Lecture 8

• Financial innovation is somewhat controversial and not always considered good in finance
• Innovation can go too far and lack strict regulation, as seen in the GFC with CDOs and credit default swaps
• Financial innovation includes creating new financial instruments, technologies, institutions, and markets
• Private companies create financial innovations to match supply and demand
• Innovations minimize taxes, such as equity savings accounts deferring tax payments until shares are withdrawn
• Securitization is converting traditional bank assets into securities like CDOs and ABSs
• Securitization was used in the Global Financial Crisis but its role is debated
• The issue with securitization is investors may depend too highly on credit ratings
• During the GFC, credit rating agencies significantly underestimated risk
• The market for CDOs and ABSs has shrunk since the GFC

Cryptocurrency

• Before Bitcoin, only banks could create money, giving them a monopoly
• Currency is used to pay for things, but bitcoin is not ideal as its value changes
• Crypto is viewed as a vehicle for speculation
• People tend to prefer stable currencies/fiat currencies for transactions
• Quick and easy payments
• Innovative financial services
• Lack strong operational, governance, and risk practices
• Consumer protection risks due to limited oversight and disclosure
• Anonymity causes use for money laundering and terrorist financing
• Fraud cases in crypto are more common in traditional banking
• The fall of FTX cryptocurrency sparked fears of a crypto GFC, though it proved agile
• Bitcoin's value is based on speculation, but it is unlikely to disappear due to global demand
• There is also a additional money market

Acceptance of Crypto

• Bitcoin's value is based on speculation, but it is unlikely to disappear due to global demand
• Originally a skeptic, Trump suggested the US become a model for the crypto market, planning a crypto division
• In 2024, the first bitcoin ETF was approved, showing SEC recognition
• The SEC clarified it was not endorsing crypto due to its speculative, volatile nature and use for illicit activity
• The SEC is launching a crypto task force for clear regulation
• Beginning with the idea of no regulation, crypto investors are now considering whether asset class classification is beneficial or not
• Unlike fiat currencies, crypto has a limited supply, raising questions of who sets the limit
• It also raises the anonymity - so we don't know who to trust

Financial Technology (FinTech)

• FinTech uses technology deliver financial solutions
• FinTech is a rapidly growing industry facing increased regulatory scrutiny
• FinTech allows newcomers into the industry, competing with traditional banking
• The payments industry, with newcomers like visa and apple pay
• The FinTech ecosystem has grown substantially in the last 20 years, with Paypal, Lending Club, and Revolut being major companies
• FinTech now faces a downturn, with drying investments

Checkout.com Case Study

• Checkout.com hit a $40 billion valuation after funding rounds
• Reflecting a hype in the sector, now there is burst of valuation in the FinTech bubble
• Peer-to-peer lending is an alternative to bank loans where individuals or companies borrow from individuals via online platforms

P-2-P Lending

• P-2-P lending took market share from traditional banks
• Traditional bank loans are funded by deposits, putting credit risk on the bank
• In P-2-P lending, credit risk falls on investors
• If risk is realized, there is no bailout
• Operating costs for P-2-P lending platforms are lower than traditional banks due to less strict capital requirements, fewer employees, and no office space
• Most costs are from marketing
• Lower capital requirements
• Lower outstanding costs
• Distrust/dislike of banks after the GFC lead in a higher likelihood of participation

Growth Drivers (circa 2015)

• Low barriers to entry, increased competition
• Different risk levels pooled for investors to invest in
• Borrowers of higher risk defaults disappointed investors causing them to lose investment
• Traditional banks perform credit worthiness analysis, if someone is not approved for a loan, the find another way
• Many peer-to-peer lending platforms had a steep drop in share prices

Regulation Impact

• Lending Club bought a commercial bank, thinking regulation and capital requirements were worth the funding from deposits providing safety.
• Crowdfunding raises money from people contributing smaller amounts
• The CMU has been pushing for alternative financing, including crowd funding
• After the first round of funding from friends and family the crowdfunding would act as an intermediate stage before turning to VCs
• Oura received its first funding round on Kickstarted, a crowdfunding site
• Oura has amassed a valuation of $5.2 billion, raised significant VC funding, which is rare
• Most crowd funded-startups are going bankrupt
• Crowdfunding faces a downturn

Investors

• Investors have faced underwhelming results, economic uncertainty, and cases of failed deliveries in crowdfunding
• Banks lobby against FinTech, stating it is unfair to not face the same regulation, even though they provide the same services
• Suggesting they lack consumer protection and risk of financial stability

Sustainability of New "Shadow Banks"

• Unsustainable growth trends
• Increased regulatory scrutiny as non-banks grow too large
• Bank lobbyists
• Challenges in expanding into other asset classes
• Mortgages where profit is higher, more volatility, and regulatory scrutiny
• incumbent banks are competitively responding in those spaces
• If incumbent banks see a new service, they may now offer it themselves, reduce prices of current services, or push for more regulations