Lemons and LIMEs - deep thinking about financial innovation

[drllau]

Having just attended a FinTech event looking for interesting techplays, I came away reflecting that we are still monkey brains with digital fistcuffs .... automation just amplifies our innate human nature, particularly greed (indicated by some attendees bemoaning they couldn't make out like bandits on ICOs and had to settle for 10x or lower returns). if you look at innovation in the long-term (centuries) then I'd like to point out particular stepups purely to give the current cryptoXYZ some context

1. Commodity-based Coinage - we can thank the Roman Empire for the denarius, whilst the coinage (and resulting debasement & inflation) was nothing special, the fact that it was widely accepted across continental Europe meant it was a standard unit of account ... even well in Middle Ages, people still (mentally) valued goods in extinct coinage simply because it was a useful reference stick which is essential for exchange
   
2. Double-Entry bookkeeping - formalise the Venetian mercantile trading which meant a systematic way of tracking profits ... as Drucker said, if you can't measure it, you can't manage it. So bean-counters are the measuring stick for firm performance though the profession is now struggling with services and intangibles
3. Negotiable Instrument - title to goods (and the monetary value thereof) became convoluted the longer the trade routes and more parties involved. Hence to do credit-worthiness check would mean inspecting every single party along the chain ... the negotiable instrument was the simplified set of rules which mean that only the endorser would need to be evaluated ... this freed up a lot of dead capital stuck in assets.
4. Joint Stock Company - the East India Company was famous in its days for ventures and the modern corporation with separation of ownership, governance and management stems from that period. Equity rather than debt rose to prominance and broadened the capital base to the middleclass (keeping in mind peasants still 80% population) mobilising more savings
5. Fraction Reserve Banking - love it or hate it, the decoupling from commodity coinage into fiat currencies increased the monetary base of a nation as industrialisation required massive investment. Nuff said
6. Derivatives - whilst give a bad press due to Global Financial Crisis, the role of derivatives is to transfer risk. Specialisation means incremental capital to targetted incremental productivity which means easier to scale up.

Now let's put blockchain et al in context of the above. Is it the financial protocol (equivalent to TCP/IP) for firms of this century? Or is it a massive Ponzi scheme with ICOs designed for the bigger fool market? When I look at this space, I analyse based on the flow of information. There is a classic article "Market for Lemons" which talks about used-cars ... essentially the role of information assymetry in any transaction. Usually the seller knows more than the buyer which means they know better whether the used car is a lemon with all the risks of breakdowns, repairs etc being passed onto the buyer. The whole definition of profit is based on fact that there are assymetries in the market (whether scale economies, superior insight, or better AI-training sets to account for black swans).

The significance of shareholder cannot be understated ... firms traditionally attempt to keep leadership in a market (aka info-assym) try not to reveal supplier, customer, dealflow info or other trade secrets. Hence the cost of extracting useful information for investors is high ... but shareholders make this bargain with firms that in return for doling out cash at intervals (investment tranches, capital calls, supplementary offerings, etc) the management reveal sufficient information to avoid forfeiting their ownership stake (note to mention activism via no-confidence motions, dumping shares, or just general gossip).

So in theory, the blockchain allows for greater transparency reducing the information asymmetry provided firms cooperate. Currently regulators, exchanges and general securities laws force firms by holding feet to fire and forbidding them to return to capital markets if they are bad actors. However, post 9/11 this has been subverted with attempting to control the source of capital if linked to terrorism. So KYC, AML and BEPS are driving up marketing, search and compliance costs. Despite the relatively low interest rates globally, borrowing is not matching due to the regulatory burden and sluggish economic growth (partly due to excess capacity). So naturally a lot of people have jumped onto the crytoXYZ bandwagon offering to solve RegTech headaches, touting AI for InsurTech, and prompting govts to bet on FinTech to pull economic chestnuts out of danger.

Coming back to the point, how to reduce information asymmetry and eliminate the market for lemons which are low grade assets (or hidden debt bombs a la GFC)? If we consider ICOs as an example, I define the eventual evolutionary form as Limited Information - Mineable ExoData (LIME) where apart from the white papers, and prospect (if any) there are external data a smart investor can consider when examining prospects

- github repository ... for security purposes (avoid obscurity) the code releases of the protocol (but not necessary UX and defensible IP) can be audited and benchmarked for activity

- community participation - it is not difficult with modern tools to separate out astroturf tweets or artificial customer users, the problem with FinTech is not technology but change management since firms need to reconfigure various internal silos for transparency

- post ICO, the token activity level can be modelled and with some luck predicted (assuming the code is delivered and works)

- academic qualifications or work history of the founders and especially technical team can be assessed. Whilst not being snobbish about only looking for Ivy-League grads, basic traits and competency can be assessed (but finding that workaholic charismatic empath founder is going to be a pipedream).

So if you look at financial innovation as where the cost of search/marketing/compliance is reduced, then tracking what information is revealed, independent veracity of claims and eliminating formalistic due-diligence in favor of operational oracle fact-checking are all examples of exo-data which create value (or more exactly redistribute away from existing gatekeepers). Will this help you become insta-millionaire by betting on the right ICO? Nope, but at least you'd get away from the sour taste and enjoy a nice lime cocktail instead. Are we having financial innovation, not really in context wrt ledgers, registries, exchanges which are basically distributed variants of existing institutions (incremental innovation) but it does set the groundwork for efficiently pricing low-grade assets, expanding capital base by recognising wider ownership, and (hopefully) shifting value creation towards high risk high payoff projects.

Lawrence

http://www.linkedin.com/in/drllau

[drllau]

Speaking on topic of financial innovation Cambridge Centre for Alternative Finance surveyed the global FinTech scene to rank the cities Singapore came in as #9 followed by HK then Sydney which placed it as a regional player but not global. Whilst noted for its ecosystem support, the lack of consumer deployment/experience (suggesting that most innovation targeted at the B2B space) pulled it down. The report noted that 3 different drivers at the top, NY traditional finance, SF with financial innovation (helped by substantial fund raising) whilst London RegTech. It looks like India and Europe is lagging China and US in general. The question for policy makers is what will to take to make SG startups hungry enough to reach the top10?