The ghosts of fintech past

Not a day goes by without a “blockchain is going to revolutionise finance” story in the press, despite no working proof of concept being available to anyone, growing volumes of vapourware doing the financing rounds and the most promising endeavours being mostly linked to nothing more spectacular than the formation of ever stronger bank cartels complying with increasingly strict origination rules.

But before we go on, a call for blockchain-related captions to this — readers, apply your wit accordingly:

The issue we really want to discuss, however, is financial innovation, scale and the blockchain.

As this piece from FT Alphaville’s Kadhim Shubber on Tuesday highlights, the real reason bankers are interested in fintech or blockchain solutions is because the cost of doing business in the post-crisis regulatory environment is so high, it makes banking a pretty undesirable trade (emphasis ours):

Hans Morris, the former president of Visa, who launched Nyca Partners last year to finance and advise fintech start-ups, said Wall Street’s top bankers have been attracted by the scope to develop new, nimble products without being held back by intense new regulation required at the traditional banks. “The cliché would be ‘regulation is driving me crazy’. It’s not like that,” said Mr Morris. “It is the scale of what has been asked and the constant wave of new regulatory initiatives. That’s what gets you down.”

Bluntly put, regulations have forced banks to descale their businesses, compromising their profits accordingly. But blockchain — by promising to cut down on both risk and cost — stands to rescale not just their businesses (and thus protect their profits) but also the businesses of competitors hoping to move in on their turf.

Blockchain is exciting for banks, in other words, precisely because it promises to protect their scale in a de-risked system and it’s exciting for non-banks because it allows them to challenge incumbent banks without being exposed to the rookie risk mistakes of non-bank challengers in the past.

Indeed, go to enough fintech conferences and you soon appreciate that the number one concern of bankers is how today’s regulation might unwind the very economies of scale which brought us everything from globalisation and internet banking to international trade and Amazon deliveries.

It’s not an insane rationalisation either.

We have, for example, already seen what a hyper-scaled up and sped-up financial system can achieve in terms of global development, trade and commerce.

Sadly, we’ve also seen the costs which come with it: wealth transfers of the unexpectedly permanent variety for people who didn’t realise they would be forced to make them for the greater good.

Indeed, the more the financial system expands and speeds up, it seems the less it can be trusted to protect value along the transfer chain. To the contrary, everything from expanded intermediary and staff network costs to theft and extortion exposures, poor due diligence practices, badly priced risk and growing incentives to legitimise ill-gotten gains expose the financial system to value leakage the bigger it gets.

To wit, the blockchain.

The holy grail of banking is and always has been the ability to clear and settle global value transactions instantly and without cost.

But, as we’ve already discussed, the bigger and more distributed banking gets, the harder it is for banks to guarantee value can really be created in accordance with the standards of investors. Guarantees of that sort require accountability, supervision, personnel and significant supervisory efforts policing the administrators themselves — all of which are costly and rumble the scaled up banking returns.

Unsurprisingly, banks have tended to depend on correspondent networks or third party agencies with pre-existing local knowledge to gain market share growth without accompanying costs. They’ve also depended on technological tools to speed up screening, clearing and verification through improved information sharing. Which would be fine, if only everyone’s standards really were the same (enter cross-border risks), if third parties were vetted to the same degree, if information availability was the same thing as trust and if sped-up digital communications didn’t make it more rather than less difficult to humanely process information.

Hence the appeal of the blockchain.

In theory, the blockchain stands to strengthen the banking union/cartel mechanism in such a way that the economic system can continue to benefit from hyper-scaled-up banking network without exposure to any additional risks.

But what does that really say about the digital processes banks introduced in the name of cost reduction and economic prosperity decades ago?

As this paper from the BIS in 1998 noted, when banks first decided to use digital tools to scale up their businesses — mostly via the creation of electronic rather than paper liabilities — the authorities and supervisors believed great things could be accomplished.

From the paper (with our emphasis):

Electronic payment media are likely to figure importantly in the development of electronic commerce, and retail electronic banking services and products, including electronic money, could provide significant new opportunities for banks. Electronic banking may allow banks to expand their markets for traditional deposit-taking and credit extension activities, and to offer new products and services or strengthen their competitive position in offering existing payment services. In addition, electronic banking could reduce operating costs for banks.

Yet even then the BIS was cognisant of the associated risks (again our emphasis):

The development and use of electronic money and some forms of electronic banking are still in their early stages. Given the degree of uncertainty about future technological and market developments in electronic banking and electronic money, it is important that supervisory authorities avoid policies that hamper useful innovation and experimentation. At the same time, the Basle Committee recognises that along with the benefits, electronic banking and electronic money activities carry risks for banking organisations, and these risks must be balanced against the benefits.

In particular, the BIS identified operational risks (loss due to significant deficiencies in system reliability or integrity, a.k.a a server goes down), security risks, reputational risks, legal risks, credit risks, liquidity risks, interest-rate risks and market risks as accompanying the introduction of electronic banking..

With respect to security specifically, the BIS said expanded computer capabilities, geographical dispersal of access points, the use of various communications paths — including public networks such as the internet — could all undermine banks’ control of access to their networks and measures to deter and detect counterfeiting. Notably, the BIS also stated, a breach of security could result in “fraudulently created liabilities of the bank” as well as direct losses, added liabilities to customers or other problems.

Finally there were risks we’ve become more than familiar with following the 2008 crisis: credit risk (by extending credit via non-traditional channels and expanding their market beyond traditional geographic boundaries); liquidity risk (because institutions might not be able to provide funds to cover redemption and settlement demands) and interest-rate risk, (because e-money providers might see a mismatch between their liabilities and the assets they use to underpin them).

You get the picture. We got our speedy digital transactions, but we also go an equal and equivalent amount of risk, not least because the easier it became for honest economic actors to use financial networks, the easier it also became for dishonest ones to use them too.

So can blockchain or “distributed e-money” really make a difference this time round? Or might it introduce an altogether new type of risk?

We’d argue the latter.

In keeping with the tradition of ignoring the risks set out by the BIS in its evaluation of new financial technologies, behold some snippets from the latest paper by the BIS on digital currencies (from November) — with regards to cryptocurrency blockchains as well as so-called permissioned private blockchains:

1) On supposed cost reduction:

…the transaction costs in these schemes are not always transparent, and other costs may exist, such as conversion fees between the digital currency and a sovereign currency if the user does not wish to maintain balances denominated in digital currency units. [Specifically the BIS refers to the use of unreliable capital gains to offset costs.]

2) On supposed security:

Somewhat analogous to cash, if a user loses specific information that provides him/her with “ownership” of digital currency units stored in a distributed ledger, then those units are likely to be unrecoverable.

3) On value protection:

The extent to which price volatility would diminish if digital currency schemes were widely used is an open question, as is the long-run risk of loss from holding digital currencies with zero intrinsic value.

4) On the mitigation of banking panics:

…unlike traditional e-money, digital currencies are not a liability of an individual or institution, nor are they backed by an authority. Furthermore, they have zero intrinsic value and, as a result, they derive value only from the belief that they might be exchanged for other goods or services, or a certain amount of sovereign currency, at a later point in time. Accordingly, holders of digital currency may face substantially greater costs and losses associated with price and liquidity risk than holders of sovereign currency.

5) on using inflexible assets rather than liabilities as money (our emphasis):

..these digital currencies are assets with their value determined by supply and demand, similar in concept to commodities such as gold. However, in contrast to commodities, they have zero intrinsic value. Unlike traditional e-money, they are not a liability of any individual or institution, nor are they backed by any authority. As a result, their value relies only on the belief that they might be exchanged for other goods or services, or a certain amount of sovereign currency, at a later point in time. The establishment or creation of new units (ie the management of the total supply), is typically determined by a computer protocol. In those cases, no single entity has the discretion to manage the supply of units over time – instead, this is often determined by an algorithm.

To the extent we created central banks to protect the economy from banking crises which threatened to collapse our scaled up way of life, it seems somewhat implausible that a blockchain can both eliminate the risk in the system and simultaneously protect scale. Somewhere, we’d argue, something will have to give.