There is a lot written about how bad the US payment system is and why crypto solutions are the future. Against that background, Tom Noyes recently published an interesting post setting out his thoughts on a project JPM Chase is running to reengineer their payment system. Tom’s posts are normally restricted to subscribers but he has unlocked the first in a 5 part series exploring what JPM Chase is doing.
His post is definitely worth reading if you are interested in the future of banking. The short version is that the traditional banking system is not sitting still while crypto and fintech attempt to eat its lunch.
Every time I read these arguments in favour of DeFi and/or stablecoins, I wonder why can’t the USA just adopt the proven innovations widely employed in other countries. I had thought that this was a problem with big banks (the traditional nemesis of the DeFi movement) having no incentive to innovate but I came across this post by Patrick McKenzie that suggests that the delay in roll out of fast payment systems may in fact lie with the community banks.
The entire post is worth reading but I have appended a short extract below that captures Patrick’s argument on why community banks have delayed the roll out of improved payment systems in the USA
Many technologists ask why ACH payments were so slow for so long, and come to the conclusion that banks are technically incompetent. Close but no cigar. The large money center banks which have buildings upon buildings of programmers shaving microseconds off their trade execution times are not that intimidated by running batch processes twice a day. They could even negotiate bilateral real-time APIs to do so, among the fraternity of banks that have programmers on staff, and indeed in some cases they have.
Community banks mostly don’t have programmers on staff, and are reliant on the so-called “core processors” like Fiserv, Jack Henry & Associates and Fidelity National Information Services. These companies specialize in extremely expensive SaaS that their customers literally can’t operate without. They are responsible for thousands of customers using related but heavily customized systems. Those customers often operate with minimal technical sophistication, no margin for error, disconcertingly few testing environments, and several dozen separate, toothy, mutually incompatible regulatory regimes they’re responsible to.
This is the largest reason why in-place upgrades to the U.S. financial system are slow. Coordinating the Faster ACH rollout took years, and the community bank lobby was loudly in favor of delaying it, to avoid disadvantaging themselves competitively versus banks with more capability to write software (and otherwise adapt operationally to the challenges same-day ACH posed).
“Community banking and Fintech”, Patrick McKenzie 22 October 2021
You, like me, might be vaguely aware of the M-Pesa story of fintech innovation in Africa. Marc Rubinstein offers one of the best accounts I have encountered of how this came about and where it might be headed. Especially interesting is his analysis of why it took off in Kenya and the challenges it has faced in other markets.
The highlights I picked up from the Alphaville column included:
Central Bank Digital Currencies (CBDCs) now seem a matter of when, not if, primarily because the BIS has concluded that they need to get ahead of Big Tech (i.e. Big Tech are pushing ahead with their own versions of digital currency in a number of jurisdictions so central banks need to respond to these initiatives)
The fact that China is committed to a digital currency with the potential to gain a “first-mover advantage” also seems to be a factor
The BIS does not however see a CBDC as adding much value if your financial system already has a well functioning, retail fast payments system with all of the safeguards required by know-your-customer regulations
In terms of design, the BIS seems to be opting for an account based (as opposed to token based) form of digital money
Two of the larger design issues associated with implementing a CBDC are privacy versus security concerns and the potential for crowding out (i.e. how the new form of digital money impacts financial systems where banks are established as the primary suppliers of digital money).
There is a lot to unpack in the BIS paper but it is worth noting one thing I found immediately curious. In responding to the concerns about privacy versus security, Alphaville noted that “The report … says CBDCs could even have a built-in layer of anonymity for very small inconsequential transactions“.
That might work from an Anti Money Laundering (AML) perspective but it is far from clear to me how you would define “very small inconsequential transactions” in a world where a relatively small number of low value payments can finance child pornography. Westpac Banking Corporation paid a high price for failing to comply with reporting requirements in this regard so it is hard to see how a CBDC could define a threshold that was inconsequential.
Alphaville is of course just one perspective. I am yet to read the BIS paper in full but these are the key takeaways that the BIS author has chosen to highlight:
. Central bank digital currencies (CBDCs) offer in digital form the unique advantages of central bank money: settlement finality, liquidity and integrity. They are an advanced representation of money for the digital economy.
• Digital money should be designed with the public interest in mind. Like the latest generation of instant retail payment systems, retail CBDCs could ensure open payment platforms and a competitive level playing field that is conducive to innovation.
• The ultimate benefits of adopting a new payment technology will depend on the competitive structure of the underlying payment system and data governance arrangements. The same technology that can encourage a virtuous circle of greater access, lower costs and better services might equally induce a vicious circle of data silos, market power and anti-competitive practices. CBDCs and open platforms are the most conducive to a virtuous circle.
• CBDCs built on digital identification could improve cross-border payments, and limit the risks of currency substitution. Multi-CBDC arrangements could surmount the hurdles of sharing digital IDs across borders, but will require international cooperation.
“CBDCs: an opportunity for the monetary system”, BIS Annual Economic Report 2021
He starts with the observation that, after a decade since its inception, we seem to have arrived at the consensus that Bitcoin is best thought of as something like a digital version of gold (or “digital gold”).
That was not necessarily the original intent and battles have been fought between different factions in the Bitcoin community over differing visions.
The most recent example being the “Blocksize War” that played out between 2015 and 2017 where an initiative to increase transaction capacity by expanding the size of each Bitcoin block was defeated by others in the community who saw this as a threat to the network decentralisation they believed to be fundamental to what Bitcoin is.
Weisenthal notes that other players in the Crypto/DeFi domain have a different vision – Ethereum is currently one of the dominant architects of this alternative vision (but not the only one).
The distinguishing feature of Ethereum in Weisenthal’s thesis is that, in addition to being a cryptocurrency, it is also a “token”
He argues that, whereas Bitcoin requires a fundamental act of faith in the integrity of Bitcoin’s vision of the future of money, token’s have a broader set of uses to which you can assign value.
Once you introduce tokens the focus shifts to what precisely do you intend to do with them – in Weisenthal’s words “… once you’re in the realm of tokens, you don’t need faith, but you still need a point“
He notes that we have already seen some dead ends play out – Initial Coin Offerings were a big thing for a while but not any more partly due to many of the projects not stacking up but also because many of them were just another form of IPO that were still unregistered (hence illegal) securities offerings in the eyes of the law.
We have also seen some developments like Non Fungible Tokens that are interesting from a social perspective but not necessarily going to shake the foundations of the status quo.
A third possibility is that DeFi starts to become a real force that starts to shake up the existing players in the conventional financial system.
This third option is the one that Weisenthal (and I) find most interesting but there is still a long way to go.
This is most definitely a topic where I am likely to be missing something but Weisenthal’s article offers an interesting discussion on the contrasting visions, assumptions and objectives of the two currently dominant tribes (Bitcoin and Ethereum). Most importantly it highlights the fact that the vision of DeFi being pursued by Ethereum (or alternatives such as Solana) is radically different to the vision of the future of money being pursued by Bitcoin.
Marc Rubinstein lays out a detailed account of his initial explorations of decentralised finance. His professional background (like mine) is grounded in the conventional financial system so I found this very useful. Even better it is a short read with some hard numbers (time and cost) on the user experience.
My only quibble is that he calls these decentralised financial enties “banks”. Call me pedantic but none of the institutions discussed are banks and I think the distinction still matters if we want to understand how much of conventional banking will remain as this new chapter in financial innovation plays out.
Link to Marc’s blog here – www.netinterest.co/p/my-adventures-in-cryptoland
Izabella Kaminska (FT Alphaville) offers another perspective on what the development of a Central Bank Digital Currency CBDC) by the People’s Bank of China means for China itself, the rest of the world and the USD in particular.
Her column is titled “Is the central bank panic about the PBOC coin justified?”. It is not clear that central banks are actually panicking at this stage (equally I am not sure that Isabella has 100% control over the titles her sub-editors apply to her articles). The article does however offer some balance to the narrative that sees China’s moves in this space forcing other central banks to follow suite.
I am yet to fully come to terms with the questions posed in her article but this (for me at least) is definitely an area to watch and seek to understand.
Izabella has been a reliable source of insight on this and the broader questions associated with the increased role of fintech in our payment systems. I can also recommend a column she wrote in July 2019 titled “Why dealing with fin techs is a bit like dealing with pirates”. A paper by Tobias Adrian and Tommaso Mancini-Griffoli titled “The Rise of Digital Money” is also worth reading if you are interested in this topic (one of my posts offers a short overview of the paper and a link to the original).
Marc Rubinstein’s post (here) on Facebook’s attempt to create an alternative payment mechanism offers a useful summary of the state of play for anyone who has not had the time, nor the inclination, to follow the detail. It includes a short summary of its history, where the initiative currently stands and where it might be headed.
What caught my attention was his discussion of why central banks do not seem to be keen to support private sector initiatives in this domain. Marc noted that Facebook have elected to base their proposed currency (initially the “Libre” but relabelled a “Diem” in a revised proposal issued in December 2020) on a stable coin approach. There are variety of stable coin mechanisms (fiat-backed, commodity backed, cryptocurrency backed, seignorage-style) but in the case of the Diem, the value of the instrument is proposed to be based on an underlying pool of low risk fiat currency assets.
A stable value is great if the aim for the instrument is to facilitate payments for goods and services but it also creates concerns for policy makers. Marc cites a couple of issues …
But this is where policymakers started to get jumpy. They started to worry that if payments and financial transactions shift over to the Libra, they might lose control over their domestic monetary policy, all the more so if their currency isn’t represented in the basket. They worried too about the governance of the Libra Association and about its compliance framework. Perhaps if any other company had been behind it, they would have dismissed the threat, but they’d learned not to underestimate Facebook.”
One more reason why stable coins might be problematic for policy makers responsible for monetary policy and bank supervision?
Initiatives like Diem obviously represent a source of competition and indeed disruption for conventional banks. As a rule, policy makers tend to welcome competition, notwithstanding the potential for competition to undermine financial stability. However “fiat-backed” stable coin based initiatives also compete indirectly with banks in a less obvious way via their demand for the same pool of risk free assets that banks are required to hold for Basel III prudential liquidity requirements.
So central banks might prefer that the stock of government securities be available to fund the liquidity requirements of the banks they are responsible for, as opposed to alternative money systems that they are not responsible for nor have any direct control over.
I know a bit about banking but not a lot about cryptocurrency so it is entirely possible I am missing something here. If so then feedback welcome.
Firstly, he starts with the observation that there are very few neat solutions to policy choices – mostly there are just trade-offs. He cites as a case a point the efforts by financial regulators to introduce increased competition over the past forty years as a means to make the financial system cheaper and more efficient. Regulators initially thought that they could rely on market discipline to manage the tension between increased freedom to compete and the risk that this competition would undermine credit standards but this assumption was found wanting and we ended up with the GFC.
When financial regulators think about trade-offs, the one they’ve traditionally wrestled with is the trade-off between financial stability and competition. It arises because banks are special: their resilience doesn’t just impact them and their shareholders; it impacts everybody. As financial crises through the ages have shown, if a bank goes down it can have a huge social cost. And if there’s a force that can chip away at resilience, it’s competition. It may start out innocently enough, but competition often leads towards excessive risk-taking. In an effort to remain competitive, banks can be seduced into relaxing credit standards. Their incentive to monitor loans and maintain long-term relationships with borrowers diminishes, credit gets oversupplied and soon enough you have a problem.
The Policy Triangle, Marc Rubinstein -https://netinterest.substack.com/
We have learned that regulators may try to encourage competition where possible but, when push comes to shove, financial stability remains the prime directive. As a consequence, the incumbent players have to manage the costs of compliance but they also benefit from a privileged position that has been very hard to attack. Multiple new entrants to the Australian banking system learned this lesson the hard way during the 1980s and 1990s.
For a long time the trade-off played out on that simple one dimensional axis of “efficiency and competition” versus “financial stability” but the entry of technology companies into areas of financial services creates additional layers of complexity and new trade-offs to manage. Rubinstein borrows the “Policy Triangle” concept developed by Hyun Song Shin to discuss these issues.
Firstly, he notes that financial regulators don’t have jurisdiction over technology companies so that complicates the ways in which they engage with these new sources of competition and their impact on the areas of the financial system that regulators do have responsibility for.
Secondly, he discusses the ways in which the innovative use of data by these new players introduces a whole new range of variables into the regulatory equation.
New entrants have been able to make inroads into certain areas of finance, the payments function in particular. Some regulators have supported these areas of innovation but Rubinstein notes that regulators start to clamp down once new entrants start becoming large enough to matter. The response of Chinese authorities to Ant Financial is one example as is the response of financial regulators globally to Facebook’s attempt to create a digital currency. The lessons seems to be that increased regulation and supervisions is in store for any new entrant that achieves any material level of scale.
The innovative use of data offers the promise of enhanced competition and improved ways of managing credit risk but this potentially comes at the cost of privacy. Data can also be harnessed by policy makers to gain new real-time insights into what is going on in the economy that can be used to guide financial stability policy settings.
Rubinstein has only scratched the surface of this topic but his post and the links he offers to other contributions to the discussion are I think worth reading. As stated at the outset, I hope to one day codify some thoughts on these topics but that is a work in progress. That post will consider issues like the “prisoner’s dilemma” that are I think an important part of the competition/stability trade-off. It is also important to consider the ways in which banks have come to play a unique role in the economy via the creation of money.
Tony – From the Outside
p.s. There are a few posts I have done on related topics that may be of interest
It is partly a story of the battle currently being played out in the “payments” area of financial services but it also introduced me to the story of Dee Hock who convinced Bank of America to give up ownership of the credit card licensing business that it had built up around the BankAmericard it had launched in 1958. His efforts led to the formation of a new company, jointly owned by the banks participating in the credit card program, that was the foundation of Visa.
The interesting part was that Visa was designed from its inception to operate in a decentralised manner that balanced cooperation and competition. The tension between cooperation (aka “order”) and competition (sometimes leading to “disorder”) is pervasive in the world of money and finance. Rubinstein explores some of the lessons that the current crop of decentralised finance visionaries might take away from this earlier iteration of Fintech. Rubinstein’s post encouraged me to do a bit more digging on Hock himself (see this article from FastCompany for example) and I have also bought Hock’s book (“One from Many: VISA and the Rise of Chaordic Organization“) to read.
There is a much longer post to write on the issues discussed in Rubinstein’s post but that is for another day (i.e. when I think I understand them so I am not planning to do this any time soon). At this stage I will just call out one of the issues that I think need to be covered in any complete discussion of the potential for Fintech to replace banks – the role “elasticity of credit” plays in monetary systems.
“Elasticity of credit”
It seems pretty clear that the Fintech companies offer a viable (maybe compelling) alternative to banks in the payment part of the monetary system but economies also seem to need some “elasticity” in the supply of credit. It is not obvious how Fintech companies might meet this need so maybe there remains an area where properly regulated and supervised banks continue to have a role to play. That is my hypothesis at any rate which I freely admit might be wrong. This paper by Claudio Borio offers a good discussion of this issue (for the short version see here for a post I did on Borio’s paper).