Artificial intelligence (AI) in finance: Six warnings from a central banker

Prof. Joachim Wuermeling Member of the Executive Board of the Deutsche Bundesbank spoke about AI.  Consumers may be rated by AI when applying for a mortgage. Pooling data points from internal transactions, social networks and other sources provides a more meaningful picture of banks’ borrowers. But if too much trust is put in “intelligent” systems, the stability of financial markets may be at stake.

1.  Don’t miss out on the opportunities of AI in finance …

AI in finance could impact on the functioning of our financial system in a profound way. Some suggest that AI is enhancing the power of the human brain in the same way that electricity enhanced the power of the body 150 years ago. Hence, it could become a big thing in finance.

Artificial intelligence and big data are currently the strongest and most vivid innovation factors in the financial sector. Using AI in finance may trigger dramatic improvements in many businesses. AI elevates the role of data as a key commodity. Used wisely, big data make outcomes more reliable and may improve financial mediation. Process chains can be organised in new ways. “The scope and nature of banks’ risks and activities are rapidly changing,” as a recent Basel Committee analysis puts it.

This evolution towards increased use of non-human intelligence is not something that has just occurred in the last few years. The first invention of neural networks, a central pillar of most AI systems, dates back to the year 1943.

Until a few years ago, the main users of big data and AI in the area of finance were certain hedge funds and high-frequency trading firms. In recent times, the application of AI in finance has begun to spread widely, via “normal” banks, FinTechs and other financial service providers, to the general public.

Since 2011, HFT has accounted for about 45–50 % of all trading in US equities. The figures for the main European indices are in the same region (with about 40 % for German DAX futures). Taken together with all other “normal” algorithmic trading activities, we currently estimate the amount of algorithmic trading to be in the realm of 80–90 % of the entire trading volume for equities (and somewhat less but still very high in other market segments).

A single normal trading day generates about 3–6 million data points about prices, order deletions and modifications in DAX futures alone. No human can analyse these amounts of data simply by looking at them in an Excel spreadsheet. More sophisticated and sometimes also AI-driven techniques are necessary to do the job.

AI profoundly changes the functioning of our financial system in at least three areas: products, processes and analysis. This is true for both front office functions (eg customer business, trading) and back office functions (eg executing trades, risk management, market research). Special-purpose AI can solve specific problems, eg in customer engagement, financial management or cybersecurity.

Applications focused on market operations cover various core areas eg trading, portfolio composition, backtesting and validation of models, market impact analysis, modelling trading of large positions and stress testing. Dynamic portfolio adjustment, depending on the macro environment, may be strengthened by AI.

With the help of AI, various human shortcomings in dealing with finance can be mitigated. As behavioural finance has taught us, biases, inertia and ignorance lead to the malfunctioning of markets. AI allows humans to reach out beyond their intellectual limits or simply avoid mistakes.

2 … but beware of the risks

But opportunities are always accompanied by risks. As regards the financial system, if too much trust is put in “intelligent” systems, the stability of financial markets may be at stake. The workings of AI can be a mystery; it can trigger loss of control, make fatal errors, and have a procyclical effect due to its mechanistic functions. Pattern recognition has its limits. This can be dangerous particularly in crisis scenarios. An autopilot would never have been able to land a jet on the Hudson River. Nor can algorithms stabilise in periods of financial stress.

Looking at the recent turbulence in equities and the market for VIX-related financial products, it can be concluded that the events of 5 February share many similarities with a “flash crash”. Unfortunately, as with the original flash crash of May 2010, we have only limited knowledge about the direct drivers that triggered the event. It can be assumed that algorithmic market participants were quite active during the relevant period. But as to which strategies were applied and to what effect, we have no knowledge so far. The rise in volatility in the S&P 500 then nearly instantly affected the VIX industry, making it not the cause but more the first victim of this market event, with losses up to 95 % on assets. We do not expect this phenomenon to disappear in the future. On the contrary, more of these flash events are to come.

AI is still in its infancy. Continuous processes for the entire AI lifecycle still have to be defined and scaled for business needs. That means that AI must be embedded in the process of acquiring and organising data, modelling, analysis and delivering analytics. The skills gap, particularly with regard to data science and machine learning expertise, is the foremost challenge. At this stage, non-human intelligence is far from replacing the human brain in any respect. Computers are like school pupils dividing numbers mechanically without having understood what they were doing.

3. Consumers should take care: they remain the risk-takers

What makes this development so significant is the fact that it is not just occurring at the level of systemic institutions, markets and stock exchanges. With robo advisers, for example, AI can directly influence and control the daily financial decisions of customers and ultimately their personal wellbeing. Society has barely begun to understand the economic, ethical and social implications of AI.

While client interaction is made more convenient by mobile banking, chatbots or virtual customer assistants, banks can find out more about customer habits and provide them with tailor-made financing.

Consumers may be rated by AI when applying for a mortgage. Pooling data points from internal transactions, social networks and other sources provides a more meaningful picture of banks’ borrowers. But denials may be hard to understand. It may become even harder to challenge a decision made by algorithms.

The proper functioning of the applications is not a given. Simple flaws, cyberattacks and criminal behaviour render the systems extremely vulnerable. Consumers should be cautious. They need to be protected. Laws may have to be modified to cover new threats. Responsibility and liability in the case of malfunctioning machines have to be clarified.

4. FinTechs should not ignore the legitimate concerns of society and supervisors

Agile tech companies are driven by an admirable energy and inspiration. By nature, they take risks. They create an idea, build a prototype and try it out immediately in the real world. Regulation, supervision, obligations and requirements must make them extremely nervous.

But the wellbeing of society depends on rules. The public demands cybersecurity, data privacy, consumer protection and financial stability. FinTechs should not brush aside the concerns of their stakeholders. Business can only flourish if it is broadly accepted by citizens.

FinTechs usually pick up specific elements of the work chain of finance or create new features. Using technology, they modularise and customise products as a third party or standalone provider.

FinTechs are part of the finance sector but are not necessarily supervised. As long as they carry out tasks for supervised entities, these institutions are responsible for the behaviour of the FinTech.

5.  AI needs new forms of supervision

“Artificial intelligence” may sound glamorous from a technological perspective, but in banking supervision, the well-established principle of “same business, same risk, same rules” has so far proved to be a sound standard for innovations. Whether they employ AI themselves or outsource it to FinTechs, from the supervisors’ point of view responsibility remains entirely with the bank.

For German supervisors, IT governance and information security nowadays are equally as important as capital and liquidity requirements.

All financial institutions should address the risks posed by new technologies. Banks have to implement effective control environments needed to properly support key innovations. This includes the requirement to have appropriate processes for due diligence, risk assessment and ongoing monitoring of any operations outsourced to a third party.

The European MiFID II includes the requirement that firms applying algorithmic models based on AI and machine learning should have a robust development process in place. Firms need to ensure that potential risks are considered at every stage of the process.

Regulators increasingly have to apply AI-supported analytical methods themselves to recognise vulnerability patterns, scan lengthy reports or analyse incoming data.

In any case, we must strike a balance between financial stability and avoiding barriers for potential new entrants, products and business models. Alongside technological progress, regulators have to constantly reassess the current legal framework, supervisory models and resources.

6. Central banks should embrace AI

Central banks have access to huge amounts of very valuable data stemming from market operations, supervision, payments and statistics. They are well positioned to tap the benefits of AI so they can enhance their ability to fulfil their mandate for price stability and the stability of the financial system.

Machine learning is already being used at the Bundesbank in different narrow segments. The experiences of all users have been good without exception. While monitoring the technical progress, we are currently discovering further use cases and defining our AI foundation, strategy, organisation and processes.

Here is a list of examples, which is by no means exhaustive:

In risk management, neural networks assess and evaluate the financial soundness of the markets. Market research is supported by adopting web mining techniques and machine learning in content analysis, topic modelling and clustering of relevant articles. In statistics, machine learning enables new methods for data quality management, eg in the context of securities holdings or the classification of company data. Furthermore, the informational content of seasonality tests is assessed by a random forest machine learning technique. For our IT user help desk, the handling of routine requests via automated chatbot responses could be a useful support measure. We use social media data to detect trends, turning points or sentiments. Machine learning methods can be applied for variable selection purposes in econometric models.

ANNEX: Use case – monitoring of real estate markets

An interesting data source is internet platforms. For example, some rental and housing platforms have the potential to improve the analysis and monitoring of real estate markets via the provision of information such as list prices and structural and locational characteristics of the property market at a disaggregated level.

This is mainly based on the assumption that these data contain information on the expectations and interests of economic agents with respect to future decisions. In such contexts, a wide range of topics or “search strings” are often potentially relevant. This can result in many different, highly correlated time series.

Furthermore, the “textual analysis” method is increasingly applied in research, as large amounts of “unstructured” information on businesses and the economy are available electronically on the internet. In order to operationalise textual data for econometric analysis, machine learning algorithms can be helpful. Learning methods can be applied to classify textual documents into different categories which can then be used to draw statistical inferences.

 

ANZ partners with Data Republic to speed up innovation

ANZ has announced a strategic investment and partnership with local start-up Data Republic to speed up innovation through secure data-sharing environments.

The partnership will provide ANZ access to the Data Republic platform, which delivers a ‘data sharing control centre’ for organisations to store, categorise and share data while maintaining strict governance and auditing frameworks. ANZ will be able to use the platform to share data with trusted third parties in a secure and well-governed environment.

Announcing the partnership, ANZ Chief Data Officer Emma Gray said:

“Using data analytics and insights to deliver better customer outcomes more often is an essential part of how we need to operate in the digital economy.

“This partnership allows us to get more out of the data we already have, but in a safe and secure environment that provides the highest levels of governance.

“Through the cloud-based platform we will now be able to access trusted experts and other partners to develop useful insights for our customers in hours rather than months,” Ms Gray said.

Data Republic CEO Paul McCarney said: “We are very excited to welcome ANZ as both a strategic investor and technology client.

“ANZ clearly understand the importance of secured data sharing practices in today’s data-driven economy.

“This partnership is about ANZ investing in the right technology to future-proof their data collaboration capabilities and will ultimately position ANZ to overcome many of the challenges and potential risks associated with open data, data sharing and the Federal Government’s recently announced Open Banking reforms.”

ANZ will start using the Data Republic platform from late March to develop greater customer insights and a series of operational improvements.

ACCC Seek Views on News and Digital Platforms Inquiry

The ACCC says is looking forward to hearing the views of consumers, media organisations, digital platforms, advertising agencies and advertisers after today outlining the key issues it will be considering in its digital platforms inquiry.

The ACCC is seeking submissions in response to its issues paper by 3 April 2018 and will issue a preliminary report into its findings in December 2018.

As part of its public inquiry into the impact of digital platforms on media and advertising markets in Australia, the ACCC is seeking feedback on:

  • Whether digital platforms have bargaining power in their dealings with media content creators, advertisers or consumers and the implications of that bargaining power.
  • Whether digital platforms have impacted media organisations’ ability to fund and produce quality news and journalistic content for Australians
  • How technological change and digital platforms have changed the media and advertising services markets, and the way consumers access news
  • The extent to which consumers understand what data is being collected about them by digital platforms, and how this information is used
  • How the use of algorithms affects the presentation of news for digital platform users.

“Digital platforms like Google and Facebook are part of the sweeping technological and cultural changes overhauling the media landscape in Australia and globally,” ACCC Chairman Rod Sims said.

“While these technological changes have brought many benefits for consumers, this inquiry will have a particular focus on examining whether the changes affect the quality and range of news supplied to Australian consumers.”

“Considering the longer term impacts of digital platforms and the ability of traditional media to remain financially viable will also be key to understanding the media and advertising markets,” Mr Sims said.

“Our aim is also to understand better the digital platforms’ business models and how they operate behind the scenes, and the evolving nature of the way consumers search for and receive news in Australia. We are particularly interested in the extent to which digital platforms curate news and journalistic content.”

The ACCC is seeking submissions in response to its issues paper by 3 April 2018 and will issue a preliminary report into its findings in December 2018.

Consumers may alternatively provide feedback to the inquiry more informally via the ACCC consultation hub.

As part of this inquiry, the ACCC will use its compulsory information gathering powers to obtain information from digital platforms and media organisations that is not publicly available.

Background

In December 2017 the Australian Government directed the ACCC to undertake a public inquiry into the impact of digital platforms on competition in media and advertising services markets, in particular in relation to the supply of news and journalistic content.

The ACCC must provide a preliminary report to the Treasurer by 3 December 2018 and a final report by 3 June 2019.

Around 60 Banks Using NPP; Distributed Ledger Next?

At its meeting today, the Payments System Board considered a number of issues.

  • The public launch of the New Payments Platform (NPP). Members welcomed the successful delivery of this important new payments infrastructure. Around 60 banks, credit unions and building societies are already using the NPP to provide their customers with real-time payments, with close-to-immediate funds availability to the recipient on a 24/7 basis, and the number of financial institutions and accounts linked to the NPP will progressively increase over the coming months. Members highlighted the convenience of addressing payments simply with a mobile phone number and the added benefits of sending more complete remittance information with payments. The Board was briefed on the performance of the NPP since the launch, the increasing number of users registered with PayID and the growing number and value of payments.
  • Least-cost routing of transactions on contactless debit cards. The Board noted the benefits in terms of holding down payment costs in the economy from the continuing issuance of dual-network cards and the ability of merchants to set preferences as to which network is used when transactions are authorised. Members were encouraged that some financial institutions have made progress towards providing least-cost routing functionality to their merchant customers. The Board expects to make a decision at its May meeting as to whether the market is providing this functionality or if the Bank should issue a draft standard for consultation.
  • Card-not-present fraud. The Board noted that a broad range of industry participants had recently come together to begin the process of developing a coordinated strategy to tackle rising card-not-present fraud. Members welcomed the willingness of the participants to collaborate on this issue and encouraged them to continue to work closely with the Australian Payments Network to develop a clear and effective strategy that balances the interests of all stakeholders, including merchants. Members looked forward to the strategy being finalised within the next six months and implemented soon after that.
  • Technology and the evolving nature of payments in Australia. Members discussed the ongoing shift to electronic payments and the importance of these payments being secure, convenient and low-cost. They also discussed the potential for further innovation in retail payments from new players and technologies. This will be a major focus of the Board over the period ahead. The Board also discussed the potential for distributed ledger technology to be used for new methods of settlement of financial and other obligations.
  • Cryptocurrency markets. The Board considered recent developments in the price of cryptocurrencies. Members noted the speculative nature of much of the trading and the risks to investors. While linkages between cryptocurrencies and the broader financial system are limited in Australia, the Board continues to monitor developments in these markets.
  • The Bank’s Assessment of Chicago Mercantile Exchange Inc. for the 12 months ending 31 December 2017. The Bank undertakes formal assessments of clearing and settlement facilities licensed to operate in Australia. The assessment will be published once it has been provided formally to the Minister for Revenue and Financial Services and the Australian Securities and Investments Commission and to the relevant overseas regulators.

Digital Finance Disruption Index Tracks Higher

The latest edition of the Digital Finance Disruption Index, a joint initiative by Digital Finance Analytics and Moula – a fast and friendly way to give small businesses access to capital – has been released. The Disruption Index tracks change in the small business lending sector, and more generally, across financial services.

Financial Services are undergoing disruptive change, thanks to customers moving to digital channels, the emergence of new business models, and changing competitive landscapes. Using combined data from the DFA SME Survey, and from Moula on loans processed, we track the momentum of this disruption in Australia.

This quarter the index climbed from 38.06, to 41.57.  Highlights include:

  • SME Business Confidence of those borrowing is on the up, reflecting stronger demand for credit, with the indicator jumping a healthy 15.8%, however, the amount of “red tape” which firms have to navigate is a considerable barrier to growth.
  • Awareness of new funding options continues to rise if slowly, creating a significant marketing opportunity for the new players, and a potentially larger slice of the pie.
  • Greater willingness to share data and use of cloud-based services continue to rise. One-third of businesses have data held within the cloud, including accounting, customer management, invoicing, human resource, and tax management. We see variations across the segments in their use of these services.
  • Of the businesses applying for funding, almost 90% now provide some form of electronic data via online loan application and are clearly comfortable in doing so (suggesting security concerns are less of a deterrent than the incentive of the speed of application and execution.
  • Average loan size continues to move upwards to register above $40k for the first time, indicating that better businesses are embracing alternative finance arrangements. More than likely, these businesses have traditional banking relationships, but either choose (or are forced to) look elsewhere for liquidity.

The Disruption Index is an important tool which will highlight the changing face of financial services in Australia. There is no doubt that new business models are emerging in the context of the digital transformation of the sector, and bank customers are way ahead of where many incumbents are playing. The SME sector in particular is underserviced, and it offers significant opportunity for differentiation and innovation.

In the last three months we have seen a significant shift in attitudes among SMEs as they become more familiar with alternative credit options and migrate to digital channels. The attraction of online application, swift assessment and credit availability for suitable businesses highlights the disruption which is underway. There is demand for new services, and supply from new and emerging players to the SME sector.

Read more on the Disruption Index Site.

Crypto Is Just A Side Show

While there may be risks to individual investors, a report from S&P Global Ratings “The Future Of Banking: Cryptocurrencies Will Need Some Rules To Change The Game”, say digital currencies such as Bitcoin do not have much capacity to meaningfully upset the financial services industry at large. This from InvestorDaily.

Despite the buzz surrounding the virtual currency, the report said: “As far as rated financial institutions’ risk exposure is concerned, however, S&P Global Ratings believes that it is much ado about nothing.

“In our opinion, in its current version, a cryptocurrency is a speculative instrument, and a collapse in its market value would be just a ripple across the financial services industry, still too small to disturb stability or affect the creditworthiness of banks we rate.”

And if crypto markets were to collapse, the brunt of the impact would not fall on major banks or its credit ratings but rather on retail investors, given they were the main contributors to activity in this market, with investors in the US, China, Japan and South Korea seemingly most exposed.

“We expect banks rated by S&P Global Ratings to be largely insulated, given that their direct or indirect exposure to cryptocurrencies appears to remain limited.”

The contribution of cryptocurrencies to global wealth was also described by the report as “limited”.

“For example, the global stock market capitalization reached approximately $80 trillion at year-end 2017, meaning that cryptocurrencies are still a marginal instrument.

“Therefore, we do not foresee any systemic wealth-effect risk.”

And even if cryptocurrencies were backed by central banks and became an asset class, the effect on firms in the financial system would be “gradual”.

“We believe that the future success of cryptocurrencies will largely depend on the coordinated approach of global regulators and policymakers to regulate and enhance market participants’ confidence in these instruments,” said S&P Global Ratings Financial Institutions Sector Lead Dr. Mohammed Damak.

Issues of consumer protection and illegal activity would need to be addressed by supranational bodies such as the G20, the report pointed out.

It also discussed the potential of the technology underpinning cryptocurrencies, blockchain, as a “positive disrupter for various financial value-chains”.

“If widely adopted, blockchain could have a meaningful and lasting impact on the celerity, traceability and cost of financial transactions.

“The financial market infrastructure segment might also see medium-term benefit from cryptocurrencies and blockchain through the launch of new income-generating products, such as futures or exchanges based on cryptocurrencies, or the replacement of current practices by new ones based on blockchain,” the report concluded.

Fintech’s Digital Disruption In Five Scenarios

The BIS task force has developed five scenarios which highlight how Fintech disruption might play out, in a 50 page report “Implications of fintech developments for banks and bank supervisors.”  Bankers will find it uncomfortable reading!

Under the The Bank For International Settlements (BIS) five scenarios, the scope and pace of potential disruption varies significantly, but ALL scenarios show that banks will find it increasingly difficult to maintain their current operating models, given technological change and customer expectations.

The fast pace of change in fintech makes assessing the potential impact on banks and their business models challenging. While some market observers estimate that a significant portion of banks’ revenues, especially in retail banking, is at risk over the next 10 years, others claim that banks will be able to absorb or outcompete the new competitors, while improving their own efficiency and capabilities.

The task force used a categorisation of fintech innovations. Graph 1 depicts three product sectors, as well as market support services. The three sectors relate directly to core banking services, while the market support services relate to innovations and new technologies that are not specific to the financial sector but also play a significant role in fintech developments.

The analysis presented in this paper considered several scenarios and assessed their potential future impact on the banking industry. A common theme across the various scenarios is that banks will find it increasingly difficult to maintain their current operating models, given technological change and customer expectations. Industry experts opine that the future of banking will increasingly involve a battle for the customer relationship. To what extent incumbent banks or new fintech entrants will own the customer relationship varies across each scenario. However, the current position of incumbent banks will be challenged in almost every scenario.

1. The better bank: modernisation and digitisation of incumbent players

In this scenario the incumbent banks digitise and modernise themselves to retain the customer relationship and core banking services, leveraging enabling technologies to change their current business models.

Incumbent banks are generally under pressure to simultaneously improve cost efficiency and the customer relationship. However, because of their market knowledge and higher investment capacities, a potential outcome is that incumbent banks get better at providing services and products by adopting new technologies or improving existing ones. Enabling technologies such as cloud computing, big data, AI and DLT are being adopted or actively considered as a means of enhancing banks’ current products, services and operations.

Banks use new technologies to develop value propositions that cannot be effectively provided with their current infrastructure. The same technologies and processes utilised by non-bank innovators can also be implemented by incumbent banks, and examples may include:

  • New technologies such as biometry, video, chatbots or AI may help banks to create sophisticated capacities for maintaining a value-added remote customer relationship, while securing transactions and mitigating fraud and AML/CFT risks. Many innovations seek to set up convenient but secure customer identification processes.
  • Innovative payment services would also support the better bank scenario. Most banks have already developed branded mobile payments services or leveraged payment services provided by third parties that integrate with bank-operated legacy platforms. Customers may believe that their bank can provide a more secure mobile payments service than do non-bank alternatives.
  • Banks may also be prone to offer partially or totally automated robo-advisor services, digital wealth management tools and even add-on services for customers with the intention of maintaining a competitive position in the retail banking market, retaining customers and attracting new ones.
  • In this scenario, digitising the lending processes is becoming increasingly important to meet the consumer’s demands regarding speed, convenience and the cost of credit decision-making. Digitisation requires more efficient interfaces, processing tools, integration with legacy systems and document management systems, as well as sophisticated customer identification and fraud prevention tools. These can be achieved by the incumbent by developing its own lending platform, purchasing an existing one, white labelling or outsourcing to third-party service providers. This scenario assumes that current lending platforms will remain niche players.
    While there are early signs that incumbents have added investment in digitisation and modernisation to their strategic planning, it remains to be seen to what extent this scenario will be dominant.

2. The new bank: replacement of incumbents by challenger banks

In the future, according to the new bank scenario, incumbents cannot survive the wave of technology-enabled disruption and are replaced by new technology-driven banks, such as neo-banks, or banks instituted by bigtech companies, with full service “built-for-digital” banking platforms. The new banks apply advanced technology to provide banking services in a more cost-effective and innovative way. The new players may obtain banking licences under existing regulatory regimes and own the customer relationship, or they may have traditional banking partners.

Neo-banks seek a foothold in the banking sector with a modernised and digitised relationship model, moving away from the branch-centred customer relationship model. Neo-banks are unencumbered by legacy infrastructure and may be able to leverage new technology at a lower cost, more rapidly and in a more modern format.

Elements of this scenario are reflected in the emergence of neo- and challenger banks, such as Atom Bank and Monzo Bank in the United Kingdom, Bunq in the Netherlands, WeBank in China, Simple and Varo Money in the United States, N26 in Germany, Fidor in both the United Kingdom and Germany, and Wanap in Argentina. That said, no evidence has emerged to suggest that the current group of challenger banks has gained enough traction for the new bank scenario to become predominant.

Neo-banks make extensive use of technology in order to offer retail banking services predominantly through a smartphone app and internet-based platform. This may enable the neo-bank to provide banking services at a lower cost than could incumbent banks, which may become relatively less profitable due to their higher costs. Neo-banks target individuals, entrepreneurs and small to medium-sized enterprises. They offer a range of services from current accounts and overdrafts to a more extended range of services, including current, deposit and business accounts, credit cards, financial advice and loans. They leverage scalable infrastructure through cloud providers or API-based systems to better interact through online, mobile and social media-based platforms. The earnings model is predominantly based on fees and, to a lesser extent, on interest income, together with lower operating costs and a different approach to marketing their products, as neo-banks may adopt big data technologies and advanced data analytics. Incumbent banks, on the other hand, may be impeded by the scale and complexity of their current technology and data architecture, determined by factors such as legacy systems, organisational complexity and historical acquisitions. However, the customer acquisitions costs may be high in competitive banking systems and neo-banks’ revenues may be offset by their aggressive pricing strategies and their less-diverse revenue streams.

3. The distributed bank: fragmentation of financial services among specialised fintech firms and incumbent banks

In the distributed bank scenario, financial services become increasingly modularised, but incumbents can carve out enough of a niche to survive. Financial services may be provided by the incumbents or other financial service providers, whether fintech or bigtech, who can “plug and play” on the digital customer interface, which itself may be owned by any of the players in the market. Large numbers of new businesses emerge to provide specialised services without attempting to be universal or integrated retail banks – focusing rather on providing specific (niche) services. These businesses may choose not to compete for ownership of the entire customer relationship. Banks and other players compete to own the customer relationship as well as to provide core banking services.

In the distributed bank scenario, banks and fintech companies operate as joint ventures, partners or other structures where delivery of services is shared across parties. So as to retain the customer, whose expectations in terms of transparency and quality have increased, banks are also more apt to offer products and services from third-party suppliers. Consumers may use multiple financial service providers instead of remaining with a single financial partner.

Elements of this scenario are playing out, as evidenced by the increasing use of open APIs in some markets. Other examples that point towards the relevance of this scenario are:

  • Lending platforms partner and share with banks the marketing of credit products, as well as the approval process, funding and compliance management. Lending platforms might also acquire licences, allowing them to do business without the need to cooperate with banks.
  • Innovative payment services are emerging with joint ventures between banks and fintech firms offering innovative payment services. Consortiums supported by banks are currently seeking to establish mobile payments solutions as well as business cases based on DLT for enhancing transfer processes between participating banks (see Box 4 for details of mobile wallets).
  • Robo-advisor or automated investment advisory services are provided by fintech firms through a bank or as part of a joint venture with a bank.

    Innovative payment services are one of the most prominent and widespread fintech developments across regions. Payments processing is a fundamental banking operation with many different operational models and players. These models and structures have evolved over time, and recent advances in technological capabilities, such as in the area of instant payment, have accelerated this evolution. Differences in types of model, technology employed, product feature and regulatory frameworks in different jurisdictions pose different risks.

The adoption by consumers and banks of mobile wallets developed by third–party technology companies – for example, Apple Pay, Samsung Pay,12 and Android Pay – is an example of the distributed bank scenario. Whereas some banks have developed mobile wallets in-house, others offer third-party wallets, given widespread customer adoption of these formats. While the bank continues to own the financial element of the customer relationship, it cedes control over the digital wallet experience and, in some cases, must share a portion of the transaction revenue facilitated through the third-party wallets.

Innovation in payment services has resulted in both opportunities and challenges for financial institutions. Many of the technologies allow incumbents to offer new products, gain new revenue streams and improve efficiencies. These technologies also let non-bank firms compete with banks in payments markets, especially in regions where such services are open to non-bank players (eg the Payment Service Directives in the European Union and the Payment Schemes or Payment Institutions Regulation in Brazil).

4. The relegated bank: incumbent banks become commoditised service providers and customer relationships are owned by new intermediaries

In the relegated bank scenario, incumbent banks become commoditised service providers and cede the direct customer relationship to other financial services providers, such as fintech and bigtech companies. The fintech and bigtech companies use front-end customer platforms to offer a variety of financial services from a diverse group of providers. They use incumbent banks for their banking licences to provide core commoditised banking services such as lending, deposit-taking and other banking activities. The relegated bank may or may not keep the balance sheet risk of these activities, depending on the contractual relationship with the fintech company.

In the relegated bank scenario, big data, cloud computing and AI are fully exploited through various configurations by front-end platforms that make innovative and extensive use of connectivity and data to improve the customer experience. The operators of such platforms have more scope to compete directly with banks for ownership of the customer relationship. For example, many data aggregators allow customers to manage diverse financial accounts on a single platform. In many jurisdictions consumers become increasingly comfortable with aggregators as the customer interface. Banks are relegated to being providers of commoditised functions such as operational processes and risk management, as service providers to the platforms that manage customer relationships.

Although the relegated bank scenario may seem unlikely at first, below are some examples of a modularised financial services industry where banks are relegated to providing only specific services to another player who owns the customer relationship:

  • Growth of payment platforms has resulted in banks providing back office operations support in such areas as treasury and compliance functions. Fintech firms will directly engage with the customer and manage the product relationship. However, the licensed bank would still need to authenticate the customer to access funds from enrolled payment cards and accounts.
  • Online lending platforms become the public-facing financial service provider and may extend the range of services provided beyond lending to become a new intermediary between customers and banks/funds/other financial institutions to intermediate all types of banking service (marketplace of financial services). Such lending platforms would organise the competition between financial institutions (bid solicitations) and protect the interests of consumers (eg by offering quality products at the lowest price). Incumbent banks would exist only to provide the operational and funding mechanisms.
  • Banks become just one of many financial vehicles to which the robo-advisor directs customer investments and financial needs.
  • Social media such as the instant messaging application WeChat13 in China leverage customer data to offer its customers tailored financial products and services from third parties, including banks. The Tencent group has launched WeBank, a licensed banking platform linked to the messaging application WeChat, to offer the products and services of third parties. WeBank/WeChat focuses on the customer relationship and exploits its data innovatively, while third parties such as banks are relegated to product and risk management.

5. The disintermediated bank: Banks have become irrelevant as customers interact directly with individual financial services providers.

Incumbent banks are no longer a significant player in the disintermediated bank scenario, because the need for balance sheet intermediation or for a trusted third party is removed. Banks are displaced from customer financial transactions by more agile platforms and technologies, which ensure a direct matching of final consumers depending on their financial needs (borrowing, making a payment, raising capital etc).

In this scenario, customers may have a more direct say in choosing the services and the provider, rather than sourcing such services via an intermediary bank. However, they also may assume more direct responsibility in transactions, increasing the risks they are exposed to. In the realm of peer-to-peer (P2P) lending for instance, the individual customers could be deemed to be the lenders (who potentially take on credit risk) and the borrowers (who may face increased conduct risk from potentially unregulated lenders and may lack financial advice or support in case of financial distress).

At the moment, this scenario seems far-fetched, but some limited examples of elements of the disintermediation scenario are already visible:

  • P2P lending platforms could manage to attract a significant number of potential retail investors so as to address all funding needs of selected credit requests. P2P lending platforms have recourse to innovative credit scoring and approval processes, which are trusted by retail investors. That said, at present, the market share of P2P lenders is small in most jurisdictions. Additionally, it is worth noting that, in many jurisdictions, P2P lending platforms have switched to, or have incorporated elements of, a more diversified marketplace lending platform business model, which relies more on the funding provided by institutional investors (including banks) and funds than on retail investors.
  • Cryptocurrencies, such as Bitcoin, effect value transfer and payments without the involvement of incumbent banks, using public DLT. But their widespread adoption for general transactional purposes has been constrained by a variety of factors, including price volatility, transaction anonymity – raising AML/CFT issues – and lack of scalability.

In practice the report highlights that a blend of scenarios is most likely.

The scenarios presented are extremes and there will likely be degrees of realisation and blends of different scenarios across business lines. Future evolutions may likely be a combination of the different scenarios with both fintech companies and banks owning aspects of the customer relationship while at the same time providing modular financial services for back office operations.

For example, Lending Club, a publicly traded US marketplace lending company, arguably exhibits elements of three of the five banking scenarios described. An incumbent bank that uses a “private label” solution based on Lending Club’s platform to originate and price consumer loans for its own balance sheet could be characterised as a “distributed bank”, in that the incumbent continues to own the customer relationship but shares the process and revenues with Lending Club.

Lending Club also matches some consumer loans with retail or institutional investors via a relationship with a regulated bank that does not own the customer relationship and is included in the transaction to facilitate the loan. In these transactions, the bank’s role can be described as a “relegated bank” scenario. Other marketplace lenders reflect the “disintermediated” bank scenario by facilitating direct P2P lending without the involvement of a bank at any stage.

NAB Job Cuts 1,000 Jobs as ‘Digitisation’ Takes Hold

From Investor Daily.

NAB staff were informed by chief people officer Lorraine Murphy yesterday that “the next phase in transforming our business is underway, as part of a three-year process”.

In November 2017, InvestorDaily reported on the major bank’s plans to cut 6,000 jobs and create 2,000 new digital-focused jobs by 2020.

A NAB spokesperson told InvestorDaily approximately 1,000 jobs will be cut every six months for the next three years.

InvestorDaily understands the exact number of job losses in the first half of 2018 will depend on the number of voluntary redundancies and redeployments into digital-focused roles.

“The proposed new structure will reduce the layers and complexity in the bank so that we can be simpler, make decisions faster and be even closer to our customers,” the bank said in a statement.

Ms Murphy said there was “no doubt” this transition was right for the bank business.

“We will acknowledge the contribution that people who are leaving us have made. We will show through our actions that we care,” said Ms Murphy.

Staff that leave the bank will have “world-class support” through the bank’s career transition program titled ‘The Bridge’, which will offer employees made redundant with six months of support and resources.

“We said we would provide the utmost care and respect for all of our people. This remains our priority,” Ms Murphy said.

“I encourage you to ensure that all of our people understand the changes and are supported, and that those who remain with us can deliver the type of bank we have promised our customers – a simpler, faster bank.”

InvestorDaily also reported on comments made by NAB chief executive Andrew Thorburn, who signalled the number of bricks-and-mortar branches was declining.

“What’s happening is that more and more customers are using their mobile device and online banking, and some branches are being used less and less and less,” Mr Thorburn said in November.

“And as that happens, like any business, we need to adjust.”

However, in a statement, the Finance Sector Union (FSU) expressed concerns that the job cutting “does not meet community expectations”, pointing out that with the royal commission underway, Australian banks are being watched closely and NAB should take this responsibility to “rebuild its brand”.

“This is not just 6,000 workers that will lose their jobs – it’s 6,000 people that will have to go home and tell their families they no longer have work,” said FSU national secretary Julia Angrisano.

Many of the workers whose jobs would be axed or made redundant will have been at the bank for years and were a driving force behind NAB’s profits, Ms Angrisano pointed out.

“It’s not like NAB is in trouble – they can afford to retrain their workers. They made $6.7 billion dollar profit last year,” she said.

“Post retrenchment support is too little too late, workers need to be re-skilled to move into the jobs of the future now.”

Terrified of Bitcoin, banks forced to innovate for the first time in 40+ years

From Sovereign.com

Yesterday morning, several banks in Australia started rolling out a new payment system they’re calling NPP, or “New Payments Platform.”

Until now, sending a domestic funds transfer in Australia from one bank to another could take several days. It was slow and cumbersome.

With NPP, payments are nearly instantaneous.

And rather than funds transfers being restricted to the banks’ normal business hours, payments via NPP can be scheduled and sent 24/7.

You can also send money via NPP to mobile phones and email addresses. So it’s a pretty robust system.

Across the world in the United States, the domestic banking system has been working on something similar.

Domestic bank transfers in the Land of the Free typically transact through an electronic network known as ACH… another slow and cumbersome platform that often takes 2-5 days to transfer funds.

It’s pretty ridiculous that it takes more than a few minutes to transfer money. It’s 2018! It’s not like these guys have to load satchels full of cash onto horse-drawn wagons and cart them across the country.

(And even if they did, I suspect the money would reach its destination faster than with ACH…)

Starting late last year, though, US banks very slowly began to roll out something called the Real-time Payment system (RTP), which is similar to what Australian banks launched yesterday.

[That said, the banks themselves acknowledge that it could take several years to fully adopt RTP and integrate the new service with their existing online banking platforms.]

And beyond the US and Australia, there are other examples of banking systems around the world joining the 21st century and making major leaps forward in their payment system technologies.

It seems pretty clear they’re all playing catch-up with cryptocurrency.

The rapid rise of Bitcoin and other cryptocurrencies proved to the banking system that it’s possible to conduct real-time [or near-real-time] transactions, and not have to wait 2-5 days for a payment to clear.

Combined with other new technologies like Peer-to-Peer lending platforms, fundraising websites, etc., consumers are now able to perform nearly every financial transaction imaginable– deposits, loans, transfers, etc.– WITHOUT using a bank.

And it’s only getting better for consumers… which means it’s only getting worse for banks.

All of these threats from competing technologies have finally compelled the banks to innovate– literally for the FIRST TIME IN DECADES.

I’m serious.

When the CEO of the company launching RTP in the US announced the platform, he admitted that the “RTP system will be the first new payments system in the U.S. in more than 40 years.”

That’s utterly pathetic. The Internet has been around for 25 years. Even PayPal is nearly 20 years old.

Yet despite the enormous advances in technology over the past several decades, the last major innovation in bank payments was back when Saturday Night Fever was the #1 movie in America.

Banks have been sitting on their laurels for decades, enjoying their monopoly over our savings without the slightest incentive to improve.

Cryptocurrency has proven to be a major punch in the gut. The entire banking system keeled over in astonishment over Bitcoin’s rise, and they’ve been forced to come up with an answer.

And to be fair, the banks have reclaimed the advantage for now.

NPP, RTP, and all the other new protocols are faster and more efficient than most cryptocurrencies.

Bitcoin, for example, can only handle around 3-7 transactions per second. Ethereum Classic maxes at around 15 transactions per second. Litecoin isn’t much better.

By comparison, there were 25 BILLION funds transfers in 2016 using the ACH network in the US.

Based on the typical holiday schedule and the banks’ 8-hour working days, that’s an average “throughput” of roughly 3500 transactions per second.

So, now that banks have finally figured out how to conduct thousands of transactions per second in real-time, they clearly have superiority.

But that superiority is unlikely to last.

It takes banks decades to innovate. They have enormous bureaucratic hurdles to overcome. They have endless committees to appease, including the Federal Reserve’s “Faster Payments Task Force.”

And most importantly, given that most banks are still using absurdly antiquated software, any new systems they develop have to be carefully designed for backwards compatibility.

Cryptofinance and other financial technology companies have no such limitations.

As my colleague Tama mentioned in the podcast we released yesterday, the cryptocurrency space sort of exists in ‘dog years’.

Things move so quickly that one year in crypto is like 7 years for any other industry.

Right now there is almost a unified push across the crypto sector to solve the ‘scalability’ problem, i.e. to securely transact a near limitless number of transactions in real time.

Those solutions will almost undoubtedly come from technologies that you haven’t heard very much about yet.

Hashgraph and Radix, for example, are two such ventures working on extremely elegant payment solutions that break the mold of previous cryptos.

Rather than build upon standard cryptocurrency concepts like blockchain, Proof of Work, and Proof of Stake, both Hashgraph and Radix have created their own algorithms from scratch.

This is the bleeding edge of the bleeding edge of a massively disruptive sector that has existed for less than a decade.

And there are literally dozens of other companies and technologies aiming for similar heights.

Some of them will undoubtedly succeed. And still other ventures that won’t even be conceived for years will have yet more disruptive power in the future.

The banks don’t stand a chance. The future of finance absolutely belongs to crypto.

CBA Blocks Credit Card Purchases of Bitcoin Etc.

CBA has said that due to the unregulated and highly volatile nature of virtual currencies, customers will no longer be able to use their CommBank credit cards to buy virtual currencies. This came into effect as of 14 February 2018.

Our customers can continue to buy and sell virtual currencies using other CommBank transaction accounts, and their debit cards.

We have made this decision because we believe virtual currencies do not meet a minimum standard of regulation, reliability, and reputation when compared to currencies that we offer to our customers. Given the dynamic, volatile nature of virtual currency markets, this position is regularly reviewed.

The restriction on credit card usage for virtual currencies will also apply to Bankwest credit cards.

Q&A

Why are we making this change?

  • Virtual currencies are unregulated and, as has been made clear in recent months, highly volatile. Effective 14 February, we will no longer authorise credit card purchases for these currencies.

How can I buy virtual currencies?

  • You can still buy and sell virtual currencies using other CommBank transaction accounts, and debit cards, as long as you comply with our terms and conditions and all relevant legal obligations.

I recently tried to purchase virtual currencies using my debit card and it was declined. Why did this happen?

  • We are aware of some instances where customers found that their attempts to buy or sell virtual currencies did not work. This can be due to a number of reasons, including:
    • The virtual currency exchange the customer is using has been blocked by our security systems. A currency exchange will be blocked if a number of the transactions it has previously processed are found to have been fraudulent, inconsistent with our policies or outside of the Group’s risk tolerance.
    • The payment method the customer uses is no longer accepted by the currency exchange. Some exchanges have recently stopped accepting certain payment methods.
    • The virtual currency exchange’s bank blocks the transaction for security reasons.

Can I still get credits from virtual currency exchanges paid to my credit card?

  • Yes, credits will continue to be authorised by the Bank onto credit cards.