Predicting which technology had the strongest competitive advantages and would ultimately revolutionize any given status quo is an easy task when looking back into the past. Surely anyone could have predicted that touchscreen smartphones with full operating systems would eventually surpass phones with physical keyboards (e.g. Blackberry), that crowdsourced encyclopedia (Wikipedia) would displace expert-curated encyclopedias (Encarta), or that streaming music would replace mp3 downloads (iTunes) [1]. Or would it have not been that easy to predict the future?

With the advent of traditional institutions wanting to ride the blockchain train, a similar dilemma as when the internet was first created has arisen: Should they use private blockchains or public blockchains to protect their data and carry out their business? Which one is the ‘strong’ technology that will outpace both its traditional (centralized) and blockchain counterparts? We will develop a framework for trying to understand and predict (this time into the future) what is the ‘best’ choice.

What makes a technology ‘strong’?

We previously delved into blockchain’s (or ‘DLT’) main benefits, challenges and risks. We also discussed its role in the current state of affairs, and how it can revolutionize every major industry [2]. Yet we haven’t considered the apparent rivalry between the two main types of blockchains: private and public.

To approach this subject, let us present the main differences and similarities between the two:

• Access & Identity. The characteristic that best defines each type of blockchain is the capacity of determining governance protocols and the users access. In a public blockchain, joining the network has no restrictions, so access to the sharer ledger is available to everyone. Private (or permissioned) blockchains have single authorities (usually an organization) that can determine who can join the network and grant specific access and functionalities to each node. They manage this by stripping the anonymity property that characterizes public chains and including identity management solutions.
• Authority. We can understand both types of blockchain as part of a decentralized range; public blockchains are more decentralized, while private ones enjoy the benefit of DLT technology but with a marked authority, arguably making them at best partially decentralized. This characteristic is based on the access and participation any specific individual has in the network. While public blockchains allow anyone to join, private ones need a centralized party to determine user access rights and functionalities.
• Data Handling/Ownership. When combining various categories, a spectrum of data ownership can be found. Public and private networks relate to the degree to which one can write and add to the chain, while open and closed ones relate to who is able to read the data. The easiest case is the known open public blockchains, with available-to-all read and write properties. On the other end of the spectrum, closed private chains don’t even allow for permissionless reading rights [3].
• Transaction speed. Transactions in public blockchains can bottle-neck the network depending on the consensus mechanism used and scaling layers implemented, given that the number of transactions can be exponential to the amount of users. This is not the case for private networks, where only a few have the ability to request modifications of the ledger, thus usually making them faster.
• Consensus. This is one of the most interesting features to analyze. While in original public networks various consensus mechanisms were developed accounting for game-theory based incentive structures, private ones decide beforehand who can join consensus, while most nodes won’t participate in the process.
• Transaction Cost. Similarly to the consensus mechanisms in place for public blockchains, incentive rewards must be paid out to those maintaining the infrastructure of the network (i.e miners/validators). Added to the fact that public blockchains have their own governance coin used to participate in the network (and can appreciate in value), transaction costs end up being very volatile, and even extremely expensive in relation to private chains. Private chains don’t have native coins or incentive structures, thus ensuring constant rates across transactions.
• Immutability. While public networks leverage cryptographic security for full immutability, the fact that smaller, private ones have centralized authorities arranging for permission opens an argument for partial immutability. Under private chains, owners have the authority to decide under which circumstances a verified transaction can be reversed, weighing the benefits and consequences of it (undermined confidence in the system) [4].
• Security. The security pyramid (physical, network, user, application and data) becomes highly relevant within the context of the operating model. Whether it is public, private, or hybrid, the network choice has a direct impact on each level.

 

Table I: Categories of distributed ledger technologies [5]

Private & public blockchains: adversaries or associates?

There is a common misconception that public and private blockchains are adversaries, but this could not be further from the truth. How can they be competitors if they are intrinsically different and serve specific needs? 

In fact, even public blockchain platforms (like Ethereum) can be used to build private, permissioned scenarios. It would be up to the institutions’ architecture and designer teams, because public networks don’t have private built-in tools, but it is possible. This way, an organization could leverage the security benefits of public blockchains, while keeping a tight grip on information management and security [5].

Additionally, there is one more factor that is rarely taken into account when discussing public/private blockchains, and that is the fact that public blockchains are constantly ‘in the dirt’, and need to work everyday, while private blockchains are synthetically developed in secret rooms, and never tested in the ‘real world’.

Conclusion and the SCALABLE palette

Whether you’d like to leverage the benefits of public, private, hybrid blockchain, or even if you don’t know what’s best for you, at Scalable Solutions we have the knowledge and experience to assist you in every step of the process. We strive for perfection and to provide integral solutions, so even though we understand the benefits of private networks (and are technically equipped to service them), we always recommend running a project in at least one public network.

 

 

 

 

 

References

[1] Dixon, Chris. “Strong and Weak Technologies.” Cdixonorg RSS, 18 Jan. 2019, cdixon.org/2019/01/08/strong-and-weak-technologies. 

[2] “The Decentralization of Finance (DeFi).” Scalable Solutions, 16 Oct. 2020, scalablesolutions.io/news/the-decentralization-of-finance-defi/. 

[3] Winiarsky, Andrzej. “Co-Chains: Bridging Public and Private Chains as a Way to INTEROPERABILITY?” Hacker Noon, 23 Apr. 2020, hackernoon.com/co-chains-bridging-public-and-private-chains-as-a-way-to-interoperability-1y3332kg. 

[4] It is true that under public networks the reversal of transactions is possible, but these special occasions are either accepted by the entire community or by some, resulting in hard or soft ‘forks,’ instead of being a single centralized authority deciding. Stay with us, as we will soon discuss forks in greater detail.

[5] Fan, C., Ghaemi, S., Khazaei, H., & Musilek, P. (2020). Performance Evaluation of Blockchain Systems: A Systematic Survey. IEEE Access, 8, 126927-126950.

[6] Massessi, Demiro. “Public Vs Private Blockchain In A Nutshell.” Medium, Coinmonks, 15 Oct. 2020, medium.com/coinmonks/public-vs-private-blockchain-in-a-nutshell-c9fe284fa39f. 

General Sources

Anwar, Hasib. “Enterprise Blockchain: The Industrial Transformation.” 101 Blockchains, 14 Nov. 2019, 101blockchains.com/enterprise-blockchain. 

Anwar, Hasib. “Public Vs Private Blockchain: How Do They Differ?” 101 Blockchains, 17 Mar. 2020, 101blockchains.com/public-vs-private-blockchain. 

Daruwalla, Benazeer, and Charles Carrington. “The Blockchain Is Only as Strong as Its Weakest Link.” Security Intelligence, 23 Apr. 2018, securityintelligence.com/the-blockchain-is-only-as-strong-as-its-weakest-link/. 

Peled, Eran. “Private vs Public Blockchain.” Orbs, 26 Feb. 2020, www.orbs.com/private-vs-public-blockchain/. 

Nascent blockchain technology and its main derivative -cryptocurrencies- are stealing the spotlight. Explosive returns and growing total value locked (TVL) are broadcasting the advent of a new financial ecosystem, highlighted by decentralization as well as trustless environment, minimal fees, lightning speed, and most importantly, a (better) alternative to the current traditional financial services. 

Despite being young, blockchain is not new. Though originally limited to the attention of savvy developers and open-minded seed investors, it has grown to be baptized as the “fourth industrial revolution,” and is building recognition worldwide, fast. Traditional finance players are constantly keeping an eye on new developments in the digital assets space, timing the seconds to jump in and harness everything the technology has to offer. Institutions are steadily becoming the new whales of the industry.

So, what has changed?

Historically, price volatility of digital assets (though it has been constantly decreasing for the past years), lack of fundamentals to gauge appropriate value, security concerns, private key management concerns, system complexity, lack of tax/regulatory treatment, irreversible transactions, and a lack of institutional grade service were some of the main issues that made institutional capital abstain from entering. Now, these problems are starting to resolve and institutions are placing one foot inside the door, ready to take the extra step. We are at an inflection point regarding mass adoption. 

Ever since the digital assets ATH in 2017 and its subsequent downfall, the space has been constantly growing and consolidating.

Since 2017, financial institutions have been getting more interested in securing a place within the blockchain ecosystem. In 2017, Harvard, Stanford, and MIT endowment funds have paved the way for reluctant institutions that needed a pull from pioneers of the industry [1]. Recently, over 20 companies filed the 13F form (it tracks positions, greater than US$ 100M, possibly changed to US$3.5B), declaring they have made sizable investments in Grayscale Bitcoin Trust (BTC). Grayscale Investments has been one of the first to offer traditional finance products with digital assets as the underlying, and is seeing its trust grow at a rate of US$ ~60M a week [2]. The space is starting to fill with whales, but this sea has plenty of room for everyone.

According to Deloitte’s 2020 Global Blockchain Survey, 55% of organizations responded that blockchain will be critical and is one of the top 5 strategic priorities, relative to 53% and 43% in 2019 and 2018, respectively. Similarly, Fidelity Digital Asset’ Institutional Investors Digital Asset Survey showed that almost 60% of all investors surveyed have a neutral or positive perception toward digital assets, and 36% are currently investing in them. Every category in these surveys has improved its outlook on blockchain, showcasing a predestined institutional growth. And even though sentiment is not a sufficient condition for adoption, it is necessary for establishing confidence and further involvement.

A July research report from The Block mapped over 110 institutional digital asset infrastructures by services provided, and found out that from the US$ 2.1B in investments allocated to institution-serving firms, US$ 1.2B went solely to institutions, focused mainly on derivatives, custody, and lending services [3]. 

(The Block, 2020)

Digital appeal of digital assets

The main appeal and growing interest on digital assets is based on:

• Low correlation between digital assets and traditional assets. Most renowned cryptocurrency Bitcoin has had a daily average correlation (Rolling 30D) of 0.1 with US small/mid/large cap equities, global bonds, international stocks and emerging markets in the period of January 2015 to September 2020 [4]. A correlation lower than 1 provides diversification benefits as demonstrated by Nobel prize-winning economist Harry Markowitz in his groundbreaking work on modern portfolio theory, over half a century ago. [5]
• Adoption and usage of underlying networks. As network usage grows and gains mass adoption, the path for institutions gets clearer for entering the space and taking advantage of it. 
• Decentralization. No government intervention is a characteristic that many investors find appealing. Not fueling the power struggle between national economies and being subject to its laws, regulations, and intervention, can be an enticing sweetener for participants.
• Higher returns: In a situation where current developed economies have zero or even negative nominal and real interest rates, providing investors with asset classes that have higher risk-adjusted returns is a growing challenge for traditional institutions. As the most representative case example, Bitcoin has grown +320% since its twelve month low in March [6].
• Launch of institutional grade infrastructure. Without institutional grade infrastructure, traditional finance still keeps a competitive advantage on both scalability, security, custody, and settlement/clearance processes, maintaining a reluctant stand on the space [7][8].
• The growth in talent and service providers focused on the space. Everyday, prominent traditional actors are entering the digital asset market, raising the bar. Recently, USDC issuer Center, for instance, hired former State Street and JPMorgan Chase executive David Puth as its new CEO [9]. 

Dynamics going forward

It is evident that the current dynamics will change as blockchain reaches higher levels of adoption, especially when accounting for institutional investors. We believe that as the new ecosystem unveils, new challenges as well as new opportunities will rise. For one, retail investors (the majority in the first period of digital asset ATH) will have more prepared counterparts to trade with. This is a common fact when any market expands. Liquidity will flood exchanges, provoking a higher valuation, consolidating, and reducing volatility. More and more interesting and user-centered projects will be funded, and the ecosystem will grow exponentially.

At the moment of writing, S&P Dow Jones Indices reported to launch cryptocurrency indexes in 2021. Many customizable indexes will be born, creating new benchmarks for what will probably be the fastest growing year for cryptocurrencies [10]. In our next article, we further explore the impact blockchain and cryptocurrencies are having on recent investments and adoption. 

 

SCALABLE

Regardless of whether you are a retail trader, high net worth individual, investment fund or any financial institution, with SCALABLE you can find a partner that can help you navigate every stream of this exciting wave of adoption. Innovative technology and security is at the heart of what we do, and thanks to our wide array of regulatory partners, we can help institutions along each step the way. Get in touch with us here. 

 

 

 

 

 

References

[1] Victor, Jon. “Harvard, Stanford, MIT Endowments Invest in Crypto Funds.” The Information, The Information, 10 Oct. 2018, www.theinformation.com/articles/harvard-stanford-mit-endowments-invest-in-crypto-funds. 

[2] Castillo, Michael del. “20 Institutional Bitcoin Investors Revealed, But Soon The List May Vanish.” Forbes, Forbes Magazine, 7 Aug. 2020, www.forbes.com/sites/michaeldelcastillo/2020/08/06/valuable-sec-data-on-20-institutional-bitcoin-investors-could-soon-disappear/?sh=7db31fbd1de2. 

[3] Dantoni, John. “Mapping the Institutional Digital Asset Infrastructure Space.” The Block Research, The Block, 12 May 2020, www.cryptofinance.ch/wp-content/uploads/2020/07/Mapping-the-Institutional-Digital-Asset-Infrastructure-space-The-Block-Part-1.pdf. 

[4] Morningstar Portfolio Visualizer > Asset Class Correlations;

Correlation is a statistical metric that showcases how close two variables are linked. A value of 1 is a ‘perfect’ relationship, -1 is a perfect inverse relationship, and 0 means no relationship. Note: correlation within digital assets are much higher than with traditional assets (equities, bonds, REIT, etc), and in times of economic crisis, assets tend to have higher positive correlations between classes (i.e they all can lose value together).

[5] Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91. doi:10.2307/2975974

[6] Gola, Yashu. “Bitcoin Beats Stocks, Gold, Bonds in Risk-Adjusted Returns: Research.” Bitcoinist.com, 12 Nov. 2020, bitcoinist.com/bitcoin-beats-stocks-gold-bonds-in-risk-adjusted-returns-research/;

We shouldn’t leave unmentioned that even though digital currencies provide outstanding risk-adjusted returns, these are only of significance when the assets have deep liquidity. Nowadays, sizable investments from institutional actors can cause major price shifts, affecting future returns and volatility.

[7] “$20 Billion in Crypto Under Custody: Coinbase Sees ‘Explosion of Capital’ From Institutional Investors.” Bitcoin News, 23 Nov. 2020, news.bitcoin.com/coinbase-20-billion-cryptocurrency-custody-institutional-investors/.

[8] “Crypto Hedge Fund ARK36 Partners with Coinify for Institutional Services.” Hedgeweek, 24 Nov. 2020, www.hedgeweek.com/2020/11/24/292625/crypto-hedge-fund-ark36-partners-coinify-institutional-services. 

[9] Bourgi, Sam. “USDC Issuer Centre Lands Wall Street Veteran David Puth as CEO.” Cointelegraph, Cointelegraph, 1 Dec. 2020, cointelegraph.com/news/usdc-issuer-centre-lands-wall-street-veteran-david-puth-as-ceo. 

[10] Irrera, Anna. “S&P Dow Jones Indices to Launch Cryptocurrency Indexes in 2021.” Reuters, Thomson Reuters, 3 Dec. 2020, www.reuters.com/article/cryptocurrencies-sp/sp-dow-jones-indices-to-launch-cryptocurrency-indexes-in-2021-idUSL1N2IJ0TG. 

Sources

Chandler, Simon. “Institutional Investors Could Help Push Bitcoin to New Heights.” CryptoVantage, CryptoVantage, 14 Oct. 2020, www.cryptovantage.com/news/institutional-investors-dominate-crypto-market-heres-why-thats-bullish-for-bitcoin/. 

“Are Institutional Investors Moving into Cryptocurrencies? – ET BFSI.” ETBFSI.com, 26 Oct. 2019, bfsi.economictimes.indiatimes.com/news/blockchain/are-institutional-investors-moving-into-cryptocurrencies/71770031. 

“Guggenheim Opens Door to Bitcoin Exposure for $5 Billion Macro Fund via Grayscale’s GBTC.” CryptoZ News, Medium, 30 Nov. 2020, cryptozblog.medium.com/guggenheim-opens-door-to-bitcoin-exposure-for-5-billion-macro-fund-via-grayscales-gbtc-c30328a88c38. 

Watkins, Jonathan. “The Institutional Crypto Backers: How Endowments Are Allocating to Cryptocurrency Investments.” GlobalCustodian, GlobalCustodian, The Trade Crypto, BitGo, Apr. 2019, www.globalcustodian.com/wp-content/uploads/2019/04/The-institutional-crypto-backers-How-endowments-are-allocating-to-cryptocurrency-investments.pdf. 

Decentralized lending/borrowing protocols, liquidity providers, exchanges, and other blockchain applications carry major improvements over traditional finance’s shortcomings; indeed, the current consensus on blockchain-based decentralized finance (DeFi) preaches the inevitability of how it will supplant traditional finance. 

So, why do we believe that two seemingly competing industries can coexist and leverage each other, at least in the medium term? The answer to this question was discussed in a recent blog post [1] and can be found when looking into the human emotion of fear, born from a lack of knowledge. In this instance, lack of knowledge pertains to both sides.

Why fear? Because it is caused by a perception of danger. In the case of financial services, the perceived danger is that institutions will be outpaced by blockchain-based companies. Similarly, retail users are paradoxically skeptical of those same benefits that blockchain introduces in the system; no centralized authorities that can resolve issues, state-of-the-art technology that can’t be easily understood by non-savvy investors, and no centralized regulation to keep ‘fair play,’ among others. These are some of the reasons that prevent blockchain from mass-adoption and winning the ultimate prize: gaining one of the biggest economic sectors on the planet.

Knowing this, what can centralized financial institutions (FI: banks, insurance providers, funds, etc.) do to keep the lion at bay? First, they must have a deep understanding of what their relative strengths are and pinpoint the factors that prevent blockchain from gaining mass adoption. Once they have accomplished that, they may undertake the enterprise of leveraging blockchain technology within a centralized framework. Many believe that blockchain will do to finance what the internet did to the media industry; while it didn’t completely dismantle it, it did grant higher access and cheaper products to users and forced media companies to adapt to a new status-quo. 

Competitive strengths and weaknesses of financial institutions.

Spotting some of the main competitive strengths of centralized FI is not a straightforward task. Within them we can find:

• First and foremost, borrowing & financing are the main services that characterize the banking industry, and although it is already being threatened by providers like Aave, Maker, and Compound, they still have the advantage of being renowned institutions that wary investors choose to invest in. Decentralized finance (DeFi) has a total lending value locked of US$ +6B, while the commercial and industrial loans in the United States alone amount to US$ 2.7T.
• Underwriting & decision making are two services that are hard to displace by technology alone, given that there is a high degree of human interaction, experience and intuition within them.
• Another arguable strength is the economic stability that centralized FI provides to societies and ecosystems. We say ‘arguably’ because there are debates taking place about how new cryptocurrencies can take over this role. The consensus is, however, that even if this is a strong future possibility, trust in cryptocurrencies is not a current worldwide reality [2]. 
• Facilitates the management of risks. Main financial risks include market risk, interest rate risk and credit risk. All of them are directly or indirectly present in the world of cryptocurrency, as well.
• Provides mechanisms for dealing with asymmetric information (centralized FI developed and continues to develop a series of mechanisms to account for what they don’t know). Credit ratings, liquidity and solvency scores, and others are just some of the many that are present in the current financial system.

Similarly, other services that are prone to be highly challenged by decentralized ledger technology (DLT) include some core functions of the financial system:

• Currency safekeeping: Remember the old-days, when money was limited to its physical form, and the best way to keep it safe was handing it to a bank to diminish your exposure to robbery? Nowadays, decentralized currencies are kept secure through cryptography and provide the best alternative for the safekeeping of private funds. A number of custodial and non-custodial wallets in both digital and real (hardware) formats are available for users depending on their preferences on UI, practicality and security [3][4][5]. 

• Clearing & Settlement are two processes that may not be the most glamorous, but are definitely established for FI’s clients. Moreover, despite being heavily threatened by the simplification of processes by blockchain, it is an area that can be (at least in the short term) heavily empowered with an interest cost reduction. In 2017, Accenture estimated that an average of US$ +10B a year could be saved [6]. 

• Payment systems for the exchange of goods and services are the distinguished case of the ‘lost battle.’ Explicit in Bitcoin’s whitepaper, ‘peer-to-peer electronic cash systems’ are being constantly improved upon and are ever closer to gaining the payment battle. In the meantime, FI must stand on the regulatory and technological inconsistencies of DLT that prevent growth and universal adoption, and aim to prolong the fight for as long as possible. 

• Mechanism for the pooling of funds to undertake large-scale indivisible enterprise, and the transfer of economic resources through time and across locations present two extra categories threatened by DLT.

Centralized institutions and blockchain outlook

Accounting for their relative strengths and the factors that put a stick in the blockchain evolution wheel, banks can evolve by:

• Monitoring, understanding & accepting what they can and can’t change. This is the first step before progressing onto specific transformations. Having a clear understanding of future business models, they can incorporate blockchain technology where it matters, and drop uncompetitive product lines.

• Reducing fees. Almost every service financial institutions provide either is or will be under attack, there is no way around it. Accepting that creates an opportunity for those who take the lead in reducing fees, gaining market share today and hopefully maintaining a larger client base going forward.

• Specializating & downsizing. Offering startup ventures bypass capital markets through blockchain-based offerings, personalizing products, offering guidance, and tokenization opportunities, which are some of the areas financial institutions can specialize in themselves, in order to have a fighting chance. In these same lines, downsizing soon-to-be outdated market segments permits a faster and more fluid opportunity to adapt.

• Using cryptocurrencies as investment vehicles. It’s hard to fathom that the knowledge of institutional investors can be easily surpassed by newly assembled decentralized organizations. Historically, funds had the most capable systems in place and individuals to navigate the volatile nature of most assets. Additionally, given the expected risk-adjusted returns of various cryptocurrencies v return on typical assets (stocks, bonds, etc.), it can provide investors of funds with extraordinary managed returns.

Some recent cases

Let’s take a look at some current projects that provide evidence for our position.

• Payment services provider PayPal announced the launch of a “new service enabling its customers to buy, hold and sell cryptocurrency directly from their PayPal account, and signaled its plans to significantly increase cryptocurrency’s utility by making it available as a funding source for purchases at its 26 million merchants worldwide” [7][8].
• Banks: JPM has been piloting a blockchain-based Interbank Information Network since 2017, involving over 400 participating banks and corporations. A year after the announcement, it has launched its own cryptocurrency (JPM Coin), used primarily for fund transfers and faster transaction settlements among clients [9]. Similarly, other main banks around the globe have been offering blockchain-based investment products or optimizing current processes with it.
• Exchanges: Nasdaq, a historic American exchange, has been a long-time believer and one of the earliest, most prominent blockchain adopters. Since 2015, when it partnered with Chain to power its private securities platform, to its recent association with R3 blockchain solution provider, Nasdaq continues to prove its firm stand on blockchain adoption. Comparably, Swiss digital exchange “SIX” and Australia’s “ASX” are also located in crypto-friendly regulation countries that aim to leverage blockchain benefits for improving their processes.

For more detailed information on blockchain applications in the banking industry please visit Haitham Nobanee survey and Blockchain-works 2017 article [10][11].

Conclusion

Steering the ship in the turbulent waters of what can be considered the fourth industrial revolution is not an unchallengeable mission. An unwavering mindset and strong leadership is key for making the tough decisions that financial institutions are faced with when competing with blockchain technology. 

Is it possible to succumb in the face of adversity? Definitely. Is it plausible to adapt and avoid that same route? We believe so. But the absolute condition is to start that path today. Hoping for the best is an alternative that will inevitably result in extinction.

Scalable Solutions can aid institutional clients in applying the best of blockchain technology to their systems, thus taking advantage of financial innovations happening in the industry. Find out more by getting in touch with our team here. 

 

 

 

 

 

References

[1] Marais, Piers. “Cryptocurrency Is Dead. Long Live Central Bank Digital Currency!” Finextra Research, Finextra, 28 Aug. 2020, www.finextra.com/blogposting/19256/cryptocurrency-is-dead-long-live-central-bank-digital-currency. 

[2] For a detailed explanation on digital currency wallets please visit our recent article: “Custodial v Non-custodial wallets”

[3] “Imagine 2030: The Decade Ahead.” Deutsche Bank Research, 4 Dec. 2019. 

[4] Danielsson, J. (2019). Cryptocurrencies: Policy, economics and fairness. Systemic Risk Centre Discussion Paper, 86, 2018.

[5] Breckenridge, Garrison. “Crypto and Fiat Currencies Are Worlds Apart, Here Are the Reasons Why.” Cointelegraph, Cointelegraph, 31 May 2020, cointelegraph.com/news/crypto-and-fiat-currencies-are-worlds-apart-here-are-the-reasons-why. 

[6] “SERIES: BANKING ON BLOCKCHAIN—A VALUE ANALYSIS FOR INVESTMENT BANKS.” Https://Financialservicesblog.accenture.com/, Oct. 2017, financialservicesblog.accenture.com/series/banking-on-blockchain-a-value-analysis-for-investment-banks. 

[7] “PayPal Launches New Service Enabling Users to Buy, Hold and Sell Cryptocurrency.” Https://Newsroom.paypal-Corp.com/, 21 Oct. 2020, newsroom.paypal-corp.com/2020-10-21-PayPal-Launches-New-Service-Enabling-Users-to-Buy-Hold-and-Sell-Cryptocurrency;

[8] Shevchenko, Andrey. “PayPal to Offer Crypto Payments Starting in 2021.” Cointelegraph, Cointelegraph, 21 Oct. 2020, cointelegraph.com/news/paypal-to-offer-crypto-payments-starting-in-2021. 

[9] Authors, Guest. “JPMorgan’s Blockchain Products, Explained by Ex-JPM Tech Leads.” Cointelegraph, Cointelegraph, 24 Nov. 2019, cointelegraph.com/news/jpmorgans-blockchain-products-explained-by-ex-jpm-tech-leads?_ga=2.267145614.141223522.1605272677-543740393.1604919522;

https://www.jpmorgan.com/insights/technology/blockchain

[10] Albeshr, S., & Nobanee, H. (2020). Blockchain Applications in Banking Industry: A Mini-Review. Available at SSRN 3539152;

[11] Campbell, Rebecca. “Which Major Banks Have Adopted or Are Adopting the Blockchain?” Blockchain Works, Blockchain Works, 12 Nov. 2020, blockchain.works-hub.com/learn/Which-Major-Banks-Have-Adopted-or-Are-Adopting-the-Blockchain-. 

General Sources

Cocco, L., Pinna, A., & Marchesi, M. (2017). Banking on blockchain: Costs savings thanks to the blockchain technology. Future internet, 9(3), 25.

Daisyme, Peter. “The 5 Ways Banks Must Transform to Thrive in an Era of Cryptocurrency.” Due, 24 May 2019, due.com/blog/the-5-ways-banks-must-transform-to-thrive-in-an-era-of-cryptocurrency/. 

Mogul, Zubin, et al. “How Banks Can Succeed with Cryptocurrency.” BCG Global, BCG Global, 3 Nov. 2020, www.bcg.com/publications/2020/how-banks-can-succeed-with-cryptocurrency. 

Pollock, Darryn. “The Future Of Banking: Is It All Bitcoin And Blockchain?” Forbes, Forbes Magazine, 25 July 2019, www.forbes.com/sites/darrynpollock/2019/07/25/the-future-of-banking-is-it-all-bitcoin-and-blockchain/?sh=381078f131eb. 

Digital asset exchange functionalities entail providing a safe marketplace for participants to trade in, with the intention of mitigating risks besides those inherent to the trading activity itself. The corresponding functionalities depend on a series of characteristics, with the first and most important being the type of exchange the trading takes place in (centralized v decentralized). Similarly, the type of participants, geographic location, and users’ jurisdiction are other important considerations. 

[It is worth doing a quick review on the differences and similarities between centralized (CEX) and decentralized (DEX) exchanges. The characteristic that bestows their names is the presence -or absence- of intermediaries. In the case of CEXs, exchanges take custody of users’ funds. No transaction can take place if it’s not through the exchange. DEXs, on the other hand, operate through a set of rules – smart contracts- that allow users to trade digital assets in a peer-to-peer manner. The reason we define this is to clarify in advance that the nature of each one can determine its functionalities, and will be subject to different requirements. You can find out more about the difference between the two here [1] ].

We classify functionalities in two categories. The first is a ‘utility’ one, which includes everything that is needed to run the exchange and attract users. The second one is the ‘services’ category, which aims to encompass additional offerings.

Utility functionalities

Let us start with an unusually touched upon topic on the functionalities of exchanges: the listing process. Listing determines two main things: firstly, which digital assets can be included and offered on the platform, and secondly how it will be done. Throughout the process, a variety of requirements must be met:

Token issuer requirements include understanding the business in which the issuer is in, its team, governance procedures, technological and regulatory considerations, reputational risks, and others.

• Due diligence on token issuer comprises a second requirement that must be fulfilled by exchanges. Compliance searches on token team, source code and internal procedures review, as well as record-keeping activities must be carried out. This must be done not only on a first instance basis, but with certain periodicity.

Leaving the listing process behind, we turn our attention to see how exchanges address market manipulation, pricing, and liquidity, all of which are major factors in ultimately determining how successful an exchange is.

Market manipulation: In previous articles we dove into regulation on digital currency. We saw that it failed to keep-up with the fast paced industry, leaving actors to self-police for extended periods of time. Even though countries are aiming to pass digital asset legislation and provide a clear playing field, exchanges must still carry out anti-manipulation investigations to mitigate market abuse. Setting trading rules, performing meticulous reviews of suspicious activity and establishing controls where fraud could be committed, are several actions used to level the playing field. 

Going hand-in-hand, pricing & liquidity are considered the other two main factors in determining results on digital asset exchanges. Highly liquid exchanges have minimal price impact over different order sizes, thus inviting all types of participants (individual investors, retail traders and institutional investors).

Anti-Money Laundering (AML) and Counter-Terrorism Financing (CTF) controls must be carried out by digital asset exchanges in order to comply with current regulations. Though specially utilized in exchanges that provide fiat-to-crypto currency pairs (and vice versa), it is getting increasingly more common for even unregistered exchanges to implement these, given the relative safeness they deliver, versus not having these controls in place.

Custody is a crucial functionality reserved only for centralized exchanges, who are in charge of holding and securely maintaining the users’ digital assets. Two main ways of storing funds are “hot” and “cold” storage systems. The state basically depends on whether the wallet is connected to the internet. Cold storage keeps digital assets offline while hot ones are online and used to cope with withdrawal requests. Exchanges should have best practices in mind when dealing with both types of wallets, like using hardware security modules (HSM) for keeping keys, multi-signature (“Multi-Sig”) for initiating transactions, and constant storage audits [2].

On a final note, cybersecurity intensive exchanges set the basis for how safe the funds they take custody of are. Attacks occur constantly and will continue to exist as a mechanism to ensure exchanges don’t renegade their security duties.

Exchange services

Besides utility functionalities, we can find complementary services that make it attractive for participants to utilize an exchange, giving them competitive advantages over other exchange providers.

Most – dare I say all – successful exchanges provide liquidity services. They act as intermediaries between those who want to buy and sell. Deep liquidity pools are more of a necessary (rather than a sufficient) condition for attracting large players and sizable investments.

The digital asset spectrum (stablecoins, project tokens, etc.) vary from exchange to exchange, and can ultimately determine where a participant decides to trade. Exchanges offering a wide range of stablecoins and DeFi-protocol tokens have an advantage over those who don’t. Similarly, centralized exchanges continue holding dominance over decentralized ones mainly because they ally with institutional investors (liquidity makers), and offer fiat-to-cryptocurrency and cryptocurrency-to-fiat pairs [3]. 

Including lending/borrowing and money market services helps exchanges be in the lead. Lending and borrowing cryptocurrencies have a series of advantages over regular assets; cryptocurrency lending is more accessible, faster, more flexible, with lower fees, and arguably safer. Liquid, Coinsbit, Bitrue, Tokens.net, and Crypto.com are some of the players that offer both exchange and lending/borrowing services [4]. 

Exchanges with a derivatives platform that have the option of entering into futures, contracts and/or options are more likely to mainly attract experienced traders looking for various ways of playing the market and hedging positions. At the moment, under 20 exchanges can be found on the data aggregating platform CoinMarketCap [5].

As with any blockchain application trying to outperform a traditional financial service, what good would an exchange be if it didn’t account for users’ needs for managing their assets? Integral asset management tools help investors maximize their results. Additionally, market screeners, spread analysis, watchlists, price charting and having the possibility of linking third-party softwares (trading bots, own code for regulating trading activity, etc.), is another necessary condition for exchanges to provide the best user experience and attract more participants while fueling the liquidity wheel (high liquidity attracts more participants and vice versa, creating a continuous loop). 

A note on functionality

The lines between exchanges and wallets are getting increasingly blurred. In the University of Cambridge 2017 Global Cryptocurrency Benchmarking Study [6], it was estimated that 52% of wallets surveyed provide an integrated currency exchange feature, of which 80% offer national-to-cryptocurrency exchange services using one of three existing exchange models. These numbers have since gone up given the higher competition that providers are facing, forcing them to amplify the product offering and user experience (usability).

Scalable Solutions

Given that it is nearly impossible for an exchange to hold the reins in every aspect and category mentioned above, whomever wants to trade digital assets faces a crossroad with plenty of trade-offs. The exchange that can provide the best liquidity might not be the one with the best security; the decentralized one that provides anonymity perhaps does not have institutional market makers and the best liquidity, and so on. A thorough research must be carried out to find out which one best suits one’s needs and preferences.

At Scalable, we aim to be robust in every area that is of importance. Our white label exchange solution can be tailored to focus on what matters to our clients. You want to tap liquidity from the deepest pools across the world? You got it. How about battle-tested security and impenetrable custody service? We can provide that. Setting up tokens on any real or digital asset? No problem.

Some of the world’s leading platforms already use our technology to power their exchange and provide the best possible service to their clients. 

We continuously strive for excellence and besides centralized exchange infrastructure,  we are working towards launching a decentralized exchange in the near future, which is set to: 

• Overcome the most evident and pressing challenges, technological and financial, that are present in most popular DeFi applications.
• Create an ecosystem encompassing key financial services in a decentralized fashion with focus on UX, brand, education and accessibility.
• Enable both brokerage and exchange layers, allowing for several brokerage instances to share a common liquidity pool.

Schedule a demo to access leading digital asset exchange infrastructure. 

 

 

 

 

 

 

 

References

[1] For a detailed discussion on CEX/DEX please refer to our previous entry : “Exchanges: Centralized v Decentralized”. http://scalablesolutions.io/news/2205/

[2] For a more detailed explanation of wallets used in storing users funds, please see: “Custodial v Non-custodial Wallets”. http://scalablesolutions.io/news/custodial-v-non-custodial-wallets/

[3] Uniswap, a decentralized exchange currently transacting US$ +370M in daily volume with a maximum reaching US$ 3.36B in October [6].

 “Uniswap Protocol Analytics.” Uniswap Info, info.uniswap.org/home. Accessed November 17th, 2020.

[4] Actually, hundreds of cryptocurrency lending and borrowing platforms exist, but only a small percentage of them offer other services (like integrated/third-party exchanges and wallets) 

[5] “Top Cryptocurrency Derivatives Exchanges Ranked.” CoinMarketCap, coinmarketcap.com/rankings/exchanges/derivatives/. 

[6] Hileman, G., & Rauchs, M. (2017). Global cryptocurrency benchmarking study. Cambridge Centre for Alternative Finance, 33, 33-113.

General Sources

Austen, Mark, and Laurence Van der Loo. “ASIFMA Best Practices for Digital Asset Exchanges.” Lw.com, June 2018, www.lw.com/thoughtLeadership/ASIFMA-best-practices-digital-asset-exchanges.

November 2020. Scalable Solutions is broadening their services with the introduction of Scalable Labs, an innovative digital and blockchain development powerhouse. It includes back-end and front-end services, machine learning & AI, blockchain development and hardware technology solutions. 

Scalable Solutions specializes in white label exchange technology, integrating essential services such as liquidity, custody, and tokenization as part of their product. Given their experience in the field of blockchain since its mere beginnings, the addition of Scalable Labs acts as a natural extension of their services. 

The dedicated Labs team is well versed in technologies ranging from Javascript, C++, GO, and Swift to React Native and Solidity, able to cater to all aspects of a development project. Customized applications and challenging projects are their go-to choice of venture, with an accent placed on ensuring high security. Previous works have included fraud analytics systems, smart contract development, cryptocurrencies and forking blockchains, dapps, blockchain games and more. Importantly, the team is blockchain agnostic as they have worked with over 70 different blockchains in the past. 

The possibilities are truly endless. Start or upgrade your own blockchain project by getting in touch with our team here today.