoted the International Standards on Combating Money Laundering and the Financing of Terrorism and Proliferation.

Yet even in one country law can never keep up with technological innovation. It helps that English law takes the more flexible form of common law, enabling the law to respond to new developments more quickly.  But laws everywhere do eventually catch up and so does regulation (as the much-trumpeted Mpesa payments system in Kenya found, once it achieved noticeable scale). Law catches up because the purpose of law is to make possible what society wants. In the United Kingdom, work on updating the law is in hand. Likewise with regulation, it inevitably lags technological developments, but the regulators in the United Kingdom are responding to pressure from the financial services industry to give a degree of certainty to market participants. 

Most of the start-ups and fast-growing companies that are making use of blockchain technology have a responsible attitude towards regulation, despite the uncertainty. They are mindful of the need to conduct fully compliant Know Your Client (KYC), Anti-Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks before admitting anyone to their network. They also adopt practices, and take out insurance, to protect customer assets from loss. Indeed, private sector insurance is already available to cover the loss of private keys to digital assets and collusion to steal digital assets. 

This combination of responsibility and insurance does not eliminate the risk that a minority of lightly regulated retail financial services firms will enjoy considerable success but lack the material resources and insurance backing of established firms when something goes wrong, leading to loss of investor or consumer assets. If losses of that kind become associated with blockchain, it will undermine the technology. However, the cost savings from automation of operational processes through blockchain networks can be combined with adequate regulation. Deployment of blockchain technologies is not synonymous with deregulation.

Is lack of inter-operability between blockchain protocols a major problem?

Standards are being developed that enable inter-operability between different blockchain protocols. Another solution is to make use of a blockchain agnostic enterprise platform that supports multiple blockchain protocols. This means users can rely on the enterprise platform to provide the adaptors that allow data to flow between the protocols, rather than have to write a fresh adaptor every time data has to be exchanged with a new blockchain protocol.

How can blockchain be made more user-friendly?

At present blockchain is somewhat like the early days of the Internet, in which a great deal of technical skill and knowledge is required to make use of the financial products and services the technology is creating, such as crypto-currencies, Decentralised Finance (DeFi) protocols and Non-Fungible Tokens (NFTs) and the smart contracts which run many of them. 

However, technology companies are already developing tools that enable users to interface with smart contracts via Application Programming Interfaces (APIs) that are familiar to every developer, and to build smart contracts of their own without needing deep experience of blockchain. Blockchain technology will eventually become invisible.

One way to accelerate progress towards invisibility is to combine blockchain with artificial intelligence (AI). Both blockchain networks and AI are data-driven. Blockchain nodes can hold data in encrypted form and make it available to AI machines for analysis without disclosing the full identity of the owners. The scope for using this combination to assemble new products and services, in the manner being pioneered by Open Banking, is immense – and the technology used to produce them will be invisible to the consumer.

Are blockchain-based companies and traditional financial services businesses converging or on a collision course?

Established businesses are pursuing one of three courses. The first group is embracing the technology, either by building it in-house or buying a potential blockchain disruptor. The second group is embracing the technology at one remove by joining consortiums and developing private, permissioned blockchains which abjure the decentralized, permissionless character of classic blockchain and aim instead to preserve existing intermediaries, at least in the short term. The third group are ignoring blockchain altogether and expecting it to fail. 

Just as multiple blockchain protocols are likely to persist, so too is the distinction between public, permissionless blockchains and private, permissioned blockchains. However, in future both retail and corporate consumers of financial services are likely to accept sharing information on public blockchains to fulfil certain functions, while conducting most of their business on private blockchains. In this way, clients of traditional financial institutions will force their service providers to be more flexible.

Is digital identity an example of an unmixed blessing of blockchain?

One solution to the concerns of large corporations about security and financial crime is increased use of digital identities. These have the potential to reduce the enormous costs of KYC, AML, CFT and sanctions screening, but to become universally effective a national framework of standard attributes is necessary so that multiple organisations can manufacture and use them interoperably, rather than producing them in siloes and insisting on bespoke criteria. In the United Kingdom, the Department for Digital, Culture, Media and Sport (DCMS) has published a digital identity trust framework for that purpose.

Does blockchain presage a shift from the centralised “platform” economy typified by Amazon, Facebook and Uber to a decentralised “networked” economy?

The successful businesses of the early decades of the Internet are “platform” companies such as Amazon or Uber, which cut transactions cost by providing a centralised place where buyers and sellers can meet without excessive intermediation. Blockchain offers a decentralised alternative, in which buyers and sellers find each other through networks, or networks of networks. This is the direction of travel set by blockchain – and it could fulfil the original vision of blockchain technology.

Highlights of 30th September Webinar

If you would like more information or we can assist in any way or you would like to pose questions ahead of the discussion please email Wendy Gallagher on wendy.gallagher@futureoffinance.biz