The Impact of Blockchain Technology on Finance: A Catalyst for Change

After completing this reading, you should be able to:

• Describe challenges faced by the blockchain technology in gaining widespread adoption in economic applications.
• Explain and assess questions to consider before implementing a blockchain solution to an economic activity.
• Explain the concept of cost of trust concerning legacy financial systems and blockchain technology.
• Describe the current regulatory concerns about crypto-finance and assess the steps regulators take to address these issues.

Challenges Faced by Blockchain Technology in Gaining Widespread Adoption in Economic Applications

The current market is proliferating. This calls for a faster, efficient, and risk-free means of transacting and making payments within the country as well as making cross-border payments. Blockchain technology is proving to be the best solution for these requirements. However, this technology comes with the following challenges.

Scalability: Blockchain’s blocks of data are stored on nodes. These nodes include computers, laptops, or bigger servers. They store, spread, and preserve the blockchain data. In other words, blockchain exists on nodes. However, given the exponential increase in the number of transactions daily, the blockchain becomes bulky. However, the nodes have to store all transactions for their validation on the blockchain. Bitcoin, for instance, has a restricted blocksize.

Additionally, generating a new block takes time, which means that it can only process ‘few’ transactions per second. In reality, millions of transactions are processed in a second. Moreover, most blockchains are designed in ways that make them complicated and overloaded with attendant delays limiting their transactional capacity.

Privacy and security: In a blockchain, users’ addresses are pseudonymous. Regulators have raised concerns about the pseudonymous nature of blockchain as concealing the actors’ identities. On the one hand, the official sector has goals of public policy financial stability, investor protection customer protection, and guard against illegal activities, tax evasion, as well as terrorism financing in mind. On the contrary, financial institutions worry that the privacy may not be strong enough since the first ledgers were designed to show transparency allowing the participants to view every transaction. Generally, the private sector is more interested in guarding the privacy of their data. Although firms and individuals have genuine reasons to maintain privacy, they may be hiding from government oversight; this creates contradictory tensions.

Concerns about the interoperability of blockchain applications: It would be useful to link blockchains and legacy financial systems. This linkage raises concerns as to who can be trusted to coordinate information and assets transfer into the blockchain as well as across chains.

Blockchain adoption requires a collective action: The blockchain applications can only be useful if there are multiple parties in the network. The current projects that utilize blockchain have been successful since they involve consortia to ensure participation.

There are trade-offs caused by the governance of blockchains: Amending some blockchains software updates require consensus amongst a distributed network. This poses a lack of a controlling entity. The updates are not easily achieved, especially the contentious ones that may have some value at stake. Without full consensus, the updates can lead to a chain split. The splitting results from a software change that is adopted by some participants, posing some incompatibilities with an earlier version that other participants are using. The incompatibility leads to a ‘hard fork’ or a chain split.

Selfish Mining: Some miners can keep their mined blocks private until various requirements are met. By so doing, they create a private branch. The honest miners spent most of the time trading on the public branch, which is regarded as short. Once they reveal their private branch to the public, the honest miners switch to the newly arrived private branch, abandoning the shorter public branch. The selfish miners then collect more revenue with the honest miners realizing that they had wasted their efforts on the short public branch.

Questions to Consider Before Implementing a Blockchain Solution to any Economic Activity

Although blockchain technologies are up-and-coming, they still pose some serious challenges. The firm should answer the following questions before it considers adopting these technologies to critical functions.

What costs linked to trusted intermediaries can be eliminated by using a blockchain or distributed ledger? The firm should assess the extent to which the blockchain or distributed ledger solution leads to lower transaction costs. There is a need to understand how the blockchain or distributed ledger technology can achieve those improvements by understanding how it can mitigate the transaction costs in the organization and its processes. Coase’s theorem of the firm can be applied to blockchain-based applications to assess the relative costs and benefits of operating a financial transaction on a distributed basis versus relying on an intermediary.

What security benefits would result from decentralization? Blockchain or decentralization technology provides a secure and verifiable transfer of value between parties who have no trust for each other, without the use of a mutually trusted third party. However, requiring a decentralized network to process every transaction can create latency and capacity constraints and often consumes a significant amount of resources. The question is, can decentralization support the process without creating latency and capacity constraints?

Which inefficiencies and technical limitations of decentralized systems pose particular challenges for the activity in question? There are several challenges attributed to blockchain or decentralized ledger systems. They have been described above, and they include scaling, security, privacy concerns, among others. It is therefore wise to consider those constraints before deciding on the implementation of a blockchain solution.

Can those constraints be adequately addressed and still preserve some of the benefits of decentralization for this particular use case? Blockchain technology faces several challenges, as previously discussed. However, some of these challenges have been addressed. Capacity constraints often consume resources. Therefore, blockchain technology potentially reduces the costs of trust imposed by reliance on trusted centralized intermediaries. However, this is possible only if those collective costs are more significant than the costs for achieving distributed consensus securely.

Can the benefits obtained from moving a given process to a blockchain be enough to compensate for the switching costs? The firm needs to assess the costs incurred in the centralized ledgers that are not incurred in the decentralized ledgers, for example, the cost of trust. The worthiness of the switch comes in when the cost of trust and all other costs can fund the switching cost and provide further benefits to the firm. Some of the costs of centralized ledgers arise from the need to reconcile transactions between different centrally maintained ledgers. Blockchain technology can reduce reconciliation and other infrastructure costs. However, those benefits must be weighed against various disadvantages. In financial sector applications, some of the challenges include the capacity constraints, the potential lack of privacy, governance constraints, among others. According to Vitalik Buterin, the founder of Ethereum, the existing blockchains cannot achieve scalability without sacrificing either decentralization or security.

The Concept of Cost of Trust Concerning Legacy Financial Systems and Blockchain Technology

Cost of trust is defined as any investment, for example, financial resource, time resource, human resource, among others, that a firm puts in place to ensure that all transactions are done fairly and transparently to the bank and the customer.

The cost of trust includes but not limited to:

1. Cybersecurity
2. Settlement procedures
3. User identification
4. Compliance teams
5. Security guards
6. Antifraud regimes
7. Overcharge to customers

Clients and customers have to trust their money at the firm by depositing, buying insurance, through secondary trading, among others. Trust must also exist in the market place as traders hope that trades are carried out fairly and transparently. Banks and other financial institutions lay their trust in the back-office procedures of reconciliation of the centralized ledgers and accounting systems. However, this is very costly. Some of how the cost of trust affects the day to day business are discussed below:

Cross-border payments: Country-specific regulations have hit international payments. On the other hand, transactions channeled through intermediary banks often take days to complete and come with specific fees. These payment processes are often opaque, leading to pricing uncertainty and an increase in fraud and counterparty risk. Foreign exchange payments rely on Nostro accounts or correspondent banking networks. Nostro accounts are accounts of banks (in their local currencies) at other banks. These layers of intermediation increase costs and introduces operational complexity and counterparty risks. The use of blockchain technologies would reduce these risks and fraud during transactions. Ripple, for example, uses a blockchain-based protocol, and inter ledger protocol, and connects existing bank ledgers to enable near real-time cross-border payments. This kind of payment reduces costs and provides additional pricing transparency by running instant auctions to source FX liquidity at the best price available.

Customer identity: Financial institutions are required to know their customers and beneficial ownership. The firm goes through numerous amounts of data to verify the identity of potential individuals or corporate customers. A cryptography algorithm is being developed for specific blockchains. The zero-knowledge proofs will make it possible to verify customers’ information without accessing them directly. This technology addresses security and privacy concerns related to the blockchain-based identity solutions in addition to saving time.

Primary securities issuance: The currents processes of issuing bonds or loans are highly manual. They involve PDF copies of loan documents with amendments distributed by emails; a central trustee manages cash flows in databases or even spreadsheets. The banks spend ridiculous amounts of money, just reconciling all the siloed information to execute a simple mechanical process. With blockchain technology ways of loan issuance, all parties get to keep a record of the transaction and any updates. Distribution of the cashflows is automated as per the parties’ legal rights by the use of smart contracts.

Securities clearing and settlement: Despite the transactions of securities taking just less than a second, their settlement and clearance may take one to three days, and some types of bonds up to weeks. These delays result from technical or market-structure related reasons. However, blockchain or decentralized systems may significantly reduce these delays to a near-real-time clearance and settlement by the use of a shared ledger. It also reduces some risks like counterparty risk resulting from such delays.

Current Regulatory Concerns Surrounding Crypto-finance and Steps Taken by Regulators to Address these Issues

The rise of technological innovations, including crypto-assets, have significant benefits to the economy. Although crypto-assets are not a threat to global financial stability, they pose risks to investor protection, anti-money laundering, and countering the financing of terrorism. In this section, we discuss the current regulatory concerns surrounding crypto-finance and steps that the regulators have taken to address these issues.

Illicit activity: The pseudonymous nature of blockchain is raising concern to regulators as the identities of the real actors are concealed. Their main aim is to protect the customers, investors, but the regulators are concerned about illicit activities such as tax evaders, terrorism financing, among others. Most countries have established regulations on exchanges regarding guarding against illicit activities. These regulations have been made with the help of money transmission laws or bank secrecy laws concerning anti-money laundering, combatting the financing of terrorism, among others. In Korea, regulators prohibited exchanges from trading for the anonymous accounts. They also started investigating several fraud exchanges and other forms of misconduct. The tax office raided Bithumb and Coinone. UPBit was also raided over suspected fraud in 2018. In the US, several states have acted to bring exchanges within money transmission laws.

Custodial duties: Many exchanges have been hacked in the past leading to the loss of a significant amount of customer funds. In Japan, for instance, crypto exchanges are required to register and meet some custodial duties to protect customer funds. Japan has also started preparing to regulate exchanges more by requiring them to meet statutory capital requirements to protect investors and limit systemic risk.

Investor protection and market integrity: The US SEC recently commented on how some technological platforms perform exchange-like functions, offering order books with updated bid and ask prices and data about executions on the system. He also commented that such information does not have the same integrity as that provided by national securities exchanges.

Some selfish miners have been able to manipulate the price of blocks by keeping them private and revealing them when certain conditions are satisfied. The US Futures Industry Association aired their concern about the lack of transparency and regulations. They also raised a concern about exchanges ensuring the crypto assets are not prone to manipulation, fraud, and operational risk. An investigation was conducted in 2018 to determine whether bitcoin had manipulated the Bitfinex exchange in a scheme using a token tether.

Practice Question

Which one of the following is a key feature of blockchain technology?

A. Centralization

B. Presence of intermediaries

C. Distributed ledger

D. All of the above

The correct answer is: C).

Blockchain technology uses a distributed ledger. Every computer in the network contains a copy of the blockchain. The distribution ensures that there are thousands or even millions of copies of the same blockchain. 

A is incorrect: Blockchain technology is a decentralized system, and this is the main benefit of the technology.

B is incorrect: One of the main features of blockchain technology is that it allows the completion of payments without any intermediary or banks.

D is incorrect.