CFA INSTITUTE

THE STATE OF FINTECH IN 2017

Sviatoslav Rosov, PhD, CFA

FINTECH – WHAT IS IT?

• Introduction of software into bricks-and-mortar business models. Can

use experiences in other industry to predict future?

• Software typically enables:

• Accelerated industry development cycles Increased

responsiveness to consumers.

• Greater efficiency in serving consumers Fewer employees?

• Free services New business models?

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FINTECH – WHAT IS IT?

• Three conceptual pillars:

• Decentralisation

• Disintermediation

• Automation

• Three technological pillars:

• Marketplace Lending

• Robo-advisors

• Blockchain

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WHY DECENTRALISATION?

• Decentralisation allows removal of single points of failure:

• No need for centralised record keeping (e.g. depositories)

• No need for centralised decision making (e.g. bank lending)

• More resilient to security attacks?

• Fintech that decentralises:

• Blockchain - can decentralise any activity.

• P2P lending – decentralises capital marketplace?

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WHY DISINTERMEDIATION?

• No need for intermediaries to match forces of supply and demand.

• Removes the cost of the intermediary ecosystem lower costs for

consumers or higher profits for producers?

• Fintech that disintermediates:

• P2P lending – brings savers and borrowers into direct contact.

• Blockchain – removes the need for CCPs, Brokers, Custodians,

Clearing Houses and CSDs.

• Robo-advisors – no need for human financial advisors?

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WHY AUTOMATION?

• Can remove the need for human labour, or free up human capital for

more productive tasks.

• More efficient at serving large numbers of consumers.

• Fintech that automates:

• Robo-advice – more efficient way of providing simple diversified

portfolios.

• Smart contracts – execute automatically once pre-specified

conditions are met.

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STATE OF FINTECH

Let‟s get an update on the three fintech areas:

1. P2P lending

2. Blockchain

3. Robo-advisors

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STATE OF PEER TO PEER LENDING

• In an ideal world, P2P removes the need for

intermediaries (i.e. banks) to introduce

borrowers and lenders.

• Like an uber for personal/business credit.

• Removes the cost of the intermediary

ecosystem:

• Lower costs for consumers or higher profits

for producers?

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LENDINGCLUB EXAMPLE

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STATE OF PEER TO PEER LENDING

• New entrants typically not interested in selling directly to investors

(exceptions – 1G firms like Lending Club and Prosper Marketplace).

• Increasingly looking like ordinary banking/ asset management.

• Many source institutional funding to make loans:

• P2Ps apply for bank loans arguing they are serving a near-prime

customer base the banks don‟t serve.

• Some P2Ps are applying for banking licences (e.g. Zopa). Why?

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P2P – WHAT NEXT?

• Not enough retail lenders to sustain the growth rates demanded by VC

investment. Need „deposits‟ to fund loan books.

• Adopting banking/ asset management techniques to survive/ grow:

• Bundled products (look like collective investment schemes!)

• Provision funds (look like deposit insurance)

• Redemption (look like deposits)

• Graham Wellesley, founder of Wellesley & Co. says “P2P is a little bit of a

red herring”, the business is more like an “…old-fashioned building

society”.

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P2P – WHAT NEXT?

• Let‟s look at one example – Ratesetter, one of the larger UK P2Ps. Offers investment „products‟ that look like CIS.

• Regulators: “If they look like banks why aren‟t they regulated like banks?”

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P2P – WHAT NEXT?

After early enthusiasm driven by UK Treasury, the FCA has been casting a

more critical eye at the industry:

• Innovative Finance ISA (tax-free investment vehicle) has been delayed

for a second year.

• FCA consulting on tougher rules after finding “inadequate disclosures

about risk and loan performance”.

• Firms “testing the boundaries” of what crowdfunding regulations allow.

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P2P – SIDE NOTE

In many ways, P2P in China is unrelated to rest of world:

• Scale - up to 75% of global P2P market (USD 100 billion). 20% of

consumer credit.

• Late-starter advantage with consumers moving from cash & no

investment opportunities to online payments & P2P + savings culture.

• P2P are funded by individual investors, not institutional.

• To-date has been almost unregulated. Recent significant scams have led

to a looming regulatory wipe-out for majority of P2P firms.

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STATE OF BLOCKCHAIN

• 2 years ago, Bitcoin‟s design-issues caused industry to pivot towards

alternatives based on underlying blockchain tech:

• “Bitcoin bad, blockchain good”

• The industry‟s version of Bitcoin is the permissioned blockchain.

Advantages:

• Faster

• Scalable

• Conforms to regulation

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PERMISSIONED BLOCKCHAINS

• ASX was early frontrunner of blockchain commercialisation - no news

recently.

• DTCC efforts now seem to be more significant (in size and scope):

• Trade Information Warehouse – cleared & bilateral credit

derivatives ($11 trillion) post-trade to move to blockchain.

• Large firms will have their own peer nodes.

• Smaller users can access via DTCC node.

• Future Government node for complete transparency?

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BLOCKCHAIN – CHALLENGES

• Blockchain benefits proportional to network effects – the more users the

higher the benefits.

• Past attempts to cooperate on sharing databases failed.

• What will overcome cultural and competitive differences this time?

• Disadvantages of private/permissioned blockchains:

• Similar to difference between intranet (better for corporates) and

intranet (bigger impact).

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BLOCKCHAIN – NOT THE ONLY SOLUTION

• SWIFT is working on its Global Payments Innovation project.

• Not using blockchain.

• SWIFT says blockchain is not ready and not necessary to significantly

improve cross-border transactions.

• One of the biggest original Blockchain „consortiums‟ R3 now is

„Blockchain-inspired‟ consortium (i.e. does not use a blockchain).

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BLOCKCHAIN – BACK TO BITCOIN?

• Overall, commercialisation is much slower than the hype promised.

Recently another change of mood can be detected:

• “Blockchain is boring, let‟s look at Bitcoin again!”

• In part driven by large BTC price appreciation. Due to …

• Japan – legalization + Bic Camera adoption.

• India – Modi demonetization/ pending legal recognition?

• China – PBOC crackdown on KYC/AML on Bitcoin exchanges has

limited ability for miners to „cash out‟ of BTC – correction coming?

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STATE OF ROBO ADVISORS

• The UK Financial Conduct Authority (FCA) estimates 2/3 of retail financial

products are purchased without advice.

• Advice gap created by a ban on commission payments by producers to

advisors selling funds (2012).

• Retail clients don‟t want to pay EUR 100s per hour for financial advice,

advisors don‟t want low-asset clients either!

• To solve advice gap, FCA is pinning its hope on robo-advisors. Will it

work?

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ROBO ADVISORS – WHAT‟S NEXT?

• CFA Institute - 2016 Fintech Survey.

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STATE OF ROBO ADVISORS

• For independent robos, fees typically do not cover customer acquisition

costs.

• To solve this problem:

• Robos are aiming to attract older/wealthier clients that are even more

costly to acquire, but proportionally more profitable.

• Others are working with/ selling out to incumbent managers with large

client lists.

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STATE OF ROBO ADVISORS

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• Wealthfront AUM $3 billion vs. Blackrock AUM $5 trillion.

Chart source: US Census Bureau, TabbFORUM (TABB Group)

ROBO ADVISORS – WHAT‟S NEXT?

• ETF industry sees robos as promising distribution channel. Why?

• Robo-advisors sell finite number of products (typically ETF portfolios),

not „investment advice‟ in the broader sense.

• The underlying demand is for the latter.

• Future of robo advice – hybrid human/robo „lifestyle planning‟?

• Betterment – the largest US robo has recently introduced the option of

„premium‟ service – a human financial advisor.

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ROBO ADVISORS – WHAT‟S NEXT?

• Inevitably, basic financial advice (i.e. ETF diversification) will be given

away for free.

• What can you charge for? Lifestyle financial planning:

• Identifying goals and what is necessary to achieve them.

• Identifying psychological biases and how to overcome them.

• Considering personal circumstances.

• ‟What if‟ scenario planning.

• Asset managers are actually „life coaches‟?

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ARTIFICIAL INTELLIGENCE – SIDE NOTE

• In last 18 months, deep learning/ neural networks/ machine learning have

made dramatic progress.

• Impressive results in certain fields – driving/ object recognition/ game

playing.

• Essentially, machine learning is very complex pattern recognition/ data

fitting. Will it find the „secret factors‟ determining returns?

• Machine learning can only learn what is in the data – cannot cope with

„black swans‟:

• This is the main impediment to driverless cars.

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HAS FINTECH DELIVERED?

• Most interesting fintech likely to be:

1. Payments technology

• Apple Pay/ Android Pay/ Open banking API regulations

2. Blockchain

• Will anyone care if markets/ settlement move to blockchain?

3. Robo-advice

• How will it change incumbent business models?

Will artificial intelligence deliver?

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CHALLENGES FOR FINTECH

• Fintech is usually pitched as addressing „millennial‟ & „tech-savvy‟

market.

• But millennials have relatively little wealth…

• Why bother? To influence early adopters…

• Start-up business model – growth now, profit later – risky.

• VC funds „disruption‟, not „improvement‟.

• Most fintechs will „exit‟ via sale to incumbents?

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CHALLENGES FOR FINTECH

• As a result, we will likely see reinvention/ reform of existing institutions

rather than wholesale displacement:

• More efficient banking.

• Cheaper asset management.

• More efficient payments.

• We may also see increases in financial inclusion?

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FINTECH – IN THE WRONG PLACE?

• Fintech may not be life-changing for developed world.

• The „West‟ is already „overbanked‟ and any gains likely to be marginal.

• Developing world may see the biggest impact – low-hanging fruit of

financial inclusion potentially enormous.

• Similar to countries bypassing telephone lines and going straight to

3G/4G mobile networks.

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FINTECH – IN THE WRONG PLACE?

• Great use case is blockchain-based land registries. Why?

• Consider:

• Haiti reconstruction impeded by endless land ownership claims

and counterclaims.

• Land registry records held in paper form, some destroyed in

earthquake.

• Even before earthquake, most land owned „informally‟.

• Blockchain land registry schemes underway in Sweden, Ukraine, and

Georgia.

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ROLE FOR REGULATORS

• CFA Institute advocates in support of new technologies but not at

expense of:

• Market fairness/ market integrity/ investor protections

• Need to ensure new businesses that look like old business model but on

a smartphone do not fall through regulatory cracks.

Need to manage the entry of retail players mega-brands like Amazon/

Alibaba/ Facebook into financial services.

Need to ensure regulations are technologically-agnostic.

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