Financial Services: The Coming Cataclysm

Alex Tapscott is a venture capital investor, co-author (with Don Tapscott) of "Blockchain Revolution: How the Technology Behind Bitcoin and Other Cryptocurrencies is Changing the World" and co-founder of the Blockchain Research Institute in Toronto. The following excerpt, written by Alex Tapscott, is from his new book "Financial Services Revolution."

Facebook’s foray into cryptocurrencies should surprise no student of technology. After all, the digital revolution has transformed nearly every aspect of our lives, except banking. Financial intermediaries depend more or less on pre-internet technologies. Libra is simply the latest innovation to punch holes in the old model, establishing the battle lines for the future of our digital economy.

The stakes are high: The next era of commerce, economic activity and money is uncertain. Computer scientists are rewiring the economic power grid, and software engineers are re-coding the order of human affairs, exposing our lack of understanding of fundamental concepts like privacy, free speech and the role of large corporations in our lives. As the digital landlords of this new economy – Facebook, Google and others – challenge the supremacy of big banks, decentralized cryptocurrencies like bitcoin (BTC) force us to confront our understanding of money, value, and the fortress of regulations erected around these concepts, originally to protect those who used the system, and now to preserve the status quo. This is ultimately a struggle for control, as many parties – totalitarian governments in China and elsewhere, legacy financial institutions, big social media companies and other digital conglomerates, technology upstarts and other stakeholders – vie for even greater influence.

Human beings have become increasingly comfortable with software and technology replacing human actors in many industries and many facets of daily life. Finance is the largest, most consequential and thus far most immovable industry of them all. The legacy banking system, digital conglomerates like Facebook, free and open cryptocurrency platforms such as bitcoin and, of course, governments are heading inexorably for a collision of historic proportions. The crash will be cataclysmic. Prepare for impact.

Crypto assets and open finance

“They say that software is eating the world. Soon, tokens will be eating the world,” said Tyler Winklevoss. He’s right. Blockchain is the first native digital for value: We can use it to program virtually every asset under the sun. In the latest edition of "Blockchain Revolution," we provided a taxonomy of these assets to help the reader understand their many differences. They were cryptocurrencies (bitcoin, Zcash, litecoin), platform tokens (ether, ATOMs, EOS), utility tokens (Augur’s REP), securities tokens (theDAO, Munchee’s MUN, Vocean’s crypto bond), natural asset tokens (carbon, water, air), crypto collectibles, stablecoins, and crypto fiat currencies (the Petro, China’s forthcoming crypto yuan).

In this section, we are going to focus on digitization of existing financial assets in the form of securities tokens and fiat-backed stablecoins. This is the world of open finance, which differs from decentralized finance, which we discuss later. Open finance refers to the opening of traditionally closed, analog and proprietary systems to blockchain and digital assets. Open finance will prove to be an opportunity and challenge for incumbents, regulators and market actors everywhere.

Consider equities. The global “stock market” is really a loosely knitted patchwork of local and regional exchanges, banks, broker dealers, custodians, clearinghouses, regulators, asset managers, fund administrators and other market participants and intermediaries. Though order books and market making are largely digitized, the underlying function of how these different parties actually clear, settle, custody and register ownership of assets is antiquated.

Blythe Masters, former managing director of J.P. Morgan, the investment bank, and former CEO of Digital Asset, told us:

Bear in mind that financial infrastructures have not evolved in decades. The front end has evolved but not the back end. It’s been an arms race in technology investment oriented toward speeding up transaction execution so that, nowadays, competitive advantages are measured in nanoseconds.

She was referring to high-frequency trading: “The irony is that post-trade infrastructure hasn’t really evolved at all.” Blockchain holds the potential to reduce radically the cost, complexity and friction in markets by allowing market participants to connect, clear and settle peer to peer instantaneously.

0x, an open protocol that enables P2P exchange of assets on the Ethereum blockchain, is a pioneer in this regard. Though not all the assets traded on this exchange are financial, some are. So far, 0x has conducted over 713,000 transactions worth $750 million [as of 9/2019]. As underlying platforms like Ethereum, Cosmos, Polkadot, EOS,and others scale, so, too, will the capacity of the applications and financial business use cases that employ them. tZERO, a subsidiary of publicly traded Overstock, has made great strides in this area as well. In the summer of 2019, Overstock announced that shareholders of the publicly traded company would receive dividends as a digital token listed on tZERO. Patrick Byrne, former CEO of Overstock, said of the move, “Five years ago, we set out to create a parallel universe: a legal, blockchain-based capital market. We’ve succeeded.” Byrne has reasons to be optimistic that this parallel universe of digital assets will create challenges and opportunities for new entrants and incumbents alike.

Securities tokens not only reduce friction, cost, and complexity. They also enable broader participation in capital markets, because they lower barriers and they allow us to imagine building liquid marketplaces for a wide variety of assets, from real estate to private equity and venture capital (VC). Greater transparency, market depth, and liquidity should improve price, access, and the overall healthy functioning of markets.

Not all assets will work as tokens. But we see tokenization working when several conditions are satisfied:

1. Is there an established or untapped demand for an asset?

2. Do people or institutions want to buy the asset but can’t currently?

3. Are there high barriers to transferability or liquidity in an asset?

4. Are transaction costs high, spread too wide or are other barriers so prohibitive that market participants choose to avoid the asset class altogether?

5. Is blockchain required to digitize the asset — that is, the asset simply isn’t workable in a traditional system?

6. Is the industry highly consolidated or highly fragmented?

If the answer is yes to a majority of these questions, then the asset is a likely candidate for securities tokens, and a highly fragmented market should make experimentation or innovation easier. Tokenized equity, debt and real estate already exist. We may eventually see tokenized sports teams, music catalogues, wine portfolios, fine art and event tickets, to name a few. Securities tokens may help improve access to wealth creation for average people by lowering barriers to entry and expanding investment options.

This opportunity is not without challenges: it lacks technology, business, market and regulatory infrastructure. Anthony Pompliano, co-founder and partner at Morgan Creek Digital, believes that securities regulators “took the idea of the rich get richer and … wrote it into law. They took the best performing assets with the best returns and put them behind a firewall.” He was referring to the Securities and Exchange Act of 1933, which limited many investment opportunities to high-net-worth individuals. He called it a “violation of the American dream.” If these kinds of investment opportunities remain limited to the richest of the rich, then we haven’t really democratized the benefits of blockchain-based financial innovation.

The lines defining “financial services” will begin to blur as everything becomes an asset and everyone becomes a market participant.

Consider Props. Props is a native digital token created by the popular video application YouNow, though it can work inside any application. YouNow was granted special authorization by the SEC to do a Regulation A offering of its token, approved in July, and already launched. Think of Props as stock options for the gig economy, for people like Uber drivers, homeowners who let their houses on Airbnb, or content creators. On YouNow, these people can earn money by sharing something on the platform. Otherwise, they can’t participate directly in the value creation from the growth of currently popular platforms such as Uber or Airbnb. Similarly, Uber drivers may get paid for completing a ride, but they don’t get a piece of the $75 billion that Uber is worth. The so-called “sharing economy” is really an “aggregation economy,” where powerful platforms capture most of the value, and contributors get the crumbs.

With Props, contributors to platforms like YouNow, and soon perhaps Uber, Airbnb and others, can get paid for their contributions and earn Props tokens. The supply of Props is finite and grows at a predictable rate, and so the more apps using the native token, and the more people earning and holding them, the higher the value of Props. Any application can plug into the Props application programming interface (API) and allow contributors to start earning real value in Props. Founders and investors will no longer be the sole beneficiaries of platform growth. In the context of financial services, we can view Props both as a new payment rail for organizing contributors in a network and as an incentive mechanism, like equity, for staying on the platform and adding value to it. Already, 200,000 people are using Props on YouNow with 100,000 Props transactions per day. The plan is to add more apps as time goes on. As Props becomes ubiquitous, other applications may be compelled to offer it to contributors—and, voilà, a new digital economy is born.

This new cornucopia of digital tokens will need common standards, with groups like the Enterprise Ethereum Alliance (EEA) helping to lead the charge. Marley Gray of Microsoft, who is a key contributor to the EEA’s Token Alliance, told us that common standards “remove the obstacles for defining assets. Blockchain should be just like using the payments network today. People should just use it.” He added, “You don’t need to understand the blockchain to use tokens. Let’s get to the point where we are actually driving business value. Let’s abstract this, make it common. Commoditizing tokens so any industry or company can create them.”

If different assets exist inside of silos that don’t speak to one another, then tokenization will have limited impact. Only through common standards and interoperability can tokenization reach its full potential. Fiat-backed stablecoins, such as Tether, USDC, and Libra are other examples of open finance. Not all stablecoins are backed dollar for dollar by reserves; and some, such as DAI created by MakerDao, exist entirely in the crypto asset world. Already, stablecoins have exploded in value, and for good reason. They offer an easy way to move value peer to peer instantaneously at a fraction of the cost of traditional payment systems like Venmo. Consider the findings of TradeBlock, a provider of digital currency trading tools for institutional investors:

[T]he aggregate total on-chain transfer volume across the largest stablecoins has now surpassed Venmo’s total payment volume. … [F]ees associated with sending stablecoins across the Ethereum network were dwarfed by merchant fees and fees from associated Venmo services. Across the five largest ERC-20 tokens, customers spent just $827,000 in Ethereum network fees to transfer more than $37 billion. Over this same period, fees and fees on associated services paid to Venmo are expected to reach $150 million.

Given this explosive growth, Facebook, Walmart and JPMorgan – and perhaps Google and Amazon – are including stablecoins in their growth plans.

Cameron Winkelvoss said, “We are going to see many companies issuing coins,” adding that “a company like Facebook with its size and stature is very encouraging in validating the general idea of better and new payment rails powered by crypto. Whether it’s Libra or not [that succeeds], time will tell.” Consider Amazon: “You can pretty much get a package anywhere in the world. What you can’t do is get paid for that product. Amazon Coin could create the ability to extend the payment system to the edges of the earth.” No doubt, Libra is but the opening volley in this new competition among the world’s tech behemoths.

Pompliano believes Libra is a positive development but that it is also good for bitcoin and other cryptocurrencies. He said, “It’s the token density theory. If you set up a restaurant across the street from another restaurant, traffic at both restaurants typically goes up. Everyone’s foot traffic increases as you add density. So with each legitimate crypto that gets created and gets added it increases the overall value proposition of bitcoin.” Ryan Selkis, founder of Messari, summed it up simply by saying Libra will act as a “lead blocker” for other crypto assets.

Not everyone is so optimistic about corporate coins. “I’m not afraid of nuclear meltdowns or terrorist attacks. The only thing I’m afraid of is Facebook’s cryptocurrency,” said Ethan Buchman, co-creator of Cosmos. “Facebook perfected digital colonialism. While the early colonialist companies enslaved bodies, Facebook enslaves minds. This will be [its] historical legacy.” With Facebook settling with the U.S. Federal Trade Commission for $5 billion and with the SEC for $100 million while getting grilled by lawmakers, its road to launch Libra will be a hard one, and Facebook’s leaders will need to earn back the trust of those they let down. That’s a daunting challenge.

Still, the technology has its own momentum, which makes it unlikely at this point to be derailed. Financial markets – from stocks to bonds and everything in between – will be unrecognizable. Incumbents that bet big on blockchain will survive this coming revolution.

Financialization and digitization of everything

If land was the most important asset of the agrarian age, and oil was the most important asset of the industrial age, then data is the most important asset of the digital age. Information is the foundation of our digital economy and the lifeblood of some of the world’s largest and most profitable companies, such as Facebook and Google. Consider the reordering of the world’s most valuable companies over the last 20 years (see below). In this period, data has replaced oil as the main driver of business value in the world, and information behemoths have displaced the industrial giants.

We create all this data, yet we don’t own it – the digital landlords do. This is problematic because it means we can’t use that data to better organize our lives, we can’t monetize it, and it can fall into the wrong hands.

Information is one example of an asset that has had no open, transparent marketplace where stakeholders can discover price or exchange its value. This is part of a much broader problem that the digital age has exacerbated. Many assets have been outside market forces and susceptible to overuse or capture by large intermediaries. Like water, air or the oceans, powerful companies exploit the data and, in turn, the people who created it.

In a major research report for the Blockchain Research Institute, technology theorist [and CoinDesk's very own] Michael Casey suggested that tokenization and digital scarcity brought about by crypto assets represents a solution:

Blockchain technology, and the cryptocurrencies, tokens and other digital assets that it has engendered, may be moving us toward a model of programmable money that incorporates an automated internal governance of common resources and encourages collaboration among communities. Digital scarcity, when applied to these tokens treats our increasingly digitized world differently from the pre-digital one. It raises the possibility that our money may itself become the tool for achieving common outcomes.

Developers of new decentralized applications are tokenizing all manner of resources – electricity and bandwidth for example, but also human qualities such as audience attention for online content or fact checkers honestly. … Once a community associates scarce tokens with rights to these resources, it can develop controls over token usage that help manage public goods. It’s dynamic money whose role extends beyond that of a unit of exchange, money that’s a direct tool for achieving community objectives.

In his report, Casey lays out a new taxonomy for these tokens and suggests at least five different types: media, identity, honesty, decentralized computing and the environment.

The potential is very significant for these tokens to enable new economies around assets that were either previously in the commons (such as the environment) or captured asymmetrically (such as our identities) by a few large technology intermediaries. Moreover, we can tokenize everything of value to ensure creators receive fair compensation. Now, individuals can capture the value from the data they produce in their online selves, choosing to keep it private or provide informed consent for its use, making money in the process. Individual artists can receive fair payment for the music they create as their songs roam the Internet collecting royalties. People can enter agreements enforced by smart contracts and verified by oracles in prediction markets. These capabilities will no doubt spread from the trivial (sports betting) to more meaningful markets like derivatives markets.

The lines defining “financial services” will begin to blur as everything becomes an asset and everyone becomes a market participant.