Harnessing Blockchain for Fintech
Blockchain is significantly impacting the fintech industry, which requires financial services incumbents and new solution providers to be thinking about how to harness the power of blockchain, both in terms of rearchitecting financial infrastructure and creating new sources of revenue and client engagement. We would also note that many other industries are beginning to enjoy these benefits as well, either as a byproduct of their use of the financial system or from an operational efficiency perspective.
The Early Innings
Over the past decade fintech innovation has been evolving at an accelerating pace, including the use of blockchain despite initial doubt and pushback from traditional finance incumbents, i.e., TradFi, across several topics including concerns about the lack of regulation, that decentralization of certain processes was untenable, etc. But from the beginning, at its very core, blockchain and distributed ledger technology offers tremendous opportunity for TradFi players. Now we see more and more institutions and enterprises starting to concede that cryptography, blockchain and distributed ledger technology present significant efficiency gains and potential new revenue sources for their businesses. Many TradFi incumbents are thinking about the much larger digital asset and business process change opportunity, yet many others are still ignoring or sowing doubt about these opportunities.
In one example, a recent report from Bain & Company estimates that tokenization in the issuance, secondary markets, and asset administration could save three-to-five basis points (bps), or 15-20% of total fund support costs.1 Of particular interest is private markets and while three-to-five bps may not sound like a lot, when one considers that global private equity and venture capital, global private debt and global private real estate total ~$473 trillion the cost savings are significant.
Moving Past the Noise
As with any emerging technology there is a lot of “noise.” Most of the negative news at the time of this writing relates largely to the regulatory challenges in the U.S. including Securities & Exchange Commission (SEC) lawsuits against various players such as Binance & Coinbase, uncertainty regarding the role of the SEC vs. Commodity Futures Trading Commission (CFTC), and Congressional legislation being introduced that is likely to make headlines but has little-to-no chance of passage in the near future (although the authors would note that these first passes at legislation will have an impact in terms of the path forward toward later legislation).
On the positive side, Ripple’s partial favorable verdict in their lawsuit with the SEC regarding the XRP token as a security versus a currency has provided some early legal clarity for digital assets, major players like Blackrock are making renewed attempts at getting approval for a Bitcoin ETF in the U.S., and regulatory engagement around the globe is increasing which will ultimately support growth in the space.
Filtering out the “noise” we find that a larger signal trend is emerging that isn’t as pronounced (and maybe that’s on purpose); namely, financial institutions have already begun the process of implementing blockchain solutions into ongoing operations or completely rearchitecting business functions from first principles.
Institutional Adoption Is Early but Not Insignificant
While some would argue blockchain projects have yet to yield large benefits for banks, blockchain technology is beginning to open doors for new revenue streams and increased efficiencies such as:
- JPMorgan has used its proprietary JPM Coin for settling over $300 billion2 worth of transactions since the system was launched. Given these results, the company recently announced euro-denominated payments for corporate clients using JPM Coin. This effort shows digital assets can be a differentiator providing an option for faster, more efficient settlements while also gaining institutional knowledge in the process.
- The Canton Network was launched as the industry’s first privacy-enabled blockchain network for institutional assets. The stated goal of the Canton Network is to create a decentralized blockchain infrastructure that will connect currently siloed systems in financial markets without sacrificing privacy, scalability and the ability for institutions to create and customize bespoke subnetworks. This initiative is being led by 30 notable institutions in financial services including BNP Paribas, Deutsche Borse, and Goldman Sachs.3
- Fidelity’s entry into the digital asset space beginning with an incubator in 2015 led to the creation of Fidelity Digital Asset Services, LLC which provides clients a cryptocurrency trading platform and custody solution as well as asset management products offering exposure to the space.
As adoption goes more mainstream, look for others to offer similar products and services. In the future we are likely to witness TradFi use the technology to create other products and services in such areas as natively digital financial products with smart contract automation, blockchain-enabled insurance solutions, etc.
Tokenization of Real-World Assets (RWAs)
The ability to represent real-world assets on a blockchain has long been idealized as the inevitable next step in innovation. Expected benefits include increased trading velocity of illiquid assets, the ability to fractionalize ownership and reduced administrative costs. However, while many have tried to achieve migrating RWAs to the blockchain, the failure rate in achieving this goal remains high. A primary source of this failure is often the inability to legally bind the physical with its digital counterpart(s), which ultimately is caused by variations in regulatory requirements across countries, inherent reliance on centralized parties, challenges related to fraud detection and prevention, and a lack of data standards to have a system that could support different types of assets.
Businesses are looking for solutions to resolve these challenges by creating tokens that offer the benefits of tokenization while still meeting regulatory compliance obligations. A recent example is the ERC-3643 token, formerly known as the T-Rex Protocol. The initiative is focused on a permissioned token standard for real world assets that includes smart contracting language to manage and ensure regulatory compliance of the underlying asset. While it remains to be seen if ERC-3643 will rise to become the standard, this development is significant in many ways:
- The ability to tokenize an asset in a truly digitally native format may be realized as the underlying asset and the regulatory rules of how and where the asset can trade are automatically enforced.
- The immediate benefit is likely to be better and more efficient regulatory compliance and reporting.
- Since control of asset trading is automated, transactions can happen more quickly increasing efficiency and perhaps removing intermediaries that serve as verification agents (although we do note the potential for some verification agents to become validators as part of the business model if warranted).
While blockchain has been at the center of a frothy hype cycle, it is finally starting to deliver on some of its promises. Institutional adoption is underway, with the hope for increased efficiency and new revenue streams. And while many financial services incumbents will take a “wait and see” approach until more regulatory clarity has been created, as standards for on-chain data become more robust, and ecosystems become more mature, they do so at the risk of not being prepared for the fundamental shifts that are certain to impact the industry in both positive and negative ways.
Whether they know it or not, these institutions are going to need the technical and functional capabilities to be able to operate in what is likely to be an environment that evolves at an increasingly rapid pace. There are many avenues available to institutions for participation from direct experimentation, solution building, to contributing to thought leading industry associations such as the The Wall Street Blockchain Alliance - WSBA or the Alternative Investment Management Association (AIMA).
No matter the choice, being involved in some fashion is important for future growth and industry relevance. And to ignore this innovation is akin to refusing to adopt the internet and e-commerce 20 years ago.
3For a full list please visit: www.canton.network
Catalyst - Our Current Issue: Q3 2023
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