Regulators regulate & institutions vacate, Networks are outperforming neurons in investment, 50% of global banks are at risk -- Autonomous ?NEXT #157

Hello and welcome to Fintech Focus --

We have been very busy trying to make sense of the recent chaos surrounding the massive price volatility in crypto, the tightrope Facebook seems to be walking with Libra, and the revelations taking place between FinTechs and incumbent banks. We hope you enjoy the entries below as much as we did writing them. As always, we would like to remind you that should you ever wish to refer back to previous newsletter entries, you can find them on our website HERE.

If you have any questions, comments, or suggestions regarding the content and/or structure of the newsletter, feel free to reach out to me directly on LinkedIn, Twitter, or via my email. I look forward to hearing from you.

Our top 3 thoughts for this week are:

1. CRYPTOCURRENCY & BLOCKCHAIN: Regulators regulate, whilst institutions vacate
2. DIGITAL WEALTH MANAGEMENT: Buffet called it, networks outperform neurons
3. INCUMBENT BANKS: If half the world's banks do not embrace digitalization, the next financial recession could wipe them out

Our artist of the week is Valerie Hegarty and his Fallen Bierstadt piece. Sometimes there's beauty in destruction, and maybe that's the "glass half full" perspective of the current situation with Libra.

CRYPTOCURRENCY & BLOCKCHAIN: Regulators regulate, whilst institutions vacate

“Change is the law of life, And those who look only to the past or present are certain to miss the future”

 – John F. Kennedy

Wise words from the former U.S. president whose ambitions for change were, quite literally, sky-high – the pursuit of his administration to place the first man on the moon. Such ambitions for change are what push today’s entrepreneurs to rethink products, services, systems, and value delivery to end consumers, some notable examples are: Elon Musk’s private space company SpaceX and commercial e-vehicle company Tesla, Nikolay Storonsky’s challenger bank Revolut, and Satoshi Nakamoto’s decentralized digital currency Bitcoin. Yet some would argue that such examples, especially within FinTech, are nothing more than examples of regulatory arbitrage than providers of real value (from their underlying technologies, business models and ability to automate and scale.).

 According to Investopedia regulatory arbitrage is the idea that firms capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulation (either because the regulation is not up-to-date, too slow to react, or restrictive to new entrants). Just last week we attended the OMFIF lecture by Denis Beau, First Deputy Governor of the Banque de France on ‘The role of crypto-assets in payment systems’, in which it was made clear that regulators do not have a clear cut solution to proactively address the speed at which crypto-asset entities like Libra, Binance, and Telegram move in order to ensure that they are compliant within the regulatory requirements of their operational jurisdictions.

 Now let’s talk Libra – the global digital currency and financial decentralized infrastructure that sought to empower primarily the billions of the unbanked and sparked a global debate over the role of cryptocurrencies in payments and financial services. Specifically, both private and public institutions alike have raised major concerns around the notion of a single global currency, Libra, running over new payments rails, and into a Facebook wallet called Calibra. All of which is managed by the Libra Association – a consortium of 29 private companies, including Visa, Coinbase, Spotify, Vodafone, and Andreessen Horowitz to name a few. Additionally, Libra was conceived by a global organization Facebook Inc. founded, in part, on breaking the rules, running up against the sub-global entities that created those rules, to operate a network and a currency that could unseat the power of central banks and governments to make fiscal and monetary policy.

 In early October, the Wall Street Journal reported financial partners such as Stripe, Mastercard, Visa, and PayPal were “reconsidering their involvement following a backlash from U.S. and European government officials.” Among those concerns was that Libra, backed by big private institutions, could create — as French finance minister Bruno Le Maire put it in September — “a possible privatization of money.” “The monetary sovereignty of countries is at stake,” Le Maire said – and there is a good chance he is right. But Libra threatens more than that, and both Le Maire and Beau probably know it. As regulators and governments have recently recognized that the actual idea of the countries themselves is at stake.

Needless to say that what was a tough sell at launch, has become nearly impossible four months later, and here’s why:

(1) Central banks need to accept the idea of an entirely new global financial network using an entirely new digital currency that is in part removed from their own fiat currencies (apart from those in the basket Libra is pegged to) and that could, at scale, compromise their ability to control their fiscal and monetary policies.

(2) Regulators need to be assured that Libra and Calibra – the network construct, the code, the initial digital wallet, the currency – integrates security features to prevent the likelihood of illegal activity i.e., money laundering, and ensures that, in the long run, no single representative of the 29 member consortia holds a disproportionate share of influence over the rest.

(3) Card networks and banks need to ensure that Libra and Calibra will complement their future growth and development strategy, rather than be a Trojan horse.

(4) Digital wallet providers require a similar surety that Calibra will accommodate their products and services beyond the initial P2P use cases that many of them already enable today.

(5) Attention Platforms need to be assured that Libra will help direct and enclose users into the platform via encouraged engagement and attractiveness of use (much like beautifully designed and integrated Apple software, quirky Snapchat filters, or Amazon's user-centric business model).

 Apart from this, each Calibra member has to be convinced that it’s collectively worth putting $1 billion into the Libra Association’s bank account to get it off the ground. Needless to say that over the course of the past month, seven of the Libra Association’s founding members -- mostly financial firms -- dropped out, namely: Stripe, Booking Holdings, PayPal, Mastercard, Mercado Pago, Visa, and Ebay. More importantly, Mastercard, Visa, PayPal, and Stripe represented a significant chunk of the strategic value and commercial leverage of the planned association, specifically, a huge number of payment processors and merchant touchpoints that the new cryptocurrency would need, were it to dramatically scale to the size Facebook wanted at launch.

This week, Facebook CEO Mark Zuckerberg discussed Libra before the U.S. House Financial Services Committee. Zuckerberg insisted that if America does not lead on digital payments via initiatives like Libra, foreign companies and countries will move in, perhaps without the same level of regulatory oversight. Specifically, he says, "China is moving quickly to launch similar ideas in the coming months," an allusion to the People's Bank of China's planned digital currency.

From what has been mentioned, it is clear that Libra has too many moving parts and nothing as a cornerstone to give leverage over regulators to be granted a green light, at least in the near term. Libra relied on the narrative that the financial system is broken and that the cross-border movement of money is too expensive and clunky. The only solution being a complete overhaul, the creation of a new network from scratch that would reinvent the process. Yet, the global financial system isn’t broken. The unbanked can still transfer money in minutes, via mobile money accounts (MPesa) or in cash. Entrepreneurs in emerging markets are using existing payment rails to ignite digital wallet schemes -- similar to the structure used by Alipay and WeChat Pay. 

Source: Medium (Libra — Concept and Policy Implications), BusinessInsider (Facebook’s Libra may start to lose initial backers amid regulatory pressure)

DIGITAL WEALTH MANAGEMENT: Buffet called it, networks outperform neurons

In the past, we have alluded to the fact that a major piece of the digital investment management story is the shortening of the value chain in wealth and asset management. But don’t take our word for it, take the word of the Omaha oracle Warren Buffet who in 2008 publicly bet that an unmanaged passive fund such as the S&P 500 would, over ten years, offer a higher return than an active hedge fund portfolio, evaluating the performance net of all costs and fees. The reasoning behind this bet was simple: over the long run, the active funds handled by managers would not be able to beat the market, and therefore the commissions they would charge their clients for trying to do so would make those funds less profitable than the alternative of investing in a low-cost indexed fund. Testing the idea that, over time the only winners in active management funds are those who manage them, never the investors. He wasn’t wrong.

 Let’s not give the man too much credit though, as this is hardly groundbreaking. Burton Gordon Malkiel, the Princeton University economist who wrote the 1973 investing classic “A Random Walk Down Wall Street,” famously compared the prowess of money managers to a blindfolded monkey throwing darts to pick stocks. John Clifton “Jack” Bogle, the late founder of Vanguard Group Inc. who popularized index funds, was insistent that most active managers weren’t worth the fees they charged. A pretty extreme perspective for an industry that still exists decades after making such a statement if you ask us.

 According to The Economist 35.1% of the $31 trillion in U.S. public equities are looked after by machines, driven by the low costs of new robo-markets. Specifically, passive funds charge 0.03-0.09% of assets under management each year. Whilst active managers can charge 20 times as much. Hedge funds, who use leverage and derivatives to try to boost returns further, take a 20% performance fee for incurring such risk.

 Notably, as of August this year, Bloomberg reported that “the investment industry reached one of the biggest milestones in its modern history, as assets in U.S. index-based equity mutual funds and ETFs – at $4.27 trillion -- topped those in active stock funds – at $4.25 trillion -- for the first time”. In terms of actual assets, regardless of market environment, about $20-40 billion is flowing out of active funds and into passive funds in the U.S. It’s hard to find a clearer example of a secular shift. Part of this story, of course, isn't fair to fund managers. When bad things happen in an active fund, you can blame and fire the fund; but in a passive index, you blame the market and hope it recovers. This is a permanent, psychological disadvantage.

 The second part of the story is the fantastic Backend Benchmarking Robo Report (link below). The analysis follows the performance of 34 roboadvisors, with several over a 2-year horizon, which we partly highlight. Notably – Merrill, TD Ameritrade, and Vanguard are all listed as incumbent robos. In the charts below you'll see 2 treatments of the data: (1) annualized returns vs standard deviation, sized by Sharpe ratio and colored by incumbent/startup status; and (2) an upside and downside capture ratio plot, which shows how good an allocation is at capturing alpha during market momentum. In the first analysis, incumbents like FidelityGo and Vanguard look stronger than the independents in terms of the unit of return per unit of volatility. In the second capture analysis, Personal Capital, UBS Advice Advantage, and TD Ameritrade stand out, with an upside capture ratio between 115-120%. FutureAdvisor is the worst on capture, and Merrill Edge has the worst 2-year performance. What's most telling perhaps is that 76% under-performed their benchmark (as set by this third party) YTD 2019, and 78% under-performed over a 2-year period. This seems pretty consistent with us.

Source: Autonomous NEXT Analysis, TheRoboReport (Second Quarter 2019 Robo Report)

INCUMBENT BANKS: If half the world's incumbent banks do not embrace digitalization, the next financial recession could wipe them out

We agree that this seems like a clickbait title, but there's a reason behind it thanks to the new Global Banking Annual Review 2019 report by McKinsey. Essentially the report centers around the notion that half of the world's banks are not viable due to their cost of equity being higher than their return on equity. This means that should a recession hit, the vulnerable banks will likely collapse. On a side note, to read on where we stand with regards to the digitalization of traditional banking, please refer to a previous entry here.

McKinsey notes that "Every bank is uniquely bound by both the strength of its franchise and the constraints of its markets or business model … their business models are flawed, and the sense of urgency is acute. To survive a downturn, merging with similar banks or selling to a stronger buyer with a complementary footprint may be the only options if reinvention is not feasible".

Regulators haven't helped either as newly passed regulations have aimed to increase transparency and boost competition by lowering barriers to entry, such as PSD2. These new regulations have been instrumental to consumers driving incumbents to provide more timeous, personalized, and cost-effective services across all their digital banking solutions. Whilst initially this seemed to only affect retail banking and asset management, there seems to be an expectation for similar service quality in corporate banking, capital markets, and investment banking. 

This is not the only report to raise an alarm regarding the vulnerable state incumbent banks currently find themselves in. Accenture's 5 Big Bets in Retail Payments in North America notes that "by 2025, nearly 15 percent of retail payments revenue will be at risk from card displacement by real-time payments, competition from non-banks and digital disruptors, and pricing compression" resulting in a future reality where banks exist as mere funding sources and not primary, customer-facing retail payment leaders. That 15 percent equates to a cool $82 billion directed to FinTech firms from incumbents over the next 3 years. Moreover, Accenture list five bets that show promise to help drive transformational change in the future of retail payments: (1) Reinvent revenue through new value generation, (2) Jettison legacy tech using agile technology as a foundation, (3) Run with the unicorns by embracing collaboration with FinTechs, (4) Spin data into gold via leveraging deep data analytics as the key, and (5) Treasure trust via safeguarding the consumer's best interests. 

The assault on incumbents has not purely stemmed from consumers and regulators but central banks as well. The European Central Bank (ECB) recently kept its key interest rate at a record low of -0.5 percent, whilst The Fed cut interest rates for the third time this year. With such interest rates, banks have had to pass the negative rate burden onto their customers, such is the case with Berliner Volksbank, UniCredit, and Spar Nord. That being said, it seems neobanks are taking a revolutionary stance by giving consumers a way out of this mess. Whether it's Venmo moving closer to the likes of Varo, Chime, Cleo, Stash, and N26 by announcing their first-ever credit card as part of a partnership with US-based consumer financial services company Synchrony, or zero-fee stock trading app Robinhood launching Cash Management -- a feature that earns users 2.05% APY interest on uninvested money in their account regardless of the balance. Competing directly with Betterment's 1.79% APY, and Wealthfront's Cash product with 2.07% APY interest (20 times higher than that offered by an incumbent bank). It's only a matter of time before we start to see some fireworks, let's just hope they'll be celebrations of new partnerships, rather than commiserations of missed opportunities.

Source: McKinsey Global Banking Review 2019, Accenture 5 Big bets for retail payments in North America

FURTHER READING:

• HTC's Exodus 1s can run a full Bitcoin node for under $250
• Unicef launches cryptocurrency fund
• China: Xi Jinping Tells World that Blockchain is an Important Development and China Will Take the Lead Globally

• Apple Pay is more popular than Starbucks for US mobile payments
• If you can’t beat them, join them: Fintech partnerships are here to stay
• Starling Bank Raises ￡30 Million to Fund its Expansion as it Approaches its Millionth Account
• Mobile banking app Current raises $20M Series B, tops half a million users
• Square's Robinhood competitor and Robinhood's Square competitor are rented API providers, delegating billions

• The US Military Is Trying to Read Minds
• The AI market will be worth a lot. Like, really a lot
• 40 music festivals pledge not to use facial recognition
• Liquid Warping GAN: A Unified Framework for Human Motion Imitation, Appearance Transfer and Novel View Synthesis

• Where Do Business Mafias Come From?
• Naspers Foundry is open for South African startup pitches, CEO says
• SoftBank says it has now invested $18.5 billion in WeWork, ‘more than the GDP’ of Bolivia, which has 11.5 million people

• Consuming a Virtual Reality
• The UX of virtual reality exits
• Should We Be Concerned About the Security and Privacy Risks of VR and AR?

We put this together at Autonomous NEXT, where we love Fintech, Crypto and our community. Contact us with questions and ideas.

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Thanks for reading!  

Best,

Matt