Payments in Web 3 – redefining the role of traditional banks and intermediaries

In this article, we look to unpick the impact that Web 3 will have on the payments industry. Web 3 represents an evolution of how technology and data are used. It is underpinned by principles of decentralisation and open access. Web 3 technologies are characterised by their global, permissionless, openly published consensus and validation mechanisms that are delivered through distributed ledger technology (DLT).  

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Within payments, the rise of digital assets, including: cryptocurrencies, stablecoins and central bank digital currencies (CBDCs) often hits the headlines. In addition, Web 3 supports “programmable money” through smart contracts which automates payments based on agreed rules. 

Within this context, Web 3 payments could become yet another competing payment rail, but is still in its infancy. However, with a market cap of $1.2 trillion coupled with high profile failures of crypto exchange FTX and the terra USD stablecoin in 2022, regulators globally have been grappling with how they expand their remit to protect the growing number of consumers adopting Web 3.

The challenge is further compounded by recent banking failures with Signature Bank, SVB, Credit Suisse and now First Republic. Central banks and regulators must influence the flow of capital to Web 3 to avoid further destabilisation of the existing Tradfi ecosystem. 

Influencing flow of capital to Web 3 is not easy. Crypto currencies differ from fiat because they are not held on a bank’s balance sheet as a liability to its customers but in digital wallets that are off limits to banks to facilitate their lending activities. This threatens bank’s available capital to support lending alongside risk of reduced payment transaction revenues. Banks will need to determine their strategies for dealing with reduced capital and revenues as a result of Web 3 adoption which may include providing access to crypto currencies and digital custody services for a fee. 

This balancing act may be one of the drivers behind the wave of interest from central banks exploring central bank digital currencies (CDBCs) as they have a greater level of control than decentralised crypto whilst still offering benefits of a digital asset.

We believe that the level of trust in CBDCs and conversely the success levels of Open Finance will determine the future adoption rates for digital currencies, and ultimately Web 3’s position in the payments ecosystem. It is clear that Tradfi and Web 3 will co-exist and will be fiercely competitive on both sides. 

Evolution of Web 3 payments and what it will mean for traditional finance (Tradfi) 

Trust through regulation will need to be established before banks can understand and actively participate in Web 3. We anticipate the journey will involve three broad phases: 

1. Regulatory frameworks defined and evolved to establish trust and stability (1-3 years) 
2. Evolution of Web 3 technologies to support greater use cases and adoption (3-5 years) 
3. Ubiquitous token acceptance and Web 3 interoperability maturity (6-8 years)

Web 3 regulatory frameworks established (1-3 years) 

Regulators have started at the on-ramps to cryptocurrencies, enforcing existing anti money laundering know your customer (KYC) checks for crypto exchanges. The challenge, however, lies with the borderless nature of cryptocurrencies, with regulators needing to harmonise across jurisdictions globally to avoid regulatory arbitrage, where crypto users and businesses favour Web 3 regions with more liberal oversight.  

In a world first, the EU has drawn up an extensive set of rules, known as the markets in crypto assets (MiCA) regulation, due to come into force in 2024. MiCA is the start of a blueprint for cross regional alignment but will need to continue to evolve to address known blind spots while maintaining the simplicity and efficiency that Web 3 offers.  

When taking the G20 cross-border payments initiative as a benchmark for global regulatory alignment, this indicates that existing payments rails have some time to evolve into real-time, embedded payments platforms to rival Web 3 offerings. Global real-time payment upgrades (such as FedNow in the US) coupled with open finance innovations will be the catalysts to making existing payments rails smarter, cheaper, and instant. This world, however, will still rely on a complex web of intermediaries with inbuilt limitations whereas in Web 3, the DLT platform would streamline the entire process.  

Evolution of Web3 technologies (3-5 years)  

As the Web 3 regulatory framework matures this will bring trust and stability, the pace of innovation will increase, focusing on digital services to rival the TradFi ecosystem. Acceptance of digital currencies as legitimate as fiat currencies will be the critical enabler for mainstream adoption. This is likely to come in the form of CBDCs or stable coins which will be digital equivalents of fiat currencies. Frictionless interoperability between fiat currency and Web 3 will also be a priority to drive greater adoption.  

However central banks and regulators must be extremely mindful of the web of dependencies within the Tradfi ecosystem and find a way to throttle CBDC adoption to avoid destabilisation and more banking failures. By this stage, banks and intermediaries will need to have determined their place in Web 3 and how they will manage and adapt to the outflow of capital from their balance sheets.  

Ubiquitous token acceptance (6-8 years)  

As TradFi and Web 3 evolve, the market will determine where value is transferred based on stability, ease of use and efficiency. The platform that ticks all boxes will dominate in the longer term but as we have seen from all payment rails that have come before, Tradfi payment channels must continue to be supported irrespective of the outcome. But there is a risk that future transaction volumes may no longer be commercially viable as we have seen with cheques and will become an all too familiar challenge that banks will need to grapple with. 

Web 3 is a new world

Banks will need to grapple with Web 3 for it to evolve into a trusted payment platform driven by regulation and market confidence in digital currencies. Until then, Web 3 engagement will remain speculative and will not solve the payment inefficiencies of today. Existing players, especially banks, will be incentivised, to continue improving existing payment rails to counter the advantages of Web 3. If not, banks risk being the inferior payment provider in the future, reducing their revenues and deposits and undermining current commercial model for banks.  

When digital currency adoption becomes mainstream, banks will need clarity on their role and the Web 3 commercial model for them, but there will be no shortage of fierce competition determined to disintermediate banks completely. One thing is clear, both old and new will exist in parallel and ensuring interoperability between them will be necessary to capitalise on the full payments market irrespective of how markets respond. Planning ahead for Web 3 will be the difference between those who prosper and those who are scrambling to manually patch their systems and operations just to stay in the game but at great cost.  

If you would like to know more about the impact of new innovations in modernising your payment platforms, please contact us.