A Step Towards a More Sustainable Financial Market

Undeniably, society’s concern about being green has been growing tremendously for the past years and environmental awareness is, certainly, one of the burning issues of the century. Consumers are changing their behaviors, opting for sustainable products and making more aware choices. However, is replacing a plastic bag for a paper one the only way of being green?

12 years ago, the European Investment Bank issued the first ever Climate Awareness Bond (CAB). These green bonds are designed to encourage sustainability and to support not only climate related but also other types of environmental projects. Backed by the issuer’s balance sheet, these sometimes called “climate bonds” are intended to fund projects that are environmentally friendly, going towards new or existing projects that are meant to have positive environmental or climate effects, supporting sectors such as renewable energy, transport or waste management.

“Green bonds offer investors the option to diversify their portfolio by not only income-based decisions but environment-based ones as well.”


This market works as a common bond market, in which borrowers are institutional investors trading their financial assets. Companies, local, state and national governments and supranational institutions ensure the lending of this eco-friendly project, representing the supply side of a growing market that has, nowadays, more than 50 issuers.

The field of action is large, involving several sectors of the economy. For instance, in June of 2013, Commonwealth of Massachusetts, as the North American pioneer in this field, sold green bonds amounting to $100 million and publicly shared which projects are being financed by green bonds and how does society benefit from the investment in this innovative financial asset. Being the main market supplier, the US, led by the mortgage giant Fannie Mae, plays an important role promoting this environmentally friendly financial asset and, since Poland opened the sovereign market in 2016, France, Belgium, Ireland and the Netherlands did not take long to follow the example of Uncle Sam’s country.

Throughout the years, the green bonds’ market has been experiencing a boost of investors looking for conscientious choices to allocate their funds. According to Bloomberg, until 1st October 2019, “assets under management at 644 funds focused on environmentally friendly investments stand at more than $220 billion, compared with around $80 billion at the end of 2014”. Also in the past month, George Ammond wrote for the Financial Times, concluding that Asia-Pacific issuance of green bonds had hit a record of $18.9bn. This value was raised from 44 green bond issuances that were open to international investors, which positively correlates with the growing interest from investors in green finance.

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Moreover, this green investment method has revealed to be beneficial for both parties: sellers and investors. The first ones benefit from the eco-friendly vision of the investment which is propitious to attract new investors, resembling almost to a marketing strategy and drawing the attention of the most concerned consumers. The second ones benefit from the fact that these financial assets are characterized by having tax-exempt income. Additionally, investing in green bonds enables buyers to monitor these projects, contrarily to the very little insight investors have into what happens with the funds raised on debt capital markets.

However, a major dilemma arises. Are these “bonds for the planet” truly used to start and develop eco-friendly projects or are they just part of a bigger marketing strategy?

As previously mentioned, green bonds have tax-exempt income, they are supported and sponsored by governments, what closely fills the expectations of environmentalists in trying to solve climate change problems. What about the cases in which green bonds are issued to promote other projects that are not so “green” and institutions still benefit from all of these advantages? Firstly, it depends on the perception of green. This broad concept can differ not only internationally but also nationally, making it difficult for issuers to comply with both standards. Moreover, the lack of a “standard universal certification system” allows for green bonds not to be analysed through a universal procedure that accounts for the borrower’s creditworthiness or “greenness” of a bond. For instance, China is the biggest carbon emitter and occupies the second position in issuing green bonds. The problem started when the chinese power used this concept to finance coal-burning plants which, even if less polluting than previous methods, don’t reduce the carbon emission in the long-run. Another dilemma, pointed by Boardman, the chief financial officer of clean energy developer Sindicatum, comes with the lack of benchmarks that causes green bonds not to “qualify as a mainstream investment vehicle.”

“I think we need to think differently, we need governments to sit down and say all finance has to be green. There has to be strong incentives, clarity over the status of green bonds, status of green loans and bank financing.”

— Michael Boardman

In an attempt to clarify this problem, several studies were conducted aiming to broaden the definition of “green”. Oslo-based Cicero (Center for International Climate Research) came up with the idea of using three shades of green according to the ecological impact of the project in question: dark green, for projects reducing the carbon emission in the long run (wind energy); medium green, for projects that take a good step forward; and light green for steps that won’t change the long-term outlook on their own, consisting in more efficient projects (China’s case).

Indeed, in the mesmerizing bonds’ market, if an investor understands the environmental risks better, the cost of capital will go down for green projects. The benefits this financial asset brings to the environment have evidently been shown. However, in order to really create an impact on sustainability, this market has to grow much more than the observed heretofore. Massive investments are required to change the way we produce energy, reinforcing the urgency for individuals to take a proactive approach against climate change. As an “idea that captures investor imagination to combine the force of capital markets for a good end”, green bonds arise as a “tool to reconnect the dots between finance and the real economy”. What determines the effect of this revolutionary financial asset not only on the environment, but also on society, is how institutions and companies incorporate and allocate these green investments and in which degree are individuals incentivized to engage in an eco-conscious behavior. It is crucial to acknowledge that ecological progress is not simply imposed on society, but rather a consequence of conscious and informed choices by society’s decision makers and green bonds are certainly an important step towards a more sustainable financial market.


Sources: S&P Global Report, Bloomberg, European Investment Bank, CNBC, Dealogical Data, The Financial Times, CNBC.


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Making Money in a Recession

Despite not agreeing exactly when will the next recession hit, most economists agree that it isn’t far in the future. The longest Bull Market is coming to an end, so investors should transform their portfolios to gain or reduce losses during the next economic downturn. The options are diverse, and we tried to narrow them down to the most common and effective.

Short selling

Everybody has heard of the renowned movie Big Short and how rich Michael Burry and Steve Eisman (known in the movie as Mark Baum) got, but few understand what a short sale is.


Michael Burry: The genius behind the Big Short Source: CNBC
Michael Burry: The genius behind the Big Short Source: CNBC

This investment mechanism consists in selling an asset or stock that the investor doesn’t own. Anticipating a price decline, an investor sells the previously borrowed securities having to return the same number at a later date, meaning that he intends to sell when the price is high and buy back when the securities are cheaper. The lender of the securities is the broker-dealer that the investor relies on to place a sell order. This trade is made on the margin and is leveraged, meaning an investor can make much more money than the amount of the securities, but it also represents a risk if the price increases instead of declining. This type of investment requires that 150% of the value of the securities stays in an account.

Due to its risks and margin requirements, short selling is not adequate for amateur investors or small investors due to its raised expenses: costs of borrowing the security to sell, the interest payable on the margin account that holds it, and  high trading commissions.

In times of recession, short selling poses high returns, particularly for experienced investors that predict Bear Markets before they happen. Overpriced securities are the most targeted by short sales since they fall the most in an economic downturn.

Gold

Gold has been perceived has a safe haven investment for hundreds or even thousands of years, especially in times of uncertainty in the financial markets similar to the ones we live today.

Historically it has always been used as a physical store of value due to its rarity and traded back and forth to protect value in times of war, recession, political turmoil, etc. Since gold cannot be printed and its price is resistant to changes in interest rates, gold has tended to maintain its value throughout time.

When we compare it with stock indexes (S&P 500 or Dow Jones Industrial Average), it is evident that the price of gold has continuously increased, but with much lower variations. Another aspect that stands out is the negative correlation between stocks and gold notably in times of recession: in the Dot Com Bubble in the 2000’s and in the Subprime Crisis of 2008, investors withdrew their money from stocks and stockpiled it in gold and gold derivatives. This last statement can be verified in the graph when the stock market takes a dip, gold prices raised especially before and during periods of recession. 

But how do we invest in gold? The easiest way is to buy physical gold or goods made using this rare mineral, like jewellery or coins, in the private market. But the amount we can buy this way is very limited and may not be correctly priced. Therefore, to bet on the variation of gold’s price or of other physical commodity in the public market, an investor can buy/sell Gold Futures, ETFs, Mutual Funds or stocks belonging to Gold Companies.

Even during bull markets, gold-related assets are essential in a well-diversified portfolio to guarantee stability and steady returns.


Variation in Dow Jones Industrial Average (Blue) and Gold’s Price (Orange) Source: Macrotrends
Variation in Dow Jones Industrial Average (Blue) and Gold’s Price (Orange) Source: Macrotrends

What are consumer staples?

Consumer Staples are everyday used products by households that will continue to be used regardless of their cost or the state of the economy. These types of products are unlikely to be cut from any individual budget as the consumer is unable or unwilling to do so. The level of demand on these products tends to be rather constant. Consumer staples go from foods, beverages and drugs to basic household goods like hygiene products.

These type of good are less volatile during economic cycles (non-cyclical) due to its high demand and level of utility, revealing its constant level of demand. Hence, sales and earnings growth in the consumer staples sector tend to remain constant both in good and bad times. Price elasticity of demand is very low, as the demand in this type of product doesn’t react much from changes in the prices of these goods.

What are utility stocks?

Well, utility stocks are stocks related to firms in the Utility sector, a sector in which companies provide basic amenities such as gas, water, electricity or even renewable energies. Investors often include these types of stocks in their portfolio due to their relative stability. Thus, like consumer staples, these utility goods are less volatile during economic turmoil due to their necessity and utility provided.

Utilities are often associated with stable and consistent dividends and the betas of these type of companies are usually less than 1 due to their ability to be less volatile than the equity markets. Hence, during economic slowdowns or even recessionary times of the economy, utilities tend to perform well under these hard circumstances. However, in the opposite case of an expansionary period, utilities might be stocks that will underperform the average. Not only because of the beta’s value but also because utility companies usually have high levels of debt (due to infrastructure needs) and during economic improvements, interest rates increase and investors are able to find better yielding in other alternatives such as Treasury bills. Therefore, utilities perform well under economic slowdowns since interest rates decrease and the yield related to utility stocks is greater than the risk-free assets.

What are healthcare stocks?

Healthcare stocks are stocks in this case related to firms in the Healthcare Sector which consists of businesses that provide medical services, manufacture medical equipment or drugs and/or provide medical insurance to patients. In the U.S., the healthcare sector is one of the largest accounting for one fifth of the total annual GDP. Healthcare services are associated with highly price inelastic meaning changes in prices have a little effect have on the quantity demanded.

Holding an all-stock portfolio such as the S&P 500 index fund can be improved by simply adding a value-weighted healthcare portfolio, resulting in both a higher return and a lower standard deviation (diversification-effect). Healthcare stocks were the strongest performer in this index in 2018. However, this sector is becoming more volatile with the slowing of corporate earnings, trade wars and rising interest rates.

ETF

An Exchange-trade fund is a security made of a basket of different securities combined in a single entity, which then gets traded like an ordinary stock in the major stock exchange markets.

The ETFs generally can track an infinite range of benchmarks, from commodities to every possible stock, with the purpose of getting has much return has possible in all the different segments of the markets chosen. They are most usually focused on the same type of security and so they can be characterized as Stock, Bond or Commodity ETFs. 

To invest in an ETF, you first need to choose the benchmarks you are willing to risk your money on as the economies they’re in, while also bearing in mind the proportion each company takes on that ETF.

ETFs have its pros and cons which, on the good side, offer horizontal diversification of securities and transparency, since with the help of the internet we can see its true value based on what’s inside of it, but on the other side you have trading costs related with expense ratios and commissions to brokers and the fact that very specific ETFs may not have high demand levels, making it harder to sell it in the short-run and so, less liquid.

Some of the most well-known can be the SPDR S&P 500 ETF that replicates the famous S&P 500 index, which is the general overlook of the biggest 500 public companies in the world, the SPDR Dow Jones Industrial Average ETF and the Invesco QQQ, which also track the Dow Jones and the Nasdaq-100 indexes, respectively, both providing the industrial and technological overlook of the US economy. These three ETFs have positive correlations with the evolution of most relevant global economies and so, they deal with a great variety of market segments, making you invest not in any particular benchmark but in an economy, which is not the case for the majority of them.

REITS

A real estate investment trust (REIT) is a corporation that owns and manage income-producing properties

They can be characterized in three different ways, them being:

  • Equity REITS

It is the most common one, which owns and manages real estate directly, being the revenues from the leasing and rents of tenants the primarily form of income and not the reselling of portfolio.

  • Mortgage REITS

It is mainly focused on financing real estate and the revenues are generally made by what’s earned from the interests of those mortgage loans. Also, they invest in and own residential and commercial mortgage-backed securities for their portfolios.

  • Hybrid REITS

It performs both equity and mortgage operations.

REITS can either publicly traded or private whilst the traded ones provide more liquidity to the investor than the private ones.

Investing in REITS may have its risks and most of them are directly related with the real estate current market: if property assets start to lose value, their investor will be harmed with that.; the volatility of interest rates, given that a decline in them will consequently give an opportunity to decline as well the assets rate of return; and the fact that real estate isn’t a liquid asset; However, this market shows that real estate tends to appreciate over time. In most cases there are steady flows of income from tenants if the properties are being rented and that in the long-term real estate tend to be quite profitable.

US Treasury Bonds (T-Bonds)

A US Treasury bond (T-bond) is a government debt security that ranges from 10 to 30 years maturity wise and it is known to be one of the safest investments worldwide.

The US Treasury has been around since 1776 and not once has failed to pay its lenders. Also, given that this security is backed by the “Full Faith in Credit“ clause of the United States, it faces a default risk of almost nothing, so, if the main goal to invest is to not lose money, then they are the right security to invest.

However, although being acknowledged as a risk-free asset, there are still some factors that need to be accounted before investing in it.

  • The Opportunity Cost

Considering T-Bonds are evaluated as AAA assets (risk-free), then, that will have an effect on its yields, which will consequently be lower than other potentially profitable assets with higher defaulting risk. The urge to not lose any money may let investors ignoring other safe and with high returns investments.

  • The Inflation Risk

If the T-Bond is not linked with a TIPS (Treasury Inflation-Protected Securities), the inflation risk must be acknowledged by the investor. For example, if the security provides a return of 3% and 5% inflation is occurred, then the investor will come out short since the return is not keeping up with inflation.

  • The Interest Rate Risk


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If the investor hopes to hold the bond until its maturity, then this risk does not need to be accounted. However, if that is not the case, then the investor may have serious problems to liquidate its investment if the Fed decides to increase the interest rates. This happens because, if new bonds are being issued at higher levels of return, then the demand for the original ones will fall causing the price of the bond to follow that same direction.


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Libra – Facebook’s New Currency

Facebook is set to launch a new cryptocurrency called Libra next year in early 2020. This new currency will allow its 1.7bn users to make financial transactions online from their mobile phone without a bank account, the company claims.

In early 2018, Facebook was accused of compromising over 50 million users’ data, having to pay $5bn for Cambridge Analytica privacy violations. This has been the largest levy ever imposed over a technology company by the Federal Trade Commission. Stocks plunged 20% and the company’s value dropped by $120bn.

Later on this year, Facebook announced that it is going to have a new cryptocurrency and financial infrastructure powered by blockchain technology, a series of immovable record of data that is managed by cluster of computers not owned by any single entity, which aims to provide and facilitate global transactions.  The company will have a new blockchain division ran by David Marcus, former president of PayPal and current head of the Libra project.

Zuckerberg and his team were initially able to gather 28 organizations for this new currency, such as Uber, MasterCard, Farfetch and Vodafone among many others. Thereby, they created the “Libra Association”, a non-profit organization, headquartered in Geneva, Switzerland, working to support financial inclusion worldwide. Each member funded the project with a minimum of $10bn. The association will focus on the reserve management, ensuring stability obtained by having a cluster of valuable assets composed by the dollar, the euro, the Japanese yen, the British pound and the Singapore dollar, with 50 percent, 18 percent, 14 percent, 11 percent and 7 percent, respectively.

The price stability will be the main differentiator from its cryptocurrency’s peers. It won’t have a fixed exchange rate, although it won’t be as volatile as, for example Bitcoin (another cryptocurrency run by blockchain technology). The reserve will amount around $200bn, an actual low number when looking into the financial markets.

Calibra will also complement this project, being the first product that introduces a digital wallet for the Libra, expected to launch in 2020. It will be available in apps like Messenger and WhatsApp, but it will also have its own app. It is claimed that it will have strong protection and be able to keep the user’s money information safe, although there is concern going around since the company’s history in data privacy is somewhat hazardous.  As previously mentioned, Facebook claims that the new cryptocurrency will reach the unbanked. You’ll just need to have a smartphone in order to send Libra instantly.


Problems might arise…

People who actually study the unbanked in the Federal Deposit Insurance Corporation have noticed that more than one third of the population concerned didn’t have enough money to open a bank account. This is something that is not solved by simply opening an online bank account. Almost half of the adults in the world don’t have an active bank account and these numbers worsen in developing countries and amid women, data released by the World Bank. So if this is the reality, will these people have access to a fully working smartphone? Even if they do, will they have digital means to buy Libra Coins?

Well, the certainty we have is that big companies like Apple, Google, Amazon and Microsoft have not yet signed up for the project, as well as banks. Mainly due to uncertainty going around future regulation that might be imposed by the authorities in order to secure central banks’ “monetary sovereignty”. Lawmakers and regulators in the U.S. have already raised concerns over this initiative. French Economy and Finance Minister already stood out saying France won’t allow the authorization of Libra into European soil given the issues inherent to the situation. China also considers Libra as a direct threat and is developing its own Central bank’s digital currency to meet the challenge imposed.

Facebook, however, has already stated that “people will increasingly trust decentralized forms of governance” (statement by David Marcus). The head of the Libra Association has already responded to the threats this project might have against financial institutions, playing down concerns over a potential disruption to monetary policies by the central banks. The reason of this being the fact that the Libra reserve contains multiple currencies, which makes Libra the one affected and not the other way around, he justifies, also adding that in case there is a currency crisis, they might decide whether or not to keep the certain currency in the basket.

Libra is designed to run on top of existing currencies, and claims the 1:1 backing of traditional currencies requires an equivalent value in government reserve in order for Libra to exist. “As such, there’s no new money creation,” Marcus tweets. He has also completed the statement saying that regulation should be created. Nevertheless, Facebook is maintaining the release date unchanged setting the launch for 2020.

Wait… Zuckerberg’s company knows the barriers they have to face to get the project launched. Most attacks to the Libra have to do with the technology and trust issues. The CEO himself has had a meeting with Donald Trump in order to discuss regulations, and how it will protect users’ data. The G7 nations have already formed a task force to look into concerns about cryptocurrencies, mainly the Libra. The firm’s own problems don’t lay solely on the decision of lawmakers, as this project has no “significant prior experience with digital currency or blockchain technology”. If problems are not settled, the digital currency might never launch.

One thing is certain, if Facebook is able to further develop and launch these cryptocurrency, they will centralize their platform users into their brand and profit from it. They may be able to use private information to personalize advertisements, their main source of income ($16.6bn at the end of last year), and eventually build a huge network of people around Zuckerberg’s empire. But first, they will have to overcome regulation and privacy hurdles. For now, because of the big controversy, some of the main companies involved the project have recently announced their withdrawing from supporting Libra, as it is the case of PayPal, eBay, MasterCard and many others.

What Is the Repo Market and Why Was Wall Street Worried?

Some of us may have been aware of the big fuss that started a few weeks ago in the “repo market” and that required the intervention of the Federal Reserve through the injection of money. But how many understand what is traded in this market and why is it important for the US economy?

What is a repo?

First, we must grasp this concept of Repurchase Agreements. A repo operation occurs when one party lends money to another using US Treasury notes (or other types of securities, although less usual) as collateral. The party that exchanges the securities for cash agrees to buy them back for a higher price at a later date, usually the following day. The difference between these prices is the repo rate

Repurchase agreements allow lenders to earn a low but secure return while holding safe securities as collateral and borrowers without liquid assets to meet their short-term obligations. Borrowers regularly consist of Wall Street brokers or hedge funds that must manage large portfolios through day operations. Lenders can be anyone with a money-market savings account looking for a short-term risk-free investment.

 

 

structure of a repo

 

Federal Funds Market

Besides covering short-term needs in terms of liquidity and providing a safe investment for the agents previously mentioned, repurchase agreements are also an important money-market tool in the federal funds market. As we are aware, banks work with financial assets, loans and deposits but they require cash to manage their day-to-day operations and short-term obligations (mostly payments and other transactions). Therefore, banks (and some other parties) trade their reserves at the Federal Reserve with one another overnight through repurchase agreements. The banks with excess reserves lend them to less liquid banks in exchange for US Treasury notes that will be returned next morning for a higher price. The repo rate in this market has the name federal funds rate and is the Fed’s goal to keep it between defined lower and upper bounds.

The importance of repurchase agreements

The repo market is a vital cog in the US economy by accomplishing different functions:

  • Arrange efficient short-term funding: by offering short-term deposits supported by safe securities and enabling lenders other than commercial banks, it makes funding easier, cheaper and more efficient;

  • Allow the management of day-to-day operations of low-cash portfolios: investors and especially large funds don’t keep many cash assets since they are considered unproductive, so repos allow for short-term payments without the sale of long-term positions;

  • Provide an accessible risk-free short-term investment: the fact that repos are collateralized by US Treasury notes makes them the perfect short-term choice for riskaverse investors such as money market funds or non-financial corporations; repos are also more available than other short-term options such as risk-free deposits at the Central Bank (only available to institutional agents) or Treasury bills (crowded primary market and tight secondary market);

  • Facilitate Fed operations: due to their low-risk, collateralized nature, and efficiency repurchase agreements are a widely used instrument by open market operations to increase or decrease money supply;

  • Foster price discovery: repos ease the primary market and most importantly inject liquidity in the secondary market, therefore fostering trade and arbitrage and aiding in discovering the relative prices of the securities used as collateral.

What is happening in the repo market?

Middle of September, interest rates on the obscure part of U.S lending spiked, prompting fears on broader problems. A few weeks ago, there was a big cash shortage where banks and hedge funds excessively demanded more funding that the market couldn’t supply. Monday 16th was a tax payment deadline for big companies and a holiday in Japan – which meant a large portion of funds’ sources were shut off – and after a recent Treasury auction for government bonds, there was a liquidity crunch.

These series of events shot interest rates up to 10 percent on overnight lending, more than four times the Fed’s target rate, as commercial banks saw their reserves shrinking unexpectedly. The federal funds rate hit 2.3 percent a day after, which is above the central’s bank target. This reflected in unexpected strains. (image 2.)

 

 

The Federal Reserve’s balance sheet

These increases in the interest rates of repurchase agreements were also influenced by the fact that there is less cash in the system compared to previous periods. Over the past years, the excess reserves have been declining since the Federal Reserve started shrinking its balance sheet, limiting the amount of money available in the markets. Since 2017, the Fed has been shortening their treasury and mortgage-backed securities (MBS) portfolio, now being at $3.9 trillion of assets, a significant reduction when compared to the $4.25 trillion worth of securities back in the period of 2008-2014 when there was a quantitative easing programme.

 

The Federal Reserve had to immediately intervene with a temporary injection of $75billion, open market operations to prevent borrowing costs from spiralling even higher. By fuelling the money market, the Fed was able to stabilize interest rates and slowly bring them to a suitable window within their parameters. It also announced the lowering of interest rates by a quarter percentage points as part of its effort to encourage economic growth, leaving interest rates between 1.75% and 2%.

The Fed chairman Jerome Powell said they had been expecting an extra demand because of Treasury settlements and the need for cash by tax-paying corporations. However, they were not expecting this amount of volatility in the market.

 

 


Federal Funds Chart

 

“The effective federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements. Also known as the federal funds rate, the effective federal funds rate is set by the Federal Open Market Committee, or FOMC. The effective federal funds rate is the most influential interest rate in the nation’s economy. It affects employment, growth and inflation.”

— Bankrate Sourced

Why is or should Wall Street be concerned?

Well, any unwanted and unexpected volatility in the financial market tends to distress investors, especially in what some people think is a pre-recession phase of the US economy. However, the Fed came out to say that as they were shortening their balance sheet and reducing the excess reserves in the system it was inevitable for a moment like this to happen. This could have been seen by investors as a distraction by the Central Bank or as foreseen and expected event. Unfortunately, as in the 2008 recession, people are starting to feel like someone’s not telling them something, and adding this unanticipated rise of the overnight lending rates to the $17 trillion dollars’ worth of bonds with negative interest rates and to the inverted yield curve, they feel like something’s missing them. Maybe the real problem is not only on the shortage of reserve but on the essence of the transaction: the collateral

US Treasury bonds have been perceived for a long-time now, as risk-free securities, while still giving an average annual return of 2%. However, is it that unlikely that the US defaults on its debt obligations? If so, how can some financial institution let these considered risk-free bonds be a collateral in a repurchasing agreement that goes up to 10% in interest rates and how can the Fed lose such control over these interest rates? It may only be a normal Supply-Demand situation where lenders have that power to determine the interest rates due to the borrower’s despair, but questions about its intrinsic value are starting to appear raising concerns across the markets

As mentioned previously, the repo market, though rather unknown, played an important role in the crashing of the economy in 2008, where both the lenders and borrowers were destined to lose and lost money, since mortgages bonds were being used as collaterals with triple A ratings. When the economy suffered its great contraction and some big corporations and banks that made repos went bankrupt, the other parties were then trapped with securities that were in fact worthless. On the other side, some companies tried to save themselves in the short-term by making repurchasing agreements with the same collaterals that were now considered risky, even when lenders lost faith in these securities and withdrew their funding, leaving them with no chance of negotiating and trapped as well with them.

So, what if the US economy is heading in the same direction as a decade ago and no one is noticing it like they did then? Economists are still arguing, but still, the 16th September event may have been a sign of the times to come.

João Ribeiro João Ribeiro Martim Leong Martim Leong Francisco Nunes Francisco Nunes

 

Who will survive? Fintechs, traditional banks or both?

Do Revolut or N26 sound familiar? They are some of the most known fintechs in Europe. Both present themselves as alternatives to the traditional banking sector. The first is from the United Kingdom and the latter is based in Germany.

If you’re Portuguese, you are probably familiarized to MB Way and have heard about PPL Crowdfunding, a crowdfunding platform as its name suggests.

Fintech’s are revolutionizing modern banking, among other financial services.

Briefly, “fintech” stands for financial technology and represents the term used to name companies that exploit technological advantages to provide more efficient, lower cost and more user-friendly financial services.

Revolut is maybe the most known example of a fintech unicorn [term used to name tech companies valued above $1 billion].

Without a physical presence (it doesn’t have any bank infrastructure like Barclays or BBVA), this fintech is able to provide most of the financial services offered by the big banks at a lower cost and with a more user-friendly interface. You may transfer money between two different country-based banks without any intermediation fees for example. In this case, the United Kingdom’s based unicorn is clearly a Competitive Fintech Venture as it competes with the traditional banking sector.

Another type of fintech is what may be called a Collaborative Fintech Venture: this kind of company aims instead at complementing the traditional financial services. An example of these ventures is the MB Way service, provided in Portugal by SIBS, a company mainly held by the national big banks. It initially enabled consumers to easily transfer money between different bank accounts, using only the client’s phone number. This way, consumers have an additional feature linked to their bank account and are therefore more pleased with their banking services.


So, should the big banks feel threatened by fintechs?

Fintech is creating opportunities for customers and businesses alike, Bank of England Governor Mark Carney said.

“In the process, however, it could also have profound consequences for the business models of incumbent banks,” said Carney. So, should the big banks feel threatened by fintechs?

The BoE, in its 2017 stress test, said the tested major banks (HSBC, Barclays, Lloyds, RBS, Santander UK, Standard Chartered and Nationwide) concluded that they could withstand continued low growth and fintech competition without making big changes to their business models or taking on more risk.

[Reuters] However, the BoE stated that the fintechs’ competition could cause “greater and faster disruption” to these banks’ business models than even these institutions project.

Number of commercial bank branches in Europe (per 100,000 people)Number of commercial bank branches in Europe (per 100,000 people)

Also, as digital payments gain terrain over the use of bank notes and coins, the ATM network in these same countries has dropped on average 2.5% since 2015, which leaves room for fintechs in the payments’ sector, like Stripe, based in San Francisco. Stripe started as a service to help small online sellers process payments and now serves tech giants like Amazon and Microsoft. It now presents other products, like a credit card issuing technology and its latest valuation, dated from Jan. 2019 was $22.5 billion.

As shown by Revolut, fintechs may weaken the relationship between customers and the banks. “For instance, in the future, it may be possible for a customer to manage their finances with only minimal direct engagement with their banks.” This will certainly make it harder for banks to maintain their high margins and profits.

Moreover, as digital banking wins over the traditional one, bankers as we know them are also at risk. According to the World Bank, the number of commercial bank’s branches per 100,000 people in developed countries like Belgium, France, Denmark, Germany, Italy or Spain have dropped an astonishing average of 5.9% since 2015 (to the last recorded year-worthy of data), which coincides with the foundation year of Revolut.

To cope with this already existing and growing competition, the big banks have to take one of two alternatives: to design on their own innovative alternatives and technologies that bring more value to customers as fintechs do; or to integrate these upcoming firms in their ecosystem, as it may be easier for these start-ups to be more agile and disruptive than for the “too big to fail” banking institutions. Otherwise, if these financial organizations also show themselves as “too big to innovate”, they are condemned to fail, to be replaced and outperformed by the upcoming fintech companies or even by big technological conglomerates like Apple, who are rapidly taking over some financial services (e.g. Apple Pay).

One thing is for sure: this competition will certainly benefit consumers and possibly even the whole economy, in which the new blockchain technology may have a relevant role to play.