BLOCKCHAIN ARCHITECTURE FOR CORPORATE FINANCE

Written in collaboration with J. Pham

Striking the Balance: Blockchains Architecture and Corporate Finance of Decentralized Organizations

A strong classical argument in favour of centralized organizations is certainly the value added driven by size in relation to the ability of a large firm when management of funds is centralized. In particular, according to the traditional view in corporate finance, a larger firm will be able to:

1. Raise cheaper capital from competitive capital markets,
2. Exploit greater economies of scale when investing,
3. Increase firm resilience to adverse shock thanks to higher insurance value of pooled liquidity sources.

There exists a limited literature that analyses the financial trade-offs that may favour decentralized organizations with respect to centralized ones. A notable exception is Renucci (2008) that analyses compares centralized and multidivisional organizations in the presence of moral hazard taking into account the risk of potential pitfalls that may derive from excessive centralization. In his model, divisions receive rents for incentive purposes, but the multidivisional structure is able to invest more. Thus, there is a trade-off between increasing investment and paying rents. He also shows that this trade-off applies to situations where firms consider engaging in acquisitions and joint ventures, or where entrepreneurs consider resorting to venture capitalists.

Blockchain technologies offer new opportunities to decentralize services while preserving accountability and coordination. It may serve as the backbone of organizations, encompassing a wide range of financial activities, from capital raising and investments to financial reporting and risk management.

BLOCKCHAIN ARCHITECTURES

A critical choice in the design of a decentralized organization supported by a DLT infrastructure is the effective architecture of the blockchain adopted. As blockchain technology gains traction across industries, including finance, the integration of public blockchains into corporate finance brings forth a series of challenges that demand careful consideration. In particular, the degree of information sharing and the vertical and horizontal degree of coordination and information sharing are strategic choices that deserve a careful design.

We delve into the issues surrounding the adoption of public blockchains in corporate finance and shed light on the complexities faced by businesses in leveraging these decentralized networks.  There exist four different types of prevailing blockchain architectures:

1. PUBLIC BLOCKCHAINS
2. PRIVATE BLOCKCHAINS
3. HYBRID BLOCKCHAINS
4. CONSORTIUM BLOCKCHAINS

We briefly review the concerns that may arise with the adoption of the widespread models, the public and private blockchains.

PUBLIC BLOCKCHAINS

Concerns regarding the publicity of data pose a significant challenge when considering the adoption of public blockchains in corporate finance. While public blockchains offer transparency and immutability, the inherent nature of these networks makes all data accessible to the public. This raises legitimate concerns regarding the confidentiality of sensitive financial information, trade secrets, and competitive advantage. Organizations must carefully evaluate the implications of publicly exposing financial data on a blockchain, weighing the benefits of transparency against the need for data privacy and protection. Striking the right balance is crucial, as excessive public access to sensitive financial information may lead to unintended consequences, such as the exploitation of market intelligence, compromising competitive positions, or increasing the risk of cyberattacks. Implementing measures such as data encryption, privacy-focused protocols, or employing permissioned blockchains can offer potential solutions to safeguard confidentiality while still leveraging the benefits of blockchain technology in corporate finance.

The issue of anonymity within public blockchains poses a significant challenge when considering their application in corporate finance. While the pseudonymous nature of public blockchains provides privacy for individual users, it becomes a concern in the context of corporate finance where transparency, accountability, and regulatory compliance are paramount. The anonymous nature of entities participating in transactions on public blockchains raises potential risks related to money laundering, fraud, and illicit activities. In corporate finance, it is crucial to have a clear identification and verification of entities involved in financial transactions to meet regulatory requirements and establish trust among stakeholders. Balancing the privacy benefits of blockchain technology with the need for identity verification and compliance is crucial. Integrating Know Your Customer (KYC) protocols and implementing digital identity solutions can help address these concerns by linking real-world identities to blockchain addresses, enabling more transparent and compliant financial transactions.

The limited flexibility in data visibility poses a challenge when applying public blockchains in corporate finance. In certain scenarios, businesses may have the need to selectively disclose certain data publicly while keeping other information discreet. Public blockchains inherently promote transparency by making all data accessible to the public, which may not align with the diverse information requirements of corporate finance. Striking a balance between public transparency and data discretion becomes crucial to address these concerns. Utilizing techniques such as encrypted data storage, selective disclosure mechanisms, or off-chain storage solutions can offer potential solutions to maintain the required level of flexibility in data visibility. Careful consideration of the specific data needs and regulatory requirements is necessary to navigate the challenge of balancing transparency and confidentiality effectively in corporate finance applications of public blockchains.

PRIVATE AND CONSORTIUM BLOCKCHAINS

The adoption of a purely private blockchain may limit the effective degree of decentralization of the financial solutions that may be adopted. In fact, a useful characteristic of a decentralized organization relying on blockchain technology is its ability to share public information on digital assets with third-party entities, not necessarily involved in the organization, with the goal of improving their tradeability and the possibility to implement market-based solutions to foster the exchange of illiquid assets.

HYBRID BLOCKCHAINS

Considering these challenges, one potential solution, granting some degree of decentralization lies in adopting a hybrid blockchain model. A hybrid blockchain combines the features of both public and private blockchains, offering a more flexible and customizable approach. In this model, certain data can be stored on a private or permissioned blockchain, ensuring confidentiality and control, while other data can be selectively shared on a public blockchain for transparency, compliance purposes and integration with public financial markets.

Furthermore, the connection to the public blockchain in a hybrid model opens up avenues for broader integrations and meaningful collaborations. Organizations can leverage the existing tokenomics and interact with decentralized autonomous organizations (DAOs) on the public

blockchain. This expands the range of possibilities for supply chain financing, peer-to-peer lending, or decentralized exchanges, enabling seamless integration with decentralized networks and unlocking new opportunities for innovation and collaboration. In conclusion, the adoption of a hybrid blockchain model in corporate finance offers a multitude of benefits that address the specific challenges faced in the industry. By combining the strengths of both public and private blockchains, organizations can achieve a flexible and customizable framework that caters to their complex requirements. The control over data visibility provided by the private portion of the hybrid blockchain ensures the confidentiality of sensitive financial information while facilitating robust KYC processes within a secure and trusted environment. This enables compliance with regulatory standards and establishes a foundation of trust among participants. Simultaneously, the connection to the public blockchain opens up opportunities for selective transparency, allowing for increased accountability and accessibility of relevant financial information. Moreover, the integration of public blockchain elements enables interactions with decentralized networks and leverages existing tokenomics, fostering a wider range of integrations and meaningful collaborations.

By embracing hybrid blockchains, organizations can effectively navigate the challenges of

corporate finance, unlocking the transformative potential of blockchain technology while ensuring privacy, compliance, and innovation in their financial operations.

One interesting aspect that can be explored, is the connection between the traditional functions in a private business (one should not forget that it can be managed as a private or a public company with shares traded in a public market) and the opportunities offered by the decentralization through a DLT based infrastructure.