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Question 1

Q: Types of Banks

Answer 1

a) Central Banks
b) Commercial Banks
c) Investment Banks

Question 2

Q: What are the main tasks of the central bank?

Answer 2

a) Control nations money supply (interest rates, reserve requirements)
b) Oversee the commercial banks

Question 3

Q: What are the tools a central banks have to control a nations money supply?

Answer 3

1) Open Market Operations
* Buy and sell securities in the open market.
- Buying securities = injecting money
- Selling securities = withdrawing money
2) Managing interest rates
* The rate at which commercial banks can borrow from central banks. Can courage or discourage banks from borrowing.
3) Reserve Requirements (set minimum for what commercial banks must hold)
* By adjusting, central banks can control the amount of money that banks have available to lend.
4) Lender of Last Resort
* Central bank’s role as a source of funding for banks and other financial institutions during times of financial stress or crisis

Question 4

Q: What are credit unions or mutual banks?

Answer 4

• Not-for-profit organizations, but not for charity.
• Offer many of the same services as banks
• When you invest in a credit union, you get an ownership in the union. Banks are normally owned by investor, which does not need to have money in that bank.

Question 5

Q: What is the key difference between commercial banking and investment banking?

Answer 5

a) Deposits
* IB does not take deposits
b) Risk:
* IB has freedom to take more risk.
* Commercial are governed, so less freedom. To protect the customer
c) Insured
* Commercial often insured by central bank

Question 6

Q: What is the interbank market? And why do banks use it? What rates are used?

Answer 6

A debt market among banks. Use it for:
a) Manage liquidity
* Banks may need to borrow money from other banks on a short-term basis to meet their own liquidity needs.
b) Satisfy regulations (such as reserve)
The rates that are used are:
Federal funds Rate (USA)
LIBOR (UK)
Euribor (Eurozone)

Question 7

Q: What was the Libor Scandal?

Answer 7

2012.
Banks manipulated the interest rates. Falsely inflating or deflating their rates. They did this because they wanted to:
a) Profit from trading
b) Impression of creditworthiness

Question 8

Q: What is the commercial & industrial (C&I) loan market? What are the purpose of these loans?

Answer 8

• Collateral loans made to a business or corporation either to provide working capital or CAPEX (operational purposes)
• Always collateral.

Question 9

Q: What is revolving credit or lines of credit? + Examples

Answer 9

Allows you to borrow money when you need it and pay interest only on what you borrow. Then, if you pay back any of the borrowed funds before the end of the draw period, you can borrow that money again.
Examples are Credit card loans and Overdraft

Question 10

Q: What is subprime lending? How was these loans?

Answer 10

Loans to borrowers with poor credit scores or low income. These loans had
a) Lower credit standards (to people with poor credit scores)
b) Lower down payment requirements (20% to 3.5% from early 2000s) (forskuddsbetaling)
c) More flexible terms than traditional mortgages (interest rates, maturity etc.)

Question 11

Q: What are the three main banking services?

Answer 11

1) Individual Banking - help people to manage their finances
2) Business Banming - Business gets different type of service
3) Digital Banking - Digital services

Question 12

Q: How did many financial institutions survive during/after the financial crisis?

Answer 12

Bailout of banks by national governments

Question 13

Q: What are the main reason for the past financial crisis 2008?

Answer 13

a) The Low Federal Funds Rate
* After dot-com 2000 and concerns about deflation and japanese stagnation, FED lowered the rate from 6.5& to under 2% in 2001
b) Government Housing Policy
* Fannie Mae and Freddie Mac
* LMIs
* Subprime Loans
c) Soaring Risk from Securitization
* Mortgages where packaged into complex securitization packages, which were sold to investors. Often highly rated, but, of poor quality

Question 14

Q: Why was the Federal Funds Rate so low before the financial crisis?

Answer 14

a) Dot-com bubble busted in 2001
b) Concerns about Japanese stagnation in the 90s and deflation

Question 15

Q: What was the FED real rate before the crisis?

Answer 15

1% until 2004, combined with 2% inflation. Hence, a negative real rate

Question 16

Q: What was the main factors of the Government Housing Policy?

Answer 16

a) Fannie Mae and Freddie Mac (GSEs)
* Were Government Sponsored Enterprises (GSEs) created by the U.S government. They bought mortage loans from banks and other lenders, providing them liquidity. Fannie Mae and Freddie Mac would then package these loans into mortgage-backed securities (MBS) and sell them to investors in the form of securitized packages.
b) Lending to Minorities (LMIs)
* Congress started program to expand mortage lending to minorities and low and moderate income groups.
c) Subprime lending: Loans to borrowers with poor credit scores or low income
i) Lower credit standards (To people with poor credit scores)
ii) Lower down payment requirement. Declined from 20% to 3.5% (not required to provide a significant upfront payment when purchasing a property, EGENKAPITAL)
iii) More flexible term than traditional mortgages (interest rates, longer loan terms etc.)

Question 17

Q: What did businesses and households do due to the low interest rates (before crisis)?

Answer 17

Borrowing became attractive for both businesses and households. Cheap liquidity was seen as a perfect for many that was interested in buying a home (big investment for people)

Question 18

Q: What happened to the household debt and house prices due to the cheap liquidity before the crisis?

Answer 18

Cheap liquidity, businesses and households borrowed. Big increase in both household debt and house prices

Question 19

Q: What was the main purpose of GSEs like Fannie Mae and Freddie Mac?

Answer 19

Provide liquidity to banks

Question 20

Q: How did Fannie Mae and Freddie Mac provide liquidity for banks?

Answer 20

The low interest rate made many people borrow liquidity from banks

Based on this, banks would be low on liquidity

But Fannie Mae and Freddie Mac bought mortgages from lenders and pooled them into securities, which they sold to investors.

Question 21

Q: What is securitization?

Answer 21

When assets are pooled so that they can be repackaged into interest-bearing securities.

Question 22

Q: Explain what LMIs was. What was its main goal?

Answer 22

Congress started program to expand mortage lending to minorities and low and moderate income groups
Gave away “affordable housing loans”
Credit standards was pushed lower
Main goal to push ownership higher.

Question 23

Q: What was Subprime Loans in short?

Answer 23

Loans to borrowers with poor credit scores

Question 24

Q: How low did conventional down payment decline due to Subprime Loans?

Answer 24

From 20% to 3.5%,
from early 2000s

Question 25

Q: How were the shares of pools of mortgage securitization sold as “reasonably safe securities”? and how was the pools credit rating manipulated?

Answer 25

1. The borrowers were diversified across geographical regions and economics
2. Lower tranches were put together with tranches from other pools that carried lower risk. By combining them, the overall risk of the pool was distributed over a large number of loans, making it appear less risky.

Question 26

Q: Pros and cons with securitization?

Answer 26

Pros:
* Makes market more efficient
* Bank gets to spread out risk
* Bank get to gain liquidity

Cons: Gets more complicated and difficult to price and monitor (regulate). Hence, it is more risky

Question 27

Q: explain what happens during a bank run?

Answer 27

1. Many bank customers withdraw their deposits
2. This increases probability of default
3. This makes even more people withdraw money
4. In extreme cases, the bank reserves might not be enough to cover the withdrawals

Question 28

Q: What was the LIBOR scandal?

Answer 28

2012.
Banks manipulated the interest rates. Falsely inflating or deflating their rates. They did this because they wanted to:
a) Profit from trading
b) Impression of creditworthiness

Question 29

What is TARP?

Answer 29

Troubled Asset Relief Program.
Created by U.S Treasury to stabilize the financial system.
TARP bought troubled companies assets and stocks

Question 30

Q: Whats Repo and run on repo?

Answer 30

a) Repo
* Repurchase agreement. Financial transaction where one party (usually a borrower) sells a security to another party (usually a lender) with an agreement to repurchase the security at a later date and at a slightly higher price.
b) Run on Repo:
* A run on repo occurs when lenders or investors lose confidence in the borrower’s ability to repurchase the securities in a repo agreement.
* Can lead to a situation where lenders demand their securities back, and the borrower may struggle to fulfill those demands, potentially causing a liquidity crisis

Question 31

Q: Explain “repo” and “run on repo” in the financial crisis 2008

Answer 31

• Some Banks, IBs relied heavily on repo financing to fund their activities, using mortgage-backed securities (MBS) and other collateral as the basis for these transactions
• Banks would pledge these MBS as collateral in repos, receiving cash in return, which they could then use for lending or other purposes.
• Crisis unfolded, housing market down, mortgage backed securities dropped in value
• “run on repo” – investors fearing declining value of collateral:
• Lenders and investors did not want to participate more in repo transactions, specially MBS-backed collateral
• The collapse of Lehman Brothers triggered a run on repos in the interbank market and a run in the stock market
• Both market collapsed

Question 32

Q: Provide an historical insight of fintech:

Answer 32

1950s - Credit Cards - Ease the risk and burden of only carrying cash
60s - First ATMs
70s - Electronic Stock Trading
80s - Rise of bank computers
90s - Internet and e-commerce models flourished, online stock brokerage websites aimed at retail investors

Question 33

Q: What are the two types of government interventions (injections)?

Answer 33

1) Liquidity injections (through assets purchase, debt guarantee or direct debt)
2) Equity injections

Question 34

Q: What happened to Northern Rock

Answer 34

was nationalized.

Question 35

Q: Banks and FinTech in developing countries

Answer 35

Banks have not really penetrated developing countries.
Many there use payments apps. This is also getting bigger in the western world.

Question 36

Q: FinTech: The Case of China

Answer 36

The traditional wallet has been replaced by an electronic wallet on a smartphone.
China is today the most cash-free society of any of the worlds major economies

Question 37

Q: What are financial markets in short terms?

Answer 37

Market where people trade financial securities (e.g., stocks and bonds), commodities (e.g., metal or agricultural products), and other fungible assets.

Question 38

Q: What are some of the different types of financial markets?

Answer 38

1) Loan Markets
2) Capital Markets
3) Money markets
4) Commodity markets
5) Options, futures and other derivatives
6) Insurance markets
7) Foreign exchange markets

Question 39

Q: What can capital markets be divided into?

Answer 39

1. Primarily Markets
   * Newly formed (issued) securities re bought and sold in here, such as IPOs
2. Secondary markets
   * Allows investors to buy and sell existing securities

Question 40

Q: Provide an example of imperfect information between seller and buyer in regular market

Answer 40

Sellers often have better info about the good than the buyer (selling a car)

Question 41

Q: Example of imperfect info between workers and employers

Answer 41

Workers are knowledgeable about their skill, industriousness and productivity.
Employers have limited info about the quality of prospective workers.

Question 42

Q: Example imperfect info insurers and insures

Answer 42

Adverse: Insurers have often less info about the risk that their clients are taking

Moral: insured person might take higher risks

Question 43

Q: Example of imperfect info between Professor and student

Answer 43

Ability, IQ, EQ, Exams, Student grades

Question 44

Q: Explain Adverse Selection and Moral Hazard

Answer 44

Both are examples of asymmetrical information between the buyer and the seller. This leads to market failure.
Adverse Selection:
* Called “hidden types”
* Problem that occur BEFORE contract is written. E.g., trading partner cannot observe the quality of other partner
* Mitigate problem: Signaling, screening
Moral Hazard:
* Problem that occur AFTER the contract is written. E.g., trading partner cannot be sure if the other is behaving OK after the contract is written
* Called “hidden actions”
* Mitigate: Monitoring
* No moral hazard in one-shot transactions: A seller does not need to worry about how a buyer treats a good after it is sold

Question 45

Q: How can adverse selection and moral hazard be related? Show an example.

Answer 45

Health care.
Insured person may chose to act more unhealthy due to insurance. Makes the insurance more attractive for the person that are insured.
Adverse: The person has a lot of info about his health before signing
Moral hazard: Acts different after signing

Question 46

Q: When is there no moral hazard, and why?

Answer 46

One shot transactions. A seller does not need to worry about how a buyer treats a good after it is sold

Question 47

Q: does moral hazard and adverse selection overlap?

Answer 47

1. Both are examples of asymmetrical information
2. Every case of moral hazard has adverse selection at least to some extent.
   * The person who potentially will indulge in risk-taking behavior will have prior information about his/her risk-taking tendencies

Question 48

Q: How can financial institutions mitigate Risk-Shifting Moral Hazard?

Answer 48

1) Credit bureau: Credit information
* Company that collects info and provides consumer credit information.
2) Credit rating: Evaluation of creditworthiness
* Evaluation of the creditworthiness of a debtor, a business or a government, but not individual consumers. A credit rating agency evaluates the debtor’s ability to pay back and the likelihood of default.
3) Collateral

Question 49

Q: What is the primarily role of a bank?

Answer 49

Take in funds (called deposits), pool them and lend them to those who need funds

Question 50

Q: How is a banks balance sheet different to a typical company?

Answer 50

You won’t find:

1. Inventory:
   The “product” is loans and other financial, not physical goods
2. Accounts Receivable
   Money that customers owe you. Banks do lend money, but this goes on the asset side
3. Accounts Payable
   This represent money that a company owes to its suppliers. The ‘suppliers- for banks are their depositors. This is categorized as deposits or borrowings on the liabilities side of the balance sheet.

You will mostly see:
Assets:
* Loans: Banks provide loans to customers
* Investments: Banks invests in various financial instruments, such as government bonds, corporate bonds and securities

Liabilities:
* Deposits: Customers deposit money into their accounts at a bank which is recorded as a liability
* Borrowing: Banks may borrow money from other financial institutions or issue bonds

Question 51

Q: Why does banks have cash and cash equivalent in the balance sheet?

Answer 51

Generally, for liquidity reasons

Question 52

Q: What is the majority of a banks assets

Answer 52

Loans

Question 53

Q: Will a bank typically earn more from a loan or securities?

Answer 53

Can typically earn a higher interest rate on loans than on securities

Question 54

Q: What is PP&E in the balance sheet, and how big will it be?

Answer 54

Property, Plant and Equipment.
Usually only a small fraction of the assets

Question 55

Q: What is goodwill in the balance sheet?

Answer 55

Typically reflects the value of intangible assets, like:
a) Strong brand name
b) good customer relations
c) good employee relations
d) strong reputation

Question 56

Q: What is Off-Balance Sheet (OBS)? Provide an example

Answer 56

Assets or liabilities that do not appear on a company’s balance sheet, but that are nonetheless effectively assets or liabilities in the company.

Some loans are securitized and sold off as investments. The securitized debt will be kept off the banks books (operating lease is one of the most common off-balance items)

Question 57

Q: How does a bank typically categorize their revenue? And how do they earn from this?

Answer 57

1) Interest-income
a) Earn on the loans that they give out
2) Non-interest income
a) Trading of securities
b) Commissions on securities
c) Wealth management, etc. etc

Question 58

Q: What is the “spread” for a bank

Answer 58

The difference in interest that a bank earn on loans and paid to their depositors

Question 59

Q: Why are banks required to hold reserves?

Answer 59

If many depositors withdraw their money before the loan due date, it might be difficult for the bank to fill the withdrawal.

Question 60

Q: What is capital requirement? How is it usually expressed?

Answer 60

The amount of capital a bank or other financial institutions has to hold as required by its financial regulator.

As a capital adequacy ratio of equity that must be held asa percentage of risk-weighted assets

Question 61

Q: What is Individual Banking? Provide Examples

Answer 61

Services to assist individuals in managing their finances
1. Checking accounts
2. Savings account
3. Debit credit cards
4. Insurance
5. Wealth management

Question 62

Q: What is business banking? Provide examples

Answer 62

Offer financial services for business owners who need to differentiate professional and personal finance.
1. Checking accounts
2. Savings account
3. Debit and credit cards
4. Merchant services
5. Cash management

Question 63

Q: What is Digital Banking?

Answer 63

The ability to manage your finances from your computer, tablet, or smartphone. The use of technology

Question 64

Q: What are the two major types of financial markets where firms can borrow money in form of debt?

Answer 64

1) Bank loans market
2) Capital Markets

Question 65

Q: What are capital markets?

Answer 65

Markets for buying and selling equity and debt instruments. We categorize:
a) Primarily markets: Securities INITIALLY ISSUED and sold by CORPS to RAISE FUNDS (like IPO)

b) Secondary markets: (retail) Trading of existing securities

Question 66

Q: What are the main differences between bank lending and capital markets?

Answer 66

1) A regular bank is not securitized.
* Unlike capital markets where loans can be securitized (turned into securities such as bonds or stocks), traditional bank loans usually aren’t securitized

2) Regulation
3) Risk (high vs low)

Question 67

Q: What is the predominat source of external funding in all countries? What is the role of capital markets in this?

Answer 67

Bank loans. Capital markets have never been a significant source of financing and equity markets are insignificant

Question 68

Q: What is a bond?

Answer 68

Instrument of debt of the bond to the holders. A debt security, under which the ssuer holds a debt and, depending on the terms of the bond, is obliged to pay them interest (coupon) and/or to repay the principal at a later date

Question 69

Q: Major similarity and difference between stocks and bonds?

Answer 69

Both are securities.

Main difference: (Capital) stockholders have an equity stake in a company (investors) whereas bondholders have a creditor stake in the company (lenders)

Question 70

Q: Who has priority of bondholders and stockholders?

Answer 70

Bondholders are creditors, and have a priority over stockholders. They will get repaid in advance.

Question 71

Q: Different types of Bonds?

Answer 71

1. Fixed Rate bond
2. Floaters
3. ZCB
4. Junk-bonds (high-yield)
5. Convertible
6. Inflation-indexed
7. Subordinated
8. Government

Question 72

Q: Fixed Rate Bond

Answer 72

Coupon remains throughout the life of the bond

Question 73

Q: Floating Rate Notes

Answer 73

Variable coupon linked to a reference of interest, such as LIBOR or Euriobor

Question 74

Q: ZCBs

Answer 74

No regular interest. Issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity

Question 75

Q: High-yield bonds (junk bonds)

Answer 75

Bonds that are rated below investment grade by the credit rating agencies. As these bonds are riskier, investors expect a higher return

Question 76

Q: Convertible bonds

Answer 76

• Lets a bondholder exchange a bond to a number of shares of the issuers common stock.
• Typically known as hybrid securities, because they combine equity and debt features

Question 77

Q: inflation-indexed bonds

Answer 77

Principal amount and interest payment are indexed to inflation.

Interest rate is normally lower than for fixed rate bonds with comparable maturity. However, as the principal grows, the payments increase with inflation

Question 78

Q: Subordinated bonds

Answer 78

Bodns that have a lower priority than other bonds of the issuer in case of liquidation. Lower ranked in the hierarchy on who gets paid first. Yields higher risk, and will usually have a lower credit rating.

Question 79

Q: Government bonds

Answer 79

Also called Treasury bonds. Issued by a national government and is not exposed to default risk. Is characterized as the safest bond - with the lower interest rate

Question 80

Q: In case of bankruptcy, when does the subordinated bondholders get paid? Explain the hierarchy

Answer 80

1) First the liquidation is paid
2) then the holders of senior bonds get paid
3) then the subordinated bondholders get paid

Question 81

Q: Difference between Bank Loans and Bonds: Revolving Concentrated vs. dispersed lenders

Answer 81

A bond typically has thousands of holders while a bank loan only have one or a few (syndicate) as lenders

Question 82

Q: What are the two types of covenants?

Answer 82

1. Financial covenants
   * Require the borrower to maintain certain financial ratios or performance measures. Often:
   a) Leverage
   b) Debt-to-EBITDA ratio
2. Negative covenants
   * Restrict borrower from certain actions such as
   a) Excessive investment
   b) Change in company control

Question 83

Q: What is the simplest way to justify the existence of banks?

Answer 83

Reduce transaction costs

Question 84

Q: Transaction costs include two different types of costs:

Answer 84

Observable costs (e.g., travelling, time and effort)
Unobservable costs (e.g., agency costs)

Question 85

Q: What do we mean by economies of scale?

Answer 85

The reduction in the average costs (cost per unit) associated with increasing the scale of production for a single product type.

Question 86

Q: What do we mean by economies of scope? How can banks save money due to this?

Answer 86

Lowering the average cost for a firm in producing two or more products (Example, Mcdonalds; fries & burger)

Banks save money due to INFORMATION. Enjoy access to privileged information, and can evaluate borrowers creditworthiness

Question 87

Q: How can banks reduce transaction costs?

Answer 87

a) Economies of scale
b) Economies of scope
c) Digitalization
d) Regulation and supervision of banks by the authorities

Question 88

Q: Compared to small lenders/borrowers, banks will save money from economies of scale by having less costs of:

Answer 88

1. Searching or matching,
2. screening,
3. contracting,
4. negotiation,
5. diversification,
6. monitoring

Question 89

Q: Banks advantage in relationship lending?

Answer 89

Economies of scope:
1) Lend to same firm over time, strengthens relationship and customer loyalty.
2) Customer has specialized financial products designed from demographics, such as students, seniors or the wealthy.

Question 90

Q: Customers advantage when it comes to commercial banks

Answer 90

The authorities look over the behavior of the banks. So the customers dont have to spend resources on it

Question 91

Q: How does a bank reduce transaction costs when it comes to searching and matching?

Answer 91

1. Hire professionals
2. Employs advanced equipment
3. Repeatedly conducting the searching or matching process

Question 92

Q: What are the two general techniques for reducing risk?

Answer 92

1. Diversification
2. Hedging

Question 93

Q: What is commodity money, or fiat money?

Answer 93

Money without an intrinsic value. Not backed by gold etc.

Question 94

Q: How does a bank transform assets? (only the three)

Answer 94

a) Banks choose the unit size (denomination) of its products (deposits and loans)
b) Risk transformation
c) Maturity transformation

Question 95

Q: Explain Transforming assets: convenience of denomination

Answer 95

Match small deposits with large loans and large deposits with small loans.

Without a bank, lenders and borrowers have to match by themselves. Banks are more professional to do the job due to economies of scale & scope

Question 96

Q: Explain Transforming assets: Risk transformation

Answer 96

Banks deposits better risk-return characteristics than direct investments because of:
a) Risk management: small investors cannot diversify their portfolios
b) asymmetric information: banks have better information or expertise than depositors

Question 97

Q: Explain Transforming assets: Maturity transformation

Answer 97

Transforming short-term liabilities into long-term assets. This is the source of interest rate risk and liquidity risk

Question 98

Q: How does a bank transform assets? (full)

Answer 98

1. Banks choose the unit size (denomination) of its products (deposits and loans)
   * Match small deposits with large loans and large deposits with small loans.
   * Without a bank, lenders and borrowers have to match by themselves. Banks are more professional to do the job due to economies of scale & scope
2. Risk transformation
   * Banks deposits better risk-return characteristics than direct investments because of:
   a) Risk management: small investors cannot diversify their portfolios
   b) asymmetric information: banks have better information or expertise than depositors
3. Maturity transformation
   * Transforming short-term liabilities into long-term assets. This is the source of interest rate risk and liquidity risk

Question 99

Q: What are the traditional sources of risk affecting banks

Answer 99

1) Credit Risk
* Risk that a borrower is not able to repay its debt
2) Interest rate risk and liquidity risk
* Cost of funds may rise above the interest rates that are granted by the bank
* Unexpected withdrawals of deposits may force banks to seek more expensive sources of funds
3) Off-balance-sheet operations
* This usually means an asset or debt or financing activity that are not in the company’s balance sheet

Question 100

Q: How will a bank try to limit the Credit Risk?

Answer 100

Collateral
Diversification

Question 101

Q: Bank Run, history: 1620s

Answer 101

During the Thirty Years war, German city-states minted imitations of rival cities coins using lesser metals

Question 102

Q: Bank Run, history: 1772:

Answer 102

Financial Haggis (UK):
Scottish bank had lost customer money in risky speculation. Triggered chaos that took down almost all of the country’s private banks. Inspired the parliament to pass the Tea Act.

Question 103

Q: Bank Run, history: 1873:

Answer 103

The Great Freakout of 1873 (Western Hemisphere):
Customers demanded gold for cash. Economic crisis. US sent army to war with Native Americans in area with gold

Question 104

Q: Bank Run, history: 1914:

Answer 104

Schwenk Bank run (New York):
State banking regulators seized three banks owned by Schwenk, due to dodgy accounting.

Question 105

Q: Bank Run, history: 1930s:

Answer 105

The Great Depression (U.S):
Over 9,000 banks failed.

Question 106

Q: Bank Run, history: 1980s:

Answer 106

Savings-and-Loan Crisis (U.S.):

Question 107

Q: Bank Run, history: 2001:

Answer 107

Great Depression of Argentina

Not enough dollar to cover all deposits. Had to put restrictions on withdrawal

Question 108

Q: Bank Run, history: 2011-present:

Answer 108

EuroBlown (Greece):
High public spending, big debt
A quarter of all deposits have been pulled from Greek banks over two years

Question 109

Q: Give examples of historical bank runs

Answer 109

1620s: Currency problems in Germany (Germany)
1772: Financial Haggis (UK)
1873: The Great Freakout of 1873 (Western Hemisphere)
1914: Schwenk Bank Run (New York)
1930s: The Great Depression (US)
1980s: Savings-and-Loan Crisis (US)
2001: Malos Aires (Argentina)
2011-present: EuroBlown (Greece)

Question 110

Q: What happened after stock market crash of October 1929 in US:

Answer 110

1. Wealthy people pulled out money from banks.
2. Less capital available = less capital for businesses and individuals
3. Less capital for businesses and individuals = decline in production and employment
4. Wave of Bank runs

Question 111

Q: Measures after the Great Depression? And by who?

Answer 111

Franklin D. Roosevelt
a) National Bank Holiday (Temporarily closure to access their solvency)
b) New Banking Legislation: The Emergency Banking Act of 1933 (aimed to separate good and bad banks)
c) The New Deal. For employment
d) Spoke on Radio: Public confidence “fireside chats”

Question 112

Q: What a Bank must do during a bank run

Answer 112

The bank needs to come up with the necessary cash:
a) Liquidate loans (sell the loans, securitize them, borrow from a central bank)
b) Sell assets (often at rock-bottom prices)

Question 113

Q: The story of Lehman Brothers

Answer 113

• Fourth largest U.S Investment Bank
  1. Buying the Bubble: Aimed to profit from booming housing market. Acquired several mortgage lenders.
  a) Subprime Loans: offered to those with low creditworthiness
  b) Alt-A Loans: A Type of mortgage loan. Lower income and less documentation required. Slightly better than Subprime, but still risky
  2. Securitizing Mortgage Loans: Pooled them and sold them
  3. Big profits from 2005 – 2007
• 2007: Underwrote more mortgage-backed securities than any other firm
• BNC: A Subprime mortage lender that was a subsidiary of Lehman. Known for its aggressive lending practices – offering many subprime mortgages – Which was pooled together and sold.
  4. Increased its leverage.
  5. Crisis:
  a) Heavy investments in subprime mortgage market
  b) High degree of leverage
  6. Measures after crisis
  a) Shut down BNC
  b) Closed offices of Alt-A lender Aurora
  c) Positive Public messages from CFO
  7. After Korean Bank
  a) Big plunge in Stock
  b) Big increase in credit-default swaps on the company’s debt (shows investors confidence)
  c) Hedge Fund clients started to withdraw their investments
  d) Short-term creditors cut credit lines
   Bankruptcy in September 2008

Question 114

Q: How to stop a Bank Run or Panic. With historical examples.

Answer 114

1. Suspension of Convertibility (Roosevelt, 1933: National Bank Holiday)
2. Coalition of Private Banks (Northern Rock, 2008 – Barclays, Lloyd, Royal Bank of Scotland)
3. Government Deposit Insurance (1934: Federal Deposit Insurance Corporation (FDIC))
4. Capital Requirement and Cash Requirement (always)
5. Lender of Last Resort (Reichsbank, 1914: Schwenk. Also, many in 2008)
6. Government Bailouts (2008: Several governments, U.S: TARP)
7. Equity Injections (2011: Government and International institutions provided equity to Greece)

Question 115

Q: The different tools to use during a bank run, and their disadvantages.

Answer 115

1. Suspension of Convertibility
   * Stops people who genuinely need money to withdraw.
   * Not easy to do today (digital banking)
2. Coalition of Private Banks
   * If all banks are suffering from common shock, it does not work
3. Government Deposit Insurance
   * Moral Hazard: Depositors feel that they don’t have to monitor the banks. So banks are not restricted from taking higher risks. Hence, the bank can take higher risk by lending out more money.
   * Too-Big-To-Fail: Banks covered by Deposit Insurance. Failure of a covered bank can trigger a chain reaction. Banks owe money to each other
4. Capital Requirement and Cash Requirement (always)
   * Reduces the efficiency of a bank’s use of money and hence increases the costs of credit for the entire economy
5. Lender of Last Resort
   * Moral Hazard: Banks might take higher risks (can rely on central)
   * Financial Risk: Central Bank can be exposed to significant financial risk
   * Blurring the Boundaries: Blur boundary between monetary and fiscal policy. By giving money, gets involved in fiscal matters
6. Government Bailouts (2008: Several governments, U.S: TARP)
   * Too-Big-To-Fail creates Moral Hazard. Signals to market that risky banks will be saved regardless of risky behaviour
7. Equity Injections
   * Disadvantages?

Question 116

Q: How did Government interventions raise Credit Availability after 2008?

Answer 116

1. Removing Poisonous Assets:
   * Programs like TARP, where government bought troubled assets, like mortage-backed securities from financial institutions
2. Debt Guarantee:
   * Government pays debt for another party. Makes it easier for banks to do liquidity things.
3. Relaxing the requirement of collateral
   * Bank gets to access funding by using a broader range of assets as collateral (also those who might have lost value)
4. Increase Borrowers Net Worth:
   * Individuals and Businesses. Financial Assistance

Question 117

Q: Explain the Diamon-Dybvig Model

Answer 117

Model of bank runs and related to financial crises.
* Shows how a mix of these components may create panics by depositors:
a) Illiquid assets (like mortgage loans)
b) Liquid liabilities (deposits which may be withdrawn at any time)

Question 118

Q: General Principles of Bank Regulation

Answer 118

a) Licensing and supervision
Banks usually need banking license from national bank.
The regulator supervises licensed banks
b) Minimum Requirements
National bank imposes requirements for banks, often closely tied to the level of risk exposure.
Most important: Maintaining minimum capital ratios
c) Market Discipline
Banks must publicly disclose financial statements

Question 119

Q: Instruments and Requirements of Bank Regulation

Answer 119

a) Capital Requirement
- How banks must handle their capital in relation to their assets
b) Reserve Requirement
- Lost the role it had, as the emphasis has moved to capital adequacy
c) Corporate Governments (Encourage bank to be well managed)
- Legal entity, number of directors, organization structure
d) Financial reporting and disclosure requirements
- Requirement of disclosure of banks finances
e) Credit Rating Requirement
- May be required to obtain credit rating given by credit rating agency
f) Large exposures restrictions
- Prevent banks from having overly large financial exposures to specific individuals or groups of related individuals
g) Activity and Affiliation
- Limit activities banks can engage in and the relationship they can have with other financial institutions

Question 120

Q: The FED controversy

Answer 120

Lending to private firms, hence putting taxpayers money at risk
- Could avoid these problems by not lending to private firms

Question 121

Q: What are Alt-A loans?

Answer 121

Type of mortgage loan. Lower income and fewer documentation requirement. A loan that is more easy for borrowers to get.

Question 122

Q: What was BNC?

Answer 122

A Subprime mortage lender that was a subsidiary of Lehman. Known for its aggressive lending practices – offering many subprime mortgages – Which was pooled together and sold.

Question 123

Q: Why was Lehman so vulnerable?

Answer 123

1. High degree of leverage
2. Lots of investment in the subprime mortgage market

Question 124

Q: Why is the case of Lehman Brothers similar to a traditional bank run?

Answer 124

The underlying reasons are similar. Institutional investors stopped funding the investment bank, and due to liquidity problem, they went bankrupt.

Question 125

Q: What are the different tools during a bank run? Explain them + historical example

Answer 125

1) Suspension of Convertibility (Roosevelt, 1933: National Bank Holiday)
* Banks get closed to prevent people from pulling money out
2) Coalition of Banks (Northern Rock, 2008 – Barclays, Lloyd, Royal Bank of Scotland)
* Banks go together and borrows “clearinghouse loan certificates” from “clearinghouses”
3) Government Deposit Insurance (1934: Federal Deposit Insurance Corporation (FDIC))
* The government insure the people that they will give the people their money in case of bankruptcy
4) Capital Requirement and Cash Requirement (always)
* A bank has to hold an amount of reserves. Often as a ratio of equity that must be held as a percentage of risk-weighted assets.
5) Lender of Last Resort (Reichsbank, 1914: Schwenk. Also, many in 2008)
* Bank run will stop if people are not afraid that the bank will run out of money. Hence, central banks can back up private banks.
6) Government Bailouts (2008: Several governments, U.S: TARP)
* Government aims to raise Credit Availability:
i) Liquidity injection: Asset purchase, Debt guarantee or Direct Debt (Provide immediate funds to address short term liquidity)
ii) Equity Injection (Acquiring ownership by buying newly issued preferred stocks)
7) Equity Injections (2011: Government and International institutions provided equity to Greece)

Question 126

Q: Why is Suspension of Convertibility more difficult today compared to before?

Answer 126

Because of new technology and digital banking.

a) Would be to complex blocking or restricting access to digital accounts, freezing electronic transfers, and enforcing restrictions on digital transactions
b) Cryptocurrencies that operate beyond governments

Question 127

Q: Why has Europe never had to use the Suspension of Convertibility?

Answer 127

Banks have not ran out of money because of Lender of Last Resort. Commercial banks have borrowed money from the European Central Bank.

Question 128

Q: What is a clearinghouse? And “clearinghouse loan certificates”?

Answer 128

1. A “middle-man” between buyer and seller.
2. Short term loans or promissory notes backed by the collective resources of the coalition banks

Question 129

Q: Why did central banks emerge?

Answer 129

Evolved as a response to the inability of the commercial banks to cope with panics

Question 130

Q: Where can you find Deposit Insurance today?

Answer 130

Most countries in Europe

Question 131

Q: In which cases will Deposit Insurances not be enough to prevent a run?

Answer 131

When the government itself run out of money

Question 132

Q: What is one solution that has been proposed to the risk of Deposit Insurance?

Answer 132

Deposit insurance backed by the whole eurozone.
* Taxpayers of Germany would have to pay for financial stability in Greece.

Question 133

Q: How will Capital Requirement usually be expressed? Why is this good

Answer 133

Often as a ratio of equity that must be held as a percentage of risk-weighted assets.

This is good because:
a) Bank cannot take too much leverage
b) Bank have liquid funds in times of distress

Question 134

Q: What has been essential in preventing a full-scale bank run in Europe?

Answer 134

European Central Bank as Lender of Last Resort

Question 135

Q: How does a Liquidity and equity injection work?

Answer 135

1. Liquidity: Central banks purchase private assets and debt
2. Equity: Central banks purchase newly issued preferred stock in major banks

Question 136

Q: Disadvantages of Suspension of Convertibility

Answer 136

Stops people who genuinely need money to withdraw.

Question 137

Q: Disadvantages of Coalition of Banks

Answer 137

If all banks are suffering from common shock, it does not work

Question 138

Q: Disadvantages of Deposit Insurance

Answer 138

a) Moral Hazard: Depositors feel that they don’t have to monitor the banks. So banks are not restricted from taking higher risks. Hence, the bank can take higher risk by lending out more money.
b) Too-Big-To-Fail: Banks covered by Deposit Insurance. Failure of a covered bank can trigger a chain reaction. Banks owe money to each other

Question 139

Q: Disadvantages of Capital Requirement or cash requirement

Answer 139

Reduces the efficiency of a bank’s use of money and hence increases the costs of credit for the entire economy

Question 140

Q: Disadvantages of Lender of Last Resort

Answer 140

Creates moral hazard on a massive scale, exposes the central bank to large financial risk, and blurs the boundary of fiscal policy.

Question 141

Q: Disadvantages of Government Bailouts

Answer 141

Too-Big-To-Fail creates Moral Hazard. Signals to market that risky banks will be saved regardless of risky behaviour

Question 142

Q: What is the main argument for Bank Regulation?

Answer 142

Too-Big-To-Fail
certain banks, due to their size, complexity, or interconnectedness with the financial system, pose a significant risk to the overall economy if they were to fail

Question 143

Q: What is Licensing and Supervision?

Answer 143

Bank needs license and have to comply with requirements from government

Question 144

Q: What is Minimum Requirements in Bank Regulations?

Answer 144

National bank imposes requirements on banks. Often, these will be closely linked to risk

Question 145

Q: What is Market Discipline in Bank Regulations?

Answer 145

Regulator requires that banks publicly disclose financial and other information so that depositors and creditors can see this info.

Question 146

Q: Explain Capital Requirement

Answer 146

A framework of how banks must handle their capital in relation to their assets

Question 147

Q: Explain Reserve Requirement

Answer 147

The minimum reserves each bank must hold to demand deposits and banknotes

Question 148

Q: Explain Corporate Governance

Answer 148

Intended to encourage the bank to be well managed, and is an indirect way of achieving other objectives.

Question 149

Q: What might be some Corporate Governance Requirements?

Answer 149

a) To be a body corporate
b) Be incorporated locally rather in a foreign jurisdiction
c) Minimum number of directors
d) Have an organizational structure that includes various offices and officers.

Question 150

Q: Explain financial reporting and disclosure requirements

Answer 150

Quarterly and Annual financial statements .

Question 151

Q: Explain credit rating requirements

Answer 151

Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and show it to the public

Question 152

Q: Explain large exposures restrictions

Answer 152

Banks may be restricted from having imprudently large exposures to individual counterparties or groups of connected counterparties

Question 153

Q: What did Roosevelt come with in 1933

Answer 153

The New Deal

Question 154

Q: What are different types of financial innovation?

Answer 154

a) Institutional innovation
Creation of new financial firms.

b) Product innovation
New products such as derivatives, securitized assets, foreign currency mortgages and so on. Are introduced to respond better to changes in market demand or to improve market efficiency.

c) Process innovation
New ways of doing financial business including online banking, phone banking and new ways of implementing IT-technology and so on

Question 155

Q: Examples of financial innovations?

Answer 155

a) ATM
b) Credit and Debit cards
c) Online payment systems like Paypal

Question 156

Q: Example of a bad financial innovation that was popular until 2008?

Answer 156

a) Collateralized Debt Obligations (CDOs):
Pool together various types of debt, such as mortgages, loans, or bonds, into a single investment vehicle. Divided into tranches that investors can buy.

b) Structured Investment Vehicles (SIVs):
Off-balance-sheet entities created by financial institutions, like banks. Designed to generate profit by borrowing money at a low short-term interest rate and investing those funds in longer term, higher yielding assets.

c) Credit Default Swap (CDSs):
Derivatives contracts that provide insurance-like protection against the default or credit risk of a particular debt instrument, like a bond or loan. Lets say you give a loan to a company. To protect yourself from the risk of default, you buy a CDS. You pay regular premiums to the seller of a CDS, and the seller promises to compensate you if a specific credit event occurs

Question 157

Q: Why did Collateralized Debt Obligations (CDOs), Structured Investment Vehicles (SIVs), and Credit Default Swaps (CDSs) fail during the 2008 crisis?

Answer 157

a) Collateralized Debt Obligations (CDOs):
Many of them were backed by mortgage-related assets, particularly subprime loans.

b) Structured Investment Vehicles (SIVs):
Failed due to the heavy reliance on short-term borrowing to finance long-term investments. When the crisis hit, the market for short-term debt froze. As a result, they faced liquidity problems, and many SIVs were unable to meet their debt obligations. The decline in the value of the underlying assets, particularly mortgage-related securities, further exacerbated their financial distress.

c) Credit Default Swap (CDSs):
Many financial institutions and investors bought and sold CDSs as a form of insurance against default risk. Problem arose when CDS market became highly speculative. Investors betting on failure of certain companies. Failure of one major institution triggered a chain reaction of CDS payouts, causing further financial instability

Question 158

Q: What is a CDS?

Answer 158

a financial swap agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults.

Question 159

Q: What is Securitization?

Answer 159

Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.

Question 160

Q: What is Mortgage-backed securities (MBS)?

Answer 160

Securitization. Combines mortgages into one large pool, then divides the large pool into smaller pieces based on each individual mortgage’s inherent risk of default and then sell those smaller pieces to investors.

Question 161

Q: How does Mortgage-backed securities (MBS) create liquidity?

Answer 161

The process create liquidity by enabling smaller investors to purchase shares in a larger asset pool.

Question 162

Q: Economic benefits of Mortgage-Backed Securities?

Answer 162

“originate and distribute” - spreading out credit exposures, thereby spreading risk concentrations and reducing systemic vulnerabilities

Question 163

Q: What is Asset-backed Securities (ABS)?

Answer 163

Asset-backed securities (ABS) are securities backed by the cash flows of a pool of assets. The process involves transfering the ownership of the underlying assets to a special purpose vehicle (SPV) or a trust. The SPV then issues securities backed by the cash flows generated from the underlying assets. Investors can purchase these ABS, which represent a share in the cash flows generated by the underlying assets.

Question 164

Q: Benefits of Asset-backed securities (ABS)?

Answer 164

a) Allow financial institutions to convert illiquid assets, such as individual loans, into marketable securities

b) Provide diversification for investors by allowing them to gain exposure to a pool of assets rather than holding individual loans directly.

Question 165

Q: Give an overview of the securitization market

Answer 165

a) Mortgage-backed securities (MBS)
b) Asset-backed securities (ABS)
c) HELOANs are home equity loans;
d) HELOCs are home equity lines of credit;
e) CMBS are commercial mortgage-backed securities;
f) CDOs are collateralized debt obligations

Question 166

Q: What are the options of a company to raise new capital? And what are their cons?

Answer 166

a) Loan
Often very expensive due to credit rating of company and the associated rise in interest rates
b) Bond issue:
Often very expensive due to credit rating of company and the associated rise in interest rates
c) Issuance of stock:
Dilute the ownership and control of company

Question 167

Q: Explain the process of pooling and transfer from a company’s standpoint

Answer 167

1. The originator:
   Company wants to raise capital. Loan, bond issue or issuance of new stocks are not preferred.
2. Revenue-generating assets:
   Company has a constantly revenue-generating part. This part might be more worth than the company as a whole
3. Transform future cash flows:
   Sells the rights to the cash flows to someone else. Hence, transfers the income stream to a lump sum today.
4. Creating a special purpose vehicle (SPV):
   To facilitate the transaction, the company creates a special purpose vehicle (SPV). The company then transfer some of its assets to the SPV.
5. Originator loses claim:
   Once they are here, the company (originator) doesn’t have control or claim over them anymore. Company cant use it to pay its debts.
6. Involvement of an investment bank:
   The originator often seeks the assistance of an investment bank, known as the arranger, to help structure and set up the transaction.

Question 168

Q: The Process of Securitization (short):

Answer 168

1. Pooling and transfer
2. Issuance
3. Credit enhancement and tranching
4. Servicing
5. Repayment structures

Question 169

Q: The Process of Securitization: Pooling and transfer

Answer 169

1. Originator aims to raise capital.
2. Traditional capital-raising options like loans, bonds, or stock issuance may not be ideal.
3. Revenue-generating assets with a higher credit rating than the company as a whole are identified.
4. Selling the rights to future cash flows from these assets can provide upfront capital.
5. For originators subject to capital adequacy requirements, a separate company called a special purpose vehicle (SPV) is often created.
6. The assets are pooled and transferred to the SPV, which is formed specifically to fund those assets.
7. Once transferred, there is usually no recourse to the originator, and the SPV is “bankruptcy remote,” protecting the assets from the originator’s creditors.
8. The originator may seek the assistance of an investment bank (arranger) to structure the transaction.

Question 170

Q: The Process of Securitization: Issuance

Answer 170

1. To buy the assets from the originator, the SPV issues tradable securities to fund the purchase.
2. Investors purchase these securities through private offerings or on the open market.
3. Credit rating agencies rate the securities, providing an external perspective on the risk.
4. The performance of the securities is directly linked to the performance of the assets.

Question 171

Q: The Process of Securitization: Credit enhancement and tranching

Answer 171

1. Securities in securitization deals are “credit enhanced” to have higher credit quality than the originator’s debt.
2. External credit enhancements, such as surety bonds or parental guarantees, may be used.
3. Securities are split into tranches with varying degrees of credit protection or risk exposure.
4. Tranches have a cash flow waterfall arrangement, with senior classes being paid first and junior classes receiving repayment after.
5. Senior classes typically have higher credit ratings, while lower-credit quality subordinated classes have lower ratings.

Question 172

Q: The Process of Securitization: Servicing

Answer 172

1. A servicer collects payments and monitors the assets in the structured financial deal.
2. The servicer’s collection policy influences cash flows to investors.
3. Any remaining income after payments and expenses is usually accumulated in a reserve or spread account.
4. Bond rating agencies provide ratings based on collateral performance and credit enhancements.
5. The trustee, as part of the SPV, has a fiduciary duty to protect the assets and investors.

Question 173

Q: The Process of Securitization: Repayment structures

Answer 173

1. Most securitizations are amortized, with gradual principal repayment.
2. Prepayment models and controlled amortization structures help define repayment schedules.
3. Bullet structures involve single payments, with soft bullets being more common and hard bullets guaranteeing principal payment.
4. Securitizations can be sequential pay bonds (paid based on maturity) or pro rata bond structures (proportionate share of principal throughout the life of the security).

Question 174

Q: What is “credit enhanced”?

Answer 174

It means that measures are taken to improve the credit quality or reduce the credit risk associated with those securities. Credit enhancement techniques are used to make the securities more attractive to investors.

Question 175

Q: What are the key advantages of securitization to the issuer?

Answer 175

1. Reduce funding costs
   Can get cheaper loans
2. Reduce asset-liability mismatch
   Reduce risk of imbalance between assets and liabilities
3. Lower capital requirements
   Gets to remove assets from balance sheet while maintaining the “earning power” of the assets.
4. Locking in profits
   Predictable profit
5. Transfer risks
6. Off Balance sheet
   Securitization allows certain assets or financial instruments to be moved off the balance sheet.
7. Liquidity
   Assets securitized and sold. Now gets liquidity

Question 176

Q: Key advantages of securitization to the issuer: Reduce funding costs:

Answer 176

Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. Can have big impact on borrowing costs

Question 177

Q: Key advantages of securitization to the issuer: Reduce asset-liability mismatch:

Answer 177

Securitization allows banks and finance companies to match their assets (such as loans or mortgages) with a corresponding funding source, reducing the risk of imbalances between the assets they hold and the funding they rely on. This can lead to more efficient and self-funded operations.

Question 178

Q: Key advantages of securitization to the issuer: Lower capital requirements

Answer 178

Some firms have a limit on how much debt they can have. By securitizing assets, which is considered a sale for accounting purposes, these firms can remove the assets from their balance sheets while still benefiting from the earnings generated by those assets. This can help them stay within their allowable leverage limits.

Question 179

Q: Key advantages of securitization to the issuer: Locking in profits

Answer 179

The profits associated with the asset becomes fixed and predictable. This reduces the uncertainty of future profits and allows the company to have a clearer financial outlook.

Question 180

Q: Key advantages of securitization to the issuer: Transfer risks:

Answer 180

Securitization enables the transfer of risks from one entity to another. For example, a company can transfer credit, liquidity, prepayment, reinvestment, or asset concentration risks to another party that is willing to bear those risks. This helps the company mitigate its exposure to potential losses or concentrate on more profitable business opportunities.

Question 181

Q: Key advantages of securitization to the issuer: Off Balance sheet

Answer 181

Securitization allows certain assets or financial instruments to be moved off the balance sheet. While there has been a trend toward recording derivatives on the balance sheet, securitization can still provide an avenue for off-balance-sheet treatment, freeing up capital and reducing the impact on the company’s financial statements.

Question 182

Q: Key advantages of securitization to the issuer: Liquidity:

Answer 182

When assets are securitized, the future cash flows associated with those assets become immediately available for spending or investment. This provides liquidity, allowing the company to access cash that was previously tied up in future cash flows. It also creates opportunities for reinvestment at potentially better rates.

Question 183

Q: What is amortization?

Answer 183

Amortization refers to the gradual repayment of a debt or loan over a specified period. In securitization, most securities are structured with an amortizing repayment structure.

Question 184

Q: What are the disadvantages of securitization to the issuer?

Answer 184

1. May reduce portfolio quality:
   The safest and highest quality assets often gets securitized first. Typically AAA ratings
2. Costs:
   Securitizations can be expensive for the issuer due to various costs involved, such as management and system costs, legal fees, underwriting fees, rating fees, and ongoing administration.
3. Size limitations
   The process of securitization can be complex and expensive. Might be more suitable for bigger businesses. For smaller or medium-sized transactions, costs may outweigh the potential benefits.
4. Risks
   a) Prepayment risk
   b) Credit Risk
   c) Retained Strips risk

Question 185

Q: What can be different costs related to securitization?

Answer 185

a) Management and system costs
b) Legal fees
c) Underwriting fees
d) Rating fees
e) Ongoing administration

Question 186

Q: What is “retained strips” in securitization?

Answer 186

Sometimes the issuer keeps a portion of the securities rather then selling them all. This is called a “retained strip”.

Question 187

Q: Explain the different risks associated with securitization

Answer 187

1. Prepayment Risk:
   There is a chance that borrowers may repay their loans earlier than expected. This can affect the expected cash flows
2. Credit Risk
   The underlying assets in the pool of securitization defaults or performs badly. Issuer might not receive full repayment
3. Retained Strips Risk:
   If the assets behind the securities perform poorly, the value of the retained strips held by the issuer can decline

Question 188

Q: What are the advantages of securitization to the investors?

Answer 188

1. Opportunity to potentially earn higher rate of return
2. Access to high-quality assets:
   Securitization allows for the creation of bonds with high credit ratings, such as AAA, AA, or A ratings.
3. Portfolio diversification
4. Isolation of credit risk:
   When assets are securitized, they are separated from the originating entity’s other assets. This separation allows the securitization to have a different credit risk profile than the parent entity. As a result, the securitization can potentially receive a higher credit rating than the parent entity, offering better terms and potentially lower interest rates.

Question 189

Q: What are the risks of securitization for the investors?

Answer 189

1. Liquidity Risk
   Borrowers not being able to meet their payment obligations.
2. Event Risk (Prepayment/reinvestment/early amortization)
   Event risk relates to factors that can cause the security to be paid off prematurely. This can include insufficient payments from borrowers, a rise in defaults, or a decrease in credit enhancements. Fluctuations in currency and interest rates can also impact ABS prices, with fixed-rate ABS being more affected by interest rate changes
3. Contractual agreements
   a) Moral Hazard:
   If deal manager earn fees based on performance, there may be a temptation to mark up the prices of the portfolio assets
   b) Servicer Risk:
   If the one collecting payments from borrowers and transferring them becomes insolvent. This is mitigated by having a backup servicer.

Question 190

Direct finance

Answer 190

This refers to borrowers directly borrowing from lenders in financial markets by selling them securities, which are claims on the borrower’s future income or assets.

Question 191

Financial markets

Answer 191

These are spaces (physical or virtual) where buyers and sellers participate in the trade of assets like stocks, bonds, commodities, currencies, and derivatives. The financial market offers a platform where creation of wealth for shareholders is possible.

Question 192

Intermediated finance

Answer 192

This refers to the process where financial intermediaries (like banks, insurance companies, mutual funds etc.) borrow funds from lenders and then use these funds to make loans to borrowers. These intermediaries serve as middlemen between lenders and borrowers and help to make the financial system more efficient

Question 193

Disintermediated finance

Answer 193

Disintermediation involves removing the middleman from financial transactions, allowing borrowers and lenders to interact directly. In recent years, this concept has been enhanced by blockchain technology and the advent of DeFi, which uses smart contracts on blockchain to remove intermediaries in financial transactions

Question 194

What are the different types of financial markets?

Answer 194

• Primary vs secondary markets: Primary markets are where securities are initially issued and sold by corporations to raise funds (like in IPOs). Secondary markets, on the other hand, are where previously issued securities are traded among investors.
• Money market vs capital markets: Money markets deal in short-term debt instruments whereas capital markets are involved in long-term securities. Money markets offer high safety and low return rates while capital markets involve higher risk and potentially higher returns.
• Exchange vs over-the-counter (OTC) markets: Exchange markets are organized and regulated platforms where securities are traded. OTC markets are decentralized, less regulated markets where trading is done directly between two parties without a centralized exchange or broker.

Question 195

What are the types of financial institutions?

Answer 195

• Depository Institutions: Include commercial banks, credit unions, and savings banks which accept deposits from the public and use these funds to make loans.
• Non-Depository Institutions: Include investment banks, mutual funds, hedge funds, finance companies, insurance companies, and pension funds which do not accept deposits but offer financial services.

Question 196

Big source of info asymmetry in crowdfunding

Answer 196

Often no demand for detailed financial disclosure. Can lead to information asymmetry between them.

Question 197

Agency & Info Asymmetry & Moral Hazard in IOC

Answer 197

Agency Problems: Unique to ICOs is the risk of a “pump and dump” scheme, where developers hype up a token to increase its price before selling off their own holdings and disappearing.

Information Asymmetry: The technical complexity of blockchain projects can make it particularly hard for investors to understand the true value or potential of an ICO.

Moral Hazard:
ICO issuers exaggerate the potential of their projects to inflate the value of the tokens and then sell their own holdings for profit. This is also known as a “pump and dump” scheme. This moral hazard problem is especially significant given the lack of regulation and oversight in the ICO space.

Question 198

Agency & Info Asymmetry & Moral Hazard in Reward- and donation-based crowdfunding

Answer 198

Agency Problems: There’s a specific risk that creators may fail to deliver the promised reward, or the final product may not meet backers’ expectations.

Information Asymmetry: Backers often rely on the project creator’s descriptions and updates, and there are typically no third-party audits or verifications of claims made.

Moral Hazard:
Entrepreneurs can overpromise rewards to secure funding.

Question 199

Agency & Info Asymmetry & Moral Hazard in Debt-based crowdfunding

Answer 199

Agency Problems: The risk of default is particularly relevant in debt-based crowdfunding, as borrowers might fail to repay the loan.

Information Asymmetry: Lenders might not have access to the borrower’s credit history or other key details that are typically used in traditional lending to assess risk.

Moral Hazard:
Takes excessive risk after a safety net of crowdfunding money

Question 200

Agency & Info Assymetry & Moral Hazard in Equity-based crowdfunding

Answer 200

Agency Problems: Possibility of issuance of new shares, which can dilute ownership

Information Asymmetry: Private firms do not need to public show its financial disclosure

Unlike in publicly traded companies, investors may lack regular, standardized financial reports, making it hard to accurately assess the company’s ongoing performance.

Moral Hazard:
Entrepreneurs provide overly optimistic projections, knowing that they dont have to repay id it fails

Question 201

Process of Securitization. Pooling and transfer

Answer 201

1. originator wants to raise capital
   * traditional like loans, bonds or stock issuance not ideal
2. Company has assets generating revenue (cashflows)
3. Company sells future rights to cash flows
4. SPV created (a company)
5. Assets are pooled and transferred to SPV
6. Once transferred, originator has no claim on assests. Cannot use it if they eg. goes bankrupt. “bankruptcy remote”

Often facilitated by IB

Question 202

Q: Explain the process of pooling and transfer from a company’s standpoint

Answer 202

1. The originator:
   Company wants to raise capital. Loan, bond issue or issuance of new stocks are not preferred.
2. Revenue-generating assets:
   Company has a constantly revenue-generating part. This part might be more worth than the company as a whole
3. Transform future cash flows:
   Sells the rights to the cash flows to someone else. Hence, transfers the income stream to a lump sum today.
4. Creating a special purpose vehicle (SPV):
   To facilitate the transaction, the company creates a special purpose vehicle (SPV). The company then transfer some of its assets to the SPV.
5. Originator loses claim:
   Once they are here, the company (originator) doesn’t have control or claim over them anymore. Company cant use it to pay its debts.
6. Involvement of an investment bank:
   The originator often seeks the assistance of an investment bank, known as the arranger, to help structure and set up the transaction.

Question 203

What are the options of a company to raise new capital?

Answer 203

a) Loan
Often very expensive due to credit rating of company and the associated rise in interest rates
b) Bond issue:
Often very expensive due to credit rating of company and the associated rise in interest rates
c) Issuance of stock:
Dilute the ownership and control of company

Question 204

What is Asset-backed Securities (ABS)?

Answer 204

Asset-backed securities (ABS) are securities backed by the cash flows of a pool of assets.

Question 205

Q: Why did Structured Investment Vehicles (SIVs) fail during the 2008 crisis?

Answer 205

Structured Investment Vehicles (SIVs):
Failed due to the heavy reliance on short-term borrowing to finance long-term investments.

Example:
1. A Bank creates a SIV to invest in various assets, like mortgage-backed securities (MBS) and CDOs.
2. The SIV raises funds by issuing short-term commercial paper that pays interest.
3. Investors want higher yields, and buy these commercial papers from the SIV
4. SIV uses this short term funds to invlest in long-term assets, like MBO and CDOs
5. 2008: concern about underlying assets held in SIV (specially those tied to subprime mortgages)
6. Investors become worried: SIV not able to roll over the commercial paper and achieve funding.
- Liquidity crunch
7. SIV forced to sell assets quick
8. This presser price of assets down

Question 206

Q: Why did Collateralized Debt Obligations (CDOs) fail during the 2008 crisis?

Answer 206

a) Collateralized Debt Obligations (CDOs):
Many of them were backed by mortgage-related assets, particularly subprime loans.

1. Investment bank (IB) pools together different debt assets, like mortgages
2. IB creates different tranches for investor with different risk preferences.
3. Investors invest in these for interest return
4. Then 2008 hits

Question 207

Q: Example of a bad financial innovation that was popular until 2008?

Answer 207

1. Collateralized Debt Obligations (CDOs):
   Pool together various types of debt, such as mortgages, loans, or bonds, into a single investment vehicle. Divided into tranches that investors can buy.
2. Structured Investment Vehicles (SIVs):
   Off-balance-sheet entities created by financial institutions, like banks. Designed to generate profit by borrowing money at a low short-term interest rate and investing those funds in longer term, higher yielding assets.
3. Credit Default Swap (CDSs):
   Derivatives contracts that provide insurance-like protection against the default or credit risk of a particular debt instrument, like a bond or loan

Question 208

What are different types of financial innovation?

Answer 208

a) Institutional innovation
Creation of new financial firms.

b) Product innovation
New products such as derivatives, securitized assets, foreign currency mortgages and so on. Are introduced to respond better to changes in market demand or to improve market efficiency.

c) Process innovation
New ways of doing financial business including online banking, phone banking and new ways of implementing IT-technology and so on

Question 209

what tools can financial institutions use to mitigate Risk-Shifting Moral Hazard?

Answer 209

1. Collateral
   The borrower now shares the risk of the loan
2. Debt Covenants
   Terms and conditions that limit the borrowers actions. For example, can limit a company from taking more debt.

Question 210

Explain Moral Hazard?

Answer 210

Problem that occur AFTER the contract is written. E.g., trading partner cannot be sure if the other is behaving OK after the contract is written
Called “hidden actions”
Mitigate: Monitoring
No moral hazard in one-shot transactions: A seller does not need to worry about how a buyer treats a good after it is sold

Question 211

Explain Adverse Selection

Answer 211

Called “hidden types”
Problem that occur BEFORE contract is written. E.g., trading partner cannot observe the quality of other partner
Mitigate problem: Signaling, screening

Question 212

Difference in loans: Money market (bank loan) vs capital markets, difference

Answer 212

• low risk low reward vs high risk high reward.
• Bank heavily regulated. cannot take high risk

1) A regular bank is not securitized

Question 213

• Exchange vs over-the-counter (OTC) markets

Answer 213

Exchange markets: regulated, intermediate

OTC: P2P

Question 214

Types of financial institutions:

Answer 214

Depository Institutions:
Regulated and insured by government. Accept deposits
* Commercial banks
* Credit unions

Non-Depository
Not deposits, but other services
* Investment banks

Question 215

Different Banking Risks

Answer 215

a) Credit Risk: Risk of non-payment from loans and securities.
b) Interest Rate Risk: Risk due to mismatched maturities of assets and liabilities.
c) Liquidity Risk: Risk of sudden liability withdrawals forcing asset liquidation at less than fair market prices.
d) Foreign Exchange (FX) Risk: Risk due to exchange rate changes affecting non-domestic asset values and liabilities.
e) Market Risk: Risk from changes in interest rates, exchange rates, and other prices.
f) Off-Balance-Sheet Risk: Risk due to contingent assets and liabilities held off the balance sheet.
g) Technology and Operational Risk: Risk from technological investments not producing anticipated cost savings or existing systems malfunctioning.
h) Fintech Risk: Risk of disruption from Fintech firms leading to lost customers and revenue.
i) Insolvency Risk: Risk of not having enough capital to offset a sudden decline in asset value.

Question 216

Banking Risks: Credit Risk (definition, mitigate)

Answer 216

• Definition: The risk that borrowers will default on loans or other financial obligations.
• Mitigation Techniques: Diversifying loan portfolio, setting credit limits, performing credit analysis, maintaining regulatory capital, reporting credit risk exposures.

Question 217

Banking Risks: Interest Rate Risk (definition, mitigate)

Answer 217

• Definition: The risk that changes in interest rates will negatively impact the value of the bank’s assets and liabilities.
• Mitigation Techniques: Matching maturities of assets and liabilities, using interest rate derivatives to hedge, maintaining capital, reporting interest rate risk profile.

Question 218

Banking Risks: Liquidity Risk (definition, mitigate)

Answer 218

• Definition: The risk a bank can’t meet its financial obligations due to an inability to convert assets into cash quickly or at a reasonable price.
• Types:
  a) Market liquidity risk (can’t sell assets quickly enough or at a reasonable price)
  b) funding liquidity risk (can’t obtain enough funding).
• Mitigation Techniques: Maintaining a portfolio of liquid assets, diversifying funding sources, implementing liquidity management plans, maintaining regulatory liquidity buffer, reporting liquidity risk profile.

Question 219

Banking Risks: Market Risk (definition, mitigate)

Answer 219

• Definition: The risk that changes in market prices will negatively impact the value of the bank’s assets, liabilities, and off-balance sheet positions.
• Note: Also referred to as “systematic risk”, which cannot be diversified away.

Question 220

Banking Risks: Off-balance-sheet riks (definition, mitigate)

Answer 220

• Definition: The risk a bank is exposed to through its off-balance-sheet activities, such as commitments, guarantees, and derivatives.
• Examples: Commitments like letters of credit, standby loan commitments, and contingent liabilities.
• Mitigation: Report off-balance sheet risk exposures and related capital requirements.

Question 221

Banking Risks: Technology and Operational Risk (definition, mitigate)

Answer 221

• Definition: The risk incurred when a bank’s technological investments do not produce expected cost savings, or when existing technology, auditing, monitoring, and other support systems malfunction.

Question 222

Banking Risks: Fintech Risk (definition)

Answer 222

• Definition: The risk that fintech firms could disrupt the business of financial services firms in the form of lost customers and revenue.

Question 223

Banking Risks: Insolvency Risk (definition mitigate)

Answer 223

• Definition: The risk that the bank will not be able to meet its financial obligations as they come due, and that it will be unable to continue its operations.
• Mitigation Techniques: Maintain certain levels of capital and liquidity, submit recovery and resolution plans to regulators.

Question 224

Why do banks exist? 5 arguments

Answer 224

1. The Transaction Cost Perspective
   * Efficient Intermediaries reduce transaction costs.
   a) Direct and observable: Traveling, searching
   b) Indirect and unobservable: Agency costs or information costs
2. Information Creation through Screening and Monitoring (reduce agency costs)
   * Banks have the resources and expertise to evaluate borrowers and monitor loans, reducing the risk of financial losses.
3. Diversification and Risk Sharing (pooling)
   * Banks pool resources from many depositors and lend to a diversified portfolio of borrowers, which spreads out the risk.
4. Asset Transformation and Risk Management (use pool to transform, less risky)
   * Banks convert short-term deposits into long-term loans, managing the risk difference between the two.
   * Bank use Asset-Liability Management (ALM) to match assets and liabilities + collateral
5. Liquidity Creation (from pool)
   * Banks provide liquidity to depositors and borrowers, making it easier for money to flow in the economy.
   * I can withdraw cash even with a big loan

Question 225

What is Risk Management in Banking

Answer 225

Asset Liability Management (ALM) is a process to manage a bank’s balance between assets and liabilities to minimize financial risk and maximize profitability. This includes managing interest risk, liquidity risk, currency risk, and credit risk.

Question 226

Difference of bank loan markets and capital markets

Answer 226

• Capital markets involve buying and selling of equity and debt instruments, including primary and secondary markets.
• Bank loans and bonds often include covenants, terms that ensure the borrower’s actions remain aligned with the lender’s interests throughout the loan tenure.

Question 227

Advantages and disadvantages of Debt as a funding source

Answer 227

• Debt Advantages: Retains ownership, less influenced by market swings, and is easier to raise.
• Debt Disadvantages: Legal obligation to repay, and lenders may claim on assets during bankruptcy.

Question 228

Advantages and disadvantages of equity as a funding source

Answer 228

• Equity Advantages: No legal obligation to repay, and no claims on assets during bankruptcy.
• Equity Disadvantages: Dilutes ownership, potential for shareholder activism, potential for hostile investors, and voting rights may be affected.

Question 229

Whats Asset-Liability Management (ALM) for, and what are the tools?

Answer 229

• Banks use Asset-Liability Management (ALM) to manage risks with the goal of matching assets and liabilities maturities and cash flows.

1) Market Risk Models (manage risk from market conditions, like market prices and volatilities)

2) Interest Rate Risk Models (analyze changes in interest rates)

3) Liquidity Risk Models (Manage risk with funding and cash flow availability)

Question 230

Financial innovations that went wrong 2008

Answer 230

1. Collateralized Debt Obligations (CDO)
2. Special Purpose Vehicles (SPVs) / Structured Investment Vehicles (SIVs)
3. Credit Default Swaps (CDSs)

Question 231

Why Securitization from Banks’ Perspective

Answer 231

Liquidity & Transfer risk
1. Liquidity: Can convert illiquid assets (like mortgages) into cash quickly, improving their liquidity status.
2. Risk Management: Can transfer risk associated with the loans to investors

3. Other: Move assets Off-Balance Sheet, so reduce their capital requirements

Question 232

Benefits of Securitization

Answer 232

• It brings financial markets and capital markets together.
• It results in structured financial instruments that align more closely with investor needs.
• It allows certain investors to participate in assets they otherwise couldn’t.

Question 233

Monitoring Borrowers After Securitization - problem

Answer 233

1. Banks sell the securitized packages to investors, so they no longer bear the majority of the risk
2. Can lead to loosened incentive for banks to maintain strict oversight
   a) Poor underwriting (approve loans that otherwise would have gotten rejected)
   b) Failure to monitor borrower (have less incentive to do so)

Question 234

what is Credit Default Swap (CDS) in short

Answer 234

Allows investor to protect against the risk of default on a particular debt security.

Question 235

Benefits of CDS

Answer 235

Protection & Distribution of Risk

• Individual: Protect against risk
• System: CDS distribute risk widely throughout the system, prevent large concentrations of risk, and provide important information about credit conditions.

Question 236

The Dark Side of CDS

Answer 236

A owns bonds issued by company XYZ

1. A is concerned about default and buys CDS from Investor B on XYZ
   * A is paying premium to B
   * Consequence: A stops monitoring XYZ
2. XYZ starts getting troubled
   * A does not do anything, assume that he is protected
3. XYZ goes bankrupt
   * B have financial trouble, cannot pay A
   * A is very much exposed to losses

Question 237

Iceland’s Financial Crisis:

Answer 237

1. Iceland’s banks offered high interest rates
2. This gave high value for the krona
3. When the 2008 crisis occurred, the banks defaulted on their foreign debt, causing the krona’s value and the stock market to plummet
4. The banks were too big to be saved by the Icelandic government, leading to a bailout negotiation with the International Monetary Fund (IMF)
5. Iceland’s economic collapse had impact on rest of Europe

Question 238

Stopping a bank run, tools

Answer 238

1. Suspension of Convertibility
2. Coalition of Private Banks
3. Government Deposit Insurance
4. Capital Requirement and Cash Requirement
5. Lender of Last Resors
6. Government Bailouts

Question 239

Bank Regulation - The General Principles

Answer 239

1. Licensing and Supervision (banks need banking license from regulator. Regulator supervises with requirements)
2. Minimum Requirements (requirements, often linked to risk exposure)
3. Market Dicipline (require bank to publicly disclouse financial information etc)

Question 240

Bank Regulation - Instruments and Requirements

Answer 240

1. Capital Requirement (how they must handle capital in relation to assets)
2. Reserve Requirement
3. Corporate Governance (maintain a close watch on all operations)
4. Financial reporting and discousre requirements
5. Credit Rating Requirement (obtain and maintain a current credit rating)
6. Large exposures restrictions. (restricted from being to exposed to one thing)
7. Activity and Affiliation restrictions (banks cannot be to much affiliated to eg. security firms)

Question 241

Examples of Technology-Based Business Models:

Answer 241

1. Platform-based business models,
2. SaaS (Software as a Service),
3. Data-driven models.

Question 242

Platform-Based Business Models

Answer 242

• Businesses that facilitate interactions between two or more groups through a digital platform.
• Platform owner creates value by enabling interactions, taking a commission or fee per transaction.
• Types: Two-Sided Platforms (Ex: Vipps, Paypal, Airbnb, Uber), Marketplaces (Ex: LendingClub, Kickstarter, Etsy, Amazon, Alibaba).

Question 243

The traditional models of financingg

Answer 243

• Peer-to-peer Finance Model
• Financial Markets Model
• Financial Intermediation Model

Question 244

what is crowdfunding and its different types?

Answer 244

• Crowdfunding is raising capital from a large number of people through small investments or donations, typically facilitated by online platforms.

1) Reward- and Donation-based Crowdfunding,
2) Debt-based Crowdfunding,
3) Equity-based Crowdfunding,
4) Initial Coin Offerings (ICOs).

Question 245

Reward- and Donation-based Crowdfunding. Definition, pros and Example.

Answer 245

• NON-FINANCIAL reward in return
• Benefits:
  1. Understand demand: The people who contribute to the campaign are essentially doing it in support of the idea. The number of backers overall gives the entrepreneur an indication of market demand for their gadget.
  2. Visibility
  3. Extra source of financing
• Example: Kickstarter, a platform that helps tech and creative entrepreneurs fund their projects.

Question 246

Equity-based Crowdfunding: Definition, Pros and Cons, Regulation

Answer 246

This type of crowdfunding helps small businesses or early-stage startups raise capital by offering a small amount of equity in the company to individuals.

Pros:
1. Understand demand
2. Crowd-Wisdom (collect wisdom from diverse group)

Cons:
1. Information asymmetry: entrepreneurs have more info than individual investors
2. Investor free-ride: investors rely on others to do due diligence
3. Management control: many small shareholders, complex
4. Illiquid shares: often lack a liquid secondary market

• Regulation: Varies by country, with some nations like the US easing regulations to boost small businesses.

Question 247

Debt-based Crowdfunding & P2P Lending. Definition and example

Answer 247

Also called P2P lending. Individuals lend money to entrepreneurs or businesses in for interest payments and the eventual return of the loan amount.
Pros:
* Investors can earn interest
* Lower risk than equity-based: in event of default, legally.

• Example: Prosper Marketplace, a large P2P platform in the U.S., gets less than 10% of capital from retail investors.

Question 248

Blockchain-based Crowdfunding and ICOs:

Answer 248

• initial coin offerings
• An ICO is a method of raising capital in the cryptocurrency industry, similar to an IPO in the traditional financial world.
• Blockchain technology facilitates peer-to-peer transactions, potentially reducing the cost of raising capital.

Question 249

how can bigtech threaten incumbent banks

Answer 249

more convenient payment solutions and access to personal data

Question 250

Three Scenarios for European Banking in 2030:

Answer 250

• Scenario 1: Incumbent banks maintain their central role in money creation and financial intermediation.
• Scenario 2: Incumbent banks retrench, and big techs offer financial services, capturing the hard-data, transaction-based lending market.
• Scenario 3: Central Bank issues digital currency. Restructures the financial society

Question 251

Adverse selection (called, when, mitiage)

Answer 251

Called “hidden types”
Problem that occur BEFORE contract is written. E.g., trading partner cannot observe the quality of other partner
Mitigate problem: Signaling, screening

Question 252

Moral Hazard (called, when mitigage, when no?)

Answer 252

Problem that occur AFTER the contract is written. E.g., trading partner cannot be sure if the other is behaving OK after the contract is written
Called “hidden actions”
Mitigate: Monitoring
No moral hazard in one-shot transactions: A seller does not need to worry about how a buyer treats a good after it is sold

Question 253

what tools can financial institutions use to mitigate Risk-Shifting Moral Hazard?

Answer 253

1. Collateral
   The borrower now shares the risk of the loan
2. Debt Covenants
   Terms and conditions that limit the borrowers actions. For example, can limit a company from taking more debt.

Question 254

Q: What is a blockchain

Answer 254

A digital ledger that records transactions in blocks and is distributed across a network of computers.

Question 255

What is Distributed Ledger Technology (DLT)?

Answer 255

Ledger: a digital database that stores and maintains a record of transactions in a decentralized manner

So the transactions are distributed across several ledgers

Question 256

What is the main advantage of a blockchain? and why?

Answer 256

1) Transparency (open ledger, history of all transactins available to all)
2) Decentralization (no owner/boss)
3) Security (cryptography/hashes)
4) Efficiency (smart contracts, reduce need for intermediates, reduce costs)

Question 257

What are decentralised applications (DApps) in DeFi?

Answer 257

Applications that allow users to interact with smart contracts and access DeFi services.

Allows financian services such as lending, borrowing, trading, and asset management, directly through the application.

Question 258

Q: What vulnerabilities does DeFi inherit from TradFi?

Answer 258

1) Operational Fragilities
2) Liquidity and Maturity Mismatches
3) Leverage

Operational Fragilities:
* Weaknesses in the system from human error, technical failures or design flawn.
* Example: A bug in a smart contract.
Liquidity and Maturity Mismatches:
Liquidity: How fast an asset can be converted into cash
Maturity: Life span of an investment or a debt
* A mismatch between these can occur when when short-term liabilities (what you owe soon) exceed short-term assets (what you have or can quickly convert to cash).
* Example: Asset locked in a smart contract for a certain period. Not able to withdraw without penalty. Similarly, banks may lend to long-term customers using short-term deposits, which creates problems If many depositors want their money back soon
Leverage:
* Can take on leverage which can lead to substantial losses
* Example: Smart Contracts lock it. Volatile market. Big risk

Question 259

Q: What happened during the Terra Luna crash in 2022?

Answer 259

Creation of TerraUSD (UST) and Luna: Terraform Labs created two types of tokens: TerraUSD (UST), which is a stablecoin (a cryptocurrency designed to maintain a stable value, in this case, pegged to the US dollar), and Luna, which is used to back the value of UST.
Arbitrage Mechanism: The idea was that if the price of UST deviated from $1, there would be an opportunity for traders to make a profit. If UST was worth less than $1, a trader could buy UST cheaply and exchange it for $1 worth of Luna. This activity would help bring the price of UST back to $1.
Burning of Luna to create UST: To create new UST, Luna tokens needed to be “burned” or removed from circulation. For instance, if a Luna token was worth $85, a trader could exchange it for 85 UST.
Price Increase: The price of Luna rose dramatically, reaching a peak of $116 in April 2022.
High Interest Rate: Traders could deposit UST on Terra’s lending platform (the Anchor Protocol) and earn a very high annual interest rate of 20%.
Run on the Lending Platform: However, on May 2022, over $2 billion worth of UST was suddenly withdrawn from the Anchor Protocol. This is similar to a “bank run” in traditional finance, where many people withdraw their deposits at the same time, creating a liquidity crisis.
Price Crash: In the days following this bank run, the price of Luna crashed dramatically, falling to just a fraction of a penny before being delisted (removed from exchanges).
Impact: It’s estimated that this crash resulted in losses of $300 billion across the entire cryptocurrency market.

Question 260

Q: What caused the FTX collapse in 2022?

Answer 260

FTX:
* A cryptocurrency exchange platform
Alemada Research:
* Hedge-find founded by Bankman-Fried
* Used FTT as collateral for loans

Both were tied to the risky and volatile FTT.
Investors found out; starting to withdraw its FTT holdings. Liquidity problem
FTX searched for bailout: Binance said no after due diligence
Bankruptcy

Question 261

Q: What is the role of smart contracts in DeFi?

Answer 261

Automize the terms and conditions in a decentralized manner

Question 262

Q: What is an algorithmic stablecoin? Provde example

Answer 262

• Maintain stable value by utilizing algorithms to regulate supply and demand.
• Unlike volatile Bitcoin and Ethereum

Example:
If price of coin is above $1, algorithm will increase the supply. New tokens created that dilute the value and bring the price down

Question 263

What is a Peg?

Answer 263

• Fixed Exchange Rates between two assets
• Different to “floating currencies”
• Stablecoins

Question 264

Q: What is the purpose of Hashing and Encryption?

Answer 264

a) Hashing: Validate Information (uniqueness)

b) Encryption: Protect sensitive information

Question 265

Q: What is Hashing?

Answer 265

Hashing is the process of transforming data into a fixed-length string of characters using a hash function.

used to create unique identifiers for data, such as transactions or blocks in a blockchain

Question 266

What is hashing (long)

Answer 266

• To validate information
• Validate the integrity of the content (uniqueness)

In simple terms, hashing is a process that takes an input, transforms it into a unique, irreversible code, and allows for efficient data verification. It’s a fundamental aspect of data security and integrity checks.

1) Uniqueness: Every unique input generates a distinct hash value. Even a minor change in the input will yield a drastically different hash value, ensuring the uniqueness of each data set.

2) One-way: Hash functions are designed to be irreversible. This means that once a hash value is produced, it’s computationally impractical to retrieve the original input from it. This characteristic is crucial for maintaining security.

3) Integrity: Hashing is used to verify the integrity of data. By comparing hash values, one can easily determine whether the data has been modified or tampered with. A change in data results in a different hash value, signaling a potential integrity breach

Hashing is a method used in computing for ensuring data integrity and security. It uses a specific function, known as a hash function, which takes an input and converts it into a fixed-size string of characters, known as a hash value or hash code.

Question 267

Q: How does hashing ensure data integrity?

Answer 267

1. Uniqueness: all hash values are unique
2. One-way: Designed to be irreversible
3. Integrity: the chain system makes it impossible to tamper with

Question 268

12 Steps of a crypto transaction to distinguish hashing, encryption. And to put light on DLT, Miners, PoW.

Answer 268

Step 1: Sender’s Details The sender decides to send a certain amount of cryptocurrency to a receiver. They will need the receiver’s public address.

Step 2: Transaction Creation The sender creates a transaction message. This message includes the receiver’s public address, the amount of cryptocurrency to be sent, and the sender’s public address.

Step 3: Hashing This transaction message is then put through a hashing function, turning the message into a unique string of characters, a “digest.”

Step 4: Encryption (Digital Signing) The sender then uses their own private key to encrypt this hash. This encrypted hash serves as a digital signature. The sender’s private key is kept secret and never shared.

Step 5: Broadcasting The sender broadcasts the transaction, which includes the original transaction message and the digital signature, to the cryptocurrency network.

Step 6: Verification The network (or the nodes within the network) uses the sender’s public key to decrypt the digital signature back into the hash. If this hash matches the hash they get when they put the transaction data through the same hashing function, they can verify that the transaction is authentic and unaltered.

Step 7: Broadcasting to Miners The validated transaction is broadcasted to the entire network, including miners.

Step 8: Mining (Proof of Work) Miners collect these transactions and begin to form a new block. To add this block to the existing blockchain, miners must solve a complex mathematical problem—a process known as Proof of Work (PoW).

Step 9: Block Addition The first miner to solve the PoW problem adds the block to the blockchain. This process secures the network and verifies the transaction on a larger scale.

Step 10: Reward For their work, the successful miner is rewarded with some amount of the cryptocurrency.

Step 11: Update of Digital Ledger Once the block is added to the blockchain, the transaction is considered confirmed. All participants in the network update their copies of the blockchain (the digital ledger) to include the new block.

Step 12: Transaction Completion The receiver can now see the transaction in their wallet. The transaction is confirmed on the blockchain, a transparent and immutable digital ledger, ensuring the integrity and transparency of all transactions.

Question 269

What is the complete role of miners?

Answer 269

1. Maintaining the Blockchain:
   Miners validate new transactions and record them on public ledger
2. Verifying and Packaging Transactions:
   Miners check the digital signatures associated with each transaction
3. Competing in Mining:
   Proof-of-Work: Miners compete in finding a nonce (number only used once) to generate hashes
4. Adding a New Block:
   The miner who solves the puzzle (nonce) first gets to add the new block to the blockchain.

Question 270

Q: What are the incentives for miners?

Answer 270

Miners have incentives to perform mining activities due to the rewards they receive. There are two types of rewards

1. Block rewards:
   When a miner solves a complex mathematical puzzle and adds a new block of transactions to the blockchain, they receive a certain number of newly minted cryptocurrency (like Bitcoin). This is called the block reward.
2. Transaction Fees:
   Each transaction in the block includes a small fee. The miner who adds the block to the blockchain gets to keep these fees. So, the more transactions a miner validates and adds to the blockchain, the more fees they earn.

Question 271

Q: What is a nonce?

Answer 271

The nonce is a random number used in the mining process to solve the proof-of-work puzzle. Miners repeatedly change the nonce value until they find a hash that meets the required difficulty level.
Q: What is the average size of a block, and how many separate transactions does it contain?
On average 1MB in size. Generally contains around 2,500 (max 4000) separate transactions.

Question 272

Whats meant by hashing being one-way?

Answer 272

When it is said that hash functions are designed to be one-way, it means that it is extremely difficult, computationally speaking, to reverse the process and determine the original input from its hash value. In other words, given the output (the hash), it is nearly impossible to figure out what the original data or message was. This property ensures the security and integrity of the hash function, making it suitable for tasks like password storage and data verification.

Question 273

Q: What is Encryption?

Answer 273

Encryption: Protect information

The practice of encoding information in a way that only someone with a corresponding key can unscramble and read it.

• Two-way: When you encrypt something, you’re doing so with the intention of decrypting it later.

Question 274

Q: Explain the encryption process for signatures

Answer 274

1. Sender uses private key to encrypt the signature
2. The recipient uses the sender’s public key to decrypt the signature (verifies the authenticity)
3. Recipient compares decrypted signature with a newly computed hash. If it matches, its good

Question 275

Q: Similarities between hashing and encryption?

Answer 275

Both transform or change data into a different format.

Question 276

Q: Differences between hashing and encryption?

Answer 276

Hashing and Encryption have different functions. Encryption is a two-way process that includes encryption and decryption while hashing is a one-way process that changes data into the message digest which is irreversible.

Question 277

Q: What is the solution to the “double spending problem”, and why? (easy answer)

Answer 277

1. Public ledger:
   Blockchain prevents double spending by securely recording every transaction in a public ledger.
2. Consensus mechanisms (PoW/PoS):
   With consensus mechanisms, blockchain ensures that all nodes agree on transactions

Question 278

What is the solution to the “double spending problem”, and why? (hard answer)

Answer 278

1. Decentralized Public Ledger:
   Each transaction is recorded on a public ledger. This way, any double-spending attempt can be quickly identified and rejected.
2. Consensus mechanisms (PoW/PoS):
   Computers must agree on a single version of transaction history If users try to double spend, the network will reject it because it contradicts with the agrees-upon transaction history.
3. Imutability:
   Once a block is confirmed and added to the blockchain, it cannot be altered.

Question 279

Q: Is there inflation of Bitcoin?

Answer 279

The powerpoint says this: “No, the issuance has a limit”, but:

Yes, there is. But it is different from traditional currencies. Bitcoin inflation refers to the increase in the number of Bitcoins in circulation.

Question 280

Q: How does the Bitcoin inflation change over the years?

Answer 280

In the case of Bitcoin, the inflation rate decreases over time due to the “halving” events that occur approximately every four years. During each halving, the block reward for miners, which is the newly minted Bitcoins they receive as a reward for mining a new block, is cut in half. This reduction in the block reward reduces the rate at which new Bitcoins are created and introduced into circulation.

With each halving, the supply of new Bitcoins entering the market decreases, leading to a lower rate of inflation. This diminishing inflation rate, coupled with the limited supply of 21 million Bitcoins, contributes to the perception of Bitcoin as a deflationary currency. It suggests that over time, the purchasing power of Bitcoin may increase, making each Bitcoin potentially more valuable.

Question 281

Q: When will Bitcoin mining end?

Answer 281

until all 21 million Bitcoins are mined, around the year 2140.

Question 282

Explain the transaction fee rewards for miners

Answer 282

When users send Bitcoin transactions, they include a transaction fee. This fee is determined by market forces and can be set by the users themselves. Miners prioritize transactions with higher fees because they can include those transactions in the limited space available in each block. By including transactions with higher fees, miners can maximize their profits.

Question 283

Q: What is the average size of a block, and how many separate transactions does it contain?

Answer 283

On average 1MB in size. Generally contains around 2,500 (max 4000) separate transactions.

Question 284

Q: What happens if two blocks are creates simultaneously?

Answer 284

Fork:
Sometimes mines solves the puzzle and create a new block at the same time. This results in two version of the blockchain that are identical except for the last block. This situation is known as a fork.

The Longest Chain Rule:
To resolve this fork, the blockchain network follows a rule called “the longest chain rule.”
This rule states that the valid blockchain is the one with the most blocks (most Proof-of-Work). So, whichever of the two competing blocks gets another block added to it first becomes part of the longest chain and is accepted as the valid blockchain. The block from the shorter chain is discarded.

Other, simple:
“The longest chain rule.” – Miners continue to mine on top of block A and B. If the next block is mined on top of A, B becomes discarded.

Question 285

Q: How many blocks are generally recommended for security?

Answer 285

In Bitcoin, 100 additional blocks to be built on top of a particular block in the chain.

Question 286

Q: What are consensus mechanism in blockchain, in general? (dont explain PoW and PoS)

Answer 286

Rules/Protocols in how all computers (nodes) in a blockchain agree about what transactions are valid

Question 287

Explain Proof of Work

Answer 287

A consensus mechanism used by cryptocurrencies like Bitcoin. Miners compete to solve complex cryptographic problems, and the first to solve the problem gets to add a new block to the blockchain.

Question 288

Explain Proof-of-Stake

Answer 288

Validators selected randomly to confirm transactions and validate block information.

To become a validator, a coin owner must “stake” a specific amount of coins. (Ethereum requires 32 ETH, around 2000 dollars)

Blocks get validated by multiple validators, and when a specific number of validators verify that the block is accurate, it is finalized and closed.

Question 289

Difference between PoW and PoS

Answer 289

PoW relies on computational power, making it resource-intensive and leading to concerns about energy consumption. PoS, on the other hand, relies on economic measures (the staked coins) to ensure security, making it less energy-intensive and arguably more sustainable.

Question 290

Q: What are some of the advantages of PoS over PoW?

Answer 290

1. Energy Efficiency
   In PoW, mining consumes large amount of computational power and energy. This is not involved in PoS
2. Security
   PoS: Those who want to attack need to own a majority of all crypto. In PoW, attacker only needs more computable power.
3. Efficiency
   PoS can handle more transactions in a given time compared to PoW. (why/how can they do this? 10 min?)

Question 291

Q: What is the Lightning Network (LN)?

Answer 291

In the traditional Bitcoin network, every transaction needs to be recorded on the main blockchain, which is a public ledger that verifies and stores all transactions. However, this process can be slow and costly, especially when the network is congested.

The Lightning Network introduces the concept of a payment channel or a “tab” between two participants. Instead of immediately recording every single transaction on the main Bitcoin ledger, participants can open a payment channel between themselves. This payment channel acts as an off-chain arrangement.

Once the payment channel is open, participants can conduct multiple transactions between them without involving the main blockchain. These off-chain transactions are faster and usually have lower fees. The balance of the tab keeps track of how much each participant owes the other based on the transactions conducted within the channel.

Question 292

Q: How does the Lightning Network help speed up transactions on the blockchain?

Answer 292

The Lightning Network allows users to open payment channels between each other. These channels exist off the main Bitcoin blockchain (off-chain). Transactions within these channels can be made instantly and almost for free because they don’t need to be immediately recorded on the blockchain.

Inside a channel, participants can make unlimited transactions. When the participants are ready to close the channel, the final state of these transactions is written to the blockchain. Therefore, instead of potentially thousands of transactions needing to be written on the blockchain, only two are needed.

Question 293

Q: What are the steps involved in using the Lightning Network?

Answer 293

1. opening a payment channel
2. conduct off-chain transactions
3. settling the final balance on the blockchain when closing the channel

Question 294

Q: What are the three different forks?

Answer 294

) Temporary Fork:
Miners discover a block at the same time, resulting in a competition where the longest blockchain is viewed as the true one. “chain split”.

2) Soft Fork:
New rules or protocols. These are compatible with the old ones. Blockchain remains as one unified chain.

3) Hard Fork:
substantial changes lead to permanent split in the blockchain. Leads to the formation of two distinct blockchains. As a result, the cryptocurrency associated with the original blockchain continues to exist, while a new cryptocurrency is created for the forked blockchain.

Question 295

Q: What is the meaning of “permissionless”?

Answer 295

“does not require authorization”

Blockchains are open to anyone. no one owns a blockchain.

Question 296

Q: What are the key elements of the DeFi ecosystem?

Answer 296

A: The key elements of the DeFi ecosystem include
1. permissionless blockchains,
2. smart contracts,
3. DeFi protocols,
4. decentralized applications (DApps).

Question 297

Q: What is the role of permissionless blockchains in DeFi?

Answer 297

: Permissionless blockchains provide a transparent and immutable ledger for recording transactions in the DeFi ecosystem.

Question 298

Q: What are blockchain native tokens in DeFi?

Answer 298

Blockchain native tokens in DeFi refer to the digital assets or cryptocurrencies that are built on and native to a specific blockchain platform

Question 299

Q: What is self-custody in DeFi?

Answer 299

A: Self-custody means that participants in DeFi protocols maintain control of their crypto-assets and have the ability to transact without relying on third parties.

you are the only one knowing about the keys to your assets

Question 300

Q: What are oracles and bridges in DeFi?

Answer 300

Oracles:
third-part, supply smart contracts with external information. Serve as bridges between real world and blockchains

Bridges:
Connectors between different blockchains. Allow assets or information to move between different blockchains.

Blockchains are isolated and cannot directly interact with each other. Bridges allow this.

For instance, a bridge might allow a user to take a token that was issued on the Ethereum blockchain and use it on the Binance Smart Chain.

Question 301

Q: What are decentralised autonomous organisations (DAOs) in DeFi?

Answer 301

• Organization that is controlled by the organization members, and not influenced by a central authority.
• Decision-making via voting
• Votes weightened by amount of tokens

Question 302

Q: What are some of the distinguishing features of DeFi?

Answer 302

1) Smart contracts (digital agreements)
2) Blockchain native tokens (Tokens specific to a particular blockchain network)
3) Composability (Ability to build something unique, like LEGO blocks)
4) Self-custody (having full control and ownership over your assets)
5) Oracles and Bridges

Question 303

Q: How do decentralized lending platforms work in DeFi?

Answer 303

A: DeFi lending platforms rely on
1. pooled assets provided by lenders
2. use collateral instead of creditworthiness assessments
3. Require over-collateralization for loans.

Over-collateralization:
Collateral to fill potential default.

Example:
a) Alice wants to borrow 100 DAI
b) She must provide collateral worth more than 150 DAI, so she offers 1 ETH
c) Platform locks 1 ETH in a smart contract as collateral

Question 304

Q: What are flash loans in DeFi?

Answer 304

Allow users to borrow a specific amount of crypto in a very short time.

Don’t require collateral.

Borrowed funds must be returned within the same transaction

Smart contracts

Example:
All happens within the same transaction:
1. User loans an amount crypto
2. Borrower use it in arbitrage
3. Repayment. If it fails, entire transaction is reverted

Question 305

Q: What are the 2 different types of crypto-asset trading platforms in DeFi?

Answer 305

Centralized Exchanges (CEXs): Operated by centralized organizations who oversee the transactions. Act as intermediaries or third parties.

Decentralized Exchanges (DEXs): non-custodial, allow peer-to-peer trading, facilitated by smart contracts. No third party.

Question 306

Q: How do automated market makers (AMMs) work in DeFi?

Answer 306

Traditional markets: trades occur between buyers and sellers

AMM: Like vending machines for cryptocurrencies. Smart contracts on a blockchain that hold liquidity reserves (pools) of two or more tokens, and enable trades to occur directly between these reserves.

Instead of relying on the traditional buyers and sellers in a financial market, AMMs keep the DeFi ecosystem liquid 24/7 via liquidity pools

Question 307

Q: What is yield farming in DeFi?

Answer 307

Lend or stake your crypto to a liquidity pool. Receive interest or other rewards.

Question 308

Q: What is staking in DeFi?

Answer 308

A: Tokenized derivatives are tokens whose value depends on the fluctuations of referenced assets or other observable variables. They may be governed by programmable code and can require oracles for tracking underlying asset information.

Question 309

Q: What are tokenized assets in DeFi?

Answer 309

Digital representation of real-world assets.

Tokenized Gold: Gold is a widely recognized and valuable physical asset. Through tokenization, gold can be represented as digital tokens on a blockchain. Each token represents a fraction of a unit of gold, such as an ounce or gram. These tokens can be bought, sold, and traded on a blockchain-based platform

Question 310

Q: What vulnerabilities are associated with operational fragilities in DeFi?

Answer 310

A: Operational fragilities in DeFi include governance arrangements, dependence on blockchain networks, smart contracts, and oracles and bridges.

Question 311

Q: What vulnerabilities are associated with smart contracts in DeFi?

Answer 311

A: Smart contracts in DeFi are complex and prone to coding errors. Once deployed, they are immutable, making it difficult to rectify errors or fraudulent transactions.

Question 312

Q: What risks are associated with oracles in DeFi?

Answer 312

A: Oracles are crucial for executing off-chain operations and retrieving data, but they can introduce dependency on third-party providers. Errors or attacks on oracles can have negative consequences in multiple protocols.

Question 313

Q: How do bridges pose operational risks in DeFi?

Answer 313

A: bridges can be vulnerable to theft or unauthorized access. If a bridge is compromised or hacked, it can lead to the loss of assets that were being transferred

Question 314

Q: What are liquidity and maturity mismatches, and why are they concerning in DeFi?

Answer 314

Differences in the availability and timing of funds in DeFi, which can lead to problems when there is a mismatch between the demand for withdrawals and the availability of funds, potentially causing liquidity issues and risks.

Question 315

Q: How can liquidity risks arise in stablecoins and lending platforms within DeFi?

Answer 315

A: Liquidity risks in stablecoins happen when many people try to cash out their stablecoin holdings all at once. In lending platforms, liquidity risks occur when there is high demand for withdrawals but not enough funds available to meet those requests.

Question 316

Q: What is composability in DeFi, and how does it contribute to interconnectedness?

Answer 316

A: Composability in DeFi refers to the ability of different protocols to work together. This interconnectedness can create situations where problems in one protocol can quickly spread to others, increasing the risk of financial contagion.

Question 317

Q: What risks are associated with concentration and complexity in DeFi?

Answer 317

A: Concentration in DeFi means that a few protocols or entities have a lot of influence in the ecosystem. This can be risky because if one of them fails, it can have widespread effects. Complexity in DeFi makes it harder to understand and predict how different parts of the system will interact, increasing the risk of unexpected issues.

Question 318

Q: How do DeFi platforms depend on third-party providers for their functioning?

Answer 318

A: DeFi platforms rely on external services like oracles for getting off-chain data and the internet infrastructure for their operations. These third-party providers are crucial for the proper functioning of DeFi protocols.

Question 319

Q: What are some of the vulnerabilities of DeFi?

Answer 319

1) Operational fragilities
2) Liquidity and maturity mismatches
3) Leverage
4) Interconnectedness, concentration and complexity
5) Other vulnerabilities (market integrity, cross-border regulatory arbitrage, cryptoisation)

Question 320

Q: What are the three potential scenarios for the evolution of DeFi and its financial stability implications?

Answer 320

Scenario 1: DeFi remains a niche area with limited growth and interconnectedness.

Scenario 2: DeFi grows significantly and becomes mainstream, leading to deeper interlinkages with the real economy.

Scenario 3: DeFi slowly fades, but leaves behind a legacy of useful financial innovations.

Question 321

Q: What are the four key metrics used to monitor the evolution of the DeFi ecosystem?

Answer 321

The four key metrics used to monitor the evolution of DeFi are Total Value Locked (TVL), the number of DApps, stablecoin market capitalization, and the number of DApps users based on unique addresses. However, these metrics have complexities in their interpretation and require measures that account for issues such as double counting and the use of stablecoins for non-DeFi purposes.|

Question 322

Q: What is a token?

Answer 322

A digital object/currency on the internet. Represent something of value, such as money. Created by blockchain.

Question 323

Whats cryptoization

Answer 323

residents start using crypto assets instead of the local currency

Question 324

Q: What are the vulnerabilities of Cryptoisation?

Answer 324

Substitution of traditional currencies with crypto-assets, which can complicate domestic monetary policy and undermine monetary sovereignty, especially in countries with economic instability and weak banking sectors.

Question 325

Q: What are the vulnerabilities of Cross-border regulatory arbitrage?

Answer 325

DeFi platforms operating across borders, making it challenging to identify legal ownership/control and regulatory authorities, leading to difficulties in oversight and enforcement.

Question 326

Explain the chain in blockchain

Answer 326

When the block is added to the blockchain, the hash value of the previous block is also included in the new block’s data. This creates a chain of blocks where each block’s hash value is dependent on the data of the previous block.

Question 327

Whats “halving”

Answer 327

“halving”: block reward (newly minted Bitcoins) for miners is cut in half.
happens approximately every four years

Question 328

Who maintain blockchain?

Answer 328

miners

Question 329

What are consensus mechanism in blockchain?

Answer 329

Consensus mechanisms are protocols that ensure all nodes (computers) in a blockchain network are in agreement about which transactions are valid and should be added to the blockchain. These mechanisms help maintain a consistent and trustworthy ledger.
There are two commonly used consensus mechanisms:
1. Proof of Work (PoW)
2. Proof of Stake (PoS)

Question 330

Q: What are some of the distinguishing features of DeFi?

Answer 330

1) Smart contracts (digital agreements)
2) Blockchain native tokens (Tokens specific to a particular blockchain network)
3) Composability (Ability to build something unique, like LEGO blocks)
4) Self-custody (having full control and ownership over your assets)
5) Oracles and Bridges

Question 331

Q: What is margin trading in DeFi?

Answer 331

A: Margin trading in DeFi allows users to leverage their crypto-assets by borrowing additional funds to build long or short positions. Collateral acts as a guarantee, and automatic liquidation may occur if margin values fall below a certain threshold.

Question 332

How can stress originating from DeFi spill over to traditional finance and the real economy?

Answer 332

A: Stress from DeFi can spill over to traditional finance and the real economy through interlinkages and transmission channels, such as financial institutions’ exposures to DeFi, households and firms, DeFi’s impact on payments, and the failure of major crypto-asset trading platforms like FTX.

Question 333

Decentralized Autonomous Organizations (DAOs), Explanation

Answer 333

1. Concept: A complex form of a blockchain organization that is managed by smart contracts
   * The rules are written in code and mantained on a blockchain
2. Decentralization: DAOs have no central authority
   * There is no boss
3. Token Ownership: The members own tokens that represent a share of DAO’s profits, voting rights, or both
4. Decision Making:
   Token holders can vote on propolsals based on their ownership
5. Transparency: All rules, transactions and cote results are recorded on a blockchain
6. Reslilience: DAOs are resilient to censorship and external influence due to their decentralized nature

Question 334

Main purpose of DAOs

Answer 334

Democratze decision-making protocols processes and distribute benefits more equitably among participants.

Question 335

What are some examples of what DAOs can vote about?

Answer 335

1. Forks: whether to support a fork or not
   Example: after the hacking of “The DAO” on Ethereum, the community voted on whether to execute a hard fork to revert the hack. This led to a split where some members supported the fork (forming Ethereum as we know it today), while others did not, resulting in Ethereum Classic.
2. Project Development: Decisions about which new features or services to develop can be put to a vote
3. Allocation of Funds: DAO members can vote on how to allocate community funds
4. Policy Changes: DAO members may vote on changes to the rules governing the system
5. Response to Events: In response to major events, such as a security breach, DAO members might vote on the course of action. This could include decisions about system upgrades or changes to the protocol.

Question 336

Q: How does fintech companies create value?

Answer 336

By reducing financial frictions such as intermediaries.

Question 337

Q: What are the financial frictions that fintechs can reduce?

Answer 337

1. Unit costs: It costs less to offer the service (vertical integration, automation, scale)
   * PayPal reduces unit costs by enabling businesses of all sizes to accept online payments without setting up complex payment infrastructure.
2. Adverse selections: It reduces lending risks (through more data, better modeling)
   * Online lenders and peer-to-peer lending platforms reduce adverse selection by using more comprehensive data (such as online behaviour or ratings on the platform) to assess creditworthiness beyond traditional credit scores.
3. Moral hazard and agency conflicts (shirking): It aligns incentives of service providers and consumers.
   * Example: Blockchain technology allows for smart contracts.
4. Trust: It increases the trust in the system, or altogether eliminate the need for trust.
   * Example: Bitcoins decentralized, transparent ledger
5. Search costs: It easily matches service providers with customers.
   * LendingClub reduce search costs by matching borrowers with lenders
   * Peer-to-peer lending and crowdfunding platforms reduce search costs by directly connecting lenders/investors with borrowers/projects.
6. Convenience: It reduces processing time. More tailored financial services.
   * PayPal offers quick and convenient online payments and money transfers, reducing the time and complexity compared to traditional bank transfers.
   * Also crypto
7. Financial inclusion: Fintech can give more people access to financial services.
   * Mobile money and digital payment apps have increased financial inclusion, allowing unbanked or underbanked individuals to transact, save, or even access credit.
8. Behavioral Biases:
   * Robo-advisors and automated investment platforms help mitigate behavioural biases.

Question 338

Q: Provide some examples of technology-based business models in finance

Answer 338

1 Platform-based business models

2. Software as a Service (Saas)
   Subscription-based model where software is delivered over the internet rather than installed on individual computers.
3. Data-driven models:
   Businesses that collect and analyze large amounts of data to provide insights or improve decision-making for customers and other businesses.

Question 339

Q: What is Platform-based business models?

Answer 339

A platform facilitates an interraction between two or more groups, through a digital platform

The platform earn on fees

Question 340

Q: What are some examples of platform-based business models?

Answer 340

Vipps, Paypal, Airbnb, Uber, Kickstarter

Question 341

Q: What are the types of Platform-based business models?

Answer 341

Two types of platforms:

1. Two-sided Platforms:
   Bring together two distinct groups of users, typically buyers and users.
   Examples: Vipps, Paypal, Airbnb, Uber
2. Marketplaces:
   Bring together buyers and sellers of specific goods and services.
   Examples: LendingClub, Kickstarter, Etsy, Amazon, Alibaba

Question 342

Q: What are the three types of digital platforms that are expanding in financial services?

Answer 342

a) Fintech entrants: specialized in technology-enabled financial innovation
b) Big tech firms: large technology companies whose primary activity is platform-based digital services
c) Incumbent financial institutions with platform-based business models

Question 343

Q: How do platform-based business models promote financial inclusion?

Answer 343

leverage technology and offer third-party services like digital payments, credit insurance, and wealth management.

Question 344

Q: How has regulation influenced the growth of fintech?

Answer 344

A: Open banking regulations have allowed customers to share their financial data with authorized third-party providers, enabling more personalized financial services.

Question 345

Q: How does fintech contribute to financial inclusion?

Answer 345

those who did not have access before (Kenye)

Question 346

Q: What are the key challenges for platform-based business models?

Answer 346

A: Platform-based business models face challenges related to network effects, trust, safety, and monetization.

Question 347

Q: Which two countries stand out for their superior fintech ecosystem performance?

Answer 347

A: The United Kingdom and Sweden are highlighted for their strong fintech ecosystems.

Question 348

Q: Can you provide an example of fintech’s impact on financial inclusion?

Answer 348

A: M-Pesa, a mobile money transfer system introduced in Kenya, has expanded to multiple countries, providing accessible financial services to millions of users.

Question 349

Q: What are the classic economic forces that remain relevant in the digital age?

Answer 349

A: Economies of scale, economies of scope, and network effects.

Question 350

What three types of digital platforms are expanding in financial services?

Answer 350

A
a) Fintech entrants
b) Big tech firms
c) increasingly, incumbent financial institutions with platformbased business models

Question 351

Q: What are the key characteristics of platform-based markets?

Answer 351

A: Network effects, winner-takes-all dynamics, increasing returns to scale and scope, and potential inefficiencies.

Question 352

Q: What are the traditional models of finance for raising funding?

Answer 352

a) Peer-to-peer finance
b) Financial markets model
c) Financial intermediation model.

Question 353

Q: What are the pros and cons of the traditional models of finance?

Answer 353

a) The peer-to-peer finance model faces high search-and-match costs and information problems.
b) The financial markets model offers high liquidity but has high fixed costs.
c) The financial intermediation model reduces agency problems but is costly.

Question 354

Q: Two typical problems in start-up funding

Answer 354

Adverse Selection and Moral Hazard

Adverse Selection:
Investors and lenders cannot distinguish between good and bad entrepreneurs/products. With only a few good firms in the market, investors/lenders will have problems finding them and may not invest or lend -> credit rationing

Moral Hazard:
After financing, an entrepreneur might take steps that are not in the investor/lender’s best interests. May chose risky project instead of safe. The lender may refuse to lend because of the entrepreneurial firm’s limited liability -> credit rationing

Question 355

Q: Why have banks reduced lending to smaller firms?

Answer 355

A: Stricter regulations following the financial crisis have led banks to cut down on lending to smaller firms.

Question 356

Q: How does disintermediated finance differ from traditional finance?

Answer 356

A: Disintermediated finance allows individual investors to make investment decisions directly, rather than relying on intermediaries.

Question 357

Q: What is crowdfunding?

Answer 357

A: Crowdfunding is the practice of raising capital by asking a large number of people to make small investments or donations through online platforms.

Question 358

Q: What are the main types of crowdfunding?

Answer 358

a) Reward- and donation-based crowdfunding
b) Debt-based crowdfunding (P2P lending)
c) Equity-based crowdfunding.
d) Initial Coin Offerings (ICOs) is also a type of crowdfunding, based on blockchain technology.

Question 359

Q: What is P2P lending in the context of crowdfunding?

Answer 359

individuals lend money directly through borrowers in exchange for interest

Question 360

Q: What is equity-based crowdfunding?

Answer 360

A: Equity-based crowdfunding allows investors to buy shares or equity stakes in a start-up or business venture in exchange for their investment.

Question 361

Q: What is Reward- and donation-based crowdfunding?

Answer 361

A: Reward- and donation-based crowdfunding is a type of crowdfunding where individuals contribute funds to a project or cause without expecting financial returns, but instead receive non-financial rewards or simply donate to support the cause.

Question 362

Q: What is an Initial Coin Offering (ICO)?

Answer 362

A: An Initial Coin Offering (ICO) is a type of crowdfunding based on blockchain technology, where cryptocurrencies are offered to investors in exchange for funding start-up projects.

Question 363

Q: When is crowdfunding typically used?

Answer 363

A: Crowdfunding is used when raising capital for a cause or business venture, typically for start-ups or projects seeking funding.

Question 364

Q: What is the “long tail” in this context?

Answer 364

The “long tail” concept refers to a statistical pattern where the frequency distribution of products or services follows a long, shallow tail instead of a steep decline. In the context of crowdfunding, it means that instead of focusing solely on popular or mainstream projects, crowdfunding platforms enable the financing of a wide variety of niche or specialized projects that cater to specific interests or markets.

Question 365

Q: How has crowdfunding impacted the start-up funding landscape?

Answer 365

A: Crowdfunding has democratized access to capital, allowing a wider range of entrepreneurs and projects to seek funding and potentially disrupting traditional funding channels.

Question 366

Q: What regulation was signed into law in the US to encourage funding of small businesses through crowdfunding?

Answer 366

A: The Jumpstart Our Business Startups (JOBS) Act was signed into law in 2012 in the US to ease securities regulations and encourage funding for small businesses.

Question 367

Q: What are some benefits of equity crowdfunding?

Answer 367

1) wisdom of the crowd
2) information about market demand

Question 368

What are some issues associated with equity crowdfunding?

Answer 368

free-riding
limitited control
illiquid shares

Question 369

Can you provide an example of moral hazard in P2P lending?

Answer 369

A: An example of moral hazard in P2P lending is when borrowers, after receiving funds from lenders, may engage in riskier or irresponsible behavior, knowing that the lenders have limited ability to monitor their actions.

Question 370

Q: What is an Initial Coin Offering (ICO)?

Answer 370

A: An ICO is a fundraising method in the cryptocurrency industry where a company issues tokens to raise capital for creating an online platform or ecosystem, with the tokens serving as a form of payment within that system.

Question 371

Q: How do interested investors participate in an ICO? How do they invest in it

Answer 371

A: Interested investors can buy tokens in the ICO using either fiat currency or preexisting digital tokens like Bitcoin or Ether.

Question 372

Q: What happens to the tokens after an ICO?

Answer 372

A: After the ICO, the tokens are usually listed on online exchanges, providing liquidity for token-holders and indicating the quality and future prospects of the platform.

Question 373

Q: What was an example of a successful Initial Coin Offering?

Answer 373

A: The Ethereum project conducted an ICO in 2014, raising $18 million in Bitcoin or $0.40 per Ether token. Ether is used to facilitate transactions on the Ethereum network.

Question 374

Q: What are some challenges and risks associated with ICOs?

Answer 374

1) unfamialirity with blockchain
2) limited usability of tokens at the time of ICO
3) information asymmetry
4) lack of regulation –> moral hazard (pump and dump)

Question 375

Q: What are some more recent fundraising forms on blockchain-based platforms?

Answer 375

A: Initial Exchange Offering (IEO) and Initial DEX Offering (IDO) are fundraising methods that occur on centralized and decentralized exchanges, respectively, allowing firms to directly sell their tokens on exchanges.

Question 376

Q: What are some advantages and disadvantages of a world without banks?

Answer 376

Pros:
* More efficient, such as accessibility and costs

Cons:
* related to the role of central banks (concentration of power, privacy, social control)

Question 377

What main advantage do traditional banks have

Answer 377

Private money creation through deposit accounts, with a significant portion of bank liabilities taking the form of deposits.

Question 378

Q: How do incumbent banks counter competitive threats in Scenario 1 (Incumbent banks maintain dominance, incorporating new providers and products)?

Answer 378

A: Through technological adaptation, acquiring fintechs, and lobbying.