Bank Castles Of Sand: Blockchain Edition

Includes: BAC, C, GS, IBM, JPM, WFC
by: Kurt Dew

The technology to rid ourselves of the banks’ inefficiencies has been available for a decade or more.

Bank spending on blockchain, for example, is unnecessary to achieve the promised benefits.

FinTech is capable of revolutionizing finance, but the changes must come from outside banking and its political support.

Only fear motivates big change by banks. The banking system co-opts small threats by buying them off.

Don't let them fool ya,
Or even try to school ya. Oh, no.
We've got a mind of our own.
—Bob Marley

For the castle of sand that is the current banking system, hiding the negative effects on bank customers of their government-sourced protection is a full-time job which is still quite successful - despite Crisis revelations.

Banks are assisted by politicians' two-faced tepid effort to crash through the banking castles' anti-competitive walls. But the reality of politician's support for the banking system, especially for the big banks, is shown by Congress' subsidy of the dealers' derivatives and repurchase agreements, described here.

One way the banks misdirect attention from their rewards at customer expense is with billions spent on unnecessary technology they don't need. The hype of new tech disguises the reality. Banks have a long-standing proven ability to remedy the inefficiencies that produce their oligopoly profits at consumers' loss. But the claim is, "Just wait until we have the next big thing." Permissioned blockchains are the current flash-in-the-pan. This article asks, "Do the banks need blockchain to provide low-cost efficient transactions?" The answer is obvious. No.

The big banks — Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), and Wells Fargo (NYSE:WFC) — are the focus of public attention since the Crisis, but they are simply a symbol of the bigger problem, a massively over-capitalized total banking system. Dealer banks may in fact, need to grow as a group.

As I argue here, they may be joined in the future by other large banks, as smaller, less efficient banks merge; the result, on one hand, of economies of scale in the provision of most banking services as electronic transaction technology matures; on the other, of the need for more diversity in trading market participation, as trading tech is reformed to permit broader participation.

The basic function of the dealer banks, trading, is not threatened by the Volcker rule (despite appearances) nor could it be. The current trading environment, dominated by too few institutions, bloated by the excessive capital demanded by their inefficient transactions - unnecessarily - would fix itself if the markets were reformed.

The dealers have drawn our attention from the larger problem. The larger problem is that the country is over-banked. Banking liabilities and equity throughout the system support a capacity to provide credit that corporate borrowers won't pay for. Corporations can get credit more cheaply outside the banks.

This leaves the banking system in a dangerous holding pattern. The capacity for credit that the banks provide is usually in surplus, but in excess demand during crises. Credit is in surplus during normal times since the banks and their regulators do not normally charge external sources of funds like money markets enough to reward bank stockholders for their crisis backstop role.

Thus, the financial system as a whole is in denial. All that real estate tied up by branches - and to a lesser degree, extravagant corporate headquarters that the dealers foolishly erect - is a monument to the banking system of the past. The future of the banking system is electronic for transactions. The role of humans in the future of finance is in judgment: big portfolio decisions and support for economically-motivated change.

The bigger problem: too many banks providing too few services

But ridding the financial system of the torrent of revenue flowing to all banks to pay for unnecessary costs will take decades. There is too much that needs to be done: from the enormous cost of selling off the banks' massive, unproductive, real estate investments; to the cost of eliminating the bloated customer brokerage and trading revenues flowing to the broker-dealers inhabiting the cloud-cuckoo-land of securities exchange trading. There are hundreds of billions in inflated bank capital at stake. No change so dramatic as the collapse of these castles of sand is going to happen quickly. But happen, it will.

Fortunately, the effort to protect the inflated profits of the dealer banks and the profits from the inefficient transactions processing system of the banking system more generally, is under new, added, pressure. The world realized, during the financial crisis, that a castle built of sand is dangerous when it collapses. Thus, the current political vendetta against big banks.

I begin here to list the major sources of waste and inefficiency in the banking business - where it lies and which banks lose when it disappears. This article focuses on the complete failure of the banks to conduct ordinary transactions efficiently at cost. We focus on the dubious prospects of the latest darling of FinTech, blockchain developed with bank support.

The FinTech sideshow: Blockchain

One of several examples of the castles of banking capital that are indeed made of sand - others to follow - a deception worthy of the Wizard of OZ, is "tame" bank-supported blockchain. This sand castle is built upon the false notion that the banks need more technology - in this case, blockchain technology - to efficiently process transactions.

There are black sheep in the blockchain world - the two largest public blockchains, Bitcoin and Ethereum, are names that large banks and IT firms like IBM (NYSE:IBM) dare not speak. Literally. The bigs are afraid to speak their names. But note that Bitcoin is the only commercial success in the entire blockchain space. It was successful within months of its humble, unfunded, beginnings. No venture capital invited.

But Bitcoin has a bad rep in part because it has been used for illegal transactions. Not to the extent that the $100 bill is used in illegal transactions. But the $100 bill is a government-produced source of illegal finance. Big bills in other, less-developed, countries are threatened by their government, but the $100 bill is going nowhere.

Ethereum is cryptocurrency-non-grata now as well, after its code-centric baby, the DAO, predictably lost over $50 million in its investors' resources - a disaster for which nobody (everybody) developing Ethereum code was to blame.

Just one more innovation - bank-developed blockchain - bankers promise, and ordinary citizens will enter the land of milk and honey where banks provide services at cost. Dealer banks, particularly, appear eager to adopt this latest innovation. Blockchain is rapidly becoming the poster child of the hypocritical disconnect between the cost of bankers' services and their value.

What is a blockchain?

The blockchain is simply a series of distributed ledgers. A ledger is nothing but a spreadsheet, something like Excel - known as a "block." The block records transactions. A block is called a "distributed ledger" because several "nodes" - nodes are electronic transaction checkers - must agree that the spreadsheet entries are correct and identical - or "verified." Once a ledger is verified, the nodes get to work on the next ledger. As consecutive ledgers are verified, they form a chain of blocks - hence blockchain.

A chart below, with anonymous source, gives a very simple idea of when a blockchain is needed. The short answer is "almost never." I don't have the IT smarts to confirm the accuracy of this chart - perhaps comments to this article from IT savants will help. It does conform to my own understanding.

The purported purpose of these bank blockchain efforts is to make transactions more efficient and secure. Before discussing the present gyrations of the banks and developers in the "blockchain space" (IT speak for working on blockchain technology), I want to establish an obvious fact. Blockchain might be the "best" way for the banks to become more efficient, but this technology is not necessary to meet the basic changes needed. Examples follow.

Domestic same-day payments

Domestic same-day payments, never feasible, so we are told, in the United States, are a reality in Europe. They don't happen in the US because the US banks don't want them to happen. Do we need a blockchain for same-day payments? No.

But might a blockchain be the best way? Following the chart, the answer is "maybe." Start down the chart from the top left, with same day settlement in mind. Transactions require a "shared write" database. The users are known and trusted (other banks), but their interests are not unified. Banks presently use a trusted third party - a clearing bank. But this third party might be unnecessary if each bank were to separately confirm the transactions with other banks that include them as offset. Functionality is controlled - transactions only. Consensus is determined by the banks severally - or inter firm. Thus, the conclusion of the chart is that a hybrid blockchain is the answer. Maybe the best way, but certainly not the only way.

Exchange trading

How does the chart categorize exchange trading? You need a "shared write" database as before. Writers are clearing members, known and trusted. Their interests are not unified. But here the parallel with same-day payments comes to an end. A central counterparty is desirable to timestamp trades and expedite counterparty payments in the case of exchange trading. Exchange trading, the chart tells us, doesn't need a blockchain. Interesting, since the exchanges are universally pursuing the possible use of blockchain. Admittedly, the uses exchanges are examining are back office clearing functions only, relatively unimportant.

Ultimately, the pressure of decades of poor returns in the banking business will force the needed changes at every level of the banking business. FinTech will be a catalyst, but not through bank-supported ventures - through private initiatives that threaten the banking system with irrelevance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.