Commerce and Banking – What is the Difference?

21 Nov 2013

Warning… long blog.. random unstructured thoughts

This is the question I came up with in a lunch chat with my friends at Omidyar Network and not exactly something I can adequately address in a blog, a book, or a lifetime.. but hey some idiot like me may as well throw it out there.

Why am I asking this question?

My investment hypothesis is that Banking and Commerce will be undergoing a fundamental rewiring. Therefore I’m wondering who the winners will be? What needs to be built? What are the signs that progress is coming? These are my selfish drivers.

On the altruistic side, how can we massively expand the global economy? Enable millions of businesses and billions of consumers to participate in the world economy? Within emerging markets, which is more important to invest in? Banking or Commerce (see blog Expanding Global Economy).

Where am I coming from? Network View

Well I’m certainly no economist, but I do know a few things about networked businesses. How are Banking, Commerce, Society, Government influenced by network effects? How has it evolved?

One of the most influential books I’ve read on this topic is Weak Links by Peter Csermely (viewable on Google Books here). If I had one book for you to read during the Holidays this is it. This book is tremendously arcane, detailed, technical, deep.. but I guarantee you that you will have a new view of commerce, banking, advertising, social networks, payments, and society after reading it. Example below on Peter’s insights into how the creation of money altered society, established “weak links” and Capital Markets (p 263)


Wow… just when I thought I knew everything about payments. The advent of money led to the development of concept of PERSONALITY!? (Certainly a new way of thinking about networks). The idea that increasing use of money drove new social and economic structures is obvious; less obvious are the connections formed, the “weak links”, beyond the flow of funds: non monetary data, relationships, reputation, …etc. I prefer to think of this “personality” dynamic, within weak links, as behavior (as influenced by Malcolm Gladwell).

These “weak links” represent the world’s most complex network, and this network is going through a FUNDEMENTAL change as communications networks have greatly improved the efficiency of network creation to a near frictionless flow information. There are 2 fundamental questions for me here:

  1. What is the cognitive limit to networking (ie. associations, data, ..etc)? and what are the tools to improve them (ie Platform which I will cover later), and
  2. How do we connect the unconnected?

Most surprising to me, within Peter’s work, was the idea that scale free distribution (completely open networks) is not always the optimal solution to the requirement of cost efficiency. For example, Peter states in his book

in small world networks, building and maintaining links between network elements requires energy…. [in a world with limited resources] a transition will occur toward a star network [pg 75] where one of a very few mega hubs will dominate the whole system. The star network resembles dictatorships in social networks.

Therefore, there is a case to be made for specialization and “semi open” networks when it comes to COST efficiency. Logically, the boundaries for star network size are associated with the value of connection exceeding the cost.

Given the complexities of weak links discussed above, we can see (from a networked view) why managed economies (like the old USSR) lost to social structures where dynamic networks could be formed on value.  We can also see how consumers at the bottom of the pyramid are more heavily influence by the the few links they have (ex social programs, corrupt dictators, populists, …etc).

This all leads to a question for us, as a society, where should we try to “centralize” services and functions? Would it be better to provide the tools to “connect” and educate the mass market on how to discover services (ie value, reputation, price, …)? Or force everyone into a network with no other options? (Sorry for the Healthcare tangent).

Star networks naturally occur, but they also occur artificially. Banking has both dynamics, as connectivity and strong links are required for efficiency. Banking System’s network dynamic is also strongly influence by regulation that manages the connection and the information flow. What would an unmanaged banking system look like? This is what we see today in BITCOIN.

US Bank regulation impacts participation, services, value, location, communication, … etc. In a world of free information flow, should consumers have a choice? What choices should they have? The need of government is to track financial information for the purpose of taxes and management of economic activity. The need of consumers is to connect to the economy efficiently.  Thus star networks exist both as natural (self organized communities) and unnatural (regulated services, dictatorships) phenomena.

How do consumers select a Bank? Well back in 2006 we commissioned an analysis and found that branch location (convenience to home/office) was the number one factor in consumer bank selection. In the last 2 years we have seen a SEA CHANGE as US banks now work to thin out their branch network. Many drivers here, but it certainly doesn’t help that the fee restrictions from Durbin led to a consumer banking environment where the bottom 40% of consumers are no longer profitable (see Future of Banking).

Where are these bottom 40% going? Pre-paid (see Bluebird). Although Banks don’t want the bottom 40%, they also don’t want Walmart to succeed. Retailers like Walmart love these consumers, as they are their core. Banks products are becoming “banking lite” services productized and sitting on a retail shelf to buy. Pre-paid “specialists” have thus materialized, and established players hate the idea that consumers will to think of bank services in this light (a product which can be bought.. and switched). Of course it makes sense to ask your regulator from protection against consumer choice, but this is certainly not to benefit the consumer.

How do consumers select a retailer? Not all commerce is retail, and I can’t possibly do justice to answering this question. The CEO of Safeway also outlined how 80% of any given Store’s customers were within a circular proximity of his stores, and that store location was driven by density/competition/demographics.  However, this is convenience selection process is NOT the dynamic with Amazon or Walmart. It would seem that the value of connecting to Walmart and Amazon is different for certain population groups. (see Future of Retail).

Quantitative Data

Big picture first. How can we measure “networks”? Perhaps the real question is what are we trying to find. We could look for efficiency of the network itself, or the financial health of the nodes, or the scale (number of nodes). The last one makes little sense as everyone participates in Commerce and Banking to some extent.

With respect to Banking and Networks, NYU’s Thomas Philippon published jaw dropping research detailing how Payments and Banking are one of the few network businesses in the HISTORY OF MAN to grow less efficient (rail, telecom, energy, …). Consumer banking examples are plentiful: is how can the banks justify paying 0.2% interest on your savings, but charge you 15% on your card? (See Future of Banking: Prepaid..?). Obviously regulators are protecting bank margins, with some Bankers ACTIVELY discouraged from rate competition. This is the DEFINITION of regulatory capture (regulators DISCOURAGING philippon_newfig1consumer competition).

Commerce is far too broad to generalize. It encompasses manufacturing, services, retail, infrastructure, rules, codes, …etc. Logically improved information flow should improve transparency, improved transparency should lead to improved consumer choice and growth of specialists focused on serving ever smaller niches of demand. We certainly see this dynamic today in HighTech manufacturing (Cisco, Samsung, Apple, …), US capital markets, telecommunications, professional sports, ..etc. How can we measure this? One of the best scholarly articles I’ve read on networks and global commerce is from Humels, Ishii and Yi (See paper as published by US Federal Reserve). From the abstract

Using input-output tables from the OECD and emerging market countries we estimate that vertical specialization accounts for up to 30% of world exports, and has grown as much as 40% in the last twenty-five years. The key insight about why vertical specialization has grown so much lies with the fact that trade barriers (tariffs and transportation costs) are incurred repeatedly as goods-in-process cross multiple borders. Hence, even small reductions in tariffs and transport costs can lead to extensive vertical specialization, large trade growth, and large gains from trade

From a Commerce (Manufacturing) network view, over 30% of export growth was fueled by network effects associated with specialization. These effects (growth) were highly correlated to trade barriers (ie, network friction) and  infrastructure (payments, commercial banking, transport, logistics, communications, …etc).

How has information flow impacted Retailers? Net Margin in retail has taken a nose dive (from 4.2% in 2006 to 2.8%, see data by industry from CSI market). Retailers have no one to protect them from the forces of competition (ie Bank regulators) and therefore have a much tougher job as they work to sell commodity goods at the highest possible price, in a world where they don’t know the consumer’s name (see Retailer CRM).  It seems obvious that data transparency (ex show rooming) and new networks provide price and reputation information and that consumers are changing behavior.retail margins 2

Commerce and Banking

Summary: the only difference between Commerce and Banking is REGULATION. Banking is a highly regulated activity…. Commerce is not. Providing access to financial services is a much harder problem to crack because of local regulatory hurdles (see my notes on MPesa and Reaching the Unbanked).

If commerce, networks, banking, government and society are evolving how SHOULD we change our artificial structures (ie regulation, government, …etc.) to support? Have we reached an apex where the pendulum will swing quickly from centralization to hyper democracy? And hyper capitalism? Where SOCIETY creates and evaluates rules which are established based upon their aggregate network effects, not on lobbyists, politics and junk science?

The most immediate areas impacted are those networks that do not deliver value, as barriers to entry and switching costs are overcome value and scale of alternative networks and new business models. 200 years ago we could walk into our local country store and ask the shop keeper to put our purchase on our account. We could barter for goods and services.  Today, the regulatory hurdles for a store to provide this simple service are substantial.

Banks, manufacturers, retailers, service providers are all capable of issuing credit based upon identity, reputation, history, use, …etc. A home builder could take on the ability to sell, lend, lease and repair a home. Yet the enormous regulatory requirements on selling, lending, leasing inhibit the viability of this vertical service integration.

With respect to payments, as my friend Osama outlined to Tim Geithner, what if the future of payment profitability was driven not by interchange, but by the flow of data? What if Apple were to give away new iPhones, with free connectivity, with the provision that they share data on preferences and behavior? This is NOT some future state, these discussions are happening today. We tend to view these discussions in context of the companies, products and structures that exist today (ex. how could Visa enable this?). Yet existing networks have proven an inability to adapt, as they were formed around an existing value proposition in which each node became “attached”. If you change the core service, you change the entire network.

The inability of other networks to adapt is FAR less concerning to me than regulation that will destroy innovation and create artificial PROTECTIONS around existing structures. In the example above, what if the government mandates controls around PII making the prospect of free phones and free data non-viable. Who wins? Consumers gain increased protections on their PII, but loose a service. Should they not be able to make this trade themselves?

Another example is Prosper in social lending. A great example of innovation which was “guided” by the SEC to become a securities dealer (see Wikipedia, Crowd Sourced Credit, and my blog on Reputation). Now every loan must be registered as a security (see example) . This may be the right thing for us to do as a society, transparency and auditing are valuable functions which increase the flow of capital and efficiency of a market. But must we be required to submit to these regulations when we want to take on another type of risk? Having the government certify “accredited investors” or “accredited borrowers” may be best as an optional service that must prove its value.

In the emerging markets we see the MASSIVE success of MPESA. With few exceptions (Philippines, PK, Colombia, Peru, Ghana), we see every other country working to ensure this DOES NOT happen in their market. India is at the top of my list of offenders, where entrenched bureaucrats and regulators work to protect domestic banks at every level, regardless of the potential macro economic benefit (review IMPS for example).  Beyond banking the same dynamic plays out in Commerce as well capitalized companies like WalMart are hammered for making unapproved INVESTMENTS in infrastructure (see WSJ).

Clearly the pain point is around banking, but it is not something that banks alone can address as they themselves are regulated, it is a regulatory issue (see US Payment Innovation and Regulation).  Europe has done a fantastic job addressing the regulatory issue (within the ELMI construct, SEPA, …etc.), their problems are around nanny state consumer protections and EU rules do not make their way into domestic law or regulations. A government that protects against everything, inhibits free association, consumer choice and the assumption of risk. (now I sound like Milton Freedman).

“Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government.”
― Milton Friedman

“Government has three primary functions. It should provide for military defense of the nation. It should enforce contracts between individuals. It should protect citizens from crimes against themselves or their property. When government– in pursuit of good intentions tries to rearrange the economy, legislate morality, or help special interests, the cost come in inefficiency, lack of motivation, and loss of freedom. Government should be a referee, not an active player.”
― Milton Friedman

“The society that puts equality before freedom will end up with neither. The society that puts freedom before equality will end up with a great measure of both”
― Milton Friedman


Just as use money enabled a specialization and concept of “personality”, telecommunications is opening up a new world of free form association, both business and societal.

Open Source is a model most of us are well familiar with. (further reading… I ran across a very nicely done paper from 2 MIT students: Implication of Open Innovation and Open source to Mobile Device Manufacturers).  Given that mobile, advertising and payments are all networked businesses… business models supporting distributed innovation should advance at a faster pace than those controlled by a single entity. For example, Amazon, Samsung, Motorola, LG, HTC, Verizon, ATT, Vodafone, .. all make much larger investments in the Android platform (than in IOS). (I would love to see an analysis of combined capital investment in android platform)

From my blog Stage 4 Value Shift

…this distributed innovation hypothesis is NOT playing itself out (ie Apple). Apple’s 1Q12 showed iPhone revenue alone was $24.4B, which is bigger than all of MSFT revenue combined.  Analysts have shown that Apple now garners 75% of mobile handset profits, with only 9% of handset market share.  So while Samsung alone has outsold Apple in Units this quarter (41M vs. 32.6M), and Android just topped 50% market share (vs Apple’s 30.2%).. Apple’s handset business PROFITABILITY dwarfs that of all of the competition (COMBINED).

So… What are the factors of competition today? Can someone else change the game?

The big downside in distributed innovation is complexity, there is a need for a “channel master” or chaos reigns. Many Android users witness this chaos when an app won’t work on a new hardware/OS combination.. Distributed innovation is not something that established businesses are good at. It has proven most successful in product PLATFORMS where the pace of change in each component is changing at a rate where no one company can make the capital investment to remain competitive (ex. Moore’s Law, PC architecture through present day). Intel played a very important role in this process, as it worked outside the scope of the CPU in areas such as: Intel Architecture Lab (IAL, developed common standards like PCI),  stimulated external innovation (developer training, testing, Intel Capital), industry marketing, patent/licensing. Intel defined what the PLATFORM was.. something that is common sense to us today.. but rest assured it was not given to them, rather it was something that they stepped into and took leadership of.

From Delivery to Discovery

Commerce and banking have many effective platforms to coordinate supply chains and payments. Today the nature of commerce competition is on quality, price and distribution (delivery). What if the nature of competition shifts from delivery to discovery? Shifting the model by which “weak links” are established today.  Today an individual must sift through mountains of search results and travel sites to find the best deal. We see complete garbage in banner ads and TV.

Who can proactively help you form networks of value, and expand how consumers manage their network, identity, personality? Most would agree that Google is best positioned here. I’m also very excited about the prospects of a company I’m incubating in this space. Ok.. this is getting off track quickly

Summary (I just finished reading a few of the federalist papers last night.. so pardon in advance).

The key for global economic growth is allowing individuals, and companies, to assume risk. The lines between Commerce and Banking SERVICES should blur, and start from the Commerce side as regulated intuitions have an unfair advantage in their protection. New networks provide for free form associations, and will improve in their ability to organize as platforms mature. These networks are capable of higher forms of risk mitigation, but are throttled by bespoke institutions and regulations.  Bitcoin is perhaps the best example of a disruptive force to hit banking. Europe is proving to be a role model in banking regulation, but their innovation in financial regulation has been offset with a local enforcement and complex environment where consumers cannot assume risk.

My message here is for Governments and regulators as much as it is for innovators. We must allow consumers to make decisions for themselves, and avoid regulating every behavior or government centralization and control will tend toward tyranny that is unaccountable and unchangeable.

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