Views on the integrity of global capital markets
24 August 2015

Disrupting the Disruption: Will Bitcoin be Hijacked by Wall Street?

Since my last post on Bitcoin there has been a distinct shift in tone around the technology, known as the blockchain, upon which cryptocurrencies like Bitcoin rely. Chiefly:

  1. There seems to be a consensus that did not previously exist that the blockchain is here to stay.
  2. Everyone now realises the Bitcoin, or any cryptocurrency for that matter, is not the key component of the application, rather it is the underlying technology.
  3. More or less, every large global bank is working on the technology.

In addition, most mass media articles about the technology will invariably feature the word “disruption.” Disruption is all the rage today with Uber disrupting the taxi industry, Tesla disrupting the car industry, Apple disrupting the watch industry, and of course the blockchain disrupting the financial industry.

However, there is a coherent theory on the concept of disruption that was formalised by Clayton Christensen of Harvard Business School in the mid-1990s, and it is interesting to think through the blockchain’s impact more formally in the framework provided by Christensen’s work. The theory posits that an innovation can be, broadly speaking, disruptive or sustaining.

A sustaining innovation is one that brings efficiency improvements or other short-term competitive advantages that can ultimately be copied by competitors. For example, Horace Dediu, who works at the Clayton Christensen Institute, argues in the excellent Critical Path podcast that Tesla (contrary to popular belief) is a sustaining innovation because the Model S competes in an existing market with only an efficiency innovation (battery rather than combustion powertrain). We can see incumbent manufacturers already developing models that are more or less equivalent to the Model S.

A disruptive innovation needs to create a new market based on new or different values. This can either be by creating a product that has a drastically different cost/value trade-off or by creating a product for consumption that did not exist previously.

In the former case what typically happens is that an industry will over-deliver on value that the consumer doesn’t appreciate. A low-end disruptor can then sell a product that is sufficient for the consumer but at a far lower price because it is not over-engineered.

Toyota is often cited as an example of low-end disruption. In the late 1960s, its Toyota Production System allowed it to have a fundamental competitive advantage in building low-cost cars that were “good enough” for consumers (particularly in the fuel crisis-plagued 1970s) when compared to the incumbent vehicles from the Big Three US auto makers that were over-delivering on power and size. By the time the Big Three adopted the “Toyota way,” it was too late, and Toyota had captured market leadership that it has largely retained to date.

Another way disruption can occur is through new-market disruption where a product is competing not with a similar product but with nonconsumption. Low-cost airlines (e.g., Ryanair) are often cited as an example of new-market disruption. While they seem to be simply offering a low-end alternative to the legacy carriers (i.e., low-end disruption), their far larger impact has been to open up the leisure air travel market for people who were not consuming air travel at all.

So, what is the blockchain going to be: a sustaining innovation, a low-end disruptor, or a new-market disruptor? Let’s look at all three cases.

Case 1: A Sustaining Innovation

Something that never sits well with me when the blockchain is termed a disruptive innovation is that it seems every large bank is working on the technology. Deutsche Bank sees the blockchain as an area of expertise and has come up with a laundry list of blockchain applications that it is presumably integrating into its product offerings. Estonia, admittedly on the vanguard of the e-government movement, has denied that its financial system is transferring onto the blockchain. While clearly taken out of context, it is worth noting that the statement was not ridiculed, as it probably would have been a year or two ago.

Now, I may have a simplistic understanding of what disruption theory is. But on some level, if my Barclays credit card works on the blockchain, and the Estonian central bank moves its records onto the blockchain, this doesn’t feel like disruption ….

Instead, this is, at best, an efficiency improvement and if we end up with 100 proprietary blockchains the improvement is even less obvious. Efficiency improvements do not result in long-term economic growth, or new markets, or new wealth. Since the blockchain is essentially open source, there is nothing stopping incumbents from assimilating the technology and crushing the industry newcomers with their greater resources. In fact, Deutsche Bank is calling for banks to adopt the blockchain to prevent disruption!

Analogy: what would happen to Tesla if Toyota made an electric car?

Case 2: A Low-end Disruptor

The argument against my previous point is that incumbents do not get disrupted because they are stupid, they get disrupted because the profitability of new low-end innovations is initially too low for them to pursue, and by the time they can justify it internally, it is too late. So, can Deutsche Bank justify fully incorporating the blockchain, and rendering (presumably) large swathes of its operation (and people) redundant? New technology is often held up as a great disruptor in and of itself, but what really matters is whether technology can disrupt the business model.

Is the current business model susceptible to disruption anyway?

Personally, I suspect current banks are over-serving customers who simply need a payment system and do not need mortgage services, personal and home insurance services, overdraft protection, ATMs, bank branches, and all the other overhead of a legacy bank. However, I suspect Barclays (I always pick on Barclays because I bank with them) will look at the profitability of such a bare-bones account and will decide it doesn’t make sense, while a blockchain start-up on Silicon Roundabout will have evolved to function on this low-end business model. We are already seeing something like this with Internet-only banks, so the precedent is there.

Analogy: will the incumbent banks adopt the alien technology and business model more quickly than GM did in the 1960s?

Case 3: A New-Market Disruptor

Probably the most interesting impact of the blockchain will be what it means for the billions of people worldwide who are underbanked (i.e., don’t have access to a full range of financial services) or unbanked (listen also to this podcast for more discussion).

Blockchain-based finance and its second-cousin crowdfunding allow the following to occur:

  • Populations with no financial infrastructure will have access at a reasonably low cost to a comprehensive and sophisticated global financial network.
  • The blockchain is, in a sense, size-agnostic, which will allow financial services to be miniatuarised — think micropayments, microbonds, microequity, and so on. This should in theory allow the application of innovative and sophisticated financing methods to be applied to small-scale investments.

If we view, as I think most readers of the blog will, the idea of a financial system as being critical to facilitating innovation, investment, and economic growth, by marshalling resources from surplus regions to deficit regions, then the prospect of large swathes of humanity having access to investment for the first time is pretty important!

One interesting statistic I learned from ASYMCO is that the Apple app store is now a larger industry in terms of revenue than Hollywood. One can only imagine the kind of money that people might be able to make building “apps” of the back of the blockchain.

Analogy: what will this “Ryanair effect” have on finance?

My Predictions

I’ll stick my neck out now and make a few predictions (that as with most predictions will likely turn out to be wrong):

  • The new-market effect will be the most significant and unpredictable. While this almost sounds like a tautology, what I mean by this is the blockchain will not materially change the lives of people in the developed world to the disappointment of the techno-anarchists that hope for socio-political change as a result.
  • While some of the Oldsmobiles and Pontiacs of the financial world will disappear as a result of the blockchain, just as they did as a result of the “Toyota way,” a lot of the incumbents will do enough to survive. There will be no extinction event.

One criticism often levelled at the Christensen disruption theory is that a quick reading often implies that the various forms of innovation are mutually exclusive — a low-end disruption cannot be a new-market disruption or vice versa. However, this is an overly dogmatic reading of the theory. I think it is more reasonable to say that the blockchain will have different impacts depending on who you are.

In the developing world it may be a life-changing new-market disruption, while in the developed world it will likely mean a marginal improvement in the costs and convenience of accessing financial services more along the lines of a sustaining efficiency improvement or a low-end disruption of incumbent institutions.

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About the Author(s)
Sviatoslav Rosov, PhD, CFA

Sviatoslav Rosov, PhD, CFA, is an analyst in the capital markets policy group at CFA Institute. He is responsible for developing research projects, policy papers, articles, and regulatory consultations that advance CFA Institute policy positions, focusing on market structure and wider financial market integrity issues.

2 thoughts on “Disrupting the Disruption: Will Bitcoin be Hijacked by Wall Street?”

  1. Svein Ølnes says:

    I think you, and a number of other people – mostly in the finance sector, miss the the point when you declare the Bitcoinblockchain the important part and bitcoin the currency the unimportant part. The currency bitcoin is important. A blockchain in itself is nothing more than a slow database – the currency is what keeps it distributed, permissionless and leaves trusted third parties superflous.

    1. Sviatoslav Rosov, PhD, CFA says:

      Thanks for your comment.

      Actually I agree that the blockchain without the coin is a glorified database, which is why I think things like R3 are probably mostly a marketing tool and will at best render some back office staff unemployed.

      However, I think you overestimate the importance of doing without trusted third parties.Trusted third parties are useful and given the 51% attack problem, you will have to have permissioned blockchains anyway for the legal system to respect any property rights stored on the chain.

      I think Tim Swanson’s thinking on this is pretty good.

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