The Fate of a Transaction: Before (Pre-Blockchain) vs. Today (Blockchain Era)
The traditional financial system has been around for an incredibly long time, with the first rudimentary forms of banking emerging 4,000 years ago among traders in India, Sumeria, and Assyria. Since then, the financial system has evolved and grown significantly, and it is now very much ingrained in people’s lives. However, this complete reliance doesn’t necessarily mean the current financial system is satisfactory to its users.
Borrowing William Shakespeare’s saying: “All that glitters is not gold,” one can infer that the present financial system looks good on the surface, but is inefficient, intransparent, and complex. For instance, traditional finance (TradFi) relies on intermediaries like banks, brokers, and clearinghouses, increasing the cost of transactions. Moreover, TradFi is riddled with central points of failure, long settlement times, lack of transparency, and security risks.
Anyone that comprehends these inefficiencies and complexities can more easily appreciate blockchain’s emergence as a pivotal moment in the evolution of finance.
Blockchain technology functions as a new underpinning for a more robust and gratifying financial system characterized by fewer complexities, more efficiency, decentralization, fewer intermediaries, increased transparency, lower security risks, and faster settlement times.
However, to understand how the blockchain improves the current financial system and how it’s different, one must first grasp how traditional transaction processes work, using a classic stock transaction as an example.
How Transactions Worked Pre-Blockchain
Stock transactions typically take place on trading venues such as exchanges (e.g., SIX) or over-the-counter (OTC) platforms. Banks and brokers then come in as intermediaries or third parties connecting buyers and sellers. It’s a core characteristic of today’s financial system that two parties don’t have direct access to public exchanges, which means they cannot trade financial assets such as stocks and futures contracts without going through a broker or bank. The structure of the current financial system is built in such a way that parties must depend on trusted intermediaries whom they hope will act in their best interest.
After the two trading parties have been matched by the intermediary, they enter the clearing stage. Clearing entails validating and reconciling all the information regarding a trade between two parties. This is where clearinghouses come in as intermediaries. As part of their role, they verify the identities of trading parties, confirm that the trade complies with regulatory and exchange rules, and ensure the parties are able to meet their obligations.
If everything is in order, the clearinghouse releases the trade for settlement. The stock is transferred to the new owner who pays the seller their money. Generally, it still takes two business days to settle most retail stock trades.
Now what’s so bad about this from a user’s perspective, you might wonder?
Intermediary services aren’t free.
This means that the parties involved in a transaction must pay intermediaries a certain amount in fees to process and settle trades. The cost charged will vary depending on the jurisdiction and the type of security being traded. Moreover, traders must observe several security measures to reduce security risks. These mechanisms include identity verification, SSL encryption, and password protection.
What Transactions Look Like in the Blockchain Era
The blockchain is a settlement infrastructure, providing a foundation on which to build a new financial system. It retains some of the transaction processes present in the traditional financial system, but it also eliminates particular processes and unifies others into one.
Starting with trading venues, transactions occur on blockchain-based trading platforms like decentralized exchanges. Here, buyers and sellers trade directly with each other without any intermediary. This is because blockchain technology takes trusted intermediaries out of the picture, replacing them with smart contracts. These types of contracts are essentially pieces of code that execute when the involved parties fulfill predetermined conditions.
Once a transaction is executed, clearing and settlement take place at the same time. The blockchain network verifies and settles the transaction in real-time without a third party, and the settling process takes seconds or up to minutes. The exact setting time will vary from blockchain to blockchain, since blockchains aren’t built the same. To illustrate, the Ethereum blockchain, one of the most popular blockchains in decentralized finance (DeFi), takes up to 12 seconds to confirm transactions. Upon settling the transaction, the crypto asset or tokenized security is immediately transferred to the buyer, while the seller receives the money – all happening on the blockchain simultaneously.
Due to the elimination of intermediaries, blockchain transactions are cheaper and faster than the transactions in the current financial system. They are also more secure due to the fact that public, decentralized blockchains are virtually immutable. This immutability is achieved through a consensus established among the distributed network of nodes (computers participating in a blockchain network). Nodes replace a central party, ensuring that no single authority is in control.
At all times, each and every node is in possession of a constantly updated copy of the ledger, giving them a current overview of all the transactions that have happened in the network. Thanks to game-theoretic incentives, nodes are incentivized to continuously find a consensus and agree on the state of valid transactions instead of re-organizing previous transactions. Because of this game theoretic setup, practically speaking, transactions cannot be altered once they’ve been added to the ledger. As long as a network enjoys robust security, as is the case with Bitcoin or Ethereum, users are guaranteed secure transactions.
Moreover, public blockchains are transparent, meaning anyone can view the complete transaction history. Transparency can also be seen in how decisions are made. For instance, protocol decisions of public blockchains are made at the community level, unlike TradFi where decision-making happens behind closed doors by a few people.
Blockchain’s Unique Features for a new Financial System
Based on the comparison above, it is accurate to conclude that blockchain transactions on a fully decentralized and transparent platform are faster, more efficient, more secure, and more cost-effective than traditional stock transactions.
Blockchain transactions settle on a borderless, distributed, and permissionless ledger which is way more powerful than the opaque and inaccessible siloed database structure of TradFi. Blockchain transactions cannot only be initiated by anyone 24/7/365 days a year without the need of going through an intermediary. They are also transparent, enabling anyone to view the transaction history and verify the validity of transactions, which ultimately leads to a more honest and unambiguous financial system.
Finance of tomorrow will thus be more efficient and more inclusive, giving today’s unbanked population consisting of 1.4 billion people a way to take part in financial applications and services. This will make the world a fairer and better place – thanks to blockchain technology.
You can learn more about opportunities in the blockchain era in our blogpost about new options to raise funds for entrepreneurs.