Submitted by Nicolas Colas of DataTrek
JP Morgan just launched the largest ever real-world blockchain application, developed to facilitate corporate cross-border payments. In that surprising development lies several lessons for public equity investors of financial services companies.
The classic paradigm of disruptive innovation assumes incumbent companies remain quiescent as new tech-enabled competition starts to nibble away at the low end of a market. This is not an assumption of corporate laziness. Rather, it makes sense that established businesses would actually not mind losing low-margin, low average revenue/unit customers. “Let the upstart take them… our return on capital actually improves when we shed that segment of the market!”
Well, Amazon’s success over the last decade has changed that mentality to some degree within even the largest companies. No one wants to be Barnes & Noble. Or Wal-Mart, for that matter. But altering large company behavior remains difficult, so it is still unusual to see a brand-name multinational really thinking – and acting – outside the box.
We did recently come across one example: JP Morgan’s initiative to remake the cross-border payments business using an Ethereum-based blockchain system called Quorum. Sending dollars from a corporate account in the US to Europe or Asia may sound easy, but in reality anti-money laundering and know-your-customer regulations are complex and everything has to be done just so. At our prior company, partly owned by another very large multinational bank, we had to sit through hours of compliance training on such topics. It’s no joke…
Payments such as these are exactly where you would expect to see big financial institutions like JP Morgan cede ground to new blockchain-enabled startups with a cost advantage over large commercial banks. “Blockchain” is the technology that powers bitcoin and other crypto currencies. It offers a secure way to validate transactions and is much cheaper to run than a centralized, company-specific system. And payments are a low margin business for most banks, offered primarily to keep corporate Treasury customers happy so they will buy other more lucrative services. New technology meets low-profit business line = classic disruption story.
Other banks must see the same threat, because yesterday the Financial Times reported that JP Morgan has signed up more than 75 of the world’s largest banks to its new Interbank Information Network, powered by the Quorum blockchain. Two banks – RBC and ANZ – had been testing IIN since October of last year along with JPM. All this makes the IIN/Quorum the single largest real-world application of blockchain technology out there, according to JPM.
For public equity investors that have investments in financial services companies, three quick observations to finish off this section:
- There are many reasons why JP Morgan (+7.6%) has done so much better than the S&P Financials (+0.2%) this year, and the story above is too small a part of the company to have a financial impact. Still, we find the bank’s efforts to push the technological envelope refreshing and unusual for its peer group. Whether this ethos sparks a modest revaluation in JPM over the next 3-5 year remains to be seen, but it can’t hurt.
- To the degree to which traditional financial stocks suffer from a “disruption discount”, this story shows it is possible for old-line companies to adapt. Case in point: the market cap of American Express is $93 billion while PayPal’s is $106 billion. On less than half of AXP’s revenue base. That’s what disruption is worth when you do it correctly.
- Regulation is actually a friend to incumbents. All that KYC and AML paperwork makes corporate cross-border payments a tough nut to crack for disruptive new entrants. And since financial services is one of the most regulated industries in the US, there is (in theory) plenty of time for this industry to adapt.