15 Theses on the State and Future of Finance — with and without blockchain
What lies at the core of finance? How will the future of finance look with blockchain/DLT enabled infrastructures and smart financial contracts?
Based on my experience in large non-financial institutions, banks, blockchain, and economic history, I have assembled a list of hypotheses with respect to the future of finance and capital markets — with or without blockchain.
1. Innovation in payments has been mistaken for innovation in finance
2. Financial contracts are at the core of finance and are the missing link
3. Banks create, maintain, trade and securitize financial contracts
4. Regulators need forward-looking firm-specific and systemic risk risk management tools
5. Blockchain is the single most important technology innovation in Finance since the arrival of computers in Banks in the 1960s
6. Everything will be tokenized — “Real World Asset” Tokenization is bad terminology
7. Tokenization of Financial Assets is headed for disaster
8. Tokenization of cash and cash equivalent is currently the only real use case in finance on DLT/Blockchain
9. The world runs on Credit. Tokenized credit markets will drive economic growth.
10. Equity tokenization is nice to have, but a sideshow.
11. Defi and Tradfi — it’s finance, stupid!
12. Current analytic tools in Risk, Finance, and Regulation are inadequate
13. Problems of core banking transaction systems remain unaddressed — despite massive investment in technology
14. AI will not clean up the mess in banks, but may revolutionize finance in other ways
15. Addressing the mess in the financial system is a moral obligation
16. Key Links on the topic
1. Innovation in payments has been mistaken for innovation in finance
Let’s start with definitions:
- Payment = exchange of cash or cash equivalent, payments are at the fringes of finance at best
- Finance = exchange of cash over time by parties according to a financial contract
- Financial Contract = the agreement of two or more parties to exchange cash flows over time, i.e. defining the payment obligations of the parties
Shiny apps for the exchange of foreign currency on vacation and colorful mobile banking interfaces may be enough for retail, but they do not constitute innovation in finance. It seems that few of the fintechs touted as the future of banking and payments have actually made money for their investors, nor the impact they promised to deliver. Why? Because…
2. Financial contracts are at the core of finance and are the missing link
The decisive question is, what is the basic task of banks, brokers, insurance companies, pension funds, private equity funds, and other players in the financial sector: The exchange of cash flows over time defined by financial contracts.
The financial industry will find sustainable profitability, resolve the mess it has made for itself, effective regulation, clarity and actionable information, and borrowers will only get fair, risk-adjusted priced access to capital, if the financial contract is put at the center of analysis and transaction processing.
A financial contract is, by its nature:
- Digital: The exchange of cash flows is defined in numbers;
- Algorithmic: The calculation/computation of the obligations follows mathematical formulae; and
- Standardizable: The exchange of cash flows follows a limited number of patterns, which are universally applicable and the same globally.
It is not about the names of financial instruments that are driven by legal considerations or marketing efforts, but about the cash flow exchange pattern which results from the respective contractual obligations.
Financial Contracts are at the core of finance — the contractual obligations of parties must be deterministically defined with a standardized data model and standardized algorithms, and, from my perspective, based on the ACTUS standard.
Everything of interest in finance derives from cash flows — liquidity and value are derived from actual and expected cash flows in the future. Cash flows are defined by financial contracts, and are dependent on counterparties, market risk, and behavioral risk.
3. Banks create, maintain, trade and securitize financial contracts
Introduction to financial contracts.
4. Regulators need forward-looking firm-specific and systemic risk risk management tools
Forward looking, modern regulation must be cash flow based — a standardized granular understanding of cash flow obligations and assets is required. Only with a granular understanding of transaction and position data including standardized algorithmic definitions of cash flows, a firm can realistically manage its own risk on a forward looking basis, and regulators can understand systemic risks.
5. Blockchain is the single most important technology innovation in Finance since the arrival of computers in Banks in the 1960s
All assets and, perhaps more importantly, liabilities will be tokenized and represented on blockchains (or similar technology). A financial asset (and certainly a financial contract) is digital in nature and is ideally suited to live on-chain.
Why is blockchain fundamentally changing finance? In the words of Guido Buehler, Founder of SEBA Bank: 1) Blockchain is the most efficient transfer of ownership 2) The trade is the settlement 3) The private key is the perfect collateral, and 4) Tokenization is origination.
At the same time, blockchain technology development is carried out by self-interested software developers without any understanding of real finance. This is not about the war between centralized operators and the decentralized ideals of crypto, but about innovation, accountability, and profitability. Blockchain development has been siloed, and to this day we do not even have real interoperability with any legacy system beyond the control and exchange of dumb tokens
6. Everything will be tokenized — “Real World Asset” Tokenization is bad terminology
A clear distinction between real, physical assets and financial assets must be drawn. Amazingly, accountants have thought about this problem deeply and provided the financial world some pretty precise definitions.
The term Real World Asset tokenization is used to describe many kinds of tokenization initiatives. It is difficult to understand why new terminology is introduced, since accountants, regulatory bodies and the financial industry have defined the world of assets in great detail. In the very real financial world, Financial Assets, Tangible Assets and Intangible Assets are well defined. So why introduce new terminology? Makes no sense. So let’s start with definitions:
- Financial Asset = Deposits, stocks, bonds, notes, currencies, and other instruments that possess value and give rise to claims, liabilities, or equity investment.
- Tangible Asset = Tangible assets are assets with a physical form and that hold value. Examples include property, plant, and equipment. Tangible assets are seen and felt and can be destroyed by fire, natural disaster, or accident.
- Intangible Asset = Intangible assets lack a physical form and consist of things such as intellectual property, trademarks, patents, etc.
Now, let’s break down how we can tokenize each of these asset classes. Well, as financial assets are pretty much all digital today, and Intangible Assets are either natively digital or can be digitized, thus they can also be secured cryptographically, it turns out, we are in luck. Let’s look at the details.
Financial Asset Tokenization: Since the nuclear building block in finance is the financial contract, which in its nature is digital and mathematical, it is perfectly suited for unambiguous machine environments, and can therefore be tokenized with a machine readable and machine executable term sheet based on an algorithmic standard which includes the logic of the expected and actual cash flows of the underlying instrument, dramatically increasing accountability and transparency and, therefore, forecastability.
With the algorithmic and deterministic definition of the payment obligations of all parties to the financial contract, a financial asset can live on-chain as a Smart FinancialContract. Thanks to its standardization, the financial asset interoperability is ensured and enables effective price discovery, trading and settlement across platforms.
The problem today is that we have taken an elegant technology and simply created a bunch of “dumb” tokens. Hashing the PDF of the term sheet or prospectus and storing it in the token, as it is widely done, produces a dumb token, resulting in all kinds of problems and hindering adoption because of the marginal benefit such solutions offer.
The solution is simple, leverage Smart Financial Contracts supported by standardized, cross-border continuity. In other words, add real value.
Tangible Asset Tokenization: How would a house or a painting be tokenized? A tangible asset can be tokenized, however, it can not live on-chain. Of course, digital twins can be created, but you cannot live in a digital twin house or drive a digital twin car on-chain (except for the metaverse). Tangible Asset, or “physical asset” tokenization refers to all kinds of REPRESENTATIONS of claims or rights, including rights to ownership, rights to use, rights to cash flows, etc. on-chain, which must be rooted in legal concepts in the REAL WORLD.
For example, the enforcement of fractional ownership to a high value painting in a bonded warehouse. Many times, tokenization of tangible assets simply refers to obtaining certain ownership rights in tokenized form to an SPV producing cash flows or economic value through appreciation.
Commodities are a special case for tokenization of tangible assets, as they have highly differentiated asset definitions (e.g. quality specifications of oil, gold, diamonds) and often have market infrastructures, which can further benefit from a reliable digital representation of the commodity on-chain.
Intangible Asset Tokenization: Economic growth of unknown magnitude will be enabled by Intangible Asset Tokenization. Natively digital items like patents, trade secrets, technical drawings, chemical formulae, (digital) art, music, etc. will all be tied to cryptographically secured ownership rights and enable economic transactions and economic rent distribution at a level of granularity and with efficiency which to date is not possible. Established enterprises, the so-called “creator economy”, and tax authorities will greatly benefit.
7. Tokenization of Financial Assets is headed for disaster
The state of the art of tokenization of financial assets is abysmal:
- Most tokenization platforms simply store a hash of a PDF of the term sheet or prospectus, in short, produce dumb tokens and offer no innovation over the current rails. There is a lot of untapped innovation potential here, but the major forces of blockchain development are software developers with little understanding of finance.
- Some tokenization platforms, however, do in fact describe the rights of the asset holders in the token, however, they fail to represent the liability side — which means they do not meet basic principles of finance, i.e. the basic fact that financial instruments have an asset and liability side… go figure…
Tokenization offers a chance to address many of the core shortcomings of the current financial architecture, and create scalable, natively digital financial assets.
The only way to achieve this, however, is by ensuring that all cash flows are algorithmically and deterministically defined within these assets. Currently, most tokenized financial products are nothing more than a PDF of the terms or the prospectus stored as a hash in the token. A human still must access and read this definition, and process it accordingly. This is in no way innovative, and is certainly not scalable.
How to avoid Disaster in Tokenization
The current problems in Tokenization and the Future of Capital Markets
The promise of efficiency and cost savings in mid- and back-office operations will remain elusive, if the financial assets are not defined ab initio and at genesis with a standardized data model AND an algorithmic transition function, as available with the open source algorithmic financial standard ACTUS. What innovation in blockchain is currently focused on — zkproofs and account abstraction — doesn’t even begin to address these issues.
What is actually needed are smart financial contracts that encode not only the information about the tokenized financial asset, but also clearly define all payment obligations of the parties to the financial contract, i.e. cash flows and as a result define the asset and liability side.
Higher information quality, transparency, based on machine readable and machine executable term sheets, will enable innovation in analysis, price discovery, risk, trading and securitization. Company-wide risk management becomes easier and systemic risk management is again possible in a manageable, meaningful way. The entire system would be transparent and machine auditable, and could easily be stress tested for various market conditions.
Every financial institution using standardization in this way would have a real time understanding of their assets and obligations, and we would likely never have a repeat of the financial crisis we saw in 2008. This approach will truly bring about a revolution in finance.
Financial crises caused by the mania inherent in humankind are unavoidable, but having the right financial piping, tools and apparatus, transparency and assurance enabled by Smart Financial Contracts, will allow getting back to equilibrium quicker.
8. Tokenization of cash and cash equivalent is currently the only real use case in finance on DLT/Blockchain
Ask JPM Chase how much money it saves, and hence how large of profits it generates on their proprietary settlement infrastructure for bank deposits. This is why many other banks now pursue depository tokens, and an essential aspect to recognize and understand.
Delivery versus Payment experiments by a number of players in capital markets (BIS, SNB, BdF, MAS), do show efficiencies and feasibility of on-chain settlement of various assets. However, I must point out that once you move from cash and cash equivalent instruments, to cash flow based instruments which are settled in these new rails, atomic settlement infrastructure alone will not make the entire system more efficient or reliable. The nature of the cash flows in the financial asset which is settled must be well understood with less effort, in order for efficiency to be enjoyed across the entire value chain.
Frankly, without standardized machine readable and machine executable financial contract definitions any efficiencies in middle-office and back-office, price discovery will remain elusive. WORSE, we will risk situations like 2008 where even cash and cash equivalents were no longer good enough for collateral, and certainly any ABS (asset backed security) needed to be well understood to understand any of its value.
9. The world runs on Credit. Tokenized credit markets will drive economic growth.
Contrary to the common, widely repeated thesis of Adam Smith (historically unfounded, as it turns out), money was not first, credit was. What started with commodity credit in Babylonian times, developed into finance based on the exchange of cash flow, drove economic development and solved the human kind’s biggest infrastructure needs (think food, canals, railroads, electrification).
Unfortunately, today’s credit markets are no longer efficient, runing on shoddy, decades-old infrastructure inside banks, CSDs, government agencies and cross-border settlement infrastructure providers. Despite massive monetary easing in the past decades and unprecedented injections of cash for COVID-19 measures, large credit gaps for SMEs (small & medium sized enterprises) persist, even in the most developed economies (the Bank of England estimated the pre-COVID-19 credit gap for SMEs in UK at GBP19B, post-Covid at GPB22B).
It is not only that SMEs cannot access credit, many sovereign borrowers which are facing the most dramatic impact of climate change and have credit needs for all aspects of their economies, are not connected to the global capital markets and experience steep issuance and borrowing costs. The same is true for the largest industry we have, international trade. It has to deal with the financing gap for SMEs (access to credit), but there is no comprehensive solution in existing crypto projects to do so.
How are we to solve such cases of credit scarcity? By enabling highly efficient credit markets with nearly fully-automated securitization and straight through processing thanks to algorithmic standardization of the underlying financial contract. This provides a granular understanding of the cash flows of each obligation, which in turn allows to build large, diversified portfolios of revenue based financing instruments across many issuers which can be analyzed with ease and securitized on a nearly automated basis, including tranching depending on the associated risk or other parameters unique to each asset. (Underwriting policies and technology, while key to the issuance/origination of credit instruments, the underwriting function precedes the issuance and is a separate field from the efficiency to be gained through standardized financial contracts in risk and securitization.)
Such efficiency in analysis and securitization is a precondition for transparent and liquid credit markets for any loan amount, especially for small amounts needed in the SME working capital financing space.
10. Equity tokenization is nice to have, but a sideshow.
Equity tokenization makes sense for efficiency of fund management which is why KKR, Franklin Templeton, Fidelity are deeply engaged. Equity tokenization makes NO sense for Small & Medium Sized Enterprises (SME) as a means of financing:
- If an SME is running well, why would its owners want dilution of ownership?
- If an SME is in trouble and needs capital, why would anyone in their right mind buy equity of that company?
- Lawyers like and promote SME equity tokenization, mostly so they can find and track it.
- First and foremost, SMEs need risk-adjusted, appropriately priced working capital financing — and this is enabled by cash flow revenue based financing, not equity tokenization.
What is needed are supercharged, highly efficient SME working capital financing systems, not equity crowdfunding platforms. Large pools of SME loans which can be securitized on a nearly automated basis providing the needed working capital for SMEs is much more important than equity tokenization.
11. Defi and Tradfi — it’s finance, stupid!
Defi (de-centralized finance) and Tradfi (traditional finance) obviously share the word finance. Therefore, this must mean they both enable finance. Let’s revisit some definitions:
- Payment = exchange of cash or cash equivalent, whenever they occur
- Finance = exchange of cash flow over time by parties according to a financial contract
- Cryptocurrencies = a novel asset class enabled by technological innovation, used for many functions, including financial applications, and payments (especially popular are stablecoins). Whether they are a store of value or of use long-term, depends on one’s perspective of the world….
- What then, is the difference between Tradfi and Defi, if both concern themselves with finance? The nature of the counterparty. In Defi the counterparty can be a blockchain protocol, or software program, supposedly without any centralized entity or individual exerting control over the nature of the operation. In Tradfi, the assumption is that counterparties are ultimately identifiable entities or persons.
Let us then review the kind of financial instruments which exist in Defi. At this time, financial applications in Defi are very limited and simple — the only financial instrument which scaled somewhat, is over-collateralized lending. The problem is, that in the real world, hardly any over-collateralized lending exists. Which is also why Defi is tiny in comparison to Tradfi.
The reason why Defi can not scale is its inability to deal with cash flow streams OVER TIME as well as under-collateralized lending. Defi will only be able to scale when its financial instruments are based on open source algorithmic financial standards, like ACTUS.
12. Current analytic tools in Risk, Finance, and Regulation are inadequate
Unfortunately, the financial crisis of 2008 has not significantly lowered the risk in financial firms or on a systemic level. Why? Despite higher capitalization requirements, the challenges to produce consistent, reconciled transaction and position data inside firms remain. I call this the “brute force reconciliation problem”. In financial firms it stems from the illusion that enterprise-wide data warehouses solve this issue. However, while these data warehouses physically integrate different sources of data, they do not conceptually unify them. For example, a single concept like notional value still might be captured in various ways in fields that might be labeled ‘nominal value,’ ‘current principal,’ ‘par value’ or ‘balance’. Without logic data is meaningless, and this is precisely what the ACTUS standard solves for finance.
Both financial firms and regulators face the same problem. Without standardized data AND logic of the payment obligations, no effective firm-wide risk or systemic risk management is possible.
More effective financial regulation can start with the ongoing collection of granular transaction and position data in ACTUS which is the tested and validated financial contract standard that generates the promised payment obligations (i.e. cash flows). Risk factors can then be modeled to assess how they can be expected to adversely affect the promised payments/cash flow. These results form the basis of all higher-level forward-looking analysis that is needed by regulators for an early warning system to alert them to which financial firms are getting into trouble. The same granular data will also enable regulators to see the cash flow obligations between financial firms and, for the first time, be able to see the potential for cascading failures that can lead to a systemic crisis.
13. Problems of core banking transaction systems remain unaddressed — despite massive investment in technology
Generations of IT employees in banks, product managers tasked with developing new business, auditors, and operational risk managers are telling horror stories of systems architecture, 50 year old mainframes maintained by personnel in their 70s, missing amounts in the billions in systems and so on.
It seems, everyone is waiting for the all cleansing technology invention in core banking. This an illusion, when the most capitalized new core banking system companies are not providing much more than a cash ledger and credit card management platform..
Innovation in banking and finance must come from the core, and that core must consistently life-cycle manage most financial instruments reducing the complexity of all systems. BIAN has been providing the most advanced discussions on this future architecture.
The reason why problems in core banking transaction systems remain unaddressed is that the centrality of the financial contract with a standardized data model and algorithmic, deterministic definitions of cash flows, is not well understood. (ACTUS).
The only path out of the mess in transaction processing, is to start with the mapping of financial contracts in banks/financial service companies to a Smart Financial Contract Data Hub, which allows a normalization of all cash flow related event data, from which all analysis in finance flows.
Piece after piece, core transaction systems can be replaced with a consistent, expandable core architecture, based on the life-cycle management of ACTUS.
14. AI will not clean up the mess in banks, but may revolutionize finance in other ways
Naive application of AI has been shown to lead to problematic conclusions, due to the data driven discovery using modern AML and AI methods. In trying to cut through the data mess in banks and FS with respect to cash flow related events, we can anticipate many incorrect conclusions with AI and ML methods. What’s more, the AI solutions we currently have, use reiterative processes that ingrain bias and misinformation with every new version, ultimately leading to data pollution.
Humankind has developed legal frameworks to govern the interaction and functioning of society. The universe of contracts is undefined at the edges, but economic and financial contracts can be quite well identified. While human created and not a natural law, financial contracts are algorithmic in nature.
The key to clean up the mess in finance is the apply an ALGORITHMIC standard, in addition to a DATA standard, which has been the focus of most standards in finance.
Assume we will send AI into a bank and ask for all cash flow relevant events and risks associated with those events. As many disparate systems have their own language definitions and also their own algorithms (one key reason for the brute force reconciliation problem discussed above), financial contracts are stored and represented in thousands of different languages. It appears highly unlikely that AI and ML would discover the unifying principle such as ACTUS. However, once data is normalized and the cash flow streams are understood on granular level, it can be expected that AI and ML will provide much more powerful and discrete models relating to risk, expectations for the future, and causality of certain events.
15. Addressing the mess in the financial system is a moral obligation
For the first time in 40 years, we can do something about the mess in core banking and financial analytics by putting the nuclear building block of finance in the center — the open source, algorithmic financial contract. In combination with blockchain/DLT, we can create the transparency, efficiency and reliability which is required to improve firm wide risk management and make systemic risk management possible again.
16. Key Links on the topic
The current problems in Tokenization and the Future of Capital Markets: https://www.globalinvestorgroup.com/articles/3698016/blockchain-and-the-future-of-the-capital-markets
Introduction to Financial Contracts: https://www.nasdaq.com/articles/smart-financial-contracts-should-be-basis-for-innovation-of-financial-systems
How to avoid Disaster in Tokenization: https://www.youtube.com/watch?v=nMmxZYBf0Vg
Looming revolution in Regulation with ACTUS: http://www.brammertz-consulting.ch/wp-content/uploads/2022/06/THE-LOOMING-DIGITAL-REVOLUTION-IN-FINANCIAL-REGULATION.pdf
Link to video explanation of Actusfrf.org: https://clipchamp.com/watch/8Aposaw90dQ
Link to the Financial Standard ACTUS: https://www.actusfrf.org/
Video summary of the future of regulation and blockchain — Allan Mendelowitz: https://youtu.be/PcpLK-DIXEo
Video on the leasing use case with Nucleus Finance: https://www.youtube.com/watch?v=33SHj9_CPAs
Academic Presentation on Financial Asset Tokenization: https://www.blockchain.uzh.ch/events/industry-talk-actussmart-financial-contracts-the-future-of-capital-markets/
SME Loans: What Banks, goverments and fintechs do not understand: https://medium.com/@RRKUBLI/solving-the-sme-credit-gap-what-needs-to-change-to-drive-growth-2da04216e678
