The Emergent Role of Blockchain in Finance

From Pre-Trade to Post-Trade: How Blockchain Can Transform Capital Markets!

Picture a future where financial operations are seamless, trades are expedited, and assets are smoothly managed through tokenized securities. Thanks to blockchain technology, this future is not far off.

Blockchain has shifted from being a mere buzzword to a game-changer for financial transactions. As we approach its broad adoption, we are witnessing its transformational promise come to life.

Recent forecasts by Citigroup point to an impending inflection where blockchain’s potential will be actualised, impacting billions of users and accounting for trillions in value. The banking behemoth predicts a staggering “$4 trillion to $5 trillion in tokenized digital securities and $1 trillion in distributed ledger technology-based trade finance volumes by 2030.” These figures underline blockchain’s significant potential and its disruptive power in finance.

The finance sector’s legacy inefficiencies, particularly in pre-to-post-trade operations, have long been a hindrance to transaction speed, accuracy, and accessibility. Blockchain technology is poised to confront these challenges.

After 12 years working in the financial markets, working at Back, Middle, Front Office positions for custodian, private and investment banks but also in Fintech leveraging electronic and algorithmic trading, I witnessed many inefficiencies in the financial system. As we usher in this new era in finance, I will delve into how blockchain is revolutionising the industry and why it is imperative for businesses to embrace these advancements for future success.

I. The State of Finance: Inefficiencies and the Need for Transformation

A. Current Inefficiencies in the Finance Sector

The financial sector is currently facing numerous inefficiencies which, while varying in specifics, can broadly be categorised into these major areas:

Capital Markets:?Inefficiencies damage capital markets, particularly in price discovery, market monitoring, trading, and primary issuance, due largely to lack of standardised information and transparency. Slow, intermediated processes in settlement and clearing also increase costs and risks while restricting market participation. The sector urgently needs more effective, streamlined systems.

Investment Management:?Venture capital firms, private equity firms, real estate funds, and specialty markets are under pressure to improve liability risk management, incorporate dynamic decision-making structures, and navigate complex, evolving regulations.

Payments and Remittances:?Global payments and remittances are typically carried out by numerous intermediaries who charge service fees. International remittances, which take 2 to 7 days, have a global average cost of 6.94% for sending $200 between countries, equating to about $48 billion being consumed in fees and other intermediary charges.

Banking and Lending:?Traditional banking services, like loan processing, are dependent on outdated execution processes. Information verification, credit scoring, loan processing, and fund distribution for securing mortgages take 30 to 60 days for individuals and 60 to 90 days for small or medium enterprises to secure a business loan.

Trade Finance:?The trade finance industry still relies on paper-based processes that are prone to security vulnerabilities. Each transaction can take between 90–120 days to process letters of credit, verify documents, and establish trust among stakeholders.

Insurance:?Property and casualty insurance claims are susceptible to fraud and claim assessments can be time-consuming.

Regulatory Compliance:?With the pace and complexity of regulatory changes, especially for firms operating across borders, keeping up with various regulatory regimes is a significant challenge.

The general consensus in these issues is that inefficiencies stem from outdated procedures, slow processing times, susceptibility to fraud, human error, and the high costs associated with intermediaries.

B. The Maturing Market and the Role of Blockchain

The blockchain market, in 2023, has reached a significant level of maturity, emerging stronger and more robust from the tumultuous backdrop of past collapses, notably the FTX debacle. Contrary to its initial destructive impression, the FTX incident served as a catalyst for industry-wide introspection, reform, and innovation.

Predicted to reach $23.3 billion this year, the blockchain market volume nearly doubles its size from 2022, underscoring its resilience and the growing faith in its potential across diverse sectors. A noticeable shift towards private blockchains is evident, demonstrating the industry’s responsiveness to demands for enhanced data security.

Further attesting to this faith in the maturing blockchain market is the decision of one of America’s oldest banks, BNY Mellon. With trading in cryptocurrencies skyrocketing worldwide, BNY Mellon added cryptocurrencies to the assets it holds as a custody manager, signalling its readiness to tap into the popularity of bitcoins and ethers. Following the trend set by Nasdaq and BlackRock, BNY’s move confirms the increased institutional interest in the crypto market.

Recently, Digital Asset, the firm behind the DAML smart contract language, announced the creation of the Canton Network, an interoperability-focused network of blockchain networks targeting financial institutions. The network has already garnered the support of thirty organisations, including heavyweights like BNP Paribas, Deutsche B?rse Group, and Goldman Sachs, all set to begin participating in July. The Canton Network aims to break down the silos created by individual blockchains in institutional finance, thereby unlocking the benefits of composability and collateral mobility. Unlike public blockchains, DAML applications and the Canton Network are designed with privacy in mind, providing a more suitable platform for regulated financial institutions.

The increasing integration of blockchain technology into non-financial applications speaks volumes about its mainstream acceptance and versatility. Its role in streamlining operations, improving transparency, and enhancing security is being recognized across various industries, further solidifying blockchain’s position as a maturing market standard.

Major players such as Microsoft, IBM, and Amazon are offering Blockchain-as-a-Service (BaaS), which facilitates blockchain adoption among startups and enterprises, indicating a maturing underlying infrastructure. The proliferation of Decentralised Autonomous Organizations (DAOs), dApps, smart contracts, and innovative consensus mechanisms reflect the technological maturation of the blockchain market.

Despite the significant blows like the FTX collapse, the blockchain market in 2023 shows a remarkable recovery and growth, indicating its maturing nature. This resilient expansion, bolstered by substantial institutional investment from major organisations, is expected to continue, creating a myriad of opportunities across sectors, manifesting the true potential of blockchain in a matured market.

II. Blockchain’s Potential in Addressing the Capital Markets Inefficiencies

The financial industry has long grappled with inefficiencies throughout the asset life cycle, from pre-trade to trade and post-trade processes. However, blockchain technology, with its distributed ledger system and smart contract capabilities, has the potential to revolutionise the sector and address these challenges. I will here focus on what I know the best, Capital Markets and trading but many additional blockchain applications can serve the global finance sector.

A. Pre-Trade Efficiency: Information and Transparency

Blockchain technology can significantly address consolidated tape issues by providing a decentralised, tamper-resistant, and transparent platform for market data. It facilitates equal access and use of market data, minimising manipulation risk. It also creates an immutable record of all transactions, alleviating inconsistencies in market data representation and ensuring comprehensive trade reporting.

Moreover, the decentralised nature of blockchain can lower the operational expenses of managing a centralised database and its infrastructure, while its inherent security features, such as the proof-of-work system, can reduce data security costs.

Blockchain also promotes better price discovery by enabling transparent and instantaneous access to all trades, leading to more accurate pricing and reduced internalised trades. Furthermore, it can introduce mechanisms to value data contributions based on their influence on price discovery.

Finally, from a policy perspective, blockchain’s inherent transparency and accurate transaction record can streamline regulatory monitoring, compliance enforcement, and misconduct penalties, fostering market confidence and competition.

B. Trade Efficiency: Execution Speed, Accuracy, and Pricing

Tokenization of traditional financial assets such as equities and bonds, facilitated by blockchain technology, can significantly enhance their liquidity and accessibility. Blockchain, as a decentralised and transparent ledger system, enables the direct execution of trades, thus eliminating the need for intermediaries and accelerating the trading process. This attribute of blockchain provides an effective solution to the inherent challenges in the bond market, such as high transaction costs and lengthy settlement periods.

Prominent figures in the financial industry have acknowledged the potential benefits of blockchain. Sean Taor, Head of European Debt Capital Markets at RBC, underscores the efficiency of blockchain, stating, “If you can use blockchain from start to finish, you take out a lot of the costs, a lot of the risks in terms of counterparty and settlement risks.”

This claim is backed by tangible demonstrations of blockchain’s effectiveness in trade execution. Notably, Credit Suisse and the Nomura-owned broker Instinet successfully completed US equities trades via blockchain, reducing the settlement period from the typical two days to mere hours. This achievement has significant implications for traditional financial markets, where lengthy settlement periods often tie up substantial amounts of capital.

The European Investment Bank (EIB), in collaboration with Goldman Sachs Bank Europe, Santander, and Société Générale, launched Project Venus, a landmark initiative issuing the first fully digital, euro-denominated bond using private blockchain technology. Utilising the DAML technology, the €100 million bond was issued, recorded, and settled on a private blockchain, showcasing a significant step towards digitization of capital markets.

Charles Cascarilla, Paxos’s CEO, commented on the inefficiency of traditional systems, stating they tie up “$15bn to $30bn of industry capital and twice as much liquidity.” The use of blockchain, conversely, could reduce the need for posting collateral and help lower fees, thereby revolutionising the cost landscape of trading.

Tokenized bonds, specifically, offer an appealing option for investors seeking fixed-income investments. Accessible via blockchain-based platforms, they have high liquidity and transparency, enabling investors to buy and sell them readily. Furthermore, their blockchain records are tamper-proof, bolstering security and trust among investors.

In addition to enhancing liquidity and access, blockchain ensures pricing accuracy by providing a universal and immutable record of transactions. This ensures fair pricing and minimises disputes over executed trades, further establishing the technology’s potential in transforming the landscape of financial markets. Firms like LCX are capitalising on this potential, launching regulatory-compliant tokenized bonds to marry the benefits of traditional bonds with the innovative advantages of blockchain technology.

C. Post-Trade Efficiency: Settlement and Clearing

Blockchain and tokenization provide transformative solutions for the inefficiencies in traditional post-trade processes. They facilitate trustless delivery vs. payment (DVP) settlement, minimizing transaction costs and risks.

In the current system, free delivery is commonly used for settlement. This method, while manageable, introduces counterparty and settlement risks, and requires multiple financial intermediaries, increasing the complexity and cost of the process.

Alternatively, DVP settlement happens simultaneously but typically requires a clearinghouse. This reduces some risks but still involves costs and potential clearinghouse-associated counterparty risk. When various assets are involved, multiple clearinghouses may be required, further complicating the system.

Blockchain and tokenization offer a better alternative. Blockchain enables a trustless settlement process akin to DVP settlement, linking asset delivery to instantaneous payment. Tokenization allows for any assets to be mapped onto blockchain-based systems.

Using multichain atomic swap technology on blockchain allows one tokenized asset to be directly exchanged for another. This eliminates the need for intermediaries and ensures both transfers happen concurrently, mitigating counterparty risk.

Real-world applications by institutions like Credit Suisse, Nomura, and the European Investment Bank (EIB) have demonstrated the potential of blockchain in revolutionising traditional post-trade processes by reducing settlement periods and costs.

However, risks such as counterparty risks during confirmation time, operational risks like power or internet outages, and software-related risks need careful consideration.

As regulatory clarity continues to improve, these technologies are set to drive a new era of financial market efficiency.

III. The Imperative of Early Blockchain Adoption

Drawing from my seven-year experience in the highly disruptive market of electronic and algorithmic trading, I can confidently underscore the paramount importance for companies to embrace technological advancements swiftly to avoid being left in the wake of progress. I’ve observed companies forfeit their competitive advantage within just a few years due to their hesitance to automate their trading flows or their disbelief in the potential of electronic trading. I am firmly convinced that we now stand at a similar crossroads, where early adopters might initially encounter a few challenges, but will ultimately reap long-term benefits, inciting a significant shift in the market hierarchy.

A. Embracing Digital Assets: A Strategic Leap Toward the Future Financial Landscape

With the current surge in institutional investments in digital assets, it is becoming increasingly clear that early adoption of the blockchain and tokenization technologies, presents more than just a competitive edge — it is a strategic necessity for growth-oriented organisations.

Corporations are no longer viewing digital assets like Bitcoin merely as speculative assets but as reliable stores of value capable of diversifying treasury portfolios amidst challenging macroeconomic climates. This change in perspective has been influenced by the realisation that traditional cash holdings are rapidly depreciating, a concept aptly illustrated by MicroStrategy CEO Michael Saylor when he compared the company’s cash pile to “a $500 million ice cube that’s melting.”

Institutions are now investing in Bitcoin as a hedging strategy against potential inflation and dollar depreciation. With low-interest rates putting pressure on income across traditional assets, digital assets have emerged as viable alternative investments, offering better returns. This shift has been facilitated by maturing infrastructure, with advanced trading tools and secure custody accounts accommodating institutional investors’ needs.

Moreover, digital assets are starting to play an integral role in business operations strategies. Cryptocurrencies are being integrated into various organisational sectors, including payroll, accounts payable, and receivable. For international transactions, digital currencies offer a seamless, transparent, and secure way of processing payments, reducing costs related to exchange, banking, and payment processing.

Additionally, businesses can potentially drive sales volume by expanding to customers who prefer transacting in digital currencies. A host of consumer-focused platforms, including Square and PayPal, are already allowing customers to use Bitcoin and other cryptocurrencies.

Importantly, the evolution from holding digital currencies on balance sheets to integrating them into business operations can provide organisations a competitive edge through increased efficiency and lower costs compared to traditional fiat systems.

Despite the optimism surrounding digital asset adoption, it’s crucial for organisations to work with trusted partners in the field, consider the regulatory status of digital assets, and assess how digital asset purchases fit within their broader portfolio before making substantial allocations.

By accelerating their digital asset adoption, institutions not only secure a competitive advantage but also position themselves to thrive in the future financial landscape.

B. Challenges That Can Slow Down Adoption

While the benefits of blockchain adoption are significant, financial institutions must navigate various challenges to ensure successful implementation.

Regulatory uncertainty is a major hurdle. As blockchain technology disrupts traditional financial systems, regulators are grappling with how to adapt existing frameworks to the new paradigm. The introduction of the MiCA regulation aims to provide a comprehensive regulatory framework for crypto-assets and blockchain-based financial activities. Standardising regulations and providing clear guidelines will be crucial to foster trust, ensure compliance, and encourage widespread adoption.

Scalability is another challenge. Blockchain networks need to handle a large volume of transactions efficiently. As the adoption of blockchain grows, ensuring scalability becomes essential for seamless operations. Additionally, achieving network effects requires collaboration among market participants, ecosystem development, and the establishment of common standards to maximise the benefits of blockchain technology.

Security and cybersecurity risks must be addressed comprehensively. While blockchain is inherently secure, vulnerabilities can arise due to implementation flaws, smart contract weaknesses, or third-party integrations. Financial institutions must prioritise robust security measures, encryption protocols, and regular audits to safeguard data and transactions from unauthorised access or manipulation.

Integrating blockchain solutions with existing legacy systems and infrastructure is a complex task. Financial institutions need to ensure seamless compatibility, minimising disruption and maintaining operational continuity. Interoperability and standardisation across different blockchain platforms are essential for efficient data exchange and collaboration.

Education and awareness play a crucial role in driving blockchain adoption. Financial institutions must invest in training their employees and stakeholders about blockchain technology, its benefits, and potential use cases. By fostering a culture of innovation and developing internal expertise, institutions can overcome the challenges associated with implementing blockchain solutions.

In conclusion, the imperative for early blockchain adoption in the financial industry is evident. I am personnaly thrilled about this new financial era as I strongly believe it will forever transform the finance industry as we know it. By addressing the current inefficiencies and embracing DLT, financial institutions can enhance operational efficiency, reduce costs, and stay competitive in a rapidly evolving market. While challenges exist, the potential benefits, as demonstrated by industry reports, make it clear that the future of finance lies in blockchain technology.

- Marc Faubeau

This article was first published on my Medium where I occasionally write about finance, technology (Web3/Blockchain) and other entrepreneurship related topics.

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