This is Part 2/chapter 2 in The Blockchain Economy serialised book. For the index please go here.
A common refrain among Blockchainistas is “Blockchain is about a lot more than finance”.
True, but how big do you need to get excited? After decades of Financialization, Finance in the US grew to 80% of GDP at its peak. That is big enough.
This Chapter describes
- The 4 phases of Financialzation, including the first definancialization era from 1945 to 1973.
- Why Blockchain will usher in Phase 5, another era of definancialization.
- 3 Reasons why Satoshi Nakamoto’s seed hit fertile ground.
- Why real time settlement disrupts Wall Street.
- The incumbent playbook for dealing with Big Bang Disruption such as Blockchain.
- A “rising tide lifts all boats” scenario.
- Disruption to the to IPO business from “Wall Street West and East”
- Disruption to the other cash cows on Wall Street Global
Note 1: I am using “Wall Street” as shorthand for the global capital markets.
Note 2: “Bits of Destruction” is a phrase coined by Fred Wilson of Union Square Ventures to describe the disruption that incumbents face from digital ventures whose primary costs keep falling thanks to Moore’s Law. Blockchain bits are different because the bits can represent financial assets.
Note 3: it is harder to get reliable data on the Finance share of GDP in other countries, but it is likely that many countries will have a similar profile to USA.
The four phases of Financialization to date
Research by the Levy Institute at Bard College identifies four phases of Financialization to date:
Phase 1: 1900 to 1933 = early financialization (leading up to the 1929 bubble and subsequent Great Depression)
Phase 2: 1933 to 1945 = transitory phase (sadly via World War 2)
Phase 3: 1945 to 1973 = definancialization (when the middle class in America prospered from the creation of a new middle class in Europe and Japan)
Phase 4: 1973 to 2008 = complex financialization (when the Cold War came to an end and the West no longer needed to demonstrate to the people that capitalism was better than communism, leading to massive growth of inequality and a fragile global financial system).
Most discussion of Financialization focusses only Phase 4, describing how Finance took over a bigger share of GDP. The most reliable data comes from the US and the chart shown at the top from the Levy Institute report is the picture which paints a thousand words.
Blockchain will usher in Phase 5, another era of definancialization
This will usher in another era of definancialization. Unlike the last era of definancialization – from 1945 to 1973 – we won’t need another world war to get there. This is the hopeful vision of decentralisation that drove the early pioneers (when Blockchain was a nerdy subject only discussed in obscure cryptographic forums).
The first era of definancialization, from 1945 to 1973, was an era of great prosperity driven by the emergence of a new middle class from the ashes of World War 2 in Europe and Japan. The next era of definancialization will also be a time of great prosperity driven by the emergence of a new middle class, this time in the Rest of the World (China, India, Africa, etc). This chapter ends with a description of this rising tide lifts all boats optimistic scenario and the threats to that scenario.
This coming era of definancialization driven by Blockchain governance and digital cooperatives will lead to a more prosperous middle class and reduced inequality. Unlike in the previous era of definancialization, this redistribution will be driven by free market economics not state-controlled redistribution; the communist and fascist era in the 20th century taught us that state-controlled redistribution only served to put power and wealth in those connected to the state.
While we hope that this transition of power will be bloodless, it will certainly be disruptive to a lot of businesses that grew big in the Financialization era and they will not give up that wealth and power easily. In the end, a rising tide will lift all boats, but in the short term there will be a lot of destruction of wealth and power. The uncomfortable reality for incumbents is that, despite the term creative destruction, in chronological terms, destruction precedes creation. First we get painful destruction, only then is creation possible.
3 Reasons why Satoshi Nakamoto’s seed hit fertile ground
The biggest driver of startup success is timing. We may all know that intuitively but here is the data from a research study.
In the dark days of early 2009, Satoshi Nakamoto provided the seed technology, but his/her invention hit fertile ground for 3 reasons:
1. The financial crisis made incumbents more cautious. Even if a CEO musters the courage to fight the organizational antibodies attacking innovation, the CEO will be constrained by the balance sheet, aggressive regulators and nervous investors. The absence of the big financial institutions opened a window of opportunity for other entrants.
2. The 10x collapse in cost of technology. The combination of the cloud stack, open APIs and open source software has taken a great big ax to the cost, timescale and risk of building financial technology. This is classic 10x disruption. What used to cost $10m and take 3 years now costs $1m and takes 3 months. This gives a huge advantage to startups.
3. Ability to reach customers online. The low cost of building technology is meaningless if the incumbents are still the only gateway to customers. Now that nearly 50% of the world’s 7 billion people have mobile phones, it is possible to reach consumers of financial services directly and quite cheaply. This gives another huge advantage to startups.
What was missing from this fertile ground was a way to securely exchange assets online. This was the seed that Satoshi Nakamoto planted in January 2009.
Why real time settlement disrupts Wall Street.
Real time settlement, enabled by Blockchain, fundamentally changes how trading is done. This matters because all the big cash cows of Wall Street require trading
Note: the better technical term is concurrent delivery versus payment, as explained in this post from about 2 years ago.
There are 4 reasons why real time settlement changes trading and disrupts Wall Street:
- Whole categories of companies that do post trade processing and all the associated processes and costs will no longer be needed.
- Profitable trading through semi-legal practices such as front running and naked shorting become impossible.
- securities lending, a mechanism that powers short-selling and drives broker profits, will be disrupted.
- Brokers, market makers and other intermediaries will be disintermediated and transaction costs will drop by 90%; this intermediation is a big cash cow on Wall Street.
This is why the ICO market, for all its bubble characteristics and sketchy characters, shows the future.
The incumbent playbook for dealing with Big Bang Disruption such as Blockchain.
RIP the Fast Follower Model, which worked well for a long time:
- incumbent watches as a startup slowly brings some new innovation to market at the low end of the market or other niche that was ignored by incumbents .
- Then they acquire a startup and apply their capital/brand to take the innovation mainstream.
The Fast Follower Model is dead thanks to Big Bang Disruption, a term coined in this this HBR article, which defines Big Bang Disruption as follows:
“The strategic model of disruptive innovation we’ve all become comfortable with has a blind spot. It assumes that disrupters start with a lower-priced, inferior alternative that chips away at the least profitable segments, giving an incumbent business time to start a skunkworks and develop its own next-generation products.
That advice hasn’t been much help to navigation-product makers like TomTom, Garmin, and Magellan. Free navigation apps, now preloaded on every smartphone, are not only cheaper but better than the stand-alone devices those companies sell. And thanks to the robust platform provided by the iOS and Android operating systems, navigation apps are constantly improving, with new versions distributed automatically through the cloud.
The disruption here hasn’t come from competitors in the same industry or even from companies with a remotely similar business model. Nor did the new technology enter at the bottom of a mature market and then follow a carefully planned march through larger customer segments. Users made the switch in a matter of weeks. And it wasn’t just the least profitable or “underserved” customers who were lured away. Consumers in every segment defected simultaneously—and in droves.
That kind of innovation changes the rules. We’re accustomed to seeing mature products wiped out by new technologies and to ever-shorter product life cycles. But now entire product lines—whole markets—are being created or destroyed overnight. Disrupters can come out of nowhere and instantly be everywhere. Once launched, such disruption is hard to fight.
We call these game changers “big-bang disrupters.” They don’t create dilemmas for innovators; they trigger disasters”.
The HBR article lists “four strategies that incumbents have used to survive and even thrive in the face of big-bang disruption. You can see the playbook of Wall Street incumbents faced with Big Bang Disruption from Blockchain in these 4 strategies:
Strategy 1 = See it coming.
Learning to recognize the warning signs is key to survival. But since the early market-based experiments usually fail, the familiar signals sent by low-end customers jumping ship may never arrive. You need new tools to recognize sooner than your competitors do that radical change is on the way, and that means interpreting the real meaning behind seemingly random experiments.
Wall Street has seen this coming for years.
Strategy 2 = Slow the disruptive innovation long enough to better it.
The best survival strategy may simply be to ensure that disrupters can’t make money from their inventions until you’re ready to acquire them or you can win with a product of your own. You can’t stop a big-bang disruption once its unconstrained growth has taken off, but you can make it harder for its developers to cash in. Many big-bang disrupters build market share and network effects by offering their early products free. You can delay their profitability by lowering prices, locking in customers with long-term contracts, or forming strategic alliances with advertisers and other companies critical to your rivals’ plans.
That is why we see the strange juxtaposition of senior spokespeople at major banks trashing Bitcoin, while their people are trading and offering services related to Bitcoin. It also explains regulatory crackdowns in markets where incumbents have the ear of the regulators.
Strategy 3 = Get closer to the exits, and be ready for a fast escape.
It’s up to senior management to confront the reality that even long-successful strategies may be suddenly upended, requiring a radical re-creation of the business. To compete with undisciplined competitors, you have to prepare for immediate evacuation of current markets and be ready to get rid of once-valuable assets.
This is the hard part. It takes place behind closed doors, while management proclaims loudly that it is business as usual.
Strategy 4 = Try a new kind of diversification.
Diversification has always been a hedge against risk in cyclical industries. As industry change becomes less cyclical and more volatile, having a diverse set of businesses is vital. Fujifilm, a perennial also-ran in the film business, has survived the transformation to digital photography by transitioning to other products and services that draw on subsidiary technologies, ranging from nanotechnology to the manufacture of flat-panel TVs. A move into cosmetics, for example, was made possible by repurposing chemical processes developed to keep photos from fading. TomTom has begun to ease its reliance on its automotive navigation systems business by signing a deal last June with Apple to provide mobile mapping services.
This is where incumbents need to focus on going after the growth markets of the future, not defending markets of the past.
Disruption to the to IPO business from Wall Street West and East
“Wall Street West” is my name for the giant growth equity funds that invest late stage before an IPO. They are mostly West Coast ie in Silicon Valley but can just as easily be in New York or any financial centre (London, Zurich, Singapore, Hong Kong etc). The disruption can be seen in two recent massive ICOs – Telegram and EOS.
- First KIK set the bar with a $100 million ICO. Note: their currency is, confusingly, called KIN. In USD terms the post ICO price action has been good.In the closing days of the long hot summer of ICO, in early September 2017, we wrote Why the KIK ICO is the one to watch:
“KIK is one of many viable companies that would like IPO as an alternative to trade sale, but that are dammed up in front of a wall that excludes all but the most massive companies. KIK did a Pre ICO round that looks a lot like a Pre IPO round in ye olden days. That is a mega trend shift. Traditional exchanges and all who work in that ecosystem are facing disruption.”
- Then Telegram raised the bar 10x with a $1 billion ($1,000 million) ICO raise. In ye olde days, you raised $100m in an IPO, so quite daring of KIK to set that as their bar. Then Telegram showed you could raise 10x that in an ICO. Which is better as a marketing event – IPO or ICO? Measure the column inches and its hard to see the difference. Entrepreneurs used to invite you into their Slack channel. That is so 2017. In 2018, any self respecting entrepreneur is inviting you into their Telegram channel. Does that make it worth $ billions or is this a sign of bubble valuation? What is clear is that ICO is no longer the junior market. The kid is growing up and challenging the parents (cue soundtrack = Blowing in the Wind – “your kids are beyond your command”).
- Then EOS raised it another 4x with a $4 billion ICO. Err, how much capital do you need run a business?
To put things in perspective, the Microsoft IPO in 1986 raised $61mm but then we had the multi billion raises:
- Google $1.9bn
- Facebook $16bn
Grab your popcorn and watch one gravy train being derailed while a new one is built.
The traditional equity stock exchanges must be feeling the heat. The big dogs in this world – NYSE and NASDAQ are the most at risk because a) they have the lion’s share today b) they do not own the settlement layer so they cannot offer real time settlement (which is the fundamental driver behind this disruption). So we are seeing innovation from traditional equity stock exchanges that do own the settlement layer so they CAN offer real time settlement – one example is the Australian Stock Exchange (ASX).
The investment bankers are fast-moving and jumping in quickly into this space. It is no coincidence that Telegram worked with bulge bracket investment bankers and the process was just like an IPO. There are new firms jumping through this window of opportunity, but don’t expect the Wall Street firms to sit on the sidelines; whatever the public statements, they all want in on the action.
Disruption to the other cash cows on Wall Street Global
“Wall Street Global” is may name for the firms and business practices that may have originated on an actual street in a real city on the East Coast of America, but which now work this way in all major financial centres such as London, Zurich, Singapore and Hong Kong. The other cash cows that are being disrupted include:
- The 2 and 20 AUM Fund model is being disrupted by Syndicates and the Follow/Signal model.
- The Wealth Management AUM model is being disrupted by Robo Advisers at the low end and cooperation models based one networking among family offices at the high end.
- The rolodex based broking model (a list of wealthy investors in my CRM) is being disrupted by online ICO models.
- The market making business is being disrupted by automated, AI based market making technology on cryptocurrency exchanges.
A rising tide lifts all boats
Billions of people entering a global middle class is a rising tide that will lift all boats, but there is one major threat to this optimistic scenario which is cross border protectionism. The win/lose mentality of protectionism is easily fuelled by populist politicians. The post 1929 protectionism led to the Great Depression and World War 2. People need a hopeful vision not a dark win/lose narrative, but also practical policies to make that vision a reality.
Today’s intermediation cost will fall 10x. Unless incumbents deal with that reality, they cannot manage their way out of Big Bang Disruption. What normally happens when costs fall by 10x is that volumes go up 10x. That 10x growth may come from the aforementioned billions of people entering a global middle class. It may also come from all the new asset types that can be traded using Blockchain that are not usually viewed as financial assets today such as:
- Intellectual property (including creative work).
- Reputation assets.
- Hard assets where you can prove ownweship and provenance.
These can all be tokenised and traded.
Wall Street today trades equities, bonds, currencies and commodities. Wall Street 2.0 (comprised of new firms as well as transformed incumbents) will have far more assets to work with.
Cross border trade protectionism, fuelled by populist political rhetoric, could kill this rising tide optimistic scenario.
There are two other forces that can capsize the prosperity boat before it gets a chance to rise:
- incumbent protectionism. If incumbents use their political/state power to prevent change, this positive future will be prevented. I don’t think this will happen because we live in a world of jurisdictional competition. For example if a country bans Bitcoin exchanges or mining, then exchanges and mining companies will move to jurisdictions that welcome the wealth creation those companies can bring.
- short term profit takers highjack Blockchain. If the price goes down they move onto other projects. I don’t think this will happen because the clear lesson from earlier waves of disruptive change is that those who focus on long term value creation tend to win big. Early crypto/tech true believers in Bitcoin and Ethereum have already made a lot more money than all the profit-chasing traders put together.
Revenge of the Muppets
“Muppets” is the derogatory term coined by the smartest guys in the room on Wall Street for the “dumb” retail investors.
Here is some data that makes you go hmm, who is really the dumb money at the table?
- Ethereum = “dumb money” from retail muppets who invested about $18 million
- EOS = “smart money”, institutions and UHNWI who invested $4,000 million
Ethereum investors already got over 1,000x returns. Try getting 1,000x returns on $4,000 million.
This is a huge inversion. It looks like “dumb money” from retail muppets has become “smart money” (which used to come from institutions and UHNWI). The reality is that Ethereum “investors” could evaluate tech and market risk. They might have known nothing about investing but they did know that that the technology was feasible, the team was good and if the team developed something that worked it would change the world. Theoretically that is is what the smart money called VC was supposed to do, but VC sat that one out because they are more related to the asset management business (ie ripe for disruption) than they are to the innovation business.