Book Review: Web3 in Financial Services: How blockchain, digital assets and crypto are disrupting traditional finance

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Rita Martins 

Kogan Page, 2024, 288 pages

`We are done doing Proofs of Concept,’ said a senior banker at a conference. `Now we need to scale up.’

It is hard to disagree with the anonymous banker quoted by Rita Martins towards the end of this compendium of everything that has happened in the cryptocurrency markets since Satoshi Nakamoto published Bitcoin: A Peer-to-Peer Electronic Cash System in October 2008.

As Martins points out, we know that blockchain technology works, that it yields operational efficiencies and that it makes possible new ways of lending, borrowing, issuing, trading and investing. The unresolved – though not unanswered - question for both start-ups and incumbent financial institutions is how to capture these gains at scale.

There are some familiar explanations for this, and Martins rehearses them. Blockchain technology itself struggles to scale.  Visa processes 65,000 transactions a second (TPS) while Ethereum manages 12 and Bitcoin just seven. Even Solana, a blockchain protocol designed to achieve higher throughput, currently manages an average of only 400 TPS.

Interoperability between blockchain protocols is limited too. Every blockchain begins as a closed universe, designed like every business before it to share none of the value it creates with competitors.  On the safe assumption that existing financial markets will not disappear overnight, there is also a secondary problem of interoperability with traditional asset platforms. 

Then there is the lack of fiat currency on blockchains. When Martins writes that “Bitcoin disrupted money,” she means that it spawned a host of imitators – in 2013 Coinmarketcap listed just seven cryptocurrencies, against more than 10,000 today – but neither these nor Stablecoins are a permanent solution to the need to settle the cash leg on rather than off blockchains. Solutions are in prospect, in the shape of tokenised deposits and central bank digital currencies (CBDCs) but have yet to become available in inter-bank form in a major reserve currency. 

Lastly, there is regulatory uncertainty. Though increasingly implausible in the case of security and fund tokens issued on to blockchains, the fact that cryptocurrencies remain largely unregulated in almost every major jurisdiction save the European Union (EU) – much of whose Markets in Crypto-assets Regulation (MiCAR) came into force at end-June 2024 - the threat of inadvertent compliance problems is enough to persuade most regulated institutions to do nothing.

Future of Finance research found a group of just six banks, three asset managers and three established stock exchanges regularly and actively engaged in tokenisation initiatives. Martins – who, as an adviser to financial institutions, is in a good position to know – argues that incumbents are doing more than we can detect. “Many institutional players have quietly been learning, testing and developing in the background and are now ready to deploy at scale,” she says.

This implies not incremental change but a transformation. The transformation will be from the current Web 2.0 paradigm (which is characterised by closed platforms owned by centralised Big Tech firms that create value by monetising the data created by their customers) to Web 3.0 (which will be characterised by open platforms owned by users that create value by owning and controlling their own data and trading peer-to-peer).

According to Martins, in the financial services industry Web 3.0 will be synonymous with Decentralised Finance (DeFi). DeFi dispenses with intermediaries such as banks. Instead, consumers will use programmable money and digital identities to transfer value peer-to-peer between self-custodial digital wallets and save and invest via decentralised apps (dApps) hosted on blockchains, operated by self-executing smart contracts and owned by holders of tokens in Decentralised Autonomous Organisations (DAOs).

“If widely adopted, DeFi could disintermediate TradFi with significant impact to existing business models and strategies,” warns Martins. She adds that “The central question for each traditional institution is no longer whether to explore Web3 but how. Companies that do not take advantage of this new technology could be left behind and disrupted by new players.”

That makes Martins sound like a true believer, but she is not. The author is aware of how far DeFi falls short of fulfilling the vision of its inventors. For a start, the most successful cryptocurrency platforms are far from decentralised. Coinbase, for example, is as centralised as the New York Stock Exchange. Even where a blockchain network is based on a decentralised design, the nodes are almost always operated by the provider on behalf of the users.

Programmable money remains no more than a good idea. Digital identities are not just a good idea but an excellent one (“crucial for financial services’ adoption of Web 3,” says Martins). They do exist in various bastardised forms, but the end-state of consumer-owned self-sovereign identities that incorporate enough of the personal data of their owners to make Zero Knowledge Proofs (ZKPs) a viable alternative to painful, paper-based and repetitive on-boarding processes, remain a pipedream.

As for DAOs, these also exist, but not in ways that align the incentives of owners, investors, employees, customers and suppliers described by DeFi evangelists. Most DAOs are controlled by small groups of large holders, often venture capitalists, which run the business in much the same fashion as managers of a limited liability company. There is, as Martins notes, “a gap between the ideal of universal participation and the realities of community engagement and efficiency.”

There is a gap also in the way that dApps work in theory and in practice. Though Martins is right that “liquidity pools are an innovation of the DeFi industry with no equivalent in traditional finance” their operators have discovered that even a technology as innovative as smart contracts running on blockchains cannot erase the eternal truth that financial services transfer value through time, and that this creates risk.

All the problems of conventional lending – bank runs, fire sales, leveraged speculation, rehypothecation – have occurred in DeFi lending. Martins shows how automated lending and borrowing protocols have sought to overcome the necessarily hefty haircuts on collateralised lending and borrowing of such a volatile asset class as cryptocurrencies by broadening the range of eligible collateral and even (shock, horror) running credit checks (known here as the “white-listing” of borrowers).

“Web 3 is not as fully decentralised as originally envisaged,” writes Martins. Indeed, it is not, which ought to be troubling when decentralisation is as fundamental to Web 3.0 as centralisation is to Web 2.0. But Martins is not a fundamentalist. For her, centralised versus decentralised is not a binary choice. “CeFi” is not synonymous with “TradFi” but a “hybrid between the traditional model and new Web3 concepts and technologies.” A centralised platform can evolve into decentralised one (and vice versa).

This is a sensible and pragmatic way of looking at what is bound to be a long transition that ends in some form of convergence between institutions and markets. Richard Crook, in describing the eventual merging of the traditional markets with blockchain networks, is apt to quote a passage from George Orwell ‘s Animal Farm: “The creatures outside looked from pig to man, and from man to pig, and from pig to man again; but already it was impossible to say which was which.”

As it happens, progress in that convergence is easier to trace in the security and fund token markets than in the cryptocurrency markets to which Web3 in Financial Services devotes most of its pages. Token markets are the places where traditional financial institutions are identifying the elusive blockchain use cases – one of them, the use by J.P. Morgan of blockchain in intra-day repo transactions, is famous as the only instance of a blockchain investment delivering a measurable return – and Martins does allude to these investments, but she finds most of the innovation is occurring in the cryptocurrency arena.

It is true that the cryptocurrency markets are a more fruitful source of innovation than the security and fund token markets, which tend to borrow what they find interesting from the cryptocurrency markets. But if the future of finance truly is being forged mainly in the cryptocurrency markets, that makes it harder to be optimistic. As the text of Web3 in Financial Services demonstrates repeatedly, our species has a peculiar propensity to divert any new technology to rapacious ends, and cryptocurrencies issued on to blockchains have not escaped this curse. 

Since the hack and collapse of the Mt Gox Bitcoin exchange in 2014 – the proceeds of the crime were laundered, predictably, by Russians – the cryptocurrency markets and the associated paraphernalia of digital wallets, electronic bridges and smart contracts have provided a constant stream of opportunity for morally disreputable activities, including theft, fraud and inside jobs. In the six years between the beginning of 2018 and the end of 2023, Chainalysis has recorded the loss of US$113.5 billion to illicit cryptocurrency addresses. 

In November 2022, FTX, the third largest cryptocurrency exchange in the world, turned out to be a fraud. Its founder, Sam Bankman-Fried, was convicted on seven counts of fraud, conspiracy and money laundering and sentenced to 25 years in prison. In April 2024 Changpeng Zhao (“CZ”), the founder of Binance, the rival and at one stage potential rescuer of FTX, pleaded guilty to a money laundering charge in the United States and was sentenced to four months in prison. 

In 2021 hearts warmed at the news that an unemployed or impoverished Filipino could earn US$300-400, more than the average monthly wage, in just a week by playing Axie Infinity. But many of the Filipinos that took part in the Axie Infinity boom borrowed money to play, and when the price of Smooth Love Potions collapsed, they lost everything. To make matters worse, some of the money they invested was stolen by North Korea in a successful hack of a cryptocurrency exchange. 

The economics of Axie Infinity are the same as the economics of cryptocurrencies in general. There is no source of value in a play-to-earn game, just as there is no source of value in a cryptocurrency. There is only the continuous flow of new money from gullible, greedy or desperate investors to drive up the price of Bitcoin, just as new money drove up the price of Smooth Love Potions. In this context, the launch of Bitcoin spot exchange traded funds (ETFs) is not necessarily a cause for celebration, or an encouraging sign of convergence between the established and the novel.  

However ingenious the innovations, cryptocurrencies often feel less like the future of money than the past of money, with echoes of Ponzi schemes and chain letters. So it is not surprising that regulators are getting tougher. The attempt to create a global Stablecoin was defeated by regulators. Customer due diligence requirements are being applied. Restrictions on the marketing of cryptocurrencies are being tightened. Banks that want to service the cryptocurrency and Stablecoin industries are being denied full banking licences. 

In the end, the passage to a Web 3.0 future for finance does not lie through the cryptocurrency markets. It lies through building infrastructure, as Rita Martins points out. DeFi, she says, is at the equivalent of the dial-up Internet stage, pre-broadband, with terrible user experience, coloured by unreliable connections, incomprehensible jargon, high and volatile transaction fees, uncertain settlement timetables, the difficulty of remembering seed phrases, lack of standards, minimal interoperability with TradFi and technical obstructions to integrating wallets with dApps.

This reflects a search for instant profit in a poorly prepared marketplace with low barriers to entry. Martins quotes Graham Cooke, author of Web3: The end of business-as-usual, to good effect on this issue.  He has pointed out that Web 3.0 inverts the logic of Web 1.0, which was 80 per cent protocols and 20 per cent apps, by being 20 per cent protocols and 80 per cent apps. The key to the success of Web 1.0 was the open protocols that support the Internet, the World Wide Web and Email to this day, but their equivalents are not being built for Web 3.0. 

So Martins is rightly dismissive of those who think that all Web 3.0 needs to take off is a “ChatGPT moment” – the fast-growing app all those DeFi entrepreneurs are desperately searching for already. What DeFi needs is an open public blockchain infrastructure on which fast-growing apps can be built. 

“With tokenisation, all types of products can be created using one platform,” writes Martins. “Rates, coupons, rules and all token components are added to the smart contract and can be changed individually, when needed, without having to change the platform’s rules. Since there is only one stack, processes can be streamlined with lower costs and fewer resources.” It sounds boring, but it will be more effective in creating Web 3.0 in financial services than anything else.

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