Why blockchain is central to the future of finance - and why that’s more exciting than it sounds

Distributed ledger technology (DLT), or blockchain as it is more commonly called, seems to have taken the world by storm, capturing the imaginations and the wallets of financial institutions around the globe. Over the last three years alone, more than 2,500 distributed ledger technology patents have been filed, $1.4 billion in venture capital investments have been made, and the leading blockchain consortium boasts 45 of the world’s largest financial institutions.

But what does this all mean? Understanding how blockchain works is a jumble of Merkle trees, hashes and forks. For those of us without a doctorate in mathematics or computer engineering, understanding how distributed ledgers work under the hood might be the wrong approach. After all, when was the last time you asked yourself how your iPhone worked? The important question is not how it works but “how will this new technology change the way we do business?”

A new report by the World Economic Forum seeks to answer this question by exploring how distributed ledger technology could reshape the financial services industry. Using the existing World Economic Forum’s framework for “Disruptive Innovation in Financial Services”, the report identifies potential blockchain use cases from across the industry. It then uses interviews and workshops with hundreds of industry experts to conduct deep dives that map the potential impact of blockchain and consider the critical conditions necessary to its successful implementation. The key finding? Distributed ledger technology has the potential to “live up to the hype”, but will require patience and collaboration to be successfully implemented.

Want to know more? Here are our four top insights into how blockchain will transform financial services in the coming years:

1. There is no one way blockchain will drive value

While the nine use cases we explored utilize the technology in different ways, analyzing them collectively enabled us to identify the following six distinct ways in which the use of this technology has the potential to create value:

Even though a wide variety of existing technologies have the potential to drive similar types of value, we believe blockchain's ability to reduce costs could be transformational.

2. Blockchain will be central to the next generation of infrastructure, but it will not act alone

The most impactful and interesting DLT implementations that we identified were financial infrastructures, instead of standalone applications that could be built by a single financial institution.

This is important because over the past 50 years, new financial infrastructure has enabled transformative functionalities within the financial system. For example, without the advent of mainframe systems and their ability to conduct batch overnight processing, messaging services (e.g. SWIFT) might have never enabled the global payments we take for granted today. Similarly, without the collective advent of local networks and data centres, the modern fabric of electronic trading would have been impossible.

We are at an inflection point where DLTs will begin to play an equally important role in the establishment of new financial infrastructure; however, it will not do this alone. As the past has shown, an array of technologies, such as machine learning, Internet of Things and quantum computing, may have a role and converge to enable new functionality. In particular, we believe identity management improvements will play a critical role, a topic explored in detail within “A Blueprint for Digital Identity”, a separate report also launched by the World Economic Forum this week.

3. Financial infrastructure may sound boring, but changes will have far reaching and disruptive implications

The replacement of financial infrastructure may sound dry and academic, but the implications can be far-reaching and disruptive. That’s because financial infrastructure is central in shaping the day-to-day business practices of the global economy. When infrastructure IT changes, the assumptions central to existing business models are thrown into question. For example, while the electrification of trading enabled the creation of new derivative markets and hedging products, it also eliminated the need for many businesses built around processing paper-based trade documentation. What implications will new financial infrastructure built on DLT have?

To answer this question, it is important to understand how infrastructure built on DLT will be different. Illustrated and detailed below, our research suggests that the three core features of the technology, immutability, transparency and autonomy, will each have a role in reshaping financial practices and business models.

Immutability means better record keeping

Today, every financial institution maintains a digital ‘book of record’ containing asset and transaction data. The issue is that each financial institution’s book of record frequently don’t line up, necessitating a highly manual process called reconciliation. As the need to trust and transact with other institutions has risen, central intermediaries have proliferated the industry to provide reconciliation services between counterparties to ensure that everyone is on the same page.

Blockchain has the potential to radically simplify record keeping since it stores information chronologically, replicates the single ‘book of record’ across nodes in real-time and ensures data cannot be modified after being recorded. This means that all financial institutions are on the same page at all times. As a result, information silos within the ecosystem can be broken down, reconciliation disputes can be eliminated and the role of central intermediaries can be reduced.

Transparency means more certainty for less effort

Today’s aged and fragmented financial information systems limit transparency and foster information asymmetry between a wide range of actors including buyers and sellers, borrowers and lenders, and institutions and their regulators. This privileges certain market participants over others, and makes the liquidity of markets and solvency of financial institutions difficult to assess.

Distributed ledger technology provides ‘out of the box’ infrastructure that is vastly more transparent than existing systems. While technology continues to be developed that allows data to be obfuscated when there is a social rationale for doing so, the shift to full transparency as the default will have serious implications. For example, financial institutions will be able to more accurately quantify risk, reducing the need for external agencies to evaluate financial health and, potentially, lowering systemic risk by making it easier for market participants to identify ‘good banks’ from ‘bad banks’ in a crisis. In addition, since every transaction can be made visible automatically, regulators will be able to utilize distributed ledgers to receive real-time compliance data that is not only more granular than current reporting, but generated with a significantly lower compliance burden on reporting institutions.

Autonomy means never having to say you’re sorry

Lastly, distributed ledger technology enables financial agreements to be codified on a shared platform that ensures execution based on a set of mutually agreed conditions. These ‘smart contracts’ simultaneously eliminate manual effort associated with resolving disputes and enable financial service interactions to occur without the need to trust a counterparty’s willingness or ability to fulfill obligations.

We can envision a world that, again, has less uncertainty and more efficiency; but it is just as easy to imagine the risks that an autonomous financial system could create. For example, how would a flash crash created by a cascade of smart contract executions be stopped? How would ‘fat finger errors’, such as ordering 1,000 shares instead of 100, be reversed? In other words, how will autonomy in distributed financial infrastructure be governed and secured?

This question leads us directly to our fourth and final insight: the need for collaboration across the financial ecosystem to enable financial infrastructure built on distributed ledger technology and support the long road to deployment.

4. New financial infrastructure won’t be built overnight, and will require collaboration to be successful

Just as bridges are not built in a day, mainframe systems in financial services were not deployed overnight and, for the same reasons, new financial infrastructure built on blockchain will take time to deploy.

One key impediment is that DLT is simply not ready to meet the high volume and high velocity demands of financial markets today. More importantly, the roll-out of multi-party and multi-jurisdictional infrastructure will require proactive regulator engagement and collaboration across large stakeholder groups to support standardization despite their frequently diverging interests. Finally, it will be essential to ensure the system’s security and stability. Recent instances, such as the DAO breach, show the dangers of combining immutability and autonomy with human error, especially in a situation where the governance of DLT is undefined and untested.

Unlocking the potential of blockchain will be a difficult undertaking with many interlocking challenges to overcome. However, with the tremendous potential of this technology to deliver a more efficient, more equal and more stable financial system, we believe it is well worth the effort.

The Future of Financial Infrastructure report is available here.

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