The technology that supports our financial system needs an overhaul. Basic transactions have high intermediary costs and long clearance times, while billions remain unbanked, and consumer trust is likely to be impacted by recent bank failures.
For all of its capabilities, industry leaders must update financial market infrastructure (FMI) to meet the demands of a 24/7/365 digital world. New technologies such as Artificial Intelligence (AI) and Cloud Computing will help advance FMI. Still, many acknowledge that blockchain technology is central to a future where financial markets are open and secure and are managed in real-time.
Blockchain allows for the transparent creation of immutable records accessible by all participants in a network – therefore everyone in the network can see the same relevant information – hence its nickname as a “trustless” technology. A blockchain database consists of several of these blocks “chained” together with a reference in each block to the previous block.
Blockchain technology can provide faster and more secure asset movement, lower transaction fees and shorter settlement times across all asset classes – reducing operational cost and improving cash flow.
But why is blockchain so intricately tied to the future of our financial system? To understand why, it’s helpful to be aware of some of the shortcomings of the aged technology behind the world’s banking and money movement systems.
Modern financial infrastructure isn’t modern
Without clear and concise ownership, one of the first issues in updating financial infrastructure is figuring out who should lead the effort. This lack of leadership may be why it’s been a decade since the Bank for International Settlements established FMI standards by releasing “The Principles for Financial Market Infrastructures” (a.k.a. PFMI). The standards present a series of 24 principles to guide FMI in all aspects of finance, including international standards for payment, clearing and settlement systems. The principles apply to all systemically important payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories (collectively “financial market infrastructures”).
In the decade since the release of these guiding principles, FMI is still crumbling. Aside from lack of leadership, operational infrastructure risks often go unnoticed until something goes wrong and the upfront costs of changing these systems can be significant. For all of these reasons and more, the only real changes have been to the infrastructure supporting time-tested transactions — think ATMs — and those changes have generally been incremental and ad hoc.
Much of the industry still needs to catch up to embrace large-scale change, specifically regarding some processes, such as settlement. In that historical context, cryptocurrency and the blockchain are recent innovations indeed. Still, many in the industry consider these newer technologies to be additive to existing fintech stacks: a unique opportunity loosely connected to mainstream banking.
That assumption, however, ignores the structural weaknesses and inefficiencies baked into the current systems — and the ways crypto and blockchain technologies can eventually replace the industry’s aging infrastructure with more secure, reliable and efficient systems.
Flaws in the current infrastructure system may only sometimes rise to operational breakdowns. Still, they are exacerbated by a financial system that needs to be built for the demands of modern digital financial markets. Flaws in current banking infrastructures can come in at least three categories:
- Security – most existing FMI systems were implemented before cybercrime became a global business projected to cost companies $10.5 trillion by 2025. As a result, the system is more likely to be targeted for hacking and other cybercrime.
- Reliability – in any scenario, outdated components are more likely to fail, causing bank outages and disruptions that inconvenience customers and incur costs.
- Capability – older infrastructure wasn’t designed to handle the volume and complexity of recent transactions, making it less effective at scale and unable to meet growing customer expectations.
Recent warning signs of stress to the system
Over the last half-century, there have been numerous cases in which FMI has, at the least, hindered progress in digitizing financial markets and, in some cases, specifically caused instances of outright failure. While issues such as hacks and outages can occur with blockchain technology, it’s still considered a more secure technology when managed correctly.
As technology and consumer expectations continue to accelerate, we will likely see more problems with current financial infrastructure similar to these recent examples:
- April 2018: UK-based TSB Bank attempted to migrate its banking system to a new platform, resulting in a major outage that locked almost 1.9 million customers out of their accounts for weeks. According to an independent report, the IT arm of TSB’s parent company Sabadell had tested only one of TSB’s two new data centers, and the TSB board had rushed the migration. “TSB went live with a platform that was, in the event, neither stable nor complete,” the report said.
- February 2019: Wells Fargo suffered a data center shutdown when something accidentally tripped a fire suppression system. The resulting online banking outage prevented customers across the United States from accessing their accounts, receiving or making payments, or transferring funds.
- July 2019: Capital One announced a data breach in which a hacker downloaded the personal information of more than 100 million customers, including names, addresses, credit scores and Social Security numbers. The breach exploited a vulnerability in the company’s cloud-based infrastructure; it led to a class-action lawsuit that Capital One settled in 2022 for $190 million.
- March 2020: The trading app Robinhood faced a series of systemwide outages that prevented users from accessing their accounts, executing trades or accessing customer support. Robinhood co-founders and co-CEOs Baiju Bhatt and Vlad Tenev blamed stress on an infrastructure that couldn’t handle the “unprecedented load” of a volatile market. In January 2021, Robinhood again struggled to hold a spike in trading volume and restricted trading of certain stocks, including GameStop and AMC.
- February 2021: Federal Reserve systems suffered an “operational error” that affected its ACH system, disrupting everything from payroll to tax refunds to interbank transfers for about four hours.
Four fixes for an aged financial system
Decentralization is foundational to crypto and blockchain and decentralization represents a clear alternative to the systemic flaws in centralized infrastructures that compromised these banking systems. In using blockchain technology, the future of financial infrastructure will see at least four major improvements:
Improving the overall capabilities of FMI is difficult but far from impossible. It must grow to meet customer and enterprise expectations while simultaneously meeting the expanding nature of regulatory oversight.
If the financial service industry wants to improve efficiencies and lower costs, it must catch up — and keep up — with the latest technology, which smaller, faster competitors are already embracing. In a recent PwC survey, 70% of the leaders said the speed of technological change was a concern. At the same time, new services are slow to launch and high implementation costs hamper innovations.
Blockchain can improve speed and efficiencies in a variety of asset transaction types and in record keeping. Traditional processes that are exposed to error would be streamlined and automated. Smart contracts are one example of blockchain’s ability to automate a process and ensure its execution.
In the quest for T+0 settlement, blockchain technology can capture securities and cash positions 24/7 for multiple entities across multiple markets and time zones, leveling barriers like settlement liquidity and trading hours. This is game-changing for tokenized real world assets (RWA), precious metals and equities.
When settling securities trades, the principal risk is a key concern. This is the risk that one counterparty will lose the full value of a transaction – for example, the risk that a seller of securities will irrevocably deliver them but not receive payment.
The primary problem with today’s settlement is counterparty risk – defaults, as well as third party involvement, are costly. Blockchain technology can provide faster settlement, without counterparty risk.
Transactions verified by thousands of computers on a blockchain network and stored in a decentralized ledger are much more difficult to infiltrate and manipulate, hence the data within these ledgers is considered immutable. Because bad actors can’t alter immutable data in a distributed ledger, blockchain can help prevent data breaches, cyberattacks and other security threats.
Blockchain offers a different path toward greater security — narrow and highly encrypted, eliminating onramps for cybercriminals seeking to steal assets. This approach reduces vulnerabilities, provides strong encryption, and verifies data ownership and integrity more effectively.
Crypto and blockchain technologies can provide greater transparency in banking transactions. Because every transaction is recorded and stored in a decentralized ledger that anyone with permission can access, blockchain can help prevent fraud and provide customers and financial institutions greater visibility into the movement of funds.
Transparency can be valuable in all areas of enterprise. Supply chain information sharing has improved since using enterprise resource planning (ERP) systems in the 1990s. However, transparency remains challenging in supply chains with complex transactions and mistakes are often impossible to catch in real time. As an example, among other large companies turning to blockchain, Walmart is attempting to use its real-time transparency for tracing vegetables.
Blockchain’s potential to replatform financial infrastructure
Along with the advances in FMI, service providers and regulators will also need to make progress in creating rules for the road and accountability. As more participants see the ways blockchain technology can help our financial market infrastructure reach its full potential, there will be more calls for industry-wide regulatory standards. And with more regulation in place, we should see enhanced trust in the ecosystem, eventually spurring mainstream institutional adoption of blockchain.
Legacy FMI might be worse than people think or it may hold up for another 50 years, but the fact is, it’s not built to support the requirements of the digital age. With trillions of dollars in assets at stake, there must be a move toward new technology that’s faster, more reliable, secure and scalable.