Are Crypto-Currencies more Democratic?

The internet, as I’m sure you know, is formed of millions of connections between nodes, or access points for all its users.

Concurrent with, or alongside, this network a new network has sprung up, consisting of the Bitcoin miners and its payment system. This is supposedly money at its most ‘democratic’ because supposedly no one entity can gain control of a majority of the miners on which this consensus rests.

(for an explanation of the Bitcoin creation mechanism, see https://jessking1311.wordpress.com/2015/10/01/what-is-the-real-problem-with-bitcoin/  )

A fintech explosion

Goldman Sachs’ widely read ‘Future of Finance’ report cited three trends which two of its authors, Heath Terry and Ryan Nash on the Global Investment Research team, expanded on further in a podcast. These were: regulation, technology, and changing consumer habits.

The financial crash and ensuing regulation “effectively created a greenfield opportunity during the recovery… following Facebook’s IPO in 2012, a lot of opportunists asked themselves, ‘What sectors don’t have a Facebook, a Google, an Amazon yet. And financial services was the only one of those.”

A friendly credit environment also contributed to the exponential growth in ‘shadow banking’, – here defined more narrowly than the Fed which has tracked a recorded $15 trillion in liabilities by non-bank lenders like private debt funds – as so-called P2P or marketplace lenders.

The Goldman Sachs analysts predict $10-12 billion could move out of the traditional sector and into shadow banking. Marketplace lenders have been quick to adopt innovations like risk pricing algorithms, and analytics to predict consumer demand for loans. Thus they benefit from ‘lower cost of customer acquisition’ and ‘efficient delivery channels’, where banks are hampered by due diligence restrictions which give loans applicants offputting mountains of paperwork.

The third factor cited is regulation. Where Basel III imposed rigid capital adequacy ratios, the Dodd-Frank stress test limits made bank lending even more restricted, because they needed to consider also the value at risk of certain assets under stress scenarios. This severely limits the type of assets they can hold on balance-sheet.

Finally, the Credit Card Accountability Responsibility and Disclosure Act of 2009, or Credit CARD Act of 2009, created a unified pricing standard which also meant credit providers’ losses were absorbed to some extent. And profits in the industry as a whole became more attractive, spurring innovation and start-ups to capitalise on the benign regulatory environment.

Crypto-currencies are more ‘democratic’ than fiat currencies

Bitcoin is a new currency but unlike sterling or the dollar it is not controlled by a national government, which can intervene to buy and sell the currency to preserve its value. And which are traded on mass by foreign exchange funds.

This means Bitcoin’s value depends almost entirely on how much it can be exchanged for in terms of goods and services on the internet. Or, to be more accurate, what people believe these items to be worth in Bitcoin at any given time. Which depends on the amount of Bitcoin in circulation.

For an explanation of the historic issue of the ‘capacity crunch’ and the competing plans to increase the size of transactions and transfers to scale up the payment system, again see my previous post on the issue.

But more important in revolutionising the way money is lent in the modern world is the Distributed Ledger Technology used to record Bitcoin transactions. Everyone in the Bitcoin network has access to this record, and its only alterable by mutual consensus or agreement.

So no one can fraudulently claim they have made or recorded a transaction, because the online ledger called the blockchain shows exactly who had made and received the transaction. Many companies and governments, like that of Estonia, are adapting this technology because it is a secure way of record-keeping for other purposes, such as health records, marriage and birth certificates, taxes and property.

The new distributed ledgers would have different rules. For example, there would likely be an administrator who would have overall control over access and permission to transact. Each system would also have its own encoded rules of conduct.

Some Real-life Examples

Some payment systems like Coinify already use the blockchain to enable consumers to make guaranteed payments, via small businesses which act as merchants.  Within some payment networks, such as Lending DApp (see https://jessking1311.wordpress.com/2016/01/13/back-to-the-future-bitcoin-blockchain-and-how-marketplace-lenders-are-using-technology-to-overtake-banks-in-the-race-to-attract-new-lenders/), ordinary people can act as intermediaries to guarantee that the terms of a contract have been fulfilled. Or the computer programme can be designed such that it recognises e.g. when a certain number of hours have clocked on a timesheet.

It occurs to me that this could be the solution to many of the problems in the banking system. Processing payments by the big banks like HSBC, RBS, Barclays et al. can take several days, even need, your money right away. Because they have to comply with so many regulations, banks have to do a lot of checks to make sure the payment is for legitimate activity and by a legitimate entity.

Alternative, more immediate providers like Paypal charge a transaction fee for every payment they process. But a pretty insignificant one. And Paypal seems to be cornering the market in micropayments. What does blockchain and DLT have that existing providers don’t?

It struck me the other day that the systems in place to connect us with the money we have earned or need to conduct our life and business are grossly inefficient.

I was waiting for a sum of money I had collected from a crowdfunding platform, Indiegogo. But when I tried calling HSBC, I had to wait on hold for 20 mins. When I finally got through to someone, he did not speak enough English to process my request. Three times I told him I was waiting for a transfer to my account and if he could put me through to whoever was responsible for bank checks, that maybe the depositor was concerned it was an individual not a business account.

Three times he asked me ‘If I would like to make a transaction’? When I tried to contact Indiegogo to ask the same question, initially I couldn’t find the contact form. Eventually I got a response, and my money, after I Twitter-bombed the crowd-funder. But the point is that I couldn’t access my money when I needed it. I had to pay it out of my own pocket and then be tardily reimbursed.

Now I’m not saying we need to overhaul the entire financial system, but if the service is flawed it would make sense to encourage competing providers, like those using the blockchain network, to let individuals like you or me moderate payments for a fee that corresponds with their efficiency and success rate at doing so.

And I’m not the only one this thought has occurred to.

Back to the Future: Bitcoin, Blockchain and how Marketplace Lenders are Using Technology to Overtake Banks in the Race to Attract New Lenders.

4/12/15

Encumbent institutional investors themselves admit that they have a lot of catching up to do before they can compete with the ‘upstart’[1] marketplace lending providers. A Morgan Stanley research paper published in June discussed how banks were hampered both by their due diligence restrictions, and by the backwardness of their big data analysis techniques.

Because the new marketplace lenders have less operating costs, they are attractive to borrowers as they are able to offer lower commissions; their risk assessment criteria are less exacting than banks, and they incorporate demographic data into their analysis. Thus they are able to offer lower interest rates to interested investors.

Morgan Stanley analysts wrote: “Traditional banks excel at originating loans and underwriting credit, but are slowed by the batch process and portfolio approach to their deposit and loan legacy systems, which are the backbone of the US and global payments system, and by liquidity and capital rules.”

Disruptive Innovations

As well as raising the bar in big data analysis, both for existing users and in targeting potential loan seekers, many in the marketplace lending sector have enthusiastically adopted Bitcoin and the blockchain in their payments system.

BTCjam was among the first forums to facilitate lending in Bitcoin. Founded in late 2012, in 2013 it gained a wealth of sponsors in Ribbit Capital, 500 Startups, FundersClub and the Bitcoin Investment Trust. By the end of 2014, BTCjam had facilitated bitcoin loans of over of $10 million in value, with more than 100,000 users in over 200 countries. The fact that its due diligence procedure only goes so far as an “optional soft credit check” helps explain its popularity.

Bitcoin and BTCPOP both offer bitcoin-denominated loans, of the ‘instant’ and collateral-tied variety. Loanbase, formerly known as BitLendingClub, specialises in bitcoin loans to developing countries, where beneficiaries might not have a bank account.

Why Not Create A New Currency With Your Payments System?

Another start-up has created an entire new currency, LoanCoin, which appreciates as interest is paid on a loan. Once the interest and principal are paid off, the attached LoanCoin is destroyed and exchanged for a currency of the Coinholders’ choice, so the currency value is preserved.

Within the system created by the developers Lending DApp, aspiring loan issuers, or ‘officers’, can source and guarantee new loans for Coinholders and charge fees for their service. Financial institutions, marketplace lenders, and even individuals can act as loan officers; though their commission and the size of the credit or ‘Trust line’ extended to them is dependent on their credit record. Lending is also at the issuer’s own risk and in the event of default or missed payment, the loan officer loses their collateral.

The Trust line is calculated by applying an aggregate function to its collected weighted trust ratings. The network is thus able to draw on the accumulated knowledge of its participants when assessing a loan officer’s reputation and creditworthiness. Percentage of performance fees is dependent on the difference between the risk-adjusted performance of the loans selected by the loan officer, and the mean risk-adjusted loan performance of all loans in the network.

Lending DApp, with its innovative decentralised business model, which relies almost wholly on pre-programmed systems, is typical of the new hybrid marketplace lending product, where banks and what we loosely define as “P2P” lenders co-exist to mutual profit.

Smittipon Srethapramote, who covers the North American payments industry at Morgan Stanley, confirms this is a growing trend. He says “The fastest growing marketplace platforms are not really peer-to-peer but institutional investors partnering with tech platforms to cherry-pick borrowers, often with offline marketing.”

 What The Future Holds

Max Rangeley, who works for the Cobden Centre, a thinktank which has been charged with creating a Bitcoin exhibition for the European Parliament, explains how the Bitcoin transfer system, the ‘blockchain’, might be adapted for other purposes. One potential use is to allow users to better insure the asset they use as collateral on a loan.

“Transactions can be conditional on any event which can be programmed into the blockchain (or even other events, if there is third-party verification whether the event occurred or not). Smart property (property registered on the blockchain) can be used either as collateral or for repo loans, are when the “lender” effectively buys the property from the borrower and sells it back to them at the original price plus interest after a specified period of time.”

 

 

 

 

 

 

 

[1] https://www.morganstanley.com/ideas/p2p-marketplace-lending