The Future of Financial Infrastructure

Fat Protocols, Applied to Finance

If crypto can evolve to surpass current financial infrastructure on performance, decentralization, and security, then it could gain widespread global adoption as payment rails. Wealth will be pulled from the modern financial system to the holders of public cryptocurrencies if this happens.

Modern Financial Infrastructure Is Outdated

The ACH payment system is one of the primary ways of moving money within the US today. It’s used to process payroll, pay bills, and issue government payments like Social Security. It’s a means of transferring money through computers, but it’s remarkably slow for a digital system. This Planet Money episode from 2013 delves into the reasons why, but it comes down to a few main factors:

1. It’s built on top of legacy systems from the 1970s and earlier, when physical checks were mailed from bank to bank to process payments.
2. ACH is regulated by the government and an organization called NACHA (which is essentially consortium of banking executives). Both of which have little competition or incentive to change.
3. Speeding up ACH transfers could make it harder for banks to prevent fraud risk (a legitimate concern), and would also cannibalize banking revenue such as fees from same day wire transfers.

(Oh, and SWIFT – the main protocol used to transfer money internationally – is even worse. 2-5+ business days and higher fees of $50 or more).

ACH payments are processed in batches a few times per business day. The system doesn’t operate on evenings, weekends, or holidays. Transactions take 3-7 business days to clear, though they recently introduced support for same day transactions that are executed by 1pm and are below $25k.

From the Planet Money Episode:

“BLUMBERG: Another question I thought would be simple but wasn’t – what is the deal with weekends? Amazon and Chase both told us that part of the reason it took so long to transfer our money was that there was a weekend in there. And you see this all the time in online banking and bill payment. It’ll take 3 to 5 business days or 5 to 7 business days. It’s always business days. But if you think about it, why should that matter? I mean, I can look at my account online on weekends. I can even go to the bank on weekends.

So why does this system, the ACH system, close down on weekends?

MCQUERRY: At some point, ACH does cut off its operating hours. It more or less has bankers’ hours.

BLUMBERG: And let me just pause there. So this is – when you talk about the ACH, you said the ACH takes bankers’ hours. Are we talking about people or are we talking about machines?

MCQUERRY: We’re pretty much talking about machines.

BLUMBERG: So if we’re talking about machines, why do they need to take bankers’ hours?

MCQUERRY: That’s a good question. (LAUGHTER)

BLUMBERG: Do you have any answer?

MCQUERRY: I think you have to really – you have to think of it as a system that was conceived and implemented in the 1970s.

KESTENBAUM: The 1970s – 40 years ago. This piece of financial plumbing, it is 40 years old. That’s the reason it’s so slow. It’s old.”

From first principles, this makes no sense. Banks are sending packets of light back and forth, just like Google does when rendering your search results and Facebook does when delivering new content to your news feed. Could you imagine if any other large digital system wasn’t operable outside of business hours? The beauty of computers is that they don’t need rest or sleep. The financial system hasn’t gotten the memo (this was quite visible when the first round of COVID relief payments were often delayed by months).

Fintech companies like PayPal, Stripe, Square, Visa, and others are doing great work in innovating on top of this system. While they offer highly centralized financial services, they provide a substantial improvement to direct ACH payments in terms of speed & convenience (i.e. credit card and PayPal transactions are much faster). The downside is that fees are often higher on these platforms, and transactions can still take days to settle on credit & debit card systems. In the end, they’re still forced to use much of the same plumbing that was designed prior to the dawn of the modern internet.

Crypto Promises Improvement, But Has to Get Better

Cryptonetworks like Ethereum and Bitcoin run 24/7, work internationally, and can process same-day transactions of nearly unlimited value. They also don’t require customers to go through Know Your Customer (KYC) or anti-money laundering documentation prior to transacting (like banks do when you create an account).

The issue is that cryptonetworks are still not as efficient as modern payment rails at transferring money. Even though the ACH system for wiring money is slow, companies like Visa have built systems that can process up to 65k transactions per second. Bitcoin can’t compete with that yet at 7 transactions per second. Neither can Ethereum with 15 transactions per second. For crypto overtake modern payment protocols, it will need to find innovative ways to process transactions faster, without compromising on security or decentralization.

This problem is known as the blockchain scalability trilemma. Layer one blockchains can be evaluated based on their levels of security, decentralization, and processing speed. Today, blockchain projects have to choose 2 of the 3. Ethereum founder Vitalik Buterin is credited with popularizing this concept, and he believes that with sufficient innovation, it’s possible to build a network that can solve for all 3 variables of this conundrum.

Many people recognize the power of decentralization and trust minimized finance. The ability to transact without a 3rd party in the middle is a huge innovation. However, for blockchains to displace much of the world’s modern financial technology, these systems will need to get faster.

Crypto-philosophers like Nick Szabo argue that focusing on speed and engineering efficiency might be missing the point when it comes to blockchains. After all, isn’t having options to transact without a centralized party in the middle enough? Szabo is correct in that this is important to call out, but it will not be enough to enable crypto to reach its full potential. We are pushing the limits of computer science by trying to build faster blockchain networks, but isn’t the point of innovation to push limits?

Wouldn’t it be cool if we could build systems with blockchains that can improve the entirety of the modern financial system? After all, that would fulfill the dream of a peer to peer digital currency that Satoshi Nakamoto outlined in the original Bitcoin white paper.

If It Works? The Result is Fat Protocols in Finance

The creators of the protocols that built the internet created it in academic & military settings. They didn’t get wealthy directly from their creations. Internet companies like Google and Facebook came along and built applications on top of these protocols. In today’s internet, the applications are closed and worth trillions, while the protocols are open and free for anyone to use.

The creators of the digital financial protocols like ACH and SWIFT did not build immense wealth through their inventions. Instead, financial institutions use them for their benefit. With crypto, the value of the protocols will be captured by the creators of the protocols via a token, and the financial institutions will receive a much smaller chunk of value creation.

If crypto innovators can solve the scalability trilemma to build decentralized, secure, and scalable solutions, they could replace modern financial protocols. This will create a dynamic in which those that get richest are the ones who own a different part of the value chain: the protocols themselves.

Crypto is open source software, with a catch: value can be captured via tokens. Ethereum is open source, and so are the many ‘financial primitives’ are being built on top of it. These primitives include applications like collateralized lending, decentralized exchanges, derivatives, and more. Many call these open source financial applications ‘money lego blocks’ because they can be strung together to form a sort of parallel financial system – one that doesn’t require central banks or nation states.

Ethereum developers have built countless applications that are proving to be quite effective at delivering financial services in an open source manner. Protocols like Ethereum & its competitors are being eyed by executives at companies like JP Morgan and Visa for their efficacy as financial technology.

If major institutions adopt these protocols, then who gets rich? Those who hold ETH, BTC, or the native token of another chain that supports the financial ecosystem (other contenders include projects like Solana, Algorand, Tezos, Tron, Cosmos, and many more.). The demand for these native tokens would skyrocket, because users would need required to use the network’s currency to transfer value.

Perhaps the new payment rails are ones that convert middlemen into blockchains, instead of institutions. This could all be done through open source software, rather than via archaic protocols and banking databases. If this is the future, then banks will still certainly have a valuable place in the world. We’ll still need things like credit, custody, and derivatives. Because banks are massive stokeholds of wealth, they can become credit providers on open cryptonetworks. They can also play a role in keeping your digital assets secure. Caitlin Long’s Avanti Bank and some forward thinking major banks are gearing up for this future. I can also see a future in which banks see value in creating new derivative assets on blockchains that weren’t possible in the normal financial world.

Just like the web made media internet first, crypto will do the same for finance. Crypto has more innovating to do if it’s to achieve its DeFi dreams. The ACH and SWIFT systems are slow and inefficient, as they were modeled after processes built 50+ years ago. What crypto needs is to build the payment rails of the future. If the new projects with the potential to scale blockchain systems start to deliver, we could see it happen.

Slowly, then all at once.

Further Reading: Fat Protocols, by Joel Monegro of Union Square Ventures