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Money makes the world go round

  • Published at 04:58 pm June 2nd, 2017
Money makes the world go round

The financial industry is the last place for innovation to reach. Schumpeter’s idea of “creative destruction” just cannot get in there.

But, things changed quite a bit when the internet came into play. Inspired by the possibilities of internet and digitalisation, some brave souls from Silicon Valley came to play in this old and boring industry (eg Paypal).

Taking due notice of this development, top industry players got busy in bringing innovations in the industry.

However, the roles these products played in the global financial crises of 2007 and 2008 have generated a vigorous debate about the true value of financial innovation -- leading some to believe that financial innovation is largely useless.

The financial sector is the most regulated one which happens to be highly networked as well. To implement any new idea, it is imperative to convince numerous parties in the network.

Moreover, banks have a relatively rigid hierarchical organisational structure. Ideas easily get lost in this complex chain of command.

Furthermore, the main capital of financial industry is trust. No firm can afford to risk this trust by taking high risk in its operation and failing in the process.

The road to innovation is a risky one. Even politicians cannot afford any failure of this industry due to its adverse domino effect on other institutions and on society.

All these barriers of innovation within the industry have let the door open for fintech startups from all over the world to break into the game.

Start-ups are starting to provide traditional financial services such as payments, fund transfer, insurance, etc using technology with much less effort and resources than the traditional financial firms.

All these fintech startups/firms (eg Paypal, Square) have made our lives easier. However, they couldn’t reduce our dependency on financial institutions, let alone disrupt the industry.

Things would have gone like this forever, if it weren’t for “Bitcoin: A Peer-to-Peer Electronic Cash System.”

This apparent naïve publication that introduced the idea of blockchain and cryptocurrency have changed the whole scenario. This is the revolution we have been waiting for.

Challenging old ideas

Blockchain is an “enormous catalyst for change that hit at governance, ways of life, traditional corporate models, society, and global institutions.”

It challenges the old ideas which have been locked in our minds for decades, if not for centuries, and is ready to challenge the governance and the centrally controlled ways of enforcing transactions.

Blockchain is trustless in the sense that a user does not need to trust the other party involved in the transaction, but does need to trust the system: The blockchain protocols.

The financial industry is the world’s most powerful industry, moving trillions of dollars daily, and in the process, serving a $100 trillion global economy consisting of billions of people.

As Blockchain does not require any trusted third party in performing a transaction, full implementation of blockchain technology in finance could fundamentally change the whole structure of the financial industry.

Due to the very complex nature of the existing financial system, there is high risk.

Blockchain, with its ‘trust protocols,’ for the first time in history, enables two parties who neither know nor trust each other to do transaction and business

A new decentralised financial system created by blockchain could make the whole system much simpler by removing layers of intermediation and could help insure against risk.

Blockchain technology promises to mitigate several forms of financial risk, such as settlement risk, counter-party risk, and most importantly, systemic risk. Instant settlement on blockchain could eliminate almost all these risks completely.

Irrevocability of a transaction and instant reconciliation of financial reporting would eliminate one aspect of agency risk -- the risk that unscrupulous managers will exploit the cumbersome paper trail and significant time delay to conceal wrongdoing.

There are 2.4 billion people who cannot present a proper identity card and 2.2 billion people who earn less than $2 a day.

All these people are considered ineligible and unprofitable for the financial industry. Cryptocurrencies could open up the financial system to all these people. Regulators could remake the financial system by re-thinking the best way to achieve policy goals, without diluting standards.

Blockchain, with its “trust protocols,” for the first time in history, enables two parties who neither know nor trust each other to do transaction and business.

It un-crowns the sole authority of financial intermediaries to verify identity and ensure trust.

Blockchain network both clears and settles peer-to-peer value transfers at the same time and keeps its ledger up to date.

If all banks could harness this capability, they could eliminate an estimated $20 billion in back-office expenses without changing their underlying business model.

With radically lower costs, banks could offer individuals and businesses greater access to financial services, markets, and capital, especially for underserved communities.

Instant value transfer

Even in today’s highly connected world, sending remittances is a lengthy and costly process.

It takes three to seven days to settle. On the other hand, stock trades take two to three days, and bank loan trades take on average 23 days to settle.

The SWIFT network handles 15 million payment orders a day between 10 thousand financial institutions globally, but takes days to clear and settle them. The same is true of the Automated Clearing House (ACH) system, which handles trillions of dollars of US payments annually.

The bitcoin blockchain takes an average of 10 minutes to clear and settle all transactions conducted during a particular period.

Other blockchain networks are even faster, and new innovations, such as the Bitcoin Lightning Network aim to dramatically scale up the capacity of blockchain, while dropping settlement and clearing times to a fraction of a second.

Indeed, the shift to instant and frictionless value transfer would free up capital otherwise trapped in transit, and reduce the cost of sending remittance from 8-10% to 1-2%. This is big.

Blockchain offers enormous opportunity, especially to the underdeveloped and developing countries where financial infrastructure is weak, archaic, and shady.

Existing industry players in our financial industry could make use of this technology to bring speed, transparency, and equality in the process.

But if they fail to grasp the true importance of blockchain, they are bound to face disruption in near the future.

SM Musa is doing research on Strategy & Innovation at RSM. He writes from the Netherlands and can be reached at [email protected]