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S-Bank Mgmt > Topic 5: Disruptive Technology > Flashcards

Topic 5: Disruptive Technology Flashcards

1
Q

SHADOW BANKS
What are they?
Why were hedge funds of concern?

A

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

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2
Q

Two general challenges of the shadow banking sector

A
  1. It is often less transparent in the risks it drives / contains
  2. It is difficult to isolate shadow banking from more traditional banking
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3
Q

Addressing “too big to fail”

A
  1. change the economics of the banks
  2. some regulators starting to encourage innovation (“FinTech”) and new entrants into financial services
  3. 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”
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4
Q

Two types of Banking Innovators

A
  1. 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
  2. Disruptors (including “FinTech”)
    – Often start‐up ventures and almost exclusively technology driven
    – Aim to provide new or highly modified financial services more efficiently
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5
Q

Parallel Service Providers

  • Name alternative businesses that now have banking licence
  • Australia?
A

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.

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6
Q

Pros / Cons of entering a parallel business

PROS

A

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
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7
Q

Pros / Cons of entering a parallel business

CONS

A

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
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8
Q

Disruption in Australian banking system

A 
concerned about:
- threat of new entrants
- threat of substitution
(porter analysis)
- banking is becoming increasingly data driven (consider Google)
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9
Q

Disruptive Disintermediation

Payments (networks access)

  • list disruption in existing currencies
  • list disruption via new currencies
A

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

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10
Q

Disruptive Disintermediation

Investment (Risk Assessment)

  • list disruption in Debt
  • list disruption in Equity
A

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
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11
Q

Disruptive Disintermediation - Banks, key points

A
  • 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
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12
Q

Consider the DELTA model in the context of Disruptive competition.

A
  1. Delta model is the triangle; one point is Access / System Lock In; one is best product; final is total customer solution
  2. 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
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13
Q

What are limiting constraints on parallel service providers that restrict building / growth of traditional lending services (6)

A
  1. Demand for credit (network effects =- social media etc. Infinite amt of bad borrowers
  2. availability of funding (solid trusted reputation? credibility)
  3. margin
  4. risk assessment
  5. regulatory constraints (NSFR, LCR etc) (risk of over-regulation vs poor reg, eg Ponzi schemes. Current reg is for deposit takers (ADIs)
  6. Other
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14
Q

LEDGERS

Bank ledgers and money

A
  1. Banking and money is an eco system of maintained ledgers.
  2. Physical forms of money have evolved to bank (trusted) ledgers, backed up by central bank ledgers. Electronic version of a paper system
  3. The modern banking system is a network of trusted, regulated “ledger custodians”
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15
Q

LEDGERS and TECHNOLOGY

List two big challenges to directly substituting banks with pure technology

A
  1. 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
  2. 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
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16
Q

Distributed database technology is good at …

A

Distributed database technology is good at transmitting, updating, and storing records

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17
Q

PUBLIC KEY CRYPTOGRAPHY

  • describe
  • Security keys and identity verification
A
  1. mathematical ‘padlock’ (mathematical algorithm) with 2 keys
  2. 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)
18
Q

PUBLIC KEY CRYPTOGRAPHY
Challenges with ‘signed’ transactions:
Solution:

A

– 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)

19
Q

Blockchain Basics

- custodians and blocks

A

• 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

20
Q

Blockchain Basics

- how is an individual’s balance determined

A

• 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

21
Q

Blockchain basics

  • How does the custodian validate the block / relationship with individual’s account
  • Once solution is found…
  • why is it a “chain”
A

• 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

22
Q

Blockchain Challenges & Solutions

A

– 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

23
Q

Blocks deeper in the chain..

A

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.

24
Q

Block Chain

Proof of work - solving the problem

A
  • 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
25
Q

Block Chain

Proof of work - once problem is solved

A
  • The network will find a solution, but quite unlikely for any specific custodian (“lottery”)
  • It is the proof‐of‐work solution that is broadcast, causing other custodians to stop looking
26
Q

Block Chain

Proof of work - minimising tampering

A
  • Tampering with a block deep in the chain will require extensive CPU resources to rebuild all of the subsequent blocks – or requires winning the lottery many times
  • The chain is also growing continually, so you need to beat the entire network and catch up
  • To be safe, transactions not considered finalised until several new blocks added after them
  • Problem can be designed to get harder over time to account for technological innovation
27
Q

BITCOIN

  • relationship to Blockchain
  • relationship to traditional currency
A

BITCOIN
Relationship to Blockchain:
• Blockchains originally proposed to support Bitcoin ‐ a new, purely virtual (crypto) currency

Relationship to traditional currency
• Quantities transferred don’t relate to anything external to the system, they are just amounts
• Bitcoin acts as currency (exchanged for goods) because people believe others will accept it
Bitcoin = the first decentralised “fiat” currency

28
Q

BITCOIN

- where are bitcoins created / who controls the money supply?

A

Where created / who controls money supply if no central bank?
• Answer: the protocol itself
• Ledger custodians (“miners”) get credited newly‐minted bitcoins for validating blocks, effectively in return for their services in the network (including CPU power consumed) (ie remuneration / incentivisation)
• Designed to occur at a decreasing rate until eventually the stock of coins in circulation will
become fixed (in 2040). This is the ultimate non expansionary currency (cf central banks - cannot inflate money supply)
• After that, transactions will need to allocate a fractional Bitcoin amount for their processing (ie txn charge)

29
Q

Cryptocurrency

  • Building blocks are comprised of existing components
  • Alternative cryptocurrencies exist
A

Cryptocurrency
- comprised of Fault Tolerant Network and Secure Asymmetric Encryption (already existed)
- Bitcoin “wrapped” these with a protocol that could act as a currency. Elements added: Transactions recorded in Tamper Proof Encryption Chain; Incentives to Participate
• Alternative cryptocurrencies:
– Auroracoin, Dash, Decred, Dogecoin, Ethereum, Gridcoin, Litecoin, Namecoin,
Peercoin, Emercoin, PotCoin, Ripple, Titcoin, + many hundred others…
• Some of these even try to use the proof‐of‐work concept to do useful (numerical) tasks

30
Q

Cryptocurrency Challenges

  • Legality
  • Money Supply
  • Anonymity
  • Proliferation and Dilution
  • Offline Use
  • Computing Breakthroughs (Quantum Computing)
A

Cryptocurrency Challenges
• Legality (passive acceptance through to outright bans); As yet, no country has granted legal tender status to any cryptocurrency. Caveat emptor.
• Money Supply (Broad adoption would undermine a main tool of economic management as the amount of cryptocurrency in circulation is not linked to the state of the economy.
• Anonymity (Seen by proponents as an advantage, but by many governments as a threat)
• Proliferation and Dilution
• Offline Use
• Computing Breakthroughs (Quantum Computing)
However there is significant interest in the underlying distributed ledger technology

31
Q

Regulatory Disruptors - ideas by Mervyn King

Thesis 
– Disequilibria
– Prisoner’s Dilemma
– Radical Uncertainty
– Coping Mechanisms
A

Thesis:
– Disequilibria
Financially linked economies can persist in radically different states of health
– Prisoner’s Dilemma
Actions to benefit global financial system may feel bad for countries taking them
– Radical Uncertainty
Financial system is not always statistically well‐behaved, it is a complex system
– Coping Mechanisms
Analytical models not appropriate for radical uncertainty, better to use simple heuristics

32
Q

Regulatory Disruptors - ideas by Mervyn King

Proposals:

A

Proposals:
– Central Banks move from Lender‐of‐Last‐Resort (LOLR) to Pawnbroker‐of‐All‐Seasons (POAS)
– Ring‐fenced transactional banks to have liabilities 100% invested in highly liquid government debt
– Banks with liabilities >1yr to preposition their assets with Central Bank for “instant” repo funding
– Central Bank assigns haircuts to asset values, based on estimated eventual sale value in “normal state”
– Banks to publish their “repo coverage” and remain within a fixed range mandated by regulation
– This would essentially institutionalise QE as an instant “on demand” facility

33
Q

Advantages of QE Assets

A
  • no firesale, CB can hold for a longer period of time than a commercial bank
  • CB acts as specialist bank for lending for a period of time, can underwrite this by printing money
  • Mervyn King proposes CB provising insurance to commercial banks which then lend to the economy. Australia does this through the CLF concept.
34
Q

BoE Mark Carney speech 2016 Enabling the FinTech Transformation

Ledger
FinTech can deliver…(3)

A
  1. Ledger: centralised, now digital and may be distributed
  2. FinTech may deliver
    - more resilient financial infrastructure,
    - more effective trade & settlement,
    - new ways to encode, share and analyse data
35
Q

Cryptocurrency Challenges

A

Cryptocurrency Challenges

  • Legality
  • Money Supply
  • Anonymity
  • Proliferation and Dilution
  • Offline Use
  • Computing Breakthroughs (Quantum Computing)
36
Q

Mark Carney speech FinTech

There is no finance without..
Money & credit could not exist without..

A

There is no finance without the ability to record transactions, balances and obligations
Money & credit could not exist without
- recording and netting of debits, credits;
- debt to circulate as currency,
- money to replace memory
- trade

37
Q

Mark Carney speech FinTech

Advantages of FinTech

A 
Potential for:
1. more resilient financial infrastructure
2. more effective trade & settlement
3. new ways to encode, share and analyse data
4. shorter / speedier txn chains
5. greater capital efficiency
6. stronger operating resilience
For consumers:
a) more choice
b) better targeted services
c) keener pricing
38
Q

Mark Carney speech FinTech

New entrants in FinTech include

A
  1. pmt providers
  2. peer-to-peer lenders
  3. robo-advisers
  4. innovative trading platforms/FX agents
39
Q

Mark Carney speech FinTech

Enabling FinTech (BoE)

A
  1. widen access to CB money to non bank Payment Service Providers (PSPs); by providing access to BoE RTGS (diversifies the # of settlement firms)
  2. provide access to CB money for new forms of wholesale securities settlement (welcomes the potential of distributed ledger technology)
  3. Explore Distributed Ledger technology including in the operation of RTGS (BoE)
  4. Partner with FinTech Cos (Big Data; cyber security etc)
  5. Calibrate regulatory approach to FinTech developments
40
Q

Mark Carney speech FinTech

Distributed Ledger technology - pros…

A
  1. simplify the settlement chain
  2. reduce its cost
  3. raise speed
  4. increase resilience (multiple copies exist, therefore continues to operate if parts are knocked out)
41
Q

Mark Carney speech FinTech

Requirements of CB payment system (in the context of potentially accepting DL):

A
  1. must be able to be scaled
  2. retain data integrity
  3. operate at speeds & volumes required by CB architecture
  4. Maintain privacy

S-Bank Mgmt (5 decks)

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