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Integrating Blockchain Technology into Traditional Financial Systems: Pros and Cons

Integrating Blockchain Technology into Traditional Financial Systems: Pros and Cons

As regulatory clarity emerges, traditional finance (TradFi) is moving to integrate blockchain technology.

In 2008, the collapse of Lehman Brothers triggered a global financial meltdown. The US housing market bubble burst, creating a tidal wave of mortgage defaults, financial panic, and estimated losses of around $15 trillion in global equity value. The ripple effect plunged countries worldwide into a global recession.

Citizens clamored for reform; governments responded. Financial firms and executives avoided fines even as millions of retirement accounts fell apart and the mortgage default rate soared. Young and middle-aged families bore the brunt of the consequences. Over time, the dust settled uneasily, leaving lingering resentment and distrust of traditional financial (TradFi) institutions.

Some groups saw Tradfi as a lost cause. In response to the meltdown, on October 31, 2008, an individual or a group of people calling themselves Satoshi Nakamoto released the Bitcoin Whitepaper to a cryptography mailing list on the Metzdowd platform.

The paper outlined Bitcoin as a digital alternative currency and blockchain as its ledger system to eliminate TradFi intermediaries.

Fast forward 15 years, and we all know Bitcoin and cryptocurrency have been on a volatile and controversial adoption curve. Unsurprisingly, governments and the powerful Tradfi industry have not given cryptocurrency carte blanche to take over and reform the global financial system.

Even so, the public’s growing interest in cryptocurrency proves a persistent demand for better alternatives to TradFi business as usual.

Industry heavyweights are taking note. In August, PayPal launched a stablecoin. In July, the SEC accepted Blackrock’s Bitcoin ETF application, causing a wave of follow-on applications and a lot of speculation from FinTok creators about the beginning of “the greatest transfer of wealth in history.”

Apart from the volatility and shocking losses of the cryptocurrency markets, blockchain technology is the critical innovation that powers the underlying benefits of cryptocurrency.

Let’s look at how integrating blockchain technology might affect traditional finance systems.

Integrating Blockchain in Traditional Finance (TradFi)

In contrast to traditional ledger systems, blockchain is a decentralized ledger. Bitcoin’s founder invented blockchain to address weaknesses inherent in conventional finance’s centralized models. Blockchain introduces more transparency, reduces cost, and improves security.

Enhancing Transparency and Trust

At its core, finance is a series of transactions. Blockchain technology provides an immutable and decentralized ledger that records those transactions. Unlike traditional centralized systems, where a single entity controls data, blockchain operates on a distributed network where all participants can access the same information.

Every transaction is securely recorded in a chronological chain of blocks, preventing alteration or deletion. This transparency builds trust among participants as they can independently verify transactions, reducing the need to rely on intermediaries for validation.

Auditing becomes more efficient as the entire transaction history is easily traceable, fostering accountability and reducing the potential for fraud.

Potential for Reducing Intermediaries and Overhead

By facilitating peer-to-peer transactions and automating contract execution through smart contracts, blockchain streamlines processes that traditionally required intermediaries’ involvement.

Cutting out the middleman like this leads to faster transactions and lower costs. Participants can engage directly with one another, eliminating delays and fees associated with intermediaries.

Additionally, cross-border transactions benefit from blockchain’s ability to operate seamlessly across jurisdictions, reducing the need for currency conversion and intermediary services. However, governments are still concerned that bad actors can (and do) exploit blockchain and crypto for money laundering and other financial crimes.

Blockchain’s Improved Security and Financial Data Integrity

Consensus mechanisms, like proof-of-work or proof-of-stake, validate transactions before they are added to the chain, reducing the risk of fraudulent or unauthorized activities. Blockchain transactions are also cryptographically secured and difficult to tamper with afterward.

Decentralization adds an extra layer of security, as there’s no central point of failure that malicious actors can exploit. Altering a block once it’s added to the chain is difficult, and doing so secretly is almost impossible. This heightened security not only safeguards sensitive data but can also boost user confidence.

Furthermore, data stored on a blockchain is tamper-resistant and time-stamped, making it ideal for applications such as proving and tracking ownership of assets. In general, any situation where authenticity and provenance are crucial is an ideal use case for blockchain.

Increasing Access to Financial Services

Blockchain integration in TradFi can create greater financial inclusion and access to services. In many countries, TradFi does not adequately serve lower-income citizens. Lack of access to TradFi services is one reason we’ve seen high cryptocurrency adoption rates in India and many African countries.

In some countries with a growing middle class, such as Mexico and Brazil, corporate banks issue credit cards and loans with exorbitant interest rates (some well over 100%) and high fees that exploit people with low financial literacy.

Lack of access to fair financial services contributes to global income equality by stunting entrepreneurship, business development, education and skills development, property ownership, and investment activities. Limited access to capital reinforces global income inequality by restricting economic advancement and wealth accumulation opportunities.

Increasing Access to Financial Services
Source: The World Inequality Report, 2022

Individuals without access to traditional banking infrastructure can participate in a financial ecosystem through blockchain and cryptocurrencies. Decentralized finance (DeFi) platforms built on blockchain enable users to access financial services like lending, borrowing, and trading without intermediaries.

TradFi systems are infamous for being overly bureaucratic. Smart contracts automate processes and reduce the need for traditional paperwork and manual verification.
Overall, blockchain’s borderless nature, automation, and transparency support currencies that open up opportunities for those previously underserved by traditional financial systems.

Use Cases of Blockchain in Traditional Finance

Finance is a vast sector, and it’s impossible to sum up blockchain’s impact on the entire industry in one blog post. For a deep dive into blockchain finance use cases, check out this post from Consensys. Below are some areas of finance and a brief sample of how blockchain might affect them.

Global Funds Settlement

Global fund transfers currently require multiple intermediaries, resulting in delays, costs, and security concerns. Blockchain technology offers a solution as a secure decentralized ledger for direct transaction settlement, eliminating the need for intermediaries like correspondent banks.

Blockchain-based transfers could replace traditional methods like SWIFT’s complex, multi-step process, reducing transfer times for international and domestic transactions and improving overall efficiency in the funds transfer system.

Trade Finance

Trade finance is a pivotal aspect of the global financial system, aiming to minimize risks and enhance credit accessibility for international trade. However, the industry is hindered by outdated manual documentation systems, leading to inefficiencies and bottlenecks.

Blockchain’s adaptability offers a solution by securely storing trade processes, such as letters of credit, on-chain. Digitization enables cost-effective verification of transaction details like origin and product information. Trading partners gain and build trust through heightened transparency and data security.

Ultimately, blockchain has the potential to mitigate prevalent trade risks, including documentation discrepancies and uncertainties related to goods’ movement.

Modernize Transaction Flow

Leading financial institutions like Visa, PayPal, and Blackrock handle vast volumes of sensitive financial data, requiring secure and accurate transfers, reviews, and audits. By leveraging private blockchains, these institutions can enhance internal operations through transparent, immutable, and chronological data flow.

This approach offers heightened security, utilizing blockchain’s traceability to detect fraud and establish trustworthy audit trails, thereby addressing the challenges of maintaining and reconciling ledgers while improving overall efficiency.

Decentralized Identity

TradFi companies must engage in a cumbersome “Know Your Customer” (KYC) process that involves verifying customer identity through document submissions, sometimes taking weeks.
They store the customer data on centralized systems, exposing customers to hacking risk.

To make matters worse, individuals must submit the same sensitive information to every institution, further spreading their risk of identity theft and fraud.

Blockchain offers a streamlined solution where customers upload KYC information once, enabling quick and secure verification through a “Decentralized Identity” (DID) on-chain. This approach enhances efficiency, reduces costs, and increases security.

Blockchain and Tradfi: The Downside

While integrating blockchain into TradFi offers numerous benefits, it does have some downsides. One challenge is the scalability issue for some blockchain networks. On-chain growing pains can lead to bottlenecks and slower transaction processing times.

Another challenge is balancing decentralization. While decentralization is a core feature of blockchain that offers transparency and potential cost savings, it also introduces security concerns. Traditional financial systems prioritize centralized control, simplifying robust security measures, regulatory compliance, and accountability.

Striking the right balance between decentralization and security is crucial as the financial sector embraces blockchain technology. Blockchains with fewer nodes (less decentralized) may be able to shut down fraud more quickly, for example.

On the legal side, the regulatory landscape for blockchain and crypto in finance is still uncertain, creating a need for clear guidelines to ensure compliance and mitigate risks associated with money laundering, fraud, and consumer protection.

These factors underscore the need for detailed scenario planning, legal advice, and phased integration when incorporating blockchain technology into an established financial infrastructure.

Moving Ahead

TradFi is one of the most highly regulated industries, and the lack of clarity around cryptocurrency regulation has slowed TradFi’s movement into the crypto space. But 2023 has seen more progress on crypto regulation than in any year previously.

As we see more cryptocurrency regulatory clarity from governments, it’s reasonable to assume that we’ll see an uptick in TradFi adopting blockchain and crypto products.

Do you invest in both TradFi and crypto? ZenLedger can help you easily calculate your crypto taxes and find opportunities to save money and trade smarter. Get started for free now or learn more about our tax professional-prepared plans!

​​Disclaimer: This material has been prepared for informational purposes only and is not intended to provide tax, legal, or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.

Kala Philo