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Introduction
The
economist Ronald Coase explained that firms,
and banks, only exist because of what he
called ‘transaction
costs'. All this really means is that firms
have economies of scale. It is easier for a bank
to match borrowers and lenders than it is for each
of us to do it on our own. The optimum size of
a bank, following Coase, is determined by those
info rmation costs. Banks were at their biggest
and most powerful when info rmation costs were
very high. As the internet leads to plummeting
info rmation costs, banks will get much smaller – and
may even be completely unnecessary. It is not just
the Zopa model (www.zopa.com)
of matching borrowers and lenders via a website
but something much more revolutionary that
follows from this.
But
that is running ahead of the argument. What I
will do first is give a brief overview of some
of the issues in banking, look at what is on the
technological horizon, draw some lessons from the
history of banking and financial trading and then
make a few predictions about where the new technology
might lead.
1.
Bank payments cartel
I
was chairing some e-finance conference
a few years back when a director of one
of the big clearing banks said that he didn't
worry about the internet because it didn't
impact on his core business - ‘the
management of the money transmission
network'
Payment
systems are big business. According
to the Boston Consulting Group banks
around the world are taking out fees of some
$228 billion dollars a year just for sending
money from one database to another over their
networks. In the US about 5% of the value
of an average purchase is eaten up in payment
costs. In the UK money transmission amounts
to almost 1% of GDP or £4.5
billion.
Don
Cruickshank, in his report Competition
in UK Banking, wrote:
"Money
transmission services are
supplied through a series of unregulated networks,
mostly controlled by the same few large
banks who in turn dominate the markets
for services to SMEs and personal customers.
This market structure results in the
creation of artificial barriers to
entry, high costs to retailers for accepting
credit and debit cards, charges for
cash withdrawals up to six times their cost,
and a cumbersome and inflexible payment
system that is only slowly adapting
to the demands of e-commerce."
There
is a reasonable defence of the payment
systems cartel: the banks do need to co-operate
to make the model work: those databases do have
to talk to each other. But still, the
cartel will protect its profits so don't expect
any threatening innovation to come from the banks.
Paypal caught the banks napping and they
still don't know how to respond to that. It is
not just Paypal and Zopa though: there are other
options emerging.
2.
Historical context
If
we take a very long term view, some of
the underlying trends become clearer.
Money
At
the turn of the first millennium, there
were many private currencies but the
quality of the coins varied enormously.
For this reason coins tended to be used
locally as exchange was difficult. Trade
was limited.
The
commercial revolution that started round
1100 created a demand for reputable money.
The more efficient mints exploited economies
of scale and drove their less efficient
competitors out of business. Governments
were not slow to take advantage of the
situation. States had economies of scale
in enforcement and monitoring. They could
demand payment of taxes in the coins
the state issued. Doing so helped the
state to maximise minting revenues, the
tax base and its authority over local
and feudal rivals.
The
dominance of state currencies took a
couple of centuries to complete. When
done, states had an effective monopoly
of money.
We
can then roll
the clock forward to, say, 1995, and contemplate
the business
case for launching a private currency in the UK – perhaps
called Shillings .
First one has to build enormous printing
and minting plants. One needs an army
to defy the High Court and Parliament.
And then we need a huge marketing budget
to persuade merchants and consumers to
accept Shillings.
It
is clear that there are fairly substantial
barriers to entry to the private currency
market.
But
technology has struck back. Today there
are various cryptographic protocols
that, with the internet, mean that
I can create a currency out of anything
I like, largely for free.
I
can create a glob of bits that says
that I, the issuer and underwriter,
based somewhere on the net, promise
to pay the bearer on demand x Shillings.
The issue cost is close to zero.
Of
course,
it is another matter to persuade you to accept
it but the fact remains that I
can
create a currency, issue a currency, circulate
a currency, offer a free and instant payment
service
and take $228 billion of COSTS out of the global
economy.
It is only a matter of time before someone does
it.
Private currencies are on their way – and
it won't be the banks in the vanguard.
Mobile phone minutes, air miles, loyalty
points are all forms of money as soon
as they are made fungible – transferable.
Banking
In
his
books on the history of banking, Ron Chernow
illustrates the trends in banking by looking at
the changing relative
power of borrowers, lenders and middlemen. In
the
18 th Century Wilhelm IX, the local nobleman
and landgrave of Hesse was the heir to an enormous
fortune. A certain Mayer Amschel Rothschild used
to grovel in front of this man, to bow and to
scrape. Ultimately, Rothschild was rewarded with
a monopoly of negotiating the numerous and highly
lucrative state loans issued by Wilhelm. In this
case, the
provider of capital was powerful. The banker
was powerless as Wilhelm could have shut him down
with a grunt or a nod. The consumers of capital,
impoverished European noblemen, were also largely
powerless.
A
hundred years later, in 1840, Chancellor
Otto von Bismarck stayed at the Rothschild
chateau at Ferrieres during the siege
of Paris in the Franco-Prussian War.
Even the Kaiser was dazzled by the
wealth. Within a century, the Rothschilds,
once the obsequious servants of monarchs,
had grown to be their equal, able to
thumb their noses at the Kaiser and
other minor characters on the European
scene.
What
happened was nationalism, the nation
state. Governments have an insatiable
appetite for money for wars, economic
development and pandering to special
interests. The histories of the great
banking dynasties are full of episodes
in which they daringly raised money for
cash-strapped governments.
There
were just a handful of these great banking
dynasties. Perhaps the greatest was J
Pierpont Morgan. His forte was acting
as a middleman between British investors
and American borrowers.
His
power stemmed not from the millions he
personally owned but from the billions
he could command or lay his hands on.
The pockets of capital were small,
few and widely scattered and he became
a crucial communications node matching
the two sides of the banking equation.
In
the early 1900s, most US companies were
small and local and were far less known
than the giant Morgan. The main thing
that a Morgan could confer on a fledgling
company was not so much his capital as
his cachet, his reputation - a signal
to jittery investors that they could
safely invest their money. He charged
handsome fees for the privilege.
This
was a man for whom brand, above all reputation,
really did matter.
By
1960 the providers of capital were accumulating
power over bankers in unit trusts, mutual
funds and pension funds. Companies were
relying less on the traditional banker
and had a choice of different capital
instruments. For the first time in the
20 th Century the banker middleman's
power is dwarfed.
It
is that
shift of
power that
explains why
100 years
ago the
image of
a banker
was of
a rotund,
grim, humourless
man in
late middle
age with
iron-grey hair,
wire-rimmed spectacles
and a
permanent scowl.
His role
was to ration
scarce
credit
and
charge
a
hefty
fee
as
the
middleman.
The
banker
today
is
slight
by
comparison – mere
salesmen dispatched
to scatter
bountiful credit.
As
money and credit are banal commodities
the role of the banker as the middleman
between borrowers and lenders has become
powerless: there are bountiful means
of exchange in an interconnected world.
Even hedgefunds are now dabbling in commercial
lending.
Capital
markets
The
capital markets
will change
in a different
way.
Towards
the end of the 18 th century, investors
would sit under the buttonwood tree on
Wall Street and gossip about the market.
When it came to trading, when a price
was agreed, trading, clearing and settlement
all took place in one seamless, costless
transaction. I would hand you a stock
certificate and you would hand me cash.
This
model began to change when Samuel Morse
perfected the telegraph in the mid-nineteenth
century. Investors became enthusiastic
adopters of the new technology, the Victorian
internet, and used it to trade from afar
on the most liquid market, Wall Street.
Suddenly those quaint, cheap, instant
and secure bearer transactions were open
to delay, clearing and settlement risk,
repudiation, dispute and simple fraud.
The
market's solution was to create an independent
third party to arbitrate errors and disputes.
Therefore, we established a rule-based
clearing house, a regulatory system and
a legal system to deal with mistakes
and fraud. In the market today, the ultimate
error handling routine is, ‘And
then
you
go to
jail.'
This
made economic sense. The advantage of
having an enormous pool of liquidity
in New York or London more than outweighed
the disadvantage of having settlement
delays and regulation. It was also very
good for brokers. Membership of the clearinghouse
was restricted to market intermediaries
and the club or cartel was able to agree
on high fixed fees.
So,
the telegraph, and the telephone, caused
a seismic change in the structure of
the financial industry.
Technically
we can now trade person-to-person, digital cash
for digital certificates in real time over the
internet without the need for a clearing house,
without the need for a central counterparty, and
without the risk of repudiation or fraud and
all achievable in a seamless, frictionless and
costless way.
Being
able to do it technically doesn't mean that it
will happen. But if, as many of us believe, it
is massively cheaper to do it this way, then
it almost certainly will happen. How long before
someone
has the courage to issue a digital bearer bond
on the internet? Their reputation really will
be on the line.
So,
I see four distinct phases of trading,
clearing and settlement. The
transition from each phase to the next has been
caused by an order of magnitude or more reduction
in the total cost of trading, clearing and
settlement.
In
phase 1, the bearer phase, traders would sit
under the buttonwood tree on Wall Street
and swap bearer certificates for cash. Trading,
clearing and settlement is a single and costless
transaction.
In
phase 2, the advent of the telegraph means that
Wall Street has to cope with long distance
orders. A regulator/clearing house has to arbitrate
disputes. Trading, clearing and settlement become
three
distinct operations. The cost of sending my
Securicor van to your cage, and vice
versa, is offset by the liquidity of the marketplace.
In
phase 3, the mainframe computer means that we
can immobilise and then dematerialise stock
into book entries in a database. Trading, clearing
and settlement remain separate operations,
partly out of habit and partly because the clunkiness
of the bank payment mechanisms. Clearing and
settlement in computerised databases is
cheaper than physical delivery but is neither cheap
nor simple: multiple message formats have to be
processed
in a steep hierarchy of connections between
participating institutions.
In
phase 4, the invention of financial cryptography
and the dominance of the internet, as a
universal network, means that database
entries, and immobilised
documents, can be represented in digital bearer
form on the internet. Digital cash can
be exchanged for digital equity in real
time in a costless transaction. The processing
can be distributed on client devices meaning
that there are
very limited hardware overheads. Trading, clearing
and settlement merge again into a single
transaction.
3.
Conclusions
We
have established that the banking
cartel exercises its power today
over the money transmission network – extracting
$228 billion a year in fees. We can
look forward to new models, such
as Paypal, mobile phone payment
methods and many others, killing the
cartel.
We
have established that government
control of money has slipped back to
the market: the barriers to entry for
private currencies are simply too low
not to make it attractive.
We
have also established that the banker's
role as the middleman matching up borrowers
and lenders had its heyday perhaps
100 years ago and has been in continuous
decline.
Finally,
I contend that we will return
to bearer markets on the
net – digital
bearer markets overturning
all of our financial
structure.
Because it can happen, because
it will be massively
cheaper, and because
there is money to be
made by making it happen,
it is only a matter
of time.
If
you would like to know HOW to
issue a digital bearer instrument
on to the internet, come along
to a conference next February and
learn all about it. It is called Financial
Cryptography and the website is http://www.ifca.ai/ . Duncan Goldie-Scot is a director of
the International Financial Cryptography Association.
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Ariadne
Capital Journal - Through the Maze Volume
5, Edition 3
