The aim of this paper is to present the writer’s opinion on the historical and current events that have led to the development of two worlds: finance and distributed ledger technology (DLT). Whilst spanning several centuries of events, this article is intentionally broken down into accessible language and concepts to empower those who do not have financial or technological backgrounds to understand many of the coming financial changes that will likely affect them, both nationally and internationally. The article similarly discusses complex financial happenings that the financially and technologically savvy are likely unaware of at present. These events and inevitable changes will eventually impact the day-to-day lives of all citizens worldwide and how we interact with the financial systems of the future.
Table of Content
· The Basics
∘ What is Banking?
∘ Clearing and Settlements
∘ Wealth Creation
∘ What Are Digital Ledger Technology and Blockchain?
· Challenges of the Traditional Banking Model
∘ Currency Devaluation to Zero
∘ Currency Pairing, Foreign Denominated Assets and International Commodities Pricing
∘ Money Is Not Currency
∘ Good Money vs Bad Money
∘ World Wars and Trade Wars
∘ Quantitative Easing (QE)
∘ Uninsured QE Distribution
∘ Abnormally Low Central Bank Interest Rates
∘ Technological Impact on Product Innovation
· The Decline of Traditional Banking
∘ Faster Payments, P2P Mobile Transactions, Digitalisation and Contactless Payments
∘ Trade Optimisation Among Bloc Nations (SEPA, PSD1, PSD2, Open Banking, etc)
∘ Increased Operational Costs
· The Aligning
∘ Transaction Fees vs Customer Interest Payments
∘ Revamping National Clearing House Infrastructures
∘ The Depository Trust and Clearing Corporation
∘ Consortium-Led Financial Grade Blockchain Solutions
∘ Creating National Central Bank Digital Currencies (CBDCs)
∘ Circumventing US and NATO Monetary Restrictions
∘ Internet Currency Domination
∘ Decentralised Finance (DeFi)
∘ DeFi 1.0
∘ DeFi 2.0
A majority of people have bank accounts, and many bank with multiple institutions. The scope of understanding by most regarding the financial world is limited to the particular banking products and stocks which they trade back and forth via these accounts. This limited view prevents the average person from understanding the emerging opportunities outside the realm of traditional banking, as well as the limitations of the traditional banking and finance sector. This includes the reasons why traditional banks will be forced to radically evolve or soon become extinct. To comprehend such changes, it is necessary to first understand the fundamental purpose of banks, how they operate and the challenges that have been faced by nations that have operated as centres of financial trade over the last 80 to 100 years.
What is Banking?
Simply put, banking is the bookkeeping of funds entrusted to one’s care. Banks also find ways to generate income via various means using these entrusted funds. They act as conduits for the flow of currency across society. Governments and authorised financial supervisory institutions, for instance, central banks such as the US Federal Reserve, use banks to apply monetary policies that control the flow of currency in an economy. They do this by applying various tools, including interest rate changes, quantitative easing or quantitative tightening, for example. This centralised control of banking and financial institutions is why it is presently referred to as Centralised Finance (CeFi).
Clearing and Settlements
In the process of banking, transactions occur between individuals, businesses and financial institutions. The process by which these transactions are reconciled so that every participant and transaction are accounted for is normally termed as clearing and settlements. For example, buying vegetables at a supermarket using a debit card involves the buyer, the supermarket, the bank that issued the buyer’s debit card, the supermarket’s bank, the card processor (e.g., Visa, Mastercard) and the clearing network.
It is interesting to note that bookkeeping and banking both use ledgers, which take either a paper or electronic form. Blockchain technology is merely a type of digital ledger technology (DLT). We will delve deeper into this relationship later.
Banks typically create wealth through debt creation. This means they take a customer’s savings on which they pay out a small rate — e.g., 1–2%. The bank then loans out those funds at a higher rate — e.g., 17%. They generate a profit in currency from the difference — e.g., 15%. Companies and individuals that take these loans or facilities then exert themselves in order to make a higher return than the loan repayment of 17%, which would therefore enable them to pay off both the loan and interest. This leads to productivity expansion, and the company’s higher return becomes part of its economic expansion. In an environment where interest rates are low, there is generally an increase in low-cost borrowing, resulting in greater investments and expansion, for instance. This cycle is repeated over and over using both simple and complex financial tools — e.g., small loans, derivatives and other such tools. This in turn leads to wealth creation, higher public consumption and job creation. According to Investopedia, the global banking market stood at approximately $8.58 trillion as of the first quarter of 2021, while the actual netted value of the derivative sector as of 2021 was 12.4 trillion. Interestingly, the derivative market is larger than the banking sector. Much of the derivative market is based on trading the movement of an underlying asset without buying the actual asset. Combined, this amplifies the profits or losses based on the asset’s performance due to the amount of leverage applied. While leverage amplifies profits, it also increases the fragility of the traditional banking sector when a major banking or macroeconomic crisis occurs and affects those same assets. The resulting scenario is like a house of cards. The higher the leverage, the higher the stack of cards and possible contagion. This leverage has contributed greatly to the last few financial collapses.
What Are Digital Ledger Technology and Blockchain?
Ledgers have always existed. Historically, they have taken physically written forms, such as in books, and more recently have been recorded electronically via some digital medium. Ledgers have been called by many names throughout their history: general ledger, profit and loss ledgers, etc. Digital ledger technology (DLT) is merely the next iteration of the implementation of ledgers. Michel Rauchs et al. described a distributed ledger technology as:
“An umbrella term to designate multi-party systems that operate in an environment with no central operator or authority, despite parties who may be unreliable or malicious (‘adversarial environment’). Blockchain technology is often considered a specific subset of the broader DLT universe that uses a particular data structure consisting of a chain of hash-linked blocks of data.” (p.15).
Distributed ledger technology helps its users to store, distribute, and exchange data with the help of a private or public network of computers. There are many types of DLTs available. These include distributed acyclic graphs (DAGs) and the more commonly known blockchain technology. Each type has its own benefits and challenges, and each type of DAG, blockchain, etc, varies in its implementation approach.
In simple terms, a blockchain is a network of data elements linked together where:
· The data elements (blocks) generally consist of transactions and/or messages.
· Each data element (block) is chained to the prior data element, thus creating a chained network.
· Each chain segment (link) is an encryption of the data of the previous blocks and the links connecting them.
· Both the data elements and links are encrypted using an advanced mathematical formula.
· A copy of the chained network is present on multiple computers that run the network. This is why it is said to be decentralised — i.e., not running on one system, computer or server. It is not centralised.
The combination of these traits, as well as a few more, provides the network with a major component of its security. In order to corrupt the information in a block of data, one must hack and corrupt both the encrypted links and the data blocks that came before that singular piece of information.
For the purpose of this article, the term “blockchain” will be used interchangeably with “DLTs”, depending on whether the reference is to a specific blockchain or to the general category of DLTs. The important point is that they are all DLTs.
Now that you understand these basics, let’s delve deeper into these concepts.
Challenges of the Traditional Banking Model
Unfortunately, there are several present-day challenges that fracture the traditional banking model and have long since deemed it unsustainable. The list below is not exhaustive but it highlights a few of the factors at play.
Currency Devaluation to Zero
Throughout monetary history, hundreds of currencies have been created and debased. These include currencies that traditionally used coins, but where these same coins no longer hold their intrinsic value — take, for example, the Sterling Chilling. Of the 775 paper-based currencies ever created, 75% have declined in value “close to zero” or sunk to an unsustainable low percentage value of their original purchasing power. They are now “undesirable” as a means of financial exchange.
Examples of countries that at some time had failed currencies:
· Germany Weimer Republic 1922–1923
· Hungary 1945–1946
· Chile 1971–1981
· Argentina 1975–1992
· Peru 1988–1991
· Angola 1991–1999
· Yugoslavia 1992–1995
· Belarus 1994–2002
This is normally the result of a number of factors:
· The civilisation or nation has peaked in its ability to generate real economic growth and enters a period of stagnation, or they simply plateau against a continually increasing population size.
· Continual taxation increases by the governing authority in order to maintain expenditures previously funded by real economic expansion.
· Unexpected cost expansion resulting from repeated participation in wars, both local and foreign. This usually drains the treasuries as it diverts national resources and manufacturing capacities into these efforts with no guarantee of a return on expenditure. This also tends to lead to hyperinflation, which posed a common challenge for nations post-World War I and II.
· Finally, a dilution of the circulating currency is witnessed in order to again sustain and stimulate economic expansion. This also leads to national inflation and international currency wars.
The excessive printing of money by modern governments is not a recent strategy. One of the earliest recordings of the decline of currencies is referred to by some as “The Debasement of the Dollar of the Middle Ages”. This involved the degradation of the Byzantine gold coin during the reign of Constantine IX Monomachus (1042–1055), marking the end of more than seven centuries of near stability and the beginning of a sharp fall in the coin’s gold content.
“The Great Debasement and Its Aftermath” by Stephen Deng refers to the period in the sixteenth century when a similar example occurred in the United Kingdom (UK). Stephen Deng explained that:
“Between 1544 and 1551 Henry VIII and Edward VI systematically debased currency — replaced precious metal content of coins with base metals — for the sake of fiscal profit. With rapid population growth in the early sixteenth century straining the money supply, and with his military endeavours in France, Scotland, and Ireland producing fiscal pressure, Henry turned to exploitation of his coinage after he had already exhausted the bounteous resources he had acquired from the dissolution of the monasteries.” (p.87).
The key takeaway here is that currency debasement is a practice that governments and ruling monarchs have been employing for centuries. Some of the more recent names for currency debasements include: The money printer, quantitative easing and government bond buybacks etc.
The recent extreme printing of the US dollar has caused it to lose 96% of its value since the establishment of the Federal Reserve in 1913. More than 40% of all US dollars in circulation have been printed within the last two years since the emergence of the COVID-19 pandemic. It is important to note that in the same period, all countries globally have also resorted to currency debasement via currency printing. This is one of the main reasons for the global inflation currently being experienced.
Currency Pairing, Foreign Denominated Assets and International Commodities Pricing
Most debt assets in various countries are frequently denominated in the currency of a different nation over which they have no monetary control. For example, petroleum exports generated in Nigeria, Venezuela and other such countries are traded internationally in US dollars. Various other commodities produced in different countries follow a similar fate. This trend disfavours the individual countries involved in the trades and skews international financial security in favour of the nation issuing the dominant currency. This is presently the United States, even though many of these products do not originate from it.
James Chen outlined that In July 1944, Bretton Woods Agreement was established under the auspice of 44 countries that negotiated through their delegates to the United Nations Monetary and Financial Conference congregated in Bretton Woods, New Hampshire. The agreement introduced gold as the basis for the U.S. dollar, with other currencies pegging their currencies to the value of the dollar. In the same conference, the delegates established International Monetary Fund and the World Bank Group. Bretton Woods sought to improve currency convertibility between countries and enhance their cooperation against competitive devaluations, ensure stability in exchange rates, and boost economic growth. According to Michael Bordo, Bretton Woods became unsuccessful because of adjustment problems that caused price and wages and price rigidity, which interfered with the normal price adjustments to the gold standard. Likewise, adjustment challenges between the US and other countries due to the asymmetry of the pegged exchange rate system ensured the US did not have to adjust its balance of payments, leading to huge deficits that preceded the collapse of the Bretton Woods system. Liquidity problems were also a challenge given the abolition of the US balance of payments which other countries including Germany and France saw as a concern for global liquidity shortage.
In simple terms, most countries were indebted to the United States. As most countries held their reserves in gold, which was held in the US Federal Reserve, the US dollar became the actual representation of gold in fiat (paper money). This enabled the US dollar to fulfil one of the key attributes of money that gold could not: portability. This is why some denominations of the US dollar used to bear the words “PAYABLE TO THE BEARER ON DEMAND”. In 1963, these words were removed from all newly issued Federal Reserve notes. As more and more countries began to request repatriation of their dollars held as gold by the US Government, the US Government could no longer honour those requests because they had printed more dollars in circulation globally than they held gold.
Although the Bretton Woods Agreement ended on 15 August 1971, the strength of the dollar as the denominate currency for international trade had already been well established” and to this date, it remains the dominant currency.
Money Is Not Currency
Currency is not the same thing as money. Money is meant to be the economic reward of the output of labour which should vary based on the units of work performed. In society, the compensation for work is, however, expressed via currency. Presently, currencies are typically represented by fiat which, outside of being used as a medium of exchange, holds no intrinsic value of their own. Unfortunately, if a worker is paid in the same amount of fiat currency — e.g., $500 per day — but inflation over time reduces the purchasing power of that $500 currency without an equal increase in fiat compensation for the same unit of work, then a disconnect occurs between work, money and currency. The result is that the individual no longer earns the same amount of worth via fiat currency for their unit of labour.
See below for a comparison of the top five differentiating factors between money and currency, according to this link from Educba:
Good Money vs Bad Money
It is worth noting that the terms “good money” and “bad money” are often used. Historically, some major characteristics of bad money were that it held no intrinsic value and could be printed at will, such as fiat currencies. Good money generally implied the opposite, with examples including precious metals, such as silver and gold, especially gold which was often acquired as a hedge against inflation. Unfortunately, when tracked over several decades, gold’s traditional position as good money is becoming more questionable and is reflected in its gradual and steady price decline versus inflation. This is a result of two main reasons:
1. Eric Sepanex explained that gold is created in outer space when “inside massive stars explode into a supernova.” After its formation, gold finds its way into the earth through asteroids. This implies that there may be entire asteroids of gold waiting to be discovered. As humans venture beyond Earth, the likelihood of such discoveries will increase.
2. More importantly, repeated discoveries of vast deposits of gold on Earth greatly reduce its fixed supply and scarcity as a valued asset. M. Garside’s 2021 review of the gold sector states that “the total market value of gold worldwide in 2018 amounted to nearly 8 trillion US dollars. Jewellery was the leading sector, accounting for 3.75 trillion US dollars of the global market value of gold.” However, TBS News reported in 2022 that 31 million metric tons of gold, equivalent to twelve trillion US dollars worth of gold, was newly discovered in Uganda.
If true, the discovery dwarfs the prior entire world market capitalisation of gold. This, unfortunately, would have similar effects as government fiat printing. As most countries hold their financial reserves in gold, a notable loss in the value of gold would present major financial ramifications for all nations.
World Wars and Trade Wars
As countries engage in wars, both domestic and overseas, these wars are funded by their active economic components. Such funds would, in principle, have been redeployed to grow their gross domestic product (GDP), and inherently strengthen their currencies and their sovereign independence. The treatment of sovereign debts from World War I and II had a skewed impact on the financial institutions of many countries and nations struggled internally, as well as with trade partners.
The Bretton Woods agreement was mainly introduced by Britain and the United States in 1944 after World War I to serve political interests, similar to the Treaty of Versailles which seemed to lean on divergent national interests. G. John Ikenberry remarked that its failure was likely similar to Versailles Treaty, which President Wilson found to have been guided by unrealistic demands. The convergence at Bretton Woods hoped to avoid a similar fate, which had actually inspired World War II. According to Alan Sharp, Germany looked at the Versailles Treaty as a dodgy document that culminated in its humiliation after World War I with threats to invade Frankfurt if Germany failed to honour its post-war commitments to the allied nations. The banking system bore the brunt of the aftermath of the Versailles Treaty, facing huge reparations to the allies including France, America, and Britain. Anatol Murad explained that Germany’s debt was in excess of its “foreign and gold exchange resources.” Therefore, bank balance sheets involving foreign loans in European economies were unrecoverable and culminated in the 1931 banking crisis exacerbated by the Great Depression which led to low volumes of international trade.
In 1920, as one of the means of repaying its debts arising from World War I and II, the UK changed the nature of its circulating currency. Bullion By Post report how:
“Following the First World War and the resulting global economic depression, silver content in British coins was reduced to 50% due to cost and supply shortages. The period was short-lived…and silver coins were eliminated from circulating currency altogether in 1947. This meant that the UK’s coinage no longer held its intrinsic value and had been reduced to fiat currency which can be printed, manipulated and “devalued” as deemed necessary.”
Further, according to John Maynard Keynes, as cited in Wikipedia:
“Like other dominant economic nations of its time, devaluating the UK currency would have far reaching consequences. Britain in the 1930s had an exclusionary trade bloc with nations of the British Empire known as the “Sterling Area”. If Britain imported more than it exported to such nations, recipients of pounds sterling within these nations tended to put them into London banks. This meant that though Britain was running a trade deficit, it had a financial account surplus, and payments balanced.”
The challenge with this financial model is that each time the UK Government attempts to resolve an internal economic issue which triggers a devaluation of the GBP pound, it would also result in a devaluation of the wealth of the countries holding their trade reserves in UK banks. A similar effect occurs for other nations holding the surplus of trade with their former “colonial masters”, such as France and Portugal.
The alternative is that the countries within those sovereign blocs could sell these reserves for other strong currencies. This would, unfortunately, potentially result in a run on the currency being sold, for instance, the British pound. This would still result in weakening the strength of the British banking system. Depending on the size of the run, a domino effect could cause global markets to spiral. A similar spiral event occurred in September 2022 when Liz Truss, the newly appointed UK Prime Minister, announced a mini-budget that was deemed to be questionable by financial institutions worldwide. Within less than a week, global institutions sold off the currency causing it to reach a low of $1.035 in some regions, sending it to its lowest level against the US dollar since 1985. The Bank of England had to immediately intervene by buying UK Gilds (bonds) which again meant more money printing in an attempt to stabilize the financial markets. Failure to intervene would have led to the collapse of the UK pension system in possibly less than a week.
This vicious cycle is similar to that which is presently facing many other countries. For example, The Japanese Government also had to intervene in its currency market in the same month of September 2022. The cycle has been exasperated by the challenge as to which currency member bloc countries should sell and hold their reserves in. Presently, it is the US dollar. This was one of the factors behind the spike in the exchange price of the US dollar compared to the basket of foreign currencies referred to as the US Dollar Index. While this temporarily further empowers the US dollar, the question analysts have raised is: What happens to everyone when the US dollar declines in value in comparison to other currencies? The political nature of the Russian ruble and the Chinese yuan inherently make them unfavourable.
It is believed that this is one of the fundamental reasons why the enigmatic Satoshi Nakamoto (whoever he, she or they might comprise) developed Bitcoin. This was the first decentralised currency not controlled by a singular entity, government or collective, but rather it has a fixed limited supply and is not bound to one particular region. A decentralised currency runs on a form of decentralised ledger technology: Blockchain.
Quantitative Easing (QE)
In simple terms, quantitative easing is a mechanism by which governments print fiat currency (holding no intrinsic value) and attempt to inject it into their economies to stimulate growth and financial markets.
How it works is that when a central bank employs quantitative easing, it does so by purchasing large quantities of assets, such as government bonds, with the aim of lowering borrowing costs, boosting consumer spending, supporting economic growth and increasing inflation.
Quantitative easing is often used in times of critical national importance. Since the financial crash of 2008–2010, governments around the world have resorted to this approach as a means of jump-starting economic activities. While it was supposed to have stopped after the financial crash of 2008 when governments were meant to extract the billions printed after their economies started to recover, they did not do so. In 2020, when the COVID-19 crisis struck, governments resorted to further quantitative easing. The diagram below shows the change in money printing by the US from 2013 until 2022:
The Washington Standard reports that between 2020–2022, the US Government alone printed 80% of all US dollars in circulation. Unfortunately, every other developed nation is adopting the same monetary policy. The Atlantic Council’s “Global QE Tracker” report explained that:
“To address the economic shock from COVID-19, the world’s four major central banks have expanded their balance sheet by a total of $11.3 trillion to support their economies and the functioning of global financial markets. The banks’ new asset purchases have increased the size of their cumulative balance sheet by roughly 73% since the beginning of 2020.”
The total value of the currency of a sovereign state is meant to be directly proportional to its economic output. Therefore, if the amount of currency in circulation becomes exponentially disproportionate, then the value of the currency itself declines. As the volume of a currency within a country increases for the same volume of goods and services, the price of those goods and services also increases, resulting in inflation. With inflation significantly above their long-term targets, all central banks have slowed, stopped, or begun to unwind their QE purchases to make way for raising interest rates. Presently, inflation has run so rampant that governments are struggling to control its surge. As of October 2022, these efforts have resulted in the highest inflation that Europe has experienced in its history. The Levelsio’s list shows some of the most negatively affected countries:
These levels of inflation are not limited to Europe or the UK. In some regions, it is even worse:
Despite this global rise in inflation, the International Monetary Fund (IMF) recently warned that the situation will likely worsen with a further global downturn to be expected. The greatest global economic threat has now expanded from banking defaults to sovereign defaults. This has led some of the largest global investment firms, such as Fidelity Investments, to reposition into Bitcoin. Bitcoin is a decentralised blockchain currency which acts as an insurance hedge against other national currencies. As explained by Siamak Masnavi, “comparatively, bitcoin remains one of the few assets that does not correspond to another person’s liability, has no counterparty risk, and has a supply schedule that cannot be changed .”
Due to the intertwined nature of global banking and macroeconomics, the cause-and-effect relationship between the two has become similar to the case of the “chicken and the egg”. Determining which one is the catalyst for the other is no longer fixed. This is primarily due to the size and reach of some major banks and financial institutions. Many are classified as G-SIB — i.e., their collapse would present a risk not only to other banks but also to the global financial system, with the effect of crippling sovereign nations.
Uninsured QE Distribution
During the last credit financial crash, central banks around the world, such as in the US and UK, were involved in extended periods of quantitative easing (QE). While QE provides liquidity via low borrowing interest rates to banks, with the onus placed on the banks to make this liquidity available to public institutions, a central bank like the Federal Reserve cannot force banks to act in this way. Unfortunately, it is believed that many financial institutions did not do this, especially just after the financial credit crisis. These institutions were in need of capital at the time, and it is believed that some financial institutions used the low-interest funds to first repair and “shore up” their own balance sheets.
As these events occurred internally within centralised institutions, it is impossible to know the scale of the QE distribution. The transparent nature of the DLTs would have made such distributions of funds visible to the general public, as well as to the regulatory bodies. In future, because of the nature of DLTs, central banks can easily distribute QE funds directly to citizens at an extremely negligible cost without banks. This is a result of the low cost of DLT transactions. Such a distribution can be implemented via CBDCs.
Abnormally Low Central Bank Interest Rates
Banks typically set the interest rates they offer to customers relative to interest rate increases and decrease set by their central banks (the base rate). Extremely low commercial saving interest rates disincentive customer saving. This results in fewer deposits for financial institutions to invest. Financial institutions that charge fees on products are then faced with the challenge of attempting to ensure that such fees do not result in a negative yield. This is when customers are charged more than the interest paid to them on their deposits, meaning customers are paying banks to hold their funds. During such periods, retail customers are more incentivised to divert their funds to seek returns in riskier markets such as stock markets and more recently blockchain-type crypto ventures.
Banks practise fractionalised reserve banking. This permits banks to take deposits from the public and only hold a proportion of the deposit liabilities in liquid assets as a reserve. The combined effects of:
· prolonged periods of low interest rates; and
· reduced durations with which banks are able to leverage customers’ funds due to the increased velocity of money (a term used to express the speed with which money moves within an economy)
have hindered the ability of many banks to remain profitable. Many smaller financial institutions have in recent years struggled to stay afloat. At the end of the day, it is still a game of mass customer numbers. Unfortunately, customers are increasingly finding traditional banking less appealing.
Technological Impact on Product Innovation
The rate of change in technology has brought about a considerable increase in implementation costs for financial institutions. For over 120 years to date, industrialisation followed by technology has constituted a larger factor in wealth creation. This can be seen by the work output increase as evidenced by industrial and electronic manufacturing, through to the explosion of the internet. This has facilitated the rise of small and large companies alike. This includes the rise of new sectors, such as social media, which has gone hand-in-hand with the disruption of various traditional business models by new innovative platforms like Airbnb and Uber.
Bank’s deployed cheque processing systems. Financial institutions partnered with payment providers like Visa and Mastercard and shared 3% of customer-merchant payments globally. Earning from such retail payments increased with the convenience of faster payments and mobile contactless payments. The drive to adopt mobile and pair-to-pair (P2P) payments has also been accelerated by other environmental factors, such as the COVID-19 pandemic. The mobile payment market is projected to grow from USD 1.97 trillion in 2021 to USD 11.83 trillion in 2028 at a compound annual growth rate (CAGR) of 29.1% from 2021 to 2028. The global impact of COVID-19 has been staggeringly unprecedented with a positive impact on the increase in demand for mobile payments across all regions amid the pandemic. The global markets also exhibited considerable growth of 27.9% in 2020, as compared to the year-on-year average growth between the period from 2017–2019”.
You may ask, how do all the above points have anything to do with affecting banks and financial institutions?
The Decline of Traditional Banking
The continual evolution of technology has now shortened the time required for the processing of transactions, both within countries and across borders. Some examples of these are discussed below.
Faster Payments, P2P Mobile Transactions, Digitalisation and Contactless Payments
The following improvements have been made:
· Enabling banks to share in upfront gains on retail-merchant transactions. However, these are not the bedrock avenues of how banks make “consistent” money. The gross increase in the number of participants competing in the same space has also reduced their margins.
· Encouraging customer usage of bank accounts. This results in an increase in the velocity of money in a society, which reduces the duration of time that the financial institutions retain customer wholesale funds that can be used for institutional gains, such as through trading.
These improvements include the transition from paper cheque processing to electronic cheque processing. Traditional paper cheque processing used to take 5–6 days, enabling banks to utilise customers’ funds for interbank trading and other activities. The eventual progression towards phasing out electronic cheque processing entirely in the next few years will favour more efficient payment instruments. This will further reduce banks’ overnight funds. The digitalisation of corporate instruments, such as stocks, dividends and other value bearing instruments, will also have a similar impact.
Trade Optimisation Among Bloc Nations (SEPA, PSD1, PSD2, Open Banking, etc)
Over the years, optimisation of trade among member nations of bloc economic regions e.g., the EU resulted in new initiatives such as the single European payment area (SEPA) payment standard. This was followed by the payment services directive (PSD sometimes referred to as PSD1). Among its various benefits are that financial entities authorised by one member state automatically qualify to operate in other member states within the blocs.
In the UK, there is the competitive pressure of innovations such as Open banking. Open banking requires banks to make customers’ financial data available to be shared with trusted third parties. This enables Fintechs to provide services that were previously limited to financial institutions. Open banking also allows major merchant platforms, for instance, Amazon, the ability to directly check that clients’ bank accounts hold sufficient transactions for their purchases without going through third-party card providers or banks. This allows such platforms the ability to debit the customer directly. This provides a huge benefit to such platforms, including Amazon and eBay, but disincentivises payment processors such as Visa, Mastercard and banks. They previously served as payment middlemen and benefited from payment commissions.
Recently, Big Tech companies have also joined the list of those with interests in banking — e.g., Uber announced that it was launching Uber Money, principally for use by Uber drivers. This positions Uber to branch into current accounts, payments and settlements in the future.
The adoption of the global payment messaging standard ISO 20022 is geared towards ensuring uniformity across all financial institutions, irrespective of the geo-political location or affiliation. This is a considerable upgrade from the earlier SWIFT payment network and requires the SWIFT network itself to adopt the standard. The need to ensure smother translation of data that supports such processes and prevent failures between financial institutions that implement different technologies. The adoption of different data formats and payment messaging standards across different financially regulated regions has previously been a hindrance to global payment settlements. Previously, all institutions were meant to have adopted the ISO 20022 standard by April 2022, but due to the cost and logistics of its implementation, the deadline was extended to November 2022. All of these improvements lead to the following points outlined below.
Increased Operational Costs
Traditional banks and financial institution margins are being continually squeezed between:
· the costs of implementing various different standardisation requirements
· vastly enlarged compliance teams needed to monitor the new systems
· heightened requirements for loans provision by regulator attempting to prevent bank liquidations and another Lehman Brothers’ moment
· the duration for which that financial institutions are able to retain customers’ funds for internal use due to the advancements these same technologies have encouraged (discussed above)
· the low interest-bearing environment that has existed for over a decade since the credit crash of 2008–2010
The reduction in profits is also reflected in the general long-term decline in share prices and the notable increase in higher-risk activities that many have engaged in — e.g., leverage, questionable commodities trading leading to accusations of commodities price fixing and other such activities. Unfortunately, the impact of these changes and trends has disproportionately affected smaller financial institutions over their larger counterparts.
The domino effect of the Lehman Brother’s collapse would have led to the collapse of many other banks around the world had it not been for their bail-out by their national governments. However, again in October 2022, the financial market became concerned about the possible collapse of two other major banks: Credit Suisse and Deutsche Bank. Their joint collapse would have had at least a potential four-fold impact greater than that of Lehman Brothers.
Transaction Fees vs Customer Interest Payments
In 2026–2017, while I was redesigning the payments interface of an international banking system being implemented for Private Commercial Finance Group (PCF Bank) London, the importance of ensuring that transactions fees for customers do not exceed the interest earned on their accounts became a notable consideration in my technical design model. This was brought on by the almost-zero macro interest policy of the Bank of England at the time. At the time, similar interest rate policies were common for many central banks around the world. This was the credit crisis aftermath of the Lehman Bank collapse.
In order to define the solution, I bypassed the traditional mode of processing of the banking system in question and implemented a more efficient transaction prioritisation structure. Fees vs interest earned is a challenge, but in previous times it was not as critical an issue for banks due to higher central bank rates. These rates would normally translate into higher interest rates being paid to customers than their cumulative transaction fees. Unfortunately, this period of low interest rates has persisted for over a decade.
Revamping National Clearing House Infrastructures
This remodelling of the banking system’s payment interface highlighted a larger more important financial infrastructure issue. That is the cost of transaction processing through the UK’s clearing house. Like many other clearing houses around the world, the clearing house infrastructure was probably no longer fit for purpose in light of the broader macro-economic climate of low interest rates, sovereign monetary policies, global pandemic, wars and power games between world leaders.
In 2021, I further highlighted this challenge during a crypto currency podcast hosted by Bimbola Kolawole for Blue Sitron, an energy consultancy. The representative of this organisation asked, “So, what are the governments going to do about this issue? And are they aware?” to which I replied that I don’t know, but my hope is that some people are aware and thinking of how to handle these out of date clearing house infrastructures.
Fortunately, several governments and dominant clearing house corporations have been researching a solution, as set out below.
In 2022, the US Government announced their intention to launch FedNow, a payment process that would provide instant settlement of merchant transactions. While testing will occur in the last quarter of 2022, it is set to fully launch in 2023. It is rumoured that it will be implemented using technology from Ripple Corporation, a blockchain-based technology company that facilitates intra- and cross-border payments. It is expected that this will compete with the likes of innovation from:
· Strike’s Bitcoin Lighting Payments: Recently launching an instant payments platform using the Bitcoin Blockchain Lighting network. This network would exclude traditional transaction middlemen like Visa, and Mastercard and thus possibly remove the 3% merchant transaction cost charged for processing. This was also launched in 2022. The 3% cost savings would result in billions of dollars of annual cost reduction on goods and services worldwide.
· Various decentralised blockchain-based P2P payments projects are available in a 24/7 decentralised manner. These projects can be found on a diverse range of blockchain and DLT platforms.
The FedNow project being a brainchild of the US Federal Reserve is a clear indication of the adoption of blockchain as part of the US’s national payment and settlement infrastructure framework.
The importance of this framework adoption cannot be overemphasised. This is essential for traditional centralised financial institutions if they are to survive the innovation challenge from decentralised finance (DeFi) which is built on blockchain and runs 24/7.
While the limelight of blockchain technology was initially popularised by Bitcoin, the acknowledgement and adoption of blockchain technology have since been hindered by the lack of regulatory clarity by the US Securities and Exchange Commission (SEC). This lack of clarity includes the US Federal Reserve and other central banks that ironically frequently take their cue from the US Fed.
Various intentional attempts at hindering the adoption of Blockchain can be seen in efforts at early posturing by key financial institutions and bans by various countries, such as India and China. In 2017, Jamie Dimon, CEO of JP Morgan, infamously stated that Bitcoin was a fraud and he would “fire in a second” any trader who touched it. “If you’re stupid enough to buy it, you’ll pay the price for it one day,” he said at the time.
Ironically, on 16 September 2017, Bitcoin.com news stated that:
“JP Morgan Securities Ltd., and Morgan Stanley bought roughly 3M euro worth of XBT note shares… his firm bought the dip on September 15. In fact, out of all the companies on the list, like Goldman Sachs and Barclays, the JP Morgan team of buyers purchased the most XBT notes.”
Since then, JP Morgan bank has not only expanded its crypto asset portfolio but now enables clients to invest in crypto. Not to mention that JP Morgan “has applied for a “bitcoin alternative” patent with the US over 175 times in 2013” and has been rejected each time.
The gradual acceptance of Bitcoin has since been followed by well over 300 banks positioning investing in facilitating BTC for clients in the first half of 2022.
While the crypto and blockchain sector has witnessed a rollercoaster ride similar to any new emerging technology, its market cap has seen a steady and continuous rise. The environment is also beginning to see a shift, resulting in the identification of projects that attempt to solve real-world problems other than just Bitcoin’s possible monetary use.
The Depository Trust and Clearing Corporation
Another example of infrastructure-wide application of blockchain to clearing and settlements is in respect of the DTTC. The Depository Trust and Clearing Corporation (DTCC) is a US post-trade financial services company providing clearing and settlement services to the financial markets. In 2019, the DTCC settled $2.15 quadrillion worth of transactions and is considered the world’s highest value processor. In 2020, the DTTC ran various tests related to using digitisation technology for clearing transactions in the near future. DTCC outlines their efforts in the commissioning of two projects as:
· Project ION: DTCC’s Project Ion Case Study proposes “a future vision of an alternative digital settlement service, with the potential to offer the benefits of accelerated settlement, retain the advantages of central netting and prevent fragmentation of the clearing and settlement ecosystem. DTCC developed a proof of concept (POC) to validate the proposed business and operational concepts included in this initiative and is now engaging the industry to assess market demand.”
· Project Whitney: DTTC’s Project Whitney Case Study recognizes that “companies are staying private longer and continue to see increased investor interest, Project Whitney is a prototype focused on exploring the potential for asset tokenization and digital infrastructure to support private market securities, from issuance through secondary markets. While public markets are highly efficient, that same efficiency is not enjoyed in the private market where many operating functions are still dominated by manual processes and the few digital solutions that are available exist in silos.”
I believe that these two projects by the DTCC, in conjunction with the FedNow launch, vindicate my earlier assessment that the clearing house infrastructures of the world need to be radically upgraded. I would estimate that we will soon see more of such projects emerging from other countries and institutions involved in clearing and settlements in other geographical regions.
Consortium-Led Financial Grade Blockchain Solutions
After observing the potential of the decentralised blockchain projects, behind the scenes, various banking consortiums with active participants like JP Morgan have now invested heavily in efforts to adapt blockchain technology into private permission financial security grade digital ledger platforms — e.g., Corda, Quorum, Hyperledger.
Since the development of these private permissioned networks, financial institutions are now developing their own institutional applications, as well as collaboratively developing numerous others. Some such applications are:
· Voltron (Trade Finance System): Bangkok Bank, BNP Paribas, CTBC Holding, HSBC, ING, NatWest, SEB and Standard Chartered.
· Liink (Payment Application): Developed by J.P. Morgan and adopted by 382 banks.
· E-Krona (CBDC): Swedish Central Bank etc.
· Digital Trade Chain (Trade Finance system): Deutsche Bank, HSBC, KBC, Natixis, Rabobank, Société Générale and UniCredit.
· Bakong (Payment App): National Bank of Cambodia.
· Kate Coin (Banking Loyalty Reward Token): KBC bank in Belgium.
Creating National Central Bank Digital Currencies (CBDCs)
Some nations, for instance, China and India, have repeatedly banned and unbanned cryptos while seeking to hinder the adoption of crypto currencies and public blockchains, Russia, China, Brazil, Sweden and the ECB have raced behind the scenes to develop their own central bank digital currencies (CBDCs). These are based on blockchain technology. Much of this activity is to combat the threat of loss of governmental financial control over their citizens. This is a major threat that decentralised blockchain based currencies and assets present to traditional finance and governments.
CBDCs also represent a form of financial-socio-political experiment where governments are able to:
· Directly track the spending habits of citizens from their bank accounts
· Directly enforce monetary restrictions and campaigns via people’s bank accounts — e.g., the direct payment of economic stimulus funds
· Intrusively grant or hinder social restriction of individuals based on social credit ranking systems within the society — e.g., citizens that do not meet certain recommended living habits may be banned from making payment for certain leisure benefits or events, such as internet access, travel restrictions
It is important to note that China’s CBDC is presently operational and earlier this year it had planned to distribute $6.2 million to its citizens. Their social credit ranking system is always live and is used to punish and reward citizens based on their social behaviour. As stated by Katie Canales and Aaron Mok in a Business Insider report:
“China has already started punishing people by restricting their travel, including banning them from flights. Authorities banned people from purchasing flights 17.5 million times by the end of 2018, according to the National Public Credit Information Centre…”
Circumventing US and NATO Monetary Restrictions
CBDCs apply blockchain technologies that are not controlled by foreign entities, such as the US Office of Foreign Assets Control (OFAC). This enables these national currency networks to potentially provide more efficient alternative means of payment settlements between nations that otherwise feel ostracised by the traditional US influenced SWIFT network. Bearing in mind the fact that tests have already been conducted between China and Russia to assess the ability of their CBDCs to communicate with each other, it is only a matter of time for other non-US friendly nations, such as Iran, Iraq and others, to align to form collaborative CBDC networks. This will eventually influence a change in the monetary world and the balance of global power, accelerated by:
· What is seen as the weaponization of the SWIFT payment network by NATO countries and the United States during the ongoing Russia and Ukraine war
· The fact many of these non-US friendly nations are major oil and energy producers who feel coerced to have to denominate their products in US dollars
It is interesting to note that while these competing nations have raced to develop their CBDCs, the US has repeatedly stated that it is yet to develop its CBDC.
Internet Currency Domination
After the experiences of the post-World War I and II periods, the following situations arose:
· the indebtedness of many nations to the US
· the direct denomination of gold in US Dollars
· the failure of the US dollar to retain its parity to the volume of US held gold
There has since been a currency battle among different world governments, particularly between China, Russia and the United States.
As the dominant world currency generally dictates the currency commodities, loans and debt-bearing assets are denominated in worldwide, that currency yields extensive influence in international payments. It, therefore, follows that the more widely a specific currency is used, the more economically powerful the country that issued it becomes. Such countries go to considerable lengths to retain their dominance as they consider it a priority as part of their national security strategy.
As decentralised blockchains have, to some extent, been functioning outside the strict control of sovereign states, they:
· threaten the present order of currency dominance internationally. Most of the stable coins used in the “Cryptoverse” are US dollar based. Recently, other currencies have emerged, including the Euro (EUR) and British pound (GBP), however, they are less popular. Yuan and Rubble-backed stable coins are basically non-existent in terms of their usage. It is believed that this present domination of US backed stable coins is a reason why the US would never ban cryptos, and also why they do not feel rushed to commission a US CBDC.
· threaten the control of currency within individual nations. They present a potential cash flight risk. For instance, irrespective of one’s wealth in China, its citizens have a cap on how many US dollars they are able to withdraw daily out of China without government authorisation. Citizens alternatively attempt various means to circumvent this, such as using virtual private networks (VPNs) to access the internet on a private connection in order to connect to international crypto exchanges and convert their currencies into US dollar backed stable coins that are not controlled by the Chinese government. The success of the Tether USDT stable coin has largely been believed to be due to the volume of USDT traded by Chinese citizens.
Accessibility to VPNs also provides citizens of nations whose currencies are being alarmingly devalued the ability to transfer their wealth into less volatile currencies. The most popular are US dollar-backed stable coins. It is also important to note that while a large portion of the world is still unbanked and exists outside of the normal monetary circle of their governments, these citizens generally all have mobile phones which give them access to the internet. This offers them the potential to circumvent governmental financial control.
It is the opinion of this analyst that becoming the dominant currency of the global internet holds a major incentive for the US and its financial security. This is a major reason why the US favours a regulated version of the existing decentralised crypto world instead of disbanding it. This is reflected in why US Democrat and Republican senators are both in support of The US Stable Coin Transparency Act currently being considered by the US legislature. This bill is expected to be passed before the end of 2022. The bill lays out their expectations for acceptable stable coins issuance — for example, “Issuers of so-called “stablecoins,” virtual currencies with their values pegged to traditional currencies would face bank-like regulation and oversight.”
Decentralised Finance (DeFi)
Decentralised finance is set to pose the biggest future threat to traditional finance and banking. It requires no middlemen as banks do, nor any third-party payment processor, such as Visa or Mastercard, and it runs mainly on mathematics and the validity of the underlying programming code that executes it. The primary risk of DeFi is the security of its code and logic. As each DeFi project becomes more battle-tested, this alternative financial ecosystem will become more secure. It eliminates the “exorbitant” fees charged by traditional transaction middlemen, is faster than traditional banking, provides better ROIs and by the very nature of the blockchain, it is more transparent and the data is immutable.
On 27 September 2022 at the “Opportunities and challenges of the tokenisation of finance” event hosted by the Banque De France, the heads of central banks (Federal Reserve, ECB, Singapore, etc) appear to have jointly considered stable coins to be of notable benefit if managed with “appropriate” regulatory enforcement. However, it was also acknowledged that they do not presently know how to regulate DeFi. Ravi MENON (Managing Director, Monetary Authority of Singapore) stated: “…the biggest risk is where are you going to apply the regulation too? All our regulatory approaches are based on applying regulation to legal entities. In a decentralised world, you can’t do that to an algorithm.”
As DeFi continues to expand, regulatory bodies are becoming increasingly conscious of the volatility of most of the major DeFi products. Central bank heads believe that as DeFi grows and becomes fully interconnected to CeFi, it could pose a potential systemic risk to traditional finance. The merging of DeFi and CeFi is seen by many as an inevitability. The only question is how soon that will occur.
The main concerns surrounding DeFi arise from:
1. The ROI and yield obtainable in DeFi from staking crypto assets, including stable coins, far outweighs that available from traditional markets. The difference can range in magnitude of a multiple of 2, 8 to 1000 times and more. For a particular period, the DeFi project Wonderland Time offered an annual interest rate exceeding 150,000%.
2. Apart from stable coins, many Defi products apply a range of other crypto assets — e.g., Bitcoin, Ethereum, Solana — as part of their underlying basket of assets. These assets can be extremely volatile in value, thereby greatly affecting the stability of the products they underpin.
3. Much of DeFi is still in its experimental stages and comes with similar associated risks of maturity. A typical example can be seen in the collapse of the Terra Luna ecosystem which had assets valued at $40 billion at its peak. Terra Luna launched an algorithmic stable coin, UST, which, when staked, provided a yield of 20% until UST went into a “death spiral” which led to:
· its demise as well as the collapse of the Terra Luna platform
· the collapse of 10s of billions of dollars of other projects built on top of the Terra Luna blockchain
· The domino effect of its collapse resulted in the bankruptcy of several centralised blockchain based loans institutions, like Celsius, 3 Arrows Capital and Voyager. These institutions had all invested funds in Terra Luna, with one investor losing $ 3.6 billion in the collapse.
· The liquidation of trading positions held by thousands of customers on the liquidated centralised loan institutions. This included customers not being able to retrieve their funds from the failed institutions. Ironically, during this same period, the decentralised loan products in DeFi remained unaffected. The institutions impacted were those that attempted to operate traditional centralised finance (CeFi) styled operations in the decentralised (DeFi) space. One argument is that this reflects the dependency of rules-based code over subjective human and sometimes greed-influenced reasoning.
The collapse of Terra Luna represented a crypto version of the 2008 Lehman Brothers collapse.
Despite the failings of what is commonly referred to as Defi 1.0., DeFi 2.0 appears to be deviating from its prior iteration in order to improve and build on these same flaws. The new version seems to be aiming to avoid attracting funds and users via inflationary token emissions, and instead focusing on generating what the sector terms “real yield”. An example of this is when contributors (stakers) receive rewards from a DeFi platform as a share of the actual profit generated from that platform’s activity, such as via crypto derivatives trading. This approach can be seen in the implementation of recent DeFi projects, including GMX, GNS, Dopex, Kujira, etc. While the yields are less than in DeFi 1.0, these Defi 2.0 yields are more sustainable. They also provide interest rates that exceed those obtained in traditional finance. These DeFi 2.0 yields also presently exceed the rate of macro inflation. The increased stability and yield exceeding macro inflation rates are now attracting major institutional fund managers, rather than simply speculative retail players that flocked to DeFi 1.0.
It is the opinion of this writer that both historical and current trends illustrate the following combination of factors:
· Increased out-of-control inflation and the contagion of excess fiat printing which is causing an increase in the possibility of sovereign defaults.
· The race to develop central bank digital currencies (CBDC) for geopolitical and other reasons.
· The alignment of heads of central banks to positively consider digital stable coin adoption.
· The development of blockchain based national clearing house infrastructures for financial transaction settlements.
· The implementation of private permissioned financial institution blockchains to enable improved and more cost-effective collaborations between them.
· Profiting and positioning by the largest global investment and financial institutions such as Blackrock, Fidelity, JP Morgan, etc., in both decentralised and private blockchain assets. This includes providing blockchain custodial services for their retail, institutional and sovereign wealth clients.
· The increase in currency velocity due to citizens having faster, cheaper and more direct access to using their funds via peer-to-peer blockchain transactions.
It is hypothesised that these factors will lead to a very high probability of an imminent major change, resulting in a new global monetary system. This change will require an improved financial distribution method. In the time of a digital generation birthed in a fast-paced internet world and the emergence of artificial intelligence, that monetary change will require new technological infrastructure. An infrastructure representing a more advanced and interactive version of the current internet.
Welcome Web 3.0 and digital ledger technology.
Written by : Gbola Adewunmi
Former head of Software Development for Financial institutions, International Fintech and Blockchain Consultant