RISKS AND REWARDS OF THE NEW FINANCIAL WORLD ORDER

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 SummaryIt’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

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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.

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“FINTECH” HAS INTRODUCED SOME MUCH-NEEDED HIGH TECH AND PARADOXICALLY AUTOMATED HIGH TOUCH TO THE STAID FINANCIAL WORLD.

The Frenemies of FinanceAs 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 2020 2—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,” Economist.com, May 9, 20152. “Fintech: Friend or Foe?,” BankingTechnology.com, Dec 22, 2015.

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 Purse.io 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,’ CBInsights.com/blog, February 3, 2016.

4. Zoe Henry,“8 Emerging Fintech Startups to Watch in 2016,” Inc.com, 2016.5. Anthony Effinger, “Coinbase Leads Move to Bring Bitcoin to Masses,” Bloomberg.com, 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.

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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 ChangeOne 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.

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,” medium.com, February 11, 20157b. Fig. 2. Doug Nelson, “Financial Services Unbundling, Revisited,” medium.com, February 11, 2015

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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, solved a big problem of bookkeeping 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 anyone can verify the validity of transactions. 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,” BankingTech.com, December 21, 2015.

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“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,” coindesk.com, November 5, 2015

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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

with other chains and act solely based on information contained outside the ledger,”

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,” Crytocoinnews.com, September 4, 2015.

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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,” Trunomi.com, June 2015. 12. Izabella Kaminska, “Fintech Paradoxes, Blacklist Edition,” FTAlphaville.FT.com, January 8, 2016.

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IoT (Internet of Things) and Data MinimizationSix 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.

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“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,” Schneier.com/blog, Jan 8, 2016.14. “The Internet of Things: Privacy & Security in a Connected World,” FTC.com, January 2015.

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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),” Lexisnexis.com, December 21, 2014.

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The Financial Future Is Already HereThough 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,” FT.com, November 1, 2015.

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