Financial services remain among the final frontiers for innovators, as yet untouched by the digital transformation sweeping other consumer-oriented service industries
Can an open protocol-based network technology transform a cartelized, oligopolistic and highly regulated industry by transferring power from large corporations to individuals?
This isn’t a prediction about the future—it’s something the world has already seen with what the Internet has done to the global media industry. There was a time when media corporations set the agenda for public discourse—the advent of the Internet broke down barriers and empowered individuals to express themselves and share information with unimaginable reach and unprecedented freedom.
Today, in most countries where a large segment of the population is connected to the Internet, it is netizens that drive public discourse and media companies are struggling to reinvent their advertising-based broken business models. The technological change wrought by the Internet has eroded the grip of old media brands and opened up for competition an industry that was prone to be oligopolistic, thus enabling entrepreneurs to create pioneers such as Twitter, Facebook and Google.
A new protocol holds the potential to transform financial services in the way the Internet changed media. Cryptocurrencies like bitcoin can disaggregate, decentralize and disintermediate financial services.
Cryptocurrencies could have substantive macro-economic effects as well. Nobel Prize winning economist Milton Friedman, aware of the dangers of unexpected deflation but still sceptical of the large discretionary powers that lie with politicians and central bankers, proposed the k-percent rule in macroeconomics that the central bank should increase the money supply to grow by a fixed annual percentage, as if automated and executed by a computer. While this rule proved too simplistic, the basic idea therein survived. Today, most central banks in advanced economies rely on—though not mechanically—some version of the Taylor’s rule, which builds upon Friedman’s idea by incorporating inflation, unemployment and other factors.
Now, technology has got us to a point where Friedman’s k-percent rule and its variants can be implemented without any risk of a political figure reneging on that commitment—a new gold standard, if you will. In this case, it is not metal that is mined, but computer processing power that is deployed for “mining" to increase the stock of cryptocurrencies. Such an increase in the underlying “base" (with the rate of increase declining over time in the case of bitcoin) preempts criticism about the dangers of deflationary debt spirals. Of course, technology is also affecting the basic axiom of modern Keynesian economics—that of price stickiness—because prices can now be instantaneously changed online.
In a 1999 interview, Friedman presciently said, “The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A"—the way cash can be transferred in the offline world between two individuals who don’t necessarily know each other. The great economist had seen cryptocurrencies coming well before even the Internet entered the global mainstream.
In the post-2008 financial crisis world, the notion of innovation in finance is treated with considerable fear and even contempt. After all, it is financial innovation run amok that resulted in the creation of complex securities and derivatives products, and even the issuers themselves sometimes barely understood the risks inherent to them. But there is a critical difference between that kind of innovation, and the kind of innovation cryptocurrencies can deliver.
Innovations in cryptocurrencies are, by definition, developed bottom-up and can only come into wider use by large-scale consumer adoption, while esoteric financial products that have been blamed for causing the financial crisis were developed by investment banks and traded by entities that most consumers would never even hear of. While the former is peer-to-peer, the latter was business-to-business; while the former distributes risk, the latter concentrates it. In a peer-to-peer system, there can’t be an entity that’s “too big to fail".
India’s banking and financial services industry has incumbents that are inert, sloth-like and highly risk-averse. The banking industry in particular is heavily dominated by public sector undertakings (PSUs). PSU banks still control approximately 80% of all deposits. The industry is rife with corruption and mismanagement, for government banks know that their owner will always bail them out. But this was not always the case—before Indira Gandhi nationalized banks with the stroke of a pen, over 85% of deposits in India were held by private banks. Since the nationalization of banking, all innovation in the industry has come to a standstill.
For 2013-14, 63% of the total number and 35% of the total value of retail transactions was electronic. Average electronic transaction value has nearly tripled in four years, according to data from the Reserve Bank of India (RBI), India’s banking regulator. But Indian banks cartelize and lobby their regulator to punish consumers with outdated usage practices totally out of tune with the needs of mobile transactions and electronic commerce. Instead of prodding the banks to improve their fraud detection and redressal systems, RBI simply makes it harder for consumers to transact and introduces artificial friction by way of two-factor authentication requirements so that banks get away without having to improve themselves.
In contrast, the digital and peer-to-peer nature of cryptocurrencies such as bitcoin means that they offer a frictionless experience. Of course, it is possible for Indian regulators to destroy all prospects for cryptocurrencies by sheer force of diktat, but so far the authorities have wisely decided to wait and watch—wise because cryptocurrencies can precipitate change and bring accountability to an industry that even optimistic reformers have given up on. In other countries too, regulators are taking a cautious but largely hands-off approach.
Bitcoin has its share of critics in India already—Swadeshi Jagran Manch ideologue S. Gurumurthy recently panned it—ironically enough, on Twitter—as something that can “only be a financial disaster...only mad theories can support it."
Besides enabling transactions with reduced friction and at lower cost, there are certain applications of the protocol that can enable altogether new use cases. Cryptocurrencies can be used to write “smart contracts", or contracts that are digitally written and require no third party for enforcement. The value of this application is difficult to overstate in an environment like India, which the World Bank ranks 186 out of 189 countries globally on the enforceability of contracts. Given the slow, dysfunctional judicial system and the paucity of social capital, individuals have historically preferred to do business with people already known to them, or people who are from their own community.
An alternate approach, outside the present broken system, that offers “self-executing", tamper-proof contracts and does away with the need for third-party intervention for mediation or dispute resolution, could be truly transformational for countries like India by collapsing business risks and transaction costs. Cryptocurrencies like bitcoin could help dramatically improve contract enforcement.
Consider a bank that gives a secured loan to a person wanting to buy a car, on the assumption that the person will pay for the asset in a fixed number of monthly instalments over a period of time. If the person fails to pay the monthly instalment in any month, the bank reserves the right to take back the car. When a person has reneged on such payments, Indian banks have been known to send strongmen and professional bullies as recovery agents to intimidate and threaten customers and even the relatives of such customers. With an integrated software solution built into the car that verifies whether the monthly instalment has been deposited, a self-executing contract could remotely brick the car, making it inoperable by the consumer should he fail to make the payment. The software “key" to activate the car again would lie with the bank, which can then take possession of the asset easily.
Another game-changing application for cryptocurrencies specific to the Indian context is in the area of remittances. In 2013-14, India received nearly $70 billion in remittances from abroad. The volume of intra-country remittances is estimated to be some ₹ 75,000 crore annually. In this digital age, anachronistic and expensive modes of money transfer such as the money order persist. Not only would the cryptocurrency protocol applied to a large market such as remittances be lucrative, it would also be a tremendous service to millions of bottom-of-the-pyramid migrant workers, who have been able to get the latest smartphones for a low price, but are still deprived of cheap, efficient and user-friendly banking and money transfer services.
The Internet successfully disintermediated mass media; cryptocurrencies like bitcoin could do the same to financial services and banking, which remain among the final frontiers for innovators, as yet untouched by the digital transformation sweeping other consumer-oriented service industries.
Rajeev Mantri is executive director of venture capital firm Navam Capital. Harsh Gupta is co-founder of the India Enterprise Council.
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