Fundamentals of Financial Markets and Institutions Lecture - PDF

**Fundamentals of Financial Markets and Institutions** **30.01.2025 -- Lecture 8** Financial innovation has been somewhat controversial, with some key financial characters being unappreciative of it. - Innovation is considered good in most other, so why is it not always considered good in f...

**Fundamentals of Financial Markets and Institutions** **30.01.2025 -- Lecture 8** Financial innovation has been somewhat controversial, with some key financial characters being unappreciative of it. - Innovation is considered good in most other, so why is it not always considered good in finance? - There are cases where innovation has gone too far, or there hasn't been strict enough regulation on the innovations. - *GFC, with CDOs, and credit default swaps.* - However, overall, when looking at financial innovation there is significantly more positive than negative. Financial innovation: the creation of new financial instruments, technologies, institutions, markets. [Response to supply and demand:] - Private companies who make financial innovations need to match supply and demand of customers. - *For example, if investors want forest linked assets, they might create a forest fund.* - Solutions for sales needs are created. - Financial innovations may also occur to minimize taxes. - *Equity savings account, which only requires you to pay taxes once you start taking out the shares, shifting taxation to later.* Securitization: a process in which traditional banks assets are converted into securities. - *CDOs, ABSs.* - There were used in the GFC, whether they were the cause of simply amplified the crisis depends on viewpoint. A diagram of a company AI-generated content may be incorrect. - The issue with securitization is that the end investors do not know the true value of the riskiness, they depend on credit rating agencies. - During the GFC it became apparent that the ratings given by credit rating agencies underestimated the risk significantly.  - Since the GFC the market for CDOs and ABSs has shrunk significantly. **Cryptocurrency** A screenshot of a computer AI-generated content may be incorrect. - Before bitcoin only banks were able to create money -\> monopoly. - Since there is an additional money market. Currency is what we use to pay for things, would you buy a tesla with bitcoin? Realistically not, as you would expect it to increase in value and want to avoid regret. - Crypto is a vehicle of speculation. - For transactions we prefer stable currencies/fiat currencies -\> when we use it to buy something we do not need to consider what the value will be in a week. Pros of crypto: 1. Quick and easy payments 2. Innovative financial services Cons of crypto: 1. Lack strong operational, governance, and risk practices. 2. Consumer protection risks due to limited oversight and disclosure. 3. Anonymity causes use for money laundering and terrorist financing. - Fraud cases in crypto are more common than in traditional banking. - *The fall of FTX cryptocurrency sparked fears of a crypto GFC, however in the end this did not occur, proving to be particularly agile.* The value of bitcoin is based on how much speculators value it. - However, it is unlikely to ever go away, since it is a global phenomenon with demand. [Acceptance of crypto:] The value of bitcoin is based on how much speculators value it. - However, it is unlikely to ever go away, since it is a global phenomenon with demand. Trump had originally been a sceptic but has recently suggested that the US will become the model for the crypto market, and planning on launching a crypto division. - In 2024 there was the landmark approval of the first bitcoin ETF. - This showed recognition and approval by the SEC. - However, the SEC was clear to point out it was not endorsing it due to its speculative and volatile nature, and the fact that it is often used for illicit activity. - In response, the SEC is launching a crypto task force, to develop clear regulation. - When crypto first started it was based on the idea of no regulation, but to be classified as an asset class it must be -\> crypto investors are now considering whether this is for the better.  - Unlike fiat currencies crypto has a limited supply. - This raises the question of who sets the limit? -\> anonymous so we don't know -\> do we trust them? Financial technology (FinTech): the use of technology to deliver financial solutions. A graph of financial growth AI-generated content may be incorrect. - FinTech is large and rapidly growing industry. - Consequently, it has faced greater regulatory scrutiny.  - FinTech allows newcomers into the industry, competing with older large banks in certain sectors -\> the biggest threat to traditional banking. - *For example, the payments industry, with newcomers like visa and apple pay.* A group of logos and text AI-generated content may be incorrect. - The FinTech ecosystem has grown substantially in the last 20 years, with some major companies like PayPal, Lending Club, Revolut.  Neobank: a non-traditional bank. - However, FinTech is now facing a downturn, with investments in them drying up. [Case: checkout.com] - Checkout.com was able hit a \$40bn valuation after its funding round. - Since, it has been facing challenges in its valuations. - Reflecting how there was hype in the sector, but now the FinTech bubble has burst. Peer-to-peer lending: an alternative to bank loans, where individuals or companies can borrow directly from individuals who are ready to lend through online platforms. [Case: Lending Club] A screenshot of a computer screen AI-generated content may be incorrect. - P-2-P lending was able to take up a large market share from traditional banks. [P-2-P versus traditional lending:] - Loans from traditional banks are funded with deposits, appearing on the bank's balance sheet, with the credit risk falling on the bank. - In P-2-P lending, investors willing to lend are connected to borrowers, without intermediation from a traditional financial institution -\> the credit risk falls on the investor. - If the risk is realized, there is no bailout.  - The operating costs for P-2-P lending platforms is also significantly lower than for traditional banks. - There are less stringent capital requirements, fewer employees, no office space. - Most of the costs come from marketing. [Advantages of P-2-P lending platforms]: 1. Lower capital requirements 2. Lower outstanding costs 3. After GFC there was distrust/dislike of the banks, meaning higher likelihood of participation. A comparison of graphs and charts AI-generated content may be incorrect. - These led to the growth of the industry, circa 2015. [Disadvantages of P-2-P lending platforms:] 1. Low barriers of entry led to increased competition. 2. Pooled different levels of risk into a portfolio for investors to invest in. - Once the borrowers with the highest risk class did not pay the loans back, many investors were disappointed -\> loses for P-2-P platforms and investors leaving. - Traditional banks perform credit worthiness analysis, if someone is not approved for a loan, the find another way -\> P-2-P lending platforms.  - Consequentially, many P-2-P lending platforms show a steep drop in share prices. Lending Club opted to buy a commerical bank, coming to the conclusion that regulation and capital requirements are worth the cheap funding from deposits. - Regulation provides safety. Crowdfunding: funding by raising money from many people who contribute relatively small amounts. - The CMU has been pushing for alternative financing, including crowd funding. - After the first round of funding from friends and family, crowdfunding could work as an intermediate step before turning to VCs. [Case: Oura] - Oura received its first funding round on Kickstarted, a crowdfunding site. - Since Oura has amassed a large valuation of around \$5.2bn and managed to raise significant VC funding. - However, this case is an exception, with most crowdfunded startups going bankrupt. A graph of a graph of a graph of a graph of a graph of a graph of a graph of a graph of a graph of a graph of a graph of a graph of a graph of AI-generated content may be incorrect. - Similarly to P-2-P lending platforms, crowdfunding has recently been facing a downturn. - Many investors have faced underwhelming results, economic uncertainty and cases of failed deliveries. [Traditional banks and FinTech:] - Banks have been lobbying against FinTech, stating it is unfair that newcomers do not face the same regulation, even though they provide the same services. - Suggesting they lack consumer protection and risk financial stability. [Sustainabiliy of new shadow banks:] - Many claim that the growth trends are not sustainable due to the following reasons. 1. Increased regulatory scrutiny as non-banks become too large. - Bank lobbyists. 2. Expansion to other asset classes. - Challenges in expanding into other asset classes, particularly mortgages where profitability is higher, there is greater volatility and even more regulatory scrutiny. 3. Competitive response from incumbent banks. - If incumbent banks see a new service, they may begin to offer it themselves, reduce prices of current services, or push for more regulations.