The Boundaries of blockchains and P2P Finance

Three researchers from the School of Economics, Finance & Marketing at RMIT University have published a paper with a lofty title: Blockchains and the Boundaries of Self-Organized Economies: Predictions for the Future of Banking. In it they discuss how blockchain technology reduces the Transaction Costs for financial markets and how this will lead to the decline of traditional banking firms. I enjoyed reading the paper and I laud them for bringing into the discussion the concept of Transaction Costs Economics (TCE) which is sadly not well popularized.

In getting to their main argument the authors ask an important question: “What precisely is the robust economic function that banks provide; why do banks persistently exist?” Their answer is that banks reduce the transaction costs associated with financial markets. Particularly, banks reduce the transaction costs of borrowing money.

TCE is surprisingly undervalued in business and economics discussions. TCE is primarily based on the work of two Nobel honorees — Ronald Coase and Oliver Williamson. In TCE, the starting point of economic analysis is the individual transaction. The main question that TCE attempts to answer is this: Why are some transactions performed within firms rather than in the open market. Standard economic theory suggests that the market is the most efficient mode of economic exchange. So what gives?

The answer, not surprisingly, is that sometimes markets are not efficient and the costs associated with exchanging goods are sometimes too high on the market. It cannot be stressed enough that economic costs are not as narrow as accounting costs that deal specifically with money.

If you want to borrow money you have to solve several transaction costs problems: triangulation (find a person or persons that have money and willing to lend you), transfer (find a way to get the money from each person), and trust (why should someone trust that you will give them back the money that you borrowed).

Banks internalize these transaction costs. These transaction costs associated with borrowing money and handled by the bank so customers do not have to deal with them. And this is the main insight from TCE: firms exist because they reduce the transaction costs of open markets. If there were no firms it would be tedious and complex to have to go to the open market for every aspect of consumption.

Firms can be viewed as miniature economies: “islands” of command organization in a “sea” of spontaneous market exchanges. — Ronald Coase

This is what the authors of the paper base their arguments on. They claim: “banks intermediate two sides of a market. This intermediation is precisely what the recent wave of P2P finance endeavors to disrupt.”

And without haste they go on to say: “By matching sellers of capital (those who would otherwise make deposits in a bank) with buyers of capital (those who would otherwise seek loans from banks) directly, the P2P finance directly threatens banks.” This is the orthodoxy of banking. It is commonly accepted that some people put money into a bank and others borrow this money. And like all orthodoxies it takes some heretics to put them on trial.

As a economic heretic it would be remiss of me not to strongly dissent and indicate that the authors of the paper fail to demonstrate that they understand how banks really work. The wrong-headedness of their argument is thoroughly surprisingly but shamefully common.

Banks do not merely intermediate savings and loans, as they wrongly indicate. The amount of money available to be loaned out by a bank is not dependent on the amount of money people put in the bank as savings. In the real world, whenever a bank makes a loan it simultaneously creates a matching deposit in the borrower’s bank account. In the real work, banks create the money they use to make loans.

Many learn’d economic heretics, far wiser than I am, have been trying to dispel the fallacious orthodoxy of banking for decades; that banks do not not intermediate savings and loans. But the myth still persists. In a bulletin by the Bank of England titled Money Creation in the Modern Economy a group of economists explained how money is actually created and how loans are actually made to banking customers. The stylized balance sheet diagram below (from the bulletin mentioned) shows what really happens when a loan is made.

Orthodoxy/fallacy: Banks use the savings of some customers to lend to others.

Heresy/truth: Banks create money, in the form of bank deposits, by making loans.

If you want want to buy a beach house in Barbados you will likely need to take a mortgage to make the purchase. You will go to a bank to apply for the mortgage. If the bank approves the application then the bank will change it’s computer database to increase your account by the amount of the approved mortgage. If you think right now that all they did was type some digits on the computer and now your account has money…then you are correct. There is no ‘master account’ in a bank where all of its capital is held. And the bank does not tap into this ‘master account’ to send money to you. The bank just creates the money when it types the digits into your account — the money is created out of thin air.

For this reason, economists like James Tobin (another Nobel memorial Prize for economics honoree) in 1963, referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans. But in 2016 the money is created by typing on a computer keyboard.

This description of money creation contrasts with the notion (the false orthodoxy) that banks can only lend out pre-existing money (which is the case for P2P lenders). Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out.

Banks are not mere rusty P2P finance platforms. Getting a loan from a bank is not the same as getting money from a P2P platform as the liquidity from a P2P platform will be limited by the capital users put in the platform’s network. Banks do not have this limitation since they create money whenever they make a loan.

This is why P2P loan providers can only focus on small value loans. These firms will not have the liquidity to offer frequent large value loans like a mortgage since they cannot simply create the money. The business model of P2P firms cannot compete with banks (and they don’t try to). Contrary to the authors of paper, blockchain technology does not “compete with banks as organizations” and it is not true that “P2P finance directly threatens banks.”