Insights

Bank fix

Dr. Joseph Chen-Yu Wang

One question that often gets asked is “what use are cryptocurrencies” for the average person. After all, things seem to work with money so people assume that cryptocurrencies do not provide any real benefit. After all of the hype with cryptocurrencies and blockchain, there seem to be few examples of blockchain and cryptocurrencies changing the world. This is the wrong way of looking at things, partly because in looking from this perspective, we are adding new technologies to old systems. A good analogy in using cryptocurrencies with the legacy banking system is trying to attach a jet engine to a donkey cart.

It is not apparent what it is about the current banking system that needs fixing, after all, things seem to just work. However, the incumbent banking and financial system consists of layers upon layers of workarounds and legacy fixes for an underlying problem. The current banking system started in the Medieval era when people still used quill pens. With each layer of new technology it was augmented by additional layers to the already existing system to patch or hide faults. The trouble is that there are fundamental things which are broken deep within the core and because workarounds have been rather clever, one does not notice inherent flaws in the system when looking on the surface, until they are pointed out.

Let’s look at the donkey cart that is the current financial system...

Let me start by asking two simple questions about bitcoin and cryptocurrencies. If I can send an email and chat message anywhere in the world within seconds, and I can send bitcoin to anyone instantly, and track the transaction, why does it take two days to send an international wire, and why is it impossible to track the status of this wire? The second question is why can one buy bitcoin cryptocurrencies 24 hours a day whereas all other financial products do not have 24/7 trading available? It turns out that the answer to both of these questions is the result of fundamental limits in the current financial system, which requires crypto based systems to create work arounds when trying to connect them to this legacy infrastructure.

Let’s go through the exercise of moving money. The issue which limits what one can do with bank wires is that a bank wire is merely a request to move money and these requests do not move any money at all. When bitcoin moves from one wallet to another, the amounts of bitcoin recorded on the blockchain are modified and coins are moved from one wallet to another. Bank wires on the other hand do not move money but are merely requests to move money. Suppose person X at bank A sends a bank wire to person Y at bank B. The wire itself does not move money. It's merely a request for bank B to credit the account of person Y. When the wire is processed, person Y has money added to their account by bank B, and person X has money subtracted at bank A. However, there is still a glaring problem - bank A has taken money from person X and has sent a message asking Bank B to give money to person Y but, no money has yet moved between bank A and bank B. Since most money is electronic, and the only way of moving money from A to B is to have both A and B have an account in shared bank C.

With domestic fund transfers, banks A and B have accounts at the central bank C, and the central bank can create systems and rules for fund transfers and process the transfer very quickly. This is why domestic transfers can be fast. However, in the case of international banks, both bank A and bank B would need to find a common bank C where they both have accounts. Banks A and B may not have accounts at a common bank C, so they would have to do transfers between a chain of banks until they find banks with a shared chain of accounts at another bank. If this is confusing then you can start to understand why it is so difficult to move money internationally and how cryptocurrency solves this problem. With the traditional banking system of moving money one faces requests, scores of people managing complicated and error-prone systems, and this is all because electronic messages in the traditional world do not move value, whereas electronic messages with cryptocurrencies do move tokens from one account to another, precisely why cryptocurrencies can move money in minutes rather than days.

There are similar legacy issues in buying and selling financial products. When one has securities positions, they hold an account at a broker, and the broker holds information about how many shares and of which companies are owned. When this person trades stocks on a securities exchange, no stocks are actually immediately traded. When the trade occurs, the brokers trade IOUs and promise to exchange cash and securities at a later date. Because there is no central database of who owns which stocks, one cannot trade stocks directly between accounts. Based on the client’s orders brokers trade IOUs and once the stock market finishes trading on the day, the brokers move cash and securities back and forth netting and settling them among client accounts. The consequence of this workflow is that this system cannot function with continuous trading. IOUs in securities and cash are traded and only then while the trading systems are offline transfer of securities and cash take place. In contrast, because cryptocurrencies and securities built on top of blockchains can be moved instantly, there is no need to shut down exchanges to move crypto products.

All of these issues affect the foundation of the financial system, and create even further issues. For instance, when a person goes to a supermarket, collects goods and then pays the cashier and takes the groceries home, this is called delivery versus payment (DVP). However, because of the problem mentioned above, it can take days to move money across international borders, thus it is not possible to instantly pay a cashier for goods at say a shipping port. Since the shipper has to wait days to get paid for goods that have been delivered, very complicated systems exist to give cash advances while at the same time preventing fraud in the system. This is one of the large reasons as to why international trade is much more difficult than domestic trade. Moving money across international borders simply cannot be done in real-time, and all sorts of complicated systems to deal with payment delays have to be enacted, which increase errors, cost, friction and time wasted.

Cryptocurrency allows instant movement of money and to conduct trades instantly and continuously, with little transaction cost. It is a new and better system, but the newness brings with it more issues. Ultimately, simply trying to move the entire legacy system over to crypto is not going to work, so what will likely happen is that some of the systems will be built on new foundations with interfaces to the old system. This is what is happening now, but the process will take some years to complete. The problem is not with the new systems, but adapting old systems to use new and better processes. Ultimately cryptocurrencies are simply a better way of doing things, and people will figure out how to connect them with existing systems. Technologies based on cryptocurrency or blockchain based systems will almost certainly win out in the end, and this will prove profitable for people who get involved at the early stages of this development.

This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.

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