An article by Palak Khandelwal, published on Feb 13, 2022
To what extent will blockchain’s role play in financial disintermediation and are we ready for it? This article provides a VERY brief insight into the future of finance, whilst covering partial disintermediation and realistic use cases in today’s world.
Financial intermediation is a third-party that brings together lenders and borrowers and aims to meet their financial needs. Financial Intermediaries (FIs) create funds and manage payment systems, usually in an efficient manner such as conducting financial activities in bulk, reducing the overall costs.
- Mutual Funds
- Stock Exchanges
- Financial Advisors
- Insurance Companies
- Pension Fund
What is Disintermediation?
Disintermediation is the eradication of Financial Intermediaries (FIs) or any middleman. With banks and non-bank financial institutions present in the market, intermediation is very much our current financial situation – which this article hopes to build up on.
Non-bank Financial Institutions (NBFIs)
Non-bank financial institutions provide alternative financial services (e.g. financial consulting, risk pooling, money transmission etc), however, do not have a full banking license and therefore cannot receive deposits. NBFIs include pawn shops, insurance firms, microloan lending companies, etc. These institutions don’t directly rival banks, but instead complement them by providing niche services through the unbundling of financial packages (that are usually provided by banks) to meet the client’s needs. This generally allows the redistribution of surplus resources and provides tailored, specialised services.
What does a blockchain network look like?
Blockchain is a decentralised data-storage structure that can store transactions transparently and immutably. Data isn’t stored in a centralised manner, but it is spread across the network — so if for any reason one node fails/crashes, the same information is saved on every other node on the network and the blockchain continues to perform.
It lets you build trust in a trustless environment through authenticating transactions anonymously and securely. Public blockchains are open to the public, where anyone can add information but no one can make changes to the block (e.g. Bitcoin’s network). Having this permissionless network allows anyone on the internet to sign onto the network and become a ‘node’. As long as there are still computers on the node, it will continue to function.
Private blockchains on the other hand, are private networks which only authorised individuals have access to. Usually used in organisations, it benefits from faster speeds (due to fewer nodes compared to public networks), better security, authorisation and accessibility. An organisation could limit access to the blockchain on a user-to-user basis, though some may claim this isn’t exactly a ‘decentralised’ model that is usually promised when ‘blockchain’ is in conversation.
Hybrid blockchains also exist, which are a mix of permissionless and permissioned blockchains. And lastly, consortium blockchains enable multiple organisations on a hybrid blockchain network to collaborate with trust. This can be used between multiple banks or research bodies as it allows multiple entities to form a cortium without having to elect a ‘leader’ or moderator.
What does Blockchain bring to the finance table?
Till now there were only two ways to pay — cash or intermediated payments (which included all digital payment methods).
“The nature of digital objects, since the inception of computers, is that they are not scarce. The can be reproduced endlessly, and as such it was impossible to make a currency out of them, because sending them will only duplicate them.”*
The probability of double spending was too high, which necessitated intermediaries and their guarantee that the payer doesn’t use the same funds twice (or more). Cash was confined to physical proximity for trade, and digital banking required intermediaries for safe transactions to take place.
So where does blockchain come into all this?
Bitcoin (which is backed up by blockchain technology) was created by Satoshi Nakamoto and was the first successfully engineered solution that allowed transactions to take place without a third-party intermediary. The reason this works is because it is verifiable (by it’s strong consensus mechanism called Proof of Work) and the number of Bitcoins are scarce (there are only a total of 21 million Bitcoins).
One can argue about the extent of security between blockchains and intermediaries. But transaction costs are significantly less and it eliminates centralised control of money (e.g. from governments).
I’ve gone on about how amazing blockchain is blah blah… but acceptance, accessibility, interoperability, and scalability are just some factors recognised as a hindrance to this crazy anonymous guy called Satoshi Nakamoto, from spinning our world 180 degrees, hypnotising every single person to switch to crypto and making the banks go bust.
This obviously didn’t happen, and here is the reason why:
The remaining role of intermediaries
Integrating with the external world
Siloes can occur if blockchain is not interoperable with other existing systems (or the outside world). Without integrating with current technology and/or systems an organisation uses, blockchain will be difficult to use and therefore impact its adoptability rate and increase its lack of use cases. Just like integrating any new technology (not just blockchain), the need for integration to implement and function smoothly is required, otherwise its full potential does not come to form.
For a complex industry like finance, one blockchain would not be able to satisfy all functions, and without the ability to integrate with other systems or even other blockchains, it would be challenging to scale blockchain once adopted. On a deeper level, FIs running different versions and having various governance rules enhances the silo problem. A series of unconnected blockchains would probably generate longer lead times, therefore undoing the efficiencies of blockchains.
Blockchain executes financial activities, not financial services
Some of the basic functions that FIs carry out are providing bespoke financial advice, relevant information important for decision-making, market research data etc. which can’t be provided on a blockchain network. General advice and essential information can be easily accessed on a blockchain, however, it is shared by the entire network, and therefore case-by-case consultation is not appropriate. Additionally, less tech-savvy individuals would have difficulty learning and accessing services on a blockchain without any intermediaries. Hence, intermediaries are still required to provide financial services to fill in the gap which blockchain isn’t able to fulfil at it’s current stage.
So where is blockchain’s place in the big bad world of finance?
With blockchain expected to reduce costs, increase efficiency and improve data security, it could be implemented for automating specific financial activities.
Because of blockchain’s transparency and immutability, legally enforceable smart contracts could be saved on the network, allowing a task to take place if certain conditions are met by all parties. For example, payments are automatically transferred when predetermined T&Cs are met. In the case of non-compliant smart contracts, it doesn’t proceed and the intermediaries can step in to take appropriate action.
Blockchain can serve to reduce the risk of uncertainty of the parties involved in the transaction by reducing information asymmetry and decrease lags. By being able to automate real-time information exchange, all parties can be kept on the same page. There is a large amount of duplication in international payments and other parts of this industry, which creates delays and confusion — this can be solved by blockchain.
Know-Your-Client (KYC) is an essential activity carried out by most FIs, which is required for regulatory and compliance purposes. Services such as KYC-chain can help streamline the KYC process by providing real-time updates and improving trust. Automating customer identification and account opening can be beneficial by allowing seamless exchange of documents between banks and other parties involved.
A real life example of where blockchain has been implemented within a FI is Partior. Partior was founded by JP Morgan, DBS Bank and Temasek as an interbank payment system in Singapore which allowed an enterprise blockchain platform to improve speeds and reduce costs of cross border payments. This was an attempt by the Monetary Authority of Singapore to create a successful Central Bank Digital Currency (CBDC) to create certainty in settlements and make transactions transparent.
Whilst blockchain’s role may not be significant in today’s financial industry yet, the constantly changing environment may lead to a blockchain-based industry, accepting and adopting blockchain as a foundation. One of the main barriers is the lack of regulations, standards and frameworks in circulation for implementing blockchain in any industry. In general, it is still at an immature stage, which will only progress with time and adjacent technological development.
Blockchain is great. Not just because it’s a great buzzword, but because it has useful properties that we need in the financial industry. Transactions can be verified, financial activities can take place and trust can be established — all without the need for a third-party intermediary. It makes it a very tempting technology to adopt.
However, due to lack of standards and interoperability with existing systems, a slow growth is inevitable. Its inability to provide bespoke financial services would also limit its use cases. Therefore, successfully integrating blockchain is essential to creating an agile network of technologies, which would otherwise create a siloed environment.
By keeping up to date with new technologies such as blockchain, FIs can be made more efficient and leverage a competitive advantage. With the help of smart contracts, automating certain processes (e.g. KYC) and collaborating with parties on blockchain, it can reduce risks and ensure smoother flow of information. Going forward, integrating with not just existing systems in place, but also with laws, regulations and governance will be critical to its success.
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