Decentralizing through blockchain
The FinTech revolution being witnessed today touches upon several areas of the world of finance. In particular, the trading of financial assets, once the domain of large institutional investors, is being democratized in several ways. For instance, with the advent of apps such as Robinhood and Acorns, retail investors are able to invest in financial assets in user-friendly, low cost ways without the need of brokerage accounts with a main street bank.
However, financial institutions worldwide are still adjusting to the damage brought about by the global financial crisis of 2008. The collapse of Lehman Brothers and the subsequent domino effect on financial markets highlighted how a systemically relevant financial institution’s collapse could damage the whole global financial system. Therefore, over the last ten years, international regulators have enacted a wave of reforms aiming at reducing the impact of a single point of failure in financial markets (ie. counterparty risk), particularly in the area of derivatives.
Regulatory drive towards centralization
The Basel II framework in 2004 was an important step towards ensuring banks’ capital is adequate in managing credit, market and operational risks, which will soon be superseded by the more refined Basel III accord. In Europe, the insurance world has also taken steps forward in ensuring financial assets and liabilities are properly managed, with the introduction of the Solvency II directive of 2009.
One solution to reducing counterparty risk, particularly with regards to derivatives, has been the centralization of trading and settlements via central counterparty clearing (“CCP”) houses. CCPs bundle credit exposures from all trading counterparts and minimize single counterparty risk by netting positions across all trades, requiring collateral to be posted and monitoring the credit worthiness of all trading counterparts. Access to CCPs is limited to established and generally well capitalized financial institutions, meaning even several institutional investors need to go through another layer in order to trade certain financial assets. Again, the European Union was the main driver of this evolution in financial markets, through its European Market Infrastructure Regulation (“EMIR”).
Decentralization emerges thanks to blockchain
But over the last few years, the arrival of blockchain and distributed ledger technology is slowly changing this centralization effect. Today we see the slow emergence of decentralized, peer-to-peer trading thanks to a technology solution that addresses most, if not all, of the shortcomings of traditional financial markets. Decentralized exchanges are blockchain-based market places allowing peer to peer trading without the need to go through third party intermediaries. The trustless protocol of blockchain minimises counterparty risk and permits immediate, error-free trading and settlement of digital (or digitized) assets without the risk of hacking that have plagued centralized exchanges (eg. Mt Gox, Coincheck, BitGrail, etc).
Although decentralized trading has so far been focused on cryptocurrencies, it has not gained as much popularity as centralized crypto exchanges.
In January 2019, as reported by Diar, decentralized exchanges hit an all-time low in terms of US dollar traded value.
Industry experts indicate that part of the reason for the slowdown in trading through decentralized exchanges is the relatively poor user interface generally associated with this type of exchanges and the limited trading pairs and features (such as margin trading) offered. From the point of view of centralized exchanges, one problem has been on how to monetize a decentralized offering which by its very nature, does not require a middleman.
However, these are teething problems of what promises to be a revolutionizing business model. Obolus is a financial services company based in Tokyo, Japan and currently focusing on delivering decentralized solutions for financial markets. Mauricio Hernandes, CEO and co-founder at Obolus, recently shared his views on the momentum behind decentralization in financial services: “People often see decentralized systems as a free-for-all and detached from regulations and oversight, but it does not need to be this way. We believe that the way to achieve a healthy eco-system is through regulation and best practices that are not exclusive to centralized systems”.
There is a growing expectation of traditional markets and settlement houses adopting blockchain on their settlement layer. Mr Hernandes further commented that “at Obolus we believe that the transparency and security of a blockchain-based settlement layer can enable financial institutions to focus on their core business, whilst complying with regulation, and actually improving processes such as anti-money laundry and know your customer cheaper and automatized”.
Furthermore, finance is only but one area where decentralization can play a key role to democratize access to services: e-commerce, energy trading, the gig economy, just to name a few, are all areas where currently centralized services could give way to decentralization.
Conclusion
Whilst the long crypto winter has somewhat clipped the wings of decentralization, global financial regulators continue with their efforts to insulate financial markets from systemic risk and are starting to embrace new technology solutions proactively, for example with the recent introduction of a global FinTech regulatory sandbox. In the next few years, decentralization will play a key role in supporting financial markets’ efficiency and financial inclusion whilst ensuring a safe financial environment.
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