Financial services via blockchain

This blog summarizes the impact of delivering regulated consumer financial services via blockchain technology and is premised on the functionality of the Ethereum blockchain, with the understanding that banks are likely to use a permissioned platform.

The impact of blockchain can be anchored around the following 3 dimensions of a financial transaction:

i. First, there is an account in which value is held. Examples include bank accounts, credit card accounts, brokerage accounts.

ii. Second, different categories of values (assets or liabilities) are held in the account. Examples include cash held in bank accounts, securities held in a brokerage account, loan held in a mortgage account. The term token is used, henceforth, for such digital representations of value.

iii. Finally, there is the transaction itself, which moves tokens between two parties. In a financial transaction, a token may be exchanged for goods and services (e.g., paying cash for coffee) or one token may be exchanged for another (e.g., selling stocks in exchange of cash).

For an early-stage technology like blockchain, it is foolhardy to predict winning use cases. At the dawn of the internet, few could have predicted that the combination of internet, mobile, cloud and GPS will result in Uber. Hence, instead of use cases, I identified 3 attributes of the blockchain, which stood out to me as having transformational potential for financial services. These map to the 3 transactional dimensions listed above:

Attribute 1: Versatile accounts

In the crypto ecosystem, the blockchain address is the analog of a financial account and the private key is analogous to a password that secures it. In Ethereum, such addresses are called Externally Owned Accounts (EOAs) because they are controlled by entities (i.e., human beings) external to the blockchain.

Blockchain addresses and private keys looks formidable (example below) but they are just large numbers expressed visually using alphanumeric representational systems (instead of the decimal system):

Sample Ethereum EOA: 0xF2f5C73fa04406b1995e397B55c24aB1f3eA726C

An Ethereum EOA is dual purpose:

a. it holds the native cryptocurrency ether, just like a bank account holds fiat money and

b. it acts as a person’s identity on the blockchain, and can be listed as an owner on any financial asset or liability recorded on the blockchain

In the real world, regulators would not accept an EOA as an identity, hence EOAs can be mapped to off-chain KYC concepts like SSNs in US, Aadhar ID in India etc.

In the visual below, the owner of the EOA can use the EOA’s private key to transact across multiple financial accounts:

In practical terms, think of the EOA as a bank account that allows you transact across all your financial accounts, using its password.

However, more foundationally, the blockchain establishes a simple 2 step process of establishing ownership:

i. Tokenize:

Create a digital representation of value (a token). The value represented may be that of a tangible asset (commodities, parcel of land, painting etc.) or an intangible asset (a digital media file, shares and bonds etc.).

ii. Transfer custody:

Transfer the ownership of the token(s) to the rightful owner’s EOA.

The platform itself does not stop the user from using different EOAs for different asset and liabilities. But the ability of an account to act as an epicenter from where custody (via its private key) can be exercised on any object of value (from securities to land to your Disney Magic Key pass) can allow consumers to merge their financial and non-financial lives in innovative ways.

For instance, a non-fungible token that represents ownership of unique digital media files, converts a hobbyst’s collectible into a tradeable financial asset. Hypothetically, a holder of a tokenized share of Apple could opt to get discounts at the Apple Store instead of dividends.

Attribute 2: Atomized tokens

In traditional financial services, scale comes from aggregation. Example:

o multiple transactions are batched for settlement in payment systems like credit cards and ACH

o individual loans are combined into homogenous pools and then securitized

In traditional finance, examples of atomization like fractional shares and peer-to-peer payments are bolt-on abstractions built on an underlying system that works in batch processing mode. In contrast, atomization is native to the blockchain and hence eliminates the tradeoff between atomization and scale. For instance, the lowest divisible unit of the USD is a cent, while a satoshi is one millionth of a bitcoin.

A crypto token atomizes two aspects of any asset:

i. The what:

It is possible to define what is being owned in a granular manner. Example:

a. In a REIT, a shareholder owns all the real estate owned by the REIT. In contrast, a crypto token may represent fractional ownership of a specific single-family home on a specified street corner.

b. The voting rights and financial interests in the share of a company can be separated into different tokens.

ii. The how much:

It is possible to own minuscule fractions of what is being owned. For instance, in traditional finance, there are many real assets (e.g., residential and commercial real estate, art) and financial assets (e.g., senior secured commercial loans, asset backed securities) that are illiquid and historically offered to institutional investors who can afford large positions in exchange for an illiquidity premium. Tradeable crypto tokens can make it feasible for people to hold minuscule shares of these alternative assets.

In summary, the attribute of atomized tokens will expand the universe of investible objects available to retail investors through granular alignment with their preferences and financial resources.

Attribute 3: Programmable transactions

The outcome of a transaction on the blockchain can be made conditional on rules defined by software code. Such code, when hosted on the blockchain, are somewhat grandly called smart contracts. In traditional financial services, consumers seldom get the chance to process conditional transactions. The facility of limit orders and stop loss orders offered by brokerage firms are one such rare example.

A major impact of this attribute for financial services is the enablement of trustless transactions. Any innovation that promotes trustless transactions between two transactional peers is a powerful tool as it promotes commerce. This dynamic exists even within traditional finance, example:

a. payment facilitators like Block and Stripe facilitate trust between merchant acquiring banks and small merchants by intermediating between them

b. the card issuing platform Marqeta facilitates trust between businesses and their workers by enabling fine-grained use of business credit cards

Both the above are examples, in which, solving for trust expanded commerce in a positive sum game.

Programmable transactions on the blockchain can take this to a new level. For instance, in an e-commerce transaction, one-time ephemeral joint accounts can be setup where the buyer’s money is locked up for specified period (say 15 days) and can only be released to the vendor when a neutral third party like FedEx records delivery.

The above example illustrates a challenge in blockchain smart contracts. Often, the smart contract requires intelligence that does not exist in the blockchain (in the above example, the proof of delivery). Hence, the crypto ecosystem requires Oracles-third party services that procure external information as an input to smart contracts (FedEx is effectively the Oracle in this example). However, with the internet of things becoming a reality, the need for Oracles will reduce. For instance, a payment for a private car sale can get executed when the buyer starts driving the car.

To summarize, from the perspective of a financial services consumer:

i. the property of versatile accounts enables the consumer to create synergies between her financial and non-financial transactions

ii. the property of atomized tokens expands the universe of assets the consumer can hold in those versatile accounts.

iii. the property of transactional programmability expands the universe of counterparties she can trade with

The 3 properties combine to empower the customer.

The challenge of private keys

For crypto assets, possession is nine points of law. The person who knows the private key effectively has custody of the assets owned by that blockchain address. Thinking more broadly, proof of ownership of any asset can fit into the following 4 quadrants:

Historically, many financial assets, including shares and bonds, were issued in Quadrant 1 but over time were dematerialized to Quadrant 4, where an electronic registry of ownership is maintained by an authorized party. Since blockchain platforms were conceived without the concept of KYC and central entities, crypto assets fit into the bearer paradigm of Quadrant 3. However, intermediaries like Coinbase have effectively made crypto assets behave like Quadrant 4 by coming in between the underlying platform and the asset holder.

The challenge with private keys is that

i. they are impossible to remember.

ii. if an account holder forgets the private key to a blockchain address, there is no way to access any assets owned by it.

In the current crypto ecosystem, this challenge is principally solved through custodial wallets, where a central entity takes control of the private keys. Most people who store their crypto assets with centralized fintechs like Coinbase and Binance do not have custody of their private keys and hence their assets. The FTX debacle of 2022 illustrates what happens if the custodian of the private key is a nefarious entity (hence, the adage, not your keys, not your coins).

In the non-custodial approach, the customer holds the private keys in a wallet app, which also acts as an accessible UX to the blockchain. Hence, we can also refer to it as self-custody. This option (non custodial wallet apps like Metamask and Exodus) is mostly used today by crypto super-users.

The choice between custodial and non-custodial approach is really a choice between convenience and trust. Given this blog is premised on the provision of financial products by central entities, the trust component can be provided by regulators and auditors, just as they do now.

Hence, for the purposes of everyday retail banking, dual custody of private key ( by account issuer and account holder) should suffice. However, thinking more broadly, the entity offering the blockchain account can provide the following options to its customers across 2 dimensions:

i. Type of custody: the custody of the private keys could be with the account holder, account issuer or both (dual custody).

ii. The type of storage: the private keys are either stored on an internet connected device (hot storage) or an offline device (cold storage). Hot storage carries a higher risk of being hacked.

Each of the above quadrants come with a different risk & convenience profile and can be priced differently. For instance, a customer who choses Quadrant 1 may pay a higher fee reflecting the cost of private key loss insurance incurred by the account issuer. In, Quadrant 6, the customer may pay less but has no fallback if she loses the private key.

Concluding thoughts

The one attribute of the blockchain that gets a lot of mentions is its capacity for disintermediation and the impact on speed and efficiency. While these transactional impacts are important, in my opinion, they, by themselves, are not likely to be compelling because:

i. in the era of commission free trading and free peer-to-peer payments, the existing forms of intermediary value capture (e.g., interest on idle cash, payments for order flow) are considered notional losses by consumers. This dynamic can be observed on how consumers hold savings deposits even when money market rates become higher.

ii. speed is not valuable to everyone, for instance, transitioning to T+ instant settlement doesn’t make much difference to the vast majority of retail investors who hold passive index funds. Further, innovations running on legacy infrastructure (e.g., real time payment systems) are already delivering acceptable speed.

Rather, the compelling value proposition of the blockchain for the retail customer will arise from its ability to unlock economic value through its ability to

a. merge the financial with the non-financial

b. increase financialization of assets and democratize access

c. promote trustless transactions

The technology is powerful enough to yield benefits even within a regulated setting.