What To Look For In Cryptocurrency, Banks, and Brokerages During 2019
Executive Summary
With new currencies, new fintech bank charters, and a new stock exchange garnering momentum, 2019 is looking like a busy year for the financial world.
At the same time, after a very painful end to the markets in December, articles are appearing in the media—from Forbes to The New York Times—predicting another crash in 2019 (or at least another recession).
Issues with the potential to knock the U.S. and global economies off track
· Dominating the news is the US and China trade war and the coming Brexit.
· Changes to monetary policy can affect the bond market and increase/create risks throughout the asset classes.
· Contamination from bond market failures would mean an increase in tail risks for multi-asset portfolios where risk models are typically structured on bonds that offset equity risk.
· Changes to central bank policies can increase the risk to stocks, plus a rise in interest rates could result in stocks falling at an excessive rate.
· The level of global debt could have a detrimental impact on the 2019 financial crisis, as it reached a total of $247 trillion in Q1 of 2018 (a significant growth from $50 trillion, prior to the 2008 financial crisis).
· China’s economy is slowing—over the past decade they have “created” cash to build airports, factories and entire would-be cities, now known as “ghost” cities, to force feed their economy for growth. China’s $34 trillion pile of public and private debt is over 266 percent of their gross domestic product.
· Corporate bonds around the world issued by non-financial companies have almost tripled since 2007 from $4.7 to $11.7 trillion (see figure 1 below).
· Total US consumer credit rose to a record $3.84 trillion according to the Federal Reserve (see figure 2 below). This includes credit-card debt (with a 2.4% growth over 2008), auto loans (seeing a 35% growth over 2008), and student loans (exploding 141% over 2008 to $1.5 trillion), but does not include mortgage-related debt.
· The Fed is affecting interests rates both through incremental increases to the fed funds rate and increasing the supply of treasuries in the market as it winds down its $4 trillion balance sheet.
· Treasury yields are also linked to the global demand for the dollar—demand that often falters as the global economy improves—causing interest rates to rise.
The financial crisis of 2008-2009 was no ordinary crisis. It almost brought the U.S. banking system down, destroyed millions of jobs, and reached many industries outside the financial sector—causing it to be labeled the “Great Recession” from its mimicry of the Great Depression.
Figure 1
It’s clear that the world is unable to learn (or remember) that a massive buildup of debt tends to end in a serious financial crisis. Maybe it’s the obsession with finding and explaining the catalyst (usually a “small” liquidity event) that brings the skyscraper of debt tumbling down. We then focus on the small targets instead of the one constant—too high debt to cash ratios.
One reason to worry about today’s global debt is that there’s not as much cash around to cover it. The cash-to-debt ratio for corporate borrowers fell to 12 percent in 2017, the lowest ever. And Americans now owe more than 26 percent of their annual income to consumer debt. That’s up from 22 percent in 2010. It’s also higher than debt levels during the mid-2000s when credit availability soared.
Figure 2
Student debt is about more than the growing number of people defaulting on loans. After all, lots of that debt is owed the federal government, so it’s unlikely to poison the financial system, as mortgages (and their derivatives) did during the great recession. But this burden of debt is already beginning to wipe out the next generation of homebuyers and auto purchasers.
It’s even bigger than homes and autos! Consider all the industries profiting off of the growing pool of students financed by student loans: Technology—with its phones, laptops, software, video conferencing, etc. (think of Apple and Microsoft); student housing; investment portfolios backing student loan securitization; private college investors; the list goes on and on.
Not all the news is predicting a recession and market crash
In the U.S. expansion has actually strengthened over 2017—with the two middle quarters resulting in 4.2 percent and 3.5 percent respectively. In October alone, the economy generated 250,000 jobs.
In August of 2018, the nonpartisan Congressional Budget Office (CBO) projected that real gross domestic product (GDP) would grow 3.1 percent this year, but sees growth to slow in 2019.
“In 2019, the pace of GDP growth slows to 2.4 percent in the agency’s forecast, as growth in business investment and government purchases slows,” CBO director Keith Hall said in a statement.
According to the International Monetary Fund, the global economy in 2018 was on track to grow at the same rate as 2017—3.7 percent. The IMF’s forecast for 2019? Again, 3.7 percent.
If we didn’t know before 2008, we now should be very aware that we live in a global economy—so what does global growth look like in some key economies?
Bloomberg Economics predicts the U.K. will grow 1.6 percent in 2019, a bit faster than the estimated 1.3 percent this year. They predict that Germany will grow 1.7 percent, Italy 1 percent, Japan at .9 percent, and China at 6.4 percent.
In August, the IMF forecast that India’s gross domestic product will grow by 7.3% in the 2018-19 fiscal and 7.5% in 2019-2020 on strengthening of investment and robust private consumption.
U.S. inflation was forecast by the Federal Reserve to be 1.9 percent in 2018 and 2019. It will rise to 2.1 percent in 2020 and 2021. The core inflation rate strips out those volatile gas and food prices—which the Fed prefers doing when setting monetary policy.
What is not fully known is the core rate’s impact on the Fed’s intention on interest rate increases. Usually with the inflation rate slightly below the Fed’s 2 percent target rate, the Fed feels there’s room to continue raising rates. In fact, before the market tanking in December that was the exact message they sent. However, Fed Chairman Powell softened that message late last week—buoying the market but still leaving questions for some.
The 2017 tax breaks also appear to be helping. Companies saw their nominal tax rates reduced from 35 percent to 21 percent, leading some boards to use a portion of the savings to reduce debt.
Oil prices have dropped substantially since October, contributing to market unrest but also lowering the cost of transportation, food, and raw materials for business. That raised profit margins. It also gave consumers more disposable income to spend over the holidays.
The U.S. Energy Information Administration predicts crude oil prices will average $61 a barrel in 2019—keeping those same economic factors positive while the market has stabilized on lower prices.
When the Fed had the funding spigot wide-open bad headlines were ignored and good headlines were a reason to pile in more money. Investing in fundamentals, instead of headlines, is always a much better process—but especially so during times of market volatility. All in all, 2019 is an excellent time to reduce debt, build up your savings, and increase your wealth.
Cryptocurrency Becomes Mainstream
The Challenges of Crypto
There are three areas of weakness that keeps cryptocurrency from being a stable investment vehicle—though it is important to remember stability does not mean zero market volatility, as recently demonstrated by the stock market. These three areas are volume, security, and underlying infrastructure.
Additionally, these three areas are so interlinked that momentum to overcome them requires that all three areas achieve sufficient growth in parallel. Volume comes with more users (including institutional), more users comes with better security and underlying infrastructure. Security and underlying infrastructure will be enhanced with more oversight from regulators and other governing bodies, which usually comes with more users being affected.
Fortunately, 2018 saw significant advancement with all three key components.
Cryptocurrency Acceptance
Until a few years ago, Bitcoin’s main legal audiences were engineers and others fascinated with the digital space. Prior to that, its reputation was seen as a means of conducting illegal and terrorist activities.
While some of the dark web reputation has changed, few of those who have accepted other digital innovations understand how cryptocurrency works or question its security/safety as a vehicle of digital transactions. In fact, so few financial professionals understand cryptocurrency that a companion crypto-overview white paper is being published in follow-up to this article.
Thanks to a significant run-up on cryptocurrency prices during 2017, many younger investors began testing the cryptocurrency waters through coin and token purchases on global cryptocurrency exchanges.
This highlighted a new, and high profit margin product for institutional investors. As a result, they began expressing high levels of frustration that there was insufficient attention from regulators, and trusted financial services firms, addressing underlying weaknesses that were keeping them out of the market.
Even a drop of 80% in value over the last year has not deterred, in fact it has galvanized, institutional investors in demanding access to this investment opportunity.
The response by regulators and financial services firms suggests that 2019 will be a great year for cryptocurrency.
New Institutional Players
Intercontinental Exchange-ICE (the owner of the New York Stock Exchange) Microsoft, and Starbucks have partnered to launch a new company, named Bakkt, which will look to develop an “open, regulated, and global ecosystem for digital assets.”
Hosted on Microsoft’s cloud infrastructure, Bakkt’s platform will start with a futures exchange and clearinghouse for single day, Bitcoin contracts for physical delivery. While experiencing several regulator approval and platform delays, it appears that Bakkt may go live by the end of January.
ICE has announced it has “insurance for Bitcoin in cold storage” and will shortly be “securing insurance for the warm wallet within the Bakkt Warehouse architecture,” with a new go live date of January 24, 2019.
Phase two might use Microsoft’s cloud solutions in order to allow individuals to buy and sell virtual currencies, as well as making it possible to store and spend virtual currencies on a global network.
Starbucks will also play an important role in Bakkt’s plan to bring new customers to the virtual currency market. In the future, Starbucks customers could convert cryptocurrency to United States dollars and make purchases with them.
Fidelity is one of the world’s largest and most diversified financial services providers with more than $7.2 trillion in client assets. In October of 2018, with the stated goal to make digitally-native assets, such as Bitcoin, more accessible to investors, Fidelity Investments announced the launch of their new company, Fidelity Digital Asset services, LLC.
Fidelity Digital Assets will “offer enterprise-quality custody and trade execution services for digital assets, commonly referred to as cryptocurrencies, to sophisticated institutional investors such as hedge funds, family offices and market intermediaries.”
TD Ameritrade Holding Corporation provides investing services and education to more than 11 million client accounts totaling more than USD 1.2 trillion in assets, and custodial services to more than 6,000 registered investment advisors. One of the first financial service firms to offer approved clients with access to Bitcoin futures contracts last year, TD recently announced that it had invested in ErisX, a regulated derivatives exchange and clearing organization that will include digital asset futures and spot contracts on one platform.
Better Security for Cryptocurrency
Security involves protection from hackers (system security) and protection from fraud (product security), making this a technical and regulatory responsibility.
One of the promises of blockchain is its invulnerability to hacking attempts due to its use of distributed ledgers. As a result, many question why there is so much news around the hacking of cryptocurrency exchanges. The answer is simple; other than the dreaded 51% attack, blockchain isn’t the greatest vulnerability, it’s the layers above blockchain.
Cryptocurrency security is hierarchical: Protocol, exchange and personal wallet security are the three layers. Breach any of the upper layers (i.e. coin protocol) and it doesn’t matter how secure the lower layers are. Hence hackers attack exchanges and not the blockchain of any given currency traded on the exchange.
A combination of “Business Improvement Orders” issued by Japan’s Financial Services Agency (FSA) to 6 of its licensed cryptocurrency exchanges, and pressure from high profile hacks in 2018, has resulted in more investment into cyber security efforts by exchanges.
Historically, cryptocurrency exchanges began as ordinary centralized web application and thus have similar vulnerabilities. Because they trade currency, cryptocurrency exchanges need to be built, managed, and upgraded similar to banks.
Classic banks and banking services have been subject to constant cyber attacks since their move online and have international information security standards — for example, CobiT.
Investigators have found that crypro-hackers use tools that have been repeatedly tested on fiat banks. A study of 400 successful hacking attacks on the blockchain systems showed that slightly modified attacks like TrickBot trojan, Vawtrak, Qadars, Triba, and Marcher proved successful against cryptocurrency exchanges.
Banks use sophisticated cyber security protocols and tools, as well as actively share information through organizations such as Financial Services Information Sharing and Analysis Center (FS-ISAC), and Financial Systemic Analysis & Resilience Center (FSARC). Cryptocurrency exchanges need to follow this path if they want legitimacy.
The entry of ICE, Fidelity, and TD Ameritrade, should further push cryptocurrency exchanges to adopt banking industry standards to cyber security. If not, they will lose most of their customers seeking to protect their cryptocurrency to these three, and other financial services already well versed in securing assets digitally.
Finally, ICE noted another key ingredient to Bakkt when they stated it has “insurance for Bitcoin in cold storage” and will shortly be “securing insurance for the warm wallet.”
Insurance for cryptocurrency storage (hot and cold) has been unavailable due to poor security on exchanges. That has changed recently.
CryptoIns, which is supported by Swiss insurance broker ASPIS S, is now offering its insurance services to dozens of major cryptocurrency exchanges. The new insurance policy purportedly covers losses from “cyber-attacks on exchange software, theft, fraud and illegal actions of cryptocurrency exchange personnel.”
Entrances into the space by established financial services has also sped the process of regulatory oversight into platform security and defining which cryptocurrencies are considered securities and how Initial Coin Offerings (ICO) should be handled in the US. The SEC has been clear to state that ICOs offered in the US will usually be seen as securities and subject to security registration requirements.
Underlying Infrastructure Improvements
Like better security, these improvements rest with technical experts and regulators to deliver faster platforms and clarity on how regulators will view and govern the myriad cryptocurrency products currently offered, and yet to be introduced.
A blockchain network is only as good as its ability to process, validate, and settle transactions efficiently. For blockchain to have a chance at replacing existing banking networks, it’ll have to offer security and expediency advantages over those existing networks.
With current transaction speeds ranging from 4 seconds to transact on Ripple (XRP), and 78 minutes for a Bitcoin transaction, there is great room for improvement. Not surprisingly, the genesis of blockchain contributes to its performance.
In its creation, Bitcoin was not looked upon as a mass distributed currency. In fact, it was designed to max out at 21 million coins. Ripple on the other hand, was built to offer blockchain services to the financial services industry. However, it has less utility than Bitcoin, Ether, and Litecoin for buying goods and services.
Fortunately there are some bright people/companies addressing transaction speeds by adding a networking/infrastructure layer to existing blockchains.
Lightning Network adds its layer to Bitcoin’s blockchain to enable users to create payment channels between any two parties on that extra layer. These channels can exist for as long as required, and because they’re set up between two people, transactions will be almost instant and the fees can be extremely low or even non-existent.
The Raiden Network is a scaling solution for the Ethereum blockchain. Similar to Bitcoin’s Lightning Network it enables near-instant, low-fee, scalable, and privacy-preserving payments.
InstantSend is a feature of the Dash protocol that utilizes transaction locking and masternode consensus to facilitate instantaneous transactions on the Dash blockchain.
Like cryptocurrency networks, cryptocurrency product definitions of existing coins/tokens are evolving on the regulatory front. Last year SEC Chairman, Jay Clayton, and SEC Director of the Division of Corporate Finance, William Hinman, both made statements that neither Bitcoin or Ether were considered securities.
That said, any derivatives or ETFs tied to Bitcoin or Ether, Chairman Clayton has made clear will be considered securities, and regulated as those tied to fiat currencies.
Perhaps the best sign of regulatory progress is the recently launched new fintech-focused division within the SEC, which has the explicit goal of fostering communication with ICO startups.
Congress has also stepped in to provide more clarity for the market. In late December The “Token Taxonomy Act” — a bipartisan bill sponsored by Reps. Warren Davidson, R-Ohio and Darren Soto, D-Fla. — defines a “digital token” and clarifies that securities laws would not apply to cryptocurrencies when they progress to being a fully functioning network.
The bill is principally the result of a roundtable of over 50 industry players hosted by Davidson in September. Experts from Nasdaq, the U.S. Chamber of Commerce, Fidelity, State Street, and Andreessen Horowitz met with Davidson to discuss regulatory shortcomings.
This does not mean that cryptocurrencies will go unregulated if the bill passes. Instead, it will likely come under the Federal Trade Commission or the CFTC.
Cryptocurrency is not dead. Too many big players are joining the community, regulators are paying more attention and creating divisions to focus on it, and more people (including institutional investors) want to own it.
Financial services firms need to take a close look at the impact of this disruptive technology to their business models and prepare now to capitalize on its growing acceptance and inevitable competition.
Smart investors will realize they need a better understanding of the various forms of cryptocurrency, the players, the market, and how it best fits their portfolio before investing.
Open Banking
Traditional banking models are fading away. The desire for people to bank whenever and wherever they want makes digital banking innovators more likely to dominate. This doesn’t mean that traditional banking is out the window, but it will wither and eventually die if bankers refuse to adapt to changes in customer behavior and needs.
For instance, surveys show that banking customers have a stronger emotional connection to technology brands like Apple, Amazon, and Google than they do toward their bank. Those banks that are creating a similar sense of community are capturing tighter customer relationships.
Brick and mortar banking needs to shift from an institutional formality, to a place for professionals and consumers to congregate. Instead of filling space with bank employees that sit idle most of the day as foot traffic continues to diminish, banks need to think of using the square footage to provide office space to businesses whose clientele would make great bank customers.
Bank lobbies need to become more digitized—allowing remote servicing with bank representatives, digital self-service with standby personalized assistance, and internet café structures where customers can plug in, sip on something, and browse or work.
Figure 4 below shows findings from Deloitte’s global customer survey on digital banking.
Figure 4
Catering to customer needs typically requires a multipronged client-centric approach. Banks who recognize customer pain points and the inadequacies of their legacy systems need to collaborate with fintechs who have proven they can address customer needs.
Banks also need plans in place to take advantage of changes in market conditions that create opportunities to either partner with or purchase fintechs that provide them the best competitive advantage.
Regulations in Europe and the US will create a catalytic growth in Fintech
The European directive known as Payment Services Directive, or PSD2 (also referred to as open banking), is designed to boost competition and the variety of products in the banking, credit cards, and payments space. While enforced in Europe, global financial services firms who must compete against the directive will most certainly use their investment to be more competitive in the US.
Additionally, with over three years of preparation for open banking (PSD2) in Europe, it is likely that many of Europe’s early winners will incorporate branches in the US to take advantage of the OCC’s invitation to fintechs. In fact, both N26 and Revolut have announced intentions to launch in the U.S in 2019.
In May 2018, President Trump signed into law the Economic Growth, Regulatory Relief and Consumer Protection Act, commonly known as the Dodd-Frank repeal. While this law removes many of the regulations imposed on banks in the wake of the Great Recession, it also bears particular relevance to mobile banking and e-signatures.
The new law includes a provision called the MOBILE Act (Making Online Banking Initiation Legal and Easy). This provision makes it easier for banks to onboard new customers remotely without the need for the customer to travel to a branch to complete the process. Banks can now create an entirely digital onboarding process by verifying a scan or digital copy of a new customer’s government-issued identification, such as a driver’s license.
President Trump appointees who have discretion to adjust supervisory policies and programs now lead all regulatory agencies. While any changes are subject to Congressional oversight, the appointees have a lot of flexibility in their interpretation of laws.
One example is a July press release last year from the Office of the Comptroller of the Currency (OCC) announcing it will begin accepting applications for national bank charters from non-depository financial technology companies (fintech) engaged in the business of banking.
“Over the past 150 years banks and the federal banking system have been the source of tremendous innovation that has improved banking services and made them more accessible to millions. The federal banking system must continue to evolve and embrace innovation to meet the changing customer needs and serve as a source of strength for the nation’s economy,” said Comptroller of the Currency Joseph M. Otting. “The decision to consider applications for special purpose national bank charters from innovative companies helps provide more choices to consumers and businesses, and creates greater opportunity for companies that want to provide banking services in America. Companies that provide banking services in innovative ways deserve the opportunity to pursue that business on a national scale as a federally chartered, regulated bank.”
Traditional banks will certainly feel a significant squeeze between successful European digital banks, and profitable US based fintech’s like Square, who have announced plans to apply for a charter.
Brokerage Innovation
Wealth management business at banks should continue to drive growth in 2019, given secular demand, brand equity, and scale. At the same time, fear from recent market volatility could result in customer withdrawal from the market, turning growth into contraction.
Even with a continued strong market, growth of digital advice platforms, the drive toward low-cost options, and the push for greater price transparency will require established institutions to innovate and adapt in order to grow market share and profits.
A New Equity Exchange
There is probably no better example of established financial services firms innovating for low-cost solutions than a new initiative from banks and brokerages called Members Exchange, or MEMX.
Announced January 7th of this year, “MEMX’s mission is to increase competition, improve operational transparency, further reduce fixed costs, and simplify the execution of equity trading in the U.S.,” according to a press release announcing the exchange. “In addition, MEMX will represent the interests of its founders’ collective client base, comprised of retail and institutional investors on U.S. market structure issues. MEMX will seek to offer a simple trading model with basic order types, the latest technology, and a simple, low-cost fee structure.”
The founding members of MEMX are many of the largest U.S. retail broker-dealers, global banks, financial services firms and global market makers, including: Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS, and Virtu Financial.
MEMX will seek to offer a simple trading model with basic order types, the latest technology, and a simple, low-cost fee structure. “The launching of MEMX is a testament to the market-wide demand for competition, innovation, and transparency,” said Douglas Cifu, CEO of Virtu Financial.
Members of the investor group plan to apply for exchange status with the Securities and Exchange Commission early this year
More Fintech Pressure
Other established wealth management firms are responding to fintech pressure. JPMorgan recently launched a digital investing service You Invest that includes 100 free trades in the first year in response to feeless trading services offered by Robinhood and eToro (although you need to check their spreads and overnight fees). Robinhood and eToro also trade cryptocurrency.
In addition to equities, innovation in fixed income is coming—and in some cases—already here. The electronification of the rates market, particularly US treasuries, is already a reality, and corporate bonds are expected to move along a similar course this year.
Once again, regulatory changes in Europe, such as MiFID II, are already impacting foreign exchange platforms and should accelerate the migration of fixed-income trading onto regulated markets, further improving transparency.
According to Deloitte, “as in other areas of capital markets, the use of AI and machine learning are expected to expand at a rapid pace.” In fact, 2 years ago Elefant, Inc. was formed with the specific intent of offering “algorithmic liquidity” for corporate bonds. They define their implementation of AI combined with deep experience in the bond market as “machine intelligence meets market intelligence.”
And Nasdaq’s “Analytics Hub” uses natural language processing (a confluence of Artificial Intelligence and linguistics) to analyze company filings and earnings calls for more targeted investment insights.
More broadly, AI can help transform market infrastructure players in multiple ways—from predictive market surveillance models and prevention of predatory trading strategies to intelligent reconciliation systems to improve operational efficiencies.
Overall, established brokerages appear to be more willing to innovate and partner with fintech firms/technology than their bank counterparts. This should leave them better poised to compete as transparency increases, costs lower, and margins tighten.
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