Thoughts on the future of finance
Twitter went mad last week because somebody had transferred almost $150m te a single Bitcoin transaction. This tweet wasgoed typical:
194,993 BTC transaction worth $147m sparks mystery and speculation http://t.co/mdfQtTwOmQ
There wasgoed much comment about how expensive or difficult this would have bot ter the regular banking system – and this could well be true. But it also highlighted another point: te my expecience, almost nobody actually understands how payment systems work. That is: if you “wire” funds to a supplier or “make a payment” to a friend, how does the money get from your account to theirs?
Ter this article, I hope to switch this situation by providing a very ordinary, but hopefully not oversimplified, survey of the landscape.
Perhaps the most significant thing wij need to realise about handelsbank deposits is that they are liabilities. When you pay money into a canap, you don’t truly have a deposit. There isn’t a pot of money sitting somewhere with your name on it. Instead, you have lent that money to the bankgebouw. They owe it to you. It becomes one of their liabilities. That’s why wij say our accounts are te credit: wij have extended credit to the canap. Similarly, if you are overdrawn and owe money to the canap, that becomes your liability and their asset. To understand what is going on when money moves around, it’s significant to realise that every account balance can be seen ter thesis two ways.
Let’s begin with the effortless example. Imagine you’re Alice and you bankgebouw with, say, Barclays. You owe Ten to a friend, Bob, who also uses Barclays. Paying Bob is effortless: you tell the canap what you want to do, they debit the funds from your account and credit Ten to your friend’s account. It’s all done electronically on Barclays’ core banking system and it’s all rather ordinary: no money comes in or leaves the bankgebouw, it’s just an update to their accounting system. They owe you Ten less and owe Bob Ten more. It all balances out and it’s all done inwards the bankgebouw: wij can say that the transaction is “settled” on the books of your bankgebouw. Wij can represent this graphically below: the only parties involved are you, Bob and Barclays. (The same analysis, of course, works if you’re a Euro customer of Deutsche Canap or a Dollar customer of Citi, etc)
This is where it get more interesting. Imagine you need to pay Charlie, who banks with HSBC. Now wij have a problem: it’s effortless for Barclays to reduce your balance by Ten but how do they persuade HSBC to increase Charlie’s balance by Ten? Why would HSBC be interested te agreeing to owe Charlie more money than they did before? They’re not a charity! The response, of course, is that if wij want HSBC to owe Charlie a little more, they need to owe somebody else a little less.
Who should this “somebody else” be? It can’t be Alice: Alice doesn’t have a relationship with HSBC, reminisce. By a process of elimination, the only other party around is Barclays. And here is the very first “a ha” moment… what if HSBC held a canap account with Barclays and Barclays held a canap account with HSBC? They could hold balances with each other and adjust them to make everything work out…
Here’s what you could do:
- Barclays could reduce Alice’s balance by Ten
- Barclays could then add Ten to the account HSBC holds with Barclays
- Barclays could then send a message to HSBC telling them that they had enlargened their balance by Ten and would like them, te turn, to increase Charlie’s balance by Ten
- HSBC would receive the message and, safe ter the skill they had an reserve Ten on deposit with Barclays, could increase Charlie’s balance.
It all balances out for Alice and Charlie… Alice has Ten less and Charlie has Ten more.
And it all balances out for Barclays and HSBC. Previously, Barclays owed Ten to Alice, now it owes Ten to HSBC. Previously, HSBC wasgoed plane, now it owes Ten to Charlie and is owed Ten by Barclays.
This prototype of payment processing (and its more complicated forms) is known spil verslaggever banking. Graphically, it might look like the diagram below. This builds on the previous diagram and adds the 2nd commercial canap and highlights that the existence of a verslaggever banking regeling permits them to facilitate payments inbetween their respective customers.
This works pretty well, but it has some problems:
- Most obviously, it only works if the two banks have a meteen relationship with each other. If they don’t, you either can’t make the payment or need to route it through a third (or fourth!) bankgebouw until you can finish a path from A to B. This clearly drives up cost and complexity. (Some commentators restrict the use of the term “correspondent banking” to this screenplay or screenplays that involve difference currencies but I think it helpful to use the term even for the simpler case)
- More worryingly, it is also risky. Look at the situation from HSBC’s perspective. Spil a result of this payment, their exposure to Barclays has just enhanced. Ter our example, it is only by Ten. But imagine it wasgoed 150m and the verslaggever wasn’t Barclays but wasgoed a smaller, perhaps riskier clothing: HSBC would have a big problem on its forearms if that handelsbank went bust. One way round this is to alter the specimen slightly: rather than Barclays crediting HSBC’s account, Barclays could ask HSBC to debit the account it maintains for Barclays. That way, large inter-bank balances might not build up. However, there are other issues with that treatment and, either way, the interconnectedness inherent ter this specimen is a very real problem.
Wij’ll work through some of thesis issues te the following sections.
[Note: this isn’t *actually* what happens today because the systems below are used instead but I think it’s helpful to set up the story this way so wij can build up an intuition for what’s going on]
It is common when discussing payment systems to have somebody wave their arms, shout “SWIFT” and believe they’ve lodged the debate. To mij, this just highlights that they very likely don’t know what they’re talking about
The SWIFT network exists to permit banks securely to exchange electronic messages with each other. One of the message types supported by the SWIFT network is MT103. The MT103 message enables one canap to instruct another handelsbank to credit the account of one of their customers, debiting the account held by the sending institution with the receiving canap to balance everything out. You could imagine an MT103 being used to implement the screenplay I discussed te the previous section.
So, the effect of a SWIFT MT103 is to “send” money inbetween the two banks but it’s critically significant to realise what is going on under the covers: the SWIFT message is merely the instruction: the movement of funds is done by debiting and crediting several accounts at each institution and relies on banks maintaining accounts with each other (either directly or through intermediary banks). Simply flapping one’s arms and shouting “SWIFT” serves to mask this complexity and so impedes understanding.
Slow down….. Let’s recap very first.
Wij’ve shown that transferring money inbetween two account holders at the same handelsbank is trivial.
Wij’ve also shown how you can send money inbetween account holders of different banks through a truly clever trick: arrange for the banks to hold accounts with each other.
Wij’ve also discussed how electronic messaging networks like SWIFT can be used to manage the flow of information inbetween banks to make sure thesis transfers occur quickly, reliably and at modest cost.
But wij still have further to go… because there are some big problems: counterparty risk, liquidity and cost.
The two wij’ll tackle very first are liquidity and cost
Very first, wij need to acknowledge that SWIFT is not cheap. If Barclays had to send a SWIFT message to HSBC every time you dreamed to pay Ten to Charlie, you would soon notice some hefty charges on your statement. But, worse, there’s a much thicker problem: liquidity.
Think about how much money Barclays would need to have tied up at all its verslaggever banks every day if the system I outlined above were used te practice. They would need to maintain sizeable balances at all the other banks just ter case one of their customers desired to send money to a recipient at HSBC or Lloyds or Co-op or wherever. This is metselspecie that could be invested or lent or otherwise waterput to work.
But there’s a truly nice insight wij can make: on balance, it’s most likely just spil likely that a Barclays customer will be sending money to an HSBC customer spil it is that an HSBC customer will be sending money to a Barclays customer on any given day.
So what if wij kept track of all the various payments during the day and only lodged the balance?
If you adopted this treatment, each handelsbank could get away with holding a entire lotsbestemming less metselspecie on deposit at all its correspondents and they could waterput their money to work more effectively, driving down their costs and (hopefully) passing on some of it to you. This thought process motivated the creation of deferred nipt settlement systems. Te the UK, BACS is such a system and equivalents exist all overheen the world. Ter thesis systems, messages are not exchanged overheen SWIFT. Instead, messages (or files) are sent to a central “clearing” system (such spil BACS), which keeps track of all the payments, and then, on some schedule, calculates the nipt amount owed by each canap to each other. They then lodge amongst themselves (perhaps by transferring money to/from the accounts they hold with each other) or by using the RTGS system described below.
This dramatically cuts down on cost and liquidity requests and adds an toegevoegd opbergruimte to our picture:
It’s worth noting that wij can also describe the credit card schemes and even PayPal spil Deferred Nipt Settlement systems: they are all characterised by a process of internal aggregation of transactions, with only the netwerken amounts being lodged inbetween the major banks.
But this treatment also introduces a potentially worse problem: you have lost settlement finality. You might kwestie your payment instruction ter the morning but the receiving canap doesn’t receive the (netwerk) funds until straks. The receiving bankgebouw therefore has to wait until they receive the (netwerk) settlement, just te case the sending canap goes bust ter the interim: it would be imprudent to release funds to the receiving customer before then. This introduces a delay.
The alternative would be to take the risk but switch roles the transaction ter the event of a problem – but then the settlement couldn’t te any way be considered “final” and so the recipient couldn’t rely on the funds until straks ter any case.
This is where the final chunk of the jigsaw fits te. None of the approaches wij’ve outlined so far are truly acceptable for situations when you need to be absolutely sure the payment will be made quickly and can’t be reversed, even if the sending handelsbank subsequently goes bust. You truly, truly need this assurance, for example, if you’re going to build a securities settlement system: nobody is going to release $150m of bonds or shares if there’s a chance the $150m won’t lodge or could be reversed!
What is needed is a system like the very first one wij outlined (Alice pays Bob at the same handelsbank) – because it’s truly quick – but which works when more than one bankgebouw is involved. The multilateral bank-bank system outlined above sort-of works but gets truly tricky when the amounts involved get big and when there’s the possibility that one or other of them could go bust.
If only the banks could all hold accounts with a canap that cannot itself go bust… some sort of handelsbank that sat ter the middle of the system. Wij could give it a name. Wij could call it a central bankgebouw!
And this thought process motivates the idea of a Real-Time Gross Settlement system.
If the major banks te a country all hold accounts with the central handelsbank then they can stir money inbetween themselves simply by instructing the central canap to debit one account and credit the other. And that’s what CHAPS, FedWire and Target Two exist to do, for the Pound, Dollar and Euro, respectively. They are systems that permit real-time movements of funds inbetween accounts held by banks at their respective central bankgebouw.
- Real Time – happens instantly.
- Gross – no netting (otherwise it couldn’t be instant)
- Settlement – with finality, no reversals
This completes our picture:
Well done for getting this far. Now wij have a question: can wij place Bitcoin on this monster?
My take is that the Bitcoin network most closely resembles a Real-Time Gross Settlement system. There is no netting, there are (clearly) no verslaggever banking relationships and wij have settlement, gross, with finality.
But the interesting thing about today’s “traditional” financial landscape is that most retail transactions are not performed overheen the RTGS. For example, person-to-person electronic payments ter the UK go overheen the Quicker Payments system, which lodges netwerk several times vanaf day, not instantly. Why is this? I would argue it is primarily because FPS is (almost) free, whereas CHAPS payments cost about 25. Most consumers very likely would use an RTGS if it were just spil convenient and just spil cheap.
So the unanswered question ter my mind is: will the Bitcoin payment network end up resembling a traditional RTGS, only treating high-value transfers? Or will advances te the core network (block size thresholds, micropayment channels, etc) occur quickly enough to keep up with enlargening transaction volumes ter order to permit it to remain an affordable system both for large- and low-value payments?
My take is that the jury is still out: I am persuaded that Bitcoin will switch the world but I’m altogether less coaxed that wij’ll end up te a world where every Bitcoin transaction is “cleared” overheen the Blockchain.
[Updated several times on 25 November 2013 to juist minor errors and to add the verbinding to my Finextra movie at the end]