Although banks have been going digital for years, and “fintechs” have been around for a while, the industry has not fundamentally changed. That is because disruption can happen only as quickly as regulators allow it. The pace is limited not only by valid safety and soundness considerations but also the painfully slow speed of regulatory innovation. We are trying to regulate a digital world with 20th century architecture that was designed for physical assets.
The growing support for central bank-backed digital currencies could finally pave the way for change by spurring the creation of 21st century regulation. It can do more than just disrupt the industry, it can tackle oligopolistic banking, too big to fail, systemic efficiency, and fulfil the promise of finance.
Our current rules are rooted in physical assets and evolved as the industry innovated. Deposit boxes were created for safekeeping coins. Lending earned returns on these deposits through pooled investments. Deposit insurance was created to prevent bank runs. Bank account numbers became a source of identity. This bundled offering of services required new laws and regulations to make the industry safe. As regulators codified this model, economies of scale created an oligopoly of conglomerates.
But politicians still worry about banks that are “too big to fail”, regulators struggle to supervise such big institutions, investors remain disappointed with returns, and customers feel overcharged and underserved.
The widespread use of innovative technology has made finance more affordable and accessible by unbundling the functions of banking. But this can only do so much to modernise a 20th-century paradigm. There have been attempts to create the veneer of something new: Facebook’s Libra mimics central bank-issued digital currency by promising convertibility into notes. But finance works on trust, and it is not clear that a digital currency issued by a social media company outside normal banking rules can engender trust.
If central banks issued digital currencies that would allow us to unbundle many banking attributes that developed from physical assets. A cyber vault can be used to store digital currency holdings, secure protocols for digital transfers and payments, and cyber wallets for identification. Central banks could offer this service, but so could tech companies, custodian banks or anyone else who agreed to follow a new set of regulations that safeguard these functions. A vault that holds digital currency would not need deposit insurance but it probably would require cyber insurance instead.
Central banks could pay interest on digital holdings but financial services companies would still play a significant role. Market-based finance companies could meet the demand for loans as well as higher rates on savings. Any company willing to abide by safety and efficiency rules could move “cyber vault” deposits to regulated lenders who then use them for loans. There are many possible iterations but, in all of them, bundling would be a choice, not a necessity.
Any new paradigm has potential pitfalls. Who will control the money supply and lending and keep the financial system safe? We need to find ways to pay for anti-money laundering controls: until now depositors have helped subsidise them. Then there is the issue of who owns information and who accesses it.
I believe that we can find answers to these questions and set up the context that will allow finance to function in a truly digital world. Central bankers understand that unleashing competition in this new architecture would be truly disruptive.
Competition can create a race to the top or a race to the bottom. Regulators must help point the system in the right direction. Let’s direct innovation to support the system before someone figures out how to bypass it.
The writer is chairman and chief executive of The Orogen Group
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