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Enterprise blockchain’s impact on financial services

Enterprise blockchain faces some barriers—but there’s little doubt that it will transform financial services. Our panelists discuss the keys to enterprise blockchain success and how our industry can prepare.

We recently invited five panelists to join our Executive Roundtable Series event on enterprise blockchain. The discussion topics ranged from decentralized finance and self-sovereign identity to attracting technical talent and major growth opportunities for Truist. The panelists were Anoop Nannra, global blockchain leader at Amazon; Caitlin Long, CEO of Custodia Bank; Joey Krug, co-chief investment officer at Pantera Capital; Rebecca Simmons, partner and co-head of fintech practice at Sullivan & Cromwell; and John Sun, co-founder of Spring Labs.

Enterprise blockchain’s impact on the financial services industry will rival that of the internet, according to our panelists. And while those blockchain experts might be a little biased, they quickly explained how enterprise blockchain is a next-step technology that enables the internet to deliver on its potential as a source of business value—especially in financial services.

John Sun, co-founder of Spring Labs, described enterprise blockchain’s impact in terms of economic theory, noting that the three main sources of friction in any business relationship are: (1) the cost of search and retrieval, (2) the cost of contracting and negotiations, and (3) the cost of enforcement.

The internet largely reduces search and retrieval costs to zero, with blockchain likely to have a similar effect on the other two types of costs. As friction costs fall below a certain critical threshold, use cases that weren’t economically feasible before suddenly become viable, triggering a cascade of innovation across the ecosystem.

The keys to enterprise blockchain success

Widespread adoption of enterprise blockchain faces few technical limitations according to Joey Krug, co-chief investment officer at Pantera Capital. Today, you can quickly spin up a proof-of-authority network with good throughput. And Krug isn’t aware of any enterprise blockchain applications that are running up against performance barriers. The main technology-related barrier is lack of mature software development tools. Blockchain applications—whether public or private/enterprise—are difficult to program, even for experts.

But the most significant barriers to enterprise blockchain initiatives are rooted in non-technical areas such as regulatory, legal, IT/operations, and talent. These barriers are largely limiting current initiatives to research, development, demos, and pilot projects that run in parallel with existing systems (rather than full implementation).

Core banking system updates

From a banking perspective, one of the biggest barriers and keys to success with adopting any type of blockchain is modernizing a bank’s core systems. According to Caitlin Long, CEO of Custodia Bank, which specializes in serving the digital asset industry, the vast majority of banks operate using traditional core systems that aren’t API-based—and that usually update the bank’s books and records only once a day. This system can’t work for cryptocurrency or anything else related to blockchain (public or private), which generally involves irreversible transactions settled within minutes or even seconds.

Once-a-day updating exposes banks to unacceptable levels of risk. The bank could experience an intraday run and not know it until closing its books for the day. FDIC concerns about these types of risks are one of the main reasons there has been so little banking involvement in the U.S. digital asset sector.

Plus, blockchain applications typically require integration with an API-based core, meaning that approximately 95% of banks in the U.S. are currently behind the curve.

These core system limitations aren’t just a blockchain or cryptocurrency issue. They’re also going to be a major issue for FedNow and any other process that involved rapid asset settlement and greatly increased transaction volumes. And while an API-based IT architecture has now become a basic necessity, Long says that in the near future, even that might not be enough. Future competitiveness in the financial services industry might require integration with architectures that are public, permissionless, and open source.

Regulators must lead the way.

Regulatory issues are another major barrier for enterprise blockchain. Part of the problem is regulator hesitancy, said Rebecca Simmons, partner and head of the fintech practice at Sullivan & Cromwell. Regulators tend to scrutinize—and sometimes discourage—approaches and solutions that are new and unproven, giving financial institutions a strong incentive to stick with the tried-and-true. Although existing systems and approaches have clear limitations, established financial institutions and their regulators are generally more comfortable with the devil they know.

Also, since the 2008 financial crisis, many banks have had their hands full addressing regulatory requirements such as Dodd-Frank. They’ve only recently had the time and resources to get excited about new innovations such as enterprise blockchain.

And in fast-moving areas such as blockchain, regulations naturally lag far behind the leading edge of innovation and adoption. The need for careful evaluation of new developments means that regulations won’t change until the first stages of innovation have passed. This frustrates entities and early adopters anxious to see cutting-edge become a practical market reality. But most people seem to agree it’s better for lawmakers and regulators to be cautious and wait to adopt regulations until both the risks and appropriate framework are clear than to try hitting a rapidly moving target and missing—which would force them back to the drawing board and create confusion in the marketplace.

It often takes decades for flaws in our financial system to reveal themselves. How can we reasonably expect legislators and regulators to develop usable rules and policies for innovations that are still evolving at breakneck speed?

Updates to our legal system

Similar to the regulatory challenges, enterprise blockchain innovations often outpace today’s legal system. For example, according to Simmons, the treatment of digital assets under commercial law is currently unclear.

The Uniform Commercial Code (UCC) governs things like the finality of payments and settlements of securities transactions. Corresponding provisions for natively digital assets haven’t been developed yet. And rules tying tokenized assets to their related tokens are also unclear. This absence of rules makes it difficult to develop certainty as to the ownership of digital or tokenized assets in the face of disputes, bankruptcy, and defaults. That, in turn, makes it difficult to accept the displacement of existing assets—which, despite their known faults, are governed by a clear commercial law framework.

Real litigation involving digital assets is already emerging, and judges today don’t have a roadmap to follow when trying to respect a contract and determine who has title to an asset.

New laws and legal concepts can take many years to develop and take root. It’s been 20 years since the Uniform Electronic Transactions Act was passed, and some states still haven’t implemented it. Clarifying the treatment of digital assets under commercial law almost certainly won’t take that long. Five states have already done so, and the Uniform Laws Commission is hard at work on amendments to address digital assets. But legal issues such as this will likely remain a barrier to digital asset adoption in the near future.

Acceptance of self-sovereign identity—or another identity system

Self-sovereign identity gives individuals control over their own digital identity. It’s been the go-to identity model for blockchain since its earliest days. But, according to Sun, it’s mostly been a buzzword that has faced formidable challenges.

One challenge that Quadrata (a Spring Labs spinoff) is focused on solving is the dichotomy between reliability and usability in Web3—a new stage of the internet driven by blockchain—digital identities. There’s a tradeoff between how easy a self-sovereign identity is to use and how much trust and reliability you can place in it. If it’s easy to create an identity, it’s easy to reboot an identity. And then you can’t trust it, which defeats the purpose. But if you make the system harder to use, it becomes exclusionary.

According to Nannra, another practical issue is broadly educating people about what self-sovereign identity is and how to use it so that when you walk into a bar and order a drink, the bartender accepts your digital ID instead of demanding a physical driver’s license.

An intermediate approach is to take a person’s off-chain identity and adopt it on-chain. It’s an ugly duckling approach that many early crypto innovators and other technologists are reluctant to adopt because it goes against blockchain’s fundamental principle of permissionless trust. But to address various regulatory issues such as know your customer and anti-money laundering, some workable identity system will be needed—even if it doesn’t achieve the lofty vision of self-sovereign identity.

The time is now.

The financial services industry is on the edge of a new era. Blockchain will cause a massive transformation that has the ability to improve the efficiency and security of financial markets. But before we can get there, blockchain must overcome several barriers preventing widespread adoption.

In the meantime, we should take a long-term view and begin to explore ways to implement blockchain. The first step is improving our current systems. Modernizing core systems will allow us to remain competitive—even beyond blockchain implementation.

Blockchain will likely change the future of financial services—and our society. The critical moment is now. We must develop open ecosystems and a willingness to engage with outside developers and innovators to ensure we’re ready and able to interact with an intelligent, distributed, Web 3.0 world.