Are Crypto-Currencies more Democratic?

The internet, as I’m sure you know, is formed of millions of connections between nodes, or access points for all its users.

Concurrent with, or alongside, this network a new network has sprung up, consisting of the Bitcoin miners and its payment system. This is supposedly money at its most ‘democratic’ because supposedly no one entity can gain control of a majority of the miners on which this consensus rests.

(for an explanation of the Bitcoin creation mechanism, see https://jessking1311.wordpress.com/2015/10/01/what-is-the-real-problem-with-bitcoin/  )

A fintech explosion

Goldman Sachs’ widely read ‘Future of Finance’ report cited three trends which two of its authors, Heath Terry and Ryan Nash on the Global Investment Research team, expanded on further in a podcast. These were: regulation, technology, and changing consumer habits.

The financial crash and ensuing regulation “effectively created a greenfield opportunity during the recovery… following Facebook’s IPO in 2012, a lot of opportunists asked themselves, ‘What sectors don’t have a Facebook, a Google, an Amazon yet. And financial services was the only one of those.”

A friendly credit environment also contributed to the exponential growth in ‘shadow banking’, – here defined more narrowly than the Fed which has tracked a recorded $15 trillion in liabilities by non-bank lenders like private debt funds – as so-called P2P or marketplace lenders.

The Goldman Sachs analysts predict $10-12 billion could move out of the traditional sector and into shadow banking. Marketplace lenders have been quick to adopt innovations like risk pricing algorithms, and analytics to predict consumer demand for loans. Thus they benefit from ‘lower cost of customer acquisition’ and ‘efficient delivery channels’, where banks are hampered by due diligence restrictions which give loans applicants offputting mountains of paperwork.

The third factor cited is regulation. Where Basel III imposed rigid capital adequacy ratios, the Dodd-Frank stress test limits made bank lending even more restricted, because they needed to consider also the value at risk of certain assets under stress scenarios. This severely limits the type of assets they can hold on balance-sheet.

Finally, the Credit Card Accountability Responsibility and Disclosure Act of 2009, or Credit CARD Act of 2009, created a unified pricing standard which also meant credit providers’ losses were absorbed to some extent. And profits in the industry as a whole became more attractive, spurring innovation and start-ups to capitalise on the benign regulatory environment.

Crypto-currencies are more ‘democratic’ than fiat currencies

Bitcoin is a new currency but unlike sterling or the dollar it is not controlled by a national government, which can intervene to buy and sell the currency to preserve its value. And which are traded on mass by foreign exchange funds.

This means Bitcoin’s value depends almost entirely on how much it can be exchanged for in terms of goods and services on the internet. Or, to be more accurate, what people believe these items to be worth in Bitcoin at any given time. Which depends on the amount of Bitcoin in circulation.

For an explanation of the historic issue of the ‘capacity crunch’ and the competing plans to increase the size of transactions and transfers to scale up the payment system, again see my previous post on the issue.

But more important in revolutionising the way money is lent in the modern world is the Distributed Ledger Technology used to record Bitcoin transactions. Everyone in the Bitcoin network has access to this record, and its only alterable by mutual consensus or agreement.

So no one can fraudulently claim they have made or recorded a transaction, because the online ledger called the blockchain shows exactly who had made and received the transaction. Many companies and governments, like that of Estonia, are adapting this technology because it is a secure way of record-keeping for other purposes, such as health records, marriage and birth certificates, taxes and property.

The new distributed ledgers would have different rules. For example, there would likely be an administrator who would have overall control over access and permission to transact. Each system would also have its own encoded rules of conduct.

Some Real-life Examples

Some payment systems like Coinify already use the blockchain to enable consumers to make guaranteed payments, via small businesses which act as merchants.  Within some payment networks, such as Lending DApp (see https://jessking1311.wordpress.com/2016/01/13/back-to-the-future-bitcoin-blockchain-and-how-marketplace-lenders-are-using-technology-to-overtake-banks-in-the-race-to-attract-new-lenders/), ordinary people can act as intermediaries to guarantee that the terms of a contract have been fulfilled. Or the computer programme can be designed such that it recognises e.g. when a certain number of hours have clocked on a timesheet.

It occurs to me that this could be the solution to many of the problems in the banking system. Processing payments by the big banks like HSBC, RBS, Barclays et al. can take several days, even need, your money right away. Because they have to comply with so many regulations, banks have to do a lot of checks to make sure the payment is for legitimate activity and by a legitimate entity.

Alternative, more immediate providers like Paypal charge a transaction fee for every payment they process. But a pretty insignificant one. And Paypal seems to be cornering the market in micropayments. What does blockchain and DLT have that existing providers don’t?

It struck me the other day that the systems in place to connect us with the money we have earned or need to conduct our life and business are grossly inefficient.

I was waiting for a sum of money I had collected from a crowdfunding platform, Indiegogo. But when I tried calling HSBC, I had to wait on hold for 20 mins. When I finally got through to someone, he did not speak enough English to process my request. Three times I told him I was waiting for a transfer to my account and if he could put me through to whoever was responsible for bank checks, that maybe the depositor was concerned it was an individual not a business account.

Three times he asked me ‘If I would like to make a transaction’? When I tried to contact Indiegogo to ask the same question, initially I couldn’t find the contact form. Eventually I got a response, and my money, after I Twitter-bombed the crowd-funder. But the point is that I couldn’t access my money when I needed it. I had to pay it out of my own pocket and then be tardily reimbursed.

Now I’m not saying we need to overhaul the entire financial system, but if the service is flawed it would make sense to encourage competing providers, like those using the blockchain network, to let individuals like you or me moderate payments for a fee that corresponds with their efficiency and success rate at doing so.

And I’m not the only one this thought has occurred to.

Marketplace Lending – A High-Risk Investment? Too Soon to Tell

09/12/15

Where banks must make full disclosures of their capital adequacy ratios (under Basel 3) – and, in their annual report, the current market value of all their assets and liabilities including derivatives, – marketplace lenders have far less transparency obligations.

Key names such as Borrowize, Accion, Fundera, Multifunding and others are seemingly not financially significant enough to be required to publish annual reports on the SEC’s electronic filing system EDGAR. The information is not readily available on their websites. And they do not willingly give such information to journalists or inquisitive citizens.

For those of whom the majority of their investors are private institutional clients, they admittedly have no real public obligation. But those marketplace lenders whose primary stakeholders are retail investors arguably do have a duty to give some detail on how they manage the key risks of conducting their conducting their business.

Market Risk

This we will broadly define as the risk that an asset will decline in value due either to macro conditions, e.g. change in interest rates; or some underlying change in the asset class, e.g. a certain number of loans defaulting on payments.

Lending Club is typical of many marketplace lenders, in that it offsets its exposure to the loan pool by selling notes, equivalent at the time of issuance to the value of the loan, to its institutional partner. Lending Club collaborates with Utah-registered WebBank, partly to take advantage of Utah’s lax stance towards interest rate-capping. But many lenders have a wider range of institutional partners.

In its 2014 annual report, Lending Club explains away its market risk thus:

“Because balances, interest rates and maturities of loans are matched and offset by an equal balance of notes and certificates with the exact same interest rates and maturities, we believe that we do not have any material exposure to changes in the net fair value of the combined loan, note and certificate portfolios as a result of changes in interest rates. We do not hold or issue financial instruments for trading purposes.

 The fair values of loans and the related notes and certificates are determined using a discounted cash flow methodology. The fair value adjustments for loans are largely offset by the fair value adjustments of the notes and certificates due to the borrower payment dependent design of the notes and certificates and due to the total principal balances of the loans being very close to the combined principal balances of the notes and certificates.”

In order for the loans’ value to continue to equal that of the notes and certificates, the debt trading forum must ensure prompt resolution of any delinquent debts. But they do not generally have the right to forcible repossession of goods to the sum of what is owed. Fixed charges placed over assets owned by the debtor would make up part of the money owed.

But how many actively are the loan issuers ensuring collateral is posted?

Collateral Posted – A Mixed Bag

Intersect Fund and Copperline, in response to our inquiry, volunteered information about their policy on collateral, and on their credit checks. The contrasting policies of these two respondents clearly demonstrate that there is no fixed industry standard on either point.

When asked under what circumstances they would require an applicant to post collateral, Intersect Fund explained: “We use collateral as a compensatory factor for recent credit blemishes and overdrafts. We don’t have a LTV (loan to value) minimum and it depends on how strong the applicant is in other areas.”

Intersect Fund makes a policy of taking four character reference numbers, in addition to running a personal credit check through TransUnion. For Copperline, “Personal credit reports (from Experian) serve as character references”.

The ‘insurance policy’ of Copperline is also more relaxed, and typifies the more liberal end of the lending market. A spokesperson summarised, “We only require collateral if the client is purchasing equipment in which case we take the said equipment as collateral. We never take additional collateral.”

In sum

While all marketplace lenders take measures to counter the risk of delinquency and default, there are limits to the measures they can take to recover missed interest payments. Fortunately there is an ever-expanding supply of fresh loan applicants to keep their portfolios at full value.

Furthermore, the actual sums at stake seem to indicate this risk is for now fully under control. To draw again on Lending Club’s 2014 annual report – this time a detail from the auditor’s notes – we can see that its ‘loan loss contingency fund’ of $1,824,739 is more than sufficient to cover the losses in its three main portfolios over the preceding two years. In fact, the maximum sum deficient, in 2012, was $512,395.

So the management has just cause to consider the loan loss contingency fund “sufficient” to cover all potential future losses from its portfolios.