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The one or two industries that have long been the most important aspects of the global economy are financial services; from personal banking through to international trade.
As crucial as it is, however, traditional financial systems have been criticized for inefficiencies, high transaction costs, and over-reliance on intermediaries. The emergence of blockchain technology gives hope to many experts that those challenges can be solved, turning the whole financial landscape upside down.
In recent years, blockchain, the technology powering cryptocurrencies such as Bitcoin and Ethereum, has come in for a great deal of attention. Although blockchain is most widely known for its ties to digital currencies, its ability to change the way money is moved is certainly not limited to cryptocurrencies.
Blockchain could reshape the way financial institutions, businesses, and we as individuals conduct economic activities through a secure, transparent, and decentralized method of recording transactions.
In this blog, we will examine the role of blockchain in finance, addressing what it does, how to apply blockchain, the benefits in finance, and challenges in finance, and how that may disrupt traditional finance systems.
What is Blockchain?
In essence, blockchain is a decentralized, distributed ledger technology (DLT) in which one can reliably record, store, and share information securely and unalterably.
Unlike centralized databases (databases owned by one organization, such as a bank or government) blockchain operates on a network of nodes (computers) collaboratively validating and confirming transactions.
A blockchain forms a list of “blocks” and the transactions it contains by linking them in chronological order to create a “chain.” Once a block is added to the chain, it is almost impossible to change or erase. That security of immutability is extremely high. Finally, blockchain doesn’t have a central authority that operates it, making it a decentralized system.
How Blockchain Works
Blockchain technology relies on several key components:
1. Decentralization: Unlike traditional systems that centralize control in a single location, blockchain network occurs across node tiers. This pretty much does away with the need for third-party service providers such as banks or payment processors.
2. Transparency: As it is for Ethereum, all participants can see the transaction history, so there is transparency in everything that takes place on the blockchain.
3. Immutability: Due to its decentralization, exchanges that take place on the blockchain cannot be altered or deleted; they create a permanent record of occurrences.
4. Consensus Mechanisms: A blockchain network employs some mathematical puzzles such as PoW or PoS in arriving at consensus or validation of the transactions.
It is easily identifiable that the characteristics of blockchain—decentralization, transparency, security, and immutability—will be an excellent match for a great many financial uses.
Application of blockchain in the finance sector
Blockchain technology holds the promise to change the face of many spheres of activity within the financial services and products industries, including payments and remittances, lending, insurance, and capital markets.
Below are some key applications of blockchain in finance:
1. Payments and Remittances
Now, one of the most popular use cases of blockchain in finance can be discussed – payments and remittance.
The conventional way of making payment relies on various middlemen such as banks, payment service providers, and clearing houses, which results in slow execution, cost, and restriction for international transactions.
One of the primary uses of Bitcoin is P2P transactions which can be completed without the services of a third party. Countries that lack elaborate banks can also make cross-border payments in bitcoins for instance from the comfort of their homes.
Thus, blockchain-related stablecoins are the fiat money equivalents of blockchain without the various inherent vices of the cryptocurrencies.
Remittance is a significant activity that includes using the blockchain instead of employing the service of a remitting company, such as Western Union or SWIFT.
Payments could be completed within minutes instead of days, and the costs are relatively cheaper given that certain overall charges are drastically reduced as compared to the conventional methods.
2. Smart Contracts
Smart contracts are automation contracts that code the conditions of the agreement. They are self-working programs that carry out pre-specified tasks on a blockchain once specific conditions are met, with or without involving lawyers or notaries.
All these contracts are non-changeable and fully transparent, meaning that anybody who is involved in the whole process has no reason to doubt anything that is taking place.
In finance, smart contracts can be used for a wide range of applications:
• Lending and Borrowing: Peer-to-peer lending is one of the primary areas of decentralized finance (DeFi) in which smart contracts replace conventional banking systems.
• Insurance: Any kind of claims, including those related to damages caused by natural disasters, may be paid based on conditions written into the smart contract and provided that other conditions stipulated in the contract are met.
• Derivatives and Trading: The use of smart contracts means that financial derivatives and trading strategies can be coded and worked out without outside interference, and it has been proved that such methods save cost.
3. Decentralized Finance (DeFi)
Decentralized Finance (DeFi) is one of the fastest-growing and most exciting areas of the blockchain in finance. DeFi platforms use smart contracts to allow for transactions without the aid of traditional financial intermediaries such as banks and brokers.
The vision of this is a more open, inclusive, and transparent decentralized financial system. Some of the key features of DeFi include:
• Decentralization: DeFi platforms are most commonly decentralized, meaning no central authority dictates what occurs on the platform. It also reduces the chance of censorship and gives users control over their own assets.
• Access to Financial Services: DeFi gives those who are excluded from traditional financial systems (i.e. people in developing countries or without a bank account) a chance to take part in financial activities (lending and borrowing).
• Tokenization: Tokenized assets are the digital representations of real-world assets (e.g. real estate, commodities) and most DeFi platforms make use of these. Traded and leveraged within the DeFi ecosystem, these tokens are more widely known as ‘synthetic’ tokens.
As the DeFi space grows rapidly, we have seen the creation of a whole host of DeFi applications, including decentralized exchanges (DEXs), lending platforms, yield farming, and liquidity pools.
4. Blockchain in Capital Markets
Blockchain could restructure how capital markets work and is able to increase the processes of trading, settlement, and clearing with improved efficiency, transparency, and security. The intermediaries play an important role in the financial industry through trades, clearing, and settlement of accounts that result in delays, and higher costs.
When we use blockchain for securities to trade and settle, transactions occur almost instantaneously and where there are no intermediaries.
Security token platforms, such as Blockchain-based Security Token Offering (STO), allow companies to raise funds by issuing Tokens representing the ownership of real-world assets (shares in a company, bonds, property, etc).
Finally, blockchain could increase transparency in capital markets via an immutable and transparent public ledger of all transactions, reducing the likelihood of fraud and increasing investors’ trust.
5. Digital Identity and KYC/AML
The financial industry cannot exist without Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations to ensure that fraud and illicit activities are prevented. Nevertheless, this process can be painstakingly time-consuming, expensive, and prone to errors in verifying identities and running background checks.
However, the KYC/AML process can be streamlined using blockchain as a secure and decentralized way to store and share important personal data. Since it’s kept on a blockchain, the digital identity on a blockchain is immutable and cannot be changed — one cannot steal someone’s digital identity or commit business fraud.
Additionally, individuals would have control over their data, and financial institutions and regulators would be able to get their hands on their data when needed.
Also, blockchain-based identity solutions could help unbanked individuals access financial services by providing a verified digital identity that can be used as KYC.
6. Asset Tokenization
Asset tokenization converts physical or financial assets (such as real estate, art, commodities, and intellectual property) into digital tokens that can be traded on blockchain networks. Each token represents a fractional ownership of the underlying asset, allowing investors to diversify their portfolios and access previously illiquid assets.
Tokenizing real estate could, for example, create fractional ownership, where investors could buy shares in a property bringing liquidity to what otherwise might not be, allowing people who had no right to deal to be able to participate in something.
Tokenization also reduces the barriers of entry for money into high-value assets and that makes them available to more investors.
Benefits of Blockchain in Finance
Blockchain technology offers a wide range of benefits to the financial services industry, including:
1. Reduced Costs: Through blocking and cutting intermediaries and processes, blockchain has the power to immensely cut the transaction fees and the operational costs for the financial institution and for the person as well.
2. Increased Transparency: Of course, the reason why everyone is so excited about blockchain is exactly because of this: blockchain’s transparent and immutable ledger will ensure that all transactions are public for everybody to see – making it much easier to spot fraud and improving accountability.
3. Improved Security: With blockchain’s decentralized nature and its cryptographic security, hacking and data breaches are not an issue with this technology.
4. Faster Transactions: Blockchain’s ability to process transactions quickly — often in real-time — can dramatically decrease cross-border settlement times.
5. Financial Inclusion: Blockchain offers a chance to offer financial services to the underbanked, most notably in developing countries that lack traditional banking.
Financial Applications of Blockchain
Despite its potential, blockchain faces several challenges that could hinder its widespread adoption in the financial industry:
1. Scalability: The more blockchain networks grow, the slower and less efficient they can also grow to become. While networks like Bitcoin and Ethereum can have limits placed on how much transaction throughput they can process, there is no limit to such issues when users desire the highest volume of financial transactions possible.
2. Regulatory Uncertainty: Blockchain technology operates in the grey areas of regulation in most jurisdictions. Even now governments and regulators are still only figuring out how to regulate cryptocurrencies, DeFi platforms, and all the other types of blockchain-based finance services.
3. Interoperability: The blockchain networks are many and they operate in isolation. To fully unlock blockchain’s potential in finance, it will need the ability to quickly conjoin other blockchains, and integrate into existing financial systems.
4. Security Concerns: Blockchain itself is one of the most secure technologies, but the application of blockchain networks (DeFi platforms, smart contracts, etc.) is highly vulnerable. Even hacks and security breaches can still occur, even with the technology undermining trust in it.
Conclusion
The financial services industry has massive potential for the blockchain technology. The framework of this system is derived from the fact that its decentralized, transparent, and secure nature is an ideal solution to many of the problems encountered within traditional financial systems.
Across payments and remittances, lending, insurance, and capital markets, blockchain has a use case for nearly everything.
While the technology is yet in its infancy with lots of challenges to overcome (such as scalability, regulatory ambiguity, and security) the benefits it brings to cost reduction, financial inclusion, and efficiency are reasons enough to attract the future of finance solutions for the finance companies.
With blockchain technology constantly progressing, more and more financial institutions or companies are going to use blockchain-based solutions, building a more decentralized and efficient financial ecosystem.
As we continue to see innovation and clarifications of our regulations, blockchain could change how we think of money, assets, or financial transactions in general.