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RA_WhitePaper_RisksRewards_Rollins_2 15 16


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RA_WhitePaper_RisksRewards_Rollins_2 15 16

  2. 2. RISKS AND REWARDS OF THE NEW FINANCIAL WORLD ORDER The financial revolution we’re witnessing can be broken into three phases: digitization, disaggregation and decentralization. Executive Summary It’s the end of financial business as usual. So-called “fintech” startups and the incumbents—traditional banks, insurance and financial services entities—are best described as frenemies, mutually dependent in many ways, but diverging most dramatically in IT capabilities that enable the startups to aim their “short stack innovations”—a multitude of consumer-friendly apps and dashboards running on advanced algorithms and APIs— at the traditional players. The financial revolution we’re witnessing can be broken into three phases. The first is the digitization of currency/capital itself, a Pandora’s Box in terms of
  3. 3. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER introducing unquantifiable risk, complexity and liability into the banking system, along with ease, speed and more financial inclusion. The next and current full-throttle phase is buffeted by the triple play of disaggregation—of data, the products/services of banks, insurance and finance companies, and the sector itself. The third incipient phase is all about decentralization of the current central electronic ledger system. The technology threatening to upend the centralized model is blockchain, which, while potentially eroding margin for Wall Street interests, is projected to save the overall financial sector $20 billion by diminishing the complexity that plagues the opaque payments and settlement systems. Blockchain technology applications range from storing client identities to handling cross-border payments, from clearing and settling bond or equity trades to smart contracts that are self-executing. Blockchain technology was once eyed warily by the incumbents in the wake of wild Bitcoin currency fluctuations and the Mt. Gox and Silk Road incidents. But now, there is no higher priority undertaking than blockchain experimentation at almost every major bank worldwide. Finally, there are huge developments in PII and identity authentication, with blockchain contributing here as well.
  4. 4. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER “FINTECH” HAS INTRODUCED SOME MUCH-NEEDED HIGH TECH AND PARADOXICALLY AUTOMATED HIGH TOUCH TO THE STAID FINANCIAL WORLD. The Frenemies of Finance As it has with media, music, transportation, and hospitality, digital technology is revolutionizing every aspect of our financial lives: How money is moved, stored, spent and managed, even what constitutes currency in the first place. The current revolution features two apparent adversaries: old guard financial institutions and the financial technology startups that are in a position to grab up to $4.7 trillion in revenue and $470 billion in profits from them, according to a recent Goldman Sachs study1 . “Fintech” has introduced some much-needed high tech and paradoxically automated high touch to the staid financial world, prompting irrational venture capital exuberance and everything from utopian post-banking-world prognostications, which bring the “unbanked” onto the global ledger, to more dystopian scenarios about shadow banking business as usual. One thing is certain: This is a high-stakes game, as global GDP is predicted to reach $85 trillion by 20202 —a four-fold increase over four decades—and this translates into greater demand for financial services everywhere. Let’s take a look at the two sides of the revolutionary coin, so to speak. Fintech’s slick, simple apps and actionable dashboards—running on data-mining algorithms that reverse centuries of financial services’ back-office opacity— should double usage in 2016, says Ernst Young. These startups are often long on innovation—algorithmic lending, pattern extraction on IT logs to detect fraud, real-time spending analysis on transaction data, block chain-based transactions, etc.—and short on regulation. But despite the appearance of a complete break with banking as usual, fintech owes a largely unrecognized (at least to the average consumer) debt to the financial infrastructure, as most use incumbent financial institutions as their backbone for real cash, regulatory bona fides and government guarantees. The NYSE, for example, began a real-time price index that tracks the valuation of Bitcoin based on data provided by Coinbase, a leading Bitcoin platform at the forefront of the industry and the first regulated Bitcoin exchange in the US. Coinbase was chosen by the exchange because of its commitments to transparency, security and regulatory compliance. 1. “Slings and Arrows,”, May 9, 2015 2. “Fintech: Friend or Foe?,”, Dec 22, 2015.
  5. 5. The traditional financial services industry, long on regulation due to 2008 crisis- precipitated changes, increased reporting and transparency requirements, is short on open source software, mobile, cloud and digital innovations. They owe fintech a debt, as some expect it to cure many of the diseases of the financial system— such as opacity, complexity, lack of competition, poor business culture, and high operational costs. From payment processors and alternative P2P or marketplace lending firms to automated investment services, aka “robo-advisers,” fintech brings fresh ideas about making the security, movement and performance of money easier and generally cheaper. One model of “easier’’ is Betterment, a startup that provides automated investment services and personalized advice. Inc. reports that Jane Bryant Quinn, a prominent financial journalist and retirement expert, recently sang the company’s praises: “I love these automated financial advisers, and not just for millennials. Betterment is the only one that has an automatic plan for dealing it [your money] out over your retirement. The others will probably get to that eventually, because you really need both kinds of automatic planning.”4 Lending Club is an example of cheaper. Its ongoing expenses as a share of its outstanding loan balance is about 2%; the equivalent for conventional lenders is 5–7%. Banks borrow heavily to fund lending; the new marketplace or P2P platforms do not. Fintech lenders like Lending Club, Prosper and Zopa simply match borrowers and savers directly. When consumers use bitcoins instead of credit cards, both merchants and consumers save. Credit card and debit fees in the U.S. totaled $72 billion in 2013, according to Gil Luria, an analyst at Wedbush Securities Inc.5 Bitcoins also make buying unused gift cards cheaper on and Starbucks, Target and Whole Foods purchases cheaper on the Fold mobile app. Insurtech, lagging fintech a bit, is nevertheless in the disaggregation game as well, “chopping up the Gecko,” as Core Innovation Capital colorfully puts it. 3. Fig. 1. “Lending, Investments, and Personal Finance: 102 Startups Attacking the Banking Value Chain,’, February 3, 2016. 4. Zoe Henry,“8 Emerging Fintech Startups to Watch in 2016,”, 2016. 5. Anthony Effinger, “Coinbase Leads Move to Bring Bitcoin to Masses,”, September 30, 2015. 6. Fig. 2. Arjan Schutte, Thomas Smythe, “Slicing Up the Gecko: How Tech Start-ups Can Disrupt A $5 Trillion Industry, Core Innovation Capital, May 2015. Fintech companies are disaggregating the financial sector via marketplace lending, direct lending and underwriting, bill pay/money transfer, online mobile banking, personal finance and robo advisors.
  6. 6. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER FINTECH COMPANIES AVAIL THEMSELVES OF APIS AND FLOAT THEIR PRODUCTS ON CLOUD SERVICES SO THEY CAN BUILD AND DELIVER FASTER. Partial and Full Stack Technological Change One way to characterize the financial revolution underway is to talk in terms of partial and full stack technological change. The consumer experiences that US-based fintech startups are engineering are shaking up incumbents using legacy systems sometimes 30 years old. Fintech companies avail themselves of APIs and float their products on cloud services so they can build and deliver faster. In effect, they access API data like an on-premises database, but not one that is compliance-constrained and resource-strapped. Stripe’s API enables merchants to accept payments in 130 different currencies and Square’s Connect API lets merchants and third- party developers improve the Square platform for payments, refunds and deposits. Big players are in the financial API game too: Google offers two popular Wallet APIs for streamlining payment and loyalty programs, and MasterCard, Visa, PayPal and Apple are advancing mobile wallet and money transfer in myriad ways. According to Joe Boroi, Associate Director of Technology at Resource/Ammirati: “Today, you no longer build a website, or build a web application, or even build a mobile app. Instead, you build a distributed system of loosely coupled solutions deployed in the cloud. The world started to embrace agile delivery because we needed to build faster, more modularized iterations that are redundant and scalable.” Insurtech startups are also using API-enabled big data, giving them a real-time edge. Traditional insurance companies pool risk by collecting disparate data about scale populations to foresee risks and price against the odds of them occurring. That actuarial advantage is eroding as data becomes more widely distributed and accessible.
  7. 7. Rather than reviewing a decade’s worth of static data, insurtech companies are using structured and unstructured data, including data from sentiment and social network analysis, to power predictive modeling. Both fintech and insurtech are unbundling the front- and back-office functionality of established “supermarket” or soup-to-nut players. But for all that, most fintech companies are not quite as disruptive as they’re perceived to be by consumers. They’re offering “partial stack technology” solutions because they don’t have the means to design, build and distribute a new product, all while creating the entire ecosystem to support it. Most rely on banks or fully disclosed clearing firms to run their businesses. On the other hand, “full stack technological” change to the financial services, banking and insurance industries would entail an end-to-end solution (similar to the cases of Uber, Tesla or Netflix). Standard Treasury is a startup creating a set of APIs that make it possible for any firm to more efficiently create a full stack solution—and to round out their own ecosystem, they were acquired by Silicon Valley Bank. Interestingly, an API survey recently conducted by Bank Innovation and the Berlin-based Open Bank Project revealed that 26% of banks surveyed already had APIs built or underway, while 38% planned to build one in the next year. FINANCIAL SERVICES VALUE CHAIN IN THE SUPERMARKET AGE THE NEXT-GEN FINTECH STACK 7a. Fig. 1. Doug Nelson, “Financial Services Unbundling, Revisited,”, February 11, 2015 7b. Fig. 2. Doug Nelson, “Financial Services Unbundling, Revisited,”, February 11, 2015
  8. 8. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER But the star of full stack technology is blockchain, whose most notorious application is Bitcoin. Ajay Vij, vice president and head of financial services at Infosys in Europe, describes blockchain technology this way: The distributed ledger—the central nervous system of the Bitcoin system—is the most sweeping departure from the long-standing financial bookkeeping practices followed since the codification of the Medici’s double entry accounting system… Satoshi Nakamoto, the mysterious creator of the bitcoin,solvedabigproblemofbookkeeping in a decentralized way. He did this through a distributed ledger called a blockchain. It takes the form of a distributed database, hardened against tampering, against which anyonecanverifythevalidityoftransactions. This operates alongside a unique set of monetary incentives (i.e. bitcoins) to encourage network’s owners (the bitcoin miners) to keep the ledger up-to date.8 8. Ajay Vij, “Blockchain: Ushering a New Era in Fintech,”, December 21, 2015.
  9. 9. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER “THERE WILL BE NO REAL, NON- CONTROLLED CURRENCY IN THE WORLD. THERE IS NO GOVERNMENT THAT’S GOING TO PUT UP WITH IT FOR LONG.” —Jamie Dimon, CEO, JP Morgan Chase The financial market is split between private blockchain consortia— such as R3 (which has 42 bank members) and DAH (Digital Asset Holdings)—developing permissible ledgers that exploit trusted networks, and open-ended blockchains—such as Ethereum— that are closely aligned to bitcoin’s original design principles and applications. Overseen by the Linux Foundation, IBM is leading a blockchain effort called the Open Ledger Project with other tech giants and leading banks, including Intel, Cisco, JP Morgan Chase, London Stock Exchange Group and State Street. The Open Ledger Project is developing a library of custom-distributed ledger solutions that are not reliant on public blockchains and are aimed at cryptocurrency but also contracts, supply chain and Internet of Things applications. IBM Fellow Jerry Cuomo said, “I think bitcoin is an interesting application for blockchain but there are thousands of applications and wider use cases beyond that.” And JP Morgan Chase CEO Jamie Dimon had this to say about bitcoin: “This is my personal opinion, there will be no real, non- controlled currency in the world. There is no government that’s going to put up with it for long...there will be no currency that gets around government controls.” However, Dimon said, bitcoin’s underlying blockchain technology has a brighter future: “The technology will be used, it may even be used to transport currency but it will be US dollars.”9 And other foreign currencies, it seems. Epiphyte’s software programs allow financial service providers to convert the currency of one nation to bitcoin, make an international transfer and change the bitcoin into the currency of the destination country. On the blockchain battlefield of established players and fintech startups, Epiphyte is somewhat unique, aiming to build a bridge between established finance and cryptofinance in a low-risk, compliant way. 9. Yessie Bello Perez, “Jamie Dimon: Bitcoin Will Not Survive,”, November 5, 2015
  10. 10. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER The Digital Identity Frontier Blockchain, beyond its distributed cryptocurrency application, holds tremendous promise as digital identity management. Vitalik Buterin, one of the originals in the Bitcoin media space as the co-founder of Bitcoin Magazine, and the creator of Ethereum, said: “I think decentralization is particularly valuable for what I call “base layer” services: stuff that everything else relies on. Identity is a great example; I think that the current regime of having to “sign in with Google/Twitter/ Facebook” to everything is simply insane, and have even made the point that if this continues 10 years from now, it may be harder to change identity providers than it is to change countries.”10 Credits, “a federated blockchain framework that can communicate agnostically withotherchainsandactsolelybasedoninformationcontainedoutsidetheledger,” is close to rolling out a KYC/identity platform with the Isle of Man government. Perhaps most audacious of all the blockchain identity and notarizing services is Bitnation, which recently announced a deal with the Estonian government (arguably—if astoundingly—the most advanced digital nation on the planet). Bitnation is giving blockchain IDs to refugees so as to provide unbanked arrivals with bitcoin debit cards. Another startup, GlobalGateway, enables businesses to perform frictionless identity verification for more than 3 billion people in over 40 countries via 145 data sources—the widest coverage in the market. GlobalGateway helps businesses comply with Anti-Money Laundering (AML) and Know Your Customer (KYC) identity verification needs, and provides a reliable way for businesses to evaluate new and existing users through one, single portal or API. 10. Vitalik Buterin Conducts AMA Re: Ethereum,”, September 4, 2015.
  11. 11. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER BANK CHALLENGERS ARE ALSO INVESTIGATING THE USE OF BIOMETRIC TOOLS LIKE VOICE RECOGNITION OR APPLE’S FINGERPRINT RECOGNITION. Me2B technologies for the financial industry will soon propel another big change; individuals will be able to update and control the use of their PII data. According to Trunomi, a fintech company providing software for financial institutions to comply with know your customer (KYC) regulations: “By granting a bank or business real-time permission to access their personal data, consumers protect their personal information and streamline processes such as opening a bank account. They will also be able to control who uses and accesses their data, eliminating the Big Brother factor and ensuring prior consent to its use is granted, backed up by regulatory enforcement.”11 For identity authentication and security, bank challengers are also investigating the use of biometric tools like voice recognition or Apple’s fingerprint recognition. But, according to Alphaville/ Financial Times columnist Izabella Kaminska: “A financial system entirely dependent on Touch ID fingerprint or voice recognition tools not only discriminates against those not lucky enough to have fingerprints or voices (the limbless, the maimed, the cancer victims) it also encourages fraud to take a more human form again—from ransom and extortion to property theft and hostage-taking. It also, by the way, encourages the propagation of counter-Touch ID tech of the fingerprint skimming or voice synthesizer variety. (After all, it’s not like we don’t leave our fingerprints behind on a lot of surfaces or our voices in the air.)”12 11. Chia In, “Hype or Here To Stay: Emerging Trends of Fintech,”, June 2015. 12. Izabella Kaminska, “Fintech Paradoxes, Blacklist Edition,”, January 8, 2016.
  12. 12. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER IoT (Internet of Things) and Data Minimization Six years ago, for the first time, the number of “things” connected to the Internet surpassed the number of people. Yet we are still at the beginning of this technology trend. Experts estimate that as of this year, there will be 25 billion connected devices, and by 2020, 50 billion. The economic impact of IoT applications could be anywhere from $3.9 trillion to $11.1 trillion per year in 2025, depending on a number of factors, including declining costs of technology and the level of acceptance by consumers and workers.
  13. 13. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER “HUMAN JUDGMENT IS BEING REPLACED BY AUTOMATIC ALGORITHMS, AND THAT BRINGS WITH IT BOTH ENORMOUS BENEFITS AND RISKS.” —Bruce Schneier, Harvard’s Berkman Center Fellow and CTO of Resilient Systems To encourage consumer acceptance and confidence, privacy and security must come with near ironclad guarantees. Because of the collection of personal information, habits, locations and physical conditions over time, that is to say, all manner of contextual, behavioral (and, with wearables and ingestibles, biometric) data, companies could use this data to make credit, insurance and employment decisions. Harvard Berkman Center fellow Bruce Schneier observes that: “Human judgment is being replaced by automatic algorithms, and that brings with it both enormous benefits and risks. The technology is enabling a new form of social control, sometimes deliberately and sometimes as a side effect. And as the Internet of Things ushers in an era of more sensors and more data—and more algorithms—we need to ensure that we reap the benefits while avoiding the harms.”13 The FTC staff discusses data minimization in its report on the Internet of Things: Privacy Security in a Connected World: Data minimization refers to the concept that companies should limit the data they collect and retain, and dispose of it once they no longer need it. Although some expressed concern that requiring data minimization could curtail innovative uses of data, the FTC staff believes that companies should consider reasonably limiting their collection and retention of consumer data. Data minimization can help guard against two privacy-related risks: larger data stores present a more attractive target for data thieves, both outside and inside a company—and increases the potential harm to consumers from such an event. Second, if a company collects and retains large amounts of data, there is an increased risk that the data will be used in a way that departs from consumers’ reasonable expectations. 14 13. Bruce Schneier, “Replacing Judgment with Algorithms,”, Jan 8, 2016. 14. “The Internet of Things: Privacy Security in a Connected World,”, January 2015.
  14. 14. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER According to a landmark study by LexisNexis® Risk Solutions, despite their view that more data is better for security, many banking experts agree with the FTC and hope to reduce the amount of PII they collect and subsequently store. The study found that unlike the retail sector, which, battered by recent breaches, has lost some consumer trust, consumers still have a high level of trust in financial institutions, with 60 percent very willing to share PII with banks, credit unions and other financial institutions. “Incidents of data breaches and identity theft have become pervasive threats to consumer trust,” said Dennis Becker, LexisNexis Risk Solutions Vice President. “Organizations need to be cognizant of how consumers’ fears and experiences affect their willingness to share sensitive data and seek ways to minimize the amount of personal information being requested.”15 15. “Companies and government agencies seek ways to reduce consumer friction by ensuring collection of most relevant personally identifiable information (PII),”, December 21, 2014.
  15. 15. RISKSANDREWARDSOFTHENEWFINANCIALWORLDORDER The Financial Future Is Already Here Though the tug of war between innovation and regulation, between access and privacy, between permission-less and permissioned-only networks will rage on for years, the financial sector’s current upheaval holds the promise of digitally demystifying personal finance—and empowering consumers everywhere. Blockchain technology, once a weapon wielded against banks by libertarians, is now being heralded as their ultimate back-office makeover. Rather than wait to see how it nets out, financial professionals would do well to prepare for the future that’s nearly here by learning blockchain and decentralization technologies and rethinking identity ownerships for their customers. Blythe Masters, formerly of JP Morgan Chase and now leading the blockchain start-up Digital Asset Holdings, said, “You should be taking this [decentralizing, blockchain] technology as seriously as you should have been taking the development of the Internet in the early 1990s. It’s analogous to email for money.”16 Dr. Nita Rollins Director of Thought Leadership Cultural Insights (and newly minted blockchain geek) 16. Jane Wild, Martin Arnold and Philip Stafford, “Technology: Banks Seek the Key to Blockchain,”, November 1, 2015.