The ‘finance franchise’ and fintech (Part 2)


In the first part of this two-parter we explained how the “financial franchise” theory of finance works, as thought up by Cornell lawyers, Robert Hockett and Saule Omarova in a new academic paper in the Cornell Law Review. (It should be noted, the theory isn’t necessarily unique as much as combinatory since it channels both Chartalist thinking and shadow banking collateralist thinking.)

What’s really interesting, however, is how it applies to the budding fintech sector, which aims to increase its independence from the official sector by recreating models based on loanable funds (credit intermediation) assumptions. These models, most famously, include peer-to-peer systems and cryptocurrency.

The authors imply these institutions will learn the hard way that once a credit generation model backed by a public-private franchise is in play in the economy, it’s almost impossible to go back. The reason being: all exclusive loanable funds systems carry a major competitive disadvantage on cost of funding vs established public-private franchise systems, and are hence likely to be outcompeted.

From the authors:

In its aspirations to render both the banks and the central banks redundant, this new-century fintech sector portrays itself as a revolutionary alternative to the existing financial system. Ironically, however, despite its disintermediation rhetoric, what this currently unfolding “fintech revolution” seeks to create in practice is a pure form of the orthodox “one-to-one” intermediation model of finance, as described in section I.A.1 above, in which traditional intermediaries such as banks or securities broker-dealers are replaced by electronic peer-to-peer transaction platforms.

Fintech enthusiasts view modern technology as the magic key enabling the flow of pre-accumulated capital among freely-contracting private parties, on a scale sufficiently large to obviate the need for publicly sanctioned and supported credit-generation. In that sense, fintech revolutionaries are essentially envisioning a sort of financial “return to Eden”—or, at least, to the putatively peer-to-peer origins of finance.

While the authors note it’s probably too early to decisively write off fintech, the way things are proceeding seems to support their theory. In short, they believe that if these systems are to expand beyond their peripheral place, they will have to reintegrate into the core finance franchise system eventually:

Without sustained direct access to the ultimate public resource flowing through that system—the public’s full faith and credit—alternative finance is not likely to outgrow its present fringe status. In fact, as this Part shows, marketplace lending is already effectively re-integrated into the core financial system, if only as a new variant of shadow banking. Cryptocurrencies may be moving in the same direction.

For more on how peer-to-peer is already turning into a conventional banking model see Kadhim’s work on the likes of Rate Setter and Zopa.

On cryptocurrencies, specifically, the authors note:

…the value of cryptocurrencies is tied fundamentally to their convertibility into conventional currencies, such as U.S. dollars backed by the full faith and credit of the United States. Cryptocurrencies are therefore likely to remain on the fringes of the financial system. Not surprisingly, startup cryptocurrency firms have reportedly been looking for partnerships with banks that have the resources and scale to reach mainstream audiences.

The second implication is that bitcoin’s high volatility as a store of value makes it an attractive underlying commodity for derivatives trading. In September 2014, TeraExchange established the first regulator-approved U.S. bitcoin derivatives trading platform. It may be only a matter of time before large U.S. FHCs enter this market and turn virtual currencies into the raw material for derivatives trading. The emergence of a deep market for hedging—and speculating on—bitcoin risk would, in turn, enable growth in the bitcoin acceptance rate in commercial transactions. Thus, as in the case of marketplace lending, the most likely mechanism for the success of cryptocurrency, ironically, involves its integration into the existing financial architecture—again, through the familiar channels of shadow banking, described above.

For more on that last part see Dan McCrum’s latest on Goldman Sach’s recent foray into investment advice on bitcoin “as an asset class” in which they predict the price will surge in a frenzy of speculation, before going on to halve — while simultaneously disclosing that the Goldman Sachs trading desk “may have a position in the products mentioned that is inconsistent with the views expressed in this material”.

Related links:
Goldman’s sketchy case to buy (and then sell) bitcoin – FT Alphaville
The finance franchise – Cornell Law Review

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