15 November 2018

How Blockchain Will Impact the Financial Sector

This article has been produced in collaboration with Knowledge@Wharton.

Blockchain / distributed ledger technologies are expected to have a transformative impact on the financial sector. Experts discuss what this means for industry players and end-users.

Cryptocurrencies and the underlying blockchain / distributed ledger technologies (DLT) are being touted as the next-big-thing after the Internet. They are expected to change the world as we know it, across industries. Experts say that one area where these technologies are likely to have the maximum impact is the financial sector. Many well-established financial operations, they note, could be completely transformed and restructured. There will be improved transparency and auditability of business practices, as well as lowering of transaction costs. Further, these technologies hold the promise of a new native digital asset class with massive potential liquidity. So what does this mean for the various players in the sector and the end users?

“Blockchains have the potential to displace any business activity built on transactions occurring on traditional corporate databases, which is what underlies nearly every financial service function. Any financial operation that has low transparency and limited traceability is vulnerable to disruption by blockchain applications. DLT is therefore both a great opportunity and also a disruptive threat,” says Bruce Weber, dean of Lerner College and professor of business administration at the University of Delaware, and Andrew Novocin, professor of electrical and computer engineer at the University of Delaware. Earlier this year, Weber, Novocin, and graduate student Jonathan Wood conducted a literature review on cryptocurrencies and DLT for the SWIFT Institute. Based on this literature review, the SWIFT institute has recently issued a grant to conduct new research on DLT and cryptocurrencies in the financial sector.

Weber and Novocin note that just as disruptors like Amazon, Google, Facebook, and Uber built software platforms and thriving businesses thanks to the connectivity provided by Internet standards, next-generation start-ups will build new services and businesses operating with blockchains. “Many pundits expect blockchain, as a distributed technology, to become the foundation for new services and applications that have completely different rules from those running on hierarchical and controlled databases. Cryptocurrencies are an early example but many others will follow,” they add.

Kartik Hosanagar, Wharton professor of operations, information and decisions, points out that the financial services sector is full of intermediaries, like banks for instance, who help create trust among transacting parties like lenders and borrowers. Blockchain, he says, is a mechanism to create trust without centralized intermediaries. “The power of eliminating intermediaries is the ability to lower transaction costs and take back control from powerful financial intermediaries.” Regarding cryptocurrencies, he point out that most of the value today is tied to speculative buying rather than actual use cases. The long-term value, Hosanagar says, lies in lower transaction fees. Also, having a currency without a central minting authority offers “certain unique kinds of protections especially in countries with troubled central banks.” For example, Venezuela’s currency is rapidly losing value due in part to actions taken by the central bank. For people who stored their savings in crypto, there was greater protection to such rapid currency devaluation. “Of course, cryptocurrencies have their own instabilities but they aren’t tied to actions by central banks and that’s particularly relevant in countries and economies where citizens don’t trust their governments and central banks,” says Hosanagar.

Hosanagar expects the first wave of applications to be rolled out in “private” blockchains where a bank and its partners are the only ones with the permission to participate (and not in the open, permissionless blockchains in which any individual can join as a node.) These applications in the private blockchains, he says, will be more secure and will offer some of the benefits of decentralized ledgers but will not be radically different from the way things work at present. However, over time, he expects another interesting area to pick up: the ability to roll out smart contracts offered on public blockchain networks like Ethereum. He explains: smart contracts allow one to run sophisticated logic/code in a decentralized manner and not just store currencies. An application of this is the creation of tokenized securities like stocks/bonds/assets that are stored and managed on a blockchain. “When securities are traded, intermediaries provide trust and charge commissions. Blockchains can help provide such trust in a low-cost manner. But trade of securities is governed by securities laws. Smart contracts offer a way to ensure compliance with the laws. They have great potential because of their ability to reduce costs while being compliant,” says Hosanagar.

According to Weber and Novocin, one area “ripe for transformation,” is reaching consensus on important benchmark prices or rates. At present, they point out, different proprietary indexes are used to determine interest rates and the price of many mainstream assets. Blockchain can transform this. “Think of the London Interbank Offered Rate (LIBOR) and the recent scandals involving manipulation of benchmark values when they are controlled by a single entity that may not be capable of detecting false or fraudulent data. Blockchain could provide greater transparency around the process of creating agreed upon reference prices, and allow more people to participate in the consensus process.”

Weber and Novocin expect that in some areas intermediaries will find their roles reduced as blockchain allows for automation through greater transparency and traceability. In other areas, intermediaries will find themselves well placed to take advantage of shifting needs of their clients, as firms will need help to manage the shift to new standards as well as the greater complexity of open and traceable blockchain infrastructure. Intermediaries in potentially disrupt-able areas, they say, “should get involved with projects seeking to set the standards, so that they can stay informed and position themselves to profit from becoming the leaders in the operations of the new markets that will emerge.”

Kevin Werbach, Wharton professor of legal studies and business ethics, and author of a recent book The Blockchain and the New Architecture of Trust, suggests that it’s usually not helpful to focus on what aspects of a major existing market will be “transformed” or “disrupted” by new technologies. Important technologies, he says, are far more likely to be integrated into the system than replace it. According to Werbach, while some firms will fail to make the transition and some new ones will take hold, “over the long-run, virtually every historic innovation that eliminated some forms of intermediation also created new forms.” Blockchain, he says, will reduce the massive duplication of information that creates delays, conflicts, and confusion in many aspects of financial services. For example, when a syndicate of lenders participates in a loan, having one shared ledger means they don’t all need to keep track of it independently. International payments and corporate stock records are other examples where there is huge inefficiency due to duplicate record-keeping and intermediaries.?”End users won’t see the changes in the deep plumbing of financial services, but it will allow new services providers to emerge and new products to be offered,” says Werbach.

Bumps Along the Way

Angela Walch, professor of law at St. Mary’s University School of Law in San Antonio, Texas, and a research fellow at the Centre for Blockchain Technologies at University College London, offers another perspective. She points out that there is a lot of excitement about DLT/blockchain in the financial sector because many believe that the technology offers a better, more efficient, more resilient form of recordkeeping. However, making use of DLT/blockchain is not as simple as just buying new software and running it. “Blockchain technology is, at core, group recordkeeping. To reap its full benefits, one needs all the relevant members of the group to join the system. This requires collaboration with and across businesses, which is a potentially big hurdle,?and may be the hurdle that most limits adoption.”

Governance is the biggest challenge in decentralized organizations, say Weber and Novocin. Members participating in a blockchain-supported financial function may have misaligned incentives, and can end up in gridlock, or with a chaotic outcome. They cite the example of the ‘DAO Hack’, which was the first prominent smart contract project on the Ethereum network to suffer a large loss of funds. The Ethereum community voted to conduct a hard fork (a radical change to the protocol that makes previously invalid blocks/transactions valid or vice-versa) reversing the transactions after the hack and essentially refunding the DAO investors. This was in effect a breach of Ethereum’s immutability – i.e. transactions once recorded cannot be deleted or altered – and it left a sizeable minority of the community bitterly dissatisfied. This group viewed the Ethereum community as forsaking its commitment to immutable, permanent records. They refused to acknowledge the hard fork, and maintained the original Ethereum blockchain, now known as Ethereum Classic (whereas the forked version supported by the Ethereum Foundation is simply Ethereum).

“Distributed organizations serving an open community need to take care to design their governance systems, incentive structures, and decision-making processes to create consensus without unduly slowing down the decision making,” say Weber and Novocin, adding: “Scenario planning or war gaming are worth exploring at the beginning of blockchain projects. Forward planning enables organizations to swiftly respond in a predictable way that is supportive of stakeholders. Publicizing?these plans in advance can also build trust and user confidence.”

Werbach lists a variety of risks and vulnerabilities related to cryptocurrencies: Bitcoin has shown that the fundamental security of its proof-of-work system is sound, but it has major limitations such as limited scalability, massive energy usage, and concentration of mining pools. There has been massive theft of cryptocurrency from the centralized intermediaries that most people use to hold it, and massive fraud by promoters of initial coin offerings and other schemes. Manipulation is widespread on lightly-regulated cryptocurrency exchanges. For example, roughly half of Bitcoin transactions are with Tether, a “stablecoin” that claims to be backed by U.S. dollars but has never been audited and is involved in highly suspicious behavior. Money laundering and other criminal activity is a serious problem if transactions do not require some check of real-world identities.?”There are major efforts to address all of these risks and vulnerabilities. Some are technical, some are business opportunities, and some are regulatory questions. There must be recognition among cryptocurrency proponents that maturation of the industry will require cooperation in many cases with incumbents and regulators,”?says Werbach.

Hosanagar cautions that while decentralization offers significant value and for a transaction to be treated as valid, a significant number of miners/validators must verify the transaction, it is still susceptible to collusion. If one or few companies running lots of miners/validators in a small network collude, they can affect the sanctity of the network. The big risk with cryptocurrencies, he adds, is that most activity as of today is ultimately tied to speculation. It’s important, he says, for cryptocurrencies to discover a “killer app soon so there is some underlying value created beyond speculation of its future value.”

The Way Ahead?

Given all these challenges, what is the current mindset in the financial sector towards adopting these new technologies? And, importantly, should one push for wide acceptance and deployment or is there need for them to stabilize first?