A Startling Prediction, Revisited: New Banking Revolution Based on DLT
Juan Villaverde is an econometrician and mathematician devoted to the analysis of cryptocurrencies since 2012. He leads the Weiss Ratings team of analysts and computer programmers who created Weiss cryptocurrency ratings.
One year ago, we made a startling prediction: That today’s banking system will be transformed, and potentially replaced, by the technology that powers cryptocurrencies.
Now, key elements of that prediction are beginning to come true. So here’s a refresh and update …
Today’s banking system is an opaque web of intermediaries and third parties that stand between you and your money.
Moreover, as I’ll demonstrate in just a moment, they’re gutting the income on your savings, while gouging you for interest on your borrowings.
But in today’s modern financial system, you have no other choice. Without a bank or bank equivalent, it’s extremely difficult to deposit your paycheck, use a credit card, make money transfers, or just write checks to pay your regular monthly bills.
Even if you never shop online, there’s no other way to fully participate in most modern economies.
Why? Because for any of these services, you first need a bank to digitize your money.
The banking industry monopolizes all the key digital functions: It converts your cash into digital form. It makes digital transactions on your behalf. And it converts your digital money back to cash.
But all at a huge, stealth cost to you!
Right now, for example, the U.S. Federal Deposit Insurance Corporation (FDIC) reports that U.S. banks pay savers an average annual yield of only 0.18%% on their money-market accounts. That’s even lower than it was one year ago.
Meanwhile, according to the latest release from the U.S. Bureau of Labor Statistics, year-over-year consumer price inflation is 1.70%. Worse, core inflation, which excludes gasoline prices, has just a hit a 13-month high of 2.4%.
So do the arithmetic: If you’re an average U.S. saver, you get 0.18%, but you lose 2.4% to inflation. Your net yield is 2.22% below zero!
That’s about twice as bad as it was one year ago!
It means that …
Instead of giving you a return on your savings, America’s banks are charging you more than two full percentage points per year for your liquid money. Then, they invest your money as they see fit, taking 100% of the return.
If you think that’s abusive, consider how much the average American consumer pays for borrowing money, especially via credit cards:
According to Bankrate.com, the average interest rate on credit card balances is 17.77%, and that’s before compounding! When you consider interest on interest, the overall yearly rate can quickly escalate beyond 30%.
Your interest payments and other fees are then divvied up among multiple second and third parties, including banks, credit card issuers, payment processors and others. Plus, a big chunk of the money goes to cover credit card delinquencies and fraud.
In sum, you get the raw end of the deal from both sides — as a lender and as a borrower.
This is insane.
What about the Great So-Called 'Fintech Revolution'?
Sure, it has created new efficiencies. But it has also helped …
Spawn the creation of more and more intermediaries …
Open the door for many to merge or be bought out, and …
Give a handful of mega-institutions highly concentrated control over your money.
Many of those same institutions have taken unprecedented risks with your savings, especially in the realm of big bets called “derivatives,” a primary culprit in the 2008 debt crisis.
According to the latest report by the U.S. Comptroller of the Currency (OCC), U.S. banks hold USD 201 trillion in derivates contracts — leveraged bets on interest rates, foreign currencies, stocks, commodities and more.
Worse, just four megabanks — Bank of America, JPMorgan Chase, Citibank and Goldman Sachs — control a whopping 88.3% of that USD 201 trillion.
That’s even more insane: A lot of money and a lot of risk in very few hands — the ultimate in centralization!
And it’s mostly with your money … for which you’re getting less than nothing in interest.
DLT-based financial system
One of the few ways to restore some sanity is a financial system based on Distributed Ledger Technology (DLT). It’s what we now call Distributed Finance, or DeFi.
Consumers are king. Their money talks loudly. They retain direct control of their assets. And the burden is on financial institutions to produce safe, positive returns.
In a DLT-based system, financial institutions can still play an important role. But you always have the option to digitize your assets without them.
If any institution fails to give you an acceptable return, you have an alternative: You can readily take possession of your assets by transferring them to your personal wallet.
In this system, the concept of banks failing to compensate savers for the annual inflation rate is unthinkable. To survive, banks have no choice but to provide a fair return.
Better yet, a 2008-style meltdown is also hard to imagine. The diffusion of power and the diversity of participants would strongly militate against it.
I repeat: Allowing consumers to digitize and retain possession of their own assets can greatly help restore sanity to the entire financial system.
Peer-to-peer lending platforms are where this revolution has begun
Cryptocurrencies have sought to reinvent the way the financial system works by restoring direct possession, ownership and control of assets to the user.
Good. But they miss a fundamental fact of life: The world economy is driven by credit formation.
This is why crypto critics argue that bypassing the banking system would be disastrous. If enough people began hoarding money in their digital wallets, they warn, credit markets would shrivel, and the global economy could collapse. True, but …
No one in the crypto world advocates hoarding. Instead, in the world of DLT, credit markets are safer, and will one day be larger and more efficient.
Why? Thanks to peer-to-peer lending platforms, such as Compound or DyDx.
Imagine a kind of Facebook or other social media platform dedicated mostly or entirely to matching up appropriate borrowers and lenders.
Imagine all participants on this online platform obeying clear, transparent, strict and immediately enforceable rules of conduct, risk and reward — all built into smart contracts.
And then imagine how many billions of people it could serve, how big it could grow and how beneficial it could be for the global economy.
Our advice to banks: If you can’t beat ’em, join ’em!
There are three possible ways peer-to-peer lending platforms will evolve:
• They could take business away from traditional banks, ultimately replacing many institutions.
• They could evolve in parallel with banks, each side mostly restricted to its own sectors. For example, although both peer-to-peer lending platforms and banks can handle loans of all sizes, the former may be better equipped for large quantities of mini- and micro-loans, while the latter may be better able to handle the larger loans. We can see this today where the average loan on Ethereum’s credit platforms is 1456 USD.
• Or many banks could adopt these platforms and integrate them into their systems, charging a nominal transaction fee. They keep the customer. They focus on aggregating various categories of loans into portfolios. Plus, they provide money management, trust services and more. We’re already seeing a number of crypto companies adopt this business model.
Which scenario will it be? Probably a mix of all three. But sooner or later, some bankers will realize that, if you can’t beat ’em, you may as well join ’em.
What we may wind up with is peer-to-peer lending platforms that are open to the broader public alongside banks and funds that analyze, categorize and aggregate loans into a wide range of portfolios. Or banks may try to co-opt the concept and create their own peer-to-peer lending facilities.
No matter what, credit and lending have been around for thousands of years and they’re not going away. Healthy credit markets are a cornerstone of advanced civilizations. That’s not going to change, either.
The main difference is that with DLT, although intermediaries can provide valuable services, they are no longer absolutely needed.
The benefits will be obvious …
Benefit #1. You regain direct control over your assets. Unless you voluntarily choose to entrust your money to a bank or a fund, only you control it, and nobody can gain access to it without your explicit permission. This alone helps greatly reduce three frightening trends that have had a big impact on recent economic history: The concentration of wealth control, the risk of black swan events and the likelihood of contagion.
Benefit #2. Most of the interest paid by the borrower goes to you. Intermediaries can still make money. But if you’re the one putting up the dough, you’re the one entitled to get most of the return.
Benefit #3. You don’t give up so much of your returns to cover defaults and fraud. When it comes to sniffing out bad credit risks and bad actors, DLT-based smart contracts are likely to greatly enhance the accuracy and efficiency of credit reviews. This doesn’t mean credit analysts and loan officers go away. But more of their time can be dedicated to helping engineers build smarter smart contracts or to perform higher levels of due diligence that smart contracts cannot cover.
Benefit #4. Transparency. Even after you’ve sent your money off to a borrower, it doesn’t get lost in a maze of banking transactions. Like tracking your FedEx package, you can see exactly where your money is, who’s got it, and what they’re doing with it.
Remember: A distributed ledger is an immutable record of true transactions. So you no longer have to rely on a financial institution’s delayed reporting of summary numbers. Virtually all the detail you might want about your investment or loan is just a few clicks away. Even if the bank is still responsible for allocating credit, with DLT, it will do so in a more public and transparent manner.
Ethereum currently leads the way. So far.
The best example of the platform that’s taken a clear leadership role in this area is Ethereum.
What’s exciting is that we’re seeing more of these protocols emerge to the point where we can state that DeFi — especially decentralized lending platforms — is one of the fastest-growing sectors in the cryptocurrency space. It’s also one of the first real-world applications of smart contracts we’ve seen to date.
These protocols are growing at an accelerated space, giving depth and complexity to the crypto markets that we haven’t seen before.
The best part is that the increased competition from DeFi platforms should give banks an incentive to sweeten the pot. They will be pressured to offer you better returns for your savings and lower rates on your loans.
Plus, they should be able to give you access to platforms that let you lend your money to your choice of funds or individuals.
Just remember that it’s still very early in this game. A lot has to happen before this kind of transformation takes hold and becomes widespread. But it’s precisely at a time like this when smart investors can get in at the lowest prices and make the most money.