[Clips] Whither Financial Markets on the Net?

R. A. Hettinga rah at shipwright.com
Tue Nov 8 09:00:20 PST 2005

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  Ariadne  Capital Journal - Through the Maze  Volume  5, Edition 3


 Whither  Financial Markets on the Net?
  by Duncan  Goldie-Scot


 The  economist Ronald Coase explained that firms,  and banks, only exist
 because of what he  called 'transaction  costs'. All this really means is
 that firms  have economies of scale. It is easier for a bank  to match
 borrowers and lenders than it is for each  of us to do it on our own. The
 optimum size of  a bank, following Coase, is determined by those  info
 rmation costs. Banks were at their biggest  and most powerful when info
 rmation costs were  very high. As the internet leads to plummeting  info
 rmation costs, banks will get much smaller - and  may even be completely
 unnecessary. It is not just  the Zopa model (www.zopa.com)  of matching
 borrowers and lenders via a website  but something much more revolutionary
 that  follows from this.

 But  that is running ahead of the argument. What I  will do first is give a
 brief overview of some  of the issues in banking, look at what is on the
 technological horizon, draw some lessons from the  history of banking and
 financial trading and then  make a few predictions about where the new
 technology  might lead.

  1.  Bank payments cartel
 I  was chairing some e-finance conference  a few years back when a director
 of one  of the big clearing banks said that he didn't  worry about the
 internet because it didn't  impact on his core business - 'the management
 of the money transmission  network'

  Payment  systems are big business. According  to the Boston Consulting
 Group banks  around the world are taking out fees of some  $228 billion
 dollars a year just for sending  money from one database to another over
 their  networks. In the US about 5% of the value  of an average purchase is
 eaten up in payment  costs. In the UK money transmission amounts  to almost
 1% of GDP or #4.5  billion.

  Don  Cruickshank, in his report Competition  in UK Banking, wrote:

 "Money  transmission services are  supplied through a series of unregulated
 networks,  mostly controlled by the same few large  banks who in turn
 dominate the markets  for services to SMEs and personal customers. This
 market structure results in the  creation of artificial barriers to  entry,
 high costs to retailers for accepting credit and debit cards, charges for
 cash withdrawals up to six times their cost,  and a cumbersome and
 inflexible payment  system that is only slowly adapting  to the demands of

 There  is a reasonable defence of the payment  systems cartel: the banks do
 need to co-operate  to make the model work: those databases do have  to
 talk to each other. But still, the  cartel will protect its profits so
 don't expect  any threatening innovation to come from the banks.  Paypal
 caught the banks napping and they  still don't know how to respond to that.
 It is  not just Paypal and Zopa though: there are other  options emerging.

 2.  Historical context
  If  we take a very long term view, some of  the underlying trends become


 At  the turn of the first millennium, there  were many private currencies
 but the  quality of the coins varied enormously.  For this reason coins
 tended to be used  locally as exchange was difficult. Trade  was limited.

 The  commercial revolution that started round  1100 created a demand for
 reputable money.  The more efficient mints exploited economies  of scale
 and drove their less efficient  competitors out of business. Governments
 were not slow to take advantage of the  situation. States had economies of
 scale  in enforcement and monitoring. They could  demand payment of taxes
 in the coins  the state issued. Doing so helped the  state to maximise
 minting revenues, the  tax base and its authority over local  and feudal

 The  dominance of state currencies took a  couple of centuries to complete.
 When  done, states had an effective monopoly  of money.

 We  can then roll  the clock forward to, say, 1995, and contemplate  the
 business  case for launching a private currency in the UK - perhaps  called
 Shillings .  First one has to build enormous printing  and minting plants.
 One needs an army  to defy the High Court and Parliament.  And then we need
 a huge marketing budget  to persuade merchants and consumers to  accept

 It  is clear that there are fairly substantial  barriers to entry to the
 private currency  market.

 But  technology has struck back. Today there  are various cryptographic
 protocols  that, with the internet, mean that  I can create a currency out
 of anything  I like, largely for free.

 I  can create a glob of bits that says  that I, the issuer and underwriter,
 based somewhere on the net, promise  to pay the bearer on demand x
 Shillings.  The issue cost is close to zero.

 Of  course,  it is another matter to persuade you to accept  it but the
 fact remains that I  can  create a currency, issue a currency, circulate  a
 currency, offer a free and instant payment  service  and take $228 billion
 of COSTS out of the global  economy.  It is only a matter of time before
 someone does  it.  Private currencies are on their way - and  it won't be
 the banks in the vanguard.  Mobile phone minutes, air miles, loyalty
 points are all forms of money as soon  as they are made fungible -

 In  his  books on the history of banking, Ron Chernow  illustrates the
 trends in banking by looking at  the changing relative  power of borrowers,
 lenders and middlemen. In  the  18 th Century Wilhelm IX, the local
 nobleman  and landgrave of Hesse was the heir to an enormous  fortune. A
 certain Mayer Amschel Rothschild used  to grovel in front of this man, to
 bow and to  scrape. Ultimately, Rothschild was rewarded with  a monopoly of
 negotiating the numerous and highly  lucrative state loans issued by
 Wilhelm. In this case, the  provider of capital was powerful. The banker
 was powerless as Wilhelm could have shut him down  with a grunt or a nod.
 The consumers of capital,  impoverished European noblemen, were also
 largely  powerless.

 A  hundred years later, in 1840, Chancellor  Otto von Bismarck stayed at
 the Rothschild  chateau at Ferrieres during the siege  of Paris in the
 Franco-Prussian War.  Even the Kaiser was dazzled by the wealth. Within a
 century, the Rothschilds,  once the obsequious servants of monarchs,  had
 grown to be their equal, able to  thumb their noses at the Kaiser and
 other minor characters on the European  scene.

 What  happened was nationalism, the nation  state. Governments have an
 insatiable  appetite for money for wars, economic  development and
 pandering to special  interests. The histories of the great  banking
 dynasties are full of episodes  in which they daringly raised money for
 cash-strapped governments.

 There  were just a handful of these great banking  dynasties. Perhaps the
 greatest was J  Pierpont Morgan. His forte was acting  as a middleman
 between British investors  and American borrowers.

 His  power stemmed not from the millions he  personally owned but from the
 billions  he could command or lay his hands on.  The pockets of capital
 were small,  few and widely scattered and he became  a crucial
 communications node matching  the two sides of the banking equation.

 In  the early 1900s, most US companies were  small and local and were far
 less known  than the giant Morgan. The main thing  that a Morgan could
 confer on a fledgling  company was not so much his capital as  his cachet,
 his reputation - a signal  to jittery investors that they could  safely
 invest their money. He charged  handsome fees for the privilege.

 This  was a man for whom brand, above all reputation,  really did matter.

 By  1960 the providers of capital were accumulating  power over bankers in
 unit trusts, mutual  funds and pension funds. Companies were  relying less
 on the traditional banker  and had a choice of different capital
 instruments. For the first time in the  20 th Century the banker
 middleman's  power is dwarfed.

 It  is that  shift of  power that  explains why  100 years  ago the  image
 of  a banker  was of  a rotund,  grim, humourless  man in  late middle  age
 with  iron-grey hair,  wire-rimmed spectacles  and a  permanent scowl.  His
 role  was to ration  scarce  credit  and  charge  a  hefty  fee  as  the
 middleman.  The  banker  today  is  slight  by comparison - mere  salesmen
 dispatched  to scatter  bountiful credit.

 As  money and credit are banal commodities  the role of the banker as the
 middleman  between borrowers and lenders has become  powerless: there are
 bountiful means  of exchange in an interconnected world. Even hedgefunds
 are now dabbling in commercial  lending.

 Capital  markets
  The  capital markets  will change  in a different  way.

 Towards  the end of the 18 th century, investors  would sit under the
 buttonwood tree on  Wall Street and gossip about the market.  When it came
 to trading, when a price  was agreed, trading, clearing and settlement  all
 took place in one seamless, costless  transaction. I would hand you a stock
 certificate and you would hand me cash.

 This  model began to change when Samuel Morse  perfected the telegraph in
 the mid-nineteenth  century. Investors became enthusiastic  adopters of the
 new technology, the Victorian  internet, and used it to trade from afar  on
 the most liquid market, Wall Street.  Suddenly those quaint, cheap, instant
 and secure bearer transactions were open  to delay, clearing and settlement
 risk,  repudiation, dispute and simple fraud.

 The  market's solution was to create an independent  third party to
 arbitrate errors and disputes.  Therefore, we established a rule-based
 clearing house, a regulatory system and  a legal system to deal with
 mistakes and fraud. In the market today, the ultimate  error handling
 routine is, 'And  then  you  go to  jail.'

 This  made economic sense. The advantage of  having an enormous pool of
 liquidity  in New York or London more than outweighed  the disadvantage of
 having settlement  delays and regulation. It was also very  good for
 brokers. Membership of the clearinghouse  was restricted to market
 intermediaries  and the club or cartel was able to agree  on high fixed

 So,  the telegraph, and the telephone, caused  a seismic change in the
 structure of  the financial industry.

 Technically  we can now trade person-to-person, digital cash  for digital
 certificates in real time over the internet without the need for a clearing
 house,  without the need for a central counterparty, and  without the risk
 of repudiation or fraud and  all achievable in a seamless, frictionless and
 costless way.

 Being  able to do it technically doesn't mean that it  will happen. But if,
 as many of us believe, it  is massively cheaper to do it this way, then  it
 almost certainly will happen. How long before  someone  has the courage to
 issue a digital bearer bond  on the internet? Their reputation really will
 be on the line.

 So,  I see four distinct phases of trading,  clearing and settlement. The
 transition from each phase to the next has been  caused by an order of
 magnitude or more reduction  in the total cost of trading, clearing and

 In  phase 1, the bearer phase, traders would sit  under the buttonwood tree
 on Wall Street  and swap bearer certificates for cash. Trading,  clearing
 and settlement is a single and costless  transaction.

 In  phase 2, the advent of the telegraph means that  Wall Street has to
 cope with long distance  orders. A regulator/clearing house has to
 arbitrate  disputes. Trading, clearing and settlement become  three
 distinct operations. The cost of sending my  Securicor van to your cage,
 and vice  versa, is offset by the liquidity of the marketplace.

 In  phase 3, the mainframe computer means that we  can immobilise and then
 dematerialise stock  into book entries in a database. Trading, clearing
 and settlement remain separate operations,  partly out of habit and partly
 because the clunkiness  of the bank payment mechanisms. Clearing and
 settlement in computerised databases is  cheaper than physical delivery but
 is neither cheap  nor simple: multiple message formats have to be
 processed in a steep hierarchy of connections between  participating

 In  phase 4, the invention of financial cryptography  and the dominance of
 the internet, as a  universal network, means that database  entries, and
 immobilised documents, can be represented in digital bearer form on the
 internet. Digital cash can  be exchanged for digital equity in real  time
 in a costless transaction. The processing  can be distributed on client
 devices meaning  that there are very limited hardware overheads. Trading,
 clearing  and settlement merge again into a single  transaction.

 3.  Conclusions
 We  have established that the banking  cartel exercises its power today
 over the money transmission network - extracting  $228 billion a year in
 fees. We can  look forward to new models, such  as Paypal, mobile phone
 payment  methods and many others, killing the  cartel.

 We  have established that government  control of money has slipped back to
 the market: the barriers to entry for  private currencies are simply too
 low  not to make it attractive.

 We  have also established that the banker's  role as the middleman matching
 up borrowers  and lenders had its heyday perhaps  100 years ago and has
 been in continuous  decline.

 Finally,  I contend that we will return  to bearer markets on the  net -
 digital  bearer markets overturning  all of our financial  structure.
 Because it can happen, because it will be massively  cheaper, and because
 there is money to be  made by making it happen,  it is only a matter  of

 If  you would like to know HOW to  issue a digital bearer instrument  on to
 the internet, come along  to a conference next February and  learn all
 about it. It is called Financial  Cryptography and the website is
 http://www.ifca.ai/ .

 Duncan Goldie-Scot is a director of  the International Financial
 Cryptography Association.

 Duncan  Goldie-Scot ) 2005 dgs at live.co.uk

 R. A. Hettinga <mailto: rah at ibuc.com>
 The Internet Bearer Underwriting Corporation <http://www.ibuc.com/>
 44 Farquhar Street, Boston, MA 02131 USA
 "... however it may deserve respect for its usefulness and antiquity,
 [predicting the end of the world] has not been found agreeable to
 experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'
 Clips mailing list
 Clips at philodox.com

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R. A. Hettinga <mailto: rah at ibuc.com>
The Internet Bearer Underwriting Corporation <http://www.ibuc.com/>
44 Farquhar Street, Boston, MA 02131 USA
"... however it may deserve respect for its usefulness and antiquity,
[predicting the end of the world] has not been found agreeable to
experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'

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