- there is a simpler way
To date, the application of the peer to peer model to banking has seen the launch various types of peer to peer lending.
This is perhaps the obvious application, but it is not necessarily the easiest, nor the largest opportunity.
The internet powered peer to peer revolution is currently sweeping through many areas of the economy disrupting many large and formerly well-established businesses. This often referred to as the “sharing economy” directly connecting service providers with service users via the internet. There are numerous examples:
- Airbnb (market cap $10 bill) connects people with rooms to spare, with people who want accommodation.
- Uber (market cap $40 bill by some estimates) and Lyft (still private) connect people with cars, with people who want rides
- eBay (market cap $34 bill) connects people with goods, with people who want them.
The directory site Compare and Share now lists over seven thousand businesses (mainly in the accommodation and transport sectors) that follow this pattern.
In the field of banking and finance, this template of connecting service provider with service user is now being pioneered e.g. Lending Club (market cap $5.4 bill), Prosper (still private) and Zopa (still private). In all of these cases, the service provider is a lender and the service user is a borrower, enabling peer to peer lending bypassing the banks.
This is an obvious application of the peer to peer template to banking, but is it not as easy to implement as many of the applications to other markets. Borrowers are not homogeneous and it is challenging for a rating system, which can work well to rate an Airbnb room or an Uber driver, to replicate the credit assessment, monitoring and enforcement of loans conducted by banks. Lenders must also come to terms with the fact that, besides bearing direct and unbuffered credit risk, they now have a long-term investment. Many lenders have been accustomed to much shorter term investments including demand deposits.
Peer to peer lending may well flourish, and in some special cases, like the Receivables Exchange (still private), it has already been successful. There is however a less obvious, but much simpler application of the peer to peer template to banking. It has so far, been overlooked, but is potentially much larger.
Banks presently fund themselves largely by way of deposits which are of a much shorter term (even on demand) than their assets (up to thirty years). That they are able to do this at all is a result of the fact that the number of depositors is large and while some depositors are withdrawing, usually, others are depositing. This makes for a reasonably stable funding base in a probabilistic sense. Nevertheless, the banks understandably charge a considerable term premium (the margin between long and short-term rates) for this risk and service.
If instead we cast investing depositors as service providers and withdrawing depositors as service users, and a means to match and transact were provided, a mutually beneficial exchange between them can take place. With this formulation, the service traded is then a deposit obligation of the issuing bank. This is homogeneous, available in very large quantity and eligible for FDIC insurance (subject to the usual limits). There is no need to rate particular borrowers as bank ratings, which are readily available, should serve this purpose well.
Rather than peer to peer lending (requiring trading in credit risk), this is then peer to peer trading of liquidity or more colloquially “money”. The trading of money is something we all do, peer to peer, almost every day and have done so for millennia. The bank notes and coins, that presently constitute the money we trade, are Government issued obligations, whose value is protected, to some degree, by central bank inflation targeting. In earlier times, banks issued their own bank notes and in Scotland and Hong Kong (against reserves), they still do.
Today, however, even Government issued bank notes are no longer the predominant form of money. The value of bank deposits is currently around ten times the value of all notes and coin on issue. Other than for small transactions, most are settled by cheques or electronic instructions, which authorize a transfer of bank deposits. Even many smaller transactions are settled using credit cards. As electronic money becomes more fully established, bank notes could well be relegated to a residual role in the way that, centuries ago, coins were relegated by bank notes and, before that, silver and gold were relegated by coins.
The use of bank deposits as money has the advantage of being easier to keep safe and they pay interest, but they have not been without problems. While bank notes are no longer convertible into gold, bank deposits are redeemable for cash, often on demand. This imposes a serious vulnerability on the banks whose assets are mostly business and housing loans, which are much longer term. This makes them susceptible to runs as was starkly demonstrated by the 2007-8 financial crisis.
For this reason, enabling peer to peer trading of bank deposits on an exchange would not only be beneficial for the traders of those deposits, it would also be very beneficial for the issuing bank. This is because they no longer need to redeem deposits as withdrawing depositors are funded by newly investing depositors. This will allow the banks to issue suitably designed, longer-term deposit instruments, freeing them from the liquidity risk that redemption obligations create. Accordingly, banks would then be able to pay depositors higher rates.
If banks can raise long-term deposits to match the maturity of their assets and these deposits were tradeable peer to peer, like bank notes, to create the liquidity depositors require, we would have the best of both worlds. Banks would then be able to do the things that they are capable of and useful for: sourcing, vetting, managing and aggregating loans while avoiding the need for them to do the thing that they have been proven to be weak at - providing liquidity. Depositors would get a share of a well diversified and managed portfolio of loans, senior to the bank’s capital (which takes the first losses on the loans), and overlayed by deposit any insurance. Crucially, fast, efficient, 24/7, and very low cost peer to peer trading of these long-term deposits at par, like bank notes, on a web based exchange can provide the depositor with the liquidity they demand - inter-depositor.
As we have seen during the financial crisis, for banks to raise the bulk of their funding through demand and short-term deposits involves serious risks, not only for them, but for the whole financial system and the economy. This is recognised in the new Basel III regulations and in the new Regulation Q which comes into force Jan 2016. Long-term deposits, designed to be peer to peer tradeable on a suitable platform, would provide the banks with a sound funding source, no longer prone to runs.
The web-based mCD Exchange is just such a platform which can realise peer to peer matching and trading of these long-term bank deposits at par. This dovetails into the present payments system run by the banks making these deposits an ideal new form of money.