Many financial services (FS) organizations begin their blockchain journey with the best intentions, but too often the solutions that emerge are counterproductively inefficient and can’t quite maximize the technology’s full potential. This can be attributed at least in part to the complex array of issues and interdependencies at play in this highly regulated industry. Also to blame is the use of general-purpose blockchains – which are fundamentally incompatible with the needs of the sector – to develop solutions for capital markets surrounding asset management, payments, and more.
Let’s take a look at the three most common mistakes FS organizations are making when it comes to implementing blockchain, and how they can be avoided by switching to a blockchain purpose-built for use in the sector.
1. Implementing an unsuitable KYC/AML solution
Most blockchains were built for pseudo-anonymity and allow anyone to transact, Ethereum included. The only identifier is a string of letters and numbers known as an address.
This is in stark contrast to the world of traditional finance, where market participants across jurisdictions must at minimum verify all parties in a transaction to comply with Know-Your-Customer (KYC) and anti-money laundering (AML) regulation. This identity verification is typically done using a government-issued ID and other supporting documents.
Permissioned, purpose-built blockchains can provide a way to close this gap by ensuring each participant is verified before interacting with the chain. For example, with Polymesh, users verify their basic identity (name, DOB, and address) during the onboarding process, with further attestations (residency, accreditation, KYC status, etc.) added as needed.
2. Underestimating compliance
The world of traditional finance is characterized by stringent regulation and reporting requirements. These can vary by geography, asset, and more, and are constantly evolving. Blockchain, on the other hand, is well-known for its resistance to governance and censorship; network rules can’t be retroactively fitted to suit a specific agenda.
To ensure regulatory compliance, some FS organizations build layer-2 applications on top of general-purpose blockchains that automate part of the compliance process, but these chains struggle with processing the complicated logic needed. As regulation increases in complexity and users layer on successive rules, the number and complexity of these applications also grows, ultimately driving the chain to its computational limits. This in turn leads to increased operating costs and significantly slower processing times.
It’s extremely difficult to deliver automated end-to-end compliance using general-purpose blockchains. With a purpose-built blockchain like Polymesh, though, compliance functionality is built into the chain’s core as opposed to existing as an external add-on. The result is that issuers have the flexibility to set rules around ownership and transfer requirements, the enforcement of which can then be automated efficiently and cost-effectively at scale.
3. The privacy conundrum
FS organizations have a duty to protect sensitive information like trades and positions, both for compliance reasons and to safeguard their financial interests. This is especially true for non-reporting entities like pension funds, central banks, state entities, and, depending on their location, organizations with a small pool of shareholders. Here we have another interesting tension between the traditional financial world and a foundational principle of blockchain: transparency. Due to its decentralized nature, transactions on general-purpose blockchains can typically be viewed by the public using blockchain explorers.
Financial institutions can in-theory implement layer-2 applications to protect sensitive information on general-purpose blockchains. However, while layer-2 applications can be used to make transactions and balances confidential, they require firms to make a significant operational trade-off. To add transaction privacy, it’s necessary to sacrifice the ability to automate compliance checks or ownership reporting– rendering this solution virtually unworkable at scale.
An emerging solution to this problem is the new MERCAT (Mediated, Encrypted, Reversible, seCure Asset Transfers) protocol developed for Polymesh, which enables FS organizations to securely manage assets on public blockchains in a confidential and auditable way. MERCAT works by combining zero-knowledge proofs (a method by which a user can prove they possess information without revealing the information itself) with restrictions enforced by so-called mediators (trusted intermediaries with some control over writing and validating transactions). Unlike existing layer-2 solutions, MERCAT gives issuers the option to make confidential transactions while still automating compliance checks and cap table updates.
The truth is that general-purpose blockchains like Ethereum, though pervasive, ultimately aren’t fit-for-purpose for the FS sector. By tying themselves to general-purpose infrastructure, FS organizations ignore the truly transformative potential of blockchain technology. While they can create solutions by using a complex array of layer-2 applications, the benefits will only be slow and incremental. To capture the true benefits of the technology, they need to use a blockchain purpose-built with market needs in mind– such as Polymesh, which was built specifically for governance, identity, compliance, confidentiality, and settlement.
To learn more about Polymesh, visit polymesh.network