Cryptographic verifiability, transparency & composability
In essence, cryptographic verifiability underpins the trust and security of public blockchains. It enables participants to prove ownership, validate transactions, and maintain the integrity of the blockchain without relying on central authorities. On blockchains with smart contract functionalities such as Ethereum, transactions can involve complex chains of operations. Assets can be pooled and structured while always maintaining the possibility of verifying the exact chain of commands cryptographically, which means that there is full transparency over the state and distribution of assets (note: there are privacy enhancing technologies [PETs] that aim to maintain the beneficial qualities of verifiability while keeping important aspects about transactions and asset ownership private). Complex structured products such as collateralized debt obligations can be built and distributed on-chain, while it is at any point possible to verify the exact composition of base assets and thus their underlying and aggregate risks (given sufficiently advanced analytics tools). Programmatic enforcement of smart contracts limits counterparty risks, which become ever more powerful as all kinds of payment flows, rights, and liabilities are represented in standardized forms on-chain.
We anticipate that increasing proportions of cash flows and instruments such as invoices will be represented on-chain. This will open up the huge opportunity of automatically enforcing claims on on-chain free cash flows for equities and bonds that are natively issued on-chain. This level of integration will arguably happen much further in the future, though. As a result of these high levels of automation and transparency, idiosyncratic and systemic risks can be significantly reduced compared to the financial legacy system.
What is more, composability allows financial innovators to build novel products on top of existing primitives and assets – many of which we probably cannot imagine yet. Automated market makers, for example, have already enabled the creation of markets for various long-tail assets in a non-custodial and thus socially scalable fashion. Even though this does not automatically imply that those markets are liquid, the universal accessibility and verifiability have allowed access to a global audience, which can lead to increased liquidity of niche or previously illiquid assets.
In addition, the open-source nature of most software components involved enables significantly accelerated innovation cycles, as developers can build on the shoulders of giants while thousands of eyes can inspect the underlying code, which should lead to a more reliable system (note: some projects use commercial software licenses, while still opening up code for inspection).