Blockchain in the Financial Sector: two trends you need to know
The banking and financial services sector, with its high regulatory demands and access to consumer data, is renowned for embracing insight-led innovation. Industry experts and policymakers - including the FCDO - view blockchain as a fundamental development in the sector, as reflected in rising investment in blockchain labs at megabanks.
Blockchain is a distributed digital ledger that is virtually impossible to hack. While the mainstreaming of cryptocurrency has been the most visible extension of this trend, with Pew Research reporting in late 2021 that 86% of all US adults had said they had some awareness of cryptocurrencies, it is also the most volatile.
As we will see in two emerging trends below, blockchain stands to disrupt the finance sector in other ways, leveraging its wider potential to prevent fraud, manage risks, and streamline transactions.
Trend: DeFi rising
⛓ Decentralised finance (or DeFi) is an expanding constellation of apps and systems based on open-source blockchains. DeFi transactions leverage “smart contracts”, and are processed via Distributed Ledger Technology (DLT) without any middlemen such as banks, guarantors, or brokers.
Bypassing traditional finance’s (or tradfi’s) gatekeepers is one of the perceived benefits. Whereas traditional fund transfers can involve long processing times and high fees due to tight regulations, DeFi transactions are quick and affordable. This is creating opportunities for an increasing number of fintechs and startups whose business models are built on bridging tradfi and DeFi.
Nigerian startup Nestcoin works to make DeFi technologies “more accessible for the everyday person” through apps, media and gaming. Partly because of the low number of tradfi bank account-holders, Africa has a booming DeFi market, and Nestcoin is a key player. Decentralisation has allowed the company to scale its operations globally; Nestcoin is backed by a US-based venture capital company, and the Philippines is one of its most valuable markets.
In a similar vein, blockchain startup Conflux helps DeFi projects enter the strictly-regulated Chinese market. The company received $5m in funding from the government of Shanghai in 2021, to further its research. Conflux uses a decentralised public blockchain created by OKEx, a Seychelles-based cryptocurrency exchange; this gets arounds the ban on fiat-to-crypto trading, which the Chinese government enforced in a bid to stamp out competition for its own digital yuan.
The banking sector has also begun to pilot DeFi solutions. In 2021, Liechtenstein-based Bank Frick worked with startup Cadeia to produce blockchain technology capable of fully securitizing corporate loans.
⛓ Why is this significant?
Bank Frick’s landmark move underscores the potential of blockchain to reduce friction and increase transparency within banking. Using smart contracts, all transactions are verified instantly. The process also produces an automatic audit trail that all stakeholders can access.
The DeFi industry is still relatively immature, and lacks the regulations and standards found in tradfi. This is creating a new ecosystem, and investment opportunities for lean startups and fintechs, which have the flexibility to pilot innovations. The impressive financing rounds achieved by Cadeia, Nestcoin and Conflux are weak signals of this.
Trend: Blockchain boomtowns
Several forward-looking governments are positioning themselves at the forefront of the rapidly expanding DLT space.
Decentralised solutions are seen as key within the UK’s own technology strategy, helping to maintain its reputation as a leading tech hub. However, in an interesting shift, smaller cities and countries are competing to become forerunners in the expanding digital economy.
Due to its geographic location, Gibraltar is already a gateway for international trade. Years of government-backed research into decentralised tech culminated in a proposed merger of Gibraltar’s stock exchange with a blockchain company in 2022, which was announced alongside a world-leading regulatory path.
Also in 2022, the Republic of Palau began offering “digital residencies” to anyone in the world, supported by a blockchain-based ID verifier. The scheme does not grant citizenship, but there are a range of purported benefits for remote “residents”, from registering a US post code, to easier trade with Palauan businesses, and potentially opening their own registered companies.
⛓ Why is this significant?
The fast-moving DLT space is allowing smaller countries and cities to emerge as new locis for investment. This could potentially syphon investment away from traditional financial hubs.
Future impact
While these use cases indicate the speed at which blockchain technology is evolving, they also demonstrate the importance of pioneering action and research-led strategies.
With nothing to underwrite them, DeFi wallets and assets can be lost irretrievably in the event of a forgotten password or misplaced hard drive. To counter this, there have been growing calls for personal and decentralised finance to be covered in the school curriculum. Educational apps that aim to help younger children learn the principles of cryptocurrency and saving, are also growing in popularity, such as Pigzbe.
Increasingly, policymakers and the industry are coming together and help set guidelines where existing regulations are lacking. Consider the united front megabanks showed at the US Senate hearing in 2021, as well as the joint statement issued by finance regulators in the US in 2021, and their UK equivalents in 2022.
Announced by the World Economic Forum in 2020, the Digital Currency Governance Consortium is made up of central banks, non-profits, big technology firms, governments and developers. The initiative offers a glimpse of how policymakers and the finance industry can work together proactively, to overcome some of the entrenched challenges, share knowledge, and map out regulation.
For a glossary for key terms, we recommend consulting the World Economic Forum’s glossary.