Bitcoin – to fork or not to fork?

Anyone following the crypto-currency markets this past two weeks will be fully aware that this has been a turbulent time for Bitcoin and other blockchain assets. First, the SEC published its Report on the DAO.  Second, there was a significant arrest in connection with the Mt Gox failure. And third, Bitcoin underwent a fork which has resulted in a new version, known as Bitcoin Cash. Meanwhile, at the time of writing, the price of Bitcoin itself is testing renewed highs, and continues to enjoy a 3-month long rally.

What implications do each of these developments have for the digital asset industry?

Photo by Andre Chinn – Image sourced from Flickr under Creative Commons

The Mt Gox-related arrest came as Japanese authorities began separate criminal proceedings against the former head of the failed exchange. These developments underscore two things: 1) as with any complex financial fraud investigation, bringing the culprits to justice takes time. 2) exploiting the financial system for ill-gotten gain is not exclusive to crypto-currencies – just ask investors in Australia’s CBA bank how they feel about losing nearly 4 per cent of the value of their shares in one day on the back of a money laundering scandal.

It also means that as regulators play catch-up, exchanges, brokers and other participants in the crypto-currency markets will need to ensure that they are updating their security and privacy systems (to prevent future hacks) while ensuring they comply with AML/KYC/CTF provisions. No bad thing, to instil confidence and trust in this emerging asset class, which is entering a new phase of maturity.

The SEC Report on the DAO, meanwhile, has put ICO’s (Initial Coin Offering) and TGE’s (Token Generation Event) on notice that in some cases, these products will be treated as securities, and will be subject to the same regulation as public offers of shares etc. As a result, token issuance programs will need to structure their sale processes to be either fully compliant with, or exempt from, the regulations; at the very least, they must remove any suggestion that these tokens are capable of creating security interests in financial or dividend-bearing assets, unless that is the express intention. (In some cases, these tokens are sold as membership services, software and IP licenses, or as network access permits. Any “return” to the buyer comes from the network value effects, service discounts or user rewards, similar to frequent flyer schemes and customer loyalty programs.)

Again, this suggests a coming of age for digital assets, and a growing maturity in the way token sales can be used as an alternative to VC funding and other traditional sources of raising operating capital and project financing.

The Bitcoin fork was hugely anticipated, with a mix of fear and excitement – fear because of the unknown consequences, excitement at the prospect of Bitcoin holders getting “free money” in the form of “Bitcoin cash“, via a 1:1 issue. Without getting into the technical details, the fork was prompted by the need to increase Bitcoin’s blockchain processing speed and transaction capacity; and while nearly everyone connected to Bitcoin’s infrastructure agreed on the need to accelerate block performance, there was a schism as to how this should be achieved. Some exchanges said they would not recognise the new currency, and only some Bitcoin miners said they would engage with it (especially as the cost of mining the new asset was more expensive than Bitcoin core). In addition, most exchanges were advising their customers not to attempt performing any Bitcoin transactions for several days, before and after the fork, until the system settles down again.

In the aftermath of the fork, at least one more exchanges has said it will probably offer some support Bitcoin cash; while due to the nature of the fork, Bitcoin cash’s own block processing time was something like 6 hours – meaning transactions could not be confirmed, and holders of the new asset could not easily transfer or sell it, even if they wanted to. It feels like a combination of a liquidity squeeze, a trading halt, and a stock split resulting from a very complex corporate action.

So far, the value of Bitcoin has held up, while the value of Bitcoin cash has steadily declined (despite an early spike), almost flat-lining to less than one-tenth of the value of Bitcoin:

Relative value of Bitcoin cash (BCH) to Bitcoin (BTC) – Market Data Chart sourced from Brave New Coin

I’m not a “Bitcoin absolutist“, as I think different currency designs and technical solutions will continue to emerge based on specific use cases. These products will continue to co-exist as markets come to understand and appreciate the different attributes and functionality of these digital assets.

As a consequence of recent events, some new token projects are refining the design of their issuance programs, more legal opinions are being commissioned, and raise targets are being adjusted in light of the current climate. But the number of new projects coming to market shows no sign of abating, and the better projects will have successful and sustainable sales. The total market cap of all digital assets is now well over $100bn (although the data reveals something of an 80:20 scenario – the top few assets account for the bulk of that value); and more institutional investors and asset managers are taking a greater interest in this new asset class.

NOTE: The comments above are made in a purely personal capacity, and do not purport to represent the views of Brave New Coin or any other organisations I work with. These comments are intended as opinion only and should not construed be as financial advice.

Next week: Bringing Back Banter   

 

 

Spaceship launches the future of superannuation

Backed by some stellar names in the tech and startup worlds, Spaceship describes itself as a superannuation fund designed to “invest where the world is going, not where it’s been”. Squarely aimed at 18-35 year-olds (and savvy people in their 40s and 50s….), it is the brainchild of Paul Bennetts (a Partner at AirTree Ventures), Andrew Sellen (ex-Marketing Manager at Australian Ethical Investments) and two tech co-founders, Dave Kuhn and Kaushik Sen. Their central thesis is that global tech stocks are the future, and that these assets should form a greater part of a fully diversified portfolio, with a 10-year plus investment horizon.

spaceship-logo-03I first connected with Paul a couple of years ago, when I was working with a legal technology startup that was an early graduate of the Melbourne Accelerator Program. He was interested in what we were doing at Ebla, but the company was at too early a stage for him to invest in. But I’ve kept an eye on what Paul has been doing since, and have followed the Spaceship story quite closely. We last caught up very briefly during a recent roadshow event in Melbourne, as part of the Spaceship beta launch.

Any new superannuation brand, especially if it is neither an industry fund nor a retail fund backed by a major financial institution, is going to struggle to attract members: the industry and public sector funds have the benefit of workplace incumbency (sometimes backed by industrial awards), and the big retail funds have extensive distribution channels via advisor platforms, dealer groups and financial planners. As for corporate superannuation funds, in my experience, many of these employer-run funds are often a re-badged or customised version of an existing retail fund, or a highly outsourced business that retains the company name for brand recognition among employees.

Spaceship is challenging the market by using technology (and very targeted marketing) to streamline the recruitment and on-boarding process. As evidence of its marketing success, Spaceship claims to have built a waiting list of 12,000 prospective members in just 30 days, mostly through social media and word-of-mouth. And as evidence of its success in attracting “smart” money, witness some of the big names who have backed the venture as investors, or joined as members themselves.*

Not surprisingly, Spaceship is also developing some interesting content marketing and social media tactics to drive member engagement. This includes thought leadership on portfolio diversification, understanding investment horizons, accessing investments in early-stage tech companies, and investing in tech brands that its members love and use.

But while much of the media coverage for Spaceship has been positive, it has already drawn detractors (almost in the same breath…). Some of the latter reckon that it won’t achieve necessary scale to be sustainable (in light of APRA moves to drive consolidation among smaller funds), it will be highly concentrated in its exposure to tech stocks (which have a tendency to be more volatile), and without face-to-face contact with members, it will be harder to drive customer engagement.

Given that, following some delays, Spaceship does not launch to the general public until the end of this month (it is still running a waitlist), it’s probably a bit churlish to say it is doomed to failure before it has even really begun. Equally, having worked in financial market research myself, I have met with a number of industry, public sector, retail and corporate superannuation funds who cite member engagement and retention as one of their biggest challenges. The main issue is this: how do you interest an 18-year old in something from which they won’t derive any benefit for at least 40 years?  And once you have got their attention, how do you sustain that interest over the lifetime of their membership and into retirement?

Now technology is having a larger part to play in disrupting the superannuation industry, and changing the way members interact with their fund. As the COO of a major industry fund said recently at a FinTech Victoria event, “consolidating your super balances is only three clicks away” (to which Spaceship, replied “it’s now only one click!”). But it’s not enough to have a smart phone app to check your balances, switch investment options or make voluntary contributions. Members are looking for other services, such as financial education, estate planning, insurance, loans and mortgages, and tailored advice. Plus, they expect much more streamlined processes and pro-active member support.

I suspect that a key factor that will likely contribute to Spaceship’s potential success is the growth of the gig economy:

First, with more people working as freelancers, contractors or becoming self-employed, they will have no ties to a fixed workplace or a single employer – so they will be drawn to a fund product that appeals to their independence and flexibility.

Second, much of the gig economy lies in the tech and startup sectors, so again, prospective members might well be looking for a fund that invests in what they are interested and involved in themselves.

Third, if we are all expected to live and work longer, and if we are going to have to rely more on our own accumulated retirement assets, a fund that fully aligns with this long-term investment philosophy is hopefully going to be better placed to help us meet our financial goals.

Of course, it’s worth remembering that the Australian superannuation industry is both large ($2.1tn in assets as at September 2016, and the 3rd largest pool of pension funds in the world), and highly regulated (for very good reason). Equally, it has been slow to adapt to a changing economy and to different market factors, and is increasingly dominated by just a few big funds. Among some large industry funds, there is almost a cosy, symbiotic relationship between their members (who work in say, construction, energy, mining) and some of the assets the funds invest in (infrastructure, buildings, utilities). (But that may prove to be Spaceship’s USP – representing members who work in the tech sector?)

Although the Australian superannuation and managed funds sectors have established strong capabilities in administration, trustee, custody and asset management services, many of these back-office operations run on legacy IT systems which are potentially ripe for disruption. Plus, while government initiatives look for ways to attract more offshore institutions to place their assets with Australian fund managers, under various financial passport arrangements Australian institutions can invest in offshore funds domiciled and managed in key investment centres such as Luxembourg and Singapore.

Finally, new entrants to the superannuation industry are less likely to be reliant on incumbent and legacy service providers, and more able to take advantage of emerging technologies such as blockchain solutions (distributed ledger platforms), and fully integrated end-to-end CX (mobile apps and tools).

* Declaration of interest and disclaimer: I was successful in signing up to Spaceship in beta/waitlist, and have allocated a small portion of my own super to the fund. I do not have any other commercial connection with Spaceship or its founders. I have not been paid to write this article, nor should it be construed or interpreted as financial advice – it has been provided for general information only. BE SURE TO SEEK YOUR OWN INDEPENDENT FINANCIAL ADVICE BEFORE MAKING ANY FINANCIAL INVESTMENT.

Next week: Gaming/VR/AR pitch night at Startup Victoria

A Tale of Two #FinTech Cities – Melbourne vs. Sydney….

Inter-city rivalry between Melbourne and Sydney is nothing new. The fact that neither city is the national capital only adds to the frisson. The usual debates as to which is the better for sport, culture, beaches, food, weather, property prices, live music, public transport and coffee normally mean Melbourne edges out Sydney in most categories. (But then, I’m probably biased – however, having lived and worked in both, I think I am reasonably objective.)*

When it comes to startups, and FinTech in particular, the debate is beginning to hot up. At a recent FinTech Melbourne Meetup the topic was “is there room for both?”. The speakers, Toby Heap for Sydney, and Stuart Richardson for Melbourne, remained tactful and diplomatic, as it’s not really appropriate to talk about which is better – more a case of choosing “which is the right location for your own particular FinTech”. So, the debate avoided mere point-scoring, and tried to establish some commonalities, as well as provide some considered views on the benefits inherent within the key differences.

Both cities have a growing reputation for startup success, built on some core foundations: groups of angel investors and VC funds with an increasing FinTech focus; several accelerator programs, incubators and co-working spaces; and a community of founders and aspiring tech entrepreneurs.

From an industry perspective, two of the four Pillar Banks are headquartered in Sydney, and two in Melbourne. More insurers have their HQ’s in Sydney compared to Melbourne (apart from health insurance, where Melbourne hosts the largest market providers), while Tier 2 and regional banks (by their very nature) are more likely to be located outside either city (not including wholly owned brands of the Big 4).

As for pension funds and asset management, particularly in relation to Australia’s superannuation sector, Melbourne is clearly the bigger player, particularly for the largest industry funds (based on their historical links to the trade union movement). In addition, Melbourne is home to some substantial family offices, as well as specialist asset managers, including overseas firms. After all, Melbourne’s establishment wealth comes from the nineteenth century gold boom.

When it comes to markets, Sydney wins out by virtue of housing the main equities exchange, as well as being a hub for futures, fixed income and forex. Sydney also hosts more investment banks, including local branches of foreign players.

In some respects, the differences can be likened to the market roles and dynamics of London vs Edinburgh, New York vs Boston, Frankfurt vs Munich, or even Hong Kong vs Singapore, for example.

For me, however, the key distinction between Sydney and Melbourne can be summarised as: “Sydney trades, Melbourne invests”.

* Note: Content in Context is taking a well-deserved break. Starting this week, the next few posts will feature some brief blogs on different aspects of FinTech. Normal service will be resumed in early November

Next week: do we need a #FinTech safe harbour?

Assessing Counterparty Risk post-GFC – some lessons for #FinTech

At the height of the GFC, banks, governments, regulators, investors and corporations were all struggling to assess the amount of credit risk that Lehman Brothers represented to global capital markets and financial systems. One of the key lessons learnt from the Lehman collapse was the need to take a very different approach to identifying, understanding and managing counterparty risk – a lesson which fintech startups would be well-advised to heed, but one which should also present new opportunities.

In Lehman’s case, the credit risk was not confined to the investment bank’s ability to meet its immediate and direct financial obligations. It extended to transactions, deals and businesses where Lehman and its myriad of subsidiaries in multiple jurisdictions provided a range of financial services – from liquidity support to asset management; from brokerage to clearing and settlement; from commodities trading to securities lending. The contagion risk represented by Lehman was therefore not just the value of debt and other obligations it issued in its own name, but also the exposures represented by the extensive network of transactions where Lehman was a counterparty – such as acting as guarantor, underwriter, credit insurer, collateral provider or reference entity.

Before the GFC

Counterparty risk was seen purely as a form of bilateral risk. It related to single transactions or exposures. It was mainly limited to hedging and derivative positions. It was confined to banks, brokers and OTC market participants. In particular, the use of credit default swaps (CDS) to insure against the risk of an obiligor (borrower or bond issuer) failing to meet its obligations in full and on time.

The problem is that there is no limit to the amount of credit “protection” policies that can be written against a single default, much like the value of stock futures and options contracts being written in the derivatives markets can outstrip the value of the underlying equities. This results in what is euphemistically called market “overhang”, where the total face value of derivative instruments trading in the market far exceeds the value of the underlying securities.

As a consequence of the GFC, global markets and regulators undertook a delicate process of “compression”, to unwind the outstanding CDS positions back to their core underlying obligations, thereby averting a further credit squeeze as liquidity is released back into the market.

Post-GFC

Counterparty risk is now multi-dimensional. Exposures are complex and inter-related. It can apply to any credit-related obligation (loans, stored value cards, trade finance, supply chains etc.). It is not just a problem for banks, brokers and intermediaries. Corporate treasurers and CFOs are having to develop counterparty risk policies and procedures (e.g., managing individual bank lines of credit or reconciling supplier/customer trading terms).

It has also drawn attention to other factors for determining counterparty credit risk, beyond the nature and amount of the financial exposure, including:

  • Bank counterparty risk – borrowers and depositors both need to be reassured that their banks can continue to operate if there is any sort of credit event or market disruption. (During the GFC, some customers distributed their deposits among several banks – to diversify their bank risk, and to bring individual deposits within the scope of government-backed deposit guarantees)
  • Shareholder risk – companies like to diversify their share registry, by having a broad investor base; but, if stock markets are volatile, some shareholders are more likely to sell off their shares (e.g., overseas investors and retail investors) which impacts the market cap value when share prices fall
  • Concentration risk – in the past, concentration risk was mostly viewed from a portfolio perspective, and with reference to single name or sector exposures. Now, concentration risk has to be managed across a combination of attributes (geographic, industry, supply chain etc.)

Implications for Counterparty Risk Management

Since the GFC, market participants need to have better access to more appropriate data, and the ability to interrogate and interpret the data, for “hidden” or indirect exposures. For example, if your company is exporting to, say Greece, and you are relying on your customers’ local banks to provide credit guarantees, how confidant are you that the overseas bank will be able to step in if your client defaults on the payment?

Counterparty data is not always configured to easily uncover potential or actual risks, because the data is held in silos (by transactions, products, clients etc.) and not organized holistically (e.g., a single view of a customer by accounts, products and transactions, and their related parties such as subsidiaries, parent companies or even their banks).

Business transformation projects designed to improve processes and reduce risk tend to be led by IT or Change Management teams, where data is often an afterthought. Even where there is a focus on data management, the data governance is not rigorous and lacks structure, standards, stewardship and QA.

Typical vendor solutions for managing counterparty risk tend to be disproportionately expensive or take an “all or nothing” approach (i.e., enterprise solutions that favour a one-size-fits-all solution). Opportunities to secure incremental improvements are overlooked in favour of “big bang” outcomes.

Finally, solutions may already exist in-house, but it requires better deployment of available data and systems to realize the benefits (e.g., by getting the CRM to “talk to” the loan portfolio).

Opportunities for Fintech

The key lesson for fintech in managing counterparty risk is that more data, and more transparent data, should make it easier to identify potential problems. Since many fintech startups are taking advantage of better access to, and improved availability of, customer and transactional data to develop their risk-calculation algorithms, this should help them flag issues such as possible credit events before they arise.

Fintech startups are less hamstrung by legacy systems (e.g., some banks still run COBOL on their core systems), and can develop more flexible solutions that are better suited to the way customers interact with their banks. As an example, the proportion of customers who only transact via mobile banking is rapidly growing, which places different demands on banking infrastructure. More customers are expected to conduct all their other financial business (insurance, investing, financial planning, wealth management, superannuation) via mobile solutions that give them a consolidated view of their finances within a single point of access.

However, while all the additional “big data” coming from e-commerce, mobile banking, payment apps and digital wallets represents a valuable resource, if not used wisely, it’s just another data lake that is hard to fathom. The transactional and customer data still needs to be structured, tagged and identified so that it can be interpreted and analysed effectively.

The role of Legal Entity Identifiers in Counterparty Risk

In the case of Lehman Brothers, the challenge in working out which subsidiary was responsible for a specific debt in a particular jurisdiction was mainly due to the lack of formal identification of each legal entity that was party to a transaction. Simply knowing the counterparty was “Lehman” was not precise or accurate enough.

As a result of the GFC, financial markets and regulators agreed on the need for a standard system of unique identifiers for each and every market participant, regardless of their market roles. Hence the assignment of Legal Entity Identifiers (LEI) to all entities that engage in financial transactions, especially cross-border.

To date, nearly 400,000 LEIs have been issued globally by the national and regional Local Operating Units (LOU – for Australia, this is APIR). There is still a long way to go to assign LEIs to every legal entity that conducts any sort of financial transaction, because the use of LEIs has not yet been universally mandated, and is only a requirement for certain financial reporting purposes (for example, in Australia, in theory the identifier would be extended to all self-managed superannuation funds because they buy and sell securities, and they are subject to regulation and reporting requirements by the ATO).

The irony is that while LEIs are not yet universal, financial institutions are having to conduct more intensive and more frequent KYC, AML and CTF checks – something that would no doubt be a lot easier and a lot cheaper by reference to a standard counterparty identifier such as the LEI. Hopefully, an enterprising fintech startup is on the case.

Next week: Sharing the love – tips from #startup founders