Thursday, November 27, 2014

The Democratic Disruption of Finance

LAGUNA BEACH – There seems to be no limit to the exciting possibilities that come from combining technical innovations, the Internet, and social media. It is a phenomenon that has been revolutionizing journalism and entertainment; and, by helping to overcome coordination challenges, it has also had political consequences in a growing number of countries – all of which means an ever-evolving set of opportunities and risks.

What is less appreciated, however, is the extent to which a broadly similar phenomenon may be starting to play out in finance, via a democratization process that could gradually reconfigure a notable part of the institutional landscape, particularly in consumer finance, while challenging regulators to adapt.

Bitcoin is the most visible – albeit far from a good – example of this nascent development, having attracted attention from specialists, regulators, and, slowly but surely, the public. But the crypto-currency phenomenon is far from the only example, and it is certainly not the most consequential one. Its impact, both actual and potential, is relatively limited when compared to ongoing attempts to enhance and democratize lending, borrowing, investing, and payments and settlements.

The underlying sequence of disruptive technology is historically familiar. A bold innovation suddenly lowers entry barriers for certain activities. Mechanisms emerge to enable a larger part of the population to participate in what is deemed desirable but, until now, had been hard to access. As the disruptive forces gain traction, existing business models face difficult adaptation challenges, and regulators begin to fall behind. The situation is often amplified by a natural human tendency to overproduce and over-consume hitherto restricted goods and services.

This, of course, is what has been occurring in media for several years. The result is a proliferation of platforms for producing, aggregating, disseminating, and consuming content. Falling entry barriers and lower access costs have significantly democratized participation, whether in production or consumption. And, as hard as they try, many traditional media outlets – especially those unable to claim quite distinctive content – find it increasingly difficult to compete.

Now something somewhat similar is starting to happen in finance as well, albeit at a less frantic pace and – at least until now – in a less disruptive manner. And, as with media, the main innovations are being spearheaded by those outside the traditional institutional setup. Most consequentially, an emerging cohort of technology entrepreneurs understand the power of online/social media innovation to disrupt components of traditional finance, and are now leading efforts that include behavioral scientists and finance experts.

Recall that Bitcoin started in 2009 as an attempt to produce a “better” currency, championed especially by those who mistrust central banks’ management of fiat money. These early adopters were joined by a growing number of financial speculators attracted by highly volatile price movements. But Bitcoin’s success, which remains highly uncertain, ultimately depends on it attaining sufficient stability to perform the most essential function of any currency (as opposed to a speculative commodity) – that of providing a relatively predictable medium of exchange.

Fulfilling that function would require a lot to happen. At a minimum, Bitcoin would need a more solid institutional foundation; and broad acceptance of it would require much greater clarity concerning regulatory and supervisory approaches.

More promising examples, albeit less well-known, may be found in Internet-driven lending and borrowing clubs or, more generally, the peer-to-peer initiatives in consumer financial services. By seeking to compress net interest margins, including through lower expenses and more efficient data assessments and aggregation, and by targeting an enhanced consumer experience, such empowerment schemes could serve to reduce the cost of financial intermediation while providing for fairer risk-pooling outcomes and better credit underwriting. Likewise, so-called digital wallets and mobile transfers are efforts to improve payments and settlement in a retail financial sector that gets a lot less attention than its institutional peers.

The prospects for each of these democratizing developments vary significantly, as do the probable cost-benefit equations. Much will depend on whether the underlying technology is stable and secure, trust is established, transparency is convincing, consumer protection is effective, new content is coupled well with strong distribution channels, and broad-based validation and institutional verification boost credibility.

Looking ahead, we should expect the underlying forces of innovation to remain strong. Some existing businesses will fend off disruptive threats, including through takeovers; others will adjust (for example, Walmart recently announced an expansion of its financial-services offerings); but many may well prove insufficiently agile. Regulators will also likely lag initially in their response to new structures and activities.

The challenges of getting this right in finance are considerably more difficult than they are in media; and the consequences are far more profound, given the centrality of finance to broad swaths of the real economy. Anyone who doubts that should recall how last decade’s securitization boom and bust – another example of a disruptive financial innovation that was over-produced and over-consumed – contributed to a credit and liquidity crisis that pushed the global economy to the verge of Great Depression II.

In their recent book, Google’s Jared Cohen and Eric Schmidt brilliantly remind us of the opportunities and risks afforded by multi-speed developments in the real and virtual worlds. Having redefined media, similar developments are slowly beginning to play out in finance – in a rather isolated way for now, but soon likely to start transforming how capital is mobilized and allocated in support of economic growth and employment. Individuals, companies, and governments would be well advised to devote more time and other resources to comprehending this important and transformative phenomenon.

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    1. Commentedatul baride

      The Virtual world seems to be growing the Multiplexed, Intricate ever expanding Rimless Universe on multiple axis over the fixed reality around. The wall around reality dissolving to connect the virtual World .
      Its a vary apt topic for economic world, too

    2. CommentedBarry McHugh

      There are many forms of innovation that may affect finance. For example, the G20 is presently interested in curtailing tax base erosion and tax avoidance techniques classified as profit shifting (BEPS). If BEPS could be significantly eradicated, perhaps the G 20, IMF, OECD and World Bank could move to measuring indebtedness as Government debt to Gross National Income, and remove references to Government debt to GDP. That would favour developed nations that have more foreign income but they also have a lion's share of debt. It would also, if all offshore income were identified, turn the tax problem into a benefit (?) as the more avoided offshore income brought to the tax net from offshore, the better their debt to GNI number would look. Better still, do away with the GDP, GNI distinction, and just use one measure (how, I don't know).

      To make this work, some portion of offshore income would need to be required to be repatriated to the county whose business controls it, as much of the offshore incomes are specifically exempted from tax where i.e. it is derived manufacturing income rather than finance, or where the offshore county’s tax laws are broadly similar to that of the business’ country.

    3. CommentedProcyon Mukherjee

      The core purpose of finance is monetary intermediation or lending to be precise, which is the fundamental source of money creation that makes the engine of growth possible. This intermediation allows the objectives of savers and borrowers to be so balanced that the Pareto principle of efficiency could be attained (no one can be made better off without the other being made worse off). Unfortunately too much credit seems to be flowing where it is already in surplus, while the deprived places seem to continue in depravity.
      The question is whether all of today’s technology could widen the scope of finance and make penetration deeper into those stranded land of depravity where credit cannot be extended as collateral is non-existent or the taker’s ilk have no prior history in borrowing; how could technology help to bridge the gap or solve the dilemma that every loan approver would face in the daunting task of allowing credit where credit worthiness can only be tested in the future. The zones of depravity of the world could be converted by the touch of credit that many other forms of aids have failed to construct; risk management in this area has so much to be done proactively but the payoffs could be huge if successful.

    4. CommentedMarc Laventurier

      Ever astute, Mohamed ticks off key functions & conditions required to support peer-to-peer transactions, financial or otherwise. But what if the new process or institution that would disintermediate commercial incumbents and provide more advanced services was a sort of not-for-profit information utility?

      There is currently a lot of hype about Big Data and Cloud Computing, technologies that have been in use by national 'intelligence' agencies and large corporations for decades. When the marketing smoke clears, it will be obvious that a secure, centralized real-time model of the characteristics, interests and activities of voluntarily aggregated individuals will afford efficiencies, conveniences and economies never before possible. (The two Google guys, Eric and Peter, know this, but they're too busy in the lab engineering a $19.99 robot hooker. Rust never sleeps.)

      Tim Berners-Lee has been promoting the Semantic Web wherein standardized and interoperable computer models of any describable phenomena, from everyones' personal genetics to individuals' daily activity and academic interest can be defined, supported, refined and coordinated, almost automatically. It might, by virtue of its' integrity, utility and participatory human universality, constitute the foundation for a new cultural and economic order wherein 'growth', 'employment' and social capital have much different meanings.