Fintech Lecture 8: Trading & Capital Markets
Earlier fintech was about bringing the whole payment industry on the internet. Then we get to this new form of technology, largely about mobile phones, but also related to open API and access to the data.
Initial Paypal was nothing but an online payment system with a good user interface. Then Robinhood came into space.
It was more of a mobile-first approach, started tackling weaknesses of the larger platforms, such as user interface, to make it more accessible for somebody to really just trade from anywhere and then the fee structure was a huge part of that too.
Robo-Advisers and Commission Rate
It is rather than having a human but analytics embedded in a program to give you advice about asset allocation, investing and more. Younger generation is a lot more used to doing things online and robo advisors provide them a new way to construct their financial portfolios rather than going to a financial advisor.
If you accumulate $100 million of assets under management and charge 1% broker fee, that’s $1 million of revenue. But robo-advisors don’t need this much fees. Same case with online brokerage.
Asset management FinTech startups, primarily we think of Robinhood, a free way to trade, but there’s a bunch of others within other markets because even the Schwabs and Ameritrades were still charging, whether it was a few pennies a share, but still charging $0.03 $0.04, $0.05 cents a share. User interface and cost provided some opportunity to move in.
So it’s delivery mechanisms, user interfaces, service, and also a cost price. In essence, can you do something better, quicker, cheaper? That’s a very simplistic way to think about it.
IBKR, which is that smaller but remarkable Institutional Brokers, in September of 2019 said they were going to go to the free brokerage for some of their accounts. It wasn’t 100% initially but within weeks, early in October 2019, Schwab finally said Zero commission.
Trading Shops want to have a first look at order flow. They want to have those orders and to route them through their algorithms and into their either exchange engines if it’s an exchange that’s paying for order flow, or a high-frequency trading shop that’s paying for order flow. The exchanges have different fee structures depending upon whether you make a bid or offer or you take a bid or offer. You will sometimes hear this called maker and taker rates. Making a bid or offer, putting a resting bid or a resting offer into an exchange engine is more valuable for the exchange because it brings other orders into the exchange.
So what Robinhood figured out was they could offer the retail public something for free because they entered into two or three major contracts with hedge funds, we will enter into something where we’re selling you the order flow for a modest amount. I don’t know the exact amount, but let’s call it a penny a share instead of the pricing of the $0.03 or so to $0.05 that the online brokers were charging, but still very valuable over time for Robinhood. And then bingo, 6 or 8 million members and account holders later and a good user interface, others drop their rates as well.
It’s what led in part in the early 1970s to break the old decades-old fixed commission rates because large investment banks wanted to discount and lower their rates for large institutions, not for the retail public. That was 50 years ago, but that was also because there’s all this revenue potential, beneath the surface.
Banks usually make money by holding deposits on a daily basis because that’s revenue to the firm. It’s especially hard to do so in the US where interest rate is near zero. But in emerging markets, such as Korea, China, or India, they basically make the revenue if you have somebody’s money and you can lend it out in a net interest margin of positive.
So one company that does pay for order flow is a large hedge fund high-frequency shop from Chicago called Citadel, it used to be about $20 billion. Citadel is one of those vendors on the other side of the Robinhood app. They find that order flow is then valuable for them. They’re routing some of it to the Stock Exchange, and that could still be worth something. They’re putting it into their analytics. They then get better-sophisticated machine learning on the analytics and that order flow is also something that can be very valuable to an operator of a dark market, one of these small electronic markets because you’re all competing.
The traditional Merrill Lynch broker from the 1930s to the 1980s was a commission-based broker. But by the 1990s, they started to charge advisory fees, maybe 1% of the assets that you left with them and if you leave $1 million, that means that they’re earning $10,000 a year on your account.
Evolution of Robo-Advisors
We haven’t gone all the way that we went with an online brokerage, to mobile brokerage, to zero accounts, zero fees. But one of the great pressures that have happened here is asset management fees have been coming down as well.
The first innovation was an innovation of the early 1970s. Jack Bogle, who was the key innovator behind Vanguard, said, wouldn’t it be great if we gave America at the time a product they can invest in the whole stock market a little bit of each company and we’re not going to manage it for them. We’re just going to algorithmically pick a little bit of every stock and it was called an index fund.
That innovation then led to another innovation in the 1990s that said, what can we do to make this even more efficient? What if we take an index mutual fund and take the interest in the mutual funds and make those securities? Took a little change in some regulations, but all of the sudden, we had exchange-traded funds, these low-cost ways to participate in the stock market, the bond market, some in the gold and silver markets.
All of these robo advisors in their packaging have said, we can get you into this market or out of this market, and use exchange-traded funds.
The second big innovation for robo advisors, of course, is everything we talked about out of artificial intelligence and natural language processing.
And the third innovation was basically some simple analytics — not machine learning, but simple analytics on portfolio and asset allocation. Some of it’s related to, if you’re in your 20s and you’re saving for retirement, you could take more risk. You could have a higher equity share versus a bond share. If you’re in your 60s, and you’re about to retire, you should be more stable, a little less risk, maybe more bonds and fewer equities.
So, if Robinhood goes to a different country they have to think If it’s actually customers using the platform, then they would have to be aware of the regulations in that jurisdiction, whether it’s the regulations in Europe or in Korea, that do they register as a broker-dealer in Korea or Japan as they are, in fact, just a mobile application for a traditional investment brokerage firm?
Crypto Exchanges
Once the cryptocurrencies were made, people wanted to trade them. So startups came to the rescue and created exchange and it became a market where users trade cryptocurrency with the help of fiat currency.
They also acted as custody and held your funds. If you are trading on crypto-exchange, you move your assets through Private key and after that trade, these exchanges keep your assets so they become your custodian.
The public has direct access to these exchanges which is a very different model than traditional exchanges. The traditional markets built upon a business model that’s multiple centuries old, we are not direct members. We have to go through somebody to get to the Stock Exchange and that’s a broker. It’s called a member of the Stock Exchange. There’s a lot of regulatory reasons we’d stay in the intermediated access. These crypto-exchanges have to be open to millions of people from their home laptops and mobile phones, a very different architecture where it’s disintermediated the broker-dealers and, by the way, are not well regulated.
Why robinhood doesn’t allow users to trade in bitcoin?
I think the regulation for any platform like Robinhood around cryptocurrencies is a bit challenging because in many jurisdictions, we have not gotten to a place where you can feel confident we have a robust investor protection regime on cryptocurrency and in fact, in most jurisdictions, it’s pretty shaky.
Crypto Decentralized Finance(DeFi) market
The traditional finance market has multiple channels regulated by the government to keep consumers safe but considering the age of cryptocurrency, we do not have many channels to explore right now.
People are exploring cryptos but currently, we have only three:
Exchange — Peer to peer Crypto exchange without a central exchange unit
Crypto Lending — You lend and borrow stock sometimes because you want to buy the stocks on margin or sometimes you lend it because you need to borrow against your assets to do something else. Maker DAO, and Compound, and Synthetix are the three big ones — that are trying to do that on crypto lending and borrowing.
Prediction market — Users can trade with another user and make a bet. Pure gamble and very volatile.
Lecture 7: Introduction — — — Lecture 9: Insurance
Lecture 1: Introduction — — — — — -Index
