Banks of the future: web 3 edition
An explainer on web 3, and how financial services may evolve
Background
In my last article on the Banks of the future, I’ve started with what a Bank is, and what it does. In short, a bank is a financial institution that accepts deposits and simultaneously lends money to its customers. All Banks are regulated by their respective Central Governments (through a Central Financial Institution) and work in a controlled centralized environment. For customers to give control of their savings and financial access to such centralized institution(s), a certain level of trust is required. But are these entities trustworthy? the answer, as usual, is — it depends.
There are many instances in history where mismanaged governments and banks have taken questionable decisions unilaterally which had affected the entire ecosystem involved with them. Depositors have lost billions of dollars to such instances. Some recent examples are the case of hyperinflation in Venezuela, financial system bail-in in Cyprus, and something closer to home — DHFL Insolvency. In the countries with monopolistic governments and financial infrastructure, the trust in these institutions is low and they do not have access to safe and stable ways of depositing their assets. The cryptocurrency was invented to solve this problem, it promises to provide an alternate financial system independent of centralized institutions and driven by the community-based trust and open infrastructure. Bitcoin, first introduced in 2009, is the first known cryptocurrency that works on a decentralized network and the internet as its medium. All transactions are executed as per open-source rules and are verified by the peers on the network in an encrypted format and recorded on a public distributed ledger called a blockchain. Over the years, the concept has evolved and decentralization has taken the center stage and it is being used as a fundamental building block to build the next generation of the internet — called as web3.
Web 3 — A brief intro
The first generation of the internet in the 1980s began with open protocols which presented a level playing field to build services like email, instant messaging, etc on them. During the second generation, businesses have built a proprietary layer on top of the open protocols to deliver the best user experience. This era has witnessed a massive user adoption of the internet due to the rise of internet-based services developed by companies. It has also generated ginormous amounts of data and has concentrated influencing power with a few large corporations. The third generation aka web 3, which is in its early stages is being envisioned to bring back the openness to the internet and the services built on it. The backbone of these services — the infrastructure is to be developed and maintained by the community for an incentive. Bitcoin is the perfect example of what a web3 service could look like. This transaction service is executed by an open-source on a decentralized network supported by the miners (individuals who provide computing power to maintain infrastructure) are rewarded with a certain amount of bitcoin.
Web 3 encompasses various technologies like blockchain, cryptographic protocols, digital assets, decentralized finance, tokenization, applied AI, etc which empower the development of open, distributed, smart, personalized, and decentralized products and services with the internet as their medium. Declining trust and growing criticism of multinational businesses for concentrating user data are drivers for the development of web 3 solutions.
Web 3 for Financial Services
Web 3 aims to bring personalization and decentralization into every product and service and Financial Services are the frontrunners in this change. While the ecosystem is still in its nascent stages, we’re seeing some fundamental shifts in the way systems are being built. The foundational building block of these new systems is the concept called a “smart contract” — a computer program or a protocol that is intended to execute, control, and document legally relevant events and actions according to the terms of a contract or an agreement. In our physical reality, all corporations and the interactions are nothing but “contracts” between individuals governed by regulators. In the web 3 reality, “smart contracts” are governed by an immutable blockchain that exists in all nodes within the network. In a way, it's the perfect democratic system. Applying these early-stage developments, several applications are built for financial services which will have a significant impact in the near future. Some of them are —
a. Decentralized Finance (DeFi)
Applications/protocols built on blockchain for the purpose of saving, lending, and exchange of something of value refer to DeFi. Three major variations of blockchain are gaining traction — Public, Private, and Permissioned blockchain networks.
Key applications in DeFi are Payment blockchains which enable peer-to-peer (P2P) digital transactions. Transactions are a tedious book-keeping activity and intermediaries such as banks and payment processors have performed the role of recording the activity as a trusted third party. In the case of DeFi, the network replaces these intermediaries’ roles. Cryptocurrencies are the fungible tokens of value that are transacted over these networks. We could see a rise in DeFi with products like P2P lending, P2P transactions, etc coming to the mainstream. P2P financial interaction is something we already do in the form of a bill of exchanges, however, it's only limited to registered entities owing to the trust issues. In the case of a DeFi, the P2P network can be more granulated eliminating intermediaries and their inefficiencies. In theory, cryptocurrency has the potential to transcend boundaries and become a truly global currency with universal acceptance.
b. Decentralized Autonomous Organization or DAOs
These are online member-owned communities governed by the consensus of their members. A real-world corollary could be an employee-owned business (companies with an ESOP policy are partly employee-owned). DAOs are like “corporations” which build applications and services on top of DeFi protocols similar to how banks build their financial services on top of Central Bank’s payment systems and regulations. DAOs are the epitome of a truly global, open, and transparent organization is trying to develop an “on-chain governance” model where each and everywhere player has equal stake and responsibility. A popular example is MakerDAO — which has active community building and utilizes blockchain applications to provide services of exchange for buying and selling cryptocurrencies, broker and custodian services for holding crypto, payment processing services like POS and marketplace, financial management such as investing, lending, personal finance and leisure services like gaming. If we were to draw parallels, MakerDAO closely mimics the super apps of South East Asia. In a few years, we could see DAOs specializing vertically and offering user experiences comparable to traditional services with a much-needed layer of transparency and openness.
c. Cryptocurrencies
Financial services exist because of the need to exchange something of value for goods and services. For the web 3 economies, the infamous cryptocurrency — are the token of value. They are designed to work as a medium of exchange, similar to any fiat currency but without a centralized authority. There’s a healthy discussion on whether crypto is humanity’s answer to the flawed system or an elaborate Ponzi scheme. I tend to stand somewhere in between, hoping and aligning slightly to the former. Cryptocurrency is the only practical way to fairly incentivize the nodes which provide essential computing power to host the blockchain and enable users to build services on it. If the services are valuable, then the supporting infrastructure is valuable and the compensation received in whatever form (here cryptocurrency) has a value. Similar to any network, this has to hit a critical adoption for it to stabilize and become useful for all users. It is widely believed that crypto could follow a similar trajectory as the Internet, with a range of speculations for timelines. After all, the internet started as a basic medium for the military to exchange information, and today it has evolved into a medium for a host of essential services with no going back. We may see consolidation over the next few years where cryptocurrencies backed by blockchains with higher utility and adoption take the lead, and hope that the “invisible hand” of the market stabilizes the value of each cryptocurrency.
It’s a scam!
As with any technology, there are some flaws and negative consequences with web 3 as well. Cryptocurrency’s popularity and meteoric rise in prices have garnered some fair criticism towards it. Scammers have exploited investors and have stolen millions of dollars over the years which has strengthed the criticism against them.
It’s not secure
Blockchain’s inherent anonymity promises absolute privacy. On one side, it has become a haven for illegal transactions, and the complexity is making it extremely difficult for authorities to take any action. Victims of theft and scams have no legal safety net in most countries. On the other side, cryptocurrencies are not truly anonymous either. Authorities in several countries were able to trace transactions and identify perpetrators. Regulators are uncertain about how the future may look in this space and are leaving it in the grey space.
It’s not scalable
Blockchains have a massive scalability problem. More the number of nodes, the more the processing required to synchronize them, hence consuming more energy and taking longer time. Without getting into specifics, some estimates put the average bitcoin transaction’s energy consumption to be 500,000x that of Visa’s. Bitcoin’s transaction time has reached upwards of 10 mins and keeps growing, while the fiat substitutes like Visa are processing in a fraction of a second. Moreover, as the resources are shared and derived from the nodes, achieving standardization on quality of experience at scale is challenging.
Web 3 is promising a fundamental shift in the way we interact with our world and striving to rebuild our systems on the grounds of transparency and privacy. While there are challenges to its adoption from various facets, it’d be naive to dismiss the possibility of web 3 becoming mainstream near future. The applications such as DeFi and cryptocurrency may have to co-exist with traditional finance and fiat currencies and there’ll be an increased need for legacy banks to integrate and build relevant services to facilitate these.
(Praneeth Pichika is a Business Consultant for Banking, Financial Services, and Insurance domain at Tata Consultancy Services Ltd. He is an MBA graduate from IIM Bangalore)
References
- web3 policy. https://a16z.com/web3-policy/
- A DAO. https://blog.aragon.org/an-dao/
- the Blockchain scalability problem. https://towardsdatascience.com/the-blockchain-scalability-problem-the-race-for-visa-like-transaction-speed-5cce48f9d44
- Is Blockchain a fad? https://nasacademy.com/blog/article/problems-with-web-3-is-it-a-fad
- How long does a bitcoin transaction take? https://coinmarketcap.com/alexandria/article/how-long-does-a-bitcoin-transaction-take
- A beginner’s guide to DAOs. https://linda.mirror.xyz/Vh8K4leCGEO06_qSGx-vS5lvgUqhqkCz9ut81WwCP2o
