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Digital financial innovation

This blog focuses on digital financial innovation, the third pillar of the financial industry’s “Transformation Agenda”. Digital financial innovation has been driven by blockchain technology that is part of the family of distributed ledger technologies (DLT). This technology is reshaping the financial systems with a number of use cases that fall under the terminology of decentralised finance (DeFi). The following blog puts the DLT technology innovation and the emergence of crypto assets in the broader context of the financial industry’s change and growth agenda.

The third pillar of the transformation agenda

Up to the Global Financial Crisis (GFC), financial innovation had been driven by financial engineering and the development of complex financial instruments. The shock of the financial system’s fragility and incoming regulatory agenda of the G20 Reform changed this fundamentally. The financial industry’s innovative power and focus have shifted over the last ten years to technology. Through the launch of Bitcoin in 2009, cryptocurrencies and coins started to emerged that were based on blockchain, a specific DLT design. DeFi has now become a broadly used term for experimental forms of finance that utilise smart contracts on blockchains to perform financial services functions. This ecosystem revolves around decentralized blockchain applications that provide similar traditional financial services but do not rely on a traditional intermediary model.

Technology innovation

Blockchain is the third emerging technology that reshapes the financial industry. DLT is the parent technology behind blockchain that has found a number of use cases in financial institutions. It facilitates identity management, value storage, and back‐office operations such as settlement. However, it has mainly been known for financial speculation through cryptocurrencies such as Bitcoin and Ether. There are many other types of other cryptocurrencies such as XRP, Cardano and NEO. Both cryptocurrencies follow the same blockchain principles but have different characteristics in their implementations. Bitcoin is written out as Bitcoin code, run by Bitcoin software which creates transactions containing data about Bitcoin coins that are recorded on the Bitcoin blockchain. Ether is a multitude of tokens that are recorded on Ethereum blockchain.

Blockchain is to be understood as a bunch of protocols (rules) that define and characterise its functioning. These protocols can best be articulated in a computer code which in turn can be compiled into a software that enacts those rules and makes them operate. This is how ownership is represented and recorded, what constitutes a valid transaction, and how participants can operate on the respective blockchain network. Transactions on a blockchain network apply a mathematical mechanism that is known as cryptography. Its most well‐known use is the encrypted data exchange (encryption) that defines the process of encoding an information in a format that only authorised parties can access it. Mining is the process of validating by adding transactions to the existing blockchain ledger distributed among all members of the blockchain. Under the traditional method of proof-of-work, minting is a part of mining when new coins come into existence. It is defined by the process of validating information, creating a new block, and recording that information into the blockchain.

Tokens represent a unit recorded on a blockchain, and is often used in reference to all crypto assets. There are so-called native coins that are tracked on the cryptocurrencies' respective blockchains. They have (theoretically) an intrinsic value by themselves and are not backed by an issuer or asset. Then there are asset-backed tokens that are tracked within smart contracts on any blockchain. These are often referred to as non-fungible token (NFT) and are an important component of the emerging DeFi system.

Smart contracts are computer protocols intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract without third‐party involvement. Several blockchains have implemented types of smart contracts with Ethereum as the most prominent representative. In a smart contract, many kinds of contractual clauses are partially or fully self‐executing, self‐enforcing, or both, which makes it very attractive in the use of financial instruments with specific cash flow and settlement specifications.

Financial speculation

At the core of the recent waves of speculation in cryptocurrencies stands the question of their inherent value. Most economist and fundamental investor struggle with applying the value concept to Bitcoin and Ether, which led to dismissive comments for the concept by many of their most prominent representatives. Without the backing of a real asset (such as gold) and/or an explicit or implicit government guarantee as well as the absence of a typical cash-flow profile, cryptocurrencies do not follow the conventional rule of asset pricing. In a historical comparison, the price evolution of cryptocurrencies may indeed follow the characteristics of an asset bubble. At the beginning of a bubble, there is usually a new idea or innovation with a limited availability and supply. As a consequence of the innovation impact, there is a lack of transparency, which makes it difficult to correctly evaluate the technology according to conventional standards. There is a high level of asymmetry in information and knowledge, resulting in a veritable supply monopoly. In case of cryptocurrencies, there was a small group of insiders who originally developed and held the assets. They controlled the supply. As the price development accelerates and the technology gets more broadly accepted, investors remain anxious to miss out. However, we need to distinguish between productive and speculative bubbles. A productive bubble in an economy that has unused capacities may lead to a positive economic effect. The speculative bubble, on the other hand, is a dynamic efficiency response to the limited investment opportunities of productive real capital. Many productive bubbles with extreme price volatility stood at the initial phase of the deployment of a new technology. This may apply to cryptocurrencies which underlines its long-term value but may also lead to a volatile cycle of wealth creation and destruction until the use of the technology finds its steady state.

Financial infrastructure

Blockchain is in the process of reshaping the financial industry in a series of a broader infrastructure applications that started a new chapter for financial innovation. DeFi goes way beyond financial speculation with cryptocurrencies and provides with stablecoins, synthetic trading, clearing and settlement coins, and tokenisation a number of financial infrastructure components with different use cases. Blockchain technologies have become the digital delivery mechanism of different underlying assets (crypto‐based assets or just crypto assets) and will replace today’s derivatives and insurance contracts. The regulatory framework for those components remains to be defined and clarified. Counterparty risk assessment and the prevention of fraud remain at the core of the regulatory agenda.


Stablecoins are crypto‐based assets that are linked to and redeemable in fiat money (different available currencies such as the USD), commodities (precious metals such as gold), and any other underlying assets. The coins are usually issued by an independent third party (known as the operator) and through the decentralised mechanism of the blockchain network with the objective to mitigate potential forms of counterparty risk. They can be traded on exchanges and are redeemable from the issuer at the conversion rate to take possession of real assets. The value of fiat‐backed stablecoins is based on the value of the backing currency, which is usually held by a third‐party regulated financial entity. USD stablecoin, which runs on different blockchain such as the Ethereum, is pegged to the US dollar.

The name stablecoin is misleading as it comes from the stabilisation effect of assets outside of crypto space and/or the combination of different assets to a lower volatility crypto assets. As stablecoins are backed by underlying assets though, they are subject to the same volatility and risk associated with the underlying pool of assets. The cost of maintaining the stability is the cost of storing and protecting the backing with an adequate level of reserves or a similar mechanism. Operators of stablecoins typically say they are backed one-for-one with reserves of the asset (e.g. USD). The largest of such a stablecoin is Tether that mirrors the USD (USDT). Its operator claims that Tether is pegged to USD, and this is maintained through dollar-based reserves that always enough to match its tokens in circulation. TerraUSD (UST), by contrast, is a USD stablecoin that is backed by a smart-contract algorithm linked to its sister-token, Luna. It is known as algorithmically stabilised coin with a mechanism to permanently destroy Luna tokens in order to mint new UST ones. Through this mechanism, UST keeps its dollar peg in check. Terra’s model was experimental and failed spectacularly when its value fell to almost zero in early May 2022. Tether had previously already be fined by two regulators for making false statements about its reserves. Both examples are good illustrations of the ongoing challenges for regulations and the wider issue of financial stability.

At the same time, stablecoins are getting considered by central banks as a tool of monetary policy. The Swiss central bank, SNB, reported in mid‐2019 that it partnered with SIX group, the Swiss stock exchange operator, to work on a digital currency proof of concept. In early 2020, the SNB clarified its position and stated that it wanted to issue and run the digital currency itself, rather than use a third party. It quoted counterparty risk consideration as the main driver of its decision. In July 2021, the Treasury Secretary convened a committee of top US officials to discuss the growth of stablecoins and the associated risks. The group issued a statement that regulators expect to make recommendations on stablecoins in the months to come.

Synthetic trading

Different smart-contract use cases facilitate the synthetic trading of assets, historically represented by derivatives contracts either traded at regulated exchanges or over the counter. They replace traditional derivatives structures with their legal and collateral requirements. Synthetix, for instance, is a protocol for minting and trading synthetic assets on Ethereum. Synths are synthetic assets on the Synthetix protocol that are designed to track the value of an asset. Uniswap, as another example, is establishing a decentralized liquidity pool through an automated market maker model. The model relies on tokens that are always paired with Ethereum, ensuring there is always enough liquidity between any two tokens. Participants can add to or withdraw their funds at any time in exchange for trading fees in proportion to their share of the pool's liquidity. Synthetic trading is still in an early stage but has huge potential for modernising trading infrastructure through more adaptable delivery mechanisms and liquidity provision.

Clearing and settlement coins

Blockchain has further been implemented for settlement of securities transaction. The objective of utility settlement coin (USC) is to remove settlement and counterparty risk to increase speed and reduce financial, operational, and frictional costs. A consortium of international financial institutions have backed under the venture Fnality International the creation of a network of distributed financial market infrastructures using blockchain to deliver the means of payment-on-chain for wholesale banking markets. Other consortiums such as R3 and ventures such as Ripple developed a real‐time gross settlement system that is based on blockchain. Digital Asset Holdings started to work early with ASX, the Australian stock exchange, to develop a blockchain-based post-trade (clearing and settlement) platform. This project however has experienced substantial delays in its deployment.

Initial coin offering and non-fungible token

Initial coin offering (ICO) is the cryptocurrency equivalent to an initial public offering (IPO). Investors receive a blockchain equivalent to a share which is a cryptocurrency token. In a similar manner, a NFT is a financial security whose ownership is recorded in the blockchain, and can be transferred by the owner. As any other asset, NFTs can be sold and traded. NFTs are uniquely identifiable which makes them different from fungible cryptocurrencies. The market value of an NFT is associated with the digital file it references. It typically contain references to digital files such as photos, videos or electronic art work. In theory, it can be based on any underlying assets and has recently gained accelerated momentum in the art markets. Legal uncertainty remains high though if NFT provides a public certificate of authenticity or proof of ownership. Ownership that is purely defined by the blockchain has no inherent legal meaning, and does not necessarily grant copyright, intellectual property rights, or any other legal rights.

The outlook for decentralised finance

Crypto assets have been a major innovation with the potential to fundamentally transform today’s financial system over the next five to ten years. As with most of innovations, it has been a volatile path for the emerging crypto industry. The Basel Committee on Banking Supervision recently commented in a speech that the jury was still out when it comes to ascertaining how best to harness the promises and benefits of crypto assets, while mitigating their risks and safeguarding financial stability. The high environmental costs have questioned the proof-of-work system of validating blockchain transactions (which underpins bitcoin and most other cryptocurrencies). This concludes to the open question if cryptocurrency are an effective means of payment. Ethereum efforts to move to a proof-of-stake validation with the objective to be less energy-intensive have been slow. Although frontier countries such as El Salvador have adopted bitcoin as a legal tender, academic research concludes that the crypto currency has scarcely been used for daily payments. In fact, the high price volatility of bitcoin makes it almost impossible to use it as a conventional form of payment.

With Web3 however, there even is a more ambitious vision with a much broader set of use cases than DeFi. At the core of Web3 is the vision of a new iteration of the world wide web which revolves around the concepts of decentralization and token-based economics. The term has become a buzzword for a broader application of various decentralizing technologies including DLT and blockchain across a variety of use cases such as data ownership, scalability, security and privacy. Finance is part of almost every daily interaction in our lives, and is in this sense well positioned to lead the way in the future.

The book “Transforming Financial Institutions” aims to contribute to ongoing discussion about the financial industry’s transformation agenda with its three pillars to facilitate commercial growth and operational change. The two blog series in combination with the book follow the objective to provide decision makers a comprehensive framework to drive their own institutions’ transformation agenda. A third blog series on transformative technologies and their value creation continues the thought leadership contribution on an ongoing basis. Further information can be found on


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