In January 2008 I started writing a book called Crumbling Behemoths. I should have finished it. In October of that year, after the Lehman collapse, it could have been a bestseller. My experience in the Fintech engine room of core banking helped me see the fragility in what looked like an invulnerable system of giant global banks. Here is the TLDR version that book, just after the 10 year anniversary of the Lehman collapse and just before the 10 year anniversary of Satoshi Nakamoto’s White Paper (January 3rd).
Banks are vertically integrated, tightly coupled, politically dependent entities. Most have been in business for hundreds of years. Their decline is inconceivable; like the decline of car manufacturing in Detroit, Blockbuster, bookshops, Kodak, etc, etc. Size gives some Banks great power today and size looks like an obvious asset on their balance sheet. However in the network age, their size is actually a liability. This post explains why, with a focus on:
- Legacy IT meltdowns and the liability of “technical debt”
- Wells Fargo and the Creative Destruction 7 Act Play
- Why Blockchain is the realisation of Coase’s post-Corporate vision
- Satoshi’s vision of 7 billion banks is the long term threat
- The networked small bank is the imminent threat
- Regulators typically arrive about the time that technology is doing the job for them
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Why Bailouts will not be possible next time
- How Analog Scale is fundamentally different from Network Scale
- Trading Takeaway – how to profit from this insight
Legacy IT meltdowns and the liability of “technical debt”
Hello, my name is Bernard and I am a core banking system salesman. Yes that sounds like the intro to an AA meeting. i should say “was”, but in honour to AA I use the present tense. My days in the engine room of Fintech, selling core banking systems to the biggest global banks for companies such as Misys, meant I was not surprised to witness the Legacy IT meltdowns and the gradual crumbling of the Bank Behemoths.. Those of us selling replacements for paper-based systems decades ago never imagined that those systems would still be operational in the 21st century. They are and now they have moved from the asset to the liability side of the Bank’s ledger.
Bankers often talk about the millions invested into IT as an asset. Anybody who writes code knows that software degrades over time and at a certain point that “technical debt” becomes a liability and not an asset. It is now cheaper to build the IT infrastructure for a startup bank, using open source and APIs, than it is to adapt Legacy IT for a modern world. The $ millions invested in IT now have a negative ROI.
I use terms such as assets, liabilities, technical debt and negative ROI is to make this accessible to non-technical bankers and investors. There is one technical concept that is critical but also easy for non-technical bankers and investors to understand, which is tight vs loose coupling.
Any programmer will tell you that a loosely coupled architecture via APIs accessible via networks is better than tightly coupled systems (aka “spaghetti code”).
The programming cost is not the issue. The big issue for the Behemoths, the reason they are crumbling is:
- The banks cannot change their business model fast enough. Bank CXO teams are perfectly away of the threat of disruptive technology and that they must change their business model at a fundamental level. They know what they should do. The problem is that they send instructions to the engine room of their ship to go faster and to change direction to due West and the person in charge of the engine room tells them that if they shovel in a lot more coal they can increase speed by 10% and will take two hours to change direction to due West, but warn them that this means they will run out of coal before they arrive at the next port. Meanwhile the Bank CXO team in the captain’s tower sees a flotilla of small boats going due West at 10x their speed.
- Loss of consumer trust. Consumers might be enraged by bailouts, but they still assume that banks are at least reliable and the only game in town. Some consumers read about Cyprus where the government unilaterally took money from their bank; this is “bailout in your face” (strangely described as a “bail-in”), but at least one can think “that is in some tiny far away island”. Closer to home, a series of IT Meltdowns, such as at TSB and RBS, mean that consumers have days when they cannot get cash from an ATM or use their credit cards; banks are no longer “reliable”. Finally they hear from a friend who is raving about one these startup banks; the big old banks are no longer the only game in town.
- Aggressive action that only makes it worse. This is what we saw in the Wells Fargo scandal.
Wells Fargo and the Creative Destruction 7 Act Play
The Wells Fargo fake accounts scandal was a more subtle version of the Cyprus bail-in. Money was taken out of your account, not by the government, but by your bank via a fee that you never actually authorised. This is Act 3 in the Creative Destruction 7 Act Play (described in Part 2, Chapter 1 of The Blockchain Economy book):
“Act 3. Denial. The changes are now real and the old guard management can see it, but they don’t know how to react so they reach for high pressure management to make the numbers work. In some cases, management also reach for creative accounting tricks to smooth out earnings and make it look as if nothing has changed (known as fraud in most circles). This Act can go on a long time as most investors work on surface numbers. A famous example of the Denial Act 3 was subprime mortgages that blew up in the Global Financial Crisis in 2008. For a long time the surface numbers looked good until a few nonconformists looked below the surface (watch The Big Short movie for an entertaining take on that story). A more recent example in Finance was the Wells Fargo fake accounts scandal (which was going on for a long time before it was uncovered). “
To understand why big Banks like Wells Fargo are under such pressure, one has to dig back to an obscure academic paper written in 1937.
Why Blockchain is the realisation of Coase’s post Corporate vision
Part 1, Chapter 14 of The Blockchain Economy book describes why Blockchain is the realisation of Coase’s post Corporate vision. Coase’s 1937 essay The Nature Of The Firm asked why hire employees instead of contracting tasks? His answer – a company exists because it is cheaper to do transactions within a company than outside. Blockchain has resurfaced this theory by dramatically reducing transaction costs.
The Internet seemed to be the realisation of Coase’s post Corporate vision. However, although Dot Com and Social Media changed our world, that change was limited to exchanging content online. The Internet was the perfect free copy copy machine. Blockchain enables us to exchange value online – where copying is not allowed (if I send you that asset I no longer have it).
This enables literally everybody on the planet to be their own bank. Satoshi’s vision of 7 billion banks (one for each person on the planet) is outrageous but not impossible.
Satoshi’s vision of 7 billion banks is the long term threat
Anybody can be their own bank. All you need is a wallet that can hold cryptocurrencies.
The Central Bank is encoded in the math (whether Deflationary for Bitcoin or mildly inflationary for Ethereum). You no longer need to trust a Central Bank and whoever guides their actions. You trust the math and the code, both of which you can verify.
Although most people won’t choose to be their own bank, it is the fact that it is possible that is such a wake-up call for big banks. This is the Napster moment. Napster proved that digital audio/video was possible. It was free and illegal. After that came cheap and legal in services such as iTunes and Spotify. Those services were only possible because the alternative of free illegal services such Napster and Kazaa was possible.
This is why a network of small banks is the imminent threat
The networked small bank is the imminent threat
SIBOS is the big annual gathering of bankers organized by SWFT. At SIBOS 2016 in Geneva I attended a session on Blockchain and correspondent banking – The way to go? This was standing room only. My observation at the time (recorded on Fintech Genome) was that:
“The problem of the current dialogue about a Blockchain replacement of today’s correspondent banking network is very simple – correspondent banks are being written out of the script. Look at the panelists and you see a) technologists and b) global banks. Both agree that the future is bright.
Elsewhere in the conference there was a lot of talk about reducing the number of Correspondent Banks in your network. The driver was Compliance. You cannot have a Correspondent Bank in your network who does not comply with the latest regulations from governments related to tax, money laundering, terrorist financing and all the other bad actors who use money alongside the good actors – and these regulations get more onerous every day.
It is fashionable to say that Correspondent Banking is dead. This conflates the current incarnation of Correspondent Banking which is batch based with the concept of Correspondent Banking itself. I am convinced that Correspondent Banking will survive the transition to real time and that SIBOS will always be key to Correspondent Banking.
The Correspondent Banking is dead meme suits the global banks. It is inconvenient for them to deal with regional banks and much simpler to have a global network that is totally under their control. The technologists will deliver that for them. Voila – a handful of global banks control global trade.
Technically this is simple – really simple. Blockchain will be like Internet – we will use it invisibly every day. TCP/IP is not rocket science (but might have been perceived that way in 1996).
If you step outside the innovation echo chamber and talk to the regional banks you can sense the discomfort. They are being forced to consider a future without themselves in that future. Yet in the real world, these regional banks are prized by their customers.
Correspondent Banking will go real time. The 9,000+ member banks of SWIFT will keep the human relationships and just switch over to a new system.
One thing preventing small banks from competing is lack of equity capital. It is much easier today to buy one mega global bank that grew by “rolling up” lots of smaller banks. That is really the only option today for investors. The gamechanger is new equity, whether from Security Tokens or traditional Equity Exchanges. That is why an unknown Community Bank filing for an IPO – Silvergate Bank – is so exciting.
Silvergate is traditional regulated bank offering services to the Blockchain Economy. It presages the future and its S-1 is data treasure trove for those seeking to understand that future.
I wrote at the start that “Banks are vertically integrated, tightly coupled, politically dependent entities”
I now want to focus on that last part about “politically dependent entities”. Banks are licensed by sovereign governments and Blockchain is inherently a stateless global network. We shall soon witness the loud bang that happens when an irresistible force meets an immovable object. Which brings us to the R word – Regulation.
Regulators typically arrive about the time that technology is doing the job for them
When 2008 happened, the regulators in America threw a complex rule book called Dodd Frank at the banks. For 10 years, the lawyers and regulators have worked through the details and now some elements seem to be up for negotiation. It has become a political football, just when technology may be making it irrelevant.
This has happened before. Regulators typically arrive about the time that technology is doing the job for them. Look at what happened in two earlier waves of technological disruption:
- IBM was being regulated just when the world was moving from mainframes to PCs.
- Microsoft was being regulated just when the world was moving from PCs to Internet.
- Today Google and Facebook are being regulated just when the world was moving against all our data being used as a tool to control us. Note: this is happening right now, which makes it a bit harder to see than the two previous waves.
The problem is that in 2008, the technological disruption was still in the mind(s) of Satoshi Nakamoto. So the regulators resorted to the only thing they knew – a complex legal document.
When the next financial crisis hits, the discussion around bailouts and regulation will be quite different.
Why Bailouts will not be possible next time.
- Populism has a political voice. The rise of extremism of both right and left is all over the globe will make it harder to bail out banks again.
- Governments are running out of firepower to pump in more liquidity. For every loan there has to be a lender and at some point lenders worry about inflation from money printing. Lack of funds will make it harder to bail out banks again.
- The disruptive alternative (Bitcoin) is now more mature and tested. People now have the tools take control over their own financial resources, regardless of what politicians say.
How Analog Scale is fundamentally different from Network Scale
Analog Scale, what most Big Banks have, is all about vertical integration, management hierarchy, secrecy and control. In short, hierarchy.
Network Scale is all about networked partnerships through APIs, online networking, knowledge networks and verifiable transparency. In short, wirearchy.
The thesis of this post is that wirearchy beats hierarchy.
Cryptoeconomics takes this wirearchy to a new level.
In October 2014, I was privileged to be at an Ethereum MeetUp in London to hear Vitalik Buterin talk about:
“Cryptoeconomic Protocols In the Context of Wider Society”
That is right. This was about as interesting to 99.999% of the population as the discussions at the Homebrew Computer Club in the 1970s when the PC revolution was starting. At the time I was more conscious of witnessing history in the making (as I recorded here) than really understanding cryptoeconomics. Today I see cryptoeconomics as an updated version of what one the greatest investor of the 20th century (Charles Munger) talked about, which is the power of aligning incentives. I knew this to be true from my years leading enterprise sales teams. What is different about cryptoeconomics is that it takes these incentives out of the closed world of the enterprise and makes them available to 7 billion people in a permissionless network.
We can already see Network Scale in the big winners in the Centralised Internet. What Vitalik Buterin was talking about in 2014 and is now making happen is Network Scale in the big winners in the decentralised Internet. As Trace Mayer puts it, this will be a once in a species level transfer of wealth.
Trading Takeaway – how to profit from this insight
Investors will start to sell/short banks & buy Bitcoin, Blockchain & Cryptocurrency. The banks will resist change and have a lot of clout, so shorting at first will only be for those banks who face traditional balance sheet problems (such as Deutsche Bank). Problems with consumer trust and regulators at banks such as Wells Fargo don’t seem to translate into stock price weakness.
That is because there is a difference between inevitable and imminent. The changes I am writing about maybe inevitable but it is really tough to figure out timing. That is why the simpler strategy is to go long Bitcoin, Blockchain & Cryptocurrency; you can hold for as long as it takes for this to play out. The Bitcoin, Blockchain & Cryptocurrency tsunami is likely to follow the usual rule of disruptive change which is is that a) it takes longer than people think and b) the change when it happens is bigger than people think.
Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is the author of The Blockchain Economy and CEO of Daily Fintech.
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