The current monoculture
Financial services, particularly those provided by banks, are dominated by a small number of large players. This severely limits choice, competition and innovation. One of the most serious consequences of this, evidenced by the current crisis, is lack of resilience over the entire financial system.
How can new entrants be encouraged to provide innovation, diversity and choice to promote resilience?
Recently “peer-to-peer” (P2P) approaches to financial services have emerged that use innovative technology platforms and business models. Policy makers should proactively support these approaches since they potentially offer new levels of innovation and choice promoting the public good.
Peer-to-Peer innovation – two waves
In recent years there has been a growth of so-called “peer-to-peer” (P2P) approaches to financial functions. For example, P2P lending and more recently P2P money.
P2P lending (1) removes the mediating role of a traditional bank by allowing savers to lend directly to borrowers. This leads to better interest rate deals for both parties although the default risk is borne by the lender. There are a number of P2P lending companies offering variants on how borrowers are matched to lenders and how risk is mitigated. P2P lending services distribute the process of borrowing and lending but rely on centralised online platforms (operated by the P2P lending companies) and on money created by traditional banks and supplied by lenders. A more recent and radical P2P innovation is to provide money itself in a P2P way.
A P2P monetary system called Bitcoin (2) has attracted much interest recently. Bitcoin does not rely on any centralised entity. The currency – Bitcoins – are created and tracked by each user within the system running a piece of software (called a client) on their computer. There is no organisation or company that owns or controls the system. Bitcoins can be exchanged using online exchanges or directly between users through their client software – similar to sending an e-mail. One way to think about Bitcoins is that they are like electronic cash without requiring an intermediary – such as a bank – to store or record transactions. It works by using a sophisticated computer algorithm based on cryptography and distributed computer concepts.
Put crudely, Bitcoin provides a distributed and trusted ledger or database. Every client program contains an up-to-date list of all accounts and how many coins they contain. Transactions are not allowed if they violate the data in the ledger – i.e. you cannot spend your coins more than once. But why would anyone trust this algorithm? Because it is open source meaning anyone can view the code to verify that it does what it claims.
Bitcoin does not depend on the whims of an owning corporation, a monetary policy committee or the political stability of a nation. It is a self-organised distributed software system. The innovations in Bitcoin could be as revolutionary as the invention of double entry bookkeeping and the joint stock company (3) – because they can be freely adapted and applied within other systems. Bitcoin could become a competitor to traditional currencies but, more importantly, it has already inspired competitors and variants (4). I do not wish to promote Bitcoin per se but rather the open and innovative P2P model that allows for rapid innovation.
We might term P2P lending as a “first wave” innovation – the focus is on disruptive business models within a traditional company structure. Systems such as Bitcoin could be termed “second wave” innovations – they disrupt the very notion of a business model in the same way that open source operating systems based on Linux offer alternatives to Apple and Microsoft.
In the future new second wave systems might provide other services such as store of value, credit creation or fully distributed markets.
Supporting second wave P2P
First wave systems already have a UK trade body and productive interactions with regulators and the policy apparatus (5) .
Second wave systems are more amorphous. Anyone can create an open source system and recruit others to participate. No formal legal entities exist that are responsible for the code. Yet this is not a bug – it’s a feature. It drives high rates of experimentation and innovation.
On the other hand for new systems to gain wide use it is necessary to promote trust, interoperability and acceptance.
How can this be achieved?
One approach might be a voluntary certification process. Where certain desirable features are present, such as open source code transparency; transaction integrity; and support of interoperable standards; then various levels of certification could be awarded via a suitability composed organisation. Such an organisation should proactively support promising second wave projects providing the necessary expertise to examine the code and provide advice to developers if they wish to attain certain certification levels.
The Bitcoin community, through the recently created Bitcoin Foundation (6) , is already pursuing these goals for Bitcoin. Policy makers should proactively engage with these kinds of initiatives in order to support the development of second wave P2P approaches.
A key outcome of such a collaboration would be to provide the right regulatory environment and interoperable standards (7) to allow for productive innovation and diversity by levelling the playing field with traditional banking – which receives huge implicit public subsidies yet provides limited resilience or choice.
David Hales is a Senior Research Fellow at The Open University. His website can be found at: http//davidhales.com
- 1 For example see http://zopa.com
- 2 http://bitcoin.org
- 3 A recent ECB report noted the potential disruptive effect of Bitcoin: http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf
- 4 http://litecoin.org
- 5 http://www.p2pfinanceassociation.org.uk
- 6 https://bitcoinfoundation.org/
- 7 Andrew Haldane, from the Bank of England, noted the importance of interoperable standards for promoting competition with specific reference to P2P approaches in a recent speech: http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech552.pdf