Software and the internet have had a relatively low disruptive impact on the financial services industry. Sure — consumer expectations have changed, and banks are doing what they can to match the online experience of the highly customizable, on-demand internet services people have grown accustomed to — but businesses models have persisted.
This is in stark contrast to the complete disruption experienced by many other industries, from retail commerce to hospitality to media. The music industry provides the clearest example of what this looks like, illustrated by the following revenue breakdown from the past 17 years:
In 2001, physical sales was virtually the only way to make money in music. By 2018, streaming revenue was growing by 34% Y-o-Y and accounted for almost half of global revenue, leaving physical sales a longing, derelict shell of its former self. The companies with dominant market shares today (Apple, Spotify, Amazon, YouTube) were not in the music business at the turn of the century. The internet changed the economics of the music industry, allowing new entrants with orthogonal business models to win the market.
In financial services, on the other hand, business models have not undergone a comparable transformation. While FinTech services are being used by substantial shares of retail clients in specific markets, most notably in China, FinTech companies have to date mostly found new niches — e.g. P2P lending platforms, crowdfunding, cross-border payments, and underserved clients, such as small businesses or people who lack a credit history — or they have cooperated with incumbents or big tech firms. Cooperation gives FinTech start-ups access to clients (through white-label, co-branded products) while in many cases reducing their regulatory compliance burden. In other words, FinTech companies generally use software to build out the existing financial system, rather than re-build it from first principles as streaming services did in music (or ride-sharing companies in transportation, Amazon in retail commerce, etc.).
Banks are hard to compete head-to-head with because they have resilient moats:
- Widespread distribution through branches.
- Monopolies on financial data, leading to unique expertise such as credit underwriting.
- Special status as regulated institutions that supply credit.
- Access to sovereign insurance on deposits (e.g. FDIC).
- Trusted brands of being safe places to keep money and manage finances.
Mobile apps and new data sources are beginning to eat at the distribution and data moats, but banks’ privileged positions in global economies are the result of a deep structural reality of our financial system: participation carries high counterparty risk. Today’s financial networks roughly boil down to messaging networks, where banks and other financial institutions are responsible for interfacing with those networks on behalf of their customers — sending the right messages and responding appropriately to messages received. To stave off excessive costs, financial institutions lean on trusted relationships with one another to efficiently manage capital flows, which exposes them to the risk that someone they do business with fails to meet their obligations. This risk is managed through regulation and centralization in a few of the most reputable financial institutions, and is passed on to the consumer in the form of high fees and restrictions when transacting outside of trusted channels. This pull towards the largest, most trusted entities strengthens big bank moats and helps explain why FinTech start-ups are in many cases forced to partner with incumbents rather than try to displace them.
It follows that incremental improvements, like better user interfaces and new data sources on the margins, are not powerful enough drivers to unseat major financial institutions. To disrupt the financial services industry, the underlying networks need to be re-architected to carry an order of magnitude lower risk. Only then might an alternative business model achieve enough of a competitive advantage to win dominant market share.
This is why blockchains are interesting from a financial services lens: they systematically lower counterparty risk in financial networks. They do this by providing guarantees around the execution of financial transactions, through the use of open source software and a public computational environment run by purely economically motivated actors. Blockchain networks are a foundation for a more transparent, secure system; one that relies on math, physics, and incentives instead of complicated inter-bank and regulatory relationships, and thus opens up new markets previously barred by the high amount of trust required for participation. And they are capable of supporting a superset of the types of financial interactions that are possible in our current system, allowing more choices around product, cost, and risk.
Today, there is a small but growing group of engineers and entrepreneurs who have realized this opportunity and are building financial services on public blockchains like Bitcoin and Ethereum. They are called decentralized finance (DeFi) networks and are mostly nascent, immature, and complex — one of the most well known examples, MakerDAO, has been called a Rube Goldberg Machine. They presently serve a small niche of businesses and individuals within the crypto ecosystem, providing payment services, credit facilities, exchanges, investment tools, savings accounts, and insurance and derivative contracts. They appear on the surface to carry more technical and regulatory risk than may warrant their long-term potential, and thus it is tempting to dismiss them as misguided efforts with no clear market fit.
However, blockchain-native financial services form the first segment of FinTech that truly has the potential to disrupt the core businesses of major financial institutions — savings, payments, lending, investing, fundraising, insurance — in ways that fundamentally benefit markets and consumers.
The unfair advantages of crypto financial services
Blockchains and the contracts that live on them are open source software projects. Like many other open source projects, including Linux and the internet itself, they evolve at the edges, through the decentralized efforts of many companies, entrepreneurs, and hackers worldwide. It took several decades for Linux to catch up to Windows, but today, Linux is the de facto operating system for cloud servers. This is because on a long enough time horizon, once an open source development ecosystem reaches escape velocity, there is simply too much omnidirectional momentum for any competing, centrally-planned software effort to keep up. The network effects around community support, infrastructure, and tooling are powerful.
Blockchains differ from existing open source projects in that they maintain a shared state. They function as global accounting machines that process financial transactions, the results of which are embedded in secure, public data structures. The validity of all transactions can be verified by checking that the blockchain includes a record of it. Nick Szabo described this record as living in computational amber, where the longer the record is stored in the blockchain, the more confidence participants can have that their actions won’t be changed without their consent. This allows for increased social scalability of financial systems: Because participants to blockchain transactions use a shared accounting system, there are less ways for them to harm one another. By providing stronger protective guarantees, blockchain systems can accommodate larger groups of people, on a global basis.
Blockchains also have programming languages that allow for the construction of ‘crypto contracts’, which are programs that miners execute as if they are regular transactions. The most widely used crypto contracts are multi-signature addresses on Bitcoin, which encumber bitcoins subject to signatures from multiple parties. Ethereum takes this concept a step further and allows developers to deploy custom crypto contracts that define arbitrary financial interactions. Because they live in computational amber, crypto contracts can expose extremely persistent APIs, where the code can’t be altered once the contract is deployed to the network, and because they run on a shared accounting system, they can be tightly integrated with one another. This tight integration property is known as composability, and has bred a design pattern of combining crypto contracts that each deliver unique services into a new service — without having to re-deploy and maintain the code bases of each of the underlying contracts.
So what we have is a new paradigm of financial computing that is based on open source software, carries an order of magnitude lower participation risk, and allows developers from different organizations to synergistically build on each other’s work. Practically speaking, the consequences of this new paradigm can be grouped into 3 buckets: open access, minimal fees, and novel assets, organizations, and markets.
Anyone with an internet connection can download and run open source software. Creating a crypto wallet — the crypto equivalent of a bank account — can be done without approval or permission from anyone (in about 30 seconds). This means that if crypto wallets can provide comparable levels of service to banks, they should at the very least win market share on the margins where people have trouble getting access to basic financial services. With 10x better service, they could become the de facto banking system for the internet economy. An early example of the type of access crypto wallets can enable is Abra, which uses multi-signature addresses with Bitcoin and Litecoin collateral to provide synthetic exposure to currencies and other assets to internet users globally. Through applications like Abra layered on top, crypto wallets become a gateway to a rich ecosystem of open financial products/services.
Open access applies to financial product/service providers, too. Crypto contracts often feature some participation aspect, where any capable party can earn fees in return for providing some service to the network. And if someone has an idea for a financial product that doesn’t yet exist, they can leverage existing crypto contracts or the underlying open source code to easily create it. This has a YouTube-like effect: In a similar way to how YouTube democratized the production of video content, crypto contracts democratize the production of financial products/services. The implications of this are far-reaching, and I suspect we will see markets for just about everything imaginable — likely including some that may never have been envisioned by financial institutions, but are useful to lots of people. Importantly, the value created by those markets will be shared amongst its participants and creators by merit, instead of being captured by a small and privileged group of legacy institutions.
By nature of being modular, combinative functions that execute specific financial logic, crypto contracts effectively unbundle financial services. Take asset management for instance — a service with many components including front office activities like product development, investing, transaction and order execution, transaction management, pre-trade compliance; and back office activities like transaction processing and settlement, custody, transfer agency, and securities lending. With crypto contracts, many of these component services can be dis-intermediated and reliably executed entirely by software, and a plethora of open source projects are being developed to do just that:
Asset managers build some of these functions in-house and outsource others to third parties including custodians, auditors, trading desks, and others. With open source crypto contracts that function like building blocks for developers, it eventually becomes trivial to spin up an asset management business at relatively low upfront cost. In other words, you no longer have to build out an extensive network of relationships within the financial services industry to get started — you can just deploy code and tap into open networks. This will represent an order of magnitude decrease in production costs for financial services, and should lead to healthier competition and savings passed through to customers.
In addition, there’s another factor that keeps crypto contract fees low: the risk of competitive forks. If a given protocol is deemed to be levying excessive fees, it’s trivial for a competitor to copy the codebase and lower the fees. To guard against competition from forks, protocols generally minimize fees to levels they feel necessary to sustain development and security. This dynamic puts consistent downwards pressure on fees for crypto contracts, incentivizing a healthy competitive environment.
In other words, both the fixed costs (infrastructure and development) and the variable costs (fees from multiple intermediaries) of running a financial services business are structurally lowered through a heavier reliance on crypto contracts.
Novel assets, organizations, and markets
Perhaps the most exciting prospects that crypto contracts offer are the new types of assets, organizations, and markets that they enable.
Crypto contracts allow for the creation of provably scarce programmable assets. Some crypto assets, like Bitcoin, are currencies, and others have been created to do a myriad of things, including to confer membership/governance/voting rights within a network, to assign ownership of real-world assets like commodities and securities, and to synthetically replicate the prices of real-world assets. Even at this nascent stage, it is already possible for any asset to be represented in some form or another by a crypto contract, a form factor which puts the asset on an openly accessible, low-cost, global accounting system. Once an asset exists as a crypto contract, it becomes easily interoperable with crypto financial services, allowing for efficient distribution, transfer, and liquidity aggregation. On a longer evolutionary arc, we have barely scratched the surface of the types of assets that are feasible, and the possibilities for how they can be used to drive economic growth.
Crypto contracts further allow for the codification of bylaws and cap tables. This means you can create a global organization — be it a legal entity in a given jurisdiction or an open source software project — and define its ownership, rules, procedures, and governance mechanics through crypto contracts. This gives organizations a toolkit for coordinating member activities in an accountable and verifiable manner, decreasing dependence on obscure local legal codes and enforcement traditions that struggle to scale across borders. In other words, crypto contracts bridge a large trust gap that has historically stood in the way of cross-border interaction. An example of one such organization is MakerDAO, a “decentralized autonomous organization” (DAO) that coordinates the management of a secured credit facility and a synthetic dollar-pegged asset called Dai. In its first year of life, MakerDAO originated over $240m of loans with zero counter-party risk, demonstrating the potential for DAOs to provide useful, open financial services to the global internet economy.
Finally, by operating on a previously unreachable part of the risk spectrum, crypto contracts allow for the formation of markets that used to be infeasible due to lack of trust, lack of access, or prohibitively high costs. A great example of this is IBISA, who has created a scalable alternative for crop micro-insurance. Historically, it has not been economical for insurance companies to cover the long tail of 500+ million small farmers, due to high overhead costs and low contract values. While mutualized risk was seen as a potential approach, mutuals have not scaled well beyond local areas because distant members have a hard time trusting each other. Using crypto contracts to provide transparent accounting, IBISA has created the world’s first incentive-compatible mutual for crop micro-insurance. Nexus Mutual is taking a similar approach for smart contract insurance, another area that no big insurer is willing to cover. These examples underscore the unique ability of crypto contracts to bring the market model to places where it has never before gone.
In sum, by operating on financial networks with qualities distinct from our current dominant networks, crypto contracts have advantages that traditional financial services providers can’t match because their business models are incompatible. If systems built on crypto contracts hit escape velocity, their open, verifiable, and cheap nature will allow them to scale to every corner of the internet, and they will win on the margins by covering markets that today’s financial institutions can’t operate in. In other words, crypto networks have the potential to do to banks what the internet did to big music companies over the last 20 years: eat them alive.
So where are we today, and where we go from here?
Make no mistake, we are in what is perhaps the first inning of a multi-decade evolution of crypto networks. Today, most crypto systems are highly experimental and will teach us a lot about optimal market structures for capital formation and productive deployment. It is easy to pick any individual experiment apart and find flaws, and pundits are quick to jump on opportunities to do so. But it is becoming increasingly clear that blockchains and crypto contracts are the most promising means of architecting a more efficient and secure way to coordinate financial services in a global, networked world — a view that is supported by major new entrants like Libra, Telegram’s TON, and the Chinese central bank’s digital currency initiative. That is why, despite a 2018/2019 bear market where crypto prices declined some 70–90% across the board, the number of full time developers working on open source crypto software grew by more than 2x (see Electric Capital’s H1 2019 dev report). Over the same period, open lending protocols on Ethereum originated more than $600m of loans — during what many insiders would call a beta phase of the first version or two of their live contracts:
However, despite early signs of traction for crypto financial services, there remain significant challenges ahead, including blockchain scalability, user experience, and a general lack of understanding of crypto contracts and their value proposition. As for scalability, layered architectures with state channels (and other techniques) are being used to increase the transactional capacity of major blockchain networks, including Lightning on Bitcoin, and Plasma for Ethereum, among others. In addition, over the next several years, Ethereum will move to a sharded database model, parallelizing transaction processing across more than 1,000 blockchains, which should provide a scalability increase of several orders of magnitude. There is also substantial research going into off-chain computation, using zero-knowledge proofs and other privacy technologies to push more computation off of the blockchain while preserving its trust benefits. Together, these new architectures and technologies should allow public blockchains to scale by several orders of magnitude, eventually allowing them to process enough transactions for most financial use cases.
At the same time, the user experience of these applications and networks is steadily improving with time. Custodians (like Anchorage) and software providers are rapidly improving private key management workflows and key recovery procedures, and browsers and hardware providers are beginning to ship crypto-native products designed for the nexus of security and usability. With enough time, the nuances and frictions presented by public blockchains will be abstracted away from the end user, who may not even be aware that their financial services run on blockchains. One day, blockchain-based financial services will set a new standard for user experience, propelled by gains in transparency, trust, and security — properties that users will come to require once they have become familiar with them. In those regards, legacy institutions risk disruption unless they adopt the most secure blockchain networks as well — a change that will not come naturally, nor quickly — and therein lies the opportunity for fast-moving startups. As for our collective understanding of blockchains, perhaps it will evolve similarly to the way the internet did: at the beginning, only experts could grasp it; today, children have a nearly innate intuition for its capabilities.
Ultimately, it will take a long time for financial products/services built on crypto contracts to compete with major financial institutions. However, this may not be the most useful framing; rather, by occupying different parts of the risk- and cost-spectrums, and by being accessible to industries and markets that are neglected or underserved by the current financial system, crypto contracts will expand the size of the economic pie through what my colleague Spencer has called a parallel financial system. The most immediate customers are organizations and individuals in the crypto industry itself, who have a difficult time accessing basic financial services, due to lack of comfort from legacy institutions with new and unfamiliar business models. By providing open, transparent financial services to the long tail of disenfranchised parties, crypto financial networks have a large addressable market that enables them to scale without directly challenging incumbent financial powerhouses. By the time they do present a real challenge to Wall Street, it may be too late for successful defense, as the network effects of blockchain-based financial networks become increasingly difficult to overcome as they grow.
Finally, it’s worth emphasizing that many of the projects building on blockchain networks are public utilities. That is, their ultimate promise is to empower internet-connected, mobile phone-bearing humans to take control of their economic lives. In the world today, human beings in different parts of the world and the socio-economic spectrum have equal agency, but they don’t have equal access to opportunity (h/t to Alan Curtis at Radar). This disparity is one of the biggest drivers of an increasing wealth gap, both within nations and between them. Financial services built on crypto networks as public internet utilities — accessible to all and minimally rent-seeking — are our best hope for a world with more equal opportunity. That’s a world people will fight for, and now software has given them the tools for the job.