The Growth of Finance as % of GDP

Source: Philippon (AER 2015) "Has the U.S. Finance Industry Become Less Efficient?"

The Financial Industry is very competitive ...  yet unit costs have been flat!

Source: Philippon (AER 2015) "Has the U.S. Finance Industry Become Less Efficient?"

What do we know from the long history of capitalism?​

Disruptive entry is bound to take place!

Prime Example of outside disruption: Equity Market Trading

Modern Day Trading

Autonomous Algorithms run the show

Why?

• Many trading strategies are more-or-less mechanical/probabilistic
• Compared to humans, computers are
  • faster,
  • cheaper,
  • more reliable,
  • operate at much wider scope

Source: Bloomberg News, Feb 20, 2015

Note: The biggest disruptors (the HFTs) came from the outside of the traditional system (kinda).

Critical enabling factor: fundamental change in  infrastructure

Easier access and greater diversity of skills.

What about the financial sector as a whole?

Technology alleviated  structural constraints

Current Financial Infrastructure

Desired Infrastructure

Illustration of Clunky Infrastructure: Money Transfer

Stock Trade

Let's take a step back: how do we transfer value?

• need to trust that the seller owns the item
• for securities: issuer needs to know owner

Common Solutions

1. Banks
   • verify ownership of assets (e.g., money)
   • must be connected for transfers
2. Central registries
   • maintain permanent record of ownership
   • special privileges needed to make changes

Some Issues

• reconciliation across silos (cash accounts, registries, fund flows)
• connectedness of system entities
• no "direct" transfers possible
  => need privileged access to the infrastructure

So how would we design value transfer?

central registry

Option 1: Centralized

Technological challenge:

• need consensus protocol to change registry

So how would we design value transfer?

Option 2: Distributed Network

Essence of Blockchain: consensus protocol in distributed network

• keep track of all transactions of digital assets
  • can re-establish current ownership
• rules for additions to chain
  • how are new transactions verified
  • who can add new transactions
• consensus mechanism to accept changes across network

Illustration: Money Transfer

And there is more to it!

Why use banks?

Blockchains essentially allow everyone to partake!

Why is Blockchain Important? What can it do?

• World Wide Web:

  • frictionless electronic transfer of information

• Blockchain:

  • ​frictionless electronic transfer of value

Stock Trade with Blockchain

Market Design Questions

• How much transparency?
  • explicit anonymization possible
  • implicit version: use many IDs
  • efficiency gains (I have a paper on this: Malinova & Park 2017)
• How to incentivize verification and block creation? 
  • low activity environments
  • with privacy features: who is allowed to verify?
• How fast should we settle?
  • capital commitment of intermediaries vs risk reduction (paper by Rotman faculty: Khapko & Zoican 2017)

Vocabulary Clarification

FinTech

Distributed Ledger Technology

Blockchain

My definition of FinTech: outside main financial institutions, usually post-2008

FinTech, DLT, Blockchain

Compliance

Wealth management

payments

Data & Analytics

Cryptocurrency

crowdfunding
(120+ FinTechs)
(19 equity CF platforms)

(P2P) lending

Public Blockchain

• anyone can read and write (in principle)
• large numbers of nodes
• anonymity of user (but visibility of records)
• immutability of records (subject to "hard forks")
• verification must be incentivized

Private Blockchain

• can have permissioned access for users
• records can be changed
• usually few nodes
• authorized authentication
• transparency, settlement speeds, user ID structure are design choices

Vocabulary Clarification

Public vs. Private

Vocabulary Clarification

Smart Contracts

Take Aways: Intrinsic Features of Blockchain

• Blockchain requires no
  • "accounts"
  • dealers/brokers/bank
• Blockchain does require
  • distributed network 
  • entities that process transactions
• Blockchain ledger can be very transparent
  • => design choice.
• Settlement is instantaneous
  • the trade is the settlement
• Peer-to-peer is possible.
  • Who is your peer?

Link of Blockchain and FinTech

1. remodel the back office 
   • traditional FI has expertise?
   • few blockchain developers
   • lose legacy systems (Fortran, Cobol, etc)
   • integrate databases
2. back office => front office
   • peer to peer 
   • scope of data usage (VBA=         )
   • new instruments
3. access for "outsiders" to larger market
   • broaden scope & offers new products to issuers and investors
4. circumvent legacy infrastructure
   • crowdfunding + blockchain
   • "ADR" (coloured coin) trading

Market Design
with Blockchain

• discussion on blockchain dominated by
  • tech talk
  • feasibility
  • cost savings
• my view: focus on economics!
  • understand underlying economic mechanisms
  • back office => front office
  • which new business models?
• market = transparent & equal access
  • BUT: marketplaces are built by self-interested parties
    • rules and institutions => frictions
    • frictions => economic implications => optimize market design

FinTech, Blockchain Technology, and its Impact on the Financial Industry

5th Annual Rotman GRI Finance Forum