NEW YORK (TheStreet) -- Business change is often brutal and sudden. Industries stay unchanged for decades but then are disrupted overnight. Recent mainstream examples include the music industry, taxis and even takeout food.
The latest and perhaps most significant example of this phenomenon concerns an economic activity that has remained unchanged for 5,000 years: lending.
Hundred of billions of dollars are at stake, as the traditional borrowing process (go to a bank, fill out papers then cross fingers) will disappear, replaced by fully automated, on-the-spot lending.
Safety in Numbers: Why Diversification Is Critical in Lending
Lending money is a risky business. For millennia, the solution to lowering risk was to pool money from multiple investors, and then lend it to a large cohort of borrowers.
Lend $100 at a 17% interest rate to one person with a 10% default risk, and you have a 90% chance of earning $17 but a 10% chance of losing $100. Lend the same $100, this time to 1,000 different people, and you'll earn an average of $5.3 per loan, almost guaranteed. Diversification transforms statistical estimates in certainties, a phenomenon named "Central Limit Theorem" by mathematicians.
Traditional pooling institutions are called banks, and they've long known how to increase fees and get what they think is theirs. They're not the most streamlined, cost-cutting organizations (think the reverse of Wal-Mart (WMT) ), but partly because they're part of a comfy oligopoly, banks take a painfully high cut to provide that pooling service unavailable anywhere else.
Additionally, because centralizing so much money puts people's savings at risk, banking is heavily regulated, which in turn makes lending more costly.
Banks also do something magical: They create money out of thin air! If Gary deposits $1,000 on his bank account, it can be used as a guarantee to lend $3,000 to Jane, $500 of which she can use to pay Gary, who in turn will put it back in the same bank. Now Gary has $1,500 in his account, $500 of which was completely fabricated by the bank. It's magical ... until it's catastrophic. So while such creation of money allowed the Western world to take the lead in the 16th century, by financing expansions beyond current economic capacities, we've since learned that this is extremely dangerous, as demonstrated during many bank runs and systemic collapses. Not only are banks costly, they are also dangerous by design.
A Way Out of the Woods: Diversification Without Pooling
The rise of the Internet has created the ability to have virtually zero-cost transactions. A few decades ago, sending a message or wiring money required filing out a piece of paper, and having someone transmit that information. Now everything is done through machines and electrical wires, transactions are immediate and of little to no cost. The result is that pooling is obsolete. Instead of lending $100 to one person, it becomes possible to wire $1 to 100 different people, statistically reducing the overall risk.
Traditional pooling institutions will disappear, as there will be no need to justify their extravagant costs. They'll be progressively replaced by relatively simple hubs gathering both the borrower's requests and the supply of money from investors. It's called "marketplace lending," and hubs such as Lending Club (LC) , Prosper and Funding Circle are already issuing billions of dollars of loans in the U.S.
Banking 2.0 Is No Banking at All
Devices like phones or cameras do not look at all like they did a few decades ago. Some hugely successful companies are operating in a way that was unthinkable a few decades ago: Amazon (AMZN) has no stores, Alibaba (BABA) doesn't even have a warehouse. AirBnB doesn't own a single hotel room, Uber doesn't own any cars, and Apple (AAPL) doesn't manufacture any of its products. Yes, when one pictures a bank, the image of a neo-classical fancy, downtown building persists. The Banca Monte dei Paschi di Siena, the oldest bank in the world, looks and operates essentially unchanged from what it was about 500 years ago.
With modern financial technologies, financial transactions are becoming easy and instantaneous, even for individuals. Lending is morphing into a real-time, continuous and transient investment. Americans will invest their money the same way they get drinkable water: taking it for granted and turning a faucet. This reality is only a few years away. For borrowers, either individuals or businesses, it means a new age in financing, with the potential to enable unprecedented economic growth (albeit ruthless and unequal). For investors, the rapture has already began, especially for those looking for both higher returns than traditional bonds and lower risk exposure than equities.
As for the Banca Monte dei Paschi di Siena and its ilk, it could go the way of the Coliseum, and it could happen overnight.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stock mentioned.