Part 11. Fintech in Investment Management

Question 1

Fintech

Answer 1

This refers to developments in technology that can be applied to teh financial services industry.

Question 2

Primary areas where fintech is developing include:

Answer 2

• Increasing functionality to handle large sets of data that may come from sources and exist in variety of forms.
• Tools and techniques such as artificial intelligence for analysing large data sets.
• Automation of financial functions such as executing trades, and providing investment advice.
• Emerging tech for financial record keeping that may reduce the need for intermediaries.

Question 3

Big Data

Answer 3

A expression that refers to all potentially useful info that is generated in the economy.

Includes:

• Traditional sources such as financial markets, company financial reports, government economic statistics.
• Alternative data from non- traditional sources.

Question 4

Non-traditional sources of data:

Answer 4

• Usable data - social media posts, online reviews, email, website visits.
• Corporate exhaust - bank records, and retail scanner data from businesses.
• Internet of things - sensors such as radio frequency identification chips embedded in smart phones, and smart buildings.

Question 5

Characteristics of Big Data:

Answer 5

• Volume - data continues to grow by magnitude; referred to in units as bytes.
• Velocity - how quickly data are communicated; real time data is low latency, but data communicated periodically or with lag is high latency.
• Variety - varying degrees of structure in which data may exist; such as spreadsheets and databases (structured form), photo and webpage code (semi structured form), video (unstructured form).

Question 6

Data science

Answer 6

This concerns methods of processing and visualising data, processing methods include:

• Capture - collecting data and transforming it into usable forms.
• Curation - assuring data quality by adjusting for bad or missing data.
• Storage - archiving and accessing data.
• Search - examining stored data to find needed info.
• Transfer - moving data from their source or storage medium to where they are needed.

Question 7

AI

Answer 7

Aim to eliminate/reduce possibilities of outliers, bad or missing data and sampling biases.

Processes larger volumes of data, programmed to simulate human cognition.

e. g. neutral networks
* machine learning = a computer algorithm is given inputs of source data, with no assumptions about their probability distributions, and may be given outputs of target data.
* Designed to learn without human assistance, via training dataset to look for relationships, validation dataset to refine relationship models, and test dataset to analyse predictive ability.

Question 8

Supervised learning

Answer 8

The input and output data labelled, the machine learns to model outputs from inputs, then machine is given new data on which model to use.

Question 9

Unsupervised learning

Answer 9

The input data are not labelled and machine learns to describe the structure of data.

Question 10

Deep learning

Answer 10

A technique that uses layers of neutral networks to identify patterns, beginning with simple patterns, and advancing to more complex ones.

May employ supervised or unsupervised learning, applications include image and speech recognition.

Question 11

Overfitting

Answer 11

This occurs when machine learns the input and output data too exactly, treats noise as true parameters, and identifies spurious patterns and relationships.

Creates a model too complex.

Question 12

Underfitting

Answer 12

This occurs when the machine fails to identify actual patterns and relationships, treating true parameters as noise.

This means model is not complex enough to describe data.

Results can be a black box, producing outcomes based on relationships not readily explainable.

Question 13

Text analytics

Answer 13

The analysis of unstructured data in text or voice forms.

e.g. frequency words and phrases, used to partially automate specific tasks

Question 14

Natural language processing

Answer 14

The use of computers and AI to interpret human language.

e. g. speech recognition, language translation.
- Potential use to check for regulatory compliance in examining employee communications.

Question 15

Algorithmic trading

Answer 15

This refers to computerised securities trading based on a predetermined set of rules.

e. g. algorithms may be designed to enter optimal execution instructions for any given trade based on real time price and volume of data.
- Useful for executing large orders by determining best way to divide orders across exchanges.
- High frequency trading = identifies and takes advantage of intraday securities mispricing’s.

Question 16

Robo-advisors

Answer 16

The online platforms that provide automated investment advice based on customer answers to survey questions, designed to elicit a investors financial position, return objectives, risk tolerance and constraints such as time horizon and liquidity needs.

Tend to offer passively managed investments with low fees, low min account sizes, traditional asset classes, and conservative recommendations.

Question 17

Pros and cons of robo adviser:

Answer 17

Pros:

• Low cost to customers
• Advice more accessible to larger number of investors.

Cons:

• Reasoning behind their recommendations might be not apparent.
• without human advisor present to explain reasoning, customers may hesitate to trust appropriateness of robo adviser’s recommendations, particularly in crisis periods.
• regulation of robo advisers are still emerging.

Question 18

Distributed ledger

Answer 18

A database shared on a network so that each participant has an identical copy.

• Must have consensus mechanism to validate new entries into ledger.
• Use cryptography to ensure only authorised network participants can use data.

Question 19

Blockchain

Answer 19

• A distributed ledger that records transactions sequentially in blocks and links these blocks in a chain.
• Each block has a cryptographically secured ‘hash’ that links to previous block.

Miners = consensus mechanism in blockchain requires some of computer on network to solve cryptographic problem.

• require substantial costs to manipulate blockchains historical record, more likely to succeed with large number of participants in its network.

Question 20

Permissionless network

Answer 20

All network participants can view all transactions, networks have no central authority, with an advantage of no single point failure.

Ledger becomes permanent record visible to all, so history cannot be altered, removing the need for trust between parties to a transaction.

Question 21

Permissioned networks

Answer 21

The users have different levels of access.

e. g. may allow network participants to enter transactions while giving gov regulators permission to view transaction history.
- Distributed ledger allow regulators to view records that firms are required to make available, increasing transparency and decrease compliance costs.

Question 22

Cryptocurrency

Answer 22

A current example of distributed ledger technology in finance.

An electronic medium of exchange that allows participants to engage in real time transactions without financial intermediary, residing to permissionless networks.

• Companies have raised capital through initial coin offerings, which they sell cryptocurrency for money or another cryptocurrency.

Question 23

Pros and cons of cryptocurrency

Answer 23

Pros:

• Reduces cost and time frame to carrying out regulated IPO
• Initial coin offerings come without voting rights.
• Distributed ledgers could automate many processes carried by custodian and other 3rd parties.
• Technology has potential to bring out real-tine trade verification, and settlement, currently taking 1 or more days for many securities.
• Reduce trading costs and counterparty risk.

Cons:

• Fraud can occur with initial coin offerings, and may become subject to securities regulations.
• Inability to alter past transactions on distributed ledger is problematic when cancelling a trade is required.

Question 24

Alt. distributed ledger technology:

Answer 24

• Smart contracts = electronic contracts programmed to self-execute based on terms agreed to by the counterparties.
  e. g. options contract could be set up to be exercised automatically if certain defined conditions exist in market.
• Tokenisation = electronic proof of ownership of physical assets, which could be maintained on a distributed ledger.
  e. g. ledger could potentially replace paper real estate deeds currently filed at government offices.