Responsible Innovation in Financial Markets: Observations from the Trenches

Digital Asset’s Manoj Ramia says responsible financial innovation should be informed by reality, focus on solving real problems and stay within regulatory guardrails.

Sometimes, the headlines about financial innovation don’t tell the whole story. Sometimes, the financial innovation that grabs the headlines—in both good times and bad—isn’t the innovation that matters. The global financial system is inordinately complex. No “one big thing” will change everything, especially overnight. Rather, what matters are the many incremental, behind-the-scenes changes—changes that are perhaps superficially boring and seem individually insignificant but can, over time, accumulate and create meaningful change. This is how real financial innovation happens. And this is how responsible financial innovation happens. This is innovation that solves real problems faced today by market participants, and does so within regulatory guardrails that ensure a safe, sound and fair financial system.

Cynicism about financial innovation is justified. From the 2008 Financial Crisis to crypto, once-heralded “innovations” turned out to be new ways to repeat the mistakes of financial history. The recent fraud and contagion plaguing the crypto sector have been particularly striking. Trillions of dollars of value were conjured up and subsequently destroyed, hurting retail investors misled by lofty promises. And all because a compelling, creative idea developed into an ideology. Rather than trying to solve real problems in the financial system, crypto “innovators” clung to their beliefs, tried to bend reality to their will, ignored the lessons of history, and failed spectacularly.

While the crypto sector has been going through increasingly destructive cycles, and its underlying ideology is proving to be hollow, real innovation has been happening outside the spotlight. Rather than trying to impose an ideology, the focus of this innovation has been on testing ideas against reality to solve real problems. Rather than trying to replace the financial system we have today, the focus of this innovation has been on trying to improve it.

Driving this innovation is blockchain technology—innovative infrastructure that shouldn’t be confused with the speculative asset classes created by crypto. And just as importantly, we shouldn’t think of blockchain as some monolithic panacea to all the ills of the financial system but, instead, as a useful tool that can help solve some (not all) of the problems in today’s financial system.

Observations from the trenches

Market leaders are already beginning to realize the benefits of leveraging blockchain technology and smart contracts. They are using these technologies today to solve real problems. In Germany, Deutsche Börse is paving the way for an innovative future for European markets with D7, a digital issuance platform that complies with German law. Goldman Sachs is leading the way for financial institutions with its digital asset platform, GS DAP™, issuing digital bonds on a blockchain. We also see more engagement from government entities. In the U.S., the NY Fed and several member banks are exploring tokenized deposits for a regulated liability network. From this vantage point, three observations stand out:

1. Data Reconciliation, not Disintermediation

The problems driving innovation are the boring ones like data reconciliation; the purported problems that grab headlines, like disintermediation, are not necessarily relevant. ​​Many of these boring problems exist because the technology underpinning the financial system today is simply an artifact of what was available as the financial system moved away from paper records. Even as technology improved, it could only be used in a way that structurally tracked old, paper-based recordkeeping systems. But blockchain technology can allow financial institutions to move beyond this skeuomorphism by enabling the creation of shared ledgers across market participants.

2. Privacy and Control Over Data are Paramount

While shared ledgers are appealing, the problem is that they can pose serious privacy challenges. A shared ledger where its contents are visible to everyone is not a workable solution for financial markets. Instead, each market participant needs to have granular control over who can see each aspect of a transaction. With technology now available to meet these privacy and data control requirements, blockchain is becoming a viable solution for financial markets.

3. Ask the Right Questions

The problem with many discussions today about blockchain is that they are clouded by false dichotomies that are not necessarily technological constraints and not responsive to real problems faced by financial institutions.

Debates over whether to choose permissioned versus permissionless networks, or centralized versus decentralized architectures, can amount to pushing technology in search of a solution and miss the point. Rather than debate what technology to use, the point is to determine how technology can be used to solve real problems faced by financial institutions and to focus on the value and utility provided by technology, all within regulatory constraints.

Many debates about regulation similarly miss the point. Rather than ask whether or not new regulation is needed for a given technology (or, implausibly, whether a new technology makes regulation unnecessary), the point is that regulation should be, as Michael Barr, the Fed’s Vice Chair for Supervision, put it, “based on the principle of same risk, same activity, same regulation, regardless of the technology used for the activity.”

So the question we need to ask should instead be: how can financial institutions use new technology in a way that follows existing regulatory principles and enables better and easier regulatory compliance?

Where do we go from here?

Just because we are justified in being cynical about financial innovation doesn’t mean we should dismiss all financial innovation. And our response can’t simply be not to innovate. Still, through our conversations with industry leaders, we know that many think the infrastructure underpinning the financial system today needs to be modernized. Instead, we need to innovate responsibly, focusing on solving real problems and doing so within regulatory guardrails.

Responsible innovation is happening today, outside the spotlight, and is being driven by blockchain technology. Rather than pursuing lofty, idealistic solutions, market participants have been pursuing blockchain solutions grounded in and informed by reality. Of course, these solutions don’t always grab the headlines. And their immediate benefits may not be apparent to anyone except those well-versed in the intricacies of the financial system. But by continuing on this path, one project at a time, market participants can meaningfully and responsibly modernize the financial system.

By Manoj Ramia, General Counsel at enterprise blockchain company Digital Asset.

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