(Part II of a series on the future of banking and finance)
This column follows my overview comparing 21st Century Finance vs. 20th Century Finance. Hopefully I convinced you that banking and finance are likely never to see the same profit margins as in previous decades and that many of the business lines are likely to be usurped.
The Financial Ecosystem
Before delving into the article let me make a brief aside to describe the financial ecosystem that is going to be the backbone of this and my future columns in the series. For starters, 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 – who I call providers of capital – exchange their monies with those with a surplus of good ideas, but a deficit of capital – who I call users of capital.
If the Fundamental Transaction takes place with smarts and wisdom then both parties are made better off. Ét voilà, you have a literal act of creation that is called economic growth, and hopefully it is in excess of the providers of capital’s required rates of return.
There are other parties acting in the financial ecosystem and they are the subject of future columns examining differences between 21st century finance and 20th century finance. [Note: I discuss the financial ecosystem in more depth in a reference article here at Sarasota Institute]. But, in brief, the other players in the ecosystem are:
- Intermediaries: Entities like investment banks, investment companies (in the U.S. they are called mutual funds most commonly), commercial banks, credit unions, pension funds, and so forth whose primary function to the ecosystem is to facilitate the Fundamental Transaction for a fee.
- Opiners: These are organizations making their living by evaluating the quality of the Fundamental Transaction by offering their opinion about its quality. Most obviously, these are research analysts, including those employed by investment companies, investment banks, and independent organizations, like investment newsletter writers.
- Traders of capital: Here ecosystem participants transact and make markets in the secondary market, which is so critical to the free flowing of capital due to the independent pricing of securities and providing of liquidity.
- Groundskeepers: These include the likes of regulatory bodies, self-regulatory bodies, accounting standards setters, transfer agents, tax authorities, the IMF, the World Bank, the OECD, et. al.
In this article I discuss the unique changes underway affecting providers of capital.
Providers of Capital & What They Want From Finance
These are the folks and institutions that save and invest their monies, and in so doing, provide capital to the financial ecosystem. Said another way, they forego consumption today in the hopes of earning a return and being able to consume more in the future. Multiple inducements currently exist for them to provide their capital to the ecosystem, and not surprisingly, these are the root businesses of 20th century finance:
- Protection of their capital by parking it at a bank;
- Interest rates paid on savings, or on fixed income investments, and;
- Dividends and/or capital appreciation on their equity investments.
Protection of Capital
In a 21st Century Finance world protection of capital is no longer the sole domain of banks. For example, blockchain technology obviates the need for banking institutions. Recall that there are two features of blockchain that are changing finance.
First is that blockchain exists transnationally and thus when the technology is used as a currency then capital is protected because its value fluctuates independent of the economic vagaries of any one nation. In 20th century finance providers of capital and their funds were subject to the volatility of the currency in which their deposits were denominated.
Most of us do not have the scale of savings or sophistication necessary to store our deposits in multiple currencies. Consequently, my deposit is exposed to the myriad risks that affect the movement of currencies. These include a nation’s: economic policies, taxation policies, economic performance, national debt levels, internal strife, and so on.
With blockchain I can deposit funds into an instrument that is not directly affected by the just mentioned risks. Yes, it is true that when I convert my blockchain units to another currency that I may experience the volatility at that moment.
However, I believe it is likely that an institution develops 21st Century Finance products that allow depositors to enter blockchains in one currency and exit in another. I can further imagine that a professional manager may even sit astride such a blockchain and decide when it is prudent to enter and exit the chain and in various currencies.
Second, the other feature of blockchain is its distributed ledger. Here all transactions are perfectly transparent because they are all made visible and each party to a blockchain must agree on the sanctity of the transaction before it can be completed. From the perspective of the sanctity of a deposit (i.e. “can I get all of my money out now”) a blockchain is much safer than it is in a bank.
Why? Again, it is because there is a permanent record of every transaction ever made, and all parties agree to every transaction. This is analogous to all depositors at a bank having access to perfect video camera surveillance of their banking institution, and all having to agree that everything is safe before new monies can be deposited, or current monies withdrawn.
In summary, for providers of capital, 21st Century Finance provides a much safer means of protecting their capital. These transactions are also likely to be cheaper in the long run because of the lack of volatility in the currency.
Historically banks pay interest on deposits. However, they pay interest rates lower than they themselves earn on their loans. Net, banks earn about a 3% spread on depositors’ monies in exchange for providing a safe place for their cash. Per my above discussion, the safety is higher in a blockchain.
A likely consequence of banks needing to compete with blockchain deposits is that they begin to pay higher interest rates for deposits in order to accumulate them, or that they charge more interest on loans on their investment-side of things. However, I consider this an unlikely scenario as competition for loans is likely to only increase in the future as banks are meant to compete, yes, with other banks, but also with many other players as well. (more on this is a moment). A higher probability exists that banks pay more interest on their deposits to attract capital, and consequently that they see their margins fall from lending activities.
21st Century Finance is likely to see non-traditional firms providing loans. Think: Alibaba, Amazon, eBay, and other large institutions that have massive customer platforms and where there is tremendous data on the financial acumen of customers. Who has more financial information on consumers, banks or the big consumer platforms? I hope the answer is obvious that it is consumer platforms.
Yet, peer-to-peer lending (discussed in Part I) also looks to supplant traditional banks in providing interest on deposits. Currently the only thing lacking in peer-to-peer lending networks is scale. With scale these organizations will be better able to attract deposits.
This is because scale means you will have heard of the institutions and know people that have worked with the institution. Consequently you will be able to trust the institution with your deposits and know that you can earn a higher interest rate on these deposits than at a traditional bank. The reason is that you eliminate the middleman in 21st Century Finance and the additional monies paid to 20th century financial intermediaries are now captured by you!
I can imagine a future in which peer-to-peer lending has a Reviews section comparable to those famous on e-commerce sites. Here you can check the creditworthiness of a credit by looking at their reviews from previous lenders. I can imagine also some of these peer-to-peer lending platforms creating a premium product that includes lending insurance. That is, you deposit monies with them – receiving depositor safety – but you then also receive higher interest rates by directly lending to a group of consumers on the other side in the form of microloans. For a small charge you receive insurance on these loans so that if a credit defaults you are guaranteed the value of your deposits. If you are confident in your lending/underwriting abilities you can foreswear the additional insurance.
Interest rates are not just paid by banks, they are also paid by municipalities, governments, and corporations on their borrowings. In 21st Century Finance, information on the quality of issuers is provided by a crowdsourced network of people, as well as by customer reviews (as described immediately above).
Here the traditional role played by financial advisors, wealth managers, research analysts, mutual funds, ETFs, and asset custodians can all be replaced by many different parties. These include: crowdsourced analysis; robo-platforms that conduct analysis with Big Data powered by machine learning algorithms; robo-adviser custodians with loss-leading, potentially negative basis point, custodial services; and peer-to-peer networks that link borrowers with providers of capital/lenders.
There is also no reason that the just mentioned businesses and networks cannot operate in the private sector and transnationally, too. This opens up the gateways of banking and finance to many more providers of capital, able to operate globally, and to many more users of capital, able to source capital globally. Again, with blockchain technology fully implemented, the notion of private debt and equity markets vs. public debt and equity markets is likely to look antiquated. With globally safe capital exchange networks in place, what is the need for such a limiting distinction, such as private and public with different sets of regulations? Regulations currently are dependent on the quality of enforcement of policing agencies and judiciaries. With peer-to-peer networks enabled by blockchain, the network itself and with its hyper-transparency is the policing mechanism.
Importantly, every single one of the above technologies and businesses already exists! So this is not some pipe dream. What is missing is scale, and global trust that 21st century finance organizations can replace their 20th century forebears. To me, if the sponsors of these technologies grow prudently with a gigantic investment in trust mechanisms, then it is only a matter of time until there is fulfillment of the above imaginings.
Dividends and Capital Gains
The case for equity investing is identical as it is for debt markets described above. In other words, peer-to-peer networks, enabled by blockchain, and policed by blockchain and crowdsourced/network analysis, is likely to supplant the traditional functioning of 20th century finance’s equity markets.
One of the most shocking data points of my entire career is that Goldman Sachs currently employs just 2 equity markets traders globally. Whereas, in 2002 they employed 800 globally. How can Goldman make do with just 2 analysts? Because equity trading is almost perfectly automated. This is one of the natural outcomes of big data, coupled with machine intelligence, and with both operating in such a narrowly defined context: equity markets.
With the checks and balances that blockchain and crowdsourcing provide, there is no reason peer-to-peer equity trading will not destroy equity trading as done in the 20th century finance. Again, there is also no reason for the artificial distinction between public and private equity trading. Or the distinction of national and international. And on, and on.
In turn, this is likely to open up and make much more accessible equity markets to brand new entrants into the marketplace. Think: your local cupcake shoppe or café; a tech startup; or your mom who wants to publish a cook book with her kids’ favorite recipes. Once more, the only burden is not imagination, or even the demand for new technologies, but adoption.
The future for providers of capital in 21st Century Finance looks to be much improved from previous centuries. Specifically, it is likely an era of lower risks, with higher returns, and certainly much lower fees. For the institutions made gigantic by 20th century finance, the future looks bleak with significantly lower margins, and with much lower influence over the financial ecosystem.