The Impacts of Blockchain Technology on Finance

During the financial crisis of 2008, Satoshi Nakamoto released his groundbreaking paper, Bitcoin: A Peer-to-Peer Electronic Cash System. Although it's still widely debated, some believe Nakamoto released his paper in response to the crisis while others believe it was purely coincidental. Although Nakamoto’s innovation was only recognized a decade later, Bitcoin has since become a mainstream currency and financial asset, despite resistance from traditional financial institutions. This digital asset class uses blockchain technology; a distributed, unchangeable, and decentralized ledger that records transactions as encrypted blocks linked by permanent chains across a peer-to-peer network. Blockchain has unparalleled potential to completely change the way society understands money, by increasing transaction transparency, reducing costs of transactions, and creating a more efficient system. 

With the help of blockchain technology, a new form of finance has emerged called Decentralized Finance (DeFi). DeFi disrupts the financial structure that allows centralized organizations to take large fees. It eliminates the “cost of trust,” which protects against criminal activity by establishing a distributed consensus of potentially malicious computers to agree on a ledger transaction history. Further, with DeFi, the risk is no longer concentrated in a centralized institution (a major concern stemming from the 2008 crisis). In addition to decentralizing risk, the blockchain ledger can help to reduce transaction costs. This has the potential to level the playing field, especially in regions of the world lacking financial inclusion, thus opening access to those without the means. Moreover, blockchain’s flexibility has the potential to create entirely new forms of financial services.

The Ethereum blockchain, launched in 2014, goes beyond simply recording transactions by incorporating smart contracts that can be automatically executed on decentralized apps (dApps) within the blockchain. The cryptographic terms “proof of work” and “proof of stake” are increasingly used in the context of finance and accounting because they are mechanisms by which transactions are validated, added to the blockchain, and tokens are created. Based on the Geneva Reports on the World Economy 21, important verticals within the finance sector impacted by DeFi include payments, digital identity, primary securities issuance, securities clearing, derivatives clearing, post-trade reporting, and trade finance.

As mentioned, the transaction speed, costs, and risk involved in payments decrease dramatically after applying blockchain due to its decentralized and transparent nature. For instance, financial institutions independently collect digital identities to verify payments, thus creating duplications among these institutions. A Know Your Customer (KYC) blockchain can be created using Distributed Ledger Technology (DLT), which would allow information to be shared among participating banks in a distributed network, as has been achieved in Singapore. A common ledger would streamline primary securities issuances. Furthermore, blockchain could solve the siloed information reconciliation between loan documents issued, which demands vast resources. Instead, institutions would have a shared record-keeping system that would be updated in real-time. Securities transactions, which take nanoseconds, have a clearing and settlement process that can take days or even weeks. A shared ledger, which has already been adopted by the Australian Stock Exchange (ASX), would allow the process to be completed in real-time. Further, post-trade derivatives transaction processes (being more complex than securities transactions) can take weeks or even years to execute. Contractual clauses involved in derivative transactions can be coded into smart contracts on the blockchain, which would enable automatic execution. The Depository Trust & Clearing Corporation (DTCC), has been working on such a process with IBM. Post-trade regulatory reporting would be streamlined due to the auditable track of transactions created by distributed ledgers. Standard Chartered’s Hong Kong DLT Trade Finance Working Group has already developed a proof of concept (POC) in collaboration with Bank of East Asia, Bank of China, HSBC, Hang Seng Bank, and Deloitte Touche Tohmatsu.

Blockchain can change the way firms are structured and the way they operate. Private Equity (PE), Venture Capital (VC), and Hedge Funds (HF) can achieve considerable gains by creating more efficient and less costly workflows using blockchain tech. PE firms, for example, rely on high net-worth individuals and entities for capital. These entities want security, transparency, and liquidity, all of which can be more easily provided by a blockchain node compared to traditional methods, which could serve to attract more investors. Since blockchain allows for a more efficient distribution of information, relevant participants in the PE fund can gain access to the firm's blockchain network via a personal node, which allows them to be notified of any updates made by fund managers or regulators. Furthermore, since the distributed blockchain ledger is immutable, changes to the network would be recorded and time-stamped, which increases transparency between PE firms and investors, in addition to decreasing the risk of hacking and fraudulent activity. Despite blockchain’s potential, regulators have pushed back against its implementation. However, blockchain’s ledger immutability streamlines regulators’ ability to perform daily tasks as well, thus allowing regulators to cut costs and increase efficiency. 

This technology has had a slow adoption process by PE and VC firms, mainly due to its novelty. That being said, one of the pioneers of blockchain implementation in PE has been Northern Trust.  Chicago-based financial services firm, in collaboration with Broadridge Financial Solutions, began using blockchain technology in their private equity arm in 2017.  As stated by Northern Trust, “PE firms can manage, communicate and engage with investors with greater efficiency. It enhances capital and cash flow management (capital calls, investments, divestments, and distributions) and automates the middle office functions for PE.” Traditionally, Private Equity firms use manual processes, such as signing and reviewing Limited Partnership Agreements, fundraising, and compliance. Northern Trust hopes to leverage its blockchain technology service while also providing strong personal and administrative support to its PE clients. Northern Trust has four US patents and is continuing to work on evolving its blockchain capabilities, most interestingly by adding an automated capital call process, live audit of the PE lifecycle, and leveraging smart contracts to replace document-heavy legal agreements. 

One of the key drawbacks for investors is a lack of liquidity in their investments. For example, current VC funds are structured to tie up investor capital for up to 10 years. Investors who want to liquidate early often pay large liquidity fees. PE firms, VC firms, and hedge funds have started to raise money through Security Tokens, a digital method to represent equity, voting rights, and revenue distribution in a company. Tokenized funds can reduce the cost of illiquidity, which can entail a discount of up to 20-30 percent, by creating a more liquid secondary market. From a company perspective, tokens can increase the amount of capital available through a crowdsourced method of fundraising, which is essentially a method of democratization. As a result, many believe that VC funds will transition away from the current series funding model. Unlike an Initial Coin Offering, which is unregulated and falls in a legal grey area, Security Token Offers (STOs) are classified as “securities” by the Securities and Exchange Commission (SEC) and thus benefit from increased reliability. 

Although financial services firms are participating in a joint effort to adopt efficient blockchain-based methods that would streamline their processes, there is still considerable space for the implementation and evolution of these methods. Given the ever-changing nature of the finance industry and the use of blockchain as a catalyst, regulators always have to adjust and create laws that would make the DeFi industry safer. However, the pace at which the industry is growing and innovating is greater than that of the regulator's ability to implement regulations, which slows the implementation of DeFi in the Finance industry. In order for DeFi to reach its maximum potential, it will require collaboration between innovators and regulators as well as increased adoption and open-mindedness from industry leaders. It is likely that as DeFi becomes more established in the financial services industry, it will force regulators to catch up and adapt and incentivize other firms to follow suit or risk being driven out of the market.