A new generation of blockchain innovations is springing to life.
But can they unlock the technology’s much-vaunted potential and finally deliver meaningful benefits to the financial market world? We’re explaining what are Layer 2, Web3 and token standards as well as what it means for financial institutions.
Bitcoin and blockchain burst into mainstream consciousness in 2015. Since then, much discussion, many projects and significant investment have been dedicated to creating real-world use cases that can take advantage of the technology’s promise.
Real progress has been made, especially in leveraging blockchains to support the issuance of financial instruments. But for the blockchain technology to be truly game-changing, it needs an upgrade. Below we highlight how the scene is evolving, and the main developments to watch in the coming months.
An added layer of protection
If you were doing business with someone multiple times a day, would you create a separate invoice for every interaction? Or record each transaction and issue a single invoice at the end of the day?
Transaction netting and clearing are essential to the efficient functioning of today’s financial markets. They simplify accounting and administrative tasks, and enable our financial system to cope with high volumes efficiently while managing the associated risks.
In the early days, every blockchain transaction had to be settled immediately. But as transaction volumes grow, this approach has become unsustainable, and needed to change. “Layer 2” offers the solution.
Layer 2 describes the new wave of technology developments such as Lightning, Plasma and Raiden that sit on top of the blockchain networks, but conduct their activity “off-chain.” Lightning, for example, is an open source Layer 2 payments technology that enables money to flow around the world quickly. Transactions on its network complete in seconds, rather than the minutes it takes directly on the bitcoin blockchain. And the network’s capacity is expanding rapidly all the time.
Such Layer 2 projects are part of attempts to overcome existing blockchain shortcomings by delivering improvements in scalability, interoperability and functionality. At present, bitcoin and Ethereum struggle to conduct more than 10 transactions per second. The two networks are processing approximately 800,000 transactions per day at almost full capacity. Layer 2 technologies allow blockchain services to scale to hundreds of transactions per second and so absorb more business.
Privacy protection is another benefit. All transactions in the original blockchain systems are in the public domain. Using a Layer 2 solution is a way to limit the amount of information released to the public.
Layer 2 systems are now being deployed, with some businesses starting to process transactions on them. When the networks are fully operational and more widely used, they will open up the possibility for new use cases, such as micro payments and distributed exchanges.
Web 3.0 heralds new generation of web applications
The 2006 Time Person of the Year was You. You had your say thanks to all those new ‘me-centred’ Web 2.0 services being launched. They allowed you to publish blog posts without being an Internet guru. You could launch a video channel that attracts millions of views. Through social media, you could share with your family and friends all the important moments of your life. But we now realise the simplification they offered came at a cost: the personal data we handed over.
Web 3.0 will see decentralised, peer-to-peer technology provide users with services, while protecting individual property and privacy. Blockchain networks can help fuel its rise. In a Web 3.0 world, Decentralised Applications (Dapps) will be provided by a swarm of computers belonging to multiple entities.
Web 3.0 is still in its early phases. Dapps are emerging though as developers flock to the space. For instance, by installing the Golem software on your personal computer, users could be paid for calculating high resolution images on behalf of a graphic designer, providing the designer with alternatives to rendering farms and cloud services.
For now, Web 3.0 has limited real-world application in financial services. However, the payment infrastructure for Dapps is new, which financial institutions may have to connect to or want to employ down the line. And Iexec, a French and Chinese collaboration, has demonstrated a similar infrastructure for natural language processing, which is increasingly used by financial services providers to process documents.
We believe impacts on the financial sector will come in time, so developments around Web 3.0 should be monitored closely.
Don’t curb your creativity
Smart contracts are the foundation for all Dapps. Smart contracts engender trust, enabling people who don’t know each other to exchange services or transact.
The ability for any developer to write a smart contract and deploy it on the network has resulted in an outpouring of ideas and initiatives in recent years. We’ve seen the rise of “digital collectibles” (video game digital objects or characters that can be bought or sold), and large Initial Coin Offering (ICO) crowdfunding schemes, where issued tokens represent a stake in a project or a means of payment. But this period of creativity has brought a chaotic jumble of tools and incompatibilities, along with a slew of hacks.
The emergence of more widely-adopted and maturing standards will help underpin the applicability and adoption of smart contracts. Ethereum’s ERC-20 standard has been at the forefront of this shift since its introduction in 2016, sparking a boom in fungible tokens. ERC-20 describes a common list of functions and events an Ethereum token contract has to implement, including ones to transfer tokens between addresses and for users to access data about a token. This allows developers to build interactions with tokens. More than 100,000 ERC-20 compatible smart contracts have already been deployed on the Ethereum blockchain.
The newly-developed ERC-1400 aims to do the same for security tokens. Introducing a standard paves the way for security tokens – which can represent ownership in bonds or equities – to be adopted in a meaningful way by all the relevant parties (developers, issuers, investors, exchanges, etc.). The standard needs to be clear and validated though before Securities Token Offerings (STOs) can be used by issuers, which is not yet the case.
Libraries of standardised smart contracts that are available for everyone to use are also now being deployed. Previously, basic smart contract codes were copied and pasted, so if they contained any bugs the users incorporated those bugs too. But the new standard libraries benefit from well-tested functions that can even be updated when a bug is found (provided the programmer included this functionality).
While the emerging standards mark progress, innovation and fragmentation will limit their effectiveness for the foreseeable future. For example, the ERC standards are purely for Ethereum. Other networks use alternatives. Competing standards could also emerge in different geographic markets, creating friction.
The continued pace of innovation further militates against true standardisation. As new, groundbreaking ideas take hold, earlier adopted standards will likely become obsolete.
Some false starts and reversals are inevitable in the coming years. Nevertheless, as the environment progressively matures – with the development of more recognised standards and deployment of smart contract libraries offering universal access – developers will remain free to express their creativity within a more rigorous, methodologically-based framework.
Time to get back together?
Bitcoin or blockchain? Public or private?
Debate has raged about the future of bitcoin and the underlying distributed ledger technology since they exploded into mainstream consciousness. Which offer the most promising use cases? And how can financial services organisations make best use of them?
Rather than an either/or approach, we are now seeing more crossover and collaboration between the different propositions.
For example, some exchanges have started to list derivatives linked to the bitcoin price. Actors in the public blockchain space have also gained experience in the safe storage of digital assets in digital vaults (also known as digital wallets). As new blockchain market infrastructures come to fruition, financial institutions can take inspiration from the public blockchain actors and use similar techniques to develop storage best practices.
Innovations in private blockchains are similarly finding their way into public blockchains. A number of consensus algorithms specifically designed for private blockchain are being reused in a public blockchain context. Some Layer 2 solutions allow the movement of assets from a public to a private blockchain and vice versa, to create more hybrid, interconnected systems.
And with the open source mode of development that has become so prevalent fostering heightened cooperation and exchange between projects, we can expect the environment to evolve significantly in the coming years.
What does it mean for me?
The market is changing fast. Technical innovation is being complemented by the advent of standards. New products based on this technology continue to appear. And while they may not be widely used at present, these initiatives provide a good sandbox to test the application of the technology.
Growing co-operation is the key. Practices finance professionals are long familiar with but that did not exist in the first generation of blockchain systems, such as netting, will be progressively adopted. This kind of collaboration is already evident in the work to secure digital assets, where the teams developing Digital Asset Vaults take advantage of the expertise of people from different professional backgrounds.
With new opportunities for financial services professionals and blockchain experts to team up emerging all the time, the strength and real-world usability of the technology will only improve.