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Sunday 10 June 2012

The End of Finance, As We Know It

Disintermediate and Die

Over the past twenty years or so we’ve seen a remarkable change in the way a lot of business is conducted.  Publishing, an industry which had run on business models largely invented in the Middle Ages, has been completely revolutionized (see: Book Value).  Other industries have had their economics completely upturned by the interconnectivity of the internet, cheap, distributed processing power and the power of peer review.

Yet this hasn’t impacted the financial industry in anything like the way it might have.  Sure, the introduction of low commission internet share dealing has undermined many old school brokerages, but that’s replaced one set of problems with another.  Now, though, the race is on to disintermediate the middle men: the financial industry is on the cusp of a revolution, and most of the intended victims haven’t got a clue that they’re already an endangered species.

Virtually Real

Disintermediation – the idea that supply chains between producer and consumer can be shrunk to reduce costs and improve responsiveness – has been the mantra of the internet age.  Nowhere has this been more self-evident than in the newspaper and music businesses, where the ability to connect customers directly to producers has seen long-standing business models destroyed almost overnight (see: Moats, Unbundled).  As technology has developed we’ve started to see the same thing happening to books, films and, indeed, virtually anything that you can digitize: why ship physical product when you can ship virtual, and cut out distribution costs?

Underpinning this revolution has been that miracle of the modern age, the internet, a global network of interconnected computers so seamlessly straightforward to use that it now seems impossible to remember a time when it didn’t exist.  What did you do before the internet, Daddy?


The interoperability of the internet is based on Tim Berners-Lee’s concept of html, the language of the net.  It’s this common language that makes the internet possible, and allows us to create and share information simply, quickly and effectively.  And this common language allows the creation of these new business cases, and others we’ve not yet thought of. 

At its most extreme level the internet allows producers and consumers to be directly connected so that I can sell to you, with no middle-men taking their cut.  In practice a whole host of digital middle-men have arisen, whose main role is to help you find me.  Amazon, Google, e-Bay, Facebook, Twitter … all, in their different ways serve to bring together the two, disparate ends of the supply chain.

Peer Review

One of the miracles of this process is that can provide ways of people signalling feedback.  So, for instance, if I publish a book on Amazon you can go and read the reviews and decide whether I’ve written junk or jewels.  Ebay provides mechanisms for assessing the trustworthiness of sellers.  Facebook allows you to canvas your friends’ opinions.  TripAdvisor uses peer review to assess hotels.  And so on.

The thing about these mechanisms is that they don’t rely on the tried and trusted methods of signalling quality.  You don’t go and read the blurbs by friends of the author before buying a book, you read the reviews by readers.  You don’t take the word of the travel agent before buying a holiday, you read the thoughts of people who’ve already done it.  Clearly these feedback mechanisms can be compromised, and there are businesses out there that will do that for you: but by-and-large these parasitic methods can only have a limited effect.

This is the effect of free-market economics writ large: competition between multiple vendors, assessed by customers with their feedback determining popularity and commercial success.  Screw your customers and the world will know about it: try and defend yourself using corporate bullshit on Facebook or Twitter and you’ll simply fan the flames.  But there’s one digital industry which is noticeably absent from this revolution: finance.


As Robleh Ali, Andrew Haldane and Paul Nahai-Williamson  relate Towards a Common Financial Language the problem is that there is no equivalent of html for financial products.  This lack of standardization lies behind the ability of higher cost producers to flog inappropriate product to gullible and behaviorally compromised consumers.  This is a market where the Law of One Price doesn’t work because it’s virtually, and deliberately, impossible to compare like for like (see: Finance: Where The Law Of One Price Doesn't Apply).

But as the development of the internet and, as the paper describes, global product supply chain technology has shown, standardizing the language used to communicate opens up the market.  If a financial product has to be defined using a common language format you can’t use weasel words to indicate that it’s somehow better than the cheaper, more applicable product from just down the road. 

A common language will allow products to be directly compared and will allow new sorts of service provider to perform the equivalent of the intermediary roles of eBay or Amazon or Facebook.  Oddly enough this may mean the survival of a form of commission based product selling, because the intermediary will take a cut – but intermediaries will be in open competition.  Fee based advisers will have to work ever harder for survival in a world where it’s transparent and easy to compare products, no matter how complex their packaging and how wonderful the associated brands.  Many will simply go the way of local bookstores.

Defence of the Distributors

Of course, we can’t expect this to happen easily.  Michael Taylor’s wonderful Parable of the Farmers and the Teleporting Duplicator parodies the way in which intermediaries fight for their lives when disintermediating technology is introduced:
“But then the distributors said something very clever. "How will people know that your food is the best unless they see that it's distributed by the best distributors? You'll never get ahead in the farming business if people can't see that the best distributors accept your food."
But, as the rise of the internet intermediaries has shown, the new distributors don't need to be the same as the old ones.  An open language opens the door and if financial regulators succeed they will do all of us a huge service.  This, of course, is how we should want our regulators to behave: the more we can rely on the mechanisms of the market, open competition and the invisible hand, and the less on under-resourced regulators trying to keep up with the latest weapons of mass financial destruction, the better.  Automate openness and then regulate the process, rather than trying to regulate the products.

Creative Destructionism

As the paper describes, non-standard open network financial products are already out there and working: Paypal is the most famous, but mobile based payment products in Africa and peer-to-peer lending in developed economies are starting to make inroads into traditional areas:
“With open access to borrower information, held centrally and virtually, there is no reason why end-savers and end-investors cannot connect directly. The banking middle men may in time become the surplus links in the chain. Where music and publishing have led, finance could follow. An information web, linked by a common language, makes that disintermediated model of finance a more realistic possibility.”
For years the financial industry has encouraged creative destructionism in other industries in order to reap the rewards.  Whole sectors have been laid waste in the name of economic efficiency (see: The Business of Capital is Bust) and now the cycle is going to come full circle. The financial web will destroy even those people who are honest and skilled, because when a computer and peer review can do the job as well as a person there’s only one possible outcome. 

The future of finance is going to be written in the language of technology.    Bring it on, I say.  The faster, the better.    

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  1. Great post and I love this quotation:

    The future of finance is going to be written in the language of technology. Bring it on, I say

    The financial services industry is now undergoing massive change and it's clear existing structures (especially at the firm level) are being threatened.

    What's less clear to me is what replaces some of this -- the exciting startups out there have gotten a lot of press but not a lot of assets.

    Any thoughts here?

  2. Time to start a peer to peer review site for financial products.

  3. "The interoperability of the internet is based on Tim Berners-Lee’s concept of html, the language of the net."

    The internet is not the web. The web is a moderately large but highly visible subset of the internet. HTML and, more importantly, HTTP are only useful to that subset.

    "...the problem is that there is no equivalent of html for financial products."

    The FIX protocol describes most financial products unambiguously. It's fairly low level but a newer variant, FIXML, brings an HTML level of accessibility to it.

  4. Interesting article, and a topic very close to my heart!

    I completely agree a core issue is the lack of a common language, and hence comparability, for financial products. I don't know if that can be achieved or not, but it's interesting to observe how startups are tackling the issue. for example are restricting their product set (to ETFs) and instead focusing more on adding value through the financial planning and asset allocation activities. InvestorBee on the flip side are attempting to bring comparability to the mutual fund market, leveraging a huge database of real portfolios, and distilling historic performance to returns and actual volatility (as opposed to a proxy for risk such as morningstar ratings)

    I strongly disagree though that this spells the end for fee based financial advisers. As above, we're a long way from enabling both product comparability and planning processes, for all types of consumer

    Which, excuse the plug, is why we founded - the first site to bring peer review to financial advisers (rather than financial products!) - we came out of Beta with a trade launch this week.

    I definitely think there's also a space for peer review of financial products and investment strategies....and again there's startups already in this space

    FYI, my thinking's moved on a little since, but here's a blog I wrote on this subject on Monevator last year -

    Interested in further thoughts....specifically on when, who and how.....because I'm sold on whether and why!

  5. The finance industry already had a wrenching disintermediation in the arrival of commercial paper. There is still too little understanding of how much this was actually the basis of recent bank instability.
    Essentially the banks once had a business where their capital could be at risk over a spread of possible companies , from the strongest to some very weak ones.
    This allowed some lending to smaller weaker credits that are now out of reach because, starting with the largest and strongest, more and more companies borrowed directly in the capital markets with commercial paper.
    The more the sound, large, good credits did not use banks the less they could afford to lend to smaller companies and the more their capital base was at risk.
    So they had to securitise their assets to try and reduce capital usage. And of course that resulted in an increasing frenzy of securitisation before they really knew how to control these new risks.
    This disintermediation of bank lending is probably
    going to move faster and further with the net but lets realise hat we are already well into the process.