Blockchain: The Third Wave of Financial Disintermediation.

Disintermediation is the rallying cry of blockchain initiatives across nearly every industry. Distributed ledgers and permissionless networks have the potential to dramatically reduce the cost of establishing the trust necessary for unfamiliar parties to interact. As a result, the role of central trust institutions under this paradigm is drastically reduced, if not, in some cases, entirely eliminated. One industry where the potential benefits of disintermediation seem particularly high is finance.

The financial sector operates on a business model of intermediaries, be it banks, brokerages, clearing houses, crowdfunding platforms, private equity funds, mutual funds, and on and on. But with the rise of blockchain, solutions are beginning to emerge to connect people who need capital directly to those who have it. The result is an impending financial disintermediation, where global financial markets are flattened, and middle men and the fees they charge are cut out.

If you’ve heard about this wave of financial disintermediation, you may think this is a welcome and unprecedented shift away from near-total reliance on centralized trust authorities (i.e. banks and other financial institutions). But it may surprise you to know that this is not the first wave of financial disintermediation. In fact, this is not even the second wave of financial disintermediation. Prior to the paradigm shift that we are currently experiencing, global financial systems have undergone two large-scale financial disintermediation events since the 1980s. Blockchain is ushering in the third wave of large-scale financial disintermediation in the history of modern finance. By studying the conditions that caused these prior shifts and the changes that emerged, we are better positioned to anticipate where the third wave of disintermediation may lead.

The First Wave: Disintermediation of Banks and the Rise of Money Markets.

Modern finance is built on banks. Before the 1980s, whether you were an individual looking to purchase a home or a corporation looking to fund operations for the next quarter, you were by no means spoiled for choice. You went to a bank and took out a loan. Of course, capital markets existed for corporations looking to raise money on a longer horizon, primarily through traditional debt or equity securities. But operational finance was the domain of the banks.

This all began to change in the early ’80s. In 1980, loans accounted for over 80% of bank balance sheets, but today they stand for less than 30%.[i] Over the last 35 years, non-bank financial institutions have risen in popularity and prominence as a source of institutional funding. This migration from bank borrowing to alternative lenders and money markets has reduced the role of banks in corporate finance. This shift away from bank borrowing was the first wave of financial disintermediation.

The seeds for the disintermediation of banks, at least in the US, were sown as early as the 1930s and 1940s. In the early days of the 20th century there were around 24,000 banks in the US.[ii] With the stock market collapse of 1933 and the dawning of the Great Depression, some 10,000 banks failed, leaving the total number of US banks relatively constant at around 14,000 until the mid-1980s when the first wave of disintermediation began.[iii] Since then, the number of banks has more than halved, with the FDIC reporting less than 5,000 banks operating in the US to date.[iv] The primary cause of this reduction was a wave of consolidations driven by banks struggling to remain competitive in a regulatory environment that increasingly gave non-bank financial institutions a competitive advantage.[v] One of the key distinctions between these new financial institutions and traditional banks was the former’s ability to connect institutional borrowers directly with investors in what came to be known as the money markets. These borrowers benefited from the lower cost of capital that came through disintermediating traditional banks.

The groundwork for this shift was first laid at the time of the Great Depression. The US government responded to the stock market collapse of the 1930s by establishing multiple federal agencies to supervise the banking and finance industries, including the SEC, the OCC, the FDIC and the FHLB, as well as passing multiple pieces of legislation affecting banking and securities.[vi] One of these new laws, The Glass-Steagall Act (GSA), prevented banks from paying interest on deposits and forced banks to separate their commercial and investment banking practices.[vii] As time went on, the GSA and other regulations limited banks’ ability to compete. With banks unable to entice depositors with interest bearing deposit accounts, and unable to combine commercial and investment banking offerings, alternative sources of funding began to emerge.

By the 1980s, the landscape of corporate finance had undergone a fundamental shift. Robust money markets and non-bank lending sources had developed. These bank-alternatives took on many shapes and sizes and began offering creative new products. For example, Government-Sponsored Enterprises (think Fannie Mae and Freddie Mac) provided liquidity for residential mortgages. Asset-backed securities, including mortgage-backed securities, brought non-bank lenders into the fold by allowing originators to offload loans from their balance sheets. Mutual funds and insurance companies began to compete in the lending field.

For corporations, bank loan-alternatives for financing operations resulted in significant savings. Corporations began leveraging their high credit ratings to raise money on their own. They could do this at better rates than what banks, which often had weaker credit ratings than large corporates, could offer. Corporations would sell short-term debt called commercial paper directly to market, often with a financial counterparty backing the offering, but without relying on a bank to stand in the middle. Since 1980, outstanding corporate debt has risen from half a billion dollars, to nearly ten billion.[viii] Many corporations even went one step further and formed their own lending arms to provide consumer financing. Many of the largest automakers, for example, developed financial subsidiaries that would provide the financing offered to car buyers, eliminating the automakers’ need to go to the bank for this money.

The rise of these short-term financing instruments, known as money markets, and their disintermediation of banks was not confined to the United States. Though the motivating conditions differ slightly from those in the US, Europe underwent its own financial disintermediation around the same time. In the 1980s, new markets began to emerge around the enormous amounts of US dollars held in Europe known as “Eurodollars.”[ix] Eurodollar fixed rate bonds and Floating Rate Notes allowed European borrowers an alternative to traditional bank loans by giving them direct access to investors holding Eurodollars, effectively disintermediating major international banks.[x] In addition to an emerging Euromoney market, a Eurosecurity market began to form in the mid 1980s, which gave issuers with strong credit the ability to raise short-term debt directly on capital markets.[xi]

As a result of institutional borrowers shifting away from bank financing, by the 1990s, non-bank lending had surpassed bank lending by a significant amount.[xii] By disintermediating banks, the cost of borrowing declined. However, with the exception of the few corporations that established their own financing arms, as with the automotive industry, the first wave of disintermediation did not eliminate the need for financial institutions. Instead, it led to greater specialization.

Non-bank financial institutions rose to prominence by developing niche products and expertise. Institutional borrowers benefited in several ways. For example, non-bank financial institutions would often facilitate, and even guarantee, financing directly between borrowers and investors. This reduced the high transaction costs imposed by a true middle man, as with bank financing, but still provided added credit comfort to borrowers. Institutional borrowers also benefited from the efficiencies created through more diverse, and thus customizable, financing options. The ability to tailor the characteristics of financing raised to the intricacies of the underlying need for financing made corporate treasury departments more efficient, and thus more profitable.

The first wave of financial disintermediation lead banks to cede ground to non-bank financial institutions that they are unlikely ever to recover. Given the choice, institutional borrowers prefer the lower cost and greater customization afforded by direct access to investor capital over the traditional bank lending model. But while disintermediation brings many advantages, the benefits of the first wave remained largely confined to institutional borrowers able to raise capital in the money markets. It wasn’t until the second wave of disintermediation that investors gained access to the benefits of flattened financial markets.

The Second Wave: Disintermediation of Private Equity and the Rise of Direct Investment.

One of the most popular structures used by institutional investors to deploy capital is the private equity fund. In this model, investors make contributions to a central fund. The fund deploys its capital through investments and delivers a return to investors. The private equity fund stands as an intermediary between investors and investment opportunities. The fund ultimately controls the timing and scope of investment opportunities. For its services, the fund collects a management fee independent of return, typically around 2% of assets under management, as well as a percentage of the fund’s investment profits, known as “carry,” typically 20%.[xiii]

Beginning in the early 1990s and accelerating rapidly in the mid 2000s, investors are circumventing private equity funds and disintermediating institutional investing.[xiv] One explanation for this is that a boom in private equity in the years leading up to the mortgage crises drew high levels of scrutiny to fund management compensation levels. This was overlaid with fund performance metrics that struggled to outpace public market benchmarks, and led to dissatisfaction with intermediaries and a desire to boost investors’ rate of return on invested capital.

In response, investors began taking a different approach: direct investing. Direct investing is just what it sounds like. Investors cut out private equity funds entirely and deploy their capital directly in the target of their investment. The appeal of direct investment is that it eliminates the drain on return of paying rent to an intermediary, but it is not without its drawbacks. In fact, the data on direct investment suggests that private equity funds do in fact add value, but whether this value makes its back into investors’ wallets is more difficult to predict.

Data collected between 1991 and 2011 shows two interesting trends. First, intermediated investments by private equity funds produced similar net returns to investors as direct investment.[xv] This suggests that that funds often produce greater gross returns that investors can produce on their own. However, whatever advantages the funds gain by virtue of their position as intermediary is offset by the management fees that investors must pay.

The second pattern that emerged is that the advantages of intermediation are more pronounced in information-poor environments, or in other words, strong performance of direct investment depends on the ample availability of high-quality information.[xvi]

One explanation for this is that the level of skill required to identify quality investments rises with the difficulty of ascertaining information about the investment. As funds generally attract high-skilled investment professionals, they are often better positioned than investors to analyze investment quality. For example, an investor looking to put money into large-cap publicly traded equities can easily access financial statements and analyst reports to help select an investment target. But if that same investor wants to invest in an emerging or niche industry or in privately held companies, it is much more difficult to acquire enough information to make an informed investment decision. In this scenario, a private equity fund presents real value as funds typically attract top investment talent and have the resources and ability to develop niche expertise and conduct due diligence where direct investors may not.

Given that net returns to investors are roughly the same between direct investment and fund investment, and given the advantages that funds provide in information-poor environments, this second wave of disintermediation is remarkable. In fact, in 2014, 52% of investors surveyed said that they planned to increase direct investment,[xvii] and 77% of individual investors with a net worth over $1 billion said they preferred direct investment to private equity.[xviii] Beyond disenchantment with paying sizeable management fees for similar net returns, what could be driving the disintermediation of private equity?

One convincing response is control. Investors have very little control over investments placed with private equity funds. Through direct investment, they regain this control. Funds exercise control over investor dollars which produces agency problems that often play out to investors’ detriment in a variety of ways. These include growing fees at the expense of returns, investing heavily in inflated markets with only modest expectation of returns, and exiting sound investments prematurely to free up capital for raising new funds. [xix]

The desire for control seems to be a key force behind the disintermediation of private equity.

While the disintermediation of private equity eliminates management fees and gives investors control over their investment opportunities, it leaves other problems unsolved. One such problem is how to overcome information asymmetry and the complexity of managing what inflow of information there is. The high costs associated with this help explain a second unresolved issue: the second wave of financial intermediation is confined to institutional investors and high-net worth individuals and does not benefit everyday investors. The third wave of financial disintermediation is poised to flatten financial markets not just for institutional borrowers, and not just for institutional investors, but for everyone with access to the internet.

The Third Wave: Disintermediation of Capital and the Rise of Blockchain.

The third wave of financial disintermediation goes beyond banks and private equity firms and presents the potential to flatten our entire global financial system. It has the ability to connect capital needs, however great or small, to capital supply, regardless of geography and without traditional financial intermediaries. The manifestation of this process is the blockchain.

The first calls for wide-spread financial disintermediation began in the early 1990s amongst groups of cryptographers known as “Cypherpunks.”[xx] The Cypherpunks challenged the need for trust institutions and called for privacy and anonymity through cryptography. The movement came to a head following the financial turmoil of 2008 when the pseudonymous Satoshi Nakamoto published a whitepaper proposing a cryptographic solution for private, anonymous, trustless, and immutable digital interactions: Bitcoin.[xxi]

Whatever role Bitcoin itself may ultimately play in the third wave of financial disintermediation, the architecture underpinning Bitcoin is proving transformative. This architecture is known as blockchain. As people became increasingly interested in removing trust institutions (think banks, private equity funds, brokerages, insurance providers, and so on) from their financial interactions, the need for digital assets, including digital currency, increases. But digital asset ownership is problematic because everything that is digital can be duplicated. Another way of boiling down the problem is this: if I send you a digital dollar, you can cut and paste the dollar into a different transaction or account, and now you’ve taken one and made two, a problem known as double spend.

Blockchain emerged as the first viable solution to the problem of digital double spend. A blockchain creates a record, or ledger, of all transactions that occur within the network of users on that blockchain. This record is distributed, meaning that every user on the network has a copy of every transaction. People commonly refer to blockchain solutions as “trustless” because it removes the role of central trust institutions as the keepers of transaction ledgers.

For example, in a traditional payment model, a series of trust institution (banks, credit card processors, merchant account brokers, etc.) stand between the purchaser and the seller. The seller is willing to hand over merchandise or provide services because she trusts that the intermediaries will ensure that she gets paid. With a blockchain-based payment system, such as Bitcoin for example, there is no central trust institution. The buyer and seller publish their transaction to the blockchain and their digital assets are exchanged immediately. The entire network sees, records, and remembers that transaction. So, while blockchain does not prevent someone from duplicating a digital asset, because all transactions are known to all parties, digital double spending would be apparent and the community would reject these transactions.[xxii] In other words, you can cut and paste your Bitcoin all you like, but everyone knows about it, and no one will accept it.

So, in this respect, blockchain technology does not eliminate the need for trust, nor does it create truly “trustless” transactions. Rather, the decentralized nature of the blockchain distributes the trust between all parties within a given network, reducing or eliminating the need for centralized trust institutions. With a blockchain transaction, the seller in our previous example does not have to trust a bank or credit card company to know that she will receive payment. She only has to trust the distributed network of users that the digital assets that the purchaser wants to use as payment are valid and have not been duplicated.

The creation of double-spend proof digital assets is the foundation of the third wave of disintermediation. As money and assets are reduced to digital form, the barriers to accessing capital disappear. In the 1980s, corporate finance departments realized savings by disintermediating banks and accessing investors directly through money markets. In the 1990s and 2000s, institutional investors and high net worth individuals took back control of their investments by cutting out private equity funds through direct investment. With blockchain, any person with access to the internet can potentially enter into any type of financial transaction allowed by law without the need to use a bank, a broker, a credit card, or any other financial intermediary.

The Andrew-Debreu economic model helps explain the third wave of financial disintermediation. This model envisions efficient transactions where supply is matched directly to demand without an intermediary. In its purest form, this model sees no need for financial intermediaries where there is a perfect flow of information.[xxiii] Indeed, blockchain technology connects suppliers of capital directly with consumers of capital in a way never before seen.

Any blockchain user can borrow or lend digital currency. Any user can buy, sell, or leverage digital assets or digital manifestations of tangible assets. Beyond the limitations and safeguards imposed by a user’s legal regime, there is no end to the creativity and customizability of financial products and services available. And unlike the benefits of the first and second wave of financial disintermediation, the benefits of blockchain are available to everyone, from the wealthiest corporation to the poorest subsistence farmer.

While this third wave of financial disintermediation brims with exciting potential, it is still only just beginning to take shape. It is far from certain at this point what a financial model influenced by blockchain will ultimately look like. However, by applying the observations we can make about the first and second waves, we can perhaps develop a general idea about what some of its major features will be.

The Future of Blockchain-based Financial Systems.

First and foremost, the ability to entirely remove financial intermediaries does not presuppose the inevitability, or even desirability, of a world without them. Indeed, financial intermediation offers certain undeniable benefits. First, think back to the Andrew-Debreu model. Remember that this model seen no need for financial intermediaries only when there is a perfect flow of information. While blockchain presents many opportunities to improve the flow of information, at this point it is difficult to imagine a world where everyone has access to perfect financial information. Financial intermediaries may continue to play an important role as brokers of information. [xxiv] Moreover, most people are not trained in finance, and are well served by relying on trusted advisors to help them make sage financial decisions.

Another benefit that financial intermediaries play is risk reduction. When multiple investors pool their assets with an intermediary, they can share the costs that go into analyzing and executing investments thereby reducing transaction costs.[xxv] We saw with private equity firms in the second wave of financial disintermediation that this benefit can easily be outweighed by fees and agency problems. But in a more perfect form, intermediaries can provide an undeniable advantage.

A third benefit that financial intermediaries play is the ability to develop specialized bodies of knowledge and expertise. An individual looking to borrow or lend a small amount of money is unlikely to have the expertise to be able to create a novel financial product that will maximize value and reduce risk to both parties. However, an intermediary that attracts top financial professionals and is exposed to huge amounts of transaction data may be able to suggest just such a financial product.

Blockchain will almost certainly reduce the role of financial intermediaries. But what is perhaps more difficult to predict is what that remaining role will look like. First of all, the financial intermediaries within a blockchain financial system need not be centralized institutions. They may instead be decentralized autonomous organizations, or associations of otherwise unaffiliated individuals. These institutions may still play an intermediary, or centralized role, albeit to a lesser degree. They will be able to bring the benefits that financial intermediaries are capable of adding, as discussed above, but they themselves will potentially be built on decentralized principles. In theory, their decentralized nature could minimize the deleterious effects that otherwise centralized intermediaries are prone to impose, without eliminating the positive contributions that financial intermediaries can make.

Another role that financial intermediaries will continue to play in a decentralized world is to provide meeting places for people to connect. While blockchain may allow a farmer in Lesotho to borrow money from a power provider in the Czech Republic, the farmer and power provider have to find each other before either of them sees any benefit. In this regard, platforms and protocols to bring parties together and provide a common technical language for them to speak are essential to extracting value from blockchain. These platforms and protocols do not emerge spontaneously, but are established and maintained by intermediaries. Again, these intermediaries may be intrinsically decentralized to varying degrees, but they are nonetheless playing a vital role intermediating blockchain financial networks.

Looking Ahead.

For those of us who grew into financial literacy within the last 40 years, disintermediation is all we know. The first wave showed us that as banks lost the ability to compete for deposits and borrowers, they were replaced by more efficient and specialized forms of financing that connected institutional borrowers more directly with sources of capital. The second wave showed us that when institutional investors were given a choice to control their investments and avoid management fees, they increasingly chose to remove private equity firms from between themselves and their investments. The third wave of financial disintermediation, the rise of blockchain, is taking everything that we have learned from the prior waves and expanding it to every corner of the financial markets, making it available to every person on the planet. By flattening financial markets and connecting the global supply of capital, blockchain-based financial markets are poised to create the fairest, most efficient, and most inclusive financial system that we have ever seen. If nothing else, the next few years of blockchain adoption will forever change the narrative of finance in the twenty-first century.

[i] Celine Choulet & Yelena Shulyatyeva, History and Major Causes of US Banking Disintermediation, BNP Parisbas (Jan. 2016), available at http://economic-research.bnpparibas.com/Views/DisplayPublication.aspx?type=document&IdPdf=27450; see also Hal B. Heaton, Commercial Banking Regulation, BYU Marriott School 16 ex. 6 (2013).

[ii] Gary Richardson, Banking Panics of 1930–31, Federal Reserve HIstory (Nov. 22, 2013) https://www.federalreservehistory.org/essays/banking_panics_1930_31.

[iii] Number of Institutions, Branches and Total Offices FDIC-Insured Commercial Banks US and Other Areas, FDIC (2018), available at https://www5.fdic.gov/hsob/HSOBRpt.asp.

[iv] Id.

[v] Hal B. Heaton, Commercial Banking Regulation, BYU Marriott School 6 (2013).

[vi] Historical Timeline, FDIC (last updated Jan. 2, 2014), https://www.fdic.gov/about/history/timeline/.

[vii] Choulet, supra, n. i.

[viii] Hal B. Heaton, Arapahoe Corporation, BYU Marriott School 16 ex. 11b (2013).

[ix] See generally, Hal B. Heaton, The Euromarket, BYU Marriott School (2013).

[x] Id. At 9.

[xi] Id.

[xii] Id.

[xiii] Lily Fang, et al., The Disintermediation of Financial Markets: Direct Investing in Private Equity, NBER Working Paper Series 7, working paper 19299 (Aug. 2013), available at http://www.nber.org/papers/w19299.

[xiv] Id. at 36.

[xv] Id.

[xvi] Id.

[xvii] Victoria Ivashina, The Disintermediation of Financial Markets: Direct Investing in Private Equity, J. of Fin. Econs. forthcoming 1 (Sep. 3, 2014).

[xviii] Mark Tosczak, Weighing Private Equity and Direct Investments, Conversations (Mar. 2017), https://privatebank.wf.com/conversations/article/weighing_private_equity_and_direct_investments.

[xix] Ivashina, supra, n.xi, at 2.

[xx] Eric Hughes, Cypherpunk’s Manifesto (Mar. 9, 1993), available at https://www.activism.net/cypherpunk/manifesto.html.

[xxi] Satoshi Nakamoto, Bitcoin: A peer-toPeer Electronic Cash System (Nov. 2008), available at https://bitcoin.org/bitcoin.pdf.

[xxii] For example, $500 million of NEM digital tokens stolen from the exchange CoinCheck have now been branded as “Do Not Accept.”

[xxiii] Id. at 1.

[xxiv] Fang, supra n.x, at 1.

[xxv] Id.