Believe it or not, a major issue that has bedeviled the financial sector, especially after the widespread adoption of digital payment methods, is an overreliance on trusted third parties — or simply ‘trust’ — to complete transactions.
It could be argued that trust is now a highly valued commodity and indeed, many players in the financial sector have it as their primary product on the market.
That is not such a good thing, however, for a number of reasons.
How exactly is trust a pain point in the delivery of financial services?
The ‘trust’ pain point can be experienced in four ways:
1. The vulnerability of user data in centralized data centers.
Data is critical in the provision of all kinds of financial services, especially so in the case of centralized payment systems. It is through data that service providers can authenticate customers, measure risk, ascertain credit score or worthiness, predict revenue flows or, to put it simply, make financial transactions possible.
But collecting, storing and manipulating this data is a very complex undertaking. In particular, keeping it safe and secure means locking bad actors out of centralized data centers who happen to be highly skilled and motivated.
Stakeholders and, in particular, consumers have to trust that those entrusted with the data centers will prevail at doing their job correctly at all times.
But most importantly, they have to trust that these data stewards do not themselves turn out to be the bad guys. The motive to misuse the data under one’s care for financial benefit is almost always present.
It must be said that in centralized systems that power many financial services, consumers are completely helpless, not only as to how their data is secured but also how it is used. They only have to trust that someone is competent and of good intentions.
Unfortunately, cases of data breaches are so common and abuse of user data is almost the norm.
2. Difficulty in authenticating an identity of counterparties in transactions.
Establishing, ascertaining and authenticating the identity of counterparties and stakeholders is at the core of transaction execution. That is the case with both centralized and decentralized payment systems.
Obviously, it is never a great idea to take at face value what people present themselves to be. That is because people always have reasons and motives to misrepresent themselves, especially where value is involved.
This is why financial service providers have to rely on robust systems to help identify those they deal with. The need is made necessary even more by the ‘know your customer’ (KYC) regulatory compliance requirements.
But to make the process easier, service providers and customers have to trust third-party validators to provide accurate data. They also have to trust that the data reaches them without being tampered with in one way or another. This is especially critical given that data in digital form, especially in centralized systems, is not immutable.
And the cost that financial institutions have to incur to establish identity is always substantial. According to a report prepared by management consulting firm Accenture on identity and banking, financial institutions spend more than 30% of their security budget on authenticating identity.
3. Difficulty in providing legitimacy to digital signatures.
Even with the substantial digitization of financial services, it is still difficult to approve transactions, especially where substantial amounts are involved, without certain steps for approval being performed manually.
In most systems, it is necessary for a few trusted persons to have the ability to ensure that transactions are legitimate and meet required specifications. While this is a helpful preventative measure, it slows the movement of value and the completion of transactions.
But even more importantly, it makes it almost impossible to sign transactions without sharing personally identifying information to trusted overseers and others. And this increases the risk of privacy infringements.
4. Slow settlement and reconciliation of transactions
Because of the need for trusted centralized facilitators to manually settle cross-border transactions and perform reconciliations, service delivery is slowed even though the internet has made the flow of information fast.
It is common for users to wait through the weekend or public holidays to the next business day to have their transactions confirmed or approved.
And even after the transaction is completed, it might take several weeks before a trusted third party gets the time to conduct reconciliation, which makes it hard to catch errors in real-time when they are fresh and easier to fix.
So what is the meaning of trust in the fintech world?
The cumulative cost that goes into acquiring different forms of the notary, auditing or approval services from trusted third parties makes financial services expensive. According to a World Bank report that was funded by the Bill & Melinda Gates Foundation, over 26% of the 2.5 billion adults who are unbanked around the globe cite the cost of transactions as their reason.
Within the fintech space, is actualized in many ways. But let’s start with what it actually means.
In general, trust means treating the customer fairly and being transparent, including the fees charged for transactions.
More practically though, it means putting data protection and user control in the hands of consumers.
It also means stakeholders having a single source of truth from which they can establish the verifiable identity of those they are doing business with. That translates to having the ability to prove that people are who they say they are without them exposing personal data or having trusted third parties to vouch for them.
It also means consumers being able to carry their proven identity, credit score and profiles across platforms with the ability to prove that the data is credible.
Trust also means having transactions settled and reconciled in real-time so that all stakeholders get to notice at the time when things are not done, executed or recorded appropriately.
In particular, this means having stakeholders have access to an immutable shared ledger where they can see transaction settlement and reconciliation.
How exactly is financial technology achieving this kind of trust?
Financial technology — or fintech — is all about using innovation to fix pain points that consumers face when accessing financial services. This can be achieved through existing institutions or new and fresh startups built as challenger financial institutions.
The ultimate goal of gaining this new form of trust is to improve service delivery, secure transactions, protect user data and cut costs involved.
The technology that is achieving this very efficiently is decentralized ledgers, popularly referred to as blockchains.
Blockchains allow for storage of digital data in an immutable state. The technology also makes it possible for many stakeholders to securely have access to a shared ledger that they maintain through real-time consensus on a peer-to-peer network.
An extremely revolutionary concept about blockchains, though, is that through public-private key cryptography, user data is encrypted on the shared public ledger. With that done, only the owner of data can grant access.
And even then the credibility of the data can be proven without its details being disclosed because not even the owner of the data can change it.
The immutability of digital data on the blockchain makes it possible for users to move across platforms with their already proven identity. Those who transact or come into contact with the identity do not have to trust the owner because they can easily and with no significant cost prove its credibility.
Beyond the blockchain and decentralized ledger
While blockchains are decentralized, the different types of ledgers currently exist as siloed systems. There are over 3,000 independent major public and private blockchains, and the number is growing very fast with new projects launching every year.
Meanwhile, it is unrealistic to think that centralized payment systems will become obsolete anytime soon. That means solutions to nudge the industry into efficiency and also deal with monopolization and make integration less complex are needed.
And that also means that for there to be free flow of value around the world, the different payment and value transfer systems have to interoperate. In other words, they have to be part of a ‘world wide web’ of some sort for value.
The quick fix to create this Internet of Value is to have trusted third parties to interpose between platforms. Unfortunately, that takes us to the initial problem of relying on trusted third parties to complete transactions.
Avoiding this cycle is exactly what open source projects like GEO Protocol and Interledger are working towards fixing.
The general solution they offer is creating trustline-based protocols that act as paths for value across different platforms without the need to trust centralized entities. This is achievable in particular through IOU architectures that rely on state channels and similar technologies to settle cross-chain transactions.
In particular, it involves leveraging trust that exists in peer-to-peer interactions, which is known as ‘transitive trust.’ Simply put, it means that we trust our family, best friends, colleagues and so on. But, we also trust those people who our family, friends, and colleagues trust. If I trust my boss, I also trust those people whom my boss trusts. This creates a chain or path of trust that value can flow through without the need to rely on a third party to determine the credibility of this or that network participant.
These trustline-based protocols that vouch on transitive trust across different blockchains and centralized payment systems can give the movement of value what the internet gave to the movement of information. And the best part? For this to occur, we don’t need to trust huge centralized entities.