January 4, 2018
At a time when disbelief in decentralized systems may end up being an offense in Silicon Valley and beyond, I’d like to give a benefit of a doubt to the concept and modern embodiments of centralized systems, and argue that centralization is not an inherently inefficient and a flawed model. In fact, centralization is a natural response of any industry to increasing complexity and globalization, and a natural push towards efficiency. To make a case for centralization, I’d like to go over three points:
Centralized systems are not inherently flawed. Comparing safe havens of private decentralized networks to modern embodiments of centralized systems is not a comparison of equals.
The history of institutional banking is the history of consolidation and centralization of resources in the name of efficiency and benefit to the end-user.
Intentionally or unintentionally, FinTech is repeating every step of the history of institutional banking.
It is at least unfair to compare centralized systems that have existed for centuries to a theoretical concept of a decentralized system, and even to POCs. The world is yet to see an international, or even national, organization fully running its data and operations on a much-hyped decentralized ledger technology; an organization serving the needs of the whole population of one country and thousands of businesses, and able to serve those needs abroad with the same success as domestically. The Federal Reserve System, the Financial Action Taskforce on Money Laundering, the United Nations, the Department of Homeland Security, BRICS, MasterCard, Google, AXA, Metlife, etc. – any entity of people, nations, businesses of national and international importance.
Modern centralized systems embodied by all existing organizations and nations have vulnerabilities because hackers had time to get to know and understand how centralized systems work so that they could test and develop advanced hacking techniques. That does not, however, mean that vulnerability to attacks is an inherent flaw of any centralized system. Some systems are protected better than others, and it is a matter of advancements in cybersecurity for centralized systems to have a chance to sustain attacks of proponents of decentralized systems.
As Adam Ludwin, Co-founder & CEO of Chain, put it in his elaborate but well-put letter to Jamie Dimon, Decentralized applications are a new form of organization and a new form of software. They’re a new model for creating, financing, and operating software services in a way that is decentralized top-to-bottom. That doesn’t make them better or worse than existing software models or the corporate entities that create them. As we’ll see later, there are major trade-offs. What we can say is simply that they are radically different from software as we know it today and radically different from the forms of organization we are used to.
As Ludwin continues, Simply put, you cannot argue that for everyone, Bitcoin is better than PayPal or Chase. Or that for everyone, Filecoin is better than Dropbox or iCloud. Or that for everyone, Ethereum is better than Amazon EC2 or Azure.
In fact, on almost every dimension, Ludwin argues, decentralized services are worse than their centralized counterparts:
They are slower
They are more expensive
They are less scalable
They have worse user experiences
They have volatile and uncertain governance
Moreover, this won’t fundamentally change with bigger blocks, lightning networks, sharding, forks, self-amending ledgers, or any other technical solutions, he adds.
That’s because there are structural trade-offs that result directly from the primary design goal of these services, beneath which all other goals must be subordinated in order for them to be relevant: decentralization.
The history of institutional banking in the history of continuous consolidation. Since the ’90s, financial institutions never stopped bringing together resources to get to the next level of operational efficiency (not mentioning thickening profits and increased weight in the global financial system, obviously – that is not the main point).
From the standpoint of financial institutions, the period from the late 1960s to the 2008 GFC was one of continual expansion in scope and scale, culminating in huge global financial conglomerates. This took place through organic growth and more significantly through mergers and acquisitions, with the merger of Travelers and Citibank to form Citigroup in 1999 being paradigmatic, the authors of FinTech, RegTech and the Reconceptualization of Financial Regulation explain.
Back in 2011, in their article called To Centralize or Not to Centralize?, Andrew Campbell, Sven Kunisch, and Günter Müller-Stewens emphasized that business leaders dating back at least to Alfred Sloan, who laid out GM’s influential philosophy of decentralization in a series of memos during the 1920s, have recognized that badly judged centralization can stifle initiative, constrain the ability to tailor products and services locally, and burden business divisions with high costs and poor service. Insufficient centralization can deny business units the economies of scale or coordinated strategies needed to win global customers or outperform rivals.
It may seem a distant past, but modern institutions that decentralization evangelists are so eager to denounce, went through the very same path – consolidation of resources, and, essentially, centralization of authority.
Take Visa as an example. Visa’s journey begins in 1958, the year that Bank of America launched the first consumer credit card program for middle-class consumers and SME merchants in the US (reminds of innovators launching solutions for small businesses in the past few years?). It didn’t take long for the company to grow and expand internationally in 1974 (just like FinTech companies do, jumping through hoops) and introduce the debit card in 1975.In 2006, Visa became a private membership association jointly owned by over 20,000 member financial institutions worldwide. In 2007, regional businesses around the world were merged to form Visa Inc. and, followed by the company going public in 2008 in one of the largest IPOs in history. In 2016, Visa completed the acquisition of Visa Europe.
What started as a BankAmericard program in Fresno, Calif., grew into the Visa we know now, which operates in more than 200 countries and territories with products and services available on any device – cards, laptops, tablets, and mobile devices. Visa played a unifying role for the financial institutions around the world instead of remaining one of many localized connecting tissues for small groups of institutions.
The short history of FinTech is no different from the history of institutional banking. Startups also come to realize that the best strategy for survival and success is to partner, merge, and acquire. The most successful companies – large, medium, and small – come to an appreciation of how a partnership can power their leap of growth and development, and how just the right acquisition brings in revitalizing and pivoting talent and technology into the company. Studies suggest that 87% of banks that have partnered with third-party financial service providers (FinTech companies) have been able to cut costs. Additionally, 54% of partnerships increased revenue, Forbes cites.
Discover is an example of an institution built its might on patching networks into one. Being a network of networks, Discover leveraged the advantages of every network under one umbrella, centralizing and concentrating the business in the name of growth, efficiency, and consumer convenience.
Some of the most successful FinTech companies follow the path of growth through acquisitions and acqui-hires: First Data acquired payment processor CardConnect; last year, Ant Financial put forward an 880-million-dollar bid for the acquisition of MoneyGram (although just recently was denied the opportunity); PayPal has acquired payment management company TIO Networks; Vista Equity Partners struck an agreement to purchase Canadian financial solutions software supplier D+H; Mastercard has won the approval from the UK’s Competition and Markets Authority to clear the way to acquire payments systems company Vocalink; payments company Worldpay has confirmed a $10-billion acquisition offer by card processing company Vantiv; Swedish FinTech unicorn Klarna acquired BillPay, which has been labeled the PayPal of Germany; Moneyfarm, the UK-headquartered digital wealth manager, acqui-hired the technology behind personal finance chatbot, Ernest, with Ernest’s CTO Lorenzo Sicilia joining Moneyfarm to oversee technology integration; FinTech lender Qbera has partnered with online automobile marketplace Droom to enable loans for vehicle purchases on the latter’s platform; and many more.
There are certainly many more examples of interesting partnerships and mergers. The point is that mergers and acquisitions change industries, and with FinTech, they lead to institutionalization and consolidation. Centralization of talent, resources, and operations, is a very natural tendency, and often the best choice for companies to grow and develop.
All this is not to say that a decentralized model of organization is a disadvantageous one; it is just different, and the tech community is probably yet to discover the best use case for a decentralized organization. That does not mean that centralized model of running a business and operations is going away.