The Financial Ecosystem — Reintroduced
Preface
A lot of people are intimidated by cryptocurrencies as there are plenty of myths making them untouchable for the majority of the population. Either people think it is all just a scam, perhaps an elaborate ponzi scheme, or they think the whole subject of crypto is just too geeky and therefore dismissed as something they would never understand. I am writing a series of posts to first dispel these myths and misconceptions around cryptocurrencies and then to gently introduce the topic with sufficient detail — beyond just scratching the surface — so that people can actually benefit by investing in this wonderful, new asset class.
Once people realize the amount of science and finance that forms the basis of cryptocurrencies, they would find how much more rewarding that knowledge can be for them and eventually appreciate and benefit from the world of Decentralized Finance (DeFi), which now appears to be the future of finance. But, we get ahead of ourselves. Lets start with some history-in-a-nutshell first.
Traditionally, in times of distress, people normally moved their wealth from all other asset classes into precious metals such as gold or silver as they are both considered as great preservers of wealth. But followers of modern portfolio theory and sage investors such as the Oracle of Omaha (Warren Buffett) hate gold due to the lack of yield i.e, it does not earn you any interest or income other than capital preservation and gentle appreciation over time. This is where crypto currencies come in as they provide you not only capital preservation, nay capital appreciation even, but also yield. Interested? Lets get started.
To be able to understand Crypto Currencies, it is more important to understand the Currency part than the Crypto part. Its just like we don’t need to understand too much about the security measures in printing a currency note to use it, similarly, one needs to spend more time to understand what is the currency in cryptocurrencies. To do that, we need to restate the ecosystem around traditional fiat[1] currencies in terms of the new terminologies and concepts that drive the crypto world. So, in the Part 1 of this post, we will better understand the conventional fiat currencies first, so that we can make the connections correctly, when I later talk about cryptocurrencies and the ecosystem surrounding them.
Traditional Currency Ecosystems
Every financial ecosystem has at its heart a currency. Of course, it could be any currency — US Dollars, Euros, Indian Rupees, Japanese Yen or Chinese Yuan. But, we need a currency at the heart of a financial ecosystem. So, there is a separate US Dollar financial ecosystem, a separate Euro financial ecosystem and so on.
For the purposes of illustration, lets consider the US Dollar. People in general deal with a currency through the Banking System, which allows everyone to transact and deal in the US Dollar, and so lets call these Banks as Layer 1 of the Financial Ecosystem of the US Dollar.
Banks allow us to deposit the currency, withdraw it, borrow it, lend it, make payments using the currency, receive goods or services for the payments made in the currency — a whole host of transactions are enabled by these banks.
So, to recap, a financial ecosystem needs a currency at its heart and the entities that manage and enable transactions of this currency, are the Layer 1 of that financial ecosystem.
Lets assume there are four banks in our US Dollar financial ecosystem — Bank A, B, C and D. These four banks execute all of the transactions in US Dollars, and therefore, form the Layer 1 institutions around it.
A Layer 1 Transaction — Payments
Now lets start with a simple transaction. Lets say, Alice needs to lend some money, say US $1,000/- to Bob[2]. This is an example of what we call a peer-to-peer transaction — but, the way, it would get implemented in our financial ecosystem is as follows:
Alice would request her banker, say Bank A, to debit her account and credit the account of Bob, which is also maintained with them (or with another bank).
Now, while the transaction is between Alice and Bob, the Bank acts as the intermediary through which the fund movements take place. These payment transactions are in units of the underlying currency the US Dollar.
Of course, there are a few uniformly accepted characteristics about these payment transactions through banks which we have all learnt to accept — (a) there is no privacy for Alice or Bob regarding the transaction, as the banker is the intermediary through which the payment transaction was executed and (b) there exists a risk that the banker does not agree to follow the orders of Alice, even though the money in the account is hers, and not credit the account of Bob.
That might seem improbable at first, but Governments and Tax Authorities the world over can instruct a banker to block a certain account and thereafter, any instructions provided even by the account holder are ignored by the bank! The Bank effectively has an over-ride over your own money. Whether you like it or not.
Layer 2 Transaction — More sophisticated than Payments
Now, lets consider a slightly more complex transaction. Instead of just transferring currency from one account to another, lets consider investments in a business. This is typically done through the purchase of equity shares of a company. The shares are listed in a Stock Exchange and are represented by symbols for each company. In our illustration below, for each of the eight different companies, there are eight different symbols listed on the Stock Exchange. And the way we would typically invest is by opening an account with a Broker and investing through that account. The Broker and the Stock Exchange are the Layer 2 Institutions in the US Dollar financial ecosystem, which allow us to do something more complex than just payments — in our case allow us to invest in a business.
While the investment will result in a Layer 1 Transaction i.e., Payments (which is a transfer of the underlying currency) between the buyer of the shares and the seller of the shares, the Layer 2 transaction is actually more than just a payment transaction. It allows the buyer of the shares to receive periodic dividends, i.e, income from the investment, as well as benefit from capital appreciation, which we also call as capital gains. This would be represented by the share prices going up. The owner of the shares can then sell it to someone else, which would lead to another payment transaction, but the nature of the transaction is transfer of the ownership of the business, represented by the shares, from the seller to the buyer.
So, lets assume Alice has bought 1,000 Shares in one of the companies and now Alice wants to sell her shares to Bob. Again, it is a peer-to-peer transaction, but, it will require Layer 2 and Layer 1 Institutions in the US Dollar financial ecosystem to generate Layer 2 and Layer 1 Transactions to enable it. These transactions would be in terms of the currency — US Dollars. It is important to remember this key point, for we will understand this point better when we switch over to crypto currencies.
Returning to the share sale for now, normally, the shares of Alice would not actually be transferred directly to Bob. What would instead happen is that Alice would sell her 1,000 shares and Bob would buy 1,000 shares in the company, as two separate transactions and what Bob buys will not even be the same shares that Alice sold. The shares being completely fungible, Bob would get ownership of 1,000 shares in the company, against payment for the shares, while Alice would get payment for the price of the 1,000 shares that she sold.
Alice would put up a Sell Order on her Broker’s Portal to sell her shares, and her Broker who execute the transaction on the Stock Exchange and then would instruct his / her banker to transfer funds from his /her account to Alice’s and that sale transaction would be completed.
Similarly, Bob would buy through his Broker and would pay to the Broker from his bank account. The payment transaction would be executed by the Layer 1 Institution i.e, his Bank, but both the Sale and Purchase transactions would be executed by Layer 2 Institutions — the Stock Exchange and the Broker.
Another example of a Layer 2 transaction would be Alice buying a Medical Insurance Policy from an Insurance Company. Here the Insurance Company is the Layer 2 Institution providing services of a medical insurance policy, although the periodic premium payments would be made as Layer 1 transactions through Banks and if there ever were to be a claim on the policy, then the payment to Alice (or a medical facility on behalf of her), from the Insurance Company too would be a Layer 1 transaction. But, all these payments related to the insurance contract would be governed by the terms of the Insurance Policy and these as we know, can be pretty complex. So, as we can see, the financial ecosystem consists of Layer 1 Institutions executing
simple Layer 1 transactions — essentially Payments while Layer 2 Institutions allow for more complex Layer 2 Transactions to be executed, although, every Layer 2 transaction (Share Purchase or Sale, or Insurance Claim) would result in some sort of a Layer 1 (Payment) Transaction, which is essentially something represented in terms of the underlying currency which is at the heart of this entire financial ecosystem.
So, the entire financial ecosystem can be considered as successive layers of institutions which allows us to execute more and more complex sets of transactions, but, which build on top of the transactions of the previous layer, which ultimately could just be reduced to transactions represented in the currency at the heart of the financial ecosystem.
We have mentioned earlier that here are different financial ecosystems surrounding each currency. Whenever we need to execute a transaction that involves two or more currencies, then we essentially end up executing separate Layer 1 and Layer 2 transactions in each of the currencies, in their respective Layer 1 and Layer 2 financial institutions and this is facilitated by banks through currency exchanges, which eventually result in Layer 1 payment transactions being generated in each currency’s financial ecosystem.
So, it is possible to execute transactions across financial ecosystems of different currencies, but it will require multiple Layer 1 transactions to be executed.
With that we reach the end of Part 1 and in the next Part, we will replace the currency at the heart of the financial ecosystem with a cryptocurrency.
Ari Pingaley is the CIO of a Social Enterprise based in Bangalore, India. He has over three decades of global experience working in the fields of finance, technology and law
[1] Investopedia Definition of Fiat Money: Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies.
[2] Alice and Bob are famous fictional characters from the cryptography world, who are used in all discussions on cryptography. You can get more background about them here: https://en.wikipedia.org/wiki/Alice_and_Bob