On-Chain Finance
The robustness of blockchain networks underpinning Web3 is what makes this technology so compelling. It is my belief that in the coming years much of the day-to-day technology we rely on will be underpinned by Web3 networks. The motivations for this shift will be driven by the same motivations of any technological change — Web3 eliminates many of the errors that today's systems are susceptible to and automate away a number of inefficient processes that many businesses are burdened with. This will be achieved in a manner that is far less costly than what it costs organisations at present. I don't just believe that companies will find significant utility in Web3, but also regulators and governments, as it has the potential to greatly streamline their worlds also.
The events in the cryptocurrency markets of mid-2022 have been chaotic, with a familiar narrative playing out, where greed has taken centre-stage and a lack of adequate risk management and disclosure by firms on their positions enabled them to profit greatly from the bull market and fail just as spectacularly in the bear market.
OTC Markets
This activity behind closed doors is the secret sauce of many an institution which is not in their interests to disclose, but in some more extreme cases can be a source of systematic risk, which has the potential to massively disrupt markets when events don't play out as expected. Off the back of the global financial crisis in 2008, we saw the Dodd-Frank legislation come into effect. This legislation forced many banks and financial market participants who were creating and trading OTC derivatives to start reporting details of their activities to trade information warehouses.
The main trade information warehouse was operated by the DTCC, and the daily submissions being made by financial entities enabled regulators to get a snapshot of the activity taking place in the OTC markets. Thus enabling them to shine a light into what prior to this point, had been an opaque part of the financial markets.
The work undertaken by participants to comply with this regulation was incredibly costly, and given the multi-sided nature of OTC contracts, the same information often had to be reported by two or potentially more distinct entities. The point was that the OTC markets were not transparent, and once the implications of all of the leverage and risk had built up in them (off the back of OTC derivatives based on mortgage-backed securities), it was too late to do anything about it, and we ended up with many of the worlds largest financial institutions begging governments and sovereign wealth funds for bailouts.
Trust in blockchain protocols
The transparency of the OTC markets forced by regulation is a good thing. But trust in the data being provided is not guaranteed. It is still susceptible to errors or manipulation, one cannot have complete faith that the data being reported is accurate. This lack of fabric for trust in our current financial plumbing is the grand opportunity for Web3. The cryptocurrencies and tokens that exist on blockchain networks, and the DeFi applications that support them all provide transparency of activities taking place on-chain. They cannot be gamed and ownership of assets can easily be proven. There are challenges with anonymity insofar as participants on the public networks are not always clear. But where this is an issue, controls can be put in place with respect to which participants can interact on these networks.
By bringing financial activities onto a blockchain, or on-chain, the need for reconciling data between organizations and regulatory reporting in its current inefficient form can become a thing of the past. Regulators can be participants in the networks that support the asset classes that are of interest to them. Participants cannot be dishonest about their holdings or activities, as the information is recorded on-chain. Challenges of privacy and sensitive data too can be addressed, as in the cases where information cannot exist on-chain, proof of activity can safely be placed there without risk of data leaks or reverse engineering of activity.
At the present time, this level of on-chain activity is not the norm in finance. We only see it taking place in the unregulated DeFi markets. However, the technology has proven itself there, and in the not too distant future, we will see regulated DeFi markets emerging. These will have all of the benefits of DeFi in terms of trust and transparency but are supported by a regulatory framework where participants know who they are dealing with on the other side of the trades.
As this approach becomes proven, more and more institutions and regulators will see first-hand the benefits that putting the trust into blockchain protocols can bring over institutions run by fallible humans. Hence it will start to permeate into the broader financial market.
Such a change, given the complexity of our modern financial infrastructure, will not happen overnight. It's likely to take years, potentially a decade or two before it fully comes to fruition.
So much of our everyday lives have been made simpler by technology, which we can rely on to perform repetitive tasks in a more timely and accurate manner than people can. Prior to the emergence of blockchain, the obstacle that we had not managed to overcome was how to transact with another party without an intermediary. We had not had the realization that the trust layer could exist purely as software.
This trust is the essence of Web3 and is driving the next big technological breakthrough online. The implications of this are still only just getting started. There's a huge disconnect between what's possible with the technology versus where we are right now.
Once broader society starts to appreciate the trust model provided by Web3, it won't just be startups, and innovative companies scrambling to use it. It will be everywhere, with governments and regulators pushing people and companies to embrace the trust model at the heart of Web3 to streamline our societies further.
While regulators have yet to push for the idea of reporting data on-chain, I believe it is inevitable and only a matter of time before it is embraced in the financial industry.
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