On-Chain Finance

The robustness of blockchain networks underpinning Web3 is what makes this technology so compelling. It is my belief that in the coming years much of the day-to-day technology we rely on will be underpinned by Web3 networks.

The motivations for this shift will be driven by the same motivations of any technological change — Web3 eliminates many of the errors that today’s systems are susceptible to and automate away a number of inefficient processes that many businesses are burdened with. This will be achieved in a manner that is far less costly than what it costs organisations at present. I don’t just believe that companies will find significant utility in Web3, but also regulators and governments, as it has the potential to greatly streamline their worlds also. 

The events in the cryptocurrency markets of mid-2022 have been chaotic, with a familiar narrative playing out, where greed has taken centre-stage and a lack of adequate risk management and disclosure by firms on their positions enabled them to profit greatly from the bull market and fail just as spectacularly in the bear market. 

OTC Markets

This activity behind closed doors is the secret sauce of many an institution which is not in their interests to disclose, but in some more extreme cases can be a source of systematic risk, which has the potential to massively disrupt markets when events don’t play out as expected.

Off the back of the global financial crisis in 2008, we saw the Dodd-Frank legislation come into effect. This legislation forced many banks and financial market participants who were creating and trading OTC derivatives to start reporting details of their activities to trade information warehouses. 

The main trade information warehouse was operated by the DTCC, and the daily submissions being made by financial entities enabled regulators to get a snapshot of the activity taking place in the OTC markets. Thus enabling them to shine a light into what prior to this point, had been an opaque part of the financial markets. 

The work undertaken by participants to comply with this regulation was incredibly costly, and given the multi-sided nature of OTC contracts, the same information often had to be reported by two or potentially more distinct entities. The point was that the OTC markets were not transparent, and once the implications of all of the leverage and risk had built up in them (off the back of OTC derivatives based on mortgage-backed securities), it was too late to do anything about it, and we ended up with many of the worlds largest financial institutions begging governments and sovereign wealth funds for bailouts. 

Trust in Blockchain Protocols

The transparency of the OTC markets forced by regulation is a good thing. But trust in the data being provided is not guaranteed. It is still susceptible to errors or manipulation, one cannot have complete faith that the data being reported is accurate. This lack of fabric for trust in our current financial plumbing is the grand opportunity for Web3. The cryptocurrencies and tokens that exist on blockchain networks, and the DeFi applications that support them all provide transparency of activities taking place on-chain. They cannot be gamed and ownership of assets can easily be proven. There are challenges with anonymity insofar as participants on the public networks are not always clear. But where this is an issue, controls can be put in place with respect to which participants can interact on these networks. 

By bringing financial activities onto a blockchain, or on-chain, the need for reconciling data between organisations and regulatory reporting in its current inefficient form can become a thing of the past. Regulators can be participants in the networks that support the asset classes that are of interest to them. Participants cannot be dishonest about their holdings or activities, as the information is recorded on-chain. Challenges of privacy and sensitive data too can be…