The World Economic Forum discussed the topic of financial disintermediation in 2015, then again in 2016 and in 2018, the forum declared that “blockchain can no longer be ignored”. The best starting point for understanding why financial disintermediation is such a talked about topic and what this has to do with blockchain is to get a clear definition of what it is.
What is financial disintermediation?
As the word implies, disintermediation occurs when parties with excess funds (let’s call them ‘surplus entities’) directly transact with parties which are in need of funds (let’s call them ‘deficit entities’), rather than using an intermediary (i.e. a financial institution) to facilitate this process. Traditionally, financial institutions were important because they were able to diversify the risk of providing funds to deficit entities. In a world of disintermediated (or direct) transactions, it was hard for surplus entities to diversify as every time they had surplus funds and wanted to earn interest by providing funding to a deficit entity, they would have high search and research costs. Of course, surplus entities are also limited by the volume of funds they have. One deficit entity’s project may require all of the available funds of a surplus entity, or the surplus entity, on their own, may not have enough funds to get the deficit entity’s project off the ground. Thus, it is not hard to understand why financial intermediaries developed. These intermediaries could pool surplus entities’ funds (offering them a fixed interest rate on their deposit) and become experts in evaluating deficit entities’ funding needs. They could therefore diversify the risk of the entire portfolio of many surplus entities’ investments in all the deficit entities’ projects.
Many of you are probably thinking, well, wait a minute, when companies do IPOs, they directly acquire funds from surplus entities. This has been occurring for ages, so this doesn’t explain why disintermediation is suddenly a hot topic. You are correct. The relative share of funding provided by the capital markets is generally considered to be a measure of how disintermediated the financial system in a geographic region is. Nonetheless, the systems which were developed to maintain records of who owns which small chunks of what assets used to be complex enough that this was only worth doing with big, valuable assets. Blockchains and distributed ledger technologies are now making this so simple that individual borrowers looking to buy personal real estate can ‘crowdfund’ their mortgage via a platform with a pool of capital providers, who are all willing to fund a small chunk of the mortgage. The platform then keeps track of interest payments and apportioning the loan repayment to the respective lenders.
what does this really have to do with blockchain?
In fact, these kinds of peer-driven lending platforms which have sprung up as part of the disintermediation trend in recent years don’t even need to be built on blockchain technology. This can be done using other, modern technologies. There are also regulatory and structural drivers which have led companies to launch these sorts of platforms. The reason the regulators of major financial markets are particularly interested in blockchain is its potential to create a decentralised guarantee of trustworthiness.
It used to be the case that the reputation of a bank was a guarantee of trustworthiness. Nowadays, it is common knowledge that even the largest banks are at risk of failing in a major financial crisis. The complex interdependencies in risk exposures between banks have led to various measures to evaluate the stability of banks. The most important of which is the Basel committee’s methodology which is used to identify ‘global systemically important banks’ (G-SIBs) and to require those identified as such to meet additional loss absorbency requirements. Nonetheless, this evaluation process still does not address the core of the issue of banks being systematically inter-connected in a complex and opaque web of exposures. In reality, it is still impossible to say where the next financial crisis will emanate from and what consequences it will have.
To be fair, although the recent headlines about Australian banks have done nothing to inspire confidence in the reputation of our banks, none of our institutions are anywhere near being G-SIBs and Australia is highly unlikely to be the epicentre of the next global financial crisis. Still, there are reasons why having a decentralised, non-corruptible record of trustworthiness and creditworthiness might be useful. For example, the Australian government has announced the Australian Business Securitisation Fund to provide additional funding to smaller banks and non-bank lenders with the ultimate goal of encouraging lending to small businesses. This is because small businesses are an important part of the Australian economy – but they are often subject to neglect when it comes to lending as they are not necessarily the most attractive debtors for major banks to have on their books.
If a small business could reliably communicate its creditworthiness to a pool of potentially interested private lenders – without having to actually expose all of its financial information to every Tom, Dick and Harry who would be an interested lender – this could help the small business to get access to credit on a more flexible basis. It would also open up a whole new world of investment opportunities for private investors, as some of the peer-to-peer lending platforms have started to do, particularly in the mortgage space. This is all possible with a clever blockchain implementation. It’s use cases like these that threaten to make banks obsolete and which will change the game for regulators of the financial system. It is both daunting and exciting in terms of the potential it holds for a whole new world of finance.
“Blockchain threatens to make banks obsolete and to change the game for regulators of the financial system. It is both daunting and exciting in terms of the potential it holds for a whole new world of finance.”
Our view (and hope) is that the difference between the emerging business models and how we have conducted finance fore the past few hundred years will be that the information asymmetry that has existed in favour of financial institutions will be mitigated. It is currently still the case that banks ask anything they want to know about you - but you don’t know what they know about you or what they think of you. Financial disintermediation and blockchain technology holds the power to give consumers the reigns.
Blog by:
Dr. Christina Kleinau & Alan Hsiao