Luna/Terra, Three Arrows, Celsius, BlockFi, and more disasters to come: Crypto 1.0 is dead, killed by its own contradictions. But the traditional world of finance cannot assume a return to business as usual. Blockchain-based finance will continue to transform capital markets, even if today’s headlines are focused on the demise of poorly conceived crypto businesses in the unregulated space.
Until recently, waves of tech innovation have been incremental without challenging the fundamental role of capital-market players.
The last time a technology trend forced a reexamination of capital markets was the electronification of equities starting in the 1990s. That changed our idea of what securities could be. It began with tech-based disruptors like Nasdaq and Instinet reshaping the rules, and was cemented in place by regulation (such as the SEC’s Reg NMS in 2005) that sought to keep up with modernity and establish new rules to ensure market fairness.
Some people may think this wave led to some not-so-great outcomes, like dark pools and high-frequency trading. But the same wave required listed markets to display quotes and provide data, and for brokers to be transparent and seek best execution for clients. The wave of going electronic is still rippling through global markets, with the focus today on fixed income, credit, and swaps.
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The electronic wave also forced banks to reinvent themselves, or perish. Comfortable, clubby arrangements no longer work when market-making technology is so effective. Buy-side dealers went from ticket punchers to masters of their destinies once they harnessed this technology.
Sell side traders, once masters of the universe, became mere sources of liquidity for their clients to trade on third-party tech platforms. They had to stay relevant by providing data-powered insights, and while some of these still come from trading and research desks (usually with a robot to help), banks also rely on boring ancillary businesses like cash management, payments, and custody.
Nevertheless, despite these changing roles, primary markets remain a traditional business. Borrowers still need debt or advice, and they need an intermediary to find investors. Ditto for companies looking to go public, notwithstanding a few high-profile direct IPOs and SPACs (which aren’t looking too healthy today). Primary markets remain a book-building process, and in fixed income, most transactions are still negotiated over a phone call.
BlockFin is still the next big thing
BlockFin (blockchain-based finance) is still the next big thing because it will have both the impact on who does what, as well as change the underlying definition of capital markets. Nasdaq transformed equities trading but IPOs were still IPOs. With blockfin, there’s scope to change both.
Its power lies in its marketplace-level connectivity. This is what has made it difficult to adopt, as a slew of failed consortia attest. Its original form has been unregulated cryptocurrency, which has been unpalatable to most financial institutions. Bitcoin is blockfin’s original sin. But consider just a few attributes:
- Instant “atomic” settlement reduces or eliminates counterparty and credit risk. DeFi enables P2P trading. It just requires regulating the end points where fiat money moves in and out.
- That means no need for investors to pre-fund transactions.
- Smart contracts can do much of the heavy lifting in areas such as reconciliations and corporate actions.
- A regulated stablecoin or a central-bank digital currency will provide the cash leg for securities issued native to blockchain. This would accelerate attempts to create demand and supply for digital assets.
Individually, there’s no need for blockchain to accomplish a given facet. The power of the tech is that it wraps everything together. Data and value are exchanged together. An asset native to blockchain still needs issuers, intermediaries, and investors. But who are they?
Peer-to-peer networks and smart contracts don’t mean the end of banks but they will have to reinvent themselves again to remain relevant. Capital-market desks will have to rely on trust, regulatory nous, and advice.
Just as today there are some high-touch sales traders at sell sides, there will be some traditional sales relationships in blockfin – but the majority of transactions will go to the new “low touch” P2P networks, ie to DeFi protocols.
CBDCs might be programmable. Banks could issue their own stablecoins – also programmable. Combine conditionality on moving money with cryptographic tools, and it could be possible to introduce private counterparty risk management to flag the next Archegos. The amount of visibility on blockchain hashes is extraordinary – it’s just a question of tying that transparency to regulated processes. That’s something worth building.
Today the space remains crammed with exchanges, tech platforms, and ideas. It’s difficult to tell which players and which regulations are going to prevail. Nor how these things will communicate or interoperate. Nor how the safer world of private clubby DLT can achieve the kind of broadcasting power of a public chain such as Ethereum.
The current crypto meltdown will be a helpful engine of consolidation. No one knows if this will lead to the sort of clarity that banks need to make serious investments. Crypto 1.0 is dead, but before we reach Crypto 2.0, the new competition among TradFi players is about wisely picking the right platforms, the right partners, the right tech – and being able to go the distance.