Part 2: How Trust Makes Traditional Financial Systems Inefficient

This article is Part 2 in a series. Read the rest here:

• Part 1: The Case for Market Decentralisation
• Part 3: Blockchain’s trustless guarantees

The financial system is built on trust. When we choose a bank to store our hard-earned money, we entrust a company to protect a very special number for us in their database next to our name. That number says how much we have. This trust extends further when we want to do stuff with our number, such as if I want to send some money to the account of a friend in another bank. When I do that, the two of us are trusting our two banks to have their computer systems connected in such a way that when my number goes down, the number of my friend goes up by the correct amount.

It is of utmost importance that either both of those things happen (my number going up and their number going down) or neither of them. This is sometimes referred to as “transactional integrity”, and it is a big deal. If it is not done correctly, money can be created out of thin air… or lost.

Such errors can have disastrous consequences. So it’s not just me and my friend who are trusting our banks to get it right – our entire society needs to be able to trust the banks to do their accounting correctly. If they do not, then the stability of the entire financial system could be called into question.

HOW TRUST BREEDS INEFFICIENCY

While the impact of intermediaries has been drastically reduced in the world of fiat currency banking, where just one asset type is moving around, the friction of the intermediaries can still be felt when it comes to the trade of more intricate financial instruments such as bonds. When a bond trades different things flow in different directions and more parties are involved.

Consider a simple example. A trade takes place in an exchange. Someone (with an account at Bank X) is getting currency, and someone else (with an account at Bank Y) is getting a bond. The issuer (who has an account at Bank Z) also needs to be able to keep track of who owns the bond so that they can pay them and so once the trade is done it needs to be reported to the company that holds the owners registry so that it can be updated.

Suddenly the simple example that we started with – of increasing a number in one bank and decreasing it in another – has turned into a picture with four or five different systems, two different asset types and at least three different parties, each with a significant financial interest. For the new bond holder and the issuer, this concern also extends into the future after the transaction has taken place. Since it is likely that each computer system involved sits within a separate company, we are also looking at a minimum requirement of two or three business relationships and custom system integrations.

Regardless of how fast each individual computer system is, reconciling all of these systems with one another to ensure that everything has taken place correctly takes time. Considering that some of the necessary processes often require manual intervention it’s easier to understand why settlement typically takes two business days.

Why does it matter that the traditional financial market is a web of complicated business relationships and disconnected proprietary systems if computers are so fast? It matters because we need to ensure that that system as a whole can be trusted, and so all of the layers of intermediaries are critical.

The way that trust is built within the traditional financial markets is the reason why, regardless of how fast the computers are, it is so inefficient.

TRANSPARENCY, IMMUTABILITY AND ROBUSTNESS

The benefits of a single unified system for financial markets is clear. The removal of intermediaries connects participants, reduces friction and lowers cost barriers to entry.  . We can’t see inside their system to see what’s going on, we can’t be sure that our balances won’t change, and we have no alternative if their system fails. In short, there is a lack of transparency, immutability and robustness.

What, then, would be required to address the risks associated with the single company unified financial markets model? We would need a system that is transparent, such that all transactions affecting all accounts are visible – in such a way that we can prove that balances are correct. The system needs to be immutable, such that the balance of an account can’t be tampered with or changed unless an authorised transaction is performed. We also need to be sure that the system cannot go down or be easily taken offline.

The good news is, a system has been built that meets these criteria. 

Read more articles in this series:

• The Case for Market Decentralisation
• Blockchain’s trustless guarantees