Finternet - Deep Dive
Introduction
Humanity has leapfrogged in all domains of life in the last couple of centuries. And since the advent of the internet, there has been a rapid pace of change in all facets of life.
This is because the internet has made communication easier, cheaper and faster. As a result of this democratization of communication, seemingly everything has gotten easier, cheaper and faster too.
And ideally as the internet gets even better, all things based on communication get better at the same pace.
Except finance.
Finance is also an elaborate method of communication but it has not kept up pace with the improvements we have been seeing in other sectors.
And this has largely been not a bug but a feature. This is because the finance communications are extremely sensitive and high-stakes. As a result, the finance sector players are often the last in line to adopt a new piece of technology. They do this to minimize, if not, eliminate risks.
That is not to say that finance has not seen its own set of good moments fueled by technology. We have lightning fast payments at the consumer level for most parts of the world. Loan disbursements are now easy and available to an erstwhile unbanked population.
But the list of the wins is small and there are large portions of the finance world stuck with legacy system and siloed communication patterns. In an interconnected world, making these systems work together is enabled by a plethora of third party bridge enablers, who make fortunes while doing so. Despite that, it is not fast or cheap.
Nandan Nilekani and Agustín Carstens worked together to propose a new ambitious communication protocol to solve for the finance world. And they call it the Finternet.
How will the Finternet work?
The finternet is proposed as a modernisation at the infrastructure level of the finance world.
Basically providing the railroads upon which players from all across the financial chain can build and improve the overall financial technology stack.
There are two key building blocks to bringing about to reality - tokenization and unified ledgers.
Let’s understand these in detail:
Tokenization:
In the past few centuries, we have seen almost all financial assets take a digital form.
From money to stocks all which were only in paper format have gradually shifted and taken a digital form. More than 80% of the currency in circulation now only exists in the digital form. Stocks in paper format are now a thing of the past.
Tokenization can be thought of as the next natural step to digitization.
It involves generating a digital representation of financial or real assets that reside on a programmable platform.
Why do we need programmability for our digital assets?
Because our digital assets while being digital are still handicapped.
Tokenization reduces the dependency on the clearing and messaging systems, enabling atomic settlement – that is the synchronous and simultaneous settlement of multiple legs of a single financial transaction.
Instead of lengthy and complicated messages exchanged between institutions, the tokens carry all the necessary information with them - this removes all the inefficiency that comes with to and fro of messaging.
Although the full extent of tokenization will be realized when they are used in tandem with unified ledgers.
Unified Ledgers:
Current financial institutions use multiple databases for record keeping in a variety of formats. Because of the mismatch in the way these databases are structured, there is a layer required to exchange information.
Unified ledgers solve for this.
Unified Ledger is a ledger where:
All information about a financial asset is stored: from the ownership records to rules about the use of the assets - all in one single place.
It also contains the asset in tokenized format - which means they are programmable and executable.
Finternet proposes the use of multiple unified ledgers - each attuned to its niche.
But still being able to exchange information seamlessly.
Unified ledger or tokens don’t propose to replace the existing system. They are proposed as evolved replicas of databases and financial assets.
Both these building blocks working together will make smart contracts a reality in traditional finance.
What are smart contracts?
Smart contracts are simply digital contracts which can execute on their own. They are pieces of code which when executed will result in a financial transaction without any manual oversight.
The code is executed only when the terms of the agreement are met.
Smart contracts will enable a whole new way to interact with the finance world that has not been possible before.
What would all this achieve?
Time, Effort and Cost Save
With increased efficiency in transactions and less manual intervention needed, there will be inadvertent saving of time and effort. Both of these are costly resources, therefore saving there would greatly save costs in facilitating transactions.
These costs are collected by middlemen who work as the bridge toll collectors for connecting two financial systems that are not fluent in each other’s format.
Increased Connectivity
As an increasing number of financial institutions start adopting Finternet, there will be much seamless communication and transaction amongst those entities. Given, the base stack will be the same for these institutions, the existing hurdles with respect to different jurisdictions, countries or entities will be less pronounced.
All the checks and oversight can be streamlined making the entire system feel much more connected than before with limited need of third party intermediaries.
Banking the Unbanked
There is a major section of the population of all developing nations that still rely on unorganized players for credit. They charge high interest and often have predatory practices.
With the implementation of Finternet working alongside the public databases for KYC, the unbanked population can be enabled faster than now to bring them into the formal banking sector. This enables the working class population and fosters their growth while bringing their money to the economy - kickstarting a good cycle of growth.
Reduced Complexity / Increased Competition
The current finance world is designed around institutions. And the users have to find a way around systems and processes. Any company or startup in the finance domain seemingly is solving to bridge this gap of complexity.
As Finternet builds the roads of the finance world, it is doing so with the core mantra of users at the center.
This means interacting and building on top of Finternet is going to be much simpler than in the present world. This will propel a new era of investments from the private sector to build on top of the Finternet layer.
Better regulatory oversight
The Finternet can significantly ease the work of regulators and central authorities in several ways:
Enhanced Transparency: The use of unified ledgers within the Finternet provides regulators with real-time access to transaction data. This transparency allows for more effective monitoring of financial activities, making it easier to detect and address fraudulent behavior and compliance violations.
Streamlined Compliance: With tokenization and smart contracts, regulatory requirements can be embedded directly into transactions. This automation simplifies compliance processes, as transactions can automatically adhere to regulations without the need for extensive manual oversight.
Improved Risk Management: The Finternet’s structure allows for better data collection and analysis, enabling regulators to assess systemic risks more effectively. Enhanced data analytics can help identify potential threats to financial stability before they escalate.
Comparison with an example
Let us understand with an example of a loan process – within the current financial system and how it might look like with Finternet.
Current System Loan Process
Loan Application: You submit a loan application to your bank, providing personal and financial information. The bank manually verifies your identity, credit score, and financial history.
Credit Assessment: The bank checks your creditworthiness by contacting credit bureaus and other financial institutions. This involves back-and-forth communication, which can take several days.
Loan Approval: The bank decides whether to approve the loan based on your credit assessment. This decision may need further internal approvals and risk assessments.
Contract Signing: You sign a physical or digital loan agreement, which the bank stores in its records. The contract may need to be notarized or otherwise legally verified.
Fund Disbursement: The bank transfers the loan amount to your account, which may involve several intermediaries, especially if the funds are coming from a different bank or financial institution.
Repayment Schedule: The bank sets up a repayment schedule, which involves regular debits from your account. Each repayment involves communication between your bank and the loan management system.
Loan Repayment: As you repay the loan, the bank updates your account and reduces your outstanding loan balance. The bank communicates with credit bureaus to update your credit score.
Loan Process Reimagined on the Finternet
Loan Application: You submit a loan application directly on the Finternet using a digital identity linked to your unified ledger account. The application and your financial data are instantly verifiable through the unified ledger, reducing the need for manual verification.
Credit Assessment: The unified ledger automatically pulls your credit history, financial data, and other relevant information stored on different ledgers. Smart contracts embedded in the ledger assess your creditworthiness in real-time.
Loan Approval: The loan approval decision is made almost instantaneously, as the smart contract automatically verifies that all conditions are met. The decision and the terms of the loan are recorded on the unified ledger.
Contract Signing: You agree to the loan terms via a smart contract on the unified ledger, which automatically enforces the terms. This contract is stored on the ledger, ensuring immutability and verifiability.
Fund Disbursement: The loan amount is tokenized and transferred to your account on the unified ledger. This transfer occurs instantly, with the ledger updating both your balance and the loan balance in real-time.
Repayment Schedule: The repayment schedule is also managed by a smart contract on the unified ledger. The contract automatically debits your account according to the agreed-upon terms.
Loan Repayment: Each repayment is recorded on the unified ledger, automatically updating your outstanding loan balance. The ledger also communicates with other financial systems (such as credit bureaus) to update your credit status in real-time.
How Many Unified Ledgers Would Be Involved?
On the Finternet, the process might involve the following ledgers:
Personal Ledger: Holds your digital identity, credit history, and personal financial data.
Bank’s Ledger: Manages the tokenized loan amount, repayment schedule, and balances.
Credit Reporting Ledger: Updates your credit status based on the loan repayments.
Collateral Ledger (if applicable): If the loan is secured, a separate ledger may manage the collateral (e.g., property or other assets).
In the current system, these functions are handled by various systems and databases managed by different entities. In the Finternet, these functions are streamlined into specialized ledgers that communicate seamlessly, reducing the need for manual intervention, decreasing processing times, and enhancing transparency.
The unified ledger system simplifies and accelerates the entire loan process, providing a more efficient, secure, and user-friendly experience.
Challenges for the Finternet
The road to Finternet is not going to be easy. There are going to be challenges in creating the architecture as well as implementing it.
Let’s take a look in detail:
The Regulators
The regulators are the slowest to accept a new change in the world of finance unless it has shown its success at a large scale and carries less risk.
And their approach is justified given the high stakes. But such high oversight will also hinder the implementation of Finternet.
Tokenization process will be scrutinized heavily for any gaps in security. The regulators may not find the technology behind tokenization trustworthy enough. They may be concerned about the data privacy issues related to the ledgers in the highly connected world that Finternet proposes.
Tokenization
Not all assets can be easily tokenized, there are some like money which may be easy to tokenize because they have no physical counterpart. Other assets like shares of a company or commodities linked assets may pose a challenge. This may be due to multiple bodies overseeing the asset or there may be a government involved in the process.
Tokenization is just one part of the equation. There needs to be absolute certainty that no tampering of any kind takes place after tokenization. This may prove to be a challenge for some complex assets.
Toll Collectors
There are a lot of players in the finance world who work as bridges between two different financial systems. They provide a user friendly way for both the systems to interact and make transactions feasible for the end user. And they charge a toll to use their services.
There is not a lot of competition here because of the highly complex and regulated nature of financial systems. As a result of which there are just a few players at each gap often charging premiums for their services.
These companies are billion dollar companies who rely very much on the inefficient nature of the financial world. And with Finternet, this inefficiency will reduce drastically. Which would in turn hurt these companies a lot.
So they have all the incentive to push against Finternet. And they may lobby governments or straight up deny participation in it. Given, the large market share these players have, this may pose a serious problem in the implementation of Finternet.
Economically attractive?
Finternet is trying to make the entire finance ecosystem as communication friendly as possible. But at the same time it is banking on the fact it will garner support from all finance institutions - both private and public.
While the public bodies can make changes for the greater common good at some cost, private players will look for some monetary gain out of that process.
So, while Finternet may solve for the common gain of all, but to see the kind of benefits it is envisioning, there needs to be a strong profit incentive for the private players to participate.
Programmable Money means more scams?
Despite the siloed world and decades of vigilance, there is an alarmingly high number of cyber attacks and digital frauds affecting businesses and individuals alike.
Finternet will make things easy for us. But it will also make us increasingly more vulnerable to cyber attacks. Smart contracts and tokenized assets will enable a new class of elaborate scams and frauds.
Potential Implementation Method
With the humongous challenge that Finternet is trying to solve, it can not be tackled all in one go. It needs to be done in phases.
This is what a potential implementation can look like:
Phase 1 : The Right Starting Point - Choose a country where the government is open to implementing new technology stacks and has a high private inflow of capital in startups. A country like India would be best. Here, choose one sub-sector in finance which does not have extremely high volumes and has limited direct touchpoints with retail. Something like corporate bonds sounds good for this.
Phase 2: The Pilot - Build the technology layer to tokenize the assets ( corporate bonds) and design the unified ledger structure keeping the attributes of bonds in mind. Team up with the central bank to tokenize money in parallel to complete both sides of a transaction. Onboard the regulatory body and the market makers to start interacting with corporate bonds via the Finternet.
Phase 3: Testing the Waters - Comply with the major players, taking the feedback on security and usability, refining the token and ledger accordingly to make the entire corporate bond chain as fool-proof as possible.
Phase 4: Sister Sector - Once the pilot is up and running smoothly, pinpoint an extremely closely related sector. For example, government bonds, in this case. Build up the ledgers and tokenization technology for government bonds. Enable transactions between the two systems.
Phase 5: Connect the Country - If all goes well till this stage, this is a major success in the idea of Finternet and now gates can be opened up to include other sectors of finance. Private players can be invited and incentivized to build on top of the Finternet layer as more and more sectors get connected.
Phase 6: Expand to the World - If an entire country’s finance is now enabled by the Finternet it becomes the testament to the prowess of Finternet for other countries. Soon, more regulators and central bodies of other countries not shying from innovation will start joining. Once a few countries are onboarded, the network effects at global stage will start kicking in, speeding up the adoption.
This is an extremely bullish scenario for Finternet’s implementation. But given the stage-wise approach, even a partial implementation at some level will still reap benefits.
A country contained approach will make sure that any roadblocks and threats are handled internally without raising disputes.
As more financial institutions adopt Finternet, there is also a very large pool of benefits by aligning the public ledgers alongside.
Use cases for Finternet and Public Ledgers to work together
There are multiple avenues where Finternet and public ledgers can work together benefitting both the financial system and the public system.
Finternet and Health Records
This would supercharge the insurance industry. The health records can be used to calculate customized insurance premiums rather than a one-size-fits-all approach.
There can be real time change in premiums as well depending on factors like age, location and lifestyle.
At a later stage in the insurance industry, the funds disbursal can also be streamlined using the health records in case of any new registered health ailments.
Finternet and Land
A juxtaposition of these two systems would create an environment where transacting with land would be much easier.
Imagine the public ledger data of land ownership and the value of transactions all being accessible on the finternet - all loans with lands as collateral would save a ton of time in validation in valuation.
Furthermore, purchase and sale of land often involves large amounts of money. And there is inherent risk of bad acting on either side of the deal. Smart contract enabled contracts would eliminate such risks.
The smart contract can act as an escrow and facilitate the money transfer only when the land ownership record has been updated in the public ledger to the new buyer.
Finternet and Municipal Records
If the municipal records of an area are paired with Finternet, it enables seamless investments and development for the area. The municipal records contain all kinds of statistics which are to be communicated with authorities to ask for funding. This system is broken in most developing nations.
Putting those records on a unified ledger of its own, will increase transparency and trust in the system. This will bolster funding opportunities for the regions. There will also be easier oversight on how the money is being utilized.
References:
https://drive.google.com/file/d/1V0xF4cUCbowcmhdV-7trIHKF2XOMVdUR/view
https://www.ndtvprofit.com/technology/successful-finternet-could-boost-india-global-economy-by-2-3-npcis-ajay-kumar-choudhary
Very comprehensive analysis, liked the graphics