(Part IV of a series on the future of banking and finance)
I began this series of articles on 21st Century Finance by comparing and contrasting the legacy finance industry put in place in the 19th and 20th centuries with the one that is emerging now. Hint: new technology and new ways of using these technologies has an outsized chance of usurping the legacy-version of finance. My next article talked about the specifics of Providers of Capital. You can think of these folks as savers and investors, both individual and institutional. Here, capital is provided to Users of Capital, who you can think of as entrepreneurs or institutions who have an idea about how to earn a return in excess of required returns with these monies. But what about those that bridge the divide between these two groups, Providers of, and Users of, Capital? These Intermediaries are the subject of this article.
Before proceeding, I am obliged to re-mention that all of finance rests on a Fundamental Transaction:
Those with a surplus of capital, but a deficit of good ideas about what to do with it whom I call providers of capital exchange their monies with those with a surplus of good ideas, but a deficit of capital, whom I call users of capital.
An entire ecosystem has developed to facilitate this Fundamental Transaction. If you are familiar with finance you know that standing between these two parties, Providers and Users of Capital are most of the institutions of finance and their staffs of financiers. These include old lions: investment banks, commercial banks, investment companies (the formal name of mutual funds), exchange traded funds (ETFs), pension funds, insurance companies, private equity funds, hedge funds, special investment vehicles, venture capitalists, money funds, securities exchanges, board of directors, and on and on.
Legacy Services Provided by Intermediaries
The above Intermediaries historically attempted to provide value add services to facilitate the Fundamental Transaction. Investment banks, for example, gathered together large pools of capital that allowed Users of Capital to execute their business plans. They also advised both Providers and Users of capital about mutually beneficial transactions meant to increase the wealth and income of both parties. Investment banks also provided legal advice to both parties, creation of investment securities (e.g. common stocks, preferred stocks, bonds, options, et. al.), and access to their extensive securities distribution networks that allowed Users of Capital in particular to sell their ideas and securities to Providers of Capital. In return for this advise and distribution investment banks charged investment banking fees.
Commercial banks, including your local savings and checking institution, also linked up Providers and Users of Capital by collecting deposits, either checking or savings, from Providers of Capital/Savers, pooling these monies together and issuing loans and other services to Users of Capital. Users of Capital ranging from single proprietorships all the way up to the largest business agglomerations imaginable made use of commercial banks to manage their businesses. From providing checking accounts that allow payroll checks to be issued, to the funding of daily cash shortfalls, to providing loans for longer-term, larger, and more strategic projects, commercial banks have greased the wheels of finance for multiple centuries now. Commercial banks earned money by the spread between what they paid on deposits and what they earned on loans, as well as fees, now too numerous to mention.
Another example of services provided by Intermediaries are those provided by investment companies was creating a vehicle (e.g. a mutual fund) that allowed investors to pool their resources together to purchase a more diversified portfolio of assets than most individuals could afford to create on their own, and (supposed) value add professional management of these monies. A secondary benefit provided by investment companies is rudimentary accounting (Question: Do you like your quarterly statements and do you understand them? I thought not.) and tax reporting. One additional service provided is liquidity, especially provided by publicly available investment companies. If you call to redeem shares in your mutual fund, even if a portion of these monies are invested in illiquid securities, you can count on receiving your funds quickly.
Though their investment universe is very different, exchange traded funds, pension funds, private equity funds, hedge funds, special investment vehicles, venture capitalists, and money funds are all very similar to investment companies. What is slightly different for each of these entities is what investment universe they “play” in. Money funds usually only purchase short-term maturity debt securities, whereas venture capitalists typically only purchase interests in early-stage firms who are in the formation, gestation, and hatching stages of their evolutions. But for each of these Intermediaries their function is to take money in on one side from Providers of Capital and provide some sort of pooling and curatorial/security-selection service in making investments which directs much needed money to Users of Capital. These Intermediaries have earned money over many decades by charging management fees (i.e. advice fees), administrative fees, and even marketing fees.
In many ways insurance companies are quite similar to the Intermediaries I just described. Those who purchase insurance policies are Providers of Capital/savers who recognize that they need a large stock of money in reserve to protect an asset that is critical to their well-being if it were lost or impaired. Houses, autos, health, and earnings (i.e. life and disability insurance) are examples of assets that people insure because they do not have a stock of capital built up to be able to replace these assets if they are lost unexpectedly. Over time as losses occur – and they usually do – the insurance companies pay out monies from the large pools of policy premiums they have collected (and invested) over the years. Most insurance companies actually lose money on this activity. Instead, they make money by investing the proceeds in their pools of policy premiums. These investments make their way into the hands of Users of Capital.
Though they are not usually thought of as Intermediaries, securities exchanges (e.g. New York Stock Exchange, London Stock Exchange, Hong Kong Stock Exchange, and all of the listed debt markets) stand between Providers and Users of Capital, too. As an aside, unless you are a finance pro you probably do not know that most debt transactions globally take place off of formal exchanges in stark contrast to publicly-traded equities that mostly change hands via stock exchanges. Furthermore, debt markets absolutely dwarf the size of stock markets. But more on this in future posts. Securities exchanges provide standards, transparency, and liquidity in assisting the Fundamental Transaction between Providers and Users of Capital. Historically they earned their money by shaving a micro-amount off of each transaction that made use of the exchange.
Last of the Intermediaries I want to discuss are Boards of Directors who legally stand betwixt Providers of and Users of Capital. Most typically Boards could give a damn about Providers of Capital and largely work in service of Providers of Capital. However, legally, they are supposed to be defenders of the needs of Providers of Capital with regard to the Users of Capital. The services provided here are, in my opinion, pretty ambiguous. Supposedly Boards provide oversight of the management teams of Users of Capital (e.g. businesses), as well as advice to Users of Capital as they go about their business. Rare is the board, however, that actually provides valuable protections for investors, or valuable advices to management. Mostly they just collect rent to fulfill a historical legal obligation.
In summary, the services traditionally provided by Intermediaries were:
- Pooling of funds;
- Curatorial advice on investments;
- Securities creation;
- Liquidity; and,
- Legal Advice.
How 21st Century Finance Threatens Legacy Services Provided by Intermediaries
Pooling of Funds
Pooling of funds is a beneficial service and one that is likely to survive as a function provided by 21st Century Finance. However, I disagree that those who pool assets need to be investment banks, commercial banks, investment companies, or other legacy organizations. With peer-to-peer technologies (see previous articles in this series) there is no reason that the network that allows pooling of assets together cannot be created and facilitated by an Internet-based platform. Such platforms already exist, though admittedly they are growing slowly and their overall size is minute as compared with those of 20th Century Finance. Missing from these peer-to-peer networks is wider dissemination of their existence, as well as trust in these platforms to aid the Fundamental Transaction to the same degree as Legacy Finance did historically. However, this is not a technological impediment, but a sociological one. What if, for example, a major social network or merchant platform where huge amounts of capital already agglomerate were to enter this kind of business? In China this is already a reality. In the United States, Amazon has already applied for banking licenses. Likewise, blockchain and cryptocurrencies allow for unique asset pools, with unique contractual understandings, and liquidity to form without the interaction of traditional finance in any way. Even if traditional finance survives as the largest player in the asset pooling space, competition is likely to ensure that margins shrink.
Net: pooling survives, many new entrants, margins shrink or disappear for legacy businesses, and capital is more widely available to Users of Capital.
It may be the case that investment banking survives in some form or format going forward. If so, it is unlikely that it is because of the quality of the curatorial advice provided by these firms. Starting in the late 1980s it became a truism that bidding firms in mergers and acquisitions actually lose money. Ouch! However, this data suffers from the lack of a control. That is, after a transaction there is no way to track how the acquiring firm would have done had they not engaged in a transaction. It is the case that many investment banking transactions are defensive in nature, meant to stave off the end of an industry or of a firm. However, is this efficient allocation of capital? Unknown; again, because there are no controls. This is why I speculate that investment banking may survive to provide curatorial advice. Another reason is that businesses that are managed by the myopic likely enjoy the protection/cover provided by the whispered advice of Ivy League-educated superstar investment bankers. In other words, they can blame the failure on those who they hired and whose advice they followed.
In a world where active investment managers, in general, and globally do not or cannot, deliver value (alpha) in excess of their fees, and where passive investment management delivers reliable results, it is hard to imagine the business for curatorial advice growing as a business. After all, passive management after the curation of an index or securities list, requires no curatorial advice. This means that it is likely active investment management goes through an existential catharsis.
Here, margins shrink, leading to consolidation of funds and the exiting of poor active managers. What survives are truly skilled active managers – a very small percentage of the total – who likely abandon the style-box as benchmark mentality that handcuffs their ability to deliver value. In other words, truly skilled active managers likely change their contracts (i.e. prospectuses) with Providers of Capital to broaden the investment mandate to include illiquid securities, global securities, and different securities types. This makes the traditional mutual fund look more like it did in the decades before the Style Box and investment consulting. Said another way, they look like hedge funds do now; whither the hedge fund that just will not be able to compete for funds. This may also spell the end of the rope for private equity, too, as investment companies hold a portion of their funds in promising, but illiquid funds. But, in summary very little of the traditional investment company business remains active in the decades to come.
On the venture capital side of things and the early capital-formation stage, peer-to-peer networks lubricated by blockchain threaten this group of Intermediaries, too. Advice was traditionally provided by venture capitalists because of their purported value add in knowing how to create a successful startup, and one that would ultimately appeal to public markets and the initial public offering (IPO) phase. But increasingly, both private equity and venture capital do not earn their costs of capital and, as I said, I expect mutual funds to encroach on this space over the coming decades. Also, equity listings globally are shrinking, not growing. One reason, I would argue is that many businesses are now able to secure private financing from a myriad of private sources (including commercial banks) that obviate the need for “going public.” As a side benefit, they avoid the quarterly earnings rat-race, as well as the regulatory expenses. Peer-to-peer networks now allow widespread qualified advice about how to manage businesses to be distributed without need for an intermediary and their cut.
What likely survives is management of large pools of funds where a specific outcome is mandated. Think: pension funds or insurance companies. In a pension fund the mandate is that retirees receive their contractually mandated benefit, typically retirement income or healthcare. For insurance company, coverage of losses contracted for in a policy is the mandate. Here, so long as the pension fund or insurance company achieves its mandate, then they likely cannot be disintermediated. Note: this is a lower threshold standard of quality than of “beating the market” over long periods of time. In part this is because pension funds can simply ask their beneficiaries to increase their contributions to compensate for poor decision-making on the part of the curatorial advisers, or they can simply reduce the size of payouts to beneficiaries. For insurance companies they can always raise the price of their insurance and refuse to underwrite a suite of risks unpalatable to their underwriters.
Net: curatorial advice survives, but again, most of the traditional players are killed, absorbed, or significantly changed. This is facilitated by peer-to-peer networks and blockchain.
Here the story is short and sweet. Blockchain allows for the creation of unique contracts for unique networks of like-minded people. This directly eliminates the need of traditional Intermediaries. Another competitor to traditional securities creators, like investment banks, is that many businesses now can finance themselves privately. In the olden days of finance money was difficult to raise privately because of a lack of transparency into the operations of individual businesses making it risky to lend to the businesses, as well as a lack of scale on the part of local banks. Simply stated, bankers were too small to underwrite and provide the necessary capital to larger businesses, so firms had to go public to access large scale capital. This is no longer true. Information technology at the enterprise level now provides bankers with amazing transparency into the inner workings of even large-scale businesses. Big data analytics also allows for the parsing of all of this data to ensure the sanctity of a credit and its ability to pay. Last, banking consolidation has led to the ability to underwrite very large private transactions.
Net: very few firms need the old lion Intermediaries of finance to conduct their business via securities creation. Sources of capital are easily identifiable, and easily secured through private networks and the contracts made within those private networks.
With all that I wrote above, it should be obvious that liquidity is not the limiting factor that it used to be. Users of Capital have ready access to capital through many sources, from both 20th and 21st Century Finances’ players. Additionally, many Providers of Capital have liquidity for their investments without the need for traditional Intermediaries and the public markets that they lubricated for several centuries. Only the very largest of firms are likely to continue to use public markets and have need of traditional Intermediaries to provide secondary markets for their assts. In fact, many of the very largest businesses are essentially self-funding, and there is no technological reason limiting them from serving as their own market-makers in the secondary markets. It is a fact that stock buybacks by corporations and options exercising by the same proves that businesses do not need public markets to serve as market makers for their securities. To me it is just a matter of time until firms issue equities and then provide their own market making services for their equity investors.
Net: Liquidity is a perennial concern for investors, but how liquidity was provided by Intermediaries in the 20th Century is no longer necessary for the overwhelming number of Users of Capital, and increasingly by the Providers of Capital.
Again, blockchain technology significantly reduces the need for gigantic regulatory and enforcement networks. So too the vast network of Intermediaries that provided their legal advice to Providers and Users of Capital. Where it is likely to survive is on the front end of the transaction as different blockchains are imagined, drafted, executed, and amended by disintermediated networks of Providers and Users of Capital.
My prediction is that standardized blockchain contracts become the norm. Think of this as the same as a programming language like C++ where the language and syntax are agreed to by all users of this platform. Another example may help…what is the standard for encoding digital movies? DVDs. This technology is agreed upon by all participants in the network and is standardized. In blockahin, for sake of argument we can easily imagine the ABC Blockchain or XYZ Blockchain as the standards for certain types of capital exchanges. Once these are tested through the global legal system there is no reason that certain blockchains do not become the standard framework for how capital transactions take place.
Net: Legal advice as a profit center shrinks for legacy Intermediaries. Blockchain, and especially standardization of certain types of Blockchains eliminates the need for legal advice except at the outset of a transaction, and in the event of any adjudication.