CNBC last week listed “Bitcoin’s 4 steps to Wall Street acceptance“, which was encouraging even for me. So far, not enough people seem convinced that bitcoin-like technology can revolutionize the current markets of plain old payment processing (bitcoin volumes supposedly surpassed PayPal’s last November, but are still only 1/40th the amount processed by Visa, according to CoinOwl), that I have a hard time even starting conversations on bitcoin-like technology applications in capital markets. In just the past 10 days here in Hong Kong, the South China Morning Post published what seemed like two conflicting articles: “Bye Bye Bitcoin” (“the bubble won’t last without Beijing’s approval”) and “Hong Kong gets the world’s 2nd Bitcoin ATM“. Another article this week pointed out the extremely lopsided holdings bitcoin “money supply” (30% held by less than 50 people and 50% held by less than 1,000) compares to that of Pyongyang, which isn’t globally known for its capital markets. As of 2012, Accenture estimated global stock markets would now be worth around US$40-70 trillion, global bond markets around US$100 trillion, and global derivative markets with total notional amount exceeding US$1,000 trillion. I think it is safe to say global capital markets are worth at least around US$200 trillion (about 3x world GDP), and that a cost savings of just 0.01 – 0.1% of that number is already tens of billions of dollars (perhaps a savings comparable to the entire GDP of a country like Luxembourg, Jamaica or Macau).
As with my focus on bitcoin as a payment technology, not a techno-anarchist substitute for gold, I use “bitcoin capital markets” to simply refer to long overdue technological advancements needed to make not just moving, but also allocating and investing, money as efficient as it should be in the 21st century. “DVP” (delivery versus payment) is certainly not a “household word”, but it is a minor technological step for an idea like bitcoin that can move banking from its current homes within billions of bricks to its future home on the equivalent of today’s e-mails, thumb drives, and Dropbox accounts.
Say you want to perform the absolute simplest and most basic task in capital markets: buying a stock or bond. As of early 2014, this still requires plenty of steps and overhead:
- Open an account with a bank or broker. I’ve done this in as little as 2-3 hours, but in some places, the paperwork can take days or longer.
- Fund the account with money. This can also involve paperwork and/or checking or wire transfer fees, and if the transfer needs to be made in another country or currency, small investors are often at the mercy of very poor exchange rates or high fees of the sending or receiving bank. A “DVP” account, as mentioned above, is an option for some larger investors.
- Now the account is ready to place an order to buy the stock or bond with the bank or broker. Stock orders can be routed electronically directly to a stock exchange, but bond orders are often shopped out in the inter-bank market and often still involve physical phone calls or manually typed messages.
- Once the order is executed on the stock exchange or selling trading desk, the trade is passed to the respective back offices of both sides for “settlement”, a process of exchanging the funds and securities which still takes between 1 to 3 business days.
- The stock or bond is typically held in custody by the bank or broker. Transferring them or any cash proceeds to another firm involves repeating step #2 in reverse, often with costs in time and money. This is just as well, since many of us do not have places to safely keep very valuable paper certificates, but can be a substantial cost for safekeeping.
Now consider instead that a few simple advances in bitcoin wallet technology allow us to hold both the cash and securities in electronic “crypto” format on our hard drives or flash drives.
- I have money in cryptocurrency form on a digital wallet on my hard drive, and want to buy bonds from you that you hold digitally in a wallet on your tablet. We agree on price and exchange “wallet addresses”, which act like e-mail addresses but are much longer and more cryptic (but still effortless to copy and paste).
- My software verifies the digital signatures on your software, confirming to me that a.) your bonds are genuine, b.) your software is a certified version I trust that I know will release the bonds to me as soon as it receives my cash. Similarly, your software verifies the digital signature on my software, confirming to you that: a.) the cash is in my wallet to buy your bonds, and b.) my software is a certified version you trust to release my cash to you at the same time it receives your bonds.
- The trade is settled over the network in minutes if not seconds, I have the bonds I want, you have the money you want, and we have plenty of time to go to the museum to see how bonds were traded in 1914 or 2014.
- Coupons or dividends automatically appear in wallets holding their respective bonds or shares – almost literally “e-mailed” directly to holders.
Electronic processing of financial transactions is of course nothing new – banks and brokers have already been using computer technology to streamline steps #1-5 of the “old way” for decades. I am young enough to have only started equity trading in the 1990s when E*Trade was already synonymous with making stock orders as easy as a few key strokes, but two decades later we still have stock exchanges, banks, and back offices, overhead that may all become obsolete if we can trade directly between digital “wallets”.
An eventual result of an advance like this will be a questioning of the role or even the fundamental necessity of banks. If a pensioner can hold $100 in her mobile phone as easily as a trader can hold $100,000,000 of bonds on a hard drive, why would anyone need an actual bank anymore? Rather than having to deposit money into a bank (with its expensive branches and other overhead), I will feel much safer holding money directly in digital wallets I can use and move as I chose. Rather than being limited by that bank’s choices of CDs, I can just as easily choose treasury bonds, bonds issued by Apple or Hilton Hotels, or shares in a real estate fund with my desired balance of risk and yield.
Changes like this may naturally sound scary and open to a wide range of criticism, but here are some points worth considering:
- Crime, money laundering, and tax evasion are supposedly why many advocates say bank accounts need to be harder, not easier, to open, and perhaps the main reason step 1 in the old way (and sometimes step 2) can be so onerous. This fear of course assumes that the current process of manual checks, gatekeepers, and KYC (know your customer) is really the most effective way to block illegal uses, but if the NSA can read all our e-mails already, is it really so difficult to track and data mine what all the different wallets in the world is doing and fish out likely wrongdoing? I would say an all-electronic financial system would actually make it far more difficult to hide illegal transactions, which can still be bridged relatively easily with much less traceable paper money.
- The older generation may feel more comfortable with their money in a bank than on their iPhones – but already people of all ages have gotten comfortable storing their photos on services like Facebook and other technologies my 83-year old great aunt has taught me things about. In Asia, the stereotype is that older people prefer paper cash to credit cards, and electronic cash and securities is in many ways closer to paper money than to statement accounts at large banks.
- Security is of course a big concern both ways: making sure someone doesn’t steal money or securities in my wallet while making sure I don’t lost access to it myself due to a forgotten password or hard drive crash. This kind of security is of course not new to electronic money: paper money or bonds are arguably far easier to steal or misplace than anything electronic, and electronic forms have many more choices for security keys and backup. Even if Google Drive or Dropbox begin holding so many of these wallets that they become “too big to fail”, that feared failure is far more preventable with appropriate disk backup practices and are far, far less scary and curable than such concentrations in current banks.
- Price discovery is arguably the main service provided by stock exchanges, but ECNs have been growing for decades and bond and currency markets have done far more volume than stock exchanges without exchanges. In the internet age, it really is not that difficult for me to Google search “highest bid on T 2.75 2013”, or for a company like eBay to specialize in aggregating bids and offers like a stock exchange with far lower cost.
- User sophistication and familiarity is, to me at least, the obvious reason we are at least years if not decades away from a world of direct finance as described above. Banks of course have little reason to make it easier for customers to trade directly with each other and cut them out of high fee businesses, but customers so far have not been demanding such efficiency yet either. It is hard to say if this is simple complacency with the current system as much as lack of imagination on how much easier it could actually be.
I believe the example of the streamlined transaction above is just the tip of the iceberg, and the potential for this kind of technology to revolutionize not just how capital is moved around, but also how it is allocated, risk managed, financed, and disclosed, can save the world far more than a few basis points on a >US$200 trillion capital market. Although I chose the SEO title “bitcoin capital markets” for this article, I hope it is clear that these changes are far more about bitcoin-like technologies than the speculative fixed pool of BTC21 million that is most famous for using it, and most importantly, I hope technology and transaction efficiency like this becomes mainstream soon, regardless what happens to Bitcoin.
For the photos of this post, I have chosen three beautiful images of paper coupon bonds from about 100 years ago, when I’m sure most of the financial world could not have imagined how bonds could trade or be paid out securely without paper certificates or coupons. If ink stamps were good enough then, shouldn’t digital signatures be far better now?