In the months following the financial crash of 2008, there were calls for increased regulation - and even an end to - the shadow banking industry. This term covers the shady, unregulated sector of the banking industry or unregulated financial instruments used by the regular banking industry of the type that kickstarted the financial crisis, the notorious ‘credit default swaps’.
But even in the wake of the catastrophe, there was little change enforced. Today, the shadow banking industry still operates with impunity in most parts of the world, and particularly in the world's second largest economy, China.
Figures from Bloomberg Economics based on data from the People’s Bank of China indicated that three major assets of shadow banking - trust lending, entrusted loans and banks’ acceptances - increased by $555 million in 2017. Entrusted loans, for example, are when businesses loan money to each other, using banks as intermediaries. Meaning that larger (state owned) companies may lend money to smaller companies and make a profit from the differences in interest.
Micro-lending is another phenomenon that has ballooned in recent years, with a proliferation of online lending or peer-to-peer lending platforms springing up. Outstanding debts on these sites increased by 256 percent between October 2015 and October 2017, topping 1.2 trillion yuan (over $179 million).
These issues have been acknowledged by the Chinese government, with China’s top banking regulator, Guo Shuqing, promising the shadow banking industry will be ‘dismantled’.
"Private companies became more reliant on shadow banks for refinancing last year amid a slowdown in overall credit supply," said Fielding Chen, a Hong Kong-based China economist at Bloomberg Economics. "Officials will focus on deleveraging in the real economy in 2018. That said, cracking down on the traditional shadow banking will be a focus, resulting in slower growth of the sector."
However, meaningful change has been slow to enact. In January 2018 alone, a record 2.9 trillion yuan ($458.3 billion) in loans was issued by China’s banks, a sum described by the Wall Street Journal as ‘absolutely monstrous’. And although ‘shadow banking’ in other economies usually refers for the most part to the activities of private investors operating outside the regulatory framework enforced by the state - like hedge funds, investment banks, mortgage lenders or payday lenders - in China, most shadow banking activities are either directly or indirectly linked to the state.
This flood of fast credit is already leading to problems of the kind symptomatic of the 2008 crash, with the South China Morning Post reporting there is an increase in missing borrowers fleeing the country and leaving their relatives saddled with debt that rapidly accumulated thanks to ludicrously high interest rates and delinquency fees enforced by unscrupulous lending agencies.
It is against this backdrop that entrepreneur, Stewie Zhu, launched his company, Distributed Credit Chain, the world’s first blockchain based, decentralised credit ecosystem. “We would like to invite the traditional financial institutions, like banks, to join our ecosystem, as well as those existing online micro-lending platforms,” says Zhu. “We would like to invite all of them to adopt our DCC protocol to transform the credit data - so basically we become the infrastructure for these providers.”
Zhu claims that this approach can offer a raft of benefits not afforded by the current financial system. “In this decentralised credit ecosystem, the main cost of the online credit business will decrease, in terms of decreasing the third party payment fees, the transaction fees, the data analytical fees and the service fees,” he says. “And in this decentralised credit ecosystem, because it is based on a blockchain, everything will be far more transparent and efficient, so the delinquency rate will go down, and the interest rate will more closely reflect market price - which is very meaningful for big countries in Asia where they have a big shadow banking industry.”
The DCC takes aim at the core model of a credit agency, which typically spreads the costs of ‘bad debts’ (that won't be paid back) and non-interest accumulating elements by charging interest to borrowers who are able to pay the money back.
But the DCC’s model isn’t just aimed at benefiting the borrower. It also offers the lender a means of bypassing the typically intensive background checking of potential borrowers to ensure they are guaranteed to return the loan. In essence, the DCC will act as the fabric between credit data agencies and banks, using blockchain to remove the bureaucracy, opportunity for fraud and error, and lack of transparency currently ingrained in the system.
Under the DCC system, all lending information would appear on a blockchain, and thus be easily accessible and transparent. This will provide a verified credit history that cannot be tampered with, which will counter issues such as repeat borrowing and long-term borrowing. Within the DCC ecosystem, transactions are facilitated through the use of the DCC token, unique to the DCC blockchain.
Institutions requesting access to data generated within the ecosystem must be paid in DCC tokens. An increase in the number of tokens in circulation within the system - the degree of ‘liquidity’ - will be pushed up as more businesses participate. Within the DCC ecosystem, there will be rewards offered via the system, for example, some DCC tokens in return for paying the money back on time, until such a time as when all the DCC tokens within the system have been released.
Given that it will be facilitated by blockchain tokens, rather than a particular currency, Zhu foresees the DCC as providing a cross-border mode of credit, meaning, for example, that an individual could apply for a loan from a lending institution in another country.
The company has raised around $55 million so far, over two funding rounds. And after China, they plan to expand to Indonesia and Korea, who have similar banking profiles to China.
"If we can persuade the current credit industry to think about this brand new technological solution to the credit problem, we trust we will be able to improve social welfare," says Zhu.
"There are so many, very problematic things with the shadow banking system and we keep talking about it - a lot of discussion, a lot of experts, a lot of policies - but so far, none of them work. We already know that the major problem that generated the last financial crisis came from the shadow banking system. And now that there is a technological solution to this problem, maybe we can prevent it."