The Great Race for Assets

Understanding the History of Custodians and the Rise of Modern Banking

Disclaimer: I wrote this post pre-CoVid but just never hit publish because I didn’t feel like it was cohesive. Hopefully it isn’t too dated.

For as long as humans have been around, we’ve been banking. Life was built around credit, and individuals often oscillated between playing the role of debtor and creditor. Everyone - whether individual, estate, or empire - was a part of a vast global network of credits and debts. Individuals didn’t pay for bread, or candles, or meat. People ran tabs, settling whenever they were able with either goods (say, from a harvest) or money, usually coin, in some form. Empires financed wars with debt, bankrupting many a wealthy family in the process when they refused to pay up or worse yet, lost the war.

Because coin was dangerous to transport, expensive to store and defend, and because differed in form from region to region, this lending and borrowing was largely dependent on relationships between people and the concept of social reciprocity. If I help my neighbor now, they’ll help me later when I need a favor. In pre-banking society, this dense web of credits and debts involving the rich and the poor alike formed the basis of the modern financial system.

Image of Usury and medieval banks Genoa 1340, sourced from the British Library.

This informal activity evolved to form the foundations of modern banking, largely driven by the introduction of double ledger accounting by Benedikt Kotruljević in 1416 (about 80 years before Luca Pacioli, the Franciscan monk who is often credited with this invention). From the 1400s onward, we saw the advent of modern banking, which relied on centralized institutions taking on deposits and custodying coin, and extending credit based on risk, and since then, banks have evolved in form but have not changed very much in their function. Banks effectively buy custodial risk to sell financial risk.

Understanding the Banking Business Model

A bank’s strength is driven by its balance sheet - the core function of a bank is to accrue deposits from people who have more money than they want or need to spend, and to use these deposits as collateral to finance all sorts of activities, primarily extending credit. I would argue the last decade of growth has primarily been driven by the utilization of leverage i.e. money borrowed against assets or equity to financing working capital needs, but let’s save that for another day.

When you deposit money at a bank, the bank owes you that money back at some point in the future with some amount of interest. However, banks can use this liability (the money they owe you) to create an income-generating asset by using the deposits as collateral to issue an interest paying loan. The spread between the rate they pay you for your deposit and the rate the charge for loans has historically been the driver of profitability. Modern banks fill a variety of functions, including investment banking, proprietary trading, advisory work, asset management, and much more - but at the core of every bank is the balance of deposits and loans. And by the way, they don’t just do this with cash. Banks can use any deposit as collateral, in a process called re-hypothecation. Mortgages, securities, and assets like gold deposits can all be used as collateral to lend more. Much credit to Caitlin Long for educating every bitcoiner on this topic.

Here’s a sample snapshot:

Now what’s really cool is how credit gets extended through not just one bank, but the broader banking system. If I’m Bank A and you give me $100, depending on the strengths of my balance sheet, I could lend say, $90, and keep $10 on my balance sheet. If I lend to another bank, they can lend $81, and keep $9 on their balance sheet. The recipient of that loan can lend again and so on and so forth.

Now if I go to the bank and ask for my $100 back, they won’t be able to give me my $100 until they get the $90 back from the bank who they lent it to. And that bank has to get back the $81 they lent out, and so on and so forth.

In this system, banks run on the assumption that no more than a set percentage of customers will want access to their cash at any time. In fact, a few weeks ago when lockdowns first started happening and people were hitting ATMs and banks, the FDIC (the body that insures bank deposits) actually put out a tweet encouraging people not to go to the bank and get cash, but to put their money in the bank.

Source: the FDIC’s own twitter account

But let’s say that one day, despite the FDIC’s best efforts, 20% of my bank’s customers come in and want their money. What do I do? I call up the biggest daddy bank of them all - the Fed. To meet the demands of their customers, banks get cash from the Fed. Most medium- and large-sized banks maintain an account at one of the 12 regional Federal Reserve Banks, and they pay for the cash they get from the Fed by having those accounts debited. Some smaller banks maintain their required reserves at larger, "correspondent" banks. The smaller banks get cash through the correspondent banks, which charge a fee for the service. The larger banks get currency from the Fed and pass it on to the smaller banks. And periodically, banks settle up the accounts and pay back the Fed when they have the cash. So - we have big banks lending to smaller banks, and then we have the Fed propping up the system.

When you give your money to the bank, it’s actually not your money anymore. What you own is an IOU that is a claim on your money. You might ask, who would make this Faustian bargain?

How Banks Get Deposits

Historically, the ability to accrue deposits has been a function of trust. In my example during the 1400s, people deposited their assets at trusted institutions and with trusted people. That could be the church, a local merchant, the nearest noble house, or your neighbors and friends. People would do mental calculus to figure out who would be the most likely to pay back the IOUs and often, spread their money around in a few places to avoid losing everything when one of their IOU holders went bust, or skipped town.

Over the last five centuries, we’ve gone from these localized webs of trust, to increasingly large, “trusted” institutions. Side note here - when I say trust, I don’t mean people trust banks. These institutions have repeatedly abused trust.

con’t: What people trust is that these intermediaries are “too big to fail.” They trust that they’ll be bailed out so long as they’re systemically important. So really, when people trust a bank, they’re trusting the system that will never let the bank fail.

The competition for deposits is fierce, and size has historically conferred significant advantages to banks who can accrue vast deposits. In the US, we’ve seen a massive wave of bank consolidation over the last 25 years. We’ve seen 36 mergers and acquisitions, which has led to the dominance of the “big four” - Citi, Bank of America, JP Morgan Chase, and Wells Fargo. These four banks in the US hold 45% of all customer bank deposits totaling $4.6 trillion.

Source: from my presentation on the Future of Finance at Slush 2019 - all slides here

As countries and people around the world get wealthier, the addressable market for banking continues to grow, because people need financial services - a way to deposit money safely and securely, a way to access short term and long term credit to finance small purchases like their monthly expenditures or a large purchase like a home.

But in other economies, people don’t trust large banks and may not trust the system.

When people do not trust institutions, who becomes the bank?

Who is going to build the mega-banks in this new world?

Will banks still exist when we can trust ourselves instead of the state?

These are the questions I think about as an investor, and technology is changing the calculus of how this will all come together. The future is coming, and its coming fast.

The current state of FinTech is just an abstraction layer built on top of the current banking system. But I believe that to build a new system, we have to re-imagine the form and function of banks entirely. Let’s talk about the mechanics of today’s
”challenger banks” and new entrants to the great race for assets.

Competing for Collateral

Today, customers have a variety of options when it comes to where to put their deposits. Big banks with branches on every corner are no longer the only option to earn a return on deposits. I earn less than 0.1% on my deposits at JP Morgan Chase. The industry average rate of return on deposits is 0.405%, and rates are mostly driven by competition.

According to MoneyRates.com, here are the best savings account yield rates:

(Note: this is all pre CoVid and given interest rates are now effectively zero and the Fed has significantly ramped up its lending activities, it will be interesting to see what happens to consumer rates.)

These so-called “challenger banks” offer higher interest rates to attract deposits, and have significantly lower expenses because they don’t have physical branches or fancy offices in Manhattan.

Now here’s the fun stuff - on the flip side, these banks often lend to higher risk clientele and charge much higher rates. Marcus charges anywhere from 10 to 28% on loans. The average net interest margin for consumer banking was 3.3% in 2018, meaning for every $1B in deposits, the bank earns $33M. Marcus has been able to accrue $60B in deposits, and booked $860M in revenue in 2019. Goldman’s first ever “Investor Day” presentation highlights Marcus’ growth, especially when it comes to deposit balances.

Now the risk with a challenger bank is that these banks are small, and may not have direct access to the Fed’s money printer. They are not yet “too big to fail.” So from a risk perspective, unless you’re depositing small amounts and relying on FDIC insurance, challenger banks are going to have a challenging time accruing massive pools of assets, and will instead have to build a high volume, low margin business by banking clients that the big banks (a) don’t want or (b) can’t service economically.

Stickiness of Deposits and Economics of Displacement

OK - here’s where it gets interesting. Banks may use attractive rates to lure in customers, but they typically decrease as AUM increases, because as banks become bigger they can charge a higher trust premium. Because banks are viewed as institutions who lower the risk of holding assets, their customers are largely insensitive to the underlying economics so long as the risk is low.

For example, Goldman Sach’s new consumer bank, Marcus, offers a high rate when you sign up, but it drops after 12 months because deposits are sticky and customers don’t often move their assets around to take advantage of yields.

Historically, once people put their deposits at a financial institutions, the probability of them switching banks is extremely low. In 2018, the reported % of US consumers switching banks accounts was four percent.

Four. freaking. percent.

That’s insanely low, and this means bank deposits are exceptionally sticky.

Now over the last decade, we’ve seen the growth of deposit displacement. Instead of storing money in banks, consumers are storing money in other places. Some examples include:

  • Tax advantaged accounts like FSAs, HSAs, and IRAs

  • Payment apps like PayPal, Venmo, and Square’s Cash App (how much do you have in your accounts right now?)

  • Emerging investment and wealth management services like RobinHood, SoFi, and more

  • Cryptocurrencies like bitcoin (wink wink nudge nudge)

These platforms have far less “stickiness” because customers use them for either utility optimization or yield maximization, whereas they use a bank account for security and risk mitigation. But as the perception of the riskiness of bank deposits continues to evolve, and as investors become more sensitive to their return on capital to risk ratio, the race for assets is taking on a new and more intense form.

The Great Race for AUM

So this brings me to my last point. We are going to see continued competition for AUM, and it’s going to be a crazy fight. Brokerage firms are already there - trading is now effectively free, and banks are snapping up brokerage firms and their billions in AUM. Next come the asset managers and their trillions in AUM.

For example, Morgan Stanley is buying eTrade for $13 billion. eTrade has 5.2M retail brokerage accounts holding $360B in assets. They have 2M corporate accounts holding $250B in assets. If Morgan Stanley can squeeze a little more margin out of these assets, or acquire more of these clients’ deposits in other parts of their business, the acquisition will pay for itself in no time.

While Wall St has been competing for collateral for over two centuries, startups are newer to the game, and platforms like LendingClub and SoFi are less than two decades into the game. But make no mistake, the range of choices available to holders of assets is expanding, and with it, the competition for these assets in the form of deposits is also heating up. However, banks and asset managers continue to have a monopoly on risk-average capital and collateral, which is the stable foundation upon which financial firms have been built since the advent of banking so many years ago. Money and state are one, and:

Because banks are the only firms that have a direct pipe from the Fed’s money printer straight onto their balance sheets, they have a monopoly on trust that was not earned, but rather given by the supreme powers of the Fed (a privately owned and operated entity) and the US government.

Banks will do anything and everything to keep their monopoly on assets. They will build, they will buy, they will partner, but they can never lose the thing that gives them relevance and power - a massive, massive pile of the public’s money that they direct and control.

The greatest shift that will happen in the coming decade is that people will find alternatives to trusting banks with their money. It may happen in emerging markets first, where there aren’t these behemoth banks and governments willing to prop them up at all costs. It may happen in developed markets as a result of market forces, like negative interest rates, or a result of the collapse of the narrative supporting state monopoly of money!

The objective of bitcoin is to separate money and state. As long as the government guarantees deposits at banks and provides confidence that banks are, indeed, too big to fail, we will not see this separation materialize.

We are not yet at the point where big pools of capital are leaving the banking system, so the displacement today is still small. For every dollar of AUM or AUC (assets under custody) a bank wins, only four cents will leave, and there is more money coming in than going out so the pie will keep growing. But at some point, there will be more money flowing out than flowing in, and as the time of inflows and outflows shifts as a result of our understanding of risk, there will be an amazing opportunity for a new model to emerge.

What Comes Next?

In my next post, I’ll talk about the role bitcoin will play in changing the dynamics of the race for AUM, thanks to some pretty unique properties that provide a new generation of asset owners a whole new set of options in how they manage, deploy, and store their wealth.

Custody is one of the least understood and most overfunded sectors of the bitcoin ecosystem, and I believe it will have to change radically as a result of market forces, technology innovation, changing investor preferences, and regulatory pressures that fundamentally change the calculus of risk for bitcoin holders.

Unfortunately, facts don’t change people’s minds. Until we shatter centuries of belief about custodial banking, risk, money and state, and the importance of ownership and agency, I have little confidence that people will actually change their behaviors. Fortunately, the gross incompetence and shameless self-dealing demonstrated by the men and women (but let’s be honest, mostly men) who run our institutions is accelerating the great global awakening.