10 July 2023

Blockchain Technology Poised to Transform Global Transactions, Unleashing Faster and Cheaper Cross-Border Payments - Uniswap Study

Uniswap Labs' research report examines the benefits of blockchain technology, liquidity improvements, cost reductions, and financial inclusion opportunities. The following is a summary of their report.

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Blockchain Technology Poised to Transform Global Transactions, Unleashing Faster and Cheaper Cross-Border Payments - Uniswap Study

    Index

    Addressing the Inherent Hurdles...
    Blockchain and DeFi: A...
    Catalyzing Financial Inclusion and...
    Global Regulatory Endorsement and...
    Mitigating Settlement Risk with...
    Enhancing Liquidity with DeFi:...
    Pricing Transparency and Fairness:...
    Harnessing On-Chain FX for...
    Boosting Efficiency and Curbing...
    Key Takeaways:

The following blog post summarizes the research report titled "Groundbreaking Research on Blockchain's Potential in FX and Cross-Border Payments" by Uniswap Labs. This summary is for informational purposes only and does not constitute an endorsement or promotion of Uniswap or its products and services. The information provided should not be considered as financial or investment advice. Readers are encouraged to conduct research and consult with professionals before making investment decisions or engaging in financial transactions.

Uniswap Labs' January 2023 paper, "Groundbreaking Research on Blockchain's Potential in FX and Cross-Border Payments," examines the transformative potential of blockchain and decentralized finance (DeFi) in the global foreign exchange (FX) market and cross-border payments.

The following blog post summarizes their research report findings and insights presented in the paper.

Addressing the Inherent Hurdles in Today's FX Market

The global FX market is a cornerstone of international trade and finance, with a daily currency exchange volume that eclipses trillions of dollars. However, its operations are steeped in a labyrinthine network of intermediaries and reciprocal agreements, often making the process less efficient. Moreover, despite its operational capability, the FX market is resistant to inherent challenges. High transaction costs, settlement risks, and protracted delays are significant pain points for non-financial businesses and individuals involved in global commerce, international payments, and remittances. These limitations underscore the urgent need for an innovative, robust solution.

Blockchain and DeFi: A Transformative Approach to FX Trading and Settlement

Seizing the opportunity presented by decentralized finance (DeFi) principles and the transparent nature of blockchain technology, researchers have tapped into the potential of payment stablecoins and automated market-making protocols. Their efforts aim to pioneer a transformative change in FX trading and settlement.

The report outlined three key findings:

  1. Better Liquidity: Blockchain-empowered foreign exchange transactions boast vibrant trading activity that underpins these platforms, providing a seamless environment for users to trade currencies. Thanks to the decentralized makeup of these platforms, notably those using automated market-making protocols, they promise an ever-present reservoir of liquidity, significantly boosting market efficiency.
  2. More Stability: With blockchain's hallmark transparency and immutable character, the technology ensures a rock-solid record of transactions, practically impervious to tampering (not in all cases, but generally speaking). Fraud, manipulation, or unauthorized tweaks to transaction details are less likely, instilling heightened confidence in the stability and integrity of the foreign exchange market.
  3. Cost Reductions: Transaction costs tied to blockchain-based foreign exchange transactions consistently undercut those of conventional models — their capacity to side-step intermediaries results in trimmed fees and overheads. The cost-cutting potential is especially pronounced in cross-border payments, with forecasts hinting at a staggering 80% plunge in remittance costs when juxtaposed with traditional payment methods.

Catalyzing Financial Inclusion and Empowering Small Businesses

The ripple effects of this technological evolution extend far beyond the confines of major financial institutions. It promises significant advantages for individuals, small enterprises, and economically disadvantaged populations. The paper emphasized that DeFi, by offering improved user interfaces and bolstering the conversion capabilities between fiat currencies and stablecoins, can streamline the transaction process. This results in faster, less expensive transfers. The anticipated cost savings, particularly in remittances, could translate into billions of dollars annually, funneling much-needed funds to households grappling with financial hardships.

Global Regulatory Endorsement and Obstacles to Blockchain Adoption

In recognizing the potential of decentralized finance (DeFi) as a feasible solution for FX settlements, worldwide regulators have supported the movement. This backing is particularly evident in Project Mariana, a joint venture orchestrated by the Bank of International Settlements (BIS) and the central banks of France, Singapore, and Switzerland. This venture investigates the potential of cross-border Central Bank Digital Currency trading and settlements using DeFi protocols. However, the researchers also shed light on hurdles that obstruct wider adoption, such as regulatory factors and the need for more stringent safeguards against illegal financial activity.

Mitigating Settlement Risk with Blockchain

A key factor that might steer widespread adoption towards on-chain trading is blockchain's ability to reduce settlement risks for organizations and the financial ecosystem. Settlement risk, sometimes referred to as "Herstatt risk," relates to the risk of one party transferring a currency without receiving the corresponding currency it purchased. The downfall of Bankhaus Herstatt in 1974 is a grim illustration of the catastrophic impacts such risks can inflict on international payment systems and financial stability.

The Real-Time Gross Settlement System (RTGS) was introduced to counter settlement risks. It embodies the concept of Payment vs. Payment (PvP) protection. This system guarantees that one-half of a transaction can only be executed with the successful completion of the other half, considerably slashing settlement risks. In addition, the Continuous Linked Settlement (CLS) system, established in 2002, has been instrumental in netting cross-border transactions among member banks. However, despite these strides, a substantial segment of FX transactions, approximating $2.2 trillion, continues to bear settlement risk on any given day.

While traditionally, PvP protection has been limited to member banks, the advent of DeFi widens the network membership to end users. This expansion curtails the necessity for protracted intermediation chains and extends PvP protection to a larger user base.

Enhancing Liquidity with DeFi: An Always-On Market

While the foreign exchange market operates round-the-clock, liquidity tends to ebb and flow throughout the day. This variability can lead to flash crashes and liquidity mirages, especially during periods of low liquidity, such as the hours between the New York and Tokyo trading sessions and weekends when traditional markets are closed.

DeFi addresses this liquidity challenge using automated market makers (AMMs) like Uniswap. These AMMs employ smart contracts to automatically set asset prices on decentralized exchanges, facilitating liquidity provision around the clock. This constant liquidity availability enables trading volumes during non-standard hours, mitigating the risk of flash crashes and enabling users to hedge against geopolitical and country-specific risks.

The volume of on-chain foreign exchange trading adheres to predictable patterns, with peaks during major market sessions and minor peaks even on weekends. While weekend trading activities constitute a smaller proportion of weekday trading, they still denote a substantial demand that DeFi can effectively cater to.

Pricing Transparency and Fairness: The On-Chain FX Advantage

Applying blockchain technology in foreign exchange transactions brings unparalleled pricing transparency and fairness. On-chain FX prices closely mirror those offered through traditional FX exchange venues. According to the report, a comparison between the EUR/USD exchange rate and the on-chain EUROC/USDC pair reveals an average pricing discrepancy of around 5 basis points, nearly the same as the breakeven fee for arbitrageurs in the main on-chain liquidity pool.

Harnessing On-Chain FX for Remittances and Financial Inclusion

The deployment of on-chain foreign exchange technology provides benefits not only to institutions but also greatly improves commerce and payments for individuals. The remittances sector is a prime area where on-chain FX technology can drive substantial impacts. Cross-border remittances, a significant income source for many families in developing countries, soared to an astounding $760 billion in 2019, with a considerable chunk directed to low and middle-income countries.

Currently, methods of cross-border remittance often take a hefty slice of these funds, imposing high fees ranging from 5% to 20% or even more. This considerably hampers the capacity of families to sustain themselves and obstructs economic development in recipient countries. However, introducing blockchain technology and DeFi can eliminate numerous intermediation layers, potentially reducing remittance fees by up to 80%.

Boosting Efficiency and Curbing Risks in Remittance Transactions

Migrant workers often face steep costs when remitting money to their home countries, prompting them to accumulate and send larger amounts less frequently. However, this method introduces delays and exposes them to heightened exchange rate risk. Blockchain technology and decentralized finance (DeFi) help solve these challenges.

Scaling solutions like Layer 2 networks diminish transaction costs to a fraction of a dollar, providing affordable and nearly instantaneous settlement while preserving the security of a public blockchain. This allows migrant workers to send remittances more frequently, evading the risks of lumping multiple transactions together. By leveraging blockchain technology, remittance transactions can become more efficient, cost-effective, and secure, ultimately enhancing the financial stability and well-being of individuals who depend on these crucial funds.

Key Takeaways:

  • The FX market is bogged down by inherent hurdles like high transaction costs, settlement risks, and long delays, which can be improved with blockchain technology and decentralized finance (DeFi).
  • The study found blockchain-based FX transactions to be highly liquid, stable, and consistent in transaction costs.
  • The utilization of blockchain in FX can reduce remittance costs by up to 80%, offering major benefits for individuals, small enterprises, and developing countries.
  • Blockchain technology can significantly enhance transparency and boost market integrity within FX transactions, making market manipulation or benchmark rigging extremely difficult.
  • Decentralized finance addresses liquidity challenges in the FX market through automated market makers (AMMs) like Uniswap, enabling round-the-clock trading.
  • Blockchain technology in FX transactions brings unparalleled pricing transparency and fairness.
  • Deploying on-chain foreign exchange technology can significantly improve commerce and payments for individuals, particularly in the remittances sector, potentially reducing remittance fees by up to 80%.
  • Blockchain and DeFi can make remittance transactions more efficient, cost-effective, and secure, enhancing the financial stability and well-being of migrant workers.

To read the full report, click the link here.

Please be aware that: Cryptocurrencies are unregulated in the UK; Cryptocurrencies are not protected under Financial Ombudsman Service or Financial Services Compensation Scheme (FSCS); Profits may be subject to capital gains tax; The value of investments can go down as well as up.

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