Convergent Evolution of Financial Standards

  Source: IMF

Source: IMF

Convergent evolution in nature is a fascinating phenomenon. Organisms that have entirely different histories can develop similar solutions to a recurring problem in the environment. For example, take the flight skills of birds and bats, or the eyes of mammals and cephalopods. Natural selection has a way of chiseling away at wetware until we get a serviceable answer. In a similar vein, we expect to see similar governance outcomes in the traditional financial services industry and the crypto economy. And we don’t mean the vanilla stuff, like the regulator presence, or industry boards that create standards. Instead, we are pointing to two different phenomena that should have the same effect: (1) the Dodd Frank legislation requiring capital standards from banks (and especially the FSB rules for Globally Significant Banks), and (2) the steady move in several public blockchains towards Proof of Stake.

Let’s back up. In traditional finance, sentiment and impression of financial stability is key to the functioning of the system. The simple reason is that banks are massively levered, especially when involved in capital markets activities, like trading and investment banking. And even in the case of the depository bank, the bank lends out the deposits it collects from clients. A run on the bank occurs when all the clients try to pull funds out at the same time, learning that the funds aren’t there, and causing further panic. Thus things like government insurance (FDIC). And in complicated cases like 2008, the run was on the banks by the banks themselves. When Wall Street thought Lehman couldn’t pay its overnight commercial paper because it was insolvent, credit dried up. And so did Lehman.

Which brings us to capital requirements. In brief, this is a regulation that forces financial institutions to hold a certain amount of assets on its books, rather than circulating out there in the markets earning a return. Instead of being 30x levered, you may only do 15x or 20x, depending on how important you are and what assets you hold. Having cash on the books is better than a bunch of junk bonds, and so on. When a confidence crisis happens, the institution – so goes the theory – will have enough buffer to absorb a shock, and no government insurance is needed. In the abstract, that means that today’s banks all hold assets in order to participate in the financial system as players (and take their economic rents). But remember the refrain – banks supposedly manufacture trust, trust in the economic system, in the presence of cash, in payments, in commerce. This capital is the government’s (and if we believe in effective representative democracy, it is our) way of putting institutional “skin in the game”, which scales with importance to the industry.

If you know your crypto consensus mechanisms, you may know where we are going. Today’s Bitcoin and Ethereum chains are secured by a computationally expensive method called “Proof of Work”, where the “Work” is the burning of electricity to power processors good at solving arbitrary math. Various groups are unhappy with this power consumption, and the centralization of mining power it has caused whispered complaints. Different consensus algorithms exist, as do controversies about them. But generally speaking, approaches like Proof of Stake, or EOS’ Delegated Proof of Stake, will work of crypto resources instead of physical ones. Your “stake” is the capital you hold, that may be committed to participating in the system and manufacturing trust, through voting or forging or something else depending on the project. Built into the economics of committing such capital to validate blocks is a probabilistic rewards, which looks a lot like interest on average.

  Source: Cointelegraph

Source: Cointelegraph

What this means is that crypto and banking have converged on the same solution. Some central authority declares the guidelines of the system, and how much capital is required to be committed to keep it humming along. Then, parties that manufacture trust put this capital aside as table stakes to be in the rent-taking business. And, by the nature of the beast, scale efficiencies of running such operations lead to consolidation and some form of global oligopoly A large bank today may find such a system to be pretty familiar and comfortable – and they certainly have the capital to deploy. Goodbye crypto utopia!