The Journey To Blockchain 2.0 and DeFi

Distributed Ledger Technology (DLT) provides a decentralized, peer-to-peer network of database nodes through which to commit, manage and ensure the immutability of transactions across a diverse set of participants. The technology utilizes a consensus mechanism built into the core protocol to ensure the integrity of data across the span of nodes.

Public DLT variants are permissionless, operating within a trustless environment, and typically utilize more computationally robust proof-of-work or proof-of-stake consensus mechanisms to arrive at a single true account of transaction history. Private DLT variants, in contrast, typically utilize the concept of selective endorsement to validate records, given that participation is limited to authorized, trusted counterparties. Whereas public platforms democratize participation and are at the center of a global Decentralized Finance (“DeFi”) movement that promises a range of peer-to-peer financial services, private platforms are closed, but offer superior transaction throughput and consistent transactional cost.

IN THE BEGINNING…

While the DLT concept was first introduced in a 1991 research paper by Stuart Haber and W. Scott Stornetta, “How to Timestamp a Digital Document”, the most significant development occurred in 2009 with the launch of Bitcoin and the blockchain network by the eponymous Satoshi Nakamoto.

Nakamoto launched Bitcoin by mining the genesis block (block 0) of a newly formed blockchain network. In a subsequent blog post in February of that year, Nakamoto highlighted several motivating factors for bitcoin’s creation, including the desire to reduce the participation of third-party intermediaries and their associated fees in a financial transaction. More significantly, Nakamoto envisioned a broader restructuring of the global financial system, at large:

“The root problem with conventional currency”, Nakamoto wrote, “is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”

The backdrop of the financial crisis of 2007-2008, otherwise known as the subprime mortgage crisis, surely influenced Nakamoto’s thinking. Precipitated by government policies and central bank monetary actions that led to an expansion of cheap credit, relaxed capital reserve requirements, predatory lending practices, and an increase in mortgage-backed securitization backed by junk collateral, the financial system was ultimately brought to its knees when the housing bubble popped. COVID, too, has led to unprecedented government action marked by periods of economic adversity, assistance, and restarts.

Nakamoto’s comments do not contemplate that the primary role of government is to consider, enact and enforce policy decisions that affect its constituents. A government’s stewardship of its fiat money supply, its financial system and its financial regulatory framework is, in fact, a byproduct of these policy decisions. This is not to debate the merits, efficacy, or unintended consequences of such policies. Governments can certainly be culpable for poor policy outcomes. If in times of extraordinary systemic financial stress, however, a government introduces accommodative monetary policy on behalf of its constituents, even if at the risk of debasing its currency, that is well within its purview. Desperate times call for desperate measures, after all.

For better or worse, such policy is not inherently built into a decentralized financial currency, like bitcoin (BTC). Policy and regulation must therefore either be layered on top of the underlying cryptocurrency network, or self-governance must be left to a diverse set of network participants with the hope that socially responsible, legally permissible, and beneficial outcomes prevail.

The former approach is clearly favored by governments, which is why work to create Central Bank Digital Currencies (CBDCs) has gained traction. Cryptocurrency regulation, too, is receiving greater attention, albeit in arrears and applied by some regimes with a blunt “all or nothing” approach. To be clear, however, well-conceived and implemented regulation, along with the investor protection it affords, would further enhance the value of crypto as an asset class and/or as a financial platform, and would be beneficial to the overall market.

BLOCKCHAIN 1.0

Twelve years after the launch of Bitcoin, both cryptocurrencies and DLT have witnessed a sizeable uptick in public acceptance and adoption, though the technology is still evolving. As with early relational database technology prior to the release of ANSI SQL-92 and the introduction of common interfaces, like ODBC, few standards exist to promote interoperability across different chains. Further, digital wallets remain clunky and bespoke. The result is a fragmented landscape of digital properties that are often difficult to understand, access and use for all but the most informed technical specialists.

We have witnessed first-hand the complexities and usability challenges attributable to the lack of interoperability standards, functional limitations, and bespoke digital wallets. As no “layer 1” protocol interoperability currently exists across different blockchains, cross-chain integration relies on separate “layer 2” frameworks that introduce interoperability as an overlay.

Here, projects like Polkadot (DOT), Binance Smart Chain (BSC), and Polygon (MATIC) have introduced “layer 2” platforms that create a network of networks. They additionally enhance performance and reduce transactional fees by posting transactions off a main-net blockchain, like Ethereum, and instead only post consolidated entries to the main-net. Think subledger feeding general ledger. Unfortunately, these “layer 2” chains also offer no interoperability amongst each other, and generally lack smart contract compatibility, consistent APIs, or common query languages. Imagine what electronic trading would look like in the absence of protocol and transport standards, like FIX. This is Blockchain 1.0.

In many ways, the current blockchain environment is analogous to the early days of the Internet, when the tools of choice – Archie and Gopher, for example – sat squarely in the province of technologists. It wasn’t until the launch of HTML and the Mosaic web browser in 1993 that the World Wide Web truly became accessible to the layperson. The subsequent ratification of HTTP/1.1 in 1997 also created a baseline standard for website interoperability across browsers. DLT must ultimately embrace a similar journey to fully realize its potential.

DEFI AND BLOCKCHAIN 2.0

Unlike the traditional financial ecosystem which largely depends on intermediaries to facilitate transactions between known counterparties, DeFi allows for the peer-to-peer execution, and ongoing maintenance of financial transactions amongst trustless counterparties with no middleman.

After Bitcoin, Ethereum is the most recognizable public blockchain network, and the one most often associated with DeFi. Initially conceived in 2013 by Vitaly Buterin and first released in July 2015, the Ethereum network is positioned as an extensible distributed computing platform. It is, in effect, an app store for financial applications that leverage its underlying blockchain.

Nodes in the Ethereum network employ a virtual machine that provides a runtime environment and a set of standard interfaces, such as ERC-20, through which to develop, deploy and run distributed applications (“dApps”). This includes so-called, “smart contracts” that can execute verifiable, traceable, and immutable transactions based on codified contractual terms. In the domain of object-oriented programming, a smart contract is basically a class instance. It exposes public methods via APIs and may be stateful or stateless. It can also interact with other smart contracts. Execution may be triggered by internal or external events, including direct API invocation.

Operations on the Ethereum network are paid in its native currency, ether (ETH). Whereas the only supported token on the Bitcoin network, itself, is the bitcoin (BTC) currency, Ethereum allows for the onboarding of a wide range of tokens, beyond just ether, to include other assets and utilities. It additionally allows for the commerce of non-fungible tokens (NFTs), which represent distinct assets with unique value, such as artwork and rare collectibles.

As with other Blockchain 1.0 platforms, Ethereum and similar chains have yet to enhance the full end-to-end developer and user experience. Not to be understated, the introduction of smart contracts really does represent an important foundational piece in the progression towards mass-adoption of blockchain and, by extension, DeFi. Still, access to wallets, smart contract discovery, development, and the network, itself, remains the province of technology specialists, just as was the case in the early days of the Internet. Tools to develop, debug and test smart contracts, typically written in the object-oriented Solidity language, are virtually non-existent. Many of the gory details of cryptocurrency transactions are hidden behind commercial exchanges, like Coinbase, Gemini, and BlockFi, but these focus on crypto as an asset class, rather than on blockchain and DeFi as an extensible platform.

The consumerization of technology made possible by broadband, Web 2.0, mobile, and cloud has democratized access to application services, data, and compute by nearly anyone, from anywhere, at any time. Whereas Web 1.0 offered foundational components, it largely consisted of static web pages, proprietary extensions, and plenty of technology barriers. Building on Web 1.0, the Web 2.0 technology renaissance has dramatically enriched the user experience, transformed business models, liberated access to information, and delivered global economic impact. Blockchain 2.0 must follow a similar path.

DATA UNLOCKS DEFI POTENTIAL

As financial assets are increasingly tokenized on public chains, access to reference, market and alternative data is critical to enable a robust DeFi marketplace, just as is the case for participants in a traditional marketplace. The availability of such data allows prospective investors to perform due diligence; it allows for the analysis, valuation, and risk management of assets; it allows for settlement and ongoing lifecycle events, like cashflows and corporate actions; and it supports necessary regulatory, compliance, and legal functions. In a DeFi environment, smart contracts also depend on this data to help automate many of these processes.

Blockchains are most effective at performing, and storing transactions between counterparties, and maintaining ledger balances. Even the required methods exposed by an Ethereum ERC-20 contract are principally oriented towards these functions. Blockchain payloads are additionally limited in size, and the performance, query capabilities and cost characteristics are not supportive of turning a blockchain into a comprehensive data warehouse. Considerable data to support the underlying assets that are tokenized and the smart contracts that operate on their behalf must therefore exist off-chain.

This necessitates the availability of data oracles: off-chain facilities that provide a bridge, sometimes bilaterally, between the on-chain and off-chain worlds. In some cases, these facilities may be offered by traditional data suppliers and intermediaries. While functionally and architecturally attainable, this does raise a conundrum for DeFi. If the whole point of DeFi is to reduce the risk and reliance on central counterparties, intermediaries, and other oligopolistic participants, isn’t the need for centralized oracles antithetical to this objective?

To a large extent, it depends on the data.

Some data sets may only be available from a single supplier, or from a very small number of suppliers. In those cases, there may simply be no way around the use of a centralized oracle. Where data is somewhat commoditized and readily available from multiple channels, however, decentralized oracles can be built to distribute anonymized queries across a wider range of suppliers based on deterministic results, rather than on contractual relationships. Several blockchain projects, like Chainlink (LINK), are already seeking to develop this capability, though data sets remain rudimentary.

Much as smart contracts accrue operational “gas” fees when executed, commercial suppliers could be compensated for queries in native cryptocurrency, such as ether, on a per-transaction basis, or utilizing some other metric. Such a payment model can be applicable to both centralized, and de-centralized oracles, and incumbent data vendors that wish to participate in the DeFi landscape would be prudent to consider such models.

There is a third scenario, too, which involves data for which no dependable supplier currently exists. Data may be highly specific to a given asset or may be inherently fragmented due to the nature of the marketplace. Often, standards may be absent, or adoption amongst participants may be subpar. Even transactional and reference data for these assets may be maintained in spreadsheets, email, or manually entered into an investor’s proprietary systems and databases. In some cases, there may simply be a physical trail of paper documents that may, or may not have been scanned and stored, electronically. Further, because of the deal-centric nature of these assets, the same bespoke processes may be replicated across multiple participants…even for the same deal. Alternative and private market assets, for example, fall squarely into this category.

For these assets, it is precisely the opacity of such data that makes them difficult to transact, both in the physical and digital worlds, and limits investment to qualified institutional and individual investors. They are further categorized as level 3 assets in financial accounting parlance, considered to be amongst the most illiquid and difficult to value. This mandates banks and insurance companies to set aside considerable regulatory capital reserves for any such assets carried on their balance sheets. Firms, like Inveniam, are seeking to tackle these challenges.

Here, a decentralized oracle may be well-suited, since the sources of data are already federated, even though the data is neither commoditized nor available from multiple suppliers. Such an oracle should remain trustless, allowing for provisioned but anonymized access to support this core DeFi tenet. It must incorporate a pipeline process that allows data to be verified, authenticated, normalized, and transformed into a standardized product taxonomy that can be queried and processed by downstream consumers, including smart contracts.

Unstructured data, like legal documents, will require pre-processing, perhaps utilizing a natural language processing (NLP) engine for scale and associated workflows to extract the structured elements required by the target taxonomy. The oracle must additionally remain agnostic as to the underlying location, repository, or format of sourced data, and must account for timely and verifiable updates. This is conceptually similar to a virtual data mart that spans organizations and repositories, albeit one architected to be highly secure, global, interorganizational, and providing sophisticated and high-performing inline processing that supports both synchronous and asynchronous modalities.

Ultimately, the availability, access to, and usability of such data will enable the broader tokenization of assets, thereby leading to enhanced liquidity, greater participation, and a more robust DeFi marketplace.

ENTERPRISE WALLETS

Early on, the decentralized nature and justification of Bitcoin specifically sought to reduce the impact of governments and corporations on the financial system. As such, participation principally catered to individuals, even though bitcoin miners are themselves often structured as corporations, given the capital investment required to support mining operations. Proof-of-work consensus mechanisms are especially energy-intensive and require special hardware and data centers to solve the complicated mathematical challenges posed by the protocol that are necessary to validate a block. While not as consumptive of energy, proof-of-stake mechanisms still require a sizeable investment in, and staking of the native cryptocurrency to be selected as a validator and earn mining rewards.

Still, the digital wallets that were initially designed to store currency and transact on these networks are not fit for enterprise use. In the case of an enterprise, for example, transactional authority is typically delegated to select staff, often on a functional or product line basis, and may be subject to risk limits, clearance, and other oversight. Further, such delegation may require role-based access, and must support the onboarding and offboarding of staff. Most importantly, the underlying transaction is performed on behalf of the enterprise, a legal entity, or a client; the individual to whom the transactional activity is delegated is often not a principal.

Most wallets, today, are bespoke to a particular chain. As is the case with existing electronic trading venues for many traditional financial instruments, it is likely that different chains, including on both public and private networks, will be preferred by users based on any number of considerations, including functional, economic, performance, participation, risk, compliance, and other factors. As such, and despite Ethereum’s sizable current market share, we believe that best practice is to remain chain-agnostic.

The creation of an enterprise wallet that does not lose transactional fidelity and maintains an audit trail of all known signatories to a given transaction, while interfacing with an enterprise omnibus wallet is a prerequisite. Similar to the distinction between off-chain and on-chain activities, the concept of master and subordinated wallets is one in which transactional activity is initiated, and audited on sub-wallets that do not, themselves, directly interface to the blockchain network. Only the master wallet, as the omnibus gateway, directly interfaces with the blockchain network and is responsible for the rollup and submission of transactions that occur in its sub-wallets.

This not only preserves the nature of the transaction’s true principal, even if anonymized, but also allows for off-chain processing, like netting, smart order routing, and batching, some of which may be deployed to private sub-chains. User-defined, or organizational rules can also seek to maximize flow and/or minimize transaction costs. Such capabilities are critical for wide-scale enterprise adoption and are currently missing from all known digital wallet, “layer 2”, and custodian implementations that we’ve thus far encountered.

Also, inasmuch as DeFi seeks to promote the role of the individual and reduce the role of the intermediary, there is still a need for cryptocurrency exchanges and other value-add participants, like the aforementioned data oracles. And while individuals may not themselves choose to engage third parties to help manage and secure single-user MetaMaskwallets, for example, organizations utilizing an enterprise wallet will most certainly require and demand such support.

Given the highly confidential financial data, and personally identifiable information (PII) housed in any digital wallet, enterprise wallets will clearly represent an even more rewarding attack surface for bad actors. While such a wallet may enable enhanced key management features, like Bring-Your-Own-Key (BYOK) or Customer Master Keys (CMK), the safe-keeping of these platforms, along with associated operational, custodial, and fiduciary responsibilities are likely best entrusted to an appropriately regulated financial institution.

CONCLUSION

As an asset class, cryptocurrency remains highly volatile and will certainly be subject to evolving regulatory constructs, as has already begun. While such regulations may impinge on the autonomy of crypto, they will also benefit the overall market by introducing greater legitimacy, stability, guidance, controls, products, and enhanced investor protection. Current market conditions aside, the uptake of cryptocurrency as an asset class is likely to continue to grow, though not all projects will be successful.

It’s important to note that the concept and potential applications of DeFi are far reaching and quite distinct from the notion of cryptocurrency as an investible asset, however. The impact of asset tokenization and DeFi is ultimately expected to be far more significant than cryptocurrencies, themselves.

The ability to realize the full potential of DeFi is not limited to the efficacy of the underlying blockchain technology, though enhanced transactional throughput and reduced costs will most certainly be important, particularly on public chains. Standards, cross-chain interoperability, enterprise wallets, and off-chain data architectures and utilities are all critical enablers to support growth, as well as bridges to the existing financial world. Support for multi-jurisdictional regulatory and legal requirements, which remain fluid, must also be incorporated. There will be other requirements, too, including improved coding and debugging tools for the development, testing, and user acceptance of smart contracts.

As with Web 2.0 and other innovations, the eventual trajectory of Blockchain 2.0 and growth of DeFi as they mature will most certainly exhibit a hockey-stick profile in terms of rich capabilities, user experience, commerce, and steep adoption that transforms business, including within financial services, real estate, manufacturing, supply chain management, healthcare, and other sectors. If this is not already on your radar and being discussed as part of your overall business strategy and data architecture, perhaps it should be.