Topic 5: Disruptive Technology Flashcards
SHADOW BANKS
What are they?
Why were hedge funds of concern?
Shadow Banks
1. offer bank‐like services that are less regulated than banks. (alternative payment services, non‐bank sources of credit, hedge funds, etc.)
2. Hedge funds were a source of concern because of “rehypothecation”
– Hedge fund borrows from a bank and pledges assets as collateral (= a secured loan); Bank can re‐pledge (“rehypothecate”) this same collateral against loans it receives; Lending appears to be asset‐backed, but in reality there are fewer assets than loans.
- Before 2007/09 crisis , pledged hedge fund collateral estimated to support x4 loa
Two general challenges of the shadow banking sector
- It is often less transparent in the risks it drives / contains
- It is difficult to isolate shadow banking from more traditional banking
Addressing “too big to fail”
- change the economics of the banks
- some regulators starting to encourage innovation (“FinTech”) and new entrants into financial services
- The FCA (UK) has also established a “Regulatory Sandbox” to allow financial innovators to create
new products in a safer (less stringent) regulator environment, “Disruptive innovation is a key part of effective competition”
Two types of Banking Innovators
- Parallel service providers
– Established businesses from non‐financial sectors
– Often from retailing (supermarkets) and/or a data‐driven industry (telecoms, internet)
– Aim to leverage and deepen existing customer relationships via financial services
– Replicate traditional banking services, often in partnership with an existing bank - Disruptors (including “FinTech”)
– Often start‐up ventures and almost exclusively technology driven
– Aim to provide new or highly modified financial services more efficiently
Parallel Service Providers
- Name alternative businesses that now have banking licence
- Australia?
Banking licenses are held by:
Ebay (PayPal); Google (banking licence in Netherlands); Walmart (Onebank); Tesco (JV with RBS; then bought out RBS); Sainsbury’s (JV with BOS; bought out BOS for full ownership)
Australia: Coles? Large submission to Murray Inquiry 2014
- increased choice, cost saving; customer convenience; developments in innovation.
Pros / Cons of entering a parallel business
PROS
Pros:
- leverage distribution network
- Control (if standalone rather than partnership)
- intellectual property/learn from partner
- profitability (all in standalone, shared in partnership)
- from regulatory perspective: diversification, competition; additional revenue streams could mean more stability
Pros / Cons of entering a parallel business
CONS
Cons:
- reputational damage to brand;
- risk of mis-selling financial instruments
- could be infrastructure intensive
- lack of financial risk expertise and knowledge
- in a partnership, leverage the IP of the bank but you won’t own it
Disruption in Australian banking system
concerned about: - threat of new entrants - threat of substitution (porter analysis) - banking is becoming increasingly data driven (consider Google)
Disruptive Disintermediation
Payments (networks access)
- list disruption in existing currencies
- list disruption via new currencies
Disruptive Disintermediation
Payments (networks access)
- list disruption in existing currencies
Paypal, ApplePay, Samsung pay, Andriod Pay, M-Pesa (telephone system in Africa to pay invoices)
- list disruption via new currencies
Bitcoin and derivative crypto currencies
Disruptive Disintermediation
Investment (Risk Assessment)
- list disruption in Debt
- list disruption in Equity
Disruptive Disintermediation
Investment (Risk Assessment) - list disruption in Debt peer to peer lending; invoice based lending (P2P receivables invoice financing) - list disruption in Equity crowdfunding, not for profit
Disruptive Disintermediation - Banks, key points
- Essentially banking is just a collection of data‐driven services
- Value proposition for payments is the provision of a network + authentication of participants
- Technology is providing strong competition to banks in both of these areas
- Payment services are valuable to a bank as they don’t consume much risk capital
- Investment services are different, as a bank ‘s value‐add includes risk assessment expertise
- However there is a segment of investors who are happy to forego this intermediation
Consider the DELTA model in the context of Disruptive competition.
- Delta model is the triangle; one point is Access / System Lock In; one is best product; final is total customer solution
- Consider Disruptor Type and whether it is Total Customer Solution, Best Product or System Lock In
- Alternative Remitters (Apple Pay?)
- Crypto Currency Platforms (Bitcoin)
- Debt Disintermediators (peer to peer lenders)
- Equity Disintermediators
What are limiting constraints on parallel service providers that restrict building / growth of traditional lending services (6)
- Demand for credit (network effects =- social media etc. Infinite amt of bad borrowers
- availability of funding (solid trusted reputation? credibility)
- margin
- risk assessment
- regulatory constraints (NSFR, LCR etc) (risk of over-regulation vs poor reg, eg Ponzi schemes. Current reg is for deposit takers (ADIs)
- Other
LEDGERS
Bank ledgers and money
- Banking and money is an eco system of maintained ledgers.
- Physical forms of money have evolved to bank (trusted) ledgers, backed up by central bank ledgers. Electronic version of a paper system
- The modern banking system is a network of trusted, regulated “ledger custodians”
LEDGERS and TECHNOLOGY
List two big challenges to directly substituting banks with pure technology
- Verifying the entities taking part in the transaction are who they say they are
• Banks check the identity of their customers, and of their transactional counterparties
• Customers rely on the regulated status of a bank, and/or on government‐backed deposit insurance - Ensuring records reconcile and that no “double spending” happens
• One great advantage of electronic records is that they are easily replicated, however…
• When records represent value, that represents a risk to the stability of the money supply
Distributed database technology is good at …
Distributed database technology is good at transmitting, updating, and storing records
PUBLIC KEY CRYPTOGRAPHY
- describe
- Security keys and identity verification
- mathematical ‘padlock’ (mathematical algorithm) with 2 keys
- either key can lock it but only the other key can unlock it
- you receive ‘package’ locked with your padlock = only you can open it
- you send package locked with your padlock that opens with B key, verifying that you locked it (this is identity verification)
PUBLIC KEY CRYPTOGRAPHY
Challenges with ‘signed’ transactions:
Solution:
– How does the world know you possessed the money / asset in the first place?
– What is to stop you transferring the same money twice via two I.O.Us?
– What do we mean by “publish”, and where?
(solution - blockchain; a trusted distributed ledger)
Blockchain Basics
- custodians and blocks
• Collect all the (signed / locked) I.O.Us written in a given period into a “block” of transactions
• Broadcast that block to a distributed population of “ledger custodians” who each add it to
their copy of an ever‐growing list of blocks that stores all of the transactions ever done
Blockchain Basics
- how is an individual’s balance determined
• The list (ledger) is structured so that it is quick to interrogate all of the payments to and from any
individual, so their balance can be found from the difference between inflows and outflows
Blockchain basics
- How does the custodian validate the block / relationship with individual’s account
- Once solution is found…
- why is it a “chain”
• Custodians check all payments to/from individual to check all transactions in the block are valid before adding it to the list
• The first custodian to finish validation broadcasts their result to the others, who then can
abandon their own work and update their copies of the list to reflect the new transactions
• Each block on the list is encrypted with a number derived from the previous block, so they
form a “chain” and changing an older block will mean recalculating all subsequent blocks
Blockchain Challenges & Solutions
– Needed to guarantee a universally agreed ordering of all blocks across the network
– Otherwise a user might broadcast many simultaneous transfers of the same funds
– And what about rogue custodians?
(as long as the majority of participants are honest, the system works, as there is validation and reconciliation through the system)
Solutions
– A voting and tiebreaking process that discards duplicate or flawed updates
– Custodians are required to do “proof‐of‐work” as part of validation process
- Solve the maths problem - the difference between one block and the next block
Blocks deeper in the chain..
Blocks deeper in the chain are extensively validated, and changing them requires a rogue agent to redo all the computational work already done to break and rebuild the chain. Chain is getting longer all the time.
Block Chain
Proof of work - solving the problem
- Computationally find a solution to a difficult numerical problem
- Problem is parameterised by the contents of the block – so is different for each block added
- Solution has to be found by trial and error, which each custodian trying different values
