Fintech Incrementalism and Responsible Innovation

on Monday, April 4, 2022

The fintech incrementalist position is that fintech (financial technology) is a force for effecting change in financial services and building a more stable, efficient and transparent economy. Here we evaluate the claim that blockchain-based financial technology can be a vehicle for more efficient markets through the development of more complex, blockchain-based financial products.

Summary

November 2022 update

We are adding a brief update to this piece to note the spectacular collapse of one of the world's largest crypto exchanges, FTX, in late 2022. This provides compelling further evidence that crypto is not a legitimate fintech evolution nor does it in any way characterise responsible innovation. Find out more via our deep dive on the FTX collapse, and its tragic vindication of our analysis.

Claim steel-manned

Building more complex financial models and products allows us to create more antifragile structures that remove or disperse risk from the broader market that the public benefits from. We can see real world examples of this: mortgage-backed securities have enabled more democratic and more liquid access to mortgage credit; volaitility in the price of products has been reduced by creating future products, eg the volatility of chicken nuggets is solved by creating synthetic futures on corn and soymeal commodities that would hedge the chicken producer’s exposure to underlying price fluctuations.

Crypto is just the evolution of this trend of good incremental fintech improvemments. We want to continue moving the economy into a hyperfinanicalized 24/7 real-time always-trading market with even more complexity and lower friction than what we have presently. Blockchain can get us there.

Blockchain can be a vehicle for increase in financialization through the development of more complex, blockchain-based financial products. This ranges from better payment rails i.e. a better Visa, Stripe etc, to more efficient clearing systems, to full-scale innovation in financial engineering.

Banks provide a clear example of what a lack of innovation looks like: banks are outdated and slow to innovate; core banking software is mostly from the 1980s; financial infrastructure is massively outdated in America and other coutrnies and the state of bit rot is vast.

Crypto is the means to fix all this. In the origial Bitcoin whitepaper Satoshi argues Bitcoin will provide a better payment rail, that we will be able to transfer money to people quickly and easily.

In addition, the future of finance will see private money and Central Bank Digital Currencies coexist and compete for market share. A global distributed ledger will provide greater market transparency and efficiency of sovereign flows.

While it’s common to have a knee-jerk reaction to financial complexity, we need to take things on a case-by-case basis rather than blanket write off financialization. Regulation can catch up with technical innovation.

Evaluation: False

The global financial crisis is a warning sign about opaque markets, complex products and moral hazard in the presence of government bailouts. Quant funds levered to the hilt on exotic products have almost universally gone very badly historically. That regulation will catch up, in the future, is not sufficient. Testing such experimental services and products live on people and markets is very questionable engineering practice.

Upending the entire space of commercial banks is a massive financial reconfiguration project which needs political will. This does not currently exist either in Europe or the United States.

If crypto payment rails are lower-cost or lower-friction then it’s likely because they’ve removed that which is costly and adds friction: fraud mitigation, transaction reversal, custodial services, customer service, and compliance. Once we add compliance back to crypto payment rails, it’s unclear that there would be any efficiency increase or cost savings.

In addition, as a remittance use-case , crypto assets such as bitcoin make no sense at face value. We still have to convert to and from the local currency on both legs of the payment. This has a non-zero cost. Currency A -> Currency B -> Currency C is a very indirect way of doing cross-border payments as compared to a two-hop transaction. Introducing a third hypervoliate intermediary step just adds more risk and makes this more expensive. See our full analysis for more: Crypto will provide better payment and remittance services

Full analysis

Fintech incrementalism

Steel-manning the fintech incrementalist position

  • Claim 1: Everything is moving towards real-time and international finance. Crypto is the evolution of this trend. We want to move the entire economy into a hyperfinanicalized 24/7 real-time always-trading market with even more complexity and lower friction than what we have presently.
    • Building a T+0 settlement system for equities is a great idea. Real-time settlements would be a boon for the liquidity of US capital markets.
    • Real-time payments are a resounding success in Europe and Asia.
    • We’ve solved volatility problems of asset classes in the past. We’ll do it again. It just requires more math and more sophisticated models.
  • Claim 2: Banks are outdated and slow to innovate: core banking software is mostly from the 1980s; state of bit rot in financial infrastructure is vast; American infrastructure is massively outdated. Crypto is the means to fix all this.
    • Subclaim 2a) Private money and Central Bank Digital Currencies will compete for market share and will coexist. This will be the future of finance.
      • The Federal Reserve, and the European Central Bank will keep all of their balance sheets and swap lines on a global distributed ledger providing greater market transparency and efficiency of sovereign flows.
      • Retail accounts will all be held directly at the central bank
    • Subclaim 2b) It’s the natural evolution that banks will simply custody thousands of types of currencies. The nature of regulatory costs simply means that customers will have to eat the risks and costs of bank runs when operating out-of-jurisdiction.
  • Claim 3: Regulation is becoming more robust (Basel III) and will catch up with technical innovation.
    • This is always the way things have worked in the past. And it more or less has worked.
  • Claim 4: We no longer have an economy that runs on two numĂ©raire for individuals: bank balance and credit score. We need to create programmable money whose representation is a hypersurface on a polytope that exists in extremely high dimensional spaces that correspond to every aspect of personhood.
  • Claim 5: It’s common to have a knee-jerk reaction to financial complexity. But when you dig into the details it’s quite a bit more nuanced than it seems at first glance. While there are toxic products, we need to take things on a case-by-case basis rather than blanket write off financialization.
    • The Roman Empire was trading options contracts.
    • Derivatives will always arise naturally in markets of sufficient sizes.
    • These types of products are natural for portfolio managers to use to hedge their exposure to complex factors.
    • Trading digital derivatives contracts detached from any underlying or benchmark are the next evolution of markets.
    • Building more complex financial models and products allows us to create more antifragile structures that remove or disperse risk from the broader market that the public benefits from.
      • Mortgages are very good financial products that enable vast access to real estate markets and for families to prosper.
      • The volatility of chicken nuggets is solved by creating synthetic futures on corn and soymeal commodities that would hedge the chicken producer’s exposure to underlying price fluctuations.
      • Petrol futures and airlines
      • There are many types of weird exotic derivative products that have very niche buyers, such as people in the energy production business.
    • If we can create completely synthetic hedges for a wide range of real-world phenomenal factors then it doesn’t really matter how we do it.
  • Claim 6: There are a few asset classes that are almost exclusively narrative-driven rather than mathematics or cashflow-driven.
    • “If gold appears to be a hedge for anything, it’s the fear of inflation, or the fear of financial instability as proxied by changes in government deficits.”
    • The demand curve for gold is, at least partially, generated by emotion and politics. This is squishy but quantifiable.
    • With crypto tokens we can create new synthetic assets whose demand curves are artificially generated by different psychological forces
    • Gold is a proxy asset for investing in the “libertarian project”. With crypto can we create a proxy asset for investing in the “anarchist project” or the “Marxism project”?
  • Claim 7: “The next step in the evolutionary tree of homo economicus, in which all aspects of our humanity sublimates into the free market.”
    • Markets no longer exclusively exist to price products corresponding to goods and services anymore. We can financialize purely imaginary things that are untethered to humanity and/or the physical world.
    • Web3 is the “financialization of everything”. Abstract notions of things like public goods goods, justice, politics, ideology, religion, philosophy, and community can become commodities to be traded.
    • “Self-fulfilling ouroboros derivatives” are the future.

Evaluating the position

  • Claim 1: "Everything is moving towards real-time and international finance. Crypto is the evolution of this trend. We want to move the entire economy into a hyperfinanicalized 24/7 real-time always-trading market with even more complexity and lower friction than what we have presently."
    • The costs present in most retail financial services have very little to do with the technology. Transaction costs associated with payments are fraud mitigation, transaction reversal, custodial services, customer service, and compliance.
      • These are a necessary and irremovable part of dealing serving the needs of real people.
      • Customers want transaction reversibility.
      • Customers want transaction privacy.
      • Customers want fraud protection.
      • If crypto solutions are lower-cost or lower-friction currently then it’s likely because they’ve removed fraud mitigation and compliance entirely. Once we add compliance back to crypto payment rails, it’s unclear that there would be any efficiency increase or cost savings.
  • Claim 2: "Banks are outdated and slow to innovate... Crypto is the means to fix all this."
    • Sub-claim 2a) "Private money and Central Bank Digital Currencies will compete for market share and will coexist. This will be the future of finance."
      • Central Bank Digital Currencies are a theoretical idea that has yet to prove its merits.
      • Upending the entire space of commercial banks in a massive financial reconfiguration project which needs political will. This does not currently exist either in Europe or the United States.
        • China may be a different story, but the reason they would want to install such a system is entirely different from western democracies.
      • It’s unclear what advantage this actually offers to end consumers.
      • Facebook Libra Coin offers a stark reminder about the realities of integrating with global finance and the regulatory push back against the idea of private money.
    • Sub-claim 2b) "It’s the natural evolution that banks will simply custody thousands of types of currencies."
      • Remittance use-case makes no sense at face value.
        • We still have to convert to and from the local currency on both legs of the payment. This has a non-zero cost.
        • Currency A -> Currency B -> Currency C is a very indirect way of doing cross-border payments as compared to a two-hop transaction.
        • Some entity has to eat the price risk while the transfer in-flight. There’s no free lunch here. Introducing a third hypervoliate intermediary step just adds more risk and makes this more expensive.
        • Does Bitcoin/Blockchain make sense for international money transfers?
        • Race to the bottom with services like TransferWise.
    • Crypto as a payment system is uniformly worse than almost any other service that exists.
      • Price risk given the volatility of the asset is a non-starter for commerce.
      • Can’t denominate contracts or debt products without obscene risk premiums attached to the contracts. This is unnecessary friction from using something not fit for purpose.
  • Claim 3: "Regulation is becoming more robust (Basel III) and will catch up with technical innovation."
    • That regulation will catch up, in the future, is not sufficient. Building an unregulated transnational payment rail, even if it did work as people claim, and then testing it out in the wild on live people is very questionable engineering practice. Imagine doing the same thing in medicine or civil engineering. It’s like “financial vivisection” or something.
      • Tesla vs Google on self-driving cars.
      • This issue divides technologists because it’s a question about engineering ethics.
      • There is a vast amount of literature and very healthy debate in machine learning about “rogue AI”, a technology that is at-best hypothetical or probably centuries away.
      • Why is there such a taboo about having that same debate about runaway crypto technology and responsible innovation?
  • Claim 4: "We no longer have an economy that runs on two numĂ©raire for individuals: bank balance and credit score. We need to create programmable money whose representation is a hypersurface on a polytope that exists in extremely high dimensional spaces that correspond to every aspect of personhood."
    • Building an enormously complex social credit system based on financializing every aspect of our lives is a nightmarish dystopia. (See Black Mirror)
      • Not compatible with our values of individual liberty and privacy.
      • We simply should not build this for reasons that seem obvious.
      • Jurisdictions like Germany would never accept such a thing.
  • Claim 5: "It’s common to have a knee-jerk reaction to financial complexity... While there are toxic products, we need to take things on a case-by-case basis rather than blanket write off financialization."
    • Global financial crisis as a warning sign about opaque markets, complex products and moral hazard in the presence of government bailouts
    • Incorrect pricing of risk
    • Financial innovation and complexity
    • Crypto would exasperate all of these problems. Look how many DeFi projects blow up every week.
      • Web3isgoinggreat.com
      • Trillions of notional “value” has simply ceased to exist because of software bugs.
      • DeFi is a consumer protection nightmare. Elizabeth Warren is right to warn about this.
  • Claim 6: "There are a few asset classes that are almost exclusively narrative-driven rather than mathematics or cashflow-driven... With crypto tokens we can create new synthetic assets whose demand curves are artificially generated by different psychological forces."
    • None of our models have any predictive power to value crypto assets that present as investments.
      • Crypto investments present as sentiment-driven greater-fool products.
      • These products are zero-sum investments, it’s unclear what advantage these products bring to retail investors who have simple needs (saving for retirement, buying a house, college funds, etc).
      • Models like stock2flow to value bitcoin have no basis in quantitative finance and wouldn’t even pass peer review.
  • Claim 7: "The next step in the evolutionary tree of homo economicus, in which all aspects of our humanity sublimates into the free market."
    • There is a massive disconnect between what is theoretically promised with regards to blockchain technology versus what is actually possible or realizable when we factor in real-world constraints.
    • It is unclear what crypto assets offer the institutional finance or asset managers.
    • We’re still looking for crypto’s killer use case. Even if we accept that expansion of advanced financialization is a good thing. It’s unclear what crypto offers to this program when brought within the regulatory perimeter.
      • Domestic Payments NO
      • Remittances NO
      • Speculative Investments NO
      • Central Bank Digital Currencies MAYBE
      • Enterprise Data Management MAYBE
      • Everything else is science fiction (possibly dystopian) at present.
    • Jury is still out on whether permissioned blockchain as a technology removed from token issuance has any applications. The answer seems like no, but if it is yes then it’s probably for mundane things.
      • Corda
      • Walmart Fruit Network project
      • This is not paradigm shifting tech. It’s just more enterprise software running on a server in some bank’s back office.
  • Recentralization is not necessarily progress, especially when it comes attached to bizarre externalities that didn’t exist before and undermine the entire project.
  • Arbitraging securities regulation for crowdfunding comes with significant public risk and no clear advantage.

Conclusion

This is the position that is possibly the most compelling and defensible position, but if and only if the tech can be shown to be demonstrably better than what already exists. There are some large economic, technical and commercial problems (or at least unproven theories) at the heart of this thesis. Much of this remains a theoretical proposition at best, but it is still interesting to consider intellectually.

Related content

Deep dives and notes

Concepts

FAQs

References

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  18. Steele, Graham. 2021. ‘The Miner of Last Resort: Digital Currency, Shadow Money and the Role of the Central Bank’. Technology and Government, Emerald Studies in Media and Communications, Forthcoming.
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  20. Weaver, Nicholas. 2018. Blockchains and Cryptocurrencies: Burn It With Fire. Berkeley School of Information. https://www.youtube.com/watch?v=xCHab0dNnj4.
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