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?

2 FINTECH – WHAT IS IT?

• Three conceptual pillars:

• Decentralisation • Disintermediation • Automation

• Three technological pillars:

• Marketplace Lending • Robo-advisors • Blockchain

3 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?

4 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?

5 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.

6 STATE OF FINTECH

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

1. P2P lending

2. Blockchain

3. Robo-advisors

7 STATE OF PEER TO PEER LENDING

• Increasingly looking like ordinary banking/ asset management.

• New entrants typically not interested in selling directly to investors (exceptions – 1G firms like Lending Club and Prosper Marketplace).

• 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. ). Why?

8 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”.

9 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?”

10 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 regulations allow.

11 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.

12 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.

• But… as commercialisation has stalled, another change in mood can be detected:

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

13 PERMISSIONED BLOCKCHAINS

• Same idea as Bitcoin, but only known users are allowed to participate in network.

• Advantages: • Faster • Scalable • Conforms to regulation

• Disadvantages: • Similar to difference between intranet (better for corporates) and intranet (bigger impact).

14 BLOCKCHAIN – WHAT’S NEXT?

• The Australian Stock Exchange (ASX) – leading attempt at significant commercialisation.

• ASX blockchain system is ready, will make final commercial decision by end of FY 2017.

• The system would have (minimum) three nodes: • ASX • Reserve Bank of Australia, and • Australian Securities and Investments Commission (i.e. regtech):

15 BLOCKCHAIN – WHAT’S NEXT?

• 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?

• Regulatory environment:

• Currently, regulators agree best approach is ‘do no harm’. How long will that last?

16 BLOCKCHAIN – WHAT’S NEXT?

• 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).

17 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?

18 ROBO ADVISORS – WHAT’S NEXT?

• CFA Institute - 2016 Fintech Survey.

19 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.

20 STATE OF ROBO ADVISORS

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

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

21 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.

22 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’?

23 HAS FINTECH DELIVERED?

Most interesting fintech likely to be:

1. Payments technology • Apple Pay/ Android Pay • Open banking API regulations

2. Blockchain • Will anyone notice if markets/ settlement move to blockchain?

3. Robo-advice • How will it change incumbent business models?

24 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?

25 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?

26 CHALLENGES FOR FINTECH

• 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.

27 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.

28 www.cfainstitute.org