What did Hong Kong protesters know that financial regulators didn’t?
The Occupy Central movement did something very smart when they heard that traditional communication methods may be cut off (or limited), hampering their capacity to organise themselves. They turned towards a mesh networking app called FireChat, so that every message sent doesn’t go via centralised communication towers but instead “jumps” from phone to phone until it reaches the recipient. In practice, this meant that they could rely on an innovative decentralised communication solution (Fig 1), bypassing a traditional centralised communication network altogether (Fig 2).
Going back to the financial crisis, it is easy to see a parallel with Hong Kong’s Occupy movement and envisage how a decentralised financial system could have limited the economic impact of this financial shock:
- Institutions that were too big to fail (e.g. AIG) needed to be bailed out in order to prevent more exposed counterparties in the system from suffering a loss
- Banks who used to access the wholesale money market as a primary source of funding could not access finance anymore (or at a higher cost than normal) due to the risk and uncertainty within financial markets
- Homogeneity of business models (e.g. most banks starting to securitise loans) and particularities of regulation meant that one flaw would uncover both the revenue sources and compliance standards of exposed institutions
These examples are an illustration that when an institution (e.g. AIG), a source of funding (e.g. wholesale money markets) or an operating environment (e.g. revenue sources/compliance obligations) becomes too dominant within the financial sector, a failure is proportionally disruptive.
Back to Hong Kong, the fact that communication capabilities were reliant on a limited number of cell-phone towers meant that disrupting could occur in case of a shut down. Protesters understood this and acted accordingly.
In the aftermath of the crisis, the financial sector has taken note on the systemic implications of a centralised system. However, regulators preferred to take an approach to make central nodes (e.g. big banks, clearing houses) more robust by increasing capital requirements instead of promoting a more decentralised system (even though it should be noted that Andy Haldane who was head of financial stability at the Bank of England promoted a more heterogeneous financial system in his speech “Rethinking the Financial Network” and arguably the revised banking licence process reflects the necessity for a more diverse banking sector).
Similarly, a legal provision in the States, found in the Riegle-Neal Interstate Banking and Branching Efficiency Act 1994, allowing US banks to merge post-2007 (Fig3) hasn’t been addressed in the Dodd-Frank Act. This means that the re-occurrence of a too-big-to fail scenario is even more likely today (see infographic below). Ironically, a too-big-to read act, reaching over 3,000 pages, has missed to fix a small detail, leaving a billion dollar loophole open.
The limitation with the regulatory approach of reinforcing central actors can be seen in UK where 5 banks represent over 90% of SME Lending. Those banks faced liquidity problems caused by the more stringent capital requirements which affected their capacity to perform their credit intermediation functions (add to this issues around credit scoring systems, IT legacies etc.).
On the back of this credit shortage, private initiatives emerged. Peer-to-peer (P2P) lending benefited from the credit contraction towards individuals and SMEs. P2P platforms offered a decentralised source of borrowing for many, not only by-passing banks but also proposing lower interest rates. Importantly, the use of financial technology (FinTech) means that new decentralised intermediary functions can be performed more efficiently (e.g. lowering origination cost & time) than the traditional centralised institutions. FinTech has challenged the threshold level at which the necessary economies of scale are reached to make a financial system efficient.
Today something similarly disruptive is occurring: the rise of Bitcoin. Taking a paragraph from Coindesk which explained the characteristics of Bitcoin:
“The Bitcoin network isn’t controlled by one central authority (Fig A). […] That means that, in theory, one central authority can’t tinker with monetary policy and cause a meltdown. […] And if some part of the network goes offline (Fig B) for some reason, the money keeps on flowing.”
Sounds familiar?
