Bitcoin has already changed the face of the financial sector, as an increasing number of corporations and funds adopt it as ‘digital gold’ in the face of Covid-induced money printing. But the blockchain technology on which Bitcoin is based has far more to offer than the infrastructure for a hedge against inflation.
The fast-growing Decentralised Finance (DeFi) movement proves that the financial sector is ready for disruption, and blockchain’s innate features offer a series of advantages over the current Traditional Finance (TradFi) system:
- Open: anyone can use public blockchains like Bitcoin and Ethereum
- Transparent: anyone can view the contents of a public ledger
- Secure: blockchains are protected by strong cryptography and are resistant to hacking
- Immutable: once data is recorded on the blockchain, it cannot be altered or deleted
- Efficient: without middlemen, there are no unnecessary fees or friction
Together, these features offer the opportunity to rebuild the financial system using decentralised technologies. While the existing infrastructure is unlikely to be fully replaced, it is already being supplemented and enhanced by the integration of blockchain-based applications and processes, powered by trustless smart contracts. A merging of the two systems is occurring, providing greater choice for consumers by enabling them to access functionality that was previously either impossible, or the preserve of the very wealthy.
Here are five ways that blockchain is already starting to change the financial sector and how individuals and corporations engage with financial services.
CBDCs: The Official Face of Crypto
There’s been a lot of interest in Central Bank Digital Currencies (CBDCs) over the past few years, and that has only become more intense as crypto has soared in popularity over the last year. Governments and central banks are seeing intense demand for a form of currency they don’t control, recognising the benefits of blockchain technology, and seeking to launch their own versions of “digital fiat”.
CBDCs won’t be cryptocurrencies as we understand them. They won’t be decentralised, for instance – no central bank would be prepared to give up control of their currency. They will likely exist on permissioned ledgers, maintained by a handful of trusted parties, rather than open blockchains like Bitcoin and Ethereum. But they do mark a dramatic shift in the nature of money, and may offer additional advantages to users.
One reason for this is that CBDCs are ‘Positive Money’, or money that is not backed by debt. Most money is effectively lent into existence by commercial banks. When someone takes out a mortgage for $100,000, the bank simply credits the customer with newly-created money, balanced by the debt they take on. While credit and debit appear to cancel out, the interest payments mean the customer repays more than they borrow. In other words, the nature of current money means value flows from the real economy into the financial sector.
CBDCs are central bank money, which is not mirrored by debt – and therefore could help create a fairer, more sustainable economy that is not prone to the booms and busts of a debt-based monetary system that is highly sensitive to interest rate changes.
Against this benefit, there is scope for money to become a tool of surveillance and financial control. China, which is pioneering a digital renminbi, already has a social credit system to help keep its population in line. It’s only a small step to use the real-time auditability of a CBDO to limit financial freedom for those deemed to be a threat to society.
A More Transparent, Stable Financial System
Aside from the benefits of so-called positive money, blockchain offers the opportunity to create a more stable financial system through the transparency of assets held on the ledger.
Perhaps one of the best illustrations of this is provided by the Credit Crunch that preceded the 2008 Global Financial Crisis – the effects of which are still being felt over a decade later. One of the immediate causes of the Crunch was the Collateralised Debt Obligations (CDOs) held by major investment banks. CDOs are complex derivatives backed by revenue-generating assets – mostly mortgages in this case. Large numbers of mortgages were bundled together and traded as CDOs. However, the quality of these packages of mortgages was unclear; when the sub-prime mortgage crisis hit and borrowers started to default, banks realised they were holding an unknown quantity of bad debt. They became unwilling to lend to other institutions because they had no way of knowing the state of their own balance sheets.
The complexity of CDOs is often blamed for the Financial Crisis. More accurately, though, it was not the complexity but their opacity. Holders of these CDOs could not see inside them well enough to gauge their value.
A transparent, blockchain-based system would have allowed real-time assessment of the quality of each and every mortgage within CDOs, enabling the market to accurately price each one, and for institutions to know exactly what their losses were. More likely, had CDOs been more transparent, the Financial Crisis might never have occurred in the first place.
Tokenising Everything for Greater Interconnectedness
Blockchain-based assets are easily transferable, which means they are easily tradeable, too. Any asset can be tokenised on the blockchain, and then bought and sold on global marketplaces.
This has a number of benefits. Stocks, for example, can be traded efficiently. Anyone can buy and sell fractions of shares, bonds and market indices, without paying the $15-20 flat fee charged by brokers (or having their data sold to hedge funds, as is the case with Robinhood). Investors can access any market, rather than being limited to their own country or region, as is often the case.
Tokenisation also enables users to put any asset on the blockchain, including unique assets like real estate, vehicles, paintings, diamonds, and just about anything else. Assets that are currently hard to monetise, like insurance policies or receivables (cash due to a company for products or services already delivered, but that has not yet been paid), can likewise be tokenised. NFTs are the perfect use case for this.
Once tokenised, those assets can be integrated with DeFi services and used as collateral, so holders can borrow money against them, then allocating the funds across a balanced portfolio of assets. All of this points to a tremendous amount of liquidity, currently locked in assets that are hard to trade, being made available to holders and the wider economy.
Effective Fraud Prevention
The transparency and immutability of the blockchain means it has great potential for reducing fraud. Consider the case of Bitcoin, ‘digital gold’, versus its real-world analogue. Testing the purity and value of gold is a specialist process, and it’s impossible to do without having physical possession of the bullion – making buying gold a trust-based process (particularly on the secondary market, which is full of unscrupulous dealers). Bitcoin, on the other hand, is instantly verifiable and of cryptographically-guaranteed ‘purity’ – the network won’t accept a fraudulent transaction.
This advantage, and the traceability of transactions, can be extended to other assets, and major industries are already experimenting with Proof of Provenance on the blockchain for everything from diamonds to seafood.
What’s more, the transparency of the blockchain makes tracking money laundering and illegal purchases easier than in the opaque and complex TradFi system. It is extremely difficult, for example, to trace physical cash linked to a drug deal. Not so with crypto, where the movement of coins can be followed through the blockchain and ultimately often linked to a real-world identity.
Frictionless International Commerce
Blockchains don’t care about borders or nationalities. They are as global as the internet. It’s as fast, cheap and easy to send BTC to a business on the other side of the world as it is to tip a friend sitting next to you. Transactions are effectively instant, and clear fully and permanently in minutes.
A global, borderless currency opens up huge opportunities. It makes e-commerce easier by reducing payment processor fees, chargebacks, and currency conversion costs. It allows citizens in countries facing high inflation and currency debasement to access a secure store of value – just like DAI is used in Argentina. It allows anyone to access freelance work in the gig economy through platforms like LaborX, without even needing a bank account.
In short, a common currency could allow the global economy to function as a near-seamless whole, rather than existing as a set of siloed sub-economies linked by outdated and inefficient banking processes.
Blockchain: A Composable Digital Economic Infrastructure
The interconnectedness of the blockchain economy will go far beyond the use of a common currency. DeFi has proven the value of composability: the way different decentralised protocols and applications can be copied and combined, snapping them together like Lego to create new functionality. Composability has driven the rapid expansion of the DeFi sector, and given rise to completely new use cases that never existed in TradFi. For the same reason, it’s highly likely that some of the most exciting and valuable applications of blockchain technology are yet to be developed.