The Future of Fintech: Part 1

Part 2 can be found here. The full article in PDF form (easiest to read by far) can be found here.

Consumer and enterprise financial applications will become the first mainstream products built on public blockchain infrastructure. Current financial infrastructure is decades old but has been immune to disruption due to expansive regulatory and network moats. These moats have afforded finance firms some of the largest market capitalizations in the world: Wells Fargo at $200bn (regulatory moat), Visa at $500bn (network moat), the list goes on.

There are four layers to finance’s current stack:

• the vaults (commercial banks, such as Wells Fargo),
• the rails that connect the vaults (back-end payment networks, such as VisaNet),
• the APIs that provide access to either the rails (payment processors, such as Stripe and Square) or the vaults’ data (data services, such as Plaid),
• and the digital wallets that build on top of these third-party APIs (such as Venmo).

Certain firms hold positions in multiple layers of the stack. Visa owns VisaNet (rails) and Plaid (data APIs). Amex is a card issuer (vault) and owns a proprietary payment network (rails). Square builds APIs that give access to the ra-ils and forces users to use their application (the Cash app) to gain the benefits of those APIs. The entire stack will be disrupted by the triple accounting technology known as public blockchain infrastructure.

Image 1: Current fintech infrastructure

Public blockchains will disrupt each layer of the stack to varying degrees:

• Public blockchains allow for the vault and the rails to exist at the same layer, the blockchain itself, which allows for full-scale disruption of the rail layer.
• Public blockchains open-source the code necessary to transact on the blockchain and return access control of user data to the users themselves, the combination of which allows for full-scale disruption of the API layer.

Thus, the rail and API layers will be disrupted fully, so long as the vault layer achieves the minimum viable disruption of moving fiat currency onto a blockchain (Mainstream users will still wish to primarily transact with and lend stable fiat currencies, not volatile cryptocurrencies such as Bitcoin or Ether.). The process of moving fiat currency onto a blockchain is already underway due to the increases in efficiency that the technology provides over today’s current banking infrastructure. However, the methods of moving fiat currency onto a blockchain vary significantly, with each method posing a different degree of disruption at the vault layer.

The Future of Vaults

The vault layer’s disruption has three possible degrees, dependent on the method of ‘fiat transitioning’ used (Once fiat currency is moved onto a blockchain, it is termed a ‘stablecoin.’):

Minimal viable disruption occurs when a company issues fiat-denominated stablecoins on a public blockchain, with each stablecoin backed 1:1 by that issuer’s deposits at a commercial bank. These stablecoins are known as dollar backed stablecoins (DBSs).

Image 2: Minimal Viable Disruption

Medium scale disruption occurs when central banks issue their currencies directly on a blockchain (either on their own proprietary blockchain or as an asset on a public blockchain — the latter being unlikely, at least initially). These stablecoins are known as central bank issued digital currencies (CBDCs).

Image 3: Medium Scale Disruption

Maximum viable disruption occurs when fiat-denominated stablecoins become backed by on-chain assets at collateralization ratios deemed to be sufficient by a decentralized community of shareholders (a decentralized, global central bank). These stablecoins are known as fully collateralized on-chain stablecoins (FCOSs).

Image 4: Maximum Viable Disruption

Trust Dependencies

These three stablecoin solutions differ significantly in their trust dependencies, dependencies which directly impact the competition generated within the banking system by the solution (as shown in the following Competition → Efficiency subsection). For reference, current holders of digital fiat currency need to trust both that currency’s central bank (namely that the central bank will not inflate away the value of the currency) and that central bank’s corresponding commercial banking system (such that their deposit credits at commercial banks are always fully redeemable).

DBSs require users to trust both the traditional banking system and the issuer of the stablecoin. While the issuer of a stablecoin could be the same entity as the vault where the issuer’s deposits are held (which would equate the trust dependencies of DBSs to the those of the traditional banking system), commercial banks have veered away from this strategy, instead focusing on building private blockchains for intra and inter-bank settlements. Commercial banks have likely shied away from launching dollar-backed stablecoins due to the incumbent’s dilemma: the system works well for them as is; switching to a blockchain-based currency would eliminate their monopoly on inter-bank transfer fees, which they capture in every payment.

CBDCs reduce (with the potential to eliminate) trust in modern commercial banks but maintain trust in central banks (The term ‘modern commercial banks’ is used to to denote federally-insured commercial banks, the global standard.). CBDCs allow users to custody their own dollars electronically: whereas the modern banking entails digital credit, CBDCs entail digital cash. Thus, users have the option of removing themselves from the modern commercial banking system at scale, through either engaging in lending directly on public blockchains (becoming their own bank) or lending their funds only to commercial banks that use free-market insurance solutions (purposefully ignoring federally-insured commercial banks). For trust dependencies on modern commercial banks to be fully eliminated, all holders of a CBDC would need to exit via one of the two methods described.

FCOSs eliminate trust dependencies in both modern commercial and central banks, shifting trust toward a decentralized network of decision makers. Anyone can join this network of decision makers by owning the FCOS’s governance token. Holders of the FCOS’s governance token make the same decisions that central banks make with regards to collateral requirements (what assets can be used as collateral, what is an appropriate collateralization rate for these assets) and interest rates (what is the cost of taking a loan from us, how much do interest do we pay on excess reserves), as well an additional decision that central banks do not make: how to establish a decentralized, resilient oracle network.

Competition → Efficiency

Of note, all of the solutions increase competition between central banks that issue fiat currencies: the open nature of blockchain-based money renders foreign exchange significantly easier to conduct, while the bearer nature of blockchain-based money highly decreases the risk of confiscation of ‘foreign fiat’ by a local’s native government (which has happened frequently in the past to citizens of the developing world). However, the set of trust dependencies described above portend whether the solution generates additional newfound efficiencies within the banking system, under the assumption that competition leads to efficiency

DBSs, due to their increase in trust dependencies, do not create any additional efficiencies in the banking system. There may be marginal efficiencies created by shifting power in commercial banking to the vaults used by the most successful DBSs, but these marginal efficiencies would seldom be felt by users.

Unlike DBSs, CBDCs have the potential to further competition in commercial banking by allowing individuals to either be their own bank or use neo-commercial banks insured by free markets. Whether competition ultimately exists between commercial banking solutions (federally-insured vs. self-insured vs. free-market-insured) will be determined by consumer preferences and central banks’ wherewithal to remove their monopoly on banking insurance solutions.

FCOSs give users a viable exit from modern commercial and central banking. They are the first stable currency to do so; other exit options, such as Bitcoin or Ether, are not stable. Due to their existence outside of the traditional banking system, FCOSs can only be lent with the advent of free market insurance providers. Consequently, FCOSs have the potential to pressure central banks into enforcing that commercial banks adopt free market insurance solutions, should consumers signal their desire to hold a currency unable to be devalued through commercial bank malpractice (Commercial bank malpractice is often amortized across all corresponding fiat holders, as governments historically bail out their failed banks.). FCOSs also have the potential to pressure central banks to discontinue the devaluation of their currencies (measured through the decrease of treasury bond yields), as consumer interest in FCOSs could also signal mainstream desire to hold a currency unable to be devalued by central banking policies. Lastly, FCOSs are inherently self-competitive: their stakeholders can always exit via hard fork, creating a new decentralized central bank with a new governance token (and a new FCOS) that follows different risk parameters from the original. A hard fork can be executed with little technical overhead: the new FCOS could copy the old FCOS’s code nearly verbatim.

Theory into Reality

The degree to which each solution is adopted is not only a byproduct of trust dependencies and these dependencies’ corresponding efficiency improvements, but also a factor of implementation difficulty. Technically, each solution suffers little implementation overhead, as public blockchains and smart contracts have been under development for approximately ten and five years, respectively. The largest implementation difficulties entail those of distribution (DBSs), reputation risk (CBDCs), and the need for new entrants (FCOSs):

• Stablecoin issuers must find and convert users for whom holding a DBS is a magnitude order of improvement over their current banking options.
• Central bank employees must convince themselves that creating a CBDC is worth the career risk of failure.
• Insurance providers must be convinced to expand their offerings, such that FCOSs can be lent fractionally by neo-commercial banks.

Table 1: Comparison of Stablecoin Solutions

It will take a significant amount of time for one of these three solutions to emerge as the ultimate winner in the pareto distribution of stablecoin solutions. It is likely that all three will thrive in tandem for the foreseeable future, as all three provide significant advantages over the current market leader, the incumbent banking system. DBSs and FCOSs exist today (with more than $5bn and $100mn stored in each, respectively). CBCDs will be widespread within two years (possibly sooner, as China is prepared to launch their solution this year). All three solutions have the potential to benefit from exponential growth due to an awaiting flywheel effect triggered across relevant parties:

• If DBSs become adopted, large commercial banks will enter the market, which will further adoption, which will further the entrance of more large banks, etc.
• If CBDCs become adopted, prominent central banks will enter the market, which will further adoption, which will further the entrance of more central banks, etc.
• If FCOSs become adopted, an insurance provider/alternative-banking firm will enter the market, which will further adoption, which will further the entrance of more insurance providers, etc.

All three solutions also benefit from the network effects of liquidity:

• As more consumers use any of the three solutions, more payment processors will offer that solution, which will increase consumer adoption, etc.

These two exponential growth impeti have yet to be triggered, leading to the assumption that, in terms of adoption, we are likely at this point of the S-curve:

Image 5: Current S-Curve Position

Triggering the S-Curve

Currencies serve three primary purposes: to save (store of value), to pay (medium of exchange), and to account (unit of account). There are three types of users who will be most likely to switch to one of the aforementioned currency solutions, one because of blockchain-based currencies’ ability to enhance their ability to save, and the others because of blockchain-based currencies’ ability to improve the efficiency of their payments:

• The savers: Citizens of developing nations who do not trust their central banks due to past or current abuse. There are numerous nations with currencies suffering from annual inflation of over 10%.
• The payers: Businesses that conduct a significant amount of international transactions, as illustrated in more detail in the following Future of Payments section.
• The payers: Individuals (specifically migrant workers from developing nations) that conduct a significant amount of international transactions, as illustrated in more detail in the following Future of Payments section.

Certain impeti could also trigger adoption sooner than expected:

• Governments (such as China’s CPC) could enforce the use of CBDCs by Chinese businesses;
• Broad central banking failure could significantly bolster the value proposition of FCOSs;
• Negative interest rates could drive citizens of developed nations to adopt DBSs or FCOSs, due to their ability to earn positive interest rates with these forms of currency.

While DBSs currently account for 90% of blockchain-based currency market share, the adoption cycle is still nascent, as $5bn is infinitesimal compared to future market size. Due to governments’ ability to enforce CBDCs by law and the unique value proposition of FCOSs, both of these solutions have the ability to achieve viral adoption at almost any point in time.

No matter which blockchain-based solutions succeed at the banking layer, the rail layer will be fully disrupted.

Part 2 can be found here. The full article can be found here. Special thanks to March Zheng, Michael Stalder, Gary Thung, Maximillian Jungreis, and Ankit Goyal for their feedback.