Advancing Capital Markets with Blockchain Technology

Joseph Lubin
Founder, ConsenSys
Co-Founder, Ethereum
 

The Role of CSDs and Ethereum in Decentralized Finance

 Authors:
Joseph Lubin | Founder of ConsenSys, Co-Founder of Ethereum
Mally Anderson, Everett Muzzy
 Ajit Tripathi, Clark Thompson, Monica Singer
 
Adapted from the keynote delivered at WFC, Marrakech, April 2019

WFC No Text-01

 

Every new economic age in modern history has been driven by an explosion of technological innovation that results in increased efficiency, throughput, and coordination. The end result has been sharp and steady growth in global GDP (Gross Domestic Product) and wellbeing.

 

During the Industrial Revolution, steam power and other forms of mechanical assist multiplied what we could do with our muscles alone, enabling us to operate bigger, better, and faster and to create more value in less time. The Information Revolution saw computation machines enable us to process information better and faster than we could with our unaided brains, magnifying the size and complexity that we could contemplate and execute, enabling us to impact broader vistas and create even more value in less time.

 

In 1984, John Gage, chief scientist at Sun Microsystems, coined the phrase, "The network is the computer," and years later many Web 1.0 and Web 2.0 companies brought that network to billions across the world. These networks supercharged our gregarious nature to create the Social Network Revolution, which enabled us to act collectively on a global scale in real-time.

 

As humans have marched from revolution to revolution, we have built out systems and technologies that have raised the quality of life for so many. But all of these developments have rested on a single, somewhat flimsy foundation: the base trust layer of our societies. People need trust between one another in order to perform even the most rudimentary transactional tasks. Thus far, all of the base trust layers in our societies have been founded on subjective trust, including:

    • trust in a single individual, or
    • in interpersonal social networks, or
    • in platforms like businesses and institutions, or
    • in large centralized authorities, like governments.

Subjective trust works reasonably well in many situations. Indeed, it has sustained global human growth for the past few millennia. It often breaks down, however, when there is a misunderstanding, information asymmetry, or especially when there is an imbalance of power. In particular, the reliance on centralized trust—i.e. when individual entities grow to dominate the trust landscape—enables intermediaries to extract too much value from a transaction flow. These trust intermediaries extract rents for providing transactional relationships with necessary trust—standing between content creators, service or resource providers, and their customers. Until recently, this was the only way we knew how to collaborate at scale on planet Earth. We now need new and better trust infrastructure on which to rest improved technology, commerce, and political systems that run the world.

 

In blockchain technology and related decentralized protocol systems, we have arrived at a breakthrough in how we can build trust into all of our systems. Automated objective trust can replace reliance on older, weaker forms of subjective trust. We are at the beginning of this next revolution, the Decentralized Trust Revolution, in which blockchain and distributed ledger technologies allow us to improve upon the extraordinary scale, efficiency, and processes that modern industries have built. The Trust Revolution will transform everything. We can now re-architect systems to enable guaranteed execution of agreements, and build fidelity, fairness and equitability into social systems, as everything we do can be recast on a more sound foundation of trust.

 

The trust characteristic of blockchain systems derives from their degree of decentralization. This emerging revolution in the global trust infrastructure—enabled by maximally decentralized blockchain and related protocols—not only will enable us to create orders of magnitude more value faster, but it will also alter the very definition of value going forward.

The question is, though, why do we need to be investing in and preparing for the Decentralized Trust Revolution? What makes it necessary?

Trust in the Financial System is at Risk!

 

The global financial crisis of 2008 was more than a failure of some banks. In fact, the failure of Lehman Brothers was followed by a failure of entire sovereign economies like Greece. In a way, 2008 marked a collapse of the foundations of modern capital markets. Sophisticated mathematics and systems were rendered worse than useless by the utter failure of information flows. No bank had a clear idea what their credit exposure to every other major counterparty was. Consequently, when defaults on subprime mortgages rose across America, the entire pyramid of debt crumbled like a pile of sand, triggering giant payouts on credit default swaps, forcing banks into panic and triggering a downward cascade of crashing prices, collateral calls, and effective insolvency.

 

The bottom line is: financial markets are markets for information, and financial markets freeze and fail when information flows are impeded. Having better information than the competition is what traders call “having an edge.” Information is what allows us to price, trust, trade and settle. When information stops flowing, markets stop working. Information and transparency strengthen the entire system by strengthening trust.

 

So why do we have these repeated information failures in today’s markets? I believe a significant part of the answer lies in technology. Our market infrastructure and our regulatory architecture today is built on technologies that once led the previous digital transformation of markets but are no longer fit for purpose. These technologies are:

  1. Relational databases which eliminated the need for paper stock certificates to be couriered and mailed around, allowing transactions to be settled by book entry, and giving rise to CSDs (Central Securities Depositories).
  2. Messaging, which allowed financial entities around the world to be connected and settle transactions within two or three days.

Using these technologies, centralized trust enablers such as CSDs and CCPs (Central Counterparty Clearing Houses) have helped markets become safer, more efficient, more liquid, and more resilient. These centralized trust enablers have enabled capital to be directed to more efficient uses and thus enabled the world to become as connected and as prosperous as it is today.

 

However, these technologies are now four or five decade-old paradigms and no longer fit for purpose. A second digital transformation of financial markets is long overdue. This one will involve natively digital assets issued and transferred on secure, internet-based shared ledgers rather than analog assets like paper stock certificates that have been digitized using centralized databases.

 

We know that this financial system built on legacy technology —while safer and more efficient than before —is far from perfect, and it certainly does not serve everyone. We know this for the following reasons:

  1. Economic inequality has risen in most parts of the world.
  2. Systemic risk has shifted from the banking system onto the shadow banking industry and central counterparties. In fact, systemic risk has become even more concentrated in a few entities and FMI as they have grown “too big to fail.”
  3. Pension plans are increasingly more underfunded on average.
  4. The cost of asset management continues to siphon away too much of the pension pot for most employees.
  5. Billions of people do not even have access to the banking system, let alone capital markets.
  6. The cost and complexity of raising capital is excessive for most small issuers, giving rise to markets for crowdfunding.
  7. The overall cost and complexity of public listing is excessive even for large issuers causing companies like Uber to stay private for longer and moving capital into private markets.

So if today’s market infrastructure does not serve most investors, issuers, and communities, how then can we serve our purpose as market participants, which is to make efficient use of capital and promote economic well-being for our communities and society?

The Solution is Decentralization to make efficient use of capital and promote economic well-being for our communities and society

 

The Role of Blockchain Technology in Financial Services

In the past fifty years or so, the breakdown of trust, of wealth equity, and of data security can largely be traced back to the shortcomings of the Internet. The Internet is a profound and revolutionary technology — but it is broken in a number of ways. It is broken with respect to: Security, Identity, Access, KYC, Empowerment, Copyright, Management, and more. These limitations of the Internet have allowed a handful of technology companies, financial intermediaries, and nations to capture an unfair share of the data value created by billions of people worldwide.


The solution is Decentralization. How does decentralization begin to mitigate the problems outlined above? Decentralization allows for the creation of all the same systems we currently use today to go about our personal and professional lives. The difference is that these systems cannot be exploited, compromised, corrupted, or leveraged in a way that is detrimental to the majority of people who interact with those systems. Decentralization removes the power and financial opportunity derived from inefficiencies while still retaining the competition, early-mover advantage, and innovation that brings fair economic return to companies and people.

Specifically, we can achieve decentralization through blockchain technology.


In early 2011, the Bitcoin Whitepaper was published by a person or group known as Satoshi Nakamoto. In releasing the Bitcoin system, Satoshi had actually invented three separate but interacting elements:

  1. Cryptocurrency: a digitally-scarce token asset that could be used as money.
  2. Blockchain: a next-generation database technology through which trust can be automated and established on a peer-to-peer basis. Blockchain technology enables us to build collaborative infrastructure that everyone can trust, rather than being forced to build siloed systems on older database technology. Siloed systems require reconciliation. Blockchain makes reconciliation unnecessary.
  3. Crypto-economics: Employing appropriate mechanism design, the protocol issues value tokens to participants who contribute necessary work and other resources, incentivizing participants to validate transactions on the network and thereby secure the platform.

Bringing these three mechanisms together, Bitcoin became an experiment in monetary theory —money that was issued on an inflation schedule controlled by rules defined in the protocol. It was the first monetary system fully of the people, run by the people, creating value for the people.


Though Bitcoin introduced a new way of approaching some narrow use cases around money, it fell short with respect to some of the larger opportunities of blockchain technology. In 2014, a new blockchain platform called Ethereum was created. Ethereum took the decentralized and secure foundations of Bitcoin and made them far more programmable, extending the capability of a blockchain far beyond peer-to-peer value transfer and cryptocurrency. The Ethereum blockchain enables distributed users to execute code and reach consensus on a fully programmable blockchain. Ethereum is an open-source platform, meaning that any developer anywhere in the world can build on top of it with ease. This was the start of Web 3.0, a natural evolution of the Internet and web protocols and a new kind of decentralized World Wide Web.


You can think of Ethereum as a next-generation database technology, in which transactions and data management can be handled and monitored cheaply and securely without the risk of centralized security breaches. Ethereum made the database technology breakthrough introduced by Bitcoin relevant to everything—not just monetary transactions. Far beyond the purview of Bitcoin, Ethereum would enable any system to be built on a decentralized application platform, a decentralized world wide web that was not subject to the whims of the actors that controlled the servers, the silos, and the walled gardens. Ethereum and related technologies introduced automated trust, where before it was subjectively conferred and often capriciously applied, and guaranteed execution of agreements (be they regulations, laws, or contracts). Once built out, this technology will serve as a more trustworthy foundation on which society can re-architect better systems.


Ethereum is emerging as one of the foundational components of a world computer. Web 3.0, the decentralized world wide web, will consist of many decentralized protocols: for trusted transactions, automated agreements, smart software objects, storage, bandwidth, heavy compute, identity, reputation, proof of location, legally enforceable agreements, certificates, equity and real estate tokenization and ease of fractional ownership, financial inclusion, clearing and settlement in the instant of the transaction, and more.


The new trust foundation enabled by the maximally decentralized Ethereum base layer is what is facilitating this evolution towards collaboration. It is trustful collaboration, even with those you don’t know or with whom you compete, that will enable a world of decentralized actors to thrive, as they no longer have to depend on embedded intermediaries —the music companies, banks, law firms, insurers, brokers, and existing sharing economy companies —who currently provide necessary trust, and from that privileged position, capture much of the value in their sectors in the form of extracted rents.

 

Our Financial System is Broken

The growth of our global GDP in the last half century has been exponential. In recent decades, this growth has stemmed from the new markets and bridging of global economies the Internet enabled. Not everyone has shared in this wealth creation, however. A closer look at the global distribution of wealth shows that while global GDP growth has been exponential, so has its concentration in the hands of the few.

 

Chart Global Wealth Concentration - Economic incentives have concentrated the growing global wealth in the hands of a few tech & finance companies who have control over the world’s most valuable asset data

 

The world is an extremely wealthy place, and it will continue to grow wealthier as economies become more robust and innovation accelerates. However, that wealth is not being returned in ratio-balanced measure to the people who are doing much of the work. Companies are not properly incentivized to create strong and equitable wealth distributions among its workers and its partners. The driving economic concept of our world is a “scarcity mindset,” where to achieve wealth requires the economic suffering of another company, country, or individual. As a result, competitive economic incentives have concentrated the growing global wealth in the hands of a few monoliths who have tremendous access and control over the world’s most valuable asset: data.


There doesn't actually exist a coherent global financial system. It is a network of walled gardens; brokerages that serve their jurisdictions, stock exchanges that serve their jurisdictions, central securities depositories for each nation, and banks that handle their business nationally and reach out using correspondent banking relationships when they need to cross into another walled garden to complete a transaction. This loosely knit network is often extremely inefficient when jurisdictions or currency boundaries need to be crossed, exposing participants to risk, delays, and high operational costs.


Post-crisis capital markets infrastructure relies on layers upon layers of rules, duct tape, and nails. The industry names for such patches are controls, collateral management, default fund contribution, reserves, capital buffers, and so on. Financial institutions spend billions auditing the systems that these nails and duct tape are holding up.


So who pays for all this market infrastructure of duct tape and glue? Well, we all do, from the taxes and the pensions whose benefits we may never receive.


Today’s financial markets are closed. To join, you have to lock yourself into interfaces that everyone else is using. And then you can never leave. This is why the European Cross Border Settlement System, or T2S, took over $275 million and over ten years to build. Today, no one would dare change it. Changing market infrastructure requires changes to multiple interfaces, which creates considerable operational risk and allows FMIs (Financial Market Infrastructures) to argue that it is too risky. This fear turns FMIs into centralized rent-seeking infrastructure monopolies, who are generally disincentivized to innovate beyond minor experiments or occasional public announcements. What we gain in terms of economies of scale, resilience, and managed operational risk, we more than lose by way of severe diseconomies from lack of innovation and transparency.


The past half-century suggests that global growth will continue, and likely accelerate as the world grows more connected and better optimized. In particular, technologies like the Ethereum blockchain will allow for the realization of wealth through the access and promotion of previously-untapped wells of wealth, namely people and economies left behind by our society’s most recent exponential growth.

  • According to the World Bank, there are currently 1.7 billion unbanked people. These people have personal, local, and community economics —but that wealth is not managed by or trusted to regional or national banks, meaning its opportunity for investment, growth, and empowerment is forgone. In Southeast Asia alone, 73% of citizens are unbanked —that’s 438 million people who are not currently customers of the financial industry.
  • An estimated $5.8 trillion held by private equity funds is currently locked up in illiquidity. A more transparent, lower cost, digital-first infrastructure that does away with some of the value-consuming intermediaries —auditors, lawyers, paperwork —can make much of this value liquid. Unlocking that capital would undoubtedly speed up growth across the board.
  • Residential real estate is valued at nearly $300 trillion globally. Real estate is a notoriously illiquid asset, and even for people who are fortunate enough to own land, it can account for up to the vast majority of their net worth —that’s, let’s say, 70% of individuals’ net worth not made available to them to invest.
  • The global art market is worth nearly $70 billion. The majority of the assets managed by the global art market are illiquid and provide no ongoing opportunity for investment besides passively accruing worth.
  • Finally, despite the growing ubiquity of the Internet, in 2016 the ITU reported that nearly 4 billion people globally did not have reliant or consistent connection to the Internet. This means 4 billion people cannot regularly or confidently use the Internet to interact with, participate in, and contribute to the global economy.

The realization of these opportunities has been hampered by the reality of the “walled gardens” of our financial industry. Barriers to entry are too high for many people to access financial services and engage in the global economy. Physical assets are stubbornly resistant to secure and traceable liquidity. On our current path of global development, worldwide economic opportunities become greater, but inversely more difficult to realize.

 

The Role of Decentralized Finance

“Decentralized Finance” is a term that describes how financial services—both B2B and B2C—will be organized, facilitated, and executed when fully underwritten by blockchain technology. Ethereum is part of the Internet, meaning companies using the technology don’t need mainframes or SWIFT messages to go about business. Decentralized means records can be accessed securely and transparently by individuals, issuers of securities and regulators, or other parties promoting industry standardization instead of requiring companies to build proprietary databases, interfaces, and messaging systems. Decentralized does not mean that companies or intermediaries sacrifice control, security, access, or transparency over their data or information.


Historically we have relied on utilities to perform logically centralized functions: standard setting, deployment and release management, network operations, and governance. CSDs now have the opportunity to be agents of change, using their authority enshrined in national laws to deliver these essential services without being a single point of failure. Instead of custodying assets in a physical center of the financial system, CSDs can be the logical center of the system, custodying the standards, processes, and governance of the system. The physical implementation can then be decentralized and rendered more robust with no single points of failure. This architecture can lead the way to harmonization across CSDs, eventually enabling a fluid, coherent, global system, thus unlocking trillions of dollars in value.


So where does this leave those of us who have so much experience and allegiance to the traditional financial sector? There are a number of ways blockchain technology, Ethereum, and decentralized finance will impact the financial ecosystem, including and particularly the CSD industry:

Settlement

Settlement currently takes two or three days in many places, involving high risk and high costs for transacting parties. On a blockchain, clearing and settlement can be collapsed into a single process, in which digital and digitized assets are delivered against payment instantly and atomically when appropriate. The optimization opportunity of blockchain technology cannot be overstated. Cash and assets will cross at exactly the same point without relying on intermediaries. Investors will tie up liquidity for less time, and balance sheets can be redeployed faster, so there is almost no risk of anyone being left short, or left holding cash and or securities at the same time. The tremendous cost of warehousing risk over time can be dramatically reduced. Furthermore, the ability of regulatory bodies to have better transparency into current and future transactions in the financial markets which will improve their understanding of the impact of these risks, while giving greater ability to see end to end asset and cash flows, not just in real time, but with accurate forecasts.

Reconciliation

Today’s markets are built on proprietary, siloed systems that do not interoperate well, if at all. The way we currently address this problem is by spending billions of dollars and millions of human hours on reconciliations.


The financial ecosystem is currently comprised of many reconciliation companies that also provide services like banking, investment management, and insurance, seemingly as a sideline. Reconciliation is a necessary evil, created to respond to the nature of database technology that drove information technology architectures to be siloed. To me, reconciliation means a disconnection in the flow of information, a chance for imbalances to build up in the system, a chance for things to go wrong, and therefore a source of systemic risk.


For CSDs and CCPs whose very role it is to reduce systemic risk, we must look to eliminate the need for reconciliation as much as possible. Decentralized market infrastructure built on standards-based Web3 technology will eliminate these islands of information, reduce the need for reconciliation, vastly improve the flow of information, and give prudential regulators and financial market infrastructure operators tools to monitor and address flows in real time before they turn into large imbalances leading to full-blown financial crises.


With real-time settlement, reconciliation will be eliminated or at least require less time, energy, and capital to execute, ensuring that companies can operate at their maximum optimization and profitability.
 With a decentralized global register, layers of intermediaries can flatten for more straightforward settlements across jurisdictions with balances that are far easier, faster, and cheaper to reconcile.


Automation via Smart Contracts

One of the most notable blockchain innovations specific to Ethereum is the smart contract. This name is a bit misleading, because they are not smart, and they are not necessarily contracts: they are just programs on blockchains. Or, for those versed in database technology: they are like stored procedures that can operate on the database data.


Smart contracts are automated actions that can be coded and executed once a set of conditions is met. They have the ability to remove some of the more manual components of the financial industry—such as the process of distributing dividends—by placing the execution of the action on the blockchain via automated code, instead of in the hands of human operators. Corporate actions: the complex process of paying out dividends, splits, issue of rights, warrants, pay-ups, and so on, now can be automated, resulting in more confidence from investors and a much lower margin of error.


We can also initiate template-driven smart contract generation of new assets with the listing requirements based on previously captured issuer data, like a smart prospectus. This has the potential to reduce fees as well as mechanical reliance on third parties. This can also enhance shareholder voting and governance in general, as automation of registry data improves certainty of beneficial ownership and to whom an entitlement or right is due without extensive research or reconciliation. A common registry of ownership associated with an ID means the issuer or issuer’s agent will know exactly who has which rights.


As this digital securities technology matures, we can expect more of the processing logic over the entire asset lifecycle to be encoded in the smart security’s intrinsic logic. Forward-looking CSDs will anticipate the inevitable impact on centralized processes. The opportunity to embrace this change should spur CSDs to rapidly adopt strategies that exploit their existing wealth of business logic and regulatory-compliant rules and leverage that business asset to accelerate this transformation.

Decentralized Finance

Asset Tokenization

Asset Tokenization is the representation of assets on the blockchain in the form of tokens, which are designed to be unique, liquid, secure, instantly transferable, and digitally scarce—and therefore impossible to counterfeit. The concept of tokenization is nothing new. Our paper money is tokenized money—originally standing in for gold. Our driver’s licenses are tokens that index into a registry maintained by the state that indicates who is legal to drive. Digital tokenization is also nothing new. We currently buy and sell digitally-configured stocks that represent ownership in a company. But even with the ability to digitally represent the physical world, we are unable to transact in digital goods without a third party providing the seller and buyer with the trust and affirmation needed to confidently execute a transaction. Tokenization on Ethereum allows physical and digital assets to be represented by almost-infinitely divisible, traceable, secure units of ownership. For assets that have proven stubbornly illiquid in the past, this allows them to become liquid, transactable, and investible at smaller units of value—opening up brand-new markets of investment, asset management, and transactions.


The legacy arrangement gives investors no option but to go through intermediaries, wait for resolution, and pay the associated fees. But in this new paradigm, more investors will be able to participate and take advantage of lower fees and reduced risk. A more transparent and fluid system can prevent now-routine imbalances from accumulating into a full-blown financial crisis. Settlement times can be shrunk from T+2 to even T+instant, where it makes sense. True, not all markets want instant settlement because of the need to move securities and collateral across different time zones and manage liquidity, but even these processes can become part of the efficient automation. Pre-funding every transaction and settling it gross is not desirable in some markets, but where instant or same day settlement is desired, it can be done in an automated and guaranteed manner using smart contracts. It is also worth noting that decentralization does not necessitate real-time gross settlement.


In April of this year, CapBridge announced 1exchange (1X), a private securities exchange built on the public Ethereum blockchain in collaboration with ConsenSys and regulated by the Monetary Authority of Singapore. 1X will tokenize securities, creating an immutable digital representation of investments on the blockchain that are easier, cheaper, and more secure to manage. Moreover, the standardization and universality of public Ethereum mainnet ensures 1X is aligning itself to a growing, global, borderless liquidity pool—positioning itself to connect with other blockchain-based exchanges in the future. 1X will provide optimized tracking ability of securities traded on its platform by investors. Additionally, investors will have real-time and ongoing visibility into their investments without having to mediate with an exchange or third party.

KYC & AML

AML (Anti-Money Laundering) & KYC (Know Your Customer) restrictions can be baked into security tokens through smart contract verification requirements to get whitelisted and become a token holder. In this way, tokenized assets are not significantly different from many existing types of digital assets. Automating issuance can bring about lower costs of issue and reduced friction. Even greater benefits can accrue from the ability to use this speed to match to meet specific investor needs, such that we can pair more exactly the terms of the issue with investor-specified demand.


If some digital securities are tied to existing contract law, and investor protection structures are encoded to behave like existing asset classes in a smart contract, then we can blaze an easier path to regulatory approval as well as faster integration and deployment in concert with existing accounting, control, compliance, and risk systems. As the standards for digital assets evolve to cover the range of business logic and rules of the full breadth of conventional securities, the distinction between these two infrastructures will continue to narrow.

  • Smart contract-based KYC and AML also allows for different tiers of privacy granularity depending on the desires of the market participants and the legal requirements.
      1. Zero trust: in which all identity is disclosed during negotiations.
      2. Partial trust: identity disclosed only after terms agreed.
      3. Total trust: parties never know each other by anything other than anonymous address but are guaranteed by terms of entry (walled garden rules) to be legally approved and trusted market participants.

Security and Resilience

Many financial institutions limit the records they keep as a reasonable defense against security breaches. The result, however, is reduced transparency and optimization across and between organizations as a result of data being unavailable. The decentralized and immutable nature of blockchain technology ensures that information can be readily accessible on demand, yet restricted only to those who have permission and secured in an unbreachable database, immune to corruption and hacking. Some of this information can even be owned and controlled by the beneficial owner, and released only at her discretion.


Much of the risk CSDs currently bear can be mitigated by decentralized technologies. One example is in cybersecurity: CSDs keep a central record of all investors in their country, which is vulnerable to a host of threats, including data breaches or facilities damage. Decentralized ledgers, which are physically as well as logically decentralized, eliminate that risk.


Running the shared processing logic and storing common data across multiple independently operating nodes has the added benefit of resilience. As we have seen already with central banks, blockchain solutions offer the opportunity to deliver the benefits of a centralized utility solution common across all participants, together with a single shared source of truth, without creating a concentration of operational risk or single point of failure.

Custody of Assets & Data

Adopting blockchain technology allows individuals and companies to have complete control over their assets and data, accessed through a set of private keys that must be kept secure. Established technologies like programmable hardware security modules and emerging technologies like decentralized key recovery will allow more and more individuals to secure custody of their own assets, removing the artificial and expensive separation between legal and beneficial ownership in most asset markets. Some will choose to shoulder that responsibility themselves, but many investors will choose to outsource the custody of their private keys and token wallets to the companies and CSDs that can offer that service securely. There are major opportunities for secure custody services at this stage of ecosystem development, both to listed companies and to investors, especially for organizations that already have the public’s trust in this regard.

Expertise and Oversight: Working Together

CSDs have the institutional knowledge and the regulatory insight these systems will continue to benefit from even as they transform. The law has already granted CSDs the permission to shepherd these complex systems. Your member firms have already chartered you to seek efficient solutions for managing operational and systemic risk. You are also most aware of the areas of different industries that would benefit most from improvement and innovation, with millions of years of combined experience developing business logic. Together we can ensure that we preserve privacy and security and protect investors as this new paradigm for securities issuance and transaction processing takes shape.


While CSDs may not need to play as active an operational role in terms of clearing and settlement in the Web3 future, they could still play the role of overseeing the entire securities token ecosystem and assist regulators in protecting investors from fraud or loss. Ethereum has developed the standards, interoperability, and a secure public/private system in which organizations like CSDs may evolve to be more like supervisors of those operations. Greater trust and efficiency and lower risk also brings greater opportunity for growth and evolution, and novel and legacy systems alike depend on the active involvement and stewardship of experts.


Across all these areas of innovation, blockchain alone is not the answer: decentralization is. We are not merely imbuing legacy systems with selective blockchain. We are catalyzing a comprehensive digital transformation across capital markets technology, legal, and regulatory infrastructure. Massive amounts of trust and capital are currently running on decades-old technology and outdated processes that consume too much value at every step. Realizing the full value add of a decentralized financial ecosystem means reshaping trust and increasing opportunities for participation and value creation at every layer.

 

In this respect, on behalf of ConsenSys and the Ethereum community, I welcome the continued recognition and acknowledgement of the role of blockchain technology in general and Ethereum in particular in the future of capital markets infrastructure as highlighted in DTCC (Depository Trust and Clearing Corporation)’s recent paper, “Guiding Principles For the Post-Trade Processing of Tokenized Securities.” We look forward to collaborating with the FMI (financial markets and infrastructures) community to implement the PFMI principles on both permissioned and permissionless Ethereum networks and realize our vision for fair, transparent, and open global capital markets.

Why Ethereum for the Future of Finance

Having established the many potential advantages that blockchain can bring to our existing financial systems, it is worth exploring in brief why Ethereum is more suitable than other enterprise-focused blockchains for re-architecting our industries.

  • IBM Blockchain or Hyperledger Fabric
    • Fabric uses point to point channels for data privacy, which creates an n-square problem. In other words, 10 counterparties need to create 100 channels for transaction level privacy. Consequently, there is no chance of Fabric evolving beyond relatively small networks for private, permissioned systems, while Ethereum has shown that it can connect tens of thousands of nodes globally in a public permissionless system—the most difficult of contexts.
    • Tokens can be created on Fabric, but only for narrowly circumscribed situations, as it does not benefit from the trust derived from maximal decentralization.
    • Each Fabric channel is its own domain; its own ledger. Each Fabric implementation is based on a unique configuration, limiting interoperability between different Fabric chains. With many participants on a network you end up with many different ledgers, rather than one shared source of truth.
    • The Fabric technology promotes platform lock-in.
  • R3’s Corda
    • R3’s Corda is not a blockchain, rather a blockchain inspired framework for mostly banking industry applications. It is more about point-to-point trust on a need-to-know basis than a shared source of truth across all parties. This makes Corda ill-suited for any process requiring agile data or process sharing across multiple parties.
    • Corda can issue tokens, but only for narrowly circumscribed situations.
    • Corda was engineered for transaction-level privacy, although the use of unspent transaction outputs and centralized notaries limits such privacy in practice. This design makes it less suited to use cases common in cash securities markets where transactions are a mix of private and public information.There is no single shared ledger to serve as a universal source of truth across all parties in a network.
    • The Corda technology promotes platform and vendor lock-in.

Only Ethereum is architected properly as an open Internet-based standard to serve as a single, shared source of truth—with the necessary privacy and confidentiality, without any vendor lock-in—to bring about the open systems future we imagine.

Private vs. Public Ethereum

We do not propose a public permissionless system for global finance. We do believe in a hybrid of publicly-shared data and reusable shared process models, combined with sufficient privacy and confidentiality around transactions or specific data within transactions, as required by the members of the market. Any state machine, like a blockchain or a traditional database with business logic, needs a common frame of reference to be able to have any real utility, to prevent problems like double-spends, reduce fails across the board, and serve as the shared source of truth. That frame of reference must be able to coordinate logic and transactions between private networks and the public. It functions as a global settlement layer, maximally decentralized for security and supporting various scaling solutions to manage and accommodate throughput.


All of us are well aware of the importance of standards for markets to work. There are important efforts underway to work with regulators on developing standards for securities definitions, asset servicing, and pan-regional settlement. One current example is the CSD-R effort in the EU, a project designed to reduce fails, which could be addressed using an Ethereum-based shared ledger across CSDs in the region.


Most of the Web 3.0 standards are being forged on Ethereum. Through organizations like the Ethereum Foundation and the Enterprise Ethereum Alliance—comprised of over 500 global companies committed to collaborating and adoption of Ethereum blockchain standards, where applicable—participants in the ecosystem are making sure we all work together. Developing standards and interoperability has been a core priority in our ecosystem from the very beginning. This is an ecosystem built on collaboration, from the protocol to the application to the market levels, and no other platform has the momentum of Ethereum at any of those layers.
 

Current Ethereum Case Studies & Use Cases

I want to share briefly a few live use cases and proofs of concept that demonstrate how the Ethereum and blockchain financial revolution is happening today. The future is already here.

Project Khokha

Project Khokha is an award-winning case study for central banking in South Africa. For the banking industry, the cost of providing the utmost reliability, availability, and resilience against attacks or equipment failure is high. Reconciliation of payments continues to be inefficient and the burden of reporting suspicious transactions falls on banks. With our ConsenSys Solutions group and a ConsenSys-incubated company called Adhara, the South African Reserve Bank (SARB), in a consortium with seven commercial banks, used Quorum, an enterprise-grade implementation of Ethereum, to create a blockchain-based interbank network that processed more than the typical daily volume of payments with full confidentiality and finality in record time. Khokha exceeded the transaction performance target at 70,000 transactions in under two hours. This project proved that a blockchain-based system can deliver real-time gross settlement, and allowed SARB to fulfill its role without being a single central point of failure.

Project i2i

ConsenSys Solutions and ConsenSys’ Software as a Service platform Kaleido collaborated to build Project i2i, a payment network built on a private instance of Ethereum to connect rural community banks in the Philippines. 56% of Filipinos live in rural island areas without access to the financial system, despite the existence of hundreds of local rural banks across the archipelago. Those rural banks are neither connected to any electronic banking service nor to domestic and international money transfer networks, thus limiting access for thousands of communities to affordable, trustworthy, and efficient payment and remittance services. Project i2i is taking advantage of blockchain to create a decentralized, cost-efficient, and near real-time payment network for those rural banks, that will not rely on existing payment infrastructure and intermediaries like SWIFT. The platform distributes across network participants the ability to issue tokenized cash and process transactions for intra-national remittance. There are currently over 100 banks on the network, soon moving to 500.

Regulation: EU Blockchain Advisory and The Brooklyn Project

Public markets and regulators rely extensively on audit firms and lawyers for supervision. In spite of the billions of GBP spent in the UK, we have witnessed the failure and mismanaged employee pension schemes of BHS and Carillion with almost no material action to create competition in the financial audit market which would in turn create incentives for auditors to perform better at a lower price. The potential of blockchain in enhancing audits has been well documented.


Through efforts such as ConsenSys’ serving as the official blockchain advisory to the European Union, as well as our initiation of The Brooklyn Project—an industry-wide initiative to promote token-powered economic growth and consumer protection in a context of regulatory compliance and regulatory evolution—ConsenSys and our colleagues in the Ethereum space are deeply committed to working with legislators around the world. We can offer the expertise and input to various regulatory bodies on the technology side, and I hope many of you will also see an opportunity to do the same. Now is the moment to get involved and influence the direction and redefinition of financial markets, and we need the collective wisdom of experts like you. 

Let’s Work Together

Many of these amazing use cases have gone live in the last year. A wait-and-see approach, as various legacy system participants might have taken in the early years of the Internet, will not suffice for the era of trust revolution. Change is here, it is accelerating, and all of us should work to embrace it. There are tremendous opportunities for blockchain builders and the trusted financial experts of today to collaborate and innovate. I hope you are as excited as I am about the possibilities we see ahead. The world is experiencing an inflection point in the nature of trust and we can all build better systems to take advantage of that sea change, together

 

 

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