BaaS 2.0 : Every Company is a Finance Company (#43)

Structural Shifts with Hasan NAWAZ, CEO at HUBUC

Today we speak with Hasan Nawaz, co-founder and CEO at HUBUC — a banking as a service (BaaS) platform that enables brands to open up new revenue lines by seamlessly embedding financial products into their customer journeys. HUBUC takes care of all the regulatory requirements and manages compliance risk. This allows their customers to get their services to market in less time with fewer resources. In this episode, you are going to learn what banking as a service or BaaS actually is, why it’s not the same as embedded finance. What’s happening right now in the BaaS landscape, the difference between BaaS 1.0 and 2.0, and more.

Before we get to the show, we want to flag that on May 1st we say happy birthday to aperture. We’re two years old! In case you are brand new to us, we design build, fund, and scale digital age companies. Now on with the episode.


Main topics discussed:

[00:02:12] Banking as a Service (BaaS) vs Embedded Finance

[00:07:43] White Labeling vs Embedded Finance

[00:15:55] BaaS landscape and main players

[00:22:42] HUBUC and BaaS 2.0.

[00:40:55] The competitive environment for BaaS 2.0.

[00:49:08] Recommendations: Hasan’s favourite book, article, company, influencer, brand.

Full transcript
BaaS 2.0 : Every Company is a Finance Company w/ Hasan NAWAZ

We combined compliance with technology, and then the magic happened.

Full transcript:

Ben: [00:01:36] Hasan, welcome to the Structural Shifts podcast. We are delighted to have you on.  I think we’re catching you early in your trajectory. You’re clearly on this massive growth journey; and even though HUBUC might not yet be a household name, I don’t think it’s a question of if, it’s a question of when. We’re so excited to have you on. We’re going to talk all about the next generation of banking as a service.

Hasan: [00:02:03] Thank you. Excited to be here. It’s amazing. I have read through some of your older articles when we were starting, and it’s a pleasure to be here.

Banking as a Service (BaaS) vs Embedded Finance

Ben: A good jumping off point might be to define what we mean by banking as a service. Hassan, what’s your definition of BaaS?

Hasan: Banking as a service, I think there is a trend right now going on that everybody seems to be doing banking as a service. It’s mixed up now. Everybody has a different definition. My personal point of view on banking as services, if you use the word ‘bank’, you should be at least a chartered bank. You can’t be an electronic money institution saying that you’re a bank.

My definition is there’s banking as a service version 1, which has existed for the last four or five years; then there’s the next generation. For me, banking as a service provider right now is normally a regulated entity who has some together on KYC, AML, and the different set of tools from different service providers, slap an API on top of it, and they go out to the market and say this is banking as a service – which worked great for the last four years.

Ben: In terms of definitions, a lot of people use the term ‘banking as a service’ interchangeably with embedded finance. How do you differentiate between those two terms?

Hasan: From our point of view, it’s a clear distinction between two different go-to-markets, two different type of customer bases, and stacks. It’s a completely different thing.

Let’s make an analogy. For example, before Amazon cloud or Google cloud or Azure cloud, there used to be these data center service providers, like they were monolithic systems where you have like a single service provider and they have a couple of data centers and they’re building some layer of software on top. There’s the previous generation or banking as a service provider, which is the Version 1 let’s say, and then there’s an embedded finance.

The Version 1 service providers, it worked great, similar to analogy of data center service providers before the cloud happened. The difference is it works great in your specific use case. It helped a lot of startups to become FinTech, and N26 were built on top of Wirecard and GPS and everybody else. That was great. But embedded finance is talking about embedding these FinTech features and these financial services into your existing products. We are talking about a whole different customer base, if I were to say, especially in the B2B space. It is like having a sleeping majority of people where you have to first educate and also they need to understand what is the value for them – mostly it’s about know monetization and retention for them. If you’re looking at how they access or they want to access the financial services, they’re not looking for signing several different contracts and waiting for a year and setting up a compliance thing. Their business might be freight forwarding, accounting, retail, vendor payout – there’s all those B2B stack companies on the business operating system.

Kind of provide services for these service providers. That’s where I think embedded banking service partners need to come in, like us for example. We target that customer base and help them understand what this can provide, but it’s like a white glove managed service, to be honest. You have to make a single layer, which takes care of compliance and all these different hard tanks, which is settlements and KYC, AML, regulation, and all that stuff.

You need to make sure that the customer is not affected with it, in a way that they want the feature, but they don’t want the hard things about it. How you can build that layer on top, is I think it.

Ben: Essentially the difference between BaaS and embedded finance is really looking from the vantage point of whether you’re on the supply side, whether you’re a license holder; or whether you’re on the demand side, with your brand that’s looking to offer financial services through your existing distribution channels or together with your existing offering. Is that the way to think about it? You are the orchestration layer that sits between the supply and the demand side – you make it possible for existing financial services providers to open up new distribution channels and you make it possible for non-financial services to offer financial services solutions for the first time? 

Hasan: It’s not about providing APIs. It’s more about managed versus non-managed. Just to give you an analogy, there are quite a few in history, but for example, before Shopify or Stripe, banks were giving acquiring channels online, so you could take payments. People were setting up e-commerce stores. I was a software developer, I set up a lot of e-commerce for companies.

The difference is now anybody can do it right. That anybody can do it comes with an enabling through a different take on the risk compliance and making sure that anybody can access that. That’s where you can seamlessly embed in your value proposition those features. If you cannot do that, if you’re going to have set up compliance calls and have to set up a whole department of looking at AML policies and drafting them, then you’re probably not there yet for that. No code embedded happening.


White Labeling vs Embedded Finance

Ben: [00:07:43] If we go back to the early 2000s, there was lots of white labeling that was happening. A lot of supermarkets started to offer insurance products, they started to offer banking products. The difference here is the extent to which this is truly seamless, and the speed with which you can change providers, the speed in which you can onboard. How would you draw the distinction between white labeling and embedded finance?

Hasan: If you see a little bit, even further down back, it seems like now everybody’s doing banking as a service with cards and accounts, which was basically co-branded card programs from the past. Every bank had one, every supply chain had a co-branded card. There are still active ones with big ones, but most of them failed, because there was no real customer pain being sold for the end user but just giving them more and more cards. I think that is very true.

That co-branding worked for some companies, bigger ones. Let’s say, for example, in Spain, there is Zara and these guys who have distribution power and they really enable their customer to use something and in return they are getting rewards and stuff. But that only works for a certain limit. How many more cards do you want?

If you look at now, what is happening, I think it’s not about how easy the access is, it’s deeper stack level features. For example, it’s not about only issuing a debit card or a prepaid card, it’s about, can you enable customers of yours to have access to real IBAN and mapped bank accounts guaranteed by a local banking partner, and they can pay taxes, salaries, receive money, send money, just like a high street bank.

In a nutshell, I think it’s about feature parity with a high street bank. It provided for a new generation like a FinTech or a non-FinTech player to be able to use those features, because normally they cannot get those. It’s about changing the scenario of how banks used to be. They are the best people to do compliance and they’ve saved that for hundreds of years.  There’s no question about it. But I think the scenario has changed in a way that now you cannot go full stack into the market, to the end user, and be also covering the wholesale side of things.

Now there’s an opportunity, I think. In this case, we work with smaller banking partners. For smaller entities who have a smaller liquidity base and user base, I think it makes sense to become the store of value and the store of compliance and safeguarding. That’s the core which they are really experts on; and leave the distribution to providers who can really make better customer experience by embedding them into different ones.

As a regulated entity, you get the deposit, and your value where you store eventually. All the features which you are distributing through your own channels now are being used through an API, and have 10 X or 100 X more reach to customer Bases because you’re getting an aggregated access to those customer Bases/

For example, one of our customers, Wage Stream, they do early salaries. They launched in Spain, and they’re like, “Look, we’re going to need 300,000 accounts.” Now, our banking partner had I think one fourth of those. For them, it was like, “Wait, what?” I think smaller entities; it’s really helped with opening a revenue stream. Indirectly, you don’t have to put your marketing, and also the regulator is happy because you’re holding more balance and you can use it for other accesses.

That is where we see both sides getting some interest. It’s not about only giving prepaid cards.

Ben: [00:11:43] It is sort of driving more of a distinction between manufacturing on the one side and distribution on the other. The reason it seems that people are so excited is because you are now distributing banking through a channel that has higher engagement, lower cost of customer acquisition, the potential for high lifetime value, because it’s easier to cross it onto an app because you understand the customer context. Is that the reason why people are just over themselves with excitement about embedded finance? Because it’s about growing the addressable market and making banking much more contextual?

Hasan: Yes and no. It’s not about only the user experience. You want to give the best features to the user, but in return what are you getting? There’s a saying: if something is free, you are the product. If you have providing the customer something, what is the benefit for the person who is providing it? Why people get excited about us or venture capitalists or investors, or in general? Every company is going to be a FinTech company, let’s say.

I think every company at some point touches the payment stack. The value prop or the USP for the company or the provider, is that I get to see and improve my retention of my customers, or I’m looking for monetization and I’ve happened to land in products and increase my unit economics by user APR by adding an intro deck provider, get affiliates to be on top of itself. If you have a distribution channel, you can add on top features by working with an embedded provider and get on top of monetizing your user base.

Then people like N26, an amazing company, they were the first ones to start overdraft, and then they started noncash to cash conversion from stores in Germany. Now, last time I checked, they were embedding. Grab also does it. They embed Chubb, for example, their insurance company product. They embed seamlessly. Instead of going and filling out forms for insurance while you’re covering for three days, just hit a button and it automatically books.

Yes, the user experience is great, but also the providers getting something out of it. It’s not about just contextual user experience. It’s about what are you getting out of it as a provider? Then of course the service provider in the background always get some revenue. I think it’s both sides of the table: the customer and the user and the provider.

Ben: What you just said there about N26 is interesting because we tend to think about embedded finance as being embedding finance into non-financial channels. But it can also be embedding into existing financial channels. The difference is you don’t have to build everything yourself.

Hasan: Exactly.  You’re not going to start doing underwriting for an insurance company. They do better. You want to work with one of them. They understand probably more risk profiles than a FinTech can, because of their wider data set across multiple services and the history of underwriting all those risks.

You end up working with one, the question is: which is the better one? Do you want to go and spend seven to eight months integrating with one, or you just want to come to a platform which provides different sets of services and pick one and use it?

That is what happened with, for example, you see Amazon web services or Google cloud as well. They started with service for internally; they were built for internal use of Amazon itself. Then they started on top of features. Now, eventually, you just join AWS for the hosting service and end up using Elasticsearch and AI models. There’s a ton of services. You think about, I don’t need to build it. I don’t need to reinvent the wheel, it’s already there. Use it as a service, and the cost is pretty similar of integrating versus managing it.

That’s why people started using a cloud provider instead of having your own data centers. I think there’s an opportunity over there.

BaaS landscape and main players

Ben: [00:15:55] Hassan, let’s talk bit about the landscape for BaaS. A lot of people think that all BaaS providers are essentially the same. ostensibly it looks like it’s just the question of APIs and linking with brands on the demand side and banks on the supply side. Everybody gets lumped into the same bracket. But it’s much more nuanced and layered than people think. Help us out here. Help us, if you can, to provide a schematic of who does what and what the differences are between the different BaaS players?

Hasan: Let’s start with somebody like SolarisBank; they are a fully chartered bank and they have the right to say they are a bank, because they have a charter. Then they have brought in a couple of service providers for KYC, AML, some processor, a lot of different things. Although everybody talks in terms of partners, but we all know the partners behind. Eventually they’ve got a license and some partners, and then stitch it up together and then have a API on the hub.

The value proposition for the customer is good because it gives them security of a full bank license, and they can passport hopefully in other European countries. The lending part, if you think about how they make more money, it’s not only on account basis. It’s more about how – and this came out of our report- I think that there’s a lot of revenue for them. That is also value proposition for the customer, because it’s not only cards and accounts, they have a German IBAN. It’s a very good proposition for the local market in Germany, especially.

Then you have the likes of Modeler, Railsbank, Swan, or older players like Treezor from France; they have powered a lot of good startups who became FinTechs. Everybody knows about them. Then there’s there was Wirecard, the original. What happened over there is bad, but what they built initially was an amazing scalability of the product. They powered the likes of Curve. They have innovative companies who build on top of the N26. Number 26, the original name, came out of Wildcard AG. I was one of the first customers; we had a card transplant and the name of the bank.

That is great. That is regulated on a lower level than a bank charter, but doing similar things – no lending, nothing like that. “Here’s an account and a wallet,” most of the time. If you want to go fast, let’s do a prepaid card instead of a debit card. How your KYC requirement for a debit card versus lower against the prepaid card, that’s where Revolut started. It didn’t say debit on the card, it just was a card for a map class. That is like having any prepaid card attached to a wallet.

Then you have, in the US if you look at Synapse. They are running on top of a banking partner, one partner. They integrated with them and they’re running on top of it. Similar to Synapse, but not having the regulatory and compliance obligations of running the whole stack by themselves.

This is where you see different service providers, but their offerings change as well because they’re mostly in their countries, wherever they are. Synapse in the US or where the partner band has access. On the Baffin, SolarisBank is in German bank eventually. it is a FinTech, but it’s also a bank. You have the likes of Railsbank, and Swan, and Treezor, and everybody else. Then in the US you have unit and bond and all those players doing different things.

This is all what I think as monolithic. Everybody does one of everything: one of service providers, one of KYC, one AML, one processor, one of everything.

Ben: It is kind of monolithic. It can be vertically integrated, like something like Solaris or Marcus, for example; or it can be modular, as you said, Synapse and so on. But it tends to be narrow in the sense that it’s a single geography or a single vertical of banking. Is that right?

Hasan: Yes. That is how it works. Somebody was powering the fintechs of neo-banks, and somebody was starting to focus on expense management software, a little bit on corporate because corporate had a higher interchange fee versus consumer, especially in Europe, they’re not super regulated. There are tons of different things inside, but eventually, if you think from a technology or software paradigm, it’s monolithic. Versus the new way, which is going to come, is how do you have a service-oriented architecture? It’s microservice architecture, for example.

In software terms, monolithic is one single system with one database, one service provider, one of everything. In microservices, it looks like chaos from the outside because you have tons of different services interchanging, but then you have a central message bus or a service process orchestrator, which we think HUBUC is. That’s where we focus, is where you have tons of different service providers. Why it’s happening – I’ll come to that in a minute –there’s tons of KYC providers. There are seven or eight different KYC providers, and we can easily name them. Then there’s different AML providers, anti-money laundering software providers. Then there are manufacturers, big ones, small ones. There’s a few of them, like five or six, ten, definitely.

Then there is the awakening of these old school entities like Treezor, who were doing that co-branding stuff from the past. Now suddenly they’re also calling themselves banking as a service. But they have accounts which are mapped to a proper bank and stuff.

What we see is that there’s this fragmentation in the service supply side. If you look at the theory of marketplaces, a really good moment is when you have fragmentation on the supply side, when you want to build a marketplace on top of it. Your customer is isolated from so much different information; seven or eight different contracts, to build a small use case, you can just provide it as a marketplace, one contract, one compliant, and one commercial relationship, and then they don’t have to do anything directly.

That is how we see the old school versus the new generation.


HUBUC and BaaS 2.0

Ben: [00:22:42] That’s great, we can dig into that. I think that’s a nice segue to talk about HUBUC. Let’s maybe just zoom out for a second and you can tell us how HUBUC started. I think that’s relevant, talking about how you’re different and BaaS 2.0. Let’s start there. How did you start HUBUC? Where did the idea come from?

Hasan: This is our fourth FinTech product, or let’s call it fourth FinTech pivot. We started on the other side of the table; we were the consumers. We started with an initial idea in 2018, me and my co-founder. Of building a high-frequency trading board for the crypto market. It’s like we’re quants build software for the crypto. Didn’t work out, what a crazy idea!

We pivoted towards launching a neo-bank for crypto. That is 2018. None of the European partners wanted to work with us. Went outside Europe to a country called Bahrain, it’s a crypto friendly regulator. They did come a compliance sandbox; it’s a copy of their FCA regulation sandbox. Got in, there was no infrastructure, came back to Spain. Said: let’s build a QR payments app because we believe offline businesses have also the right to understand their customers, and nobody’s built a Google analytics for offline businesses. In order to do that, what you want is a closed loop payment system like Alipay, and WeChat have done it in APAC. Those guys went from nothing to basically directly 4G, or 5G.

We tried to do that. We build it using a QR code library. It was a two-sided marketplace, and merchants could understand who’s coming, what their agenda is, what are their profiles, retention rates and everything, and then he could do segment. On the consumer side, we thought that that was great, to get a deal when you want. But there was not really a lot of pain, in Europe at least. Either we were early or too contrary.

QR versus MasterCard and Visa in 2018, it didn’t work out. People want to pay with cards and iWatch and iPhones and all of that. Changing market habits is very expensive. It failed. We pivoted again, let’s build something which really the market needs.

We started working on a corporate expense card. We build it on top of a banking as a service provider, from UK, Ireland. It’s a great company, but we found out that there’s a lot of work to be done, especially from a customer point of view, when you are a B2B corporate expense card, where your customers are asking questions about: where’s my money going to be safeguarded, where is your bank? Then you say, “It’s in UK. But they have a license in Estonia or Latonia,” and your customer is like, “Why do I have to change all of this just for a card.” They want feature parity.

If they are switching from the old, let’s say high street bank, towards you to get a better experience, they also want the same features. It’s not about giving wallets to kids and cards for neo-banks for kids, it’s about providing service to people like Volkswagen and these bigger, huge corporates who are going to have corporate expense. You want to enable them to do that. The CFO of the company is going to ask you: where’s my money going to be safeguarded. That’s the responsibility. Who is responsible? What is the guarantee? Why is your license in Baltics, why not here? Why are you not working with a local banking partner? It doesn’t work. It doesn’t fly.

It’s good to build an MVP with banking as service providers, but as soon as you raise money, like seed round or something, you’re going to graduate from them. I’ve seen it happen. We see Revoluts graduating from them, everybody graduates eventually because the core business of finances service.

We launched Pigari. It was a great product. Corporate expense in Spain, similar to Soldo or Conto for Spandex for Spain and Mexico. The Spanish speaking market, in March COVID hit, we just launched it the first week, end of March there was COVID lockdown. There’s not corporate expense to be managed. We tried find a distribution strategy for our product, ended up finding out that there’s other companies who want the product but under their own brand, but they don’t want the compliance hassle and everything else, which we went through; to understand and build ledgers and sub-ledgers and how these spending controls and how the CFO can give a virtual card for IT team versus a physical card for a sales guy on the road who just needs to spend in petrol pumps and parking and food and the card shouldn’t work at the end of the day and the weekend the cards should be blocked.

All of this, which is what a CFO wants, the people who have been doing corporate expense software, they understand. But they don’t understand how to make this happen on a FinTech product or with a banking partner. They will probably need expert financial service developers who have built mail banks before to consult, and then it never happens. That’s where we came in.

They reached out to us and said, “We love what you build. Can you give us under our brand?” That’s where we pivoted. We had our first NOYC. This time we were not going to pivot towards the intersection there, but we actually saw signs of real traction. That was May 2020. We are a very young company, if you think about it. It’s like not even a year old. We launched with that one customer on demand and then we built a platform. We looked at all of the market. We looked at how many different FIS and Marquette and GPS and Paymentology – there were all these different service providers who were processing. Then you have KYC providers and AML providers and manufacturers. All of this, and now with PSD 2, you will probably need an FX rate provider, because it’s mandated. It goes on, it goes like way beyond on.

I think I did twenty-four or something interviews with different companies I looked at, when we were looking at how we were going to work with each partner. The opportunity was, what if you aggregate them? There is a higher set of costs for us to work against their APIs and have three card manufacturers instead of one. But for our customer, it lowers the cost 30%, than it was before with one card manufacturer. They have a wider feature set. You can ask us gold-plated cards all the way to organic cards; all the way to dynamic SIB cards, which are for online fraud. It changes the three-digit code of the CVV PIN every five minutes.

We have this wider set because we were able to aggregate it for the insolvent. The mode eventually ended up being, yes, there’s a lot of demand, but that demand needs a white glove service and a managed service. Somebody’s not going to knock on your door to get your API. You’re probably going to go and have a chat with them, have a scope of work session, have a flow of funds meeting to understand what they want to build and if it’s the right thing to build from a regulatory and compliance and everything point of view, and then prescribed them a solution. Then you make sure that your banking partners and everybody else on the other side of the market side is also happy with the risks you are taking. Have you built a mode on manual compliance versus digitalize it in real time? Are you doing sections and transaction monitoring as you should be? Are your partners happy? Are you embedding?

We work with three banking partners right now, and we made sure that we digitalize all of their rules and requirements which they had for us, for our customers, into one policy. That is very hard to do. Our head of compliance, she comes with 30 years of experience, but still it’s an exercise that’s not been done before. You are trying to take three different compliance policies and pull them into one single and making it simpler for the end customer and us, and making sure that it’s in real time and implemented on the technology stack. It’s not about checking in PDFs and putting out PDFs on rules and regulation, it’s about really implementing and enforcing those rules on the platform.

Yeah, that’s where we come from and that’s how we think about the product.

Ben: [00:31:29] If I may try to summarize, the insight came from the fact that you were on the demand side. You understood the pain that sometimes brands go through when they want to embed financial services. Then the other insight was around that fragmentation of the BaaS space. There was room for somebody to do the aggregation. But it sounds like more than that as well. Maybe that’s just the other things you talked about, just a function of reducing the friction for the brand. You’ve talked about being able to operate across geographies, about being able to do some level of compliance. Help us out, if we were to create a list of criteria for BaaS 2.0, what would be in there? Sounds like multiple geographies, aggregation, compliance. What else would you put in that list?

Hasan: Similar to what Amazon had, their three core values. Everybody wants a cheaper product, fastest delivery, and everybody wants the widest feature set.

For us, if you follow it, it’s very simpler. But just add on top of it, which is, we want the customer to have a managed service and cheaper than probably another place. They’re not going to come in for the core feature, they are looking for monetization and revenue, so how can you enable them? You’re giving them wholesale rates, you get them better prices.

Secondly, they want the widest feature set. Okay, I can do cards; can I do accounts, can I pay salaries, can I pay taxes on these accounts? Okay, great, how many countries do you have with these accounts? Okay, you have three different islands, what are you looking for next? Okay, we have seven different countries. Can I go from Europe to US? Because naturally, European startups and companies when they grow up, the natural way is looking at the US market. There are very few who go to other countries, mostly it’s US. Can you build a bridge between both markets? Yes. Okay, what is the capability and feature parity of your service versus a high street bank versus the global scalability of your platform?

Can you do everything that you just said in Spain, Germany, UK, Netherlands? Can you also do this in the US? In US, it’s a whole different way of looking at it. There’s ACH and things, people are still taking paper cheques. There are service providers for cheques. What is the feature set over there? So, the widest feature set, a good price, speed to market is important because people want to launch in 8 to 12 weeks, maximum. They are not waiting for months.

Then it’s about the most important one: compliance. That is included. Your banking partners are looking for it, your customers are looking for it. Customers are looking not to do anything, because they don’t understand it, they are waiting for you to guide them, like managed service. “Don’t worry, you don’t have to become an agent. We will take care of your compliance. We’ll take care of onboardings. You just have to follow these different guidelines and you have to do this, this, this.”

Always, as a program manager as well, you are thinking about different programs. If you’re talking about Cardwell’s, that everything is being followed. Basically, you are taking risks and passing it through to the end customer. This is normally what happened before. With all due respect to our colleagues in the market, there were registering agents and distributors passing along the risk saying, “I’m not the only one doing it. Here’s this guy who’s actually a reseller and he’s also doing it.” When the regulator comes, they can also point to you saying, “He didn’t follow. We told them to follow these guidelines.”

Now you’re saying that HUBUC is taking the risk for you. It’s not only dilated risk, it’s about floats. Can you manage float settlements? How do you manage liquidity when you pass through three or four or five days of Visa float, or versus MasterCard asking you three days sometimes, depending on the use case? Is your customer going to put in like days of transaction volume float for you? No, HUBUC is going to take care of it.

The current customer, you’re looking for that.

The regulator is looking for: are those perhaps sanctions? What is happening to these transactions coming in, going out into ledgers? Are you monitoring them? Fintechs, all of these different things, SCA regulation now coming in – are you following? They want to see from a regulatory point of view. I think when we worked with the Central Bank of Berlin, we learned something, which was working with the regulator is very different from providing service to the market. But good regulators understand and they adapt, but they also want to build trust with you. Trust is a very key factor. To build trust is very hard. You really have to work for it. But you can lose it in a second, like Wildcard did.

Ben: [00:36:21] Yup. It’s interesting, if we continue with the Amazon analogy, you’ve talked about how the customer wants cheaper, they want faster, they want richer feature set. Amazon is also working with a whole bunch of other suppliers in its marketplace and they want fulfillment, and they want certain things as well. It seems to me that you’re doing both, and regulation or compliance is a critical interface between both because the customer doesn’t want to have to worry about it. At the same time, the banking partner wants certain levels of assurance as well. My sense is that, if we talk about BaaS 1.0, I think there was this almost lazy assumption that if I can provide the APIs and the interface between banks and brands, then I’ll always be able to attract banking partners and other BaaS services providers. But I guess it’s going to be more competition on both sites; more competition for demand, more competition for supply. Do you think that it is compliance that’s going to make the difference in terms of winning both sides of the marketplace?

Hasan: Yes. How do you make comfortable your banking partner or the regulator? It comes down to compliance. Can you make a mode out of it?

At HUBUC, the biggest team is product team, the software development team. The second biggest, and the most important one at the core of the heart of the company, is compliance. If you combine compliance with technology, that is where you can build interesting stuff. But you have to know what you’re doing, and it has to be scalable, and it has to go across all of your customer base.

Ben: That’s clear. I feel I’m getting this real picture of what’s different about BaaS 1.0 and BaaS 2.0. When you were talking about BaaS 1.0, it was almost like the tech didn’t really matter, because everybody has great API, everybody can provide a sandbox. Almost like there wasn’t that much differentiation in the tech; versus what you’ve got, which is a new tech stack. You’ve got aggregation and you’ve got compliance. There’s the basis or the kernel of something which is differentiated and defensible.

Hasan: That is very true. We are not only also providing the compliance layer or that as at the heart of the company. With regards to tech, just to give you an idea, when we think about tech (I’m a software developer with 12 plus years of experience), we have unit tests. It’s a test with automated tests, which fail if there’s any part of the platform which does not respond over 100 milliseconds. The SLA is 100 milliseconds. At 100 milliseconds, you feel everything instantly. So that is where we think about scalability from a product and technology point of view. You can build all the compliance and everything, but if your tech stack, for example, is slower, the person building on top of you is also getting that. It’s aggregates.

Ben: The compounds, right? Across the latency compounds.

Hasan: Exactly. We are not only trust-building compliance from a technology point of view, we have to be scalable as a platform, which you can power any number of Revoluts on top of you. The transaction volume, all of them aggregated generate.

We are also in a system of authorization. Just to give you an idea, we are the system of ledger as well and authorization. What it means is, our cards, when somebody touches one of our customers at the point of sale or online payment, is going to come through the scheme rails all the way to us. We have two seconds (normally SLA from the scheme is two seconds) to respond to it, implement business logic on top of it. So, if it’s a corporate expense card, somebody put some spending rules on top of it, that all needs to happen before two seconds. We have to check, that card might be having three different ledgers and three different banking partners for us.

All this orchestration, that is where we come in. I do not want to say that we only care about compliance. We are a product and a compliance company. We combine compliance with technology, and then magic happens. It’s not about just sales – which is great, we have a lot of customers – but this is where you build the mode. You build trust with your regulators and partners. You build trust with your customers by providing a great SLA on services. Then you can also scale out, that is where you build trust with your investors, because you’re not actually having larger churns, your contracts are longer term, you’re betting on the next 5 to 10 years of the market.

The competitive environment for BaaS 2.0

Ben: [00:40:55] You just raised a very healthy seed round through Y Combinator. As I understand, it was very heavily oversubscribed. It seems to me that smart investors get what you’re doing. They understand how you’re evolving into the next generation of BaaS.

My question is: what does a competitive environment look like for BaaS 2.0? Is it people like Stripe treasury? Is it potentially people coming in from different spaces, people that already manage many-to-many orchestration? I would think people like open banking platforms that already provide the routes from customers into many banking providers or potentially even some of the more advanced SAS providers that again provide many to many interactions.

When you look out, where do you see the competition coming from? Is it BaaS 1.0 competitors and step up, or is it a new generation of competitors that maybe coming from adjacent spaces?

Hasan: I think first priority is a validation of our these of one part, which is, instead of competing against the bank, we need to work with them and aggregate them. They’re aggregating or they’re at least staying on the website, their YC Lam is a great company, an amazing company. They’ve changed the internet e-commerce world. But they are talking about aggregating four big banks. We say, “That is great, somebody needs to aggregate the rest of the smaller banks.” But we are both agreeing that it’s time to build a platform which is scalable, trustworthy, and that customers don’t have to go through hoops of how to use it. It’s a management way of doing.

But then their outlook, coming from their businesses, is that: here’s the form, fill up the form. There is no touch point. It’s all automated, digitalized, and you’re going to get an API and you’re going to build it. That’s where we differ. That’s where we are completely opposite. Our approach is: we come, we look at the use case, or we have a chat with you, we understand the flow of funds. It’s a very enterprise point of view. Here we are very similar to Adrian, for example, who has 400 merchants and makes more revenue than Stripe with hundreds and thousands of merchants. It’s completely different go-to-market strategies.

With regards to Banking 1.0 competitions, here’s the thing: when I was like actively developing (I still sometimes do, but from a solutions architect or software architect point of view), if you have built a monolithic system, you’re looking at the rewrite. If you’re happy to do that, you’ll be doing that to rewrite it into a service-oriented architecture or microservice architecture. If you want to do that, that means recordings, reissuing, a lot of which people don’t know.

Ben: In short, it’s going to be hard to go from BaaS 1.0 to BaaS 2.0. But what about the people entering from adjacent spaces? People that are already not monolithic, already have pretty powerful extraction platforms?

Hasan: It’s not like there is no competition. Stripe Treasury just raised 600 million or something and are opening in Europe. They started issuing Euro. But then they are giving you cards, and their go-to-market is their Stripe connect user who is already using the Stripe connect function of taking payments for their marketplace and they’re only doing the merchant payouts with a slapping on top of a card that is a corporate expense card. Then if you have an account, you can hold it for a longer term, and that’s it. That is banking as a service, or Stripe Treasury is focused on their marketplaces business.

We, on the other hand, look at talking about petroleum companies and mobility companies and expense management companies and taxes or vendor payouts. We have customers who are doing B2B payments. It is a very different approach towards what their market is versus what should ours. The market is super huge, and we can talk how we think about marketing, and then there is the markets and there’s players Vodeno and Ion Bank, and Phoenix, for example, in the US, Modern Treasury. They have different players in different go-to markets, but it’s very hard, I still think, to understand coming from acquiring, which is easier, almost commoditized, where aggregators of aggregators and pay facts of pay facts. Aggregating pay facts, like prime ratio; versus payment method. It’s completely different. The KYCs and merchant onboardings for opening accounts for KYB is very, very hard and expensive than onboarding end consumer, which is easy. Anybody can do it. On Fiddle, take a picture, loudness check, there you go. Pass it through compliance Wantage, perhaps in sanctions, that’s it.

Now, onboarding a company, it is a corporate with complicated subsidiaries everywhere else. How do you go along that? That is where you come in. Are you taking emails of zip files of compliance KYBs, or are you actually having an API end point which actually digitalizes, at least giving it a try on first digitalizing a KYB fully completed digitalize, and going through the API, versus sending zip files over emails.

There are very diff different ways of looking at it, but there is definitely competition. But the market is huge as well. To give you a flavor on how we think about the market, there’s the trillions and all of that stuff. We have a very simple thing, coming from YC, you learn something, which is you need to go bottoms up. It doesn’t matter the market size, because that increases. We have seen examples of Coinbase and Stripe YC alumni, we have a Brexit YC alumni, Grump YC alumni, the list goes on. These are the big ones. Then you have Airbnb and everybody else.

Somebody started with air, bed-and-breakfast on air bed, literally air bed, and then it became Airbnb.

What we think about is, the market size is bottoms up we take, it’s very hard to do it because there is so many different features you can add to build a bigger market or a smaller market. We think a base point, good example is the go to the ECB, European Central Bank, and look at the non-cash transactions. If you look at non-cash transactions across the countries where we can operate, for example US, Europe, APAC – almost all of it, 58 countries we can open accounts we can issue in 22 countries MasterCard and Visa. You work with both streams. But if we take across these countries bottoms up approach, take number of non-cash transactions (any transaction which is not cash), that is around 800 billion transactions last year. It’s growing 7-8%, depending on the region. APAC is doubling almost, but Europe is still growing slowly, but not bad. Then there’s the US as well.

If you take this market size and you say: do you charge per transaction? Yes. Hypothetically, if you’re charging 20 cents, divide the total number of non-cash transactions by the total number of cents per transaction, that is around 150 billion of bottoms up market size for non-cash transactions.

Ben: Give us a flavor of how fast you’re already growing.  

Hasan: We joined YC in the stammer with $54,000 of annual recurring revenue. We did demo day in March with a $750,000 of revenue. We are currently at $890,000 revenue, and we have total booking across 11 customers of $3.6 million.


Recommendations: book, recent article, company, influencer, brand

Ben: [00:49:08] Really substantiates what I said at the start, which is you guys are really on a tear. I think those people who haven’t heard of you now will be hearing about you pretty soon. Hassan, this has been a wonderful discussion. I think everybody would have learned a lot and everybody will now have a clear sense of what is Banking 2.0.

Just before we wrap up, I wanted to talk about recommendations. So every podcast we finish with asking our guests for sets of recommendations. If you’re game, I’m going to ask you for five recommendations, the first of which is a favorite book.

Hasan: I have multiple of those.

Ben: I’m sure. You’re a very learned man. Just give us one, if you don’t mind.

Hasan: I’m just a student of trying to understand things. A very good book is, The Innovation Stack, Jim McKelvey. He’s the co-founder of Square. It talks about how to build innovation and compete with companies who have never been competed. I think Amazon and at Squarespace, and then left at quarterly. And I think it’s the only company they left the space so far. That is a very good world to understand.

Ben: [00:50:22] Is Square a company that you particularly admire?

Hasan: Uh, yes. I really like how they think about things.

Ben: I think really understand how you build grossly upon grossly.  

Hasan: Yes. I think the key over there is they take risks, but they take them in a way that they first understand the secrets behind it. For example, if I was to talk about card issuing and if I don’t know what is a APW profile to register the card with MasterCard, which is a basic thing if you do with card recommendations (CNS profiles and stuff), then you don’t really understand what you’re doing. If you don’t really understand what you’re doing, first you need to understand it and then you can innovate on top of it. They have done it multiple times.

In the book they also talk about the banks were not willing to go outside those city walls and give machines to somebody like a merchant in the marketplace, and they needed it. There are two options there: either you can be horribly wrong, or you can be very good and very right. Most of the time if you take risks and you understand the market, you might be right. They have been right multiple times so far.

Ben: Good. First recommendation, Innovation Stack by Jim McKelvey. Next one, a favorite recent article.

Hasan: It’s called The New Mode in Financial Services by Mr. Ben Robinson from Aperture. It is a very, very good read if you give it a couple of times. You have to read it a couple of times – at least in my case, I’m probably slower. I read it a couple of times and I still have it. I think it’s a great piece.

Ben: Well, that’s extremely kind. I want to tell you, I don’t know how many podcasts we’ve done, but it’s lots and nobody’s ever recommended an Aperture article before. Thank you very much, indeed. That’s very kind. The next one is a favorite influencer. Somebody who’s essays, thinking you regularly turn to for inspiration or to learn.

Hasan: There are multiples of them, but there’s somebody very interesting. They are not invested, by the way, it’s Ben Horowitz. He has a particular way of using rap to explain things directly. He also has a great book. If I was to give an option number two for a book read or listen to, Hard Things About the Hard Things from them. It’s an amazing read, especially for CEOs and founders. You feel like you’re not alone, which most of the time happens.

I think that is a very distinctive way of looking at business and entrepreneurship, and he uses those rap lyrics. Which is, if you think about it, they are amazing because in two lines they convey you a message which most of the time I would, or some good entrepreneur would spend three, four days of writing a letter to explain the same thing which they’d just explain in two to three lines. I think he’s amazing to read.

Ben: To paraphrase Ben Horowitz, would you describe yourself as a wartime or peacetime CEO?

Hasan: Uh, wartime.

Ben: That’s good, I think you need to be. I think the growth rates you were talking about, they’re not peacetime growth rates.

Hasan: It’s 39% month over month!

Ben: Yeah. The next one is, a favorite brand.

Hasan: That is hard. SpaceX. Second would be Tesla; I don’t own one and I’m not invested in any way, but it’s like somebody who came in and really disrupted something, which is not building an app for something of something.

Ben: It’s funny you say SpaceX as a brand because Elon Musk is one of these people who says he doesn’t invest in marketing, he doesn’t invest in branding. Is it the brand of SpaceX or is it the ambition that’s captured through SpaceX?

Hasan: If you ask me what SpaceX means to me, it’s the next gen thing – really hard innovation, real innovation. It’s not building just another app for something, which we have been doing as an industry for several decades. What is the big bang which has happened?

This is a cool thing, and where really the next leap lies. We, or our kids, might be able to travel and live on other places. That’s really commoditizing and bringing mainstream that space travel. But from a design and aesthetic and a product point of view, it’s an amazing achievement. It is engineering in general, so as an engineer I’m probably focused as a brand on that side. It’s very hard to make simple things. It’s very, very hard to make simple designs, and you have an example of Apple.

But the designer doesn’t work without robust nest and scalability and service levels. I used to use Ubuntu and Linux, I come from the other side of the table. I was the guy who would not use Windows, thinking, I don’t like it, I don’t want to get logged into their system. I would rather prefer Linux and compile my own kernel and all those different variables needed to use a laptop. Then one day I switched to Apple, and it had the same core, which is the BSD core of Linux. But the product itself just works, the most important part. It’s not only the design, but it also just always works. It never lets you down. That is what changes something from other competitors or other products.

Ben: [00:56:40] I also think that Elon Musk is being a bit disingenuous when he says he doesn’t invest in marketing, because product is marketing and placement is marketing. Having Tesla showrooms at the center of every major city is marketing. Anyway, let’s move on. The last one is a productivity hack. So how do you make sure that you are productive every day in your role as a wartime CEO?

Hasan: It’s really hard. Something I read from a blog from a company, also YC alumni, they’ve built an amazing tool called superhuman and they talk about gated calendars. How to make sure that the years, you have enough time for concentrated work versus just changing context from one lawn to another meeting and now with remote. It’s just going crazy. It’s a very good read about, if you can stack together, for example, in my case, your one-on-ones on Mondays, or your reports, if you have any. They have their one-on-one on Mondays, then it goes down on Tuesdays to a specific set where everybody comes in with a clear idea of what we didn’t talk about, and you have those pizza type small meetings like Amazon. Then Thursdays you have a full committee. Everything which revels from Mondays to Tuesdays can be touched on Tuesday, and then your still have two days away from managing meetings into concentrated work.

Ben: I think that’s an excellent step, particularly in the remote world. The mental gymnastics; jumping between meetings, clients, it’s tough. I think that’s an excellent productivity tip. Hasan, I’ve really, really enjoyed this conversation. Thank you so much for coming on the show, I’m looking forward to doing this again sometime.

Hasan: Thanks a lot, Ben. Really appreciate it.

Against The Tide: Embedding Engagement Into Banking (#42)

Structural Shifts with Neri TOLLARDO, VP Strategy at Tinkoff Bank.

Today we host Neri Tollardo, Tinkoff’s Vice President of Strategy. In this episode, we discuss about Tinkoff’s entrepreneurial spirit (which has no hierarchy or bureaucracy, and this is something that they plan on maintaining as they scale), about the difference between creating an ecosystem as opposed to a conglomerate of different goods and services, how Tinkoff has managed to create insane customer engagement compared to most banks by combining their content with their technology, and more. Before joining Tinkoff, Neri was a top ranked sell-side research analyst at Morgan Stanley. 

In recent years, it has become a trend to call yourself a tech company, even if you are anything but. However, Tinkoff is one of the world’s largest and most profitable independent digital banks, and they really walk the talk when it comes to being a technology company. In 2006, Tinkoff started out as a branchless credit card issuer in Russia, and it now offers a current accounts, tax support for businesses, lending, and a range of other products and services through a super app that any Western bank would envy.


Main topics discussed:

[00:03:52] Entering the Russian financial market

[00:11:34] Tinkoff Business Model and customer engagement strategies

[00:21:09] Tinkoff business strategy and customer journey

[00:32:16] Branding: bank vs technology company

[00:35:24] No-hierarchy, no-bureaucracy culture

[00:39:19] A different value proposition than other digital banks

[00:47:35] Runway for growth within the domestic and overseas market

[00:53:43] M&A

[00:55:23] Favorite book, influencer, brand and a productivity hack

Full transcript
Against the Tide: Embedding Engagement into Banking w/ Neri TOLLARDO

We are the bank acquirer. We are the payment service provider. We are the payment gateway and we have our own aggregator, so we can offer the entire suite all developed in-house.

Full transcript:

Ben: [00:01:54] Neri, thanks so much for coming on the Structural Shifts podcast. This is going to be quite a wide-ranging discussion, but I thought a good jumping off point might be for you to tell us why you were so excited to join Tinkoff bank. As you just heard from the intro, for a long time you worked in bank equity research, so you are very familiar with the market and the different players. What was it about Tinkoff bank that particularly excited you?

Neri: [00:02:20] Hi, Ben. Thanks a lot for having me on this podcast. Great to be here. I worked for Morgan Stanley for seven years in equity research. One way or another, I always covered Russia. Although I’m not Russian, I did spend a large portion of my life there. I do think of it as a bit of a second home and spent a lot of time studying it and getting to know the culture, the companies, et cetera. When I started covering financials, I started covering Middle Eastern financials and then Central and Eastern Europe, then finally I got back to covering Russia.

Basically, as soon as I started covering Russia, I realized that the Russian banking sector and more specifically Tinkoff, was way ahead of anything else that we were seeing in Europe or even in other parts of emerging markets. Tinkoff stood out as one of those financial players that was doing something genuinely different.

I tended to write a lot of research about Tinkoff, and to try to go into their business model and. That then coincided with me looking for something else to do, because I’d done equity research for seven years and at the same time Tinkoff was looking for someone to help them pitch the story and communicate with investors. I jumped at the opportunity because on the one hand, it was a great story that I knew I could be passionate about pitching; and on the other hand, because it was a company that was genuinely different from its culture, from its products, from everything that they were doing. I took it as a very good opportunity to learn something new and to work with a team, which was extremely highly regarded by the market and that has built a business from scratch – which is now probably one of the most valuable fintechs in the world.

Entering the Russian financial market

Ben: [00:03:52] There’s a lot to dig into. Let’s discuss a bit the Tinkoff story, about the Russian market and why you think it’s ahead of the rest of Europe. As I understand it, Tinkoff was the first branchless banking service in Russia. How did it start out?

Neri: [00:04:10] It was founded in 2006, predating arguably when the word ‘FinTech’ was coined. The idea was by our founder Oleg Tinkov, to basically recreate a mini capital one, early days capital one in Russia.

He looked at the US and saw in the US you’ve got two or three credit cards per capita. You look in Russia, you’ve got like 0.1, 0.2.  No one has ever done anything like branchless banking before and Oleg is a man of big bets, so he said, “Let’s try and go and do this.”

At the beginning it was a credit card model liner that used something that now sounds very outdated, but which was already very effective and very popular in the US, which was direct mail. Very different company to obviously what it is now, but it did teach us a lot about how to run a business. I’m sure we’ll touch on it later; how to be analytical about your decision-making and kind of being focused on the bottom line and generating profits.

Ben: [00:05:08] What was the point at which the company pivoted from being just a lender without its own balance sheet, if you like, towards being a full deposit-taking bank or digital bank?

Neri: [00:05:19] It was pretty early on, because as I said, the company was founded in 2006; and on the asset side it had credit cards, and on the liability side it had wholesale funding. Turns out that wholesale funding is not the best source of funding during a global financial crisis, especially if you’re in a country like Russia, which was at the time highly susceptible to shocks.

Right around that time, a decision was taken to try to diversify the liability side of the balance sheet – so to try and go into deposits and turn accounts, which also coincided about the time with the ability to start moving the acquisition channels from direct mail to online. Once we cracked the ability to acquire deposits online, which obviously at the time were quite expensive deposits, then we started building a liabilities franchise – which was deposits on current accounts. On the asset, you had credit cards, and that then built the founding blocks for the entire ecosystem to grow.

Ben: [00:06:09] How difficult was it to become a deposit taker? Because you have to do KYC in-person, right? You had to do face-to-face meetings if you want to onboard a customer. How difficult was that to do from the point of view of a branchless or a digital bank?

Neri: [00:06:24] That was something that we had to figure out from the very beginning, because even when we were a direct mail credit card model liner, we still had to have a physical meeting with the customer.

For the listeners that are not familiar with Russia, it’s not like in Europe or in UK where you can download the Revolut app and then do the whole application and get a card and off you go. In Russia, the central bank still requires every new financial product, especially bank accounts, to be certified in person. So there needs to be physical meetings. Most banks will send you to the branch. We wanted to be branchless, so we built what we call a smart courier network of representatives that will meet you anywhere in Russia, within 24 hours. In the big cities, we’re almost down to 30 minutes; to deliver the product, take your picture, get your signature, whatever has to be done for the KYC process, and then off you go, you can start using your product.

That was something that we started using from the very beginning, that we kept using once we started moving online. I think the fact that you had a direct mail start and an offline fulfillment that needed to be very, very optimized, that from the very beginning instilled a culture of, let’s try to optimize every single process that we have, funnel analysis, what conversion is at each stage of the funnel, where it makes sense to optimize it. That was something that was instilled in the culture of the company very early on and helped us to then broaden the product set over time with the same level of analysis and success and eventually.

Ben: [00:07:49] What does the domestic competitive environment, particularly with the smart Korean network you built? You probably have some pretty ingrained competitive advantages or barriers to entry, at least.

Neri: [00:08:03] Russia, to some extent, is a little bit of a walled garden. Maybe not as much as some of the Asian countries that we see, but it’s definitely one of the few countries where Facebook is not the main social network, where Uber is not the biggest taxi, where Google is not the biggest search. You have a lot of local tech companies, and they’ve made it very difficult themselves because they’re very good competitors, for the large foreign companies to build their kind of pseudo monopoly positions, let’s say.

From that perspective, it is a bit of a walled garden, but it’s also very highly regulated. It’s not a playing field where it’s very easy to do anything. There are still rules that you have to abide to, and the rules can be quite strict, especially in the space of financial services. I think what’s different about Russia is that, especially relative to the Western world, is that the banks are very advanced. You do have banks that have realized very early on in their existence (not all banks, but a few definitely) that if you’re just going to be a traditional bank with your traditional banking structure, your traditional bank employee, you’re probably not going to last very long.

Namely ourselves and Sberbank, but also a few others, they realized very early on that they needed to build a technology company. We were that from the start. If you walk around the Tinkoff office, you wouldn’t be able to discern it from a Google office or a Yandex office in terms of the average employee that’s there.

In terms of the couriers and the offline KYC, that of course is an entry barrier. It is something that on the one hand is a big operational feat that we’ve managed to build (because again, we’ve got more than 5,000 smart couriers running around Russia at any one day doing more than 70,000-80,000 deliveries per day), that requires obviously a lot of effort and a lot of investments. On the other hand, it’s very difficult to recreate that. New players that want to come to the Russian market, they would have to figure out some kind of offline KYC, which keeps them out.

Ben: [00:10:07] And like everything, you’ve leveraged that. As I understand it, you have the largest last mile delivery service in Russia as well.

Neri: [00:10:12] One of. I mean, now obviously the e-commerce players are starting to build their own logistics network, so I don’t know exactly who’s the largest last mile delivery. But for quite a long time, we definitely were.

Ben: [00:10:25] I wanted to square something. You said, rightly, that Russia is a bit of a walled garden, but at the same time you said that the banks appreciated very early on the need to be very progressive, invest in technology, make their services digital. How do you reconcile those two things? Where did the pressure come for the banks to be so adventurous?

Neri: I think to some extent, it’s the fact that the banking sector in Russia is much younger. You don’t have the same old legacy systems and legacy banks that you had in Western Europe that have been around for 40, 50 years. The Russian market was rebooted a couple of times during the 90s, and so was the banking sector. There was definitely a possibility for a lot of banks to leap-frog and have a better starting point compared to a lot of European and Western banks.

Then I think I would actually put it down to a few people that were somewhat visionaries from that perspective. Again, Oleg coming up and saying, we’re going to be the first branchless bank in Russia. I think from Sberbank side, their CEO Herman gruff realized very early on that they’ve got a huge possibility to build something very advanced, very digital, very technological, and off they went.

Tinkoff Business Model and customer engagement strategies

Ben: [00:11:34] The company has faced, or been through at least, three crises in its short history. To what extent do you think the crises that you’ve been through have made the business much stronger?

Neri: [00:11:42] The three crises are the ‘08/09 crisis as we mentioned earlier; the 2014/15 crisis, which was Russia specific, it coincided with oil prices halving, it coincided with the whole geopolitical issues around Russia and sanctions being put on, and then led to basically a full-blown banking crisis and ruble devaluation. All the stars aligned for what was a very vicious crisis for the banking sector. Then more recently, obviously, the COVID crisis, which arguably out of the three was the one that was less vicious from a banking sector perspective and from the impact that it had on the company.

Very early on, we realized that we needed a business model that would allow us to accelerate and break very quickly, because we needed to withstand the shocks. Every time that a new crisis came, we already had some experience of hitting the brakes and making sure that we could burn down the hatches and wait for the storm to pass.

Obviously, every crisis teaches you something slightly new. On the one hand, if you look at 2014/15, there was a big liquidity crisis in the market, so you learn how to deal with liquidity. In 2020 with COVID, you learn more to deal perhaps about things that might go off with your credit risk models, because that wasn’t a variable that you were predicting before. Every time you learn something slightly new. But I think the mentality of being able to accelerate and break quickly, that’s something that you learn in the first crisis and then you can adopt over time.

Over time as well, our business also became a lot more diversified with a lot more revenue sources and a lot more customers, and all our eggs weren’t in one basket. That obviously complements to the resilience of the business.

Ben: [00:13:32] Let’s get into to the business model a bit more. You’ve alluded to some of this already by talking about the extent to which the company takes an e-commerce lens when it thinks about customer acquisition and funnel management and so on, which I think is already quite interesting within the context of a banking organization. But one thing that maybe people don’t realize, you mentioned that the company is pretty diversified. For example, you have a travel agency as part of the group. What was the rationale for launching a travel agency?

Neri: [00:14:05] I think again, it’s worth maybe taking a slight step back and realize that we started with credit cards, then because of that we learned how to lend and let’s say we added other credit products. On the liability side, we were getting more and more retail customers coming through deposits and current accounts, and these customers had other financial needs beyond credit cards. On top of the lending products, we developed a retail brokerage platform. We built an SME business, an acquiring business, and insurance business.

But the idea is that if we really want to engage with a customer, build loyalty, get all the data we need to have to offer them a tailored experience, we need to find services that are going to be rewarding for them and that they can use very frequently. One of the hypotheses was that a traveling agency, where we could offer a very neat experience to the customers within the app, and we could offer significant rewards, would be something that would be liked by our customer base and would drive engagement.

It turns out that now about a fourth of all the travel expenditure of our customers – and we can see what they’re spending money on –happens through Tinkoff Travel through the mobile app. It was clearly the right hypothesis and that led us to think about other businesses and other nonfinancial services that we could integrate to drive that kind of engagement. That way we could get people to spend some more of their time and eventually their money on our Tinkoff app, increasing the number of touch points that we would have with them.

Ben: [00:15:34] User engagement. I’m just going to cite a statistic here you’re your most recent investor presentation, where you said that you have 2.4 million daily average users and 7.6 million monthly average users. Basically 25% of your customer base pretty much uses the app daily. That’s an incredible statistic for a financial services organization. Do you think that most financial services organizations are missing this point around engagement? Because without engagement, it’s very difficult to upsell and cross sell. Do you think you’re quite unique in thinking about engagement first?

Neri: [00:16:08] Yes, I can give you some more updated numbers. We’ve got I think about 3.2 million Dow and just over 9 million miles. What we call ‘the sticky factor’, which is Dow divided by miles, it’s about 33%. You have to understand that in our ecosystem, we have a number of customers that are not really active. They might have a credit card or a lending product that is not exactly the kind of customer that engages very much with the app.

If you take, for example, the debit card holders, which are the people that will come mostly for the app for the rewards, for the lifestyle banking, for that customer the sticky factor is already closer to 50%. Meaning that they use the app on average every other day.

I completely agree with your point. That was our hypothesis as well, is that if your banking app can only provide the ability to check your balance and payments, send money to someone, it’s unlikely that you will be able to build a very strong long-term relationship. And that’s a commoditized product experience.  You can make it slightly more seamless, but at the end of the day that’s not what’s going to differentiate you from the competition. The way you differentiate yourself, and again, the way we’ve in part differentiated ourselves, is by giving an experience that is much broader, but it’s still very much linked with every single product that we have. The more products you have, the more rewards you will get, the more access to certain products and promotions and services you will get. That bit is a big differentiator for us, and something that a lot of financial services providers not only haven’t figured out, but even if they did figure it out, they probably would struggle to recreate it, because it’s obviously quite a technologically advanced thing to do.

Ben: [00:17:44] You think that’s the reason why we haven’t seen more super apps in Europe, which is it’s a complicated thing to pull off? Or do you think it’s more that people like that same strategic vision?

Neri: [00:17:55] I think that’s probably why you haven’t seen them coming from banks. I don’t think that a lot of banks are capable of doing that. The reason we probably haven’t seen them coming from the tech companies as well maybe that’s slightly more specific to the markets or the culture. I think the first big hindrance is that if you want to create a super app, you need big scale; and if you think about Europe, you’ve got different languages, different countries, perhaps even different regulations. It doesn’t really make sense to have a super app for a small Central Europe or Eastern European country. It doesn’t lend itself to that kind of model. That’s one thing.

The other thing is that perhaps in European and Western countries, people don’t want to have all their data and all their experience in one bucket. Perhaps over time, they’ve already grown with this idea that it’s okay to have one platform for social media, one platform for search, one platform for e-commerce; while in other emerging markets, you’ve had companies that have had the ability to leap-frog and group a lot of these businesses into one, therefore offering that super app experience.

There are clearly some players that are trying to do that. Revolut is probably the one that stands the closest to doing that.

Ben: [00:19:07] And it’s Square in the US, right?

Neri: [00:19:10] It’s Square in the US, correct, but the jury is still out. I think it will be a bit more challenging to do in Europe and the Western world than it will be in emerging markets.

Ben: [00:19:14] How important is content to acquiring customers and deepening engagement and lowering journal? I’m not sure exactly the statistics, but they’re pretty amazing as well in terms of how many people read your content daily, how much time people spend reading that content.

Neri: [00:19:29] Content is a huge part of what we do. It’s maybe something that we don’t talk about as much as we should. We have a business called Tinkoff Journal, which is one of the largest independent personal finance magazines in Russia, that we offer completely for free. There are no advertisements. That’s purely educational and interesting content to tell people how to set up a company, how to maximize their rewards, how to save properly, how to open a brokerage account – whatever it might be that can help people become a little bit more financially educated. And have something like 10 million monthly readers for this platform.

Obviously that platform powers a lot of the stuff that we offer in the app. When you come into the app, again, it’s not just about checking your balances, sending money to someone; it’s about maybe checking if there’s some interesting offers that might be there for you, and it’s about seeing whether there’s any content that might be interesting for you to learn.

The way we push this predominantly in the app is by having stories. A storyboard similar to what you would have on Instagram or a Snapchat, the difference being that it’s not user generated content, but it’s content that we produce mostly, again, through Tinkoff Journal and that we tailor to the customers and we can target based on all the algorithms that we have. 

We do notice that over a third of our customers use the stories every month in terms of whenever they go to the app. They would just flick through, maybe find something interesting. It’s also a great way for us to cross sell products. You’ll show them a storyboard about how to save properly, then at the end you might be able to actually say: click here and you will be able to open a brokerage account or you’ll open a micro-saving account. It’s a great way to engage with customers and to get them to do more stuff with you than they would if it was just a regular app.

Tinkoff business strategy and customer journey

Ben: [00:21:09] You talked us through a number of the products that Tinkoff has launched. You made the point that it started in banking and then moved into other areas from there. But what is the strategy? What is the process you run through when you think about what’s the next product to launch?

Neri: [00:21:28] For us it’s very much about customer journey. We put ourselves in the feet of the customer, and we try to understand what this customer might want and what they might be open to trying if we give them that option. For example, in the lifestyle banking, you mentioned travel. Then we thought, what are the other high-frequency services that we can aggregate into one place that would make our customer’s life a lot easier? So we went into restaurant bookings, where we started aggregating a lot of the restaurants and a lot of the abilities to book a restaurant from one place. Cinema was one of the most popular, and it’s coming back after COVID. It was one of the most popular aggregators of services that we were able to simplify the customer journey into one place where they could find a cinema and book a ticket, choose their seat anywhere.

For us, it’s a lot about the customer journey and understanding where it would make sense for them to do a transaction with us.

At the same time, we do have pretty strict principles about how much we want to spend. We don’t want to get into businesses where we’re going to be burning tens of millions of dollars a year without forecasting some kind of profits. So the only reason we would run a business on a breakeven level or even a slight loss at times is because it does grow drive engagement, or it brings in millions of customers. We have a few of those products in the ecosystem, but other than those, every product that we launched, for us has to have a meaning on a standalone basis. That meaning most of the time needs to be some kind of bottom-line generation.

Ben: [00:22:58] Sometimes it’s difficult to think of you as being a digital bank because it’s much more now of a lifestyle service, right? The rigorous focus on unit economics is not normally something that you would associate with a bank. Then, this whole approach to the way you think about acquiring customers and monetizing those customers, again, sets you apart from most digital banks. Do you even consider yourself still to be a digital bank, or do you think your model is difficult to define as a digital bank?

Neri: [00:23:26] I think at the core we still have a digital bank, but that digital bank is part of a bigger and – unfortunately, I haven’t been able to find a non-buzzword to describe this – but it’s part of a bigger ecosystem where the bank provides lots of benefits and lots of good experiences to the customers, but is only part of why people would choose Tinkoff.

Again, the ability to offer content, the ability to offer non-financial services, supercharges that banking experience. We’ve moved beyond that, but at the core we still do think that financial services are our main area of expertise, though we may to be able to monetize our customers. We’re an ecosystem, but it doesn’t necessarily mean that we want to get into everything and anything and spend any kind of money to get there. We want to pick our battles and pick those battles where we eventually will be able to monetize the customer.

Ben: [00:24:17] As a strategist, do you think that the unique part of your business model, the magic, if you like, is the fact that you’re basically an amalgam of semi-autonomous units, all of which wash their own face? They all have to have positive unit economics, but at a group level they’re all contributing to the success of the overall group by sharing data, spreading the cost of IT. Is that the way you think about it, that that’s the magic; it’s this combination of having units that are close to the customer that have to move quickly, that have a lot of autonomy, and then bringing them all together into a synergistic group structure?

Neri: [00:24:59] I think that’s a huge competitive advantage that we have and that’s something that differentiates us from a lot of other banks, and even Russian companies, which can be extremely hierarchical and bureaucratic. We’ve always built our business on a very horizontal level, very flat organization and giving lots of responsibility to the people that can be very close to the customer and to the product.

As you rightly mentioned, every one of our business lines basically is its own mini startup, you can say. It’s got its own management team, its own head of the business line, it will have its own technologists, its own marketing people, its own user experience, user interface, experts, et cetera. These people can fuel ownership of what they’re building, so their motivation to build something that’s outstanding is obviously higher. And they’re very close to the customer, so they can create a product that solves a problem or satisfies some kind of need.

That is supplemented by some platforms that run across all of these businesses, without which obviously then we wouldn’t be able to create an ecosystem. It would just be a bunch of individual businesses that will be working on a standalone basis. The marketing platforms, the acquisition platforms, the servicing platforms – those are all platforms that run horizontally across the organization and that basically ensure that we’re all rowing in the same direction.

Then of course, some business lines will work more closely with some others. For example, our point-of-sale lending business works very closely with our credit card business, because we realized that one is a great acquisition channel for the other business lines. Within also those businesses, there will be some relationships that are stronger and that need to be developed more, but at the core having those platforms that just make sure everyone rows in the same direction is a big differentiating factor between creating an ecosystem and a conglomerate of different goods and services that are just accessible through an app.

Ben: [00:26:51] In terms of artificial intelligence and machine learning, for example, do you share data between all of these different semi-autonomous units in order to train common models for risk, for fraud, to understand people’s context and be able to start them up relevant advice and offers? Presumably at the group level, you’re pulling data in order to create data network effects, is that right?

Neri: [00:27:16] It’s obviously subject to the regulation and what we can do with the data. Any data that is stored within a certain organization can be shared within that organization. The way we thought about AI and the way we’re looking to develop our AI knowledge is to create what we call an AI center, which is basically a repository of all the AI knowledge that we can have at the bank; ranging from all the way to research and development from the kind of back-office optimization and figuring out what the right structure for that should be.

That AI center ends up being a supplier of information and solutions to any other business. Any other business can come to this AI center and say, “I would like to think about doing this, where can AI help us with this?” It’s a central place where all that knowledge is stored.

As part of that center, one of their goals is also to try and instill in everybody a culture of using AI. The idea that we want to develop is that in order for AI to really be used successfully in the organization, it’s something that not only the software engineers need to be able to get their head around, it’s something that the product people need to be able to get around to use, the marketing team and the finance team – everyone needs to be able to use AI at some point, not just people that are super qualified to do it.

One of the best ways that I’ve heard about it said is: it needs to be as easy as Excel, and as powerful as a supercomputer. Something that is just accessible to everyone. Obviously, that requires a lot of education and a lot of pushing that culture and making sure that it is ingrained everywhere in the organization.

Ben: [00:28:49] How does it work with those shared services? You said that it works a little bit like the business units or their clients. But do the business units then have to pay for that service? How does that get incorporated into the unit economics of all of those units?

Neri: [00:29:04] It might not, necessarily. It’s not like every single cost that happens in the bank or in the group is associated to an individual business line. We do have some headquarter costs and some corporate costs that are kept separate, and then they might get allocated at some point with regard to certain decisions, but this is one of those things that I think we wouldn’t necessarily be assigning to individual business lines.

Ben: [00:29:30] I guess the difference here is you consider yourself to be a technology company. I guess that’s the reason why you build all of your own systems. Is that correct?

Neri: [00:29:37] Yeah, pretty much. There are very few instances where we use partner products or partner solutions because we want to control the entire value chain. We’ve historically competed on service and product, and the only way really that you can have full control over that is if you develop everything in-house, because then you’ll know exactly what the user experience is and you can predict in advance where the hiccups might be.

One of the perfect examples of that is our acquiring business, where we are the bank acquirer, we are the payment service provider, we are the payment gateway and we have our own aggregator, so we can offer the entire suite all developed in-house. When a customer or a merchant needs to choose an acquirer, we can always ensure that it’s going to be the smoothest process to integrate ourselves with the merchant., and that if something were to happen, we’re going to be the first ones to fix it because we can see exactly what might’ve happened because we’ve got full control over the entire chain of events.

That’s just one example in acquiring, but that applies to pretty much everything else that we’ve done. We tried to do everything as much as possible in-house, because it allows us to compete on the things that we want to compete, which is service.

Ben: [00:30:46] Why do you think that hasn’t worked for other banks? So many banks historically built their systems and other in kind of a bit of a legacy mess because they’ve added an add-on to those systems and they’ve become difficult to upgrade, expensive to maintain. How are you confident that won’t happen to Tinkoff? Do you think you might start to use the patsy technology as you continue to broaden the ecosystem and move further and further outside of banking?

Neri: [00:31:14] I think at the core we will try to still develop as much as possible in-house. I think the reason why we are able to do that and a lot of other banks aren’t able to do that, is because we can get the talent. We’ve built a culture; an HR culture and an IT culture that rivals those of the tech companies and those of the banks. We compete with talent, not with the banks. But with the Yandexes,’s, the Ozones, et cetera.

If you get the best talent, then you can build the best products and the best tech. If you let that opportunity go and you’ve let your culture evolve into something that’s really outdated, then it will be very difficult for you to get rid of that image and to draw the talent that allows you to build those products. You’ll inevitably have to rely on third parties to try and catch up, but then that leads it to all sorts of other integration problems with the third parties, which we try to avoid.

Branding: bank vs technology company

Ben: [00:32:16] You’ve brought up two interesting points that I want to quickly dive into. The first is around how you’re seeing the perception, that branding of Tinkoff. To what extent do you think you’re seen as a bank versus as a technology company, and how does that differ depending on the stakeholder? Potential employees might see it as a tech company, but it might be fair to say that the market investors still consider you to be a bank. To what extent do you think it’s difficult to manage multiple facets of the brand?

Neri: [00:32:47] It’s been something that, especially when I was in investor relations, that took a lot of my time to try and tell people and explain to people why we’re more than a traditional bank. I think from an employee perspective, we’ve got to nail down. We are attracting some of the top talents. We are one of the top three brands in Russia for IT talent, and we get rewarded for our IT culture and IT programs all the time.

We have all sorts of educational programs, where we try to go to the best universities in Russia and sponsor programs and try to pick up people early on and grow them in the company.

It’s more than just empty words or words on the paper, because we do have a track record of people who started very junior in the company and now are running entire business lines because they’ve stayed at the company for 7, 8 years, and they’ve progressed in their career.

From an investor perspective, yes, of course. We do have a lot of our revenues that is still coming from financial services, and mostly credit services. There’s this perception that a credit business in a country like Russia is a high-risk business that does not necessarily deserve a high multiple. But I think we’re finally getting rid of that idea, partly because what we’ve showed, you mentioned at the very beginning that we’ve gone through three crises and we’ve never made a loss despite having a consumer book that on paper looks like it could be risky. Again, we’re showing time in and time out to the market that we know how to lend throughout various cycles.

We now have a number of businesses that are non-credit, that you could argue are more fintech-y in terms of what people would associate naturally with FinTech. Those businesses generate almost 40% of our revenues in net income.

Again, moving a little bit away from that, being a pure financial player, I think that if we were a pure financial player or purely a bank you wouldn’t be able to see the kind of growth rates that we are seeing now and the kind of cheap acquisition costs that we’re seeing now, especially in things like debit cards and Tinkoff investments.

It takes time, but hopefully we’re moving in the right direction in terms of convincing not only our employees that we’re a tech company, but the broader stakeholder base.

Ben: [00:34:54] The profitability is not like a bank either, right? Just looking at the financial report for 2020, you had a return on equity of over 40%, which it’s difficult to find examples of banks that are getting return on equity of 40%.

Neri: [00:35:11] Yeah. I think the bottom line is that there’s different ways in which you can do banking. If you do banking in a very technological way with certain principles, then it looks very little like the traditional banking that we were used to.

No-hierarchy, no-bureaucracy culture

Ben: [00:35:24] The second point I want to touch on from what you said was around culture. I’ve been looking through your investor presentation and you talk about having no hierarchy and no bureaucracy. I remember Dimitri, when we recently did the 4X4 Virtual Salon, talked a lot about how entrepreneurial the company is and how he leverages that entrepreneurial spirit within his group. My question is, how do you sustain that as you get bigger and bigger? Do you think it’s down to the business model and the organizational model? How do you ensure that that entrepreneurial spirit and the flatness of the organization doesn’t get diluted over time?

Neri: [00:36:08] It’s an interesting question, especially as you scale up a business and you have to put some structures in places and some checks and balances, and more and more of those kinds of decisions.

It started off with our founder, who is a serial entrepreneur. Especially when the company started and for the first let’s say, 10 years or so, he was very involved in the business. He instilled in everyone this kind of entrepreneurial culture where you give responsibility very early on and you expect high results, and everyone tries really hard because everyone sees the businesses as their own.

It is an interesting question. Trying to maintain the organization as far as possible and trying to delegate as much responsibility down the chain as possible, is key. So far, we’ve managed, and hopefully we can continue to do that for a long time.

Ben: [00:36:55] Does that make it difficult to hire people laterally? For example, is it quite difficult to hire bankers and bringing them into Tinkoff, and have them adopt culturally to how Tinkoff works?

Neri: [00:37:09] I can say that I’m the only banker that has joined laterally, maybe one of two or three bankers that has joined laterally to Tinkoff. We always prefer to hire young and grow inside the organization. If we were to hire laterally, banks are normally the last place we look.

Ben: [00:37:28] Fair enough. I also talk about, and this is the same diagram from the investor presentation, you talk about a culture of ‘test and learn’. There’s always been this tension in the FinTech space between the tech and the fin – the extent to which you can behave like a tech company, faster iteration cycles; and on the other hand, conform with regulation and be a regulated entity. How do you reconcile the test and learn culture with the need to be a serious regulated entity at the same time?

Neri: [00:38:01] The regulation sets the boundaries for where you’re going to test and learn, of course. You’re not going to go beyond where the regulation tells you, you can’t go. But the test and learn can be applied to so many various parts of the business, from a specific business line where you might want to test the elasticity of your take rate of a specific loan to the interest rate that you charge, all the way to: we should launch a business line, let’s do some tests around whether there’s any demand for that and how much money we would need to start spending and let’s try with an NPV and then grow it out.

For us, test and learn is, again, much more about culture and much more about telling people: look, if you don’t have an idea, here’s the budget, go ahead and try it out. You have certain frameworks that you cannot deviate from, and one of them is regulation, the other one is most likely going to be NPV, and the fact that you need to assess this idea within an NPV framework, and off you go.

That links up very well with the previous question that you asked me, how do you maintain that entrepreneurial spirit? I think giving everyone the ability to try something out, if they have an idea, is by definition what an entrepreneur would want to do. It does tend to attract those kinds of people, and that’s how you keep that culture over time.

A different value proposition than other digital banks

Ben: [00:39:19] We’ve talked about the ways in which you’re different from a traditional bank. The list is pretty long, so I won’t recap it. But you would also differentiate yourself or draw a big distinction between your model and that of a normal challenger bank or normal digital bank. Would you care to elaborate on that and how you consider yourself to be different from other digital banks?

Neri: [00:39:41] Our approach has always been: let’s bring customers in; not just for the sake of bringing customers in, let’s bring customers in with a specific purpose, and a specific path to then potentially monetizing those customers over time. That oftentimes means that we need to bring in a customer and then build a very deep relationship with them. We need to become their primary bank.

If you look at the average balances that we have for our debit card holders, there are multiple times when you wouldn’t find in a UK challenger bank, because once we bring that customer in, we work really hard to make sure that we are their main financial partner. Then we develop a number of other products that can lengthen the relationship that you’re going to have with that customer. While if you’re a one-trick-pony, like a lot of fintechs, then you’ve built a very superficial relationship. Maybe the second, third, fourth, and then at some point you’re going to have to figure out how to make money from that customer and justify your business. We’ve flipped it on its head.

The other thing is that for us, there’s never been a choice between growth and profits. We’ve always married the two, partly by virtue of necessity, because in Russia when we started there wasn’t much in terms of venture capital. There’s probably even less now than there was back then, and we had an entrepreneur who was laser focused on bottom line.

For us, we always had to find a way to grow and make money at the same time. Let’s call it the Holy Grail, of us doing that, has been the NPV approach, where any dollar that we try to spend on acquisition or on developing a certain business line, we tried to do it in such a way that we think is going to generate a certain rate of return over time. And that rate of return that we use internally is at least 30%.

We built models, we built predictive models, we built decision models, scoring models, that all allow us to build some kind of prediction of how the customer is going to behave with us over a long period of time; and to make sure that we can optimize the offering, the product, the channel, so that at some point that dollar that we spent at the very beginning will actually generate something for our shareholders down the line.

We’ve refined that philosophy over time and we still apply it to basically everything that we do. I think that’s one of the key reasons why we’ve been able to grow and make money at the same time.

Ben: [00:42:04] I think the other thing that I would add is, unlike a lot of digital banks, you’ve never been scared to do lending or to lend your balance sheet. A lot of digital banks, I agree with you, I think they don’t have the same laser focus on unit economics. They spend a lot to acquire customers without necessarily knowing how they’re going to generate enough lifetime value for that to make sense.

But the other thing is they often don’t then, right? It seems that if you’re going to have a banking business, lending is really at the heart. Would you agree with that? And do you think that also contributes to a strong lifetime value and unit economics over time?

Neri: [00:42:46] Absolutely. We’ve had a banking license from day one, which enables us to go into deposit, taking and lending. Look, I think the market had a phase where lending was almost like a dirty word, and everyone seemed to be doing fine with e-money licenses and with bringing in hundreds of thousands or millions of customers with a cheap, if not free, debit card product; only to at some point realize that that’s not a product that’s monetizable.

The other thing is that a lot of people focus on breakeven. But a business is not meant to be breakeven, a business is meant to return more than its cost of capital. The only way to do that – okay, there are some non-credit products where you can do that and we have several of them – but one of the more successful ones is definitely lending. You take deposits and you lend them out. If done well, that can be an incredibly high LTV business that can resist shocks.

I think that a lot of investors and a lot of the people in the market have been kind of scarred by some poor lenders and how badly they’ve done in some economic cycles, that now everything just got painted with one brush as something that I don’t want to touch. But I think the tide has started to turn. Partly because in our case, we’ve been able to show that you can do that crisis in crisis out; and partly because a lot of those fintechs, they used to pride themselves on having an e-money license and not having any lending products, they’re all getting banking licenses and they’re all starting to lend. There is a realization that that’s a business that fintechs should have and can be done in a very technological way and in a way that increases LTV. 

I was reading about this bank in Brazil called C6, which is one of the few ones that has started out, from what I can understand at least, right off with the lending product, because they realized that lending is the best way to increase the lifetime value of your customer.

Ben: [00:44:47] Just to talk about COVID, just bring it up again, you talked about it in the beginning as the third of the crises that Tinkoff has faced. But in some ways, do you think it might be a Philips for the business, in the sense that it’s accelerating underlying trends and therefore it’s probably making your value proposition even more compelling than it was pre-crisis? To what extent do you think that’s the case, and to what extent is that being borne out by the data, the customer growth and so on what you’re seeing?

Neri: [00:45:14] At first it was obviously a shock, and we had to pull some levers that we knew how to pull in terms of making sure that the business was going to be stable and withstand the shock, which no one really could predict how deep and how long it was going to last.

We’ve obviously benefited from the fact that in Russia, this shock has been short-lived and relatively shallow and V-shaped. It hasn’t triggered that much of a shock to the economy or to the banking sector. But obviously for those few months where you had lockdown, it was all about who could keep doing banking in an engaging way and still open bank accounts with a physical meeting, and still offer products that were relevant to our customer base.

Those companies that could adapt to the situation and tailor their products and their services to the situation, so we started implementing a number of initiatives to make sure that our offering was very relevant to what the customers wanted to satisfy or to achieve. In the case of SMEs, we really supercharged our ability to help businesses build their websites, to install online payments. We could lend them out our call centers, because obviously a lot of companies didn’t have the ability to communicate with customers. To make sure that we had the flexibility and the time to market to really come up with these new solutions and make our offering relevant, that’s something that was noticed by our customers. They realized: these guys can help me out when I need help.

Ever since COVID we’ve seen exponential growth in a number of our products, namely our recurrent accounts and Tinkoff investments, which like a lot of other retail brokers around the world has had a great time over the last year or so. I think we’ve been able to really show off our skillset when it comes to the ability to adapt to the environment.

Of course, from a digitization perspective, things have accelerated. We don’t think it’s been necessarily a seismic shift, so it’s not like every person that used to go to the branch now only uses the app. But some cohorts of the population that were maybe on the fence now have been forced to discover that actually you don’t need to go to a branch. It’s perfectly fine to have a bank that can do everything from your mobile. It hasn’t been a seismic shift, but it has accelerated some of the trends that we have been betting on forever.

Runway for growth within the domestic and overseas market

Ben: [00:47:35] How much runway do you think there is for growth within the domestic market? Ostensibly at least, there seems to be lots, right? You’ve got about 13.5 million customers, there are 144 million people in Russia. But presumably your services are very appealing to a certain demographic, so do you think you can sustain the growth rates that you’ve seen over the last few years indefinitely?

Neri: [00:47:59] This is something that we discussed quite at length during our strategy day. We have a lot of customers, as you rightly mentioned, we have just over 13 million total customers, about 9 million of which are active. We still see not only great ability to grow the number of customers, because Russia still has more than 100 million economically active population, but we still see huge potential to do more business with each customer.

The targets that we talked about are, that had 9 million active customers at the end of 2020, we think we can go over 16.5 million by the end of 2023. And very importantly, we can grow the number of products per customers from the 1.3 moving forward products per customer that we had at the end of 2020, at least 1.7 in a few years.

Another way to look at it is that in terms of the revenue pools that we are attacking in Russia, our net revenues in 2020 were about $1.4 billion. In the main business lines where we are currently present, we see that revenue pool being more than $50 billion. Still almost 40 times our existing revenue. It’s still huge potential. And that’s only with the businesses that we currently have. There’s a number of other businesses that might be adjacent to what we’re doing now, and we’ve mentioned on the strategy day BNPL or leasing or some other kinds of insurance that could bring that addressable market even further.

We’ve obviously grown a lot, but in many respects, we’re still scratching the surface. Again, one way to look at that is that we’ve only got 2% market share of all retail lending in Russia.

Ben: [00:49:37] Is that the reason why you haven’t expanded overseas? At the start of this podcast, you talked about the fact that it’d be very difficult to recreate Tinkoff in another European country because of the scale effect and other factors. If you can’t create Tinkoff in Europe, why not take Tinkoff to Europe?

Neri: [00:50:02] Historically, we haven’t really looked that much outside of Russia because there was so much to do. Over the strategy period between 2016 and 2020, we launched eight business lines. Management’s focus was entirely on scaling up those businesses, making sure that the unit economics made sense, and there were businesses that we wanted to be in. At the same time, we were generating 40, 50, 60, sometimes even 70% ROI, that it felt like there was really no need to go out and look for additional ways to deploy capital.

Russia still remains our main focus. It’s the place where we know how to make business. We know and have the confidence to disrupt, and we’re going to be generating our returns for the foreseeable future. We have looked up outside of Russia before, again, partly because we were very focused on Russia we didn’t, but also partly because some of the markets that we had looked at mostly in emerging markets weren’t quite ready or weren’t quite suited to the Tinkoff business model.

More recently we have started talking about international expansion again. It is still a little bit premature, and to some extent we’re still figuring out what the right framework is in terms of assessing potential opportunities. But it does look like there might be some areas or some geographies where a Tinkoff-like business model could work. I’ll probably leave that as a bit of a teaser. It’s not something that we’ve incorporated in our 2023 strategy, but it could be a little cherry on top of that strategy that we showed up a few weeks back.

Ben: [00:51:40] The beauty of the business model is that you could create a small unit or business line outside of Russia, that would again benefit from all of the group network effects, that you could probably again apply very conservative or very rigorous unit economics threshold to. It wouldn’t be like you’d be taking a massive gamble anyway, right?

Neri: [00:52:05] Yeah, to the extent that we can try and recreate the Tinkoff business model, it means going in with a test and learn approach, with a monetizable product that can help us get to a positive bottom line and make the business self-sufficient. Again, we’re not in the business of going somewhere and spending hundreds of millions of dollars for years perhaps, and then at some point trying to monetize it. I think to the extent that we will decide of going outside of Russia will be very much in a Tinkoff-like way.

Ben: [00:52:39] You’ve recently made a VC investment. Do you think you might be looking to make other VC investments? Is that another way in which you might expand internationally?

Neri: [00:52:49] I don’t think that’s necessarily the base case. This was a specific case, and it was two of the top managers of Tinkoff group that decided to go and start their own business in Europe. Obviously, we knew them very well, we hold them in high regard, and they’re building something quite neat in Europe. I don’t know how many other managers are willing to leave Tinkoff to go and start a startup somewhere. I don’t think they’re that many.

I don’t think that necessarily VC will be the way that we decide to go abroad if we decide to go abroad. But it’s been a very useful experience for us, because obviously we talked to these guys and they’re telling us what they’re seeing, the challenges they’re facing. They’re basically testing the Tinkoff DNA and the Tinkoff culture outside of Russia, and it seems to be working – which gives us some confidence that if we decide to at some point go outside of Russia as Tinkoff then we probably have what it takes.


Ben: [00:53:43] The last question I wanted to ask you was about M&A. Sberbank does a lot of M&A, and you’ve done very little M&A. Do you think that might change or do you think that building everything yourself organically is just so intrinsic to the business model and the DNA of the company, that that won’t change?

Neri: [00:54:03] We’ve done a little bit of M&A in the past, and you’re right in that most of the time we’ve tried to develop everything in-house. More recently, we’ve said that we do think there’s potential for some built-on acquisitions in Russia, but nothing transformational and only those businesses that either can very much complement an existing product that we have, and maybe where it’s a very competitive environment where your time to market could be a little bit too long if you were to do it in-house, and if there’s a good culture fit it might actually make sense to bring it in-house right away. Or maybe something that can supercharge your customer growth, although that might not be the top priority because we are bringing in a ton of customers anyways.

I think there is room for some built-on acquisition, predominantly in the non-credit businesses, but we’ll see. We have suspended the dividend for this year to make sure that we have enough dry powder to perhaps engage in some of these deals. But again, nothing has been formally decided, let’s say.

Ben: [00:55:07] It’s very unusual that you have an extremely fast-growing tech company that pays dividends, right? Even in itself, that’s quite an anomaly. We always finish or nearly always finish the podcast by asking for free recommendations. If you don’t mind, could you recommend a favorite book?

Favorite book, influencer, brand and a productivity hack

Neri: [00:55:23] I don’t know how creative this will sound, but it’s a book that I particularly enjoyed. It was Shoe Dog by Phil Knight, the founder of Nike. I think just, firstly, it’s an incredibly well-written book, but also it’s a great book that communicates what it feels like when you’ve got that itch and that idea that you just can’t get out of your head. I think that all of us in our space, whether it’s as an entrepreneur or as a manager or as an employee, we’re all looking for that one idea that gets us all excited and that we go out of our way to achieve. I think that was a great book to inspire people to look for that idea.

Ben: [00:56:04] Favorite influencer?

Neri: [00:56:06] I don’t know if this counts as an influencer, again, I try to use social media mostly to just keep in touch with family and friends rather than following people I don’t know. But there’s this one guy who’s crazy when it comes to motivation and mostly in working out and physical activity. His name is David Goggins, and he is a former Navy Seal, ultra-marathon runner, just an extreme guy. It’s good to watch his videos when you’re feeling a bit unmotivated, because I guarantee by the time you finish watching his videos, you’ll be either working out like a maniac or going back to your desk and finishing that one thing that you really couldn’t finish before. It’s just great motivation,

Ben: [00:56:45] Fantastic. Productivity hack?

Neri: [00:56:48] I was thinking about this, and there’s just some small things like keeping your inbox clean, that obviously helps. But I think the thing that has served me best is, it’s on the one side a productivity hack and on the other side it’s something that helps me keep my work-life balance. It’s just to make sure that in my mind, or in my calendar, I’ve got some pretty set amount of times that I want to do a certain thing. I’ll say I’m going to work until this time, so knowing that I have this kind of mental deadline that I need to get stuff done by that deadline gets me really productive because I know that after that deadline, I want to do something else.

It doesn’t mean that at that time it’s pens down and then I’ll probably not touch it again, but at least to have boundaries in your head actually forces you to work really hard in those hours. It’s a bit counter intuitive, but it’s worked really well for me.

Ben: [00:57:40] Do you find that’s become more necessary because you’re working from home?

Neri: [00:57:44] Yeah. It’s been one of the challenges, because before that deadline was pretty much imposed to you by leaving the office. Now your office is in your bedroom or it’s in your living room, so you have to be a little bit more disciplined about the fact that: okay, I’m not going to work past 8:00 PM, or at least I’m going to take a break after 8:00 PM and try to step away from your desk and not get close to it for a certain period of time. That’s been something slightly more challenging.  

Ben: [00:58:11] Last of all, a favorite brand.

Neri: [00:58:14] I think having told you Shoe Dog as the book, I think Nike probably fits that bill. From Shoe Dog and then David Goggins, you’ve probably realized I’m a pretty sporty person, so I think Nike actually fits a lot of those values that I associated myself with.

Ben: [00:58:31] What about Nike as a business model to emulate?

Neri: [00:58:34] I’m not actually all that familiar with it, but I think the emotional connection that they’ve been able to build with their customer base; we debate loyalty a lot internally. How do you get a customer to be loyal to you? I think there is no stronger loyalty than the loyalty you can build if you share the same values with your customers.

Ben: [00:58:58] Neri, thank you so much for coming on the podcast and telling us all about Tinkoff Bank, which is a difficult business, as you said, to describe and to pigeonhole, but certainly it’s a fascinating financial services company. Thank you so much for sharing the story with us.

Neri: [00:59:12] My pleasure. If anyone wants to reach out, you know where to find us, it’s

Ben: [00:59:18] Thank you so much.

Is Bitcoin an Investable Asset for Every Portfolio? (#41)

Structural Shifts with Izabella KAMINSKA, Preston BYRNE, Nic CARTER and Seamus DONOGHUE

Today, we have a special podcast episode, which is all about Bitcoin, discussing topics like: should every investor have some exposure to Bitcoin or is it still too volatile? What’s its intrinsic value anyway? And is Bitcoin a sustainable investment when it consumes more electricity than Argentina? We hosted four excellent guests: Izabella Kaminska, FT Alphaville editor at the Financial Times; Preston Byrne, partner at Anderson Kill; Nic Carter, partner at Castle Island Ventures; and Seamus Donoghue, VP Strategic Alliances at METACO.


Main topics discussed:

[00:01:49] Is Bitcoin the new gold?

[00:11:25] How does Bitcoin score on social and corporate governance?

[00:14:37] Is Bitcoin compatible with central bank digital currencies

[00:20:52] Are we in a bubble? So what?

[00:29:31] What’s the logic of large corporates starting to put Bitcoin on their balance sheet?

[00:32:51] What would happen to the price of Bitcoin when you have quite a lot of CBDC’s in circulation?

[00:37:25] Does a small allocation of Bitcoin in every portfolio make sense?

[00:45:10] Are cryptocurrencies use mainly for elicit financing? Is that even true anymore?

[00:54:56] Is there a better alternative to Bitcoin?

Full transcript
Is Bitcoin an Investable Asset for Every Portfolio? w/ Izabella KAMINSKA, Preston BYRNE, Nic CARTER, Seamus DONOGHUE

It’s gone from zero to a trillion dollars from scratch. Then maybe beyond, you’re not going to get there in a linear way. I can’t imagine any other way it would’ve gotten here, which is to say an extremely volatile and bubbly manner.

Full transcript:

Ben: [00:01:29] Welcome everybody to this 4X4 Virtual Salon, where we’re going to be discussing whether Bitcoin is now an investible asset for every portfolio. We’re going to kick off with our first topic, what’s the business case for Bitcoin? And I’m going to come to you first, Izabella, and I want to ask you, is Bitcoin the new gold?

Izabella: [00:01:49] The new gold? I thought you said ‘God’ for a second! Yeah, I don’t know if it is the new gold. I mean, it has gold-like properties, but in terms of like the pure investment case I see it in the spirit of this new phenomenon of ESG – which is about investing in stuff that is ideologically significant, not just investments that are going to deliver a profit or a return for your clients or investors, but something that is an impact investing in that sense, where Prince Harry is now a chief impact investor type.

The reason I say that is because there comes an argument where Bitcoin becomes so big that you can’t ignore it anymore. If you’re managing a portfolio, you are obliged to have a fiduciary duty to maximize the returns aside from your ESG mandates. If you don’t have the explicit ESG mandate, you also are inclined to move into Bitcoin for those reasons.

I think there’s both of those aspects in play. In that sense, you can maybe think of Bitcoin as, for the ESG side of things, a kind of divestment from Fiat; for those who don’t believe in the ideological controls that surround it and the kind of political framework of that system or one perhaps that is becoming unstuck by inflationary pressures, if you believe that thing.

And the other case is just simply portfolio management. The same way as we had the big commodities boom. Around 2014, 2015, we were having very similar debates about commodities. Or even the VIX, or something like that. Is our commodities an asset class? And many people would have said: no, it’s not an asset class because it has no yield and the pension funds have no business in only commodities. But the interesting thing about Bitcoin is that you don’t have to own derivatives to get exposure to Bitcoin. That whole physical conundrum goes out the window. Over time you may even be able to synthesize yield through the so-called re-hypothecation or lending of the Bitcoin to the capital markets. That’s how I frame it at the moment.

Ben: [00:04:13] Nic, you’ve written about this a lot. It seems an obvious follow up question, which is, can Bitcoin be an ESG investment when it’s so environmentally damaging?

Nic: [00:04:21] There’s plenty of commodities that costs energy to extract and recycle and so on, and Bitcoin is no exception. I don’t really hear a lot of chatter about gold ESG. Maybe that’s just because I’m not listening to the right places. But it seems to me that the ESG focus on Bitcoin is primarily driving from people that are trying to find critiques of Bitcoin or reasons why it should be banned or so on. But it’s pretty selective focus, generally. I don’t hear that being applied to aluminum smelting or idle devices that are sucking on electricity. Seems generally pretty selective with Bitcoin. But yeah, certainly I expect the government to use all the tools in their arsenal to suppress investment into Bitcoin in the long-term, and clearly capital is becoming extremely politicized through the mechanism of ESG and mandates in terms of what you can invest in.

I’m sure that will be used against Bitcoin in the same way that gold ownership was banned or restricted in previous episodes where various governments had an incentive or were trying to stop people divesting from treasuries or from the local sovereign currency. Certainly, I expect governments to use all the tools at their disposal, and ESG looks like a pretty convenient one.

Ben: [00:05:43] Seamus, this is a question for you, which is: inherent to this idea that Bitcoin is the new gold is the idea that Bitcoin is finite. I think something like 21 million Bitcoins can ever be mined. But the counter argument that a lot of people use is that it’s not finite, because you can have 0.00000 Bitcoins and so on. What’s the response to people that say it’s not finite because it’s infinitely divisible?

Seamus: [00:06:10] It makes me laugh, because it’s kind of a clueless statement. I mean, it’s a very specious argument, you’re saying it’s divisible. You’re not saying the total amount changes. Bitcoin indeed, it has eight decimals right now. The smallest unit is a sat, which means a hundred million sats make a Bitcoin.

It’s great. When you think about money, one of the USP’s basically is that it should be divisible, and indeed Bitcoin is. people can look at it and say: well, it’s very expensive around 50,000, but that’s not the unit you have to buy in. You can buy in a sat. But the total amount is still 21 million, and I think it’s one of the only assets that’s probably finite. I mean, we’ve been talked a little bit about gold, and gold’s relatively finite at a certain price level. But as the price goes up, more becomes economically viable to dig it out of the ground. That previous was to store wealth, and that was a big attribute that gold supply only grows a couple of percent a year. Because unless the price goes higher, nobody really invests to mine more, and it’s not necessarily economically viable.

Now you have this new, let’s say Gold 2.0, and it is specifically limited at a total amount of 21 million. It is unquestionably finite, no matter how divisible that amount is.

Ben: [00:07:23] Preston, I wanted to ask you a question because the time that people started to talk about Bitcoin as the new gold, or as Seamus said, Gold 2.0, that was about the same time as people realized that it wasn’t a very good payment mechanism. My question to you is: to what extent do you think Bitcoin is the new gold is kind of convenient post-rationalization of the fact that Bitcoin is not a brilliant global currency or payment mechanism?

Preston: [00:07:50] Bitcoin isn’t really amenable to easy description, right? People have described it as different things, but Bitcoin isn’t sentient and it wasn’t created for a particular purpose and it really has a life of its own. That’s the first part of that.

I think the second is that it’s a technology, and as such, technologies change and evolve. we’re seeing that with Bitcoin and in particular with scaling solutions such as Layer Two and the Lightning Network – which is basically an off-chain solution that ties into the chain but allows people to send large numbers of transactions without leaving a large transactional footprint on the blockchain itself.

I would expect – and this is relevant I think for investors who are investing into this space – are they investing into the potential future where money is no longer in the hands of the state and is instead fully automated and digital and based on distributed consensus, or are they investing because they think Bitcoin is the one true money that is going to deliver all those solutions?

I mean, Bitcoin, certainly is a contender for that. But I think that as a technology, we have to look at it and understand we’re still in the first or second ending of the game here, given the fact that it’s so experimental and it’s so lightly used in terms of the percentage of the population. It’s very early days.

Ben: [00:09:11] Then maybe one for you, Nic, why would Bitcoin suddenly become a substitute for gold if it doesn’t behave anything like gold? You would expect gold to be, I guess, countercyclical, right? Whereas Bitcoin hasn’t behaved like that.

Nic: [00:09:26] Well there’s the properties of the asset, and then there’s the financial performance, and those are pretty distinct. The reason people compare Bitcoin to gold is because of its inherent properties. It has some monetary hardness. In fact, it’s much harder than gold. Gold has a supply reaction when the price of gold goes up or down. You have a countercyclical effect there in terms of the reaction function. Bitcoin of course, has this defined supply schedule, so it doesn’t really react to this. There’s no alteration to the schedule in response to demand shocks.

The other thing is that people tend to use Bitcoin as this pristine collateral asset. A lot of people imagine that Bitcoin will eventually be used as this high-powered collateral within a banking system. We’ll see if that materializes or not; it’s reminiscent of the way gold used to be used with banks issuing notes against gold and things like that. Of course, Bitcoin is about 5,000 years younger than gold as a monetary commodity, so we’re still figuring out what it is and that uncertainty is expressed in volatility.

It’s naturally much more volatile than gold. Young, newly monetizing, synthetic monetary commodity that’s gone from zero to a trillion dollars from scratch. then maybe beyond, you’re not going to get there in a linear way. I can’t imagine any other way it would’ve gotten here, which is to say an extremely volatile and bubbly manner.

Ben: [00:11:03] The point you made there about gold adapting on the supply side, how is that not also true for Bitcoin? Because as the price of Bitcoin rises, there is more value to be made from mining, right?

Nic: [00:11:12] Yeah, but the miners can’t accelerate the rate of production. That’s the magic of Bitcoin. That’s the thing that it does that’s different. It’s perfectly inelastic in terms of supply.

Ben: [00:11:25] Two more questions. The first one is: Izabella, you wrote here that ESG is more than just environment, right? How does Bitcoin score on social and corporate governance?

Izabella: [00:11:36] I think that’s the issue, isn’t it? ESG is fairly subjective and that’s why it’s quite controversial. Not many people agree on all this stuff. You have very loose ideas about what qualifies as a green bond or as a green investment. That’s why it’s a competing system of values, and Bitcoin just is another ideologically-minded movement out there that is saying that we want to encourage investment into a system that is going to protect privacy, that is going to keep people to account because we’re going to take out the middleman. It’s basically another ideological offering on the table.

That does make it an ESG investment because the metrics that you’re judging about are not just about whether investing in Bitcoin is purely profitable, there are other societal impacts. Like, okay, great, you make loads of money, but is it worth it if you’re living in an authoritarian nightmare? That’s why I frame it in that sense, because I think the environmental question is a worthwhile question, obviously it has a huge footprint, but the real value proposition to the capital markets isn’t so much about whether it’s a new gold or whether it’s a payment system. It’s about anchoring, creating a level playing field for buck for value, because that’s really what we’ve been lacking.

One of the reasons gold doesn’t work is because it’s bulky and you have to own it, physically store it. There are all sorts of shenanigans that can go on in terms of warehousing it. There are many storage facilities that turned out to have not gold, and you just have to watch Goldfinger as well. But with Bitcoin or any other digital asset of its kind, the opportunity on the table is to anchor all those competing value systems into a single thing that nobody can manipulate.

My concern isn’t whether domestic systems should be centralized or not. I think within homogenous societies, it’s okay to have trusted systems that are quite centralized for efficiency purposes, because we have that embedded trust in our society. We share certain norms and legislation and culture. But it’s about operating on a global marketplace where you don’t have those similar norms, and you’d have like, say the Chinese central bank continuously de-valuing the currency on a unilateral basis, and then you end up with currency wars and all that stuff. Bitcoin regulates that, and it allows for lots of different competing systems, some of which can be centralized and some of them might not be centralized, to compete against each other. In the end, the best one, we will know from the free market, so to speak, which one will win out. But it’s not necessarily the case it will be a crypto one. But I’m interested in the collateral proposition of how it anchors everything together.

Ben: [00:14:37] Preston, is Bitcoin compatible with central bank digital currencies, and is it a matter of time before central banks try to scupper Bitcoin in favor of their own CBDCs? We’re going to get you first Preston, if that’s okay.

Preston: [00:14:46] I mean, it’s not really a question of compatibility. Bitcoin in most countries isn’t illegal, and so people are entitled to use it. If central banks want to have their own digital currencies, which run on their own databases, where they’re backed, I mean, most ‘Fiat’ currencies or just state backed money is backed by the fact that people have to use it to pay taxes. That is the primary demand for Fiat currency in most jurisdictions.

There’s not really any essential conflict between Bitcoin and something like that, in that Bitcoin is at least ostensibly subject. Even if enforcement is difficult, it’s ostensibly subject to the tax regimes of the countries in which its holders and people who transact in it reside and transact. There’s no central conflict there. Bitcoin is just like any other financial asset; you can account for your gains and your losses, and then at the end of the year, you’ve got to tally it all up and you’ll have a big bill for the revenue that you got. I don’t see any conflict there.

Whereas the central banks might decide that it presents so much of a challenge to their money that they’ll ban it, but we haven’t seen any moves like that, at least in the Western world.

Ben: [00:16:04] What do you think the likelihood of that is happening? Anybody can answer that.

Izabella: [00:16:03] I think there is a massive misconception about the legality of money and whether or not a government can force you to use their money. The answer is they can. it’s certainly here in the UK, there is no legal tender per se. It’s all opt-in, but it’s just so happens that we do opt into it because it’s useful and it’s nice to use something that everyone has a common interest in. I don’t know about other jurisdictions, but certainly here in the UK it is not legal tender in the sense that the government forces you to use it. You can use any currency you want.

Nic: [00:16:41] I’ll just add to that. I mean, the government can encourage you to use a certain monetary medium, and the dollar has certain privileges in the US. Like, if the value of the dollar appreciates, you don’t have to pay capital gains on that. You know, treasuries are sold for dollars and you need dollars to kind of participate in our securities markets and things like that. taxes, you have to suppress those liabilities in dollars.

They can encourage its usage, but you’re not going to mandate that someone completes the transaction dollars to the point of a gun. Money is just the most saleable commodity. Clearly Bitcoin has carved out a niche in its own kind of jurisdiction, which is initially the crypto landscape, the digital realm, roughly a hundred million people worldwide. I just think of that as its own separate jurisdiction, where Bitcoin is effectively the reserve currency.

Preston: [00:17:40] It’s not really the effectively the reserve currency, right? Because the way that governments discourage people from using Bitcoin is twofold, and it’s mostly through the tax code. One way is the Bitcoin when received in exchange for goods and services as taxes, income, and then you have a second tax hit when you’re disposing of it or a loss, depending on what happens. But assuming the direction is going to move and you dispose of it at a profit, you have another tax set on your capital gains, which would be short-term in one year, and long-term if it’s longer than a year.

Bitcoin is not really great money because the more you use it, the more complicated your tax affairs become. I suspect we’ll probably see aggressive tax enforcement being the mode through which governments discourage its use if they decided it’s a threat, rather than an outright ban

Seamus: [00:18:23] If I would just make one anecdotal comment on that with regards to Switzerland, Switzerland is interesting because you have the Swiss national government and you have Cantonal governments. There’s obviously a big community in places like Zug, the Crypto Valley, and the state government there allows you to pay your taxes in crypto now. I think to Preston’s point around capital gains, fortunately Switzerland is also a country where we don’t have capital gains. It could work here. That’s an interesting point, I think from the Swiss perspective.

Nic: [00:18:49] In the same way as Seamus notes, tax policy can be used to attempt to suppress Bitcoin or crypto usage, it can also be used to encourage it. We’ve seen a number of countries adopting pretty favorable tax approaches to crypto. In the same way that behavior at the state level is heterogeneous, and there is no single international order, certainly not one that the US controls, not anymore, I think you’ll just see a diverse set of reactions to crypto.

Some central banks will adopt Bitcoin in their foreign exchange reserves the same way they adopted gold. If you look at gold, that’s something that’s ostensibly hostile to monetary discretion in a bunch of countries, because gold isn’t something that you can inflate at will. Yet it has been adopted in foreign exchange reserves. Many central banks hold gold. I don’t see why it would be any different for a novel monetary commodity.

Seamus: [00:19:50] What’s funny is that Swiss national bank, although they don’t explicitly own Bitcoin, they have holdings in MicroStrategy, Square and Tesla. Indirectly they’re there.

Izabella: [00:19:59] With respect to central bank reserves, what’s interesting is that if and when like big corporations, MicroStrategy, Tesla, the investment managers, the private sector basically does accumulate a lot of Bitcoin; then the only way they can influence the market is not by actually owning Bitcoin, but by managing the shorts, because there has to be a relative shorts to offset the longs in the private sector. You might see them selling AKA borrowing Bitcoin from the private sector and selling it into the market much like they do in gold. Like if you believe in the conspiracies from gold shorting, there’s a purposeful reason for that, which is that there is an interest rate curve that encourages the Fiat monopolist to effectively short stuff to offset the longs.


Ben: [00:20:52] I wanted to move onto the second topic, which is the question of whether we’re in a bubble. Nic, I’m going to come to you first, because 71% of the people that have filled in the poll think that Bitcoin will be worth a hundred thousand dollars by the end of 2021. My question is: how would one determine what’s a fair price for Bitcoin? Is it the mining costs that should give us the best proxy for the underlying value? How does one determine the value of Bitcoin?

Nic: [00:21:21] I mean, it’s like any other commodity; you can’t construct evaluation with a DCF model, right? And we see these wall street sale side desks frantically trying to build a valuation, like JPM the commodities desk always does this. With the mining costs, it doesn’t make any sense because miners react to the price. They don’t set the price. Miners don’t have any privileged information about where Bitcoin is going to go. There’s nothing special about being a miner. They’re not valuing Bitcoin for us and then we’re inferring their valuation then trying to guide price to the valuation they’ve set.

Miner behavior is just a function of hash rate, electricity costs, basic costs really, and market prices. Hash rate is laggy, it follows price, basically. If you look at the 2017 bubble, there’s a huge hash rate spike 12 months after that. Miner behavior follows price. So, miners don’t set the price of Bitcoin at all. The price of Bitcoin is just a function of the supply, which is completely known. Then the world’s appetite for Bitcoin and the world’s expectations of the future adoption cycle of Bitcoin, which are constantly being revalued, those probabilities are changing all the time. The optimism is changing constantly and you get this unbelievable volatility.

I think it’s just about assessing where you think the world’s ultimate appetite for Bitcoin is going to settle in the long-term. You know, right now it’s roughly 10% of gold; slightly below that if you account for the free float of Bitcoin.

Do I think Bitcoin is going to be more influential than gold in the future? I certainly do. Do I know when that’s going to happen? Absolutely not.

Ben: [00:23:14] Seamus, I’m going to come to you next. Bitcoin is up 600% in the last 12 months. Listening to Nic, it’s simply a function of demand and supply, right? And this is blaze is relatively fixed or largely fixed, and so is the demand that’s changing.

The question is: how much of that demand do you think is speculative, and is there a possibility as 25% of the people that filled in the poll suggests that this is a repeat of 2017 and we’re in a really big speculative bubble? What do you say to that?

Seamus: [00:23:48] Repeat of 2017-2018? Yes, I think there’s clearly signs that there’s speculative force in the market. I mean, just this week, I think we had one of the crypto exchanges buy naming rights from the Miami Heat, over a hundred million dollars to put their company name on the stadium. Look at crypto on Twitter, people are talking about the Lambos (Lamborghini’s) and their Aston Martin’s again.

There is a lot of speculative euphoria in the market, but I think you need to look beyond just Bitcoin. I mean, we see this broadly across many assets now, whether it’s equities, real estate – just about everything seems to be, you know, profoundly exhibiting the same frothiness or bubbly characteristics.

I think the whole issue is how we measure these things. What’s the denominator, what do we re measuring this against? And I think the real question is why all these assets in that case? I think a lot of this can be correlated back to what we’ve seen in the growth in central bank balance sheets. Since the global credit crisis in 2007 to 2009, we’ve seen central banks absolutely explode their balance sheets. They’ve gone from somewhere around 5 trillion, if you look at the major central banks like The Fed, ECB, BOJ, and PVOC, it’s gone from about 5 trillion to almost 30 trillion in February of this year. That last 10 trillion, had a 50% jump basically in since 2020.

We’ve really seen a huge growth from these extraordinary monetary policy reactions we’ve had from central banks. I think what we’ve seen is reaction asset markets. All asset markets are probably to some degree in a bubble denominated dollars. I think the answer is yes.

Now, where we go from here is I think it’s very different than 2017/2018, where you had an asset specific spike. It was all retail as kind of a natural stage of, we see hype cycle around new technologies. We saw that on the internet, you had a huge run-up in 1998 to 2000, and then it crashed, and we’ve come out of that and kind of much more sustainable trend in technology. I think crypto is the same thing – we had a huge bubble and retail driven bubble that was on a lot of hype and little substance in 2017/2018. Crashed, and now without all the institutional infrastructure, the on-ramps, the large adoption by the financial incumbents, I think we see a long-term solid structural, sustainable trajectory now for crypto.

Will it have up and downs? Yes. Will it blow off tops? Yes. But I think it’s very different than 2017/2018.

Preston: [00:26:20] I’ve got to disagree with you there. Normally I’m skeptical about this stuff. I mean, if you look at the trajectory of Bitcoin and crypto adoption versus other types of software and technology adoption in the past, it’s abundantly clear that Bitcoin is still only in the very, very beginning of the adoption curve and hasn’t even made its inflection point. There are a lot of holders of Bitcoin balances on Coinbase, right. But at the same token, there are only 11,000 nodes. If this does what other software usually does, by the time they get some usability improvements and then they get things like Layer Two working well and have a decent UX, the potential for this technology is just like stratospheric. Where it’s 10,000 nodes now, it could easily a 100X or 1000X from there without really breaking a sweat. At that point, Bitcoin would be a very, very serious technology indeed, which just couldn’t be more.

But we’re still at that very nascent and early phase, wherever we recognize we have a very powerful tech on the other hand, but it still hasn’t been made usable enough for ordinary people to use it. That’s certainly coming.

Ben: [00:27:29] Preston, just to dig into that a bit more, are you saying that it’s potentially still undervalued because it’s still got so much potential, or you’re saying that it’s potentially overvalued because people got too excited versus where it really is at the moment on the maturity?

Preston: [00:27:44] It’s dramatically undervalued. If we think about how many Facebook users there are or how many web servers there are or email servers there are, that might be a better number to understand how big the cryptocurrency space is going to get. At the moment, if we look at most of the big cryptocurrencies, the number of nodes, full nodes – so that’s the people who have a complete copy of the blockchain on a computer or a server and are actively relaying transactions as part of the network – Bitcoin and Ethereum are the two biggest ones with about, I think Ethereum is 8,000 or 9,000 and Bitcoin has 10,000. If we 1000X that, it would mean that Bitcoin had 10 million instances being run or active software users all over the world. Facebook has two billion.

If we think that this is going to be something like Facebook or on the level of Facebook, it might in the short term be overvalued. It might retrace, it might have a dramatic 50% drop in the next couple of months, but I’m now fairly convinced that the way that this is going is going to look a lot more like Facebook, the adoption of Facebook and email. Just looking at how many people are running the software, it’s clear that that hasn’t happened yet. But there are people with tons of Bitcoin balances, right? They are nominally Bitcoin users, but they’re not maximizing their big point of use in the way that I think small businesses and others will be able to do it in a way that would be potentially capable of bumping off big payment processors live Visa and MasterCard. The reason they’re not there is because the tech isn’t there. But it’s going to get there because that’s what technology does.

Seamus: [00:29:23] I’ll just interject. I totally agree with you. Hopefully I didn’t come across saying this is over. I think it’s just very early days. I very much agree with your thesis.

Ben: [00:29:31] Izabella, I wanted to come see you next. We’ve already alluded to the MicroStrategy and Tesla putting so much of their treasury cash, separate treasury cash into Bitcoin. Based on the discussion we’ve just had, that would seem to be a logical move, right?

Because these companies are generating lots of cash and they’re able to raise lots of cash, and then they’re then putting that into an asset that should, based on everything we’ve said, be a pretty good inflation hedge, if we believe that the inflation is coming down the road. Where do you stand on the logic of MicroStrategy and Tesla and others starting to use Bitcoin as a treasury asset?

Izabella: [00:30:14] I am quite cynical, generally speaking. But Tesla has cash flow issues of its own, like in terms of just conventional Fiat flows. For Ilan, there are other incentives in like messing with people’s heads and divesting into Bitcoin, notably because they probably will confuse lots of analysts and they won’t really understand the cash reserve position of Tesla. That obviously skates some of the numbers and potentially it could have a cash flow impact in that sense. He’s now obviously also said that he will be selling Teslas for Bitcoin. It will have to retrain a lot of bank analysts and valuation type people in how they assess.

 I mean, you could just conceivably use it as any FX. Obviously, corporations have FX exposure across the entire world, but they are valued in that home currency.

I’m cynical, but at the same time there is some underlying logic if you think that Bitcoin is going to become an international asset that is going to be increasingly a stable source of value on the reserve books. I mean, hard to say.

For MicroStrategy, from what I understand, there was also this weird play where they are a listed stock. You know, the other incentive for putting your treasury cash into Bitcoin is that you then galvanize people to buy your stock because you’re a proxy for owning Bitcoin. In terms of like, whatever, there are lots of different investment strategies out there, different mandates. You might not be able to own Bitcoin now right, but if you buy MicroStrategy, you’re getting an exposure to Bitcoin. It expands the pool of potential investors for your own stock.

There are other factors that play. Whether it becomes a trend, there was a big rumor that Oracle were going to do it as well, but it didn’t materialize, I think it’s early days. You’ve got to imagine the treasury positions of the big, huge corporations like Google. Google’s got such a massive cash reserve position that they have active traders putting it into treasuries or cash equivalents is almost a missed opportunity. These big mega corporates have to actively manage those portfolios and manage the risk around them. They’re also operating, like many hedge funds in some ways, on an internal basis and maybe that’s another incentive. If you can make a nice return from speculative position in Bitcoin, it can bolster your PNL in other ways.

Ben: [00:32:51] Nic, what would happen to the price of Bitcoin when you have quite a lot of CBDC’s in circulation? Do you think that has a downward effect on the price of Bitcoin?

Nic: [00:33:04] I think people get hung up on the digital currency part of CBDC’s. I mean, if you look at it, most dollars are digital. The majority of dollars are digital, they’re not analog. We already have CBDC’s on it.

Izabella: [00:33:22] I totally agree with that. It really frustrates me when people kind of market it as a big innovation.  

Nic: [00:33:28] It is odd. Maybe CBDC involves giving regular people accounts at the fed. I don’t think that’s going to happen, maybe we’re going to have some hybrid model. Then the question is: okay, well, how is that different from our current model at all? Maybe fintechs will get accounts with the central bank directly instead of just banks. Doesn’t seem like a huge change to me at the end of the day.

Izabella: [00:33:58] It is a big pain. I just don’t think they’re going to do it if they really think about it, because what’s CBDC sees, it’s a euphemism for state banking. Conventionally, we don’t think state banking is a good idea – state banking to the extent that central banks are still under the supervisory mandate of a state. They’re supposed to be independent, of course. But either way, it’s either state banking or monopolistic banking, and that is not supposed to be a good thing.

The reason that becomes the case is because if everyone can just hold accounts at the central bank that will defund all the kind of respective banking competition out, the conventional licensed banks, who will be starved of deposits and we’ll have potentially a massive liquidity issue to the point that the central bank will instead attract all those deposits and be forced to reinvest them in assets.

People only think of the liability side of the balance sheet, but it’s really important to remember that if everyone puts their money into the central bank, they’re going to have to do something with that money. Do you really want the central banks to be deciding who to give loans to? Isn’t it better to have a distributed competing network? That’s my key point.

Nic: [00:35:09] Point very much taken on that. Just to maybe get to the intuition behind the question, I think people ask it because they think that CBDC will give you this maybe great transactional experience, such that you don’t need cryptocurrency. But as far as I can tell, it’s giving you a very different experience from Bitcoin or stable coins even for that matter.

If you look at the Chinese style CBDC, the DCEP, it includes a whole bunch of surveillance and you don’t get a lot of transactional freedom or autonomy with that. I haven’t really seen a central bank commit to creating strong privacy assurances in their digital cash products if they are able to create them.

Izabella: [00:35:56] Well, there’s a massive conflict. They’re faced with a massive conflict; Preston might have a view on this. They all charged with ensuring all their licensed operators comply with AML and KYC. If they then issue digital currency themselves and don’t apply the same criteria to their own accounts that they force on all the other banks, well, that’s a bit of a paradox.

There’s a massive paradigm to the hurt of private central bank money. I don’t see how they can overcome it personally, unless they could totally abandon KYC and AML rules or have an exception for themselves. But then, why would you use their currency?

Nic: [00:36:34] They’re not going to. I mean, what government creates a tool that could potentially increase their power and then walks away from that additional capability? You know, people like Bitcoin because it lets you opt out of the discretion involved in central banking. It gives you more transactional, autonomy, freedom, etc.

CBDC is growing the power of government in the central bank, as far as I can tell, if they do create them. To me, they seem like completely diametrically opposed concepts. people will get confused because they think Bitcoin is a digital currency and CBDC has digital currency and the names for their competitive products. I don’t really see them as giving you the same currencies at all.


Ben: [00:37:25] We’re going to move now to topic three, because we need to discuss this central point of whether we think Bitcoin is now an investible asset for every portfolio. Our audience is pretty clear on this, right? The ATA think that a small allocation of Bitcoin in every portfolio makes sense. But I’m going to come to you Seamus and ask whether it’s really suitable for say risk averse pension funds given its volatility. What do you think?

Seamus: [00:37:52] I think the investment market is really a broad spectrum of different risk profiles. Some of the first adopters, like the hedge funds, Paul Tudor Jones and these type of guys get in the market, and they have a strong thesis around that. They’re very agile. They have a central process around decision making. Whereas if you look in the pension space, they have advisors, they’ve got committees, processes take a long time to change risk and allocations.

Bitcoin takes a while to get into there. One of the biggest impediments to Bitcoin is obviously the size of the market. Until recently it was very small. You described the returns – we were looking at a couple of hundred-million-dollar asset class just last year. That’s something that should definitely be ignored. Now, it gets quite a bit different at a trillion dollars and rising. The size itself is not probably enough, but what I was referring to before, the extreme monetary policy we’ve had from central banks, its intent is to drive investors at the risk curve. I think to a large degree, the measure of we have in the market is broken near negative yields. It’s really broken the cost of money.

You had pension funds, I guess 2012 was a good example. You had some of the, let’s say, Texas teachers and some of the other Texas pension funds investing in physical gold in their response to kind of post the credit crisis. The monetary policy reaction to, they set the way to opt out. Nic referenced the Bitcoin takes physical delivery of gold. That obviously took a few years for them to go from the global credit crisis to doing that.

You probably have a similar lag here, but the growth trajectory of asset class is getting to a point where it can be considered. I know I’ve had some dialogues with those types of organizations that they are looking at. It’s very early. I mean, people like Grayscale say pensions are looking at it, I think it’s probably the very small pension so far. But I think if this continues and we continue to have – I mean, globally as a February 27% of fixed income was still negative yielding – fixed income no longer serves its purpose, basically. I think you’re looking at very long duration risks as rates go up, basically and cryptos or Bitcoins potentially are an alternative as well in a portfolio.

Now, obviously a good question is, how much? But I think those discussions looking at that asset class from the most conservative investors is starting now.

Ben: [00:40:10] If anybody wants to volunteer an answer to that, about what might be a sensible allocation? Because based on what you said and based on the performance and so on, and leaving aside the volatility, it does seem like it’s sensible to have some exposure to this because it’s such a high performing asset class. Preston thinks it’s super, super in its infancy still.

Why would you not allocate something to it? You know, say 2%? Preston? Also Nic?

Nic: [00:40:40] Sorry to cut in line. I mean, if you think current expectations of the future growth or Bitcoin are already expressed in the price, and so there’ve definitely been bad times to buy Bitcoin historically. Could be the one we’re in one right now.

Ben: [00:40:57] You would simply say it’s the timing.

Nic: [00:41:00] It’s a matter of determining where you are in the mini cycle. Then obviously we have a much longer-term secular movement towards monetizing the SASA class. But if you have a constraint in your portfolio or your mandate, and you can’t tolerate the volatility, then you really have to manage your position size accordingly.

Ben: [00:41:20] But wouldn’t that just be reflected in the size of the position. In the same way that people say don’t ever try to time equities, but if you are very risk averse you have a very small allocation to equities?

Nic: [00:41:29] The question is the risk of getting washed out of your position if you can’t deal with the downside volatility. I think if you don’t have a firm understanding of Bitcoin and a conviction in the asset, that’s probably guaranteed to happen, because we’re dealing with something that’s 80 to a 100% annual volatility.

Ben: [00:41:48] Preston, do you have a view on that? Because we’re facing this up-pension time bond, because we’re sitting on population pyramid that doesn’t support pensions, pension funds are not yielding what they need to be. Make the case for not making a, say 1 or 2% allocation of pension funds to Bitcoin, other than the timing.

Preston: [00:42:12] I don’t think there is. I mean, 1 or 2%, I would maybe go up. If you’re really hyper cautious, then go on the low side, 0.5%, 025%, I don’t know. But I think ignoring the asset class at this point is a mistake. I think what would be a greater mistake and what clearly some people are starting to do is they look at coin market cap and they see what the top 10 are, and there’s a new flavor of the week that bolted up the top because it’s the new thing. But then when you dust it off, and it’s like, okay, what is it? But it’s just some other, you know, repackaging of basically Ripple by another company with another entrepreneur.

There are very few things in the crypto space which are capable of rendering the current way of doing things, which is proven to work in the Bitcoin and the style of Bitcoin, obsolete as a superior mode of reaching decentralized or distributed consensus on transactions on a block-by-block basis.

I think a lot of people will wind up making mistakes, saying: well, look, there’s this one; it’s green. Of course, there are big problems with that. But yeah, I think that people, basically, the biggest mistake they would make is putting too many eggs in one basket. If they’re really interested, I think weigh heavily. This is not investment advice, I’m an attorney, but I’m watched for a really long time and I’ve seen what’s worked and what hasn’t. There’s always some flavor of the week, that doesn’t stick around very long because it’s just been pumped up by some algo trader with a large position. Most people who are new to this space don’t recognize when it’s happening.

Izabella: [00:43:50] It’s really important to remember that a lot of things that happen in capital markets are born out of convention and from organic adoption. There are obviously regulators saying you have to do this and that, but there’s many different investing norms that have been born out of just first mover advantage and the ‘QWERTY keyboard issue’. Like Libel was very much just an industry thing that came about it. It wasn’t perfect, as we later found out, but it became a trillion-dollar benchmarking system or more.

Bitcoin, the fact that it was the first one to the market in this space gives it a huge advantage over anything else, and that mustn’t be overlooked because it’s really hard to wean the market off a convention that has been organically sprung upon them.

You can also look at other concepts like credit rating agencies. Again, theoretically there’s no limit to how many people can give a stock or a security a rating. I mean, I could start Izabella Kaminski ratings tomorrow, but no one would listen to me because of the power and the influence of the first movers into that market. I just think that’s an important point to also consider.

Ben: [00:45:10] I’m going to read to you a very, very short quote, which I think was from as recently as last month, from Janet Yellen, where she said: cryptocurrencies are used, at least in a transaction sense, mainly for elicit financing.

Is that even true anymore? If it’s not true, why do you think that she said it? Does it come back to that point we’ve made early where a lot of central banks and government bodies are still quite uncomfortable with cryptocurrencies? Or is it still just this kind of legacy image that is still used by criminals? I don’t know if anybody who wants to come in on that first.

Preston: [00:45:48] I’ll do that. No, it’s because boomers don’t understand what they’re doing in this space. This is not their tactics. No offense, but the fact is that what we’re seeing Bitcoin being, yes, it is used for illicit purposes without a doubt. But law enforcement has top-notch surveillance capabilities because Bitcoin is unencrypted, right? The transaction history is publicly viewable for anyone to see.

If you commit a big enough crime with Bitcoin, you’re going to be on the radar and getting those coins out. We will see, actually we see wire fraud prosecutions and money laundering prosecutions being brought years after the fact, because someone who took some funds in Bitcoin related to a list of transactions then decides that it’s been enough time, so they then go and spend it to Coinbase, withdraw it, and try to get the money out. Boom, FBI looks at it and goes and searched in Coinbase, finds out who had the transaction. They’re all over.

Izabella: [00:47:00] But Preston, don’t you think that’s like not a feature. I find that if you’re like interested in privacy, isn’t that like one of the problems in that it is so transparent. Isn’t the issue also that Bitcoin has now become so regulated, there’s almost no differentiation from the core fiat markets with it. All the advantages it used to have gone out the window, and in that case, what really is the advantage of me using Bitcoin over PayPal? In the marketplace, I don’t see what the advantage is, especially given there are some user non-friendly issues with Bitcoin versus PayPal.

Preston: [00:47:22] That’s a great point. I think the answer is that what we’re seeing increasingly in American society is businesses effecting censorship on behalf of pressure groups that are unable to do it through the government, because the constitution stands in their way.

 Most spectacularly we saw that with the extraordinary de-platforming of a sitting president from virtually the entire internet on January 6th, in relation to the events where a group of individuals decided to trespass the Capitol and he was assigned blame for that and was de-platformed essentially for the entire internet. We’ve also seen that with large numbers of conservatives being de-platformed from the internet. They’re also being de-platformed from banks and payment process. Bitcoin for a lot of these people has operated as a real lifeline, in order for them to get in communication with their supporters and receive funds from their supporters and continue operating when the banks really have been hijacked by a partisan, hard life political agenda, or at least, the hardest left person and with the bluest hair dye in their risk department is calling the shots for the entire organization.

That’s the kind of universe that we’re moving towards and Bitcoin is an ordinary utility. If you want to be a political dissonance and spend money to someone who’s controversial, you’re still free to do that. You know our society. people are doing it right.

Izabella: [00:48:47] Preston, but are you free? Because, quite frankly, if you make donations to some terrorist group theoretically, it will be tracked on the blockchain and you will be arrested.

Preston: [00:48:59] No, you’re not free to go, someone got dinged for that, for going in North Korea.

Izabella: [00:49:05] The point here is that what you’re saying to me is what is classified as a terrorist is a fairly subjective perspective. Because for one part of society all you Republicans are terrorists now, so there’s a fine line between what constitutes a terrorist or not.  

Preston: [00:49:25] But those people who say that, you know, 74 million Americans are terrorists, those folks fortunately are not in charge of the judiciary. They’re just opinionated jerks on Twitter, and I think they’re probably a very small minority of opinionated jerks.

Izabella: [00:49:40] Yeah, but they do influence corporate culture, and we’re living in an environment where you get cultural audits, right? A bank cannot be seen lending to someone that public opinion deems a terrorist. Then you get frozen out and de-platformed and unbanked.

And I don’t see how the way Bitcoin has evolved, it has been co-opted. That’s my main criticism of Bitcoin, is that I feel it has just adapted and evolved in line with the conventional system and is not really a challenger anymore.

Preston: [00:50:16] Maybe. I see Bitcoin as basically a giant middle finger to people who would tell me where I can’t spend my money.

Izabella: [00:50:25] Sorry to monopolize, I just really want to know, how can you maintain that liberty with Bitcoin in the current regulated space where Coinbase has to deliver the names of anyone who the IRS wants or whatever police summons them to do?

Nic: [00:50:43] Can I address this? I love this tack from Izabella, I love that you’re extremely thoughtful about Bitcoin. It’s very refreshing, honestly. I think you’re right. I mean, when Bitcoiners insists that Bitcoin is fully surveilled and transparent, it’s kind of a cell phone. If you look at the facts, yeah. My firm does chain analysis, so I know how easy it is. You basically can infer with very limited effort the fraction of Bitcoin that’s being used in dark net marketplaces and things like that. Chain analysis estimates 1 to 2% a year of Bitcoin is used for illicit finance. But it’s a definitional question because any transactional activity the government doesn’t like, they can call illicit.

In one sense, Janet Yellen is wrong on the facts. But in another very real sense she’s right because she can just call everything to do with Bitcoin illicit if she wants, and people will listen to her. FinCEN will listen to her.

I mean, we have to prepare for a world where Bitcoin is 100% considered illicit by the state. What the implications of that are, because we know that they’re going to return to this world where capital flows and the financial system is wholly politicized, 100% politicized. We’re already there. We’re already there. Operation Chokepoint is being revived, you know, all capitals exposed to these political tests.

The question is: can Bitcoin resist that? I think ultimately even as an intermediate asset, something that you might use via Coinbase or Gemini or Crack or whatever, you still do have that ultimate discretion to take physical delivery of the asset.

Izabella: [00:52:30] Right. But then when they start forcing you and Coinbase to screen all incoming transactions into Coinbase from dark wallets or whatever they’re called, because that’s in the fiat space that they’re obliged to not just know who you are on the receiver and on the sender, but the sender of the sender. Then what?

I don’t see that picture improving. One of the great ironies of Donald Trump being de-platformed from Facebook, I thought, was the fact that Facebook had just so recently tried to create Libra, which was supposed to be the technology that was going to solve the unbanking problem. That’s the irony. They think they’re solving financial inclusion, at the same time they’re unbanking the president, potentially.

Nic: [00:53:21] Yeah. I think a political change will have to occur, where people become fed up with a small cartel of Silicon Valley oligarchs basically controlling who can use the internet. But I think Bitcoin is a ray of light and it it’s a potentially a way out of this. Yes, many people use Bitcoin in an intermediate fashion, but many people also use it directly. No, no one is currently censoring Bitcoin.

Izabella: [00:53:47] Are you saying there’s going to be a bifurcation of the market. You’ve got BTC and BCH and all these others, but there’s also another schism within Bitcoin, which is people who use it for the regulated space and those who use it outside of the regulated space, and will the two be able to co-interact with each other in the years to come?

Nic: [00:54:09] I think it’s a question of state capacity. If you’re China, you can probably enforce very oppressive monetary rules. If they wanted to step it up, they could. In the US there’s ultimately constitutional constraints against, seizing people’s funds and expropriation. At the end of the day, the tools that the government would use to push through the complete politicization of capital, those are pretty extreme tools. Once you start to employ them, you reveal yourself as weak.

I think Bitcoin and the Bitcoiner values will eventually prevail in the US. In certain authoritarian states they won’t, but that’s just the way it goes.


Ben: [00:54:56] Is there a better Bitcoin? Because I think most people approach this topic from the point of view of: is there a Bitcoin alternative that doesn’t use as much energy for example, or is a better payments mechanism, whatever? But we can also maybe ask it from the vantage point that Izabella’s asking, which is, is there still a cryptocurrency that protects the privacy better than Bitcoin?

Is that where it may be vulnerable? Not through energy use or any other normal arguments that people raise?

Preston: [00:55:27] Yes. The way to find this out is by reviewing court filings and seeing where the FBI describe a seizure of a particular type of asset either in a search warrant or an indictment or something like that.

We’ve seen indictments where they say: we seized X number of Bitcoin, Y number of Ethereum, and an unknown quantity of Monero. In the court filing they really can’t find it out, because otherwise they’d have to say so. I think there are some privacy focused cryptocurrencies. They’re having trouble getting those on exchanges because of the KYC implications. There is a bit of an operation choke point style cutting off those cryptocurrencies from the mainstream financial ecosystem. But I think what we’re going to see is that people will find ways to get into those assets by going to some offshore exchange that doesn’t have KYC, which is very, very bad that they don’t do that.

The fact is these utilities are there, offshore exchanges do this, and that’s the way that people can take Bitcoin, which is regulated and supervised, into something which is much more difficult if you track it.

Ben: [00:56:33] What about the other arguments, I think we had a question early on about Cardano, whether that might be a better Bitcoin because it’s proof of stake and therefore doesn’t have such a large environmental footprint.

Izabella: [00:56:47] Can I lean into the environmental question and propose the proposition that maybe it’s not an issue. First of all, it’s a question of relativity. I was super critical about Bitcoin’s energy from back in the day, but I have been thinking about it and I’ve decided that maybe it’s a feature, not a bug. On the basis that this whole ESG framing that the price of carbon like has to effectively collapsed to make us a substitute into other better systems is very wrongheaded, because you want the price of carbon and oil to go up. At the moment, we’re synthesizing the price going up by making anyone who is a polluter have to also buy carbon offsets. But this isn’t changing the underlying cost of the energy. The energy is separate, and it’s not every single jurisdiction that has to subscribe to offsets. On the black market you can still buy cheap energy, and that market will always exist.

Whereas in Bitcoin, it’s a much purer system. That the energy is costly, and therefore there is a better incentive to create technologies that create efficiencies around energy. If we lose those incentives, maybe we end up pushing technology in the wrong way. Certainly solar, wind, none of these new renewables that we’re pushing ahead with, they haven’t solved the energy problem. In fact, in many ways they consume more energy overall than they have to consume their energy upfront. In the short term, you’re spending more carbon, not less.

I’m not convinced that the energy problem is a bad one. It might be a feature. Also, it brings to mind the sheer energy costs of the internet in general. Because people are worried about pollution and not using plastic bottles and all sorts of like energy saving light bulbs, blah, blah, blah, but they don’t think about the fact that their selfies, their internet presence, all of this has a massive internet carbon footprint in fact. I think the entire ICT sector is now in terms of carbon emissions contributing more than the airline sector. It’s growing much more quickly than airlines, especially post pandemic.

By putting this into people’s minds, you’re putting pressure, not just on Bitcoin, but also on Google and all the other service supported businesses that haven’t solved these problems either.

Preston: [00:59:21] I think the reason that I mentioned earlier that people should be careful about investing into the latest all-point is because you’ve asked that question about Cardano, which has managed to somehow find its way into the top 10 cryptocurrencies in the last couple of weeks. I’ve seen perfectly reasonable people who have known for a really long time, who happened to be early members of the Cardano community, getting very excited about the increase in the points of market capitalization for the relatively low amount of flippening Ethereum.

Flippening, for those of you who are listening, is Bitcoin use, or what happens when something becomes more valuable than something else.

In any event, the thing with Cardano is it’s very much the same as everything that’s come forward. So proof of stake, maybe ‘more environmental friendly’. But if you dust that off and see what the claim means, it means that there’s no actual work being put into securing the network. From the standpoint of looking at this as a global transactional system, I would look at that and say: all right, well, what function does proof of work serve?

One, it ensures that you have some skin in the game so that when you’re providing a security network, there’s something in the real world which limits your ability to go and fake the consensus, right? Which is not the case of the proof of stake system, which is judged with a balance of points in the wallet. You could have someone sitting there and control 80% of the coins and basically playing decentralization theater, which is what a lot of these schemes do.

The second one is that proof of work is a point distribution metric, which proof of stake coins also do. The only way to get into a group of stakes system is by purchasing it from somebody else. The way that you get into a proof of work system is by performing useful work and then the coins get issued to you direct – which from at least my standpoint means that you are creating a valuable asset outside of the confines of the traditional financial system. The only thing, they would have to cut you off at the ISP level in order to prevent you from mining Bitcoin, whereas it’s very easy if you’re highly dependent on these staking systems. They just turn around and say: we’re going to deem this unlawful money transmission, or we’re going to turn around and apply some pressure on the exchanges, or we’re going to call the staking mechanism an unregistered security, which is certainly something which is within the realm of possibility, at least in the United States.

Stuff like that. When we hear there’s a new coin, it’s in the top 10, it just appeared there, there are a lot of new people around and they’re not really doing particularly in-depth thinking about why things are the way they are, or they don’t have the context of understanding who’s running them, how long they’ve been running them, what the history of these people are, and where they come from and whether their ideas are new or not.

In the case of Cardano, Charles Hoskinson, perfectly nice fellow, very intelligent guy. But I think with Cardano, he’s building 20, 15 techs today, which is a smart contract and Naval blockchain that uses proof of stake. There are, you know, 15-20 of those in the top 50, at least that you can point to. I don’t think there’s anything particularly special about that.

Nic: [01:02:23] Preston is absolutely right. I mean, proof of work is the interesting thing here. That’s what permits decentralized leaderless consensus to emerge between a set of mutually untrusting nodes, where people that make transactions with that system trust they’re not going to be censored. That’s the purpose of Bitcoin, is to make transactions that institutional power says you can’t otherwise make.

Proof of stake, people consider it an alternative to proof of work, which is completely false. Proof of stake is just a fancy word for a consortium of entities that control the chain.

Izabella: [01:03:01] I’m not a technical person, but intuitively I’ve always thought that proof of stake seems just like a replication of the standing banking system.

Nic: [01:03:11] Precisely. It’s not a novel thing. People think they have this artificial progression in their mind where we had the federal reserve and then we had proof of work, and now we have proof of stake, which is somehow even more decentralized and better for consensus. It’s just not. Proof of stake just means a cartel chain. We’ve seen these things fail. Like, you just have to look at the example of EOS or Steemit. We have seen them get taken over by cartels. That is the guaranteed fate of any proof of stake chain, because what happens is all the coins settle with the exchanges and then the exchanges make all the political decisions on behalf of the chain. The disconnect between reality and perceptions here is absolutely colossal.

Ben: [01:03:56] Does anybody want to make the case that there might be a better Bitcoin, even if it’s in a hypothetical case? Or, do you think Bitcoin for all of its imperfections is the better.

Izabella: [01:04:12] I was the biggest critic of Bitcoin that you could have found. I’ve really stressed test it on every single angle that I’ve analyzed and tried to critique it. My conclusion this year or last year was, it’s not perfect, definitely not perfect, but it’s the best of the bunch and in an ugly contest it’s the one that makes a lot of sense.

As I always say, I wouldn’t claw back any of my criticism, I think all the points I’ve always made have been valid. What I underestimated is that the conventional system – I had more trust in the conventional system, and I just thought it wasn’t worth it. I’ve always likened Bitcoin to a bit of a luxury product, which is suitable for like paranoid people who want to overspend on effectively payment security. But that becomes worthwhile when you see that maybe they weren’t so paranoid, right?

In hindsight, because certain things that have happened in the last year have made me more skeptical about whether democracy is still functioning on an accountability perspective. I’m worried about the authoritarianism that has creeped in through pandemic measures and things like that. I think in that context, Bitcoin, I’m glad some people speculated on it. I’m glad it’s there. The world is better off for it being there, is my point.

Is there a better Bitcoin? Not one that’s going to be able to overcome the first mover advantage that Bitcoin had. I think it would be very hard to retrofit anything to something else.

Preston: [01:06:02] It’s like the classical test for obscenity, right? Is there a better Bitcoin? I can’t describe what that would look like, but I’m going to know it when I see it.  And right now there isn’t right. Bitcoin is currently, in my opinion, the most effective at achieving de-centralization, as that term is almost impossible to define, but however we define it, if it’s to happen, I think Bitcoin does it pretty well. It’s the most effective at generating coins, which are distributed not to early holders or to exchanges, but by people who go and install some racks and put some mining hardware, and have some skin in the game, which is an important element of decentralization – it’s distributing coins.

Whatever’s better than that will be better at getting coins into people’s hands outside of the context of regulated exchanges. it will do everything Bitcoin does, but it’ll do it a little bit better. I call it alien proof of work because it doesn’t exist yet. Or at least, if it does exist, we don’t know about it. maybe that’s coming next year. Maybe when it’s invented it will be adopted by Bitcoin. We don’t know what’s going to happen on that front, but for now I think Bitcoin is the big, bad boy on the block.

Nic: [01:07:14] If you could invent a proof of work where there weren’t economies of scale basically, and everyone could participate in consensus, and it wasn’t possible to find optimizations such that there were large pools of hash power that developed, that would be better. But yeah, there’s unique circumstances of Bitcoin’s birth that simply cannot be replicated today.  And I can go into detail, but that’d be kind of a longer conversation. Suffice to say, you couldn’t possibly launch Bitcoin again today.

Ben: [01:07:43] We’re out of time, and I think that’s a good point to leave us at. I’m not going to attempt to summarize the whole discussion because it wouldn’t be impossible. Even if we had enough time, it’d be impossible. But basically, I think we said that there is a strong investment case for Bitcoin. It’s probably possibly in a bubble, but not. If it is, it’s not a very big one. It’s ready for the mainstream, and there isn’t a better Bitcoin.

With that, I’d just like to thank our four panelists. Thanks again for everybody who listens. Our next four by four is on the environment. Izabella, we might be coming to you to ask you back. You’d be game! Thanks again to everybody!

Real Estate Rebound Post-COVID (#40)

Structural Shifts with Zsolt KOHALMI, co-CEO of Pictet Alternative Investments

What is the future of our cities? During the pandemic, places like London have seen an exodus of people who can work from anywhere. What is the future of office space? Is co-working going to continue? We dive into these questions with guest Zsolt Kohalmi, global head of real estate and co-CEO of Pictet Alternative Advisors. We also cover the future of retail and whether the pandemic plus Amazon has permanently closed a lot of our favorite shops and what’s going to become of these spaces. We discuss real estate: is it going to become more environmentally friendly? Will technology become more embedded into our urban infrastructure? 

Zsolt earned his MBA at INSEAD and he speaks nine languages. This is such an interesting conversation and if you like the interview that we have here on this show, then you will likely enjoy Pictet’s podcast “Found in Conversation” where they interview leading experts on how we can improve the modern world. 

Main topics discussed:

[00:01:47] The urbanization trend

[00:05:59] Healthcare metrics as a decision factor

[00:16:12] Return to physical offices and co-working spaces

[00:25:05] Acceleration of e-commerce

[00:28:43] The environmental dilema with real estate

[00:37:55] Demographic composition of cities

[00:42:54] Benefits of the Internet of Things for real estate

[00:50:18] The tokenization of real estate

Full transcript
Real estate rebound post-COVID, w/ Zsolt KOHALMI

Almost 50% of the total carbon emissions of a building happened during the time of construction. And so the opportunity for us is definitely in creating better buildings, mostly from the existing buildings we have and then growing the lettable area.

Full transcript:

Ben: [00:01:47] Zsolt. Thank you very much for joining the Structural Shifts podcast. This is quite a wide-ranging topic.  What I wanted to do is jump in initially by talking about urbanization.  I read that according to the UN world population report, 70% of the world’s population will live in cities by 2050. Is urbanization the mega trend that is underpinning the real estate sector?

Zsolt: [00:02:15] Thank you very much, first of all, for having me, Ben.  I would say that urbanization is a positive trend that helps because when people move, they have new needs for location in terms of residential, but also in terms of meeting spaces that today are certainly offices. We’ll talk about that later and how that may change.

I think it helps, but I wouldn’t say it is the theme for real estate because for real estate, the real thing that you need to take care of is what changes. We as human beings change and once we change, we have different needs and that means we need different type of buildings.

We have to refocus real estate, not just to growth. We have to refocus ourselves to actually refurbishing what we already have. 

Ben: [00:02:58] You said the urbanization was one of the mega trends as it pertains to what changes and what changes is really what matters. How much has the urbanization trend been paralyzed or maybe even put into reverse because of COVID? Because, anecdotally you hear lots of talk of people moving to the countryside or at least moving to the suburbs. How much of that is really playing out in reality?

Zsolt: [00:03:21] I think one of the easy truisms of the pandemic has been that the pandemic has accelerated existing underlying trends.  It’s not that these trends didn’t exist, it’s just that we’ve seen in five, six months, what may have occurred over five to even 10 years.

 One of those trends has been the move by a certain age group to the suburbs.  In my previous life, when I was a partner at a global fund, we invested a lot into this trend already over the last decade in the US: people who have children and can no longer afford to live downtown because they simply can’t get the square meters, the square foot they require.

They’ve been moving to the suburbs for a while. That has accelerated now, but it’s not a new trend. It’s something that we have seen and there’s a certain acceleration, but I certainly don’t believe that that in turn spells the death of major cities, either. 

“Affordability is a very big factor. You can get a certain quality of life that you can obtain in a second-tier city versus a first-tier city just by the sheer affordability ratios, which normally is expressed in how many years of wages do you need in order to buy a home. That tends to be over double in the first-tier cities than the second-tier cities.”

Ben: [00:04:18] One of the trends that we’ve seen over recent years is because of the strong spiller affects you get within cities. Is it that the larger cities have been growing or doing better than all other cities?

 I feel like we’ve seen this trend towards mega cities. Do you think that stays the same or do you think one of the effects of COVID might be that people disperse a bit more? I now second that third tier cities might actually benefit. 

Zsolt: [00:04:41] I think that that trend certainly has been the case for a long time. That is correct. I also think that there has been a trend for what we’re calling second tier cities.  It’s always important to say what we believe by that. To me, second, tier cities would be Manchester in the UK or [00:05:00] Gothenburg, for example, in Sweden or Lille in France, or think about Atlanta or Denver in the US.

These cities have been growing for the last decade. They’ve really started to accelerate and mega cities are very attractive. They give amazing opportunity to the people who move to them, but we do have an increasing affordability problem. Affordability problem then gets into the problem of actually people getting access to the cities, how far they are from the downtown center and there is a pinpoint where it is no longer worth it. So second tier cities, I believe, have a real potential. Again, it’s a trend that has accelerated because of the…

“the one other thing that has been accelerated by the pandemic is that we’re thinking about healthcare metrics, which were not front and middle center of mine before. Nobody ever used to look at what is the air quality I breathe on a daily basis.  In the future, when people buy a home, that will start to become a natural metric that people will look at.”

Ben: [00:05:42] pandemic. So the trade-off is really between having enough square meters, potentially having a garden, and quality of life, versus not having a commute. Therefore, is that what’s driving people in smaller cities because there isn’t such a big trade off in that respect?

Zsolt: [00:05:59] I think it’s one of the trade-offs. I really liked the idea that you look at the cost of accessing the downtown areas or wherever you may work or go for fun, and that cost is expressed both in terms of physical costs, how many dollars, pounds it may cost, but also in time terms. There comes a time when that pain barrier becomes quite big, but that’s not the only factor.

Affordability is a very big factor. You can get a certain quality of life that you can obtain in a second-tier city versus a first-tier city just by the sheer affordability ratios, which normally is expressed in how many years of wages do you need in order to buy a home. That tends to be over double in the first-tier cities than the second-tier cities.

Then, the one other thing that has been accelerated by the pandemic is that we’re thinking about healthcare metrics, which were not front and middle center of mine before. Nobody ever used to look at what is the air quality I breathe on a daily basis.  In the future, when people buy a home, that will start to become a natural metric that people will look at.

Ben: [00:07:09] What does it say to you? We’re not actually in the same room, unfortunately, because of the pandemic, but we are both in the same city. Where does a city like Geneva rank? Because, on one level, it’s always top of the Mercer quality of life index, but on another level, it’s not a big city. And in some ways, it’s not that economically dynamic., So is Geneva a tier three, tier four city?

Zsolt: [00:07:32] I have to make a small precision there, Ben. Geneva does not make it to the top of the Mercer list. Actually, in the recent list, it’s not even in the top three for Switzerland. You normally tend to get Bern, Basel. So you’re getting more third tier cities at the top in terms of quality-of-life index, which is interesting in itself, I guess.

Back to your question, Geneva has very unique drivers. Having been in real estate 26 years and then moving to Geneva, what I realized is how peculiar the city is because the drivers here are unique and are somewhat related to the pandemic. I think there’s a real inflow at the moment in terms of new population. That’s because people tend to look for security in uncertain times and the pandemic has created uncertainty.  That has meant that globally, but in particular French and Brits are looking to Geneva as a potential solution there to that uncertainty. That has created an influence, which will push home prices more than you would have seen without them coming to Geneva.

The other factor though, is that Geneva is a very high-cost location to live. That is now truly affecting the livelihood of the middle class and so I think that Geneva will face that problem, that it will start to become less attractive for the middle class if these trends continue despite the high wages – but the high wages almost don’t compensate for the very high-cost base.

Geneva has not been a net growth city recently. I think it will grow on the margins, on the high-net-worth side, but I’m not sure that it will grow as a healthy city in the mid-market. If there’s not some kind of a rebalancing in relation to the cost base that that you need to support with the wages here.

Ben: [00:09:20] London is still a good investment from a real estate point of view, because I read that something like 700,000 people left London in 2020 because of Brexit, because of the pandemic and so on. Where does London stand on that?

Zsolt: [00:09:33] I think that global cities, London and New York, will go through a bit of a dip right now. And again, it goes back to the point I mentioned earlier. I think that the per kilometer costs both in terms of time and money to reach downtown is very high in these cities. So when people have the opportunity to feel that they can work remotely, that they can secure themselves a better quality living, then London and New York have a slightly tougher go.

As a very quick side remark, New York, has another headwind, which is tax. If you moved down to Florida and you earn above a certain minimum threshold, you will keep almost 25% more of your wages than if you stay in New York. That’s a pretty hard equation to fight against at the moment at a certain income threshold.

Back to London, I think that Brexit and the pandemic have less people looking at working from second home, sometimes even in France and beyond. I think that over time London will regain its glory. This may well take three, four or five years, but London has a unique set of features. The infrastructure, both physical, but even more the mental infrastructure, in terms of some of the smartest people from the roles being together in one city, is not something that is repeatable elsewhere in Europe. And London still has the benefit of having English as its mother tongue as well. So I think London will come back, but I expect that’s a take a little bit of a while, and that means some interesting opportunities to buy if one has a mid to long-term horizon.

Ben: [00:11:14] Where in Europe is benefiting because of Brexit? Which cities are benefiting most, because I guess a few cities are reaping of Brexit dividend?

Zsolt: [00:11:23] Ever since the Brexit debate has started, I’ve seen and followed numerous studies and had numerous, very interesting conversations. Even with former chancellors of the exchequers of the UK about this theme, about what will happen with Brexit and who will benefit.

What I am seeing so far is that the actual move has been more muted than people would have thought. It has accelerated somewhat in the last three, four, five, six months. I would say that it is interesting to observe that with all this preparation time up to Brexit, most people have decided not to make a big move. In a big way, I do see an acceleration trend.

The main benefactors are Amsterdam, definitely, because English is a very strong second language, where virtually anybody in the street will speak it, because the infrastructure is very, very good. Schiphol has many more runways than Heathrow can ever dream of attaining and the infrastructure simply works, and you have a very educated population that is very welcoming and again, speaks English. So overall, Amsterdam is one of the main beneficiaries.

Dublin is often cited. I always just feel that Dublin is not very big and it is the wrong way. Hence, the travel times, if you ever want to travel anywhere within Europe is not great. Dublin has been a benefactor in particular on the tech side, but I just don’t see many companies saying “Hey, I want to move my headquarters from London to Dublin”.

Frankfurt -often cited. The problem with Frankfurt is that very few of the people who are the actual decision makers want to live in factories.  I think it’s an image problem for Frankfurt, because I think the city has become better, more cosmopolitan. There was more leisure available around the river, but it still has a problem of how it is perceived.

 The last, and somewhat very surprising contender is Madrid. Nobody would have said three, four, five, six, seven years ago that Madrid would really be a contender. The metaphor is almost like New York to Miami. They have brought in very interesting tax for people who are willing to relocate to Madrid, so I think tax is certainly a factor. Good weather, just as in Miami, is a factor. Also, it is a city that is very easily communicable. You can get to anywhere in the city, given the very wide avenues within 14, 15, 16 minutes.

The local municipality is as business friendly as they come. They simply make things happen. Interestingly, during the pandemic, they’ve been almost fully open for the last six months, whilst everywhere else, including in Spain, people are closed. Madrid has just kept open, prioritizing business. We can debate the ethics of this, but I think that overall Madrid has shown a lot of interests. Recently, of the data point that I saw which I thought was fascinating, was that credit Suisse, a completely non-Spanish bank, has moved its European investment banking headquarters to Madrid. That is a first. We’ve seen Santander make such pronouncements moving their investment banking back from London to Madrid, but there you understand why, as it is a Spanish bank. But a Swiss bank putting its European investment banking HQ in Madrid is a first. I believe not a lie.

Ben: [00:14:36] Somewhat conspicuous by its absence in that list you just gave is Berlin, because Berlin has always been tipped as a city that was about to boom, right? It had supposedly all the right conditions. You had very young, well educated workforce, relatively cheap housing costs. Why hasn’t Berlin done better today?

Zsolt: [00:14:54] I think Berlin has done well. It’s almost a victim of its own success because the legendary price advantage that it has been chipped away at very substantially over the last few years, given its popularity. Berlin used to be famous and realistic for what we called pancake reps, because rents never grew there for well over a decade. But since 2015, we’ve seen a skyrocketing of brands in Berlin, which has actually taken away one of the key advantages that you’ve just mentioned. Now it goes back to quality of life and Berlin has the opposite of Madrid. It has a very reformist municipality that is very slow, that doesn’t necessarily create the right environments in many ways, including, for example, now rent controls, which means that many people are no longer improving the flats as they know they can no longer get higher rents. That hasn’t helped Berlin, but overall Berlin has done very well.

When we talk about benefactors, it’s always for different reasons. If there’s a tech company looking to relocate from London, that would likely look at Berlin as one of its absolute top picks because Berlin has been good on the tech side, but the tech companies are less in a need to move than, for example, financial services firms as a result of Brexit.

“Harvard Business School did a really good study on the fact that innovation that normally happens in the 10% of interactions that are spontaneous at work, where two people meet at, for example, the coffee area and they discuss something that they were not timing -that’s when innovation happens.”


Ben: [00:16:12] People are working more and more from home and they’re much more comfortable mixing going to work with working from home. I guess that opens up a much bigger remote workforce, which I think we’ve talked about in the context of cities, but what does it mean for city center office space? Does the demand go down or is it just a different type of office space that we’ll seek?

Zsolt: [00:16:33] That is the $40 trillion question. Offices have been the largest asset class for real estate investors today. I was recently on a panel for the major publication in private equity real estate and we were six different peers who run different firms and there was no agreement on the point. I’ll give you my thoughts, but I think it’s very interesting to point out that I think that there’s no full agreement. In my personal view is as follows.

I think that peak fear about people returning to offices was last June. Last June, everybody enjoyed their first three months. It was great weather throughout. Everybody said wow, I can work from home, I’m sipping my macchiato on the terrace, I’m getting a sun tan. This is great. Following that, people started to realize certain things. Harvard Business School did a really good study on the fact that innovation that normally happens in the 10% of interactions that are spontaneous at work, where two people meet at, for example, the coffee area and they discuss something that they were not timing -that’s when innovation happens. Now, innovation through Zoom or Microsoft Teams is very difficult because you don’t have by chance encounters or by chance points. That’s one. Two is collaboration just amongst the team and team spirit. On three, which is the one I never heard anybody else talking about, but I believe in very strongly, is socialization being a requirement, not only at home, but work socialization being a requirement. For our mental balance, if we’re only in a private socialization environment and we don’t get the work socialization, I think we’ll lose our balance. We’re slightly different people in these two social environments and I think we require both to be balanced. Lastly, you can’t educate young people. The young workforce that you’re trying to bring up is virtually impossible to bring forward to an online medium.

So, for these reasons, I believe we’re going back to the office. I think we’ll never go back in exactly the same way as we were pre pandemic. You will very likely see an increase on the working from home trend one of the agents just put an exact number to. They thought that on average people work from home 1.2 days a week, and they thought it would increase to 2.3 days a week. I am not sure we can say this specifically, but people will have days when they will work from home and I think you’ll, you’ll likely have Tuesday to Thursday, Tuesday to Friday or Monday to Thursday, when everybody agrees that we will be in the office because people need to meet up.

One other trend that people may not appreciate is that the average square meter per employee in 1989 in the US was 26 square meters. By 2018, that same metric was nine square meters. We’ve gone from 26 to nine. One of the things you will see as a result of the pandemic and increased focus on health is that we’re going to increase the individual space we give people almost as a benefit. The benefit is, you’re coming back to the office, I’m giving you increased space.

All of these things, what they will likely lead to is pretty strong office demand in locations of desire where somebody, a tech company like Google or Microsoft wants their people to come back with happy and energetic faces so that they can innovate. I think those places will work fine. That is the downtown center that you asked. Where I worry more is a B location where there’s a call center, because there is no real hands-on deck. It’s much harder to explain why a B location really needs to be an office today.

Ben: [00:20:17] So potentially B locations suffer and the offices within A locations, they’d probably need to be redesigned, right? To allow people to have more space. Where do you stand on the coworking trend? What do you think happens to the co-working post pandemic?

Zsolt: [00:20:32] How we work will need to have more flexibility, as we said earlier, and that will lead to various innovative ways to how we think about space. One of my favorite examples now is that Accor hotel in France is in big trouble because there’s no tourist into Melbourne, but they have repurposed many of their hotel lobbies to act as working space. There’s coffee available, there’s space available, so when people don’t want to commute into a big town, there may be a hotel lobby nearby where they can work from.

 Increasingly, we will see companies thinking on a slightly more latching way about what it really means to work from a space. Coworking has a role to play in that, obviously, because if you’re a coworking operator and you have multiple locations and you can provide that flexibility, that will have a benefit.  I foresee that there may well be companies above the co-working companies that provide that facility to various coworking operators. I think flexible space is here to stay. There were some really good thoughts around the co-working with some pretty crazy valuations at the time, but flexibility in office space is only going to grow and the need is only going to grow.

 Real estate investors that were used to buying an office building with a 10-year lease and not thinking about the office for 10 years will no longer have that luxury. One of my key themes is that real estate is growing towards the hospitality sector.

It used to be only in the hospitality that you were measured every day. In most real estate products, you have a nice, comfortable life once you’ve secured that lease for a term. I think that is changing. Our role is speeding up on us, which again is another accelerating trend and this has accelerated further. For offices, the same will hold. Hence, coworking operators have a role, but I think that the valuations that were discussed and then that they will change the role is maybe slightly overstated.

Ben: [00:22:35] Yeah. Not wanting to be too specific, but somebody like WeWork, you would say has a fundamentally sound business model, but just the valuation was elevated.

Zsolt: [00:22:44] I think WeWork is maybe the best example of a non-sound business model. Initially it started as a very sound business model and they were truly innovative in what they were trying to achieve. Unfortunately, somewhere in between, also due to the push by SoftBank, they received so much money that the business model became unsound.

WeWork was well known overpay by over 20% for every lease versus anybody else. So if you could get a rework lease at one of your buildings, you were very happy, but now they have these 10-year commitments that are 20% above the pre pandemic market levels at which they need to try to make money. WeWork in particular does not have an easy setup. They will have to renegotiate with landlords a fair few lease and really try to rebalance into something a bit more sustainable. But again, coworking as a model is not unsustainable, perhaps not on the metrics that we were trying too though.

Ben: [00:23:43] Just to go back. You get the excellent example of how the square meterage per employee has gone down and you think that it will need to go back up, people will need more space. How do you square that with the co-working model? Doesn’t the economics stack up? Because you’re doing exactly the opposite, which is you’re taking a long lease and you’re carving it up into fitting many more sub tenants into that same space.

Zsolt: [00:24:04] Not quite. The real nuance in the co-working model is the assumption that most people are not experts in real estate. I could put it as simple as that.  If a company has, for example, one person who’s responsible for the real estate lease, then that person may not do the best planning for the company. So the real benefit for a company is -I will pay more per person and per square meter for four space in a coworking space than I pay in a normal office building, but when I need that flexibility that I need to grow further, I need to reduce, I am not stuck. When I need the flexibility of more meeting rooms, less meeting rooms, I’m not stuck. That’s the real offer. So the per square meter doesn’t translate into pushing people more closely or not more closely in the coworking space. That’s not the real game. The real game is having real estate experts provide you with the flexibility that you may not be able to achieve yourself.

The last mile logistics space really competes with light industrial space, but those activities have not disappeared. The supply of this space keeps diminishing because, as we build new residential towers, there’s less and less of this space and there’s more and more needs.

Ben: [00:25:05] So it’s like a premium for optionality. Got it.  I want to ask you about the retail market, because this is a trend that’s been accelerated because of the pandemic. E-commerce has just taken off. We’ve moved in months what people projected we would move in in years. What does that mean for retail spaces? What does it mean for distribution centers? How does that mix change within cities?

Zsolt: [00:25:27] That will be probably the most noticeable change for all the listeners as they walk on their own high street and shopping centers. This trend has been here for the last three, four years unabated, but we have done, as you said, in five, six months, what would have happened in seven, eight years.  What we’re seeing is a twofold on the traditional retail space.

There will need to be a re-purposing. Now that re-purposing in my mind is actually very interesting. I think what will happen is, in particular on hunch streets, what we’ll see is a repurposing towards everything health-related. The pandemic has made us more conscious about our own health. You’re gonna see more clinics of all sorts, but you will also see more soul cycle or boxing or you name it.  You will see people taking care of their health in a much more active way being the growth sector and you will see retail gradually disappearing. It’s incredibly acute and apparent in the UK. 20% of all the stores on Oxford Street are not supposed to open up after the pandemic. We’ve never had a statistic like that. Oxford Street is the premier street in the UK. That really shows the level of the problem.

The real issue that we have for physical retail is that we have too much space. This space will need to be changed. The issue is the capital value used to be much higher because the retailers used to pay much higher rent than the next user will pay. This will unfortunately remain a falling knife or a point that needs to bottom out where the capital value works for the next use. We will be inventive.

The one last thing that will happen in the UK is that you will see the non-central part of high streets being converted into residential because we continue to have a residential shortage in the UK. Ground floor, lower ground floor, all of these work. So most smarter councils will designate a key area that they want to keep as a high street, which should be a very short area, and then let the rest become residential.  Conversely, for every billion dollars of retail that goes online, you need about 1.25 million square feet of fulfillment space. Last mile logistics, basically. This is something that we’re in our own fund. We’re investing heavily into last mile across London. It’s a strategy that I’ve liked for many years, but has accelerated now because somehow those packages that miraculously arrive on everybody’s doorstep several times a day, they need to be fulfilled from somewhere.

The last mile logistics space really competes with light industrial space, but those activities have not disappeared. The supply of this space keeps diminishing because, as we build new residential towers, there’s less and less of this space and there’s more and more needs. We have these two very different effects where last mile is becoming very valuable. These are sheds that are not very beautiful. Sometimes, near the M25, for example, in London, whilst these are becoming ever more valuable beautiful shops, sometimes in very beautiful locations are losing value. Unfortunately, it’s the reality of how we’re living now and what are the underlying needs.

Whenever we’ve had the climate debate, it’s always been about aviation cars and so on. Real estate got away almost scot-free, which is very interesting to me because people have come to the conclusion earlier that we need to live and work somewhere.

Ben: [00:28:43], I think you alluded to this at the start, when you said the real opportunity in real estate is capitalizing on what’s changing. It sounds like area to play here is in changing the purpose of buildings, right? Hotels to affordable housing, offices to warehouses retails space to housing and so on. Would you say that’s fair?

Zsolt: [00:29:01] The first point I would make is that where I definitely believe that there’s a very large opportunity is re-purposing, refurbishing buildings. 76% of all European buildings are over 20 years old. The statistic would be very different in a Southeast Asian developing country.

 Essentially, we have the buildings we need. The environmental footprint difference of demolishing that building and building something new up that is beautiful and has all the relevant energy certificates that make it sound like it’s very energy efficient, the cost of doing that is very big. Almost 50%, 40 odd percent of the total carbon emissions of a building happen during the time of construction. So the opportunity for us is definitely in creating better buildings, mostly from the existing buildings we have and then increasing the lettable area.

The opportunities that you mentioned are great, but they’re slightly harder because change of use always encouraged an even higher capex capital expenditure. There are times when it works and it’s very exciting when it does. I love doing those types of transactions when it’s possible, but one must understand that when you change from a hotel to an affordable housing or you name it, then you’ve got to knock two rooms together. That has a real cost. The repurchasing cost, whilst very exciting, is often quite expensive. So either you need low capital values or sometimes what you do is you take an old office building and you create something new, a new office building that is a building of desire because the floor layouts are different, the air quality is different than so-and-so, but it may still have the same use.

Ben: [00:30:46] You just mentioned the carbon footprint that comes from real estate. I think I’ve read something like 40% of all carbon emissions come from real estate. So, reducing the footprint of real estate will be critical to reducing emissions overall. Where is the pressure coming from to do so? Is it top down because UN’s decided that the sustainable cities need to be one of our development goals or is it bottom up from consumers? Where’s the pressure coming from to make housing more sustainable or real estate more sustainable?

Zsolt: [00:31:16] I’ll answer your question with just one remark, which is that I have always admired that now you know the statistic and it’s starting to come out that real estate is 40% of all carbon emissions over half of all cement, over half of all basic materials we use, but nobody’s mentioned real estate. Whenever we’ve had the climate debate, it’s always been about aviation cars and so on. Real estate got away almost scot-free, which is very interesting to me because people have come to the conclusion earlier that we need to live and work somewhere. So it is what it is. 

The big change now is that the urgency of improving the carbon footprint of real estate is probably the only positive outcome I see from this pandemic, more or less in real estate, because it’s suddenly been massively accelerated. Our views on how important the environment is to us and therefore the role that real estate plays in that is being accelerated by the pandemic. It’s probably the only real big, positive I can draw from this otherwise pretty dreadful time.

You asked where the pressure comes from. I think it comes from two places. If you look at commercial buildings, most firms are looking into how can I look better from an environmental standpoint to my clients and to my investors, for my shareholders. One of the easiest ways to achieve that is let me change the environmental footprint of my headquarters, of my production facility unit.  That’s a very big driver in the residential sector, people taking a harder look at the quality of the beer they’re breeding, do they have a terrace or not -much more important in today’s post COVID time.

The other side is that institutions, real estate investors tend to do value add transactions where we create then an asset that will be sold to a pension plan or insurance company that will likely hold it forever. These end investors who are holding the assets plan told us 30, 40, 50 years, they want to be able to say on their annual report how they’re contributing to the improvement of the environment. They want the ESG to be less right- middle in the transactions they knew now.

I’ve been saying for the last three, four years, there is going to be a premium for environmentally friendly buildings and I think it’s now evident that that is the case, but that hasn’t been the case up until a few months ago. That’s the pressure.

Ben: [00:33:38] You think these things are now a constant? We’ve got a combination of we’re going through a pandemic, people have become very sensitive to environmental factors, health factors at the same time as interest rates are very low. Do you think, if the circumstances changed, interest rates go up, the economy changes, there’ll still be this drive to improving buildings? Because if yields go down, more people’s still be prepared to set aside the money it takes to make buildings more environmentally friendly.

Zsolt: [00:34:03] The short answer is yes; I believe this is a long-term trend and I think it will become a bit like hygiene. It will start to become a basic must and it will turn around.  Essentially you will be shamed if you have a non-environmentally friendly building to the point where you lack liquidity and people will want to avoid that and that’s why they’ll do. Just as much as we always get more regulation or more taxes, this will become another important thing to do for business. At the moment, it’s been mainly investors who are passionate about this who’ve done it. I think it will just become a necessity.

Ben: [00:34:41] Do you think that we can reduce net emissions from big cities?  Because you’re saying that in well established, Western cities, we’re just refurbishing buildings. So we’re not adding that many new buildings. But what about cities that are growing very fast, but there’s a large influx of new people, presumably in those cities we’re having to erect in new buildings. How do you do that and still lower carbon emissions?

Zsolt: [00:35:06] One small precision is that we refurbished buildings up until their useful life. We do have to build new buildings. There’s no escaping that fact, but we shouldn’t demolish buildings that still have a strong, useful life.

Ben: [00:35:19] What’s the useful economic life of a building?

Zsolt: [00:35:23] I would say it can vary anywhere from 30 to 200 years. The opportunity on the environmental side for real estate is tremendous. The reason it’s tremendous is because we’ve never really paid sufficient attention to it. The UK is a great example. What I love is the windows that are single windows. We don’t have in the UK the double windows, which means that the amount of insulation, the amount of heat that escapes in a residential home is incredible.

If you even take old buildings and you just do a few things, if you install environmentally friendly, HVAC heating and ventilation system that can very often lead to in excess of 20% savings…

What do you mean by ventilation system?

Heating and ventilation systems up to moment… many buildings are still heated with gas boilers, gas engines. On the minute you change that to electric heating sources, this also implies that we get more energy sources that are renewable of that, you make a significant contribution to lowering the CO2 emissions. The HVAC systems, as we call them, are heating and cooling systems at the same time.

I think that is a massive contribution opportunity. If you insulate buildings better and you create double or triple glazed windows, those savings are also in the low double-digit percentages in terms of what you can spare.

Lastly, one thing that we’ve hardly done -Australia does a lot of this, because they just brought in certain tax incentives to do so and now almost half of all Australian households have solar panels and generate almost half of their electricity within their homes. Obviously, the sun shines a bit more in Australia than elsewhere, but there is a tremendous opportunity in onsite electricity generation which we haven’t done. If we do a combination of all of these, we can significantly reduce the carbon footprint that we have today. And so, the tradeoff does not have to be, as often cited, on less square foot in order to save the planet. The trade-off is whenever we have a decision on how we renew a building, how we renew an HVAC system, how we create a new wall, if we take the right decision, we put in the right insulation, we put in the right type of HVAC systems, we will achieve the goal of very significantly taking down carbon emissions without decreasing the floor plates.

Ben: [00:37:55] I wanted to come back to something that you mentioned earlier on which is around the demographic composition of cities, because I think you talked about this when we were talking about Geneva, which is a successful city. If not well managed, becomes quite bifurcated because prices go up. Middle-class people start to move to the suburbs or to other cities. The government normally always looks after a certain proportion of housing to be affordable housing. As you said, there’s a middling out of cities. How do you stop that from happening? How do you make cities desirable to live in and affordable to live in at the same time?

Zsolt: [00:38:30] That may come to that may be one of the first questions that come to my limitations because I’m not an urban planner, I am merely a real estate investor, but I think it’s a tough call. The attempts that real estate investors have done have been various trials at innovative micro living, multiple use of spaces. A space becomes an office during the day, a sleeping studio at night and so on in order to allow young people on lower salaries to still stay in very central locations. Those are the kinds of things that as real estate investors we’ve done.

Sometimes my feeling is that urban planners don’t have an easy job in achieving that lofty goal of creating that balance and I think that sometimes the harsh market economics makes it happen.  New York right now is an interesting example because the affordability has gone to relative extremes. Right now, New York house prices are down very significantly. You can pick up an apartment at 20, 30% less than you could about 18 months ago. That harsh reality may then help some of the rebalancing that you referred to, so it may happen over time, naturally.

Ben: [00:39:40] The other trend is to turn more city centers into green spaces, but that’s a difficult thing to marry with increasing density, making centers affordable to live in and so-and-so. Is there a driver to that? Is it a sustainable or a long-term driver do you think?

Zsolt: [00:39:56] If you’re trying to create a location where you want people to desire to live and work, then some green areas are very helpful. Certainly what I felt is we have 20 different things we look at for at any building that we’re looking to buy and one of them is biodiversity. So we do try to think about how can we create some kind of a livable environment, but not just for us, but something a bit more than us throughout a building. Of course, loose tops are one idea which is being more and more exploited. I see vertical gardens now, which I think are very interesting, amazingly more efficient and greater for the environment. People can walk by and buy produce that’s made there and not having to do all the shipment that happens to supermarkets.  I really liked the idea of vertical gardens.

Most recently, one thing we did, which I learned a lot that we’re doing -putting beehives on top of buildings.  It turns out that bees that live in cities actually are much healthier than bees that live in the countryside. That’s very counter-intuitive at first, but the reason for it is because bees that live in the countryside tend to be exposed to a lot of the pesticides that is used in agriculture. Bees that actually live in the cities don’t have that particular issue, which normally makes them much healthier bees. You’ll be very surprised to hear this, but they actually take bees from cities to the countryside. It’s one of those reverse migrations that actually happens not just with people, but happens with bees as well. One of the things we were putting on one of our office rooftops – bee hives, because it’s something that we believe actually adds to the biodiversity of within a five-kilometer radius.

Ben: [00:41:43] It sounds like lots of the answers to squaring the circle here, doing all the things we want to do and, within all the constraints we face, meeting yesterday targets, moving more people to cities, reducing carbon emissions, all these things that I would say, historically -tradeoffs. The onset of doing them all at the same time without those trails is probably technology. So I wanted to start by asking you how you define a smart city, because that’s very much the buzzword, right?

Zsolt: [00:42:11] I wouldn’t even try to define it. I think Google tried to build a smart city in Canada and that hasn’t gone too well for them. They’ve had to abandoned midway. We have to be very careful with this point, especially post pandemic. I think there are genuine concerns around smart city, meaning that I am being observed and monitored at all times. The solution, what we would like to get to is a city where our lives are made easier, where energy consumption and our commute are made easier and more efficient to technology, but at the same time, we don’t feel monitored and that’s not an easy midway.

Ben: [00:42:54] Yeah, I agree. It’s a delicate balance. Just talk to us about some of the benefits of the Internet of Things. Where will we see those benefits?

Because one of the examples that people always use is that you wouldn’t have people driving around the city all day, because they’d know where the free parking spaces were, but they’re probably once that much more interesting and they have much more profound impact on urban lives.

Zsolt: [00:43:16] Sure.  On the transportation, I always think it’s interesting that many people don’t talk about the easiest one. I used to live in Singapore for a while. In Singapore, for over 20 years, they’ve had an intelligence system. You simply pay more for the usage of the highway when there’s more people using the highway. How simple is that? But it works wonders. You never get the traffic jams that you get everywhere else, because there will be some price conscious people who will simply say, I don’t want to spend that much money on it, I’ll go during the low tide. I always find it interesting that that example is not yet necessarily cited as often and that it hasn’t been copied more often.

In terms of buildings, a few thoughts. One of the things that we do really badly is that in all our buildings, the number of times that we use energy, heating or even water when nobody is near is crazy.  We’ve just bought an office building, to give you an example, it’s fascinating. We did a study on the energy usage. The building uses more energy at nighttime where there’s not a single person inside than it does during daytime. It’s crazy. It’s absolutely crazy. And I am sure it’s not the only building that does that throughout the world.

When we look at any building and we’re looking at acquiring it, we do a full study of what the consumption is over what hours, over what periods, how we see it because first you need to understand that. Once you understand that, then you can actually look at how that consumption compares to neighboring similar buildings and once you get to that phase, that’s when you can actually think about how you can improve.

Ben: [00:44:29] Why is that though, that it uses energy more energy at night? Did you come to the root cause?

Zsolt: [00:44:35] It’s a variety of reasons. I think that the night guard is churning up the heating just because he likes it hot. Of course, it’s a bit colder at nighttime, but if all the heating was turned off and we only needed the night guard’s particular area and returned on at 6:00 AM, you would have tremendous savings. The amount of times water taps are left on, not monitored, we’re not aware or there’s leaks in pipes and we’re not aware, the wastage in water, I believe the statistic was for London, the London water network loses close to 20% of all water before it ever gets to consumers.

If we had sensors monitoring where that water loss leakage is, if you think about water as not an abundant resource, it would be an incredible saving.  Having these sensors- and people also don’t feel necessarily monitored because they relate to the consumption of goods, as opposed to necessarily monitoring us- would be, would be a very strong and big advancement.

For example, if you have an air conditioning system that automatically adjusted if you open your windows, these kinds of things. Because, at the moment, nothing is connected. If we connect things, the amount of savings we can handle the will be tremendous. Certainly believe that these sensors will become ever more affordable, ever more ubiquitous and they will help us become smarter, but we’re one step away from this. This is the dreaming part.

What I find is that where we really are is that 95% of the people, maybe it’s even 99, need the first step which is actually to measure what they’re consuming. People simply don’t know yet. When we look at any building and we’re looking at acquiring it, we do a full study of what the consumption is over what hours, over what periods, how we see it because first you need to understand that. Once you understand that, then you can actually look at how that consumption compares to neighboring similar buildings and once you get to that phase, that’s when you can actually think about how you can improve.

Ben: [00:46:35] I was happy when we talked about smart cities or the Internet of Things. Do we not need to invest more power into certain central bodies? Because, as you said, everything, to achieve this efficiency that we’re talking about, everything needs to be connected. Then, we can’t as individuals have this devolved responsibility because then we won’t achieve the big goal. So do we need to invest more power in governments? who would be the right person to solve control internet platforms in real estate?

Zsolt: [00:47:04] I wish governments were up to the job. The problem is that governments are always playing catch up. One of my favorite recent examples is that, in London, every single planning application was put online in a PDF format, which means they’re on a search tool. So you’ve taken something digital after 30 odd years and you’ve made it manual online, which is completely useless. That’s a very good example of unfortunately how planners and regulators think. If you had forward-looking regulators, and there are some examples I -think Singapore is probably a very good example- then with absolute pleasure.

I think it’s a great idea but the problem is you need to be in the right city because you risk having nonsensical rules and regulations if your regulators are not for the job and that would be even worse. Normally, the way innovation works is, somebody has a great idea and they just go for it. If you stifle that innovation, then your city will become a laggard.  It’s a very delicate balance and I think it only works in cities where you have truly forward-looking planners and that’s pretty rare, unfortunately. I hope it changes. It’s pretty great.

We are living in this very interesting moment where people who don’t adopt to the new technologies and it will come in every way.

Ben: [00:48:16] What about the real estate operators themselves? Because I think I read this in something that you wrote that the real estate sector spends only one and a half percent of its revenues on it.

If we compare that to the sector in which you work predominantly, which is financial services, I think financial services spends 10% of its revenues on IT. So is a sector that spends just one and a half percent of its revenues on IT in a position where it can capitalize on smart cities, the Internet of Things, sensors and new tech?

Zsolt: [00:48:45] The point that you touched upon, and that’s exactly why I wrote an article by the way -I do spend most of my time in real estate luckily, it’s something I love and I’m passionate about- is that real estate is probably the most old school industry I know. Real estate is always very backward looking. Is felt by most people that, Hey, I bought a house, I can do real estate. It is also because it’s brick and mortar people feel that this will never change, this won’t get competed out as many other industries have. We are living in this very interesting moment where people who don’t adopt to the new technologies and it will come in every way. I think artificial intelligence will help smarter people make smarter acquisition decisions. It’s already in the works and we’re trying to look at it as well. It’s not quite there, but it’s very close and it’s going to happen.

The example would be the people who manage, for example, block of residential flats. If it’s managed by a local guy who goes there and tries to talk with the tenants versus a large company that will have an app on a phone where the minute your water pipe has a leak, you just push a button and that automatically goes to the local plumbing company that you have an agreement with and they’re out in 20 minutes. You’re not going to be able to compete. Technology will go through the whole value chain of real estate from acquisition to the ownership and asset management thereof. I think it’s finally happening. It’s amazing to me that it’s taken this long and I believe it’s going to change, but we’re just at the inflection point today.

[on tokenization of real estate] This is the Holy grail that, in an ideal world, I could buy a hundred dollars’ worth of an office building in New York.

Ben: [00:50:18] This is my last question. I can’t avoid asking this question just because I think it’s going to be of interest to lots of our listeners. Where do you stand on the whole tokenization of real estate? How far away is that as an opportunity and what will it do in terms of democratizing real estate as an asset class?

Zsolt: [00:50:32] We’ve reviewed a few opportunities. There’s definitely various efforts out there to achieve that goal. This is the Holy grail that, in an ideal world, I could buy a hundred dollars’ worth of an office building in New York. My key concern around it is around the agency problem. This last 26 years, what I’ve always seen is real estate suffers when you don’t have a true owner with capital aligned and working on it.

The minute you have this slightly misaligned and you have a management team that looks after the asset and you have a disparate group of owners that can trade their shares as they wish, then the management team is going to get comfortable. They’re not going to wake up every morning thinking how am I going to push this real estate and create the best value I can for myself and my fellow investors. They’re going to think I want my long holiday. I want to do the minimum I have to and I’m good because I’m getting my management sheet.  That agency problem and conundrum, nobody has really solved.

Until that is solved, I think that will hold back tokenization the way it is in the dream. The other big benefit of tokenization, which I think is probably closer, is the simple idea that today, in real estate, the frictional costs are very big.  Buying or selling a building in order to prove that the deeds of that building have gone from you to the other, normally you have to go through a notary and they charge literally a percentage of the whole transaction. Sometimes even 0.3- 0.5% of the transaction value and that makes no sense. That could easily be taken out by a sort of tokenization of the real estate that makes it clear through a dispersed ledger as a blockchain allows to prove the beneficial owner of any real estate buildings.

 It’s a bit more regulatory driven, so that involves the regulator being a bit more forward-looking because normally, to date, it’s been a city council that had the deeds of ownership.  So the city council would have to be forward-looking enough to allow that to happen in cyberspace, as opposed to at city hall.

The other tokenization of us owning a hundred dollars of a building in Australia and another one in Austin, Texas, I’m not sure that will happen really successfully in the short-term because of agency problem.

Ben: [00:52:54] Thank you so much for this highly interesting and entertaining conversation. Thanks for coming on the show.

Zsolt: [00:53:00] Thank you so much.

Marrying Capitalism with a Zero Carbon Economy (#39)

Structural Shifts with climate crisis expert Chris GOODALL

Climate change expert Chris Goodall says that fighting climate change isn’t as challenging or as expensive as we think it is and can actually benefit our economy. In today’s episode, we discuss how the climate change movement can advance social change, whether we can save our planet without some structural shifts to capitalism, nuclear energy, the politics behind tackling the climate crisis, and more. Chris has written several books, of which What We Need To Do Now For A Zero Carbon Future and How To Live A Low Carbon Life

Full transcript
Marrying Capitalism with a Zero Carbon Economy, w/ Chris GOODALL

The world will move towards the low carbon alternatives, but it’s now China and India who are going to dominate this discussion, not the U.S.

Full transcript:

[00:01:24] Ben: We are with Chris Goodall, author and expert on new energy technologies. We’re going to be discussing with Chris the imperative of moving to a zero carbon economy and specifically discussing his book, What We Need To Do Now. Chris, welcome to the Structural Shifts podcast.

[00:01:41] Chris: Hello, nice to be here, thank you.

[00:01:44] Ben: So Chris, I thought your book was excellent, really excellent. Very accessible, very positive. And I think there’s so much that I want to cover in this podcast because it goes so much further than just sort of talking about the steps we need to take to get to a zero carbon economy. You know, it talks about a much broader opportunity to use climate to declare emergencies, to springboard us to some sort of new green deal. So, so we’re going to cover all of that during the course of the podcast, but I thought it might be a good place to start by talking about your 10-point plan for getting us to zero carbon economy. Do you mind just explaining and talking us through that 10-point plan?

[00:02:23] Chris: Well, what I wanted to try to do in the book and it crystallized into, into that few pages, is an attempt to say to people, it’s no good just thinking that the energy trends, the zero carbon transition is just about energy. It’s actually very much wider than that. Energy is the single largest source of carbon and other greenhouse gas emissions. However, when it comes to things like food, we have to radically change our behavior and that’s right across the world, right across every single economy. So I was trying to give a sense that there is a package of measures available to make the transition. It’s not just about energy and it will necessarily involve some changes to human behavior. This is not a comfortable thing for anybody to say, but we will not be able to live exactly as we have been living for the last 50 years in a zero carbon future.

[00:03:17] Ben: One of the areas where your book differs from some of the other commentary about climate change is that even though it acknowledges the need for us to change our behavior, it doesn’t sort of suggest that we need to go back in time, right? In other words, if you listen to a lot of people like Sir George Monbiot would be an example, right? If somebody sort of says, you know, we almost need to go back to the sort of 1950s or something and cut back on how much we consume. But it seems to me that it’s a paradox, we almost need to keep consuming if we’re going to create the economic incentives to, to get us to a zero carbon economy. Would you agree with that?

I think that the severity of the threat from climate change is now in most countries recognized across the political spectrum, both conservative and social democratic.

[00:03:54] Chris: This is an incredibly difficult thing. I remember I wrote my first book 12 or 13 years ago, which, I had the title, How To Live A Low Carbon Life. What would you do? How would you do things differently if you decided you yourself personally wished to live a life of zero carbon?

[00:04:12] And in it, I posed, I suggested a number of things had to happen. For example, you need to stop flying. This was very, very unpopular. I’d go and give talks to Quakers, i. e. people with exactly the right set of values to make this sort of thing possible. And I’d find that faces would drop as I began to talk about things which needed to change. That really convinced me that part of the solution has to be technology. We have to push forward in ways that make it possible to switch away from fossil fuels, but retain many of the most important aspects of our modern life. So in this book, I’m saying really, there’s a mixture. We do need to change our way of behavior. We are not going to be able to eat as much meat. We almost certainly will not be able to fly as much, but there are technological routes for making that compatible with retaining some of our freedom to travel and indeed some of our freedom to eat meat-like substances. So in the case of aviation, we need to move to synthetic fuels and away from fossil fuels, fuels that are made out of hydrogen and carbon dioxide extracted from the atmosphere, and so have a zero carbon implication. And we need to, if you want to eat meat, you’re going to have to move to meat that comes from artificial sources, such as lab cultivation or things such as the impossible foods, a burger which pretends it is meat, but is actually made entirely from plants.

[00:05:39] Ben: In your 10-point plan or at least around the 10-point plan, you talk a lot about hydrogen. Why do you put so much emphasis on hydrogen?

[00:05:46] Chris: Because without hydrogen, I suspect that the energy transition is completely impossible. And why is that? We, again, we’re trying to move, we are moving around the world to another electricity system, which is increasingly based upon renewable energy sources, predominantly wind and solar, the next and new generation, as well, of course, as existing hydro in places like Switzerland or Norway. If we build our electricity system around wind and solar, inevitably we’re going to have periods when we don’t have enough electricity. And at that time we need to have some form of stored energy carrier. Right, at the moment, all we can possibly do is to use as that backup, that complement to renewables, a gas system where the CO2 is then collected and stored underground. That’s possible in some countries, including the United Kingdom, it’s not possible in many other parts of the world. So in those places, there is no alternative way of providing electricity when the wind isn’t blowing or the sun isn’t shining. I’m thinking of places like Germany where it would be politically impossible to start to store large quantities of CO2. So, somewhere like Germany needs to move to a renewables plus hydrogen economy. There really isn’t a choice for the electricity system. And that’s why hydrogen becomes central. If we’ve got lots of hydrogen, we can then use it for a multitude of other activities; one, to generate electricity first, but also to provide the energy for steel-making, for making synthetic fuels, and so on, and so forth. So the world I envisage in the book is one where renewables completely dominate. We build 10, 100 times as much renewable capacity as we’ve got at the moment. We use the surplus to make hydrogen and that hydrogen fills all the energy needs, which we aren’t otherwise going to be able to accommodate.

[00:07:53] Ben: So in other words, hydrogen becomes the mechanism by which we can store surplus energy and then reuse it.

Over the last year, there’s been faster movement towards a zero carbon future than I could possibly have imagined at the beginning of 2020. And it’s not governments that are doing this, it’s large companies, companies, more generally, people realizing that they have to change if they’re going to survive.

[00:08:00] Chris: Yeah, yeah, exactly. Much, much, much more coherently put.

[00:08:04] Ben: Okay, I’m going to try to cover the book in different sections. So, the next section I wanted to cover was the political implications or the political shifts necessary. And, the first point I wanted to cover was one around the sort of politicization of climate change, because it is very much considered in lots of countries to be a sort of issue of the left, right? So, my first question is how do we move climate change from being a partisan issue to being a nonpartisan or center ground policy priority?

[00:08:38] Chris: I’m not entirely certain I agree with that. I think that the severity of the threat from climate change is now in most countries recognized across the political spectrum, both conservative and social democratic, i. e. the dominant, the 80% of the population of most, most countries in the West. There are places, parts of Australia, for example, where this wouldn’t be true. But if you look at public opinion polls in Europe, for example, you will find that the depth of the emergency is understood by people up to the far right, the very far right in most of these countries. So I don’t think there’s much of a political problem here.

[00:09:28] Ben: I guess I was just thinking more about the US, where it seems to be very much a polarized issue.

[00:09:34] Chris: It’s certainly changed and if you ask people in opinion polls is climate change a severe threat which government needs to do something about, or companies need to do something about, you’ll get roughly the same response as you would do in a European country, roughly, it’s not that different. However, large parts of the American political system still reject the widespread use of renewables. Today is a few days after the breakdown of the Texas electricity system…

[00:10:08] Ben: I was going to ask you about that…

[00:10:10] Chris: … and there we have, yep, the right has gone for that and said the fault absolutely lies in the failure of wind turbines to keep going when they’re frozen. There’s nothing one can do about that. But the fact is that wasn’t the case, that isn’t the case. That is, a lot of wind turbines did cease to work because they haven’t been properly weatherized. But the lesson that we ought to be drawing from the Texas problem, the series of problems in Texas, is that we need to make our electricity and energy systems much, much more resilient than they are, or they seemed to have been in Texas. The reason why the Texas system fell over, the most important reason, is the failure of gas-fired power stations to be able to cope with the temperatures systems going, systems going down, as well as to a lesser extent, problems with wind turbines. Texas isn’t well connected, if at all, into the rest of the US system, it doesn’t have a market for promises to provide electricity under emergency circumstances, what we in Britain call capacity market, and the result, it has built itself an energy system which is completely incapable of dealing with emergencies. We’ve got to do something about that. Most European countries recognized that a long time ago and I don’t think it’s a result necessarily of a political, of a particular political ideology.

I don’t think it’s ESG. I think it’s conventional greed. It’s saying that unless I do something to move my portfolio towards companies that are more fitted to the next few decades, I will lose a lot of money. And that is absolutely to be encouraged.

[00:11:33] Ben: Okay, you’ve challenged the premise of my question. So I’m going to, I’m going to rephrase it, which is, if we have broad political consensus around climate change, which, which may be the case now, how do we find the political capital to move quicker? Or put another way, if we’ve got consensus, why aren’t we moving quicker towards a zero carbon economy?

[00:11:56] Chris: I understand the sort of, if I may say, some of the pessimism behind that question, but I would say that in my experience over the last year, there’s been faster movement towards a zero carbon future than I could possibly have imagined at the beginning of 2020. And it’s not governments that are doing this, it’s large companies, companies, more generally, people realizing that they have to change if they’re going to survive. The examples of large corporations going under because they failed to move fast enough in the energy space is growing and it will continue to show, to provide examples to companies around the world of what happens if you don’t keep up with the energy transition or keep ahead of it. So, I think the move isn’t necessarily reliant upon government anymore. It’s companies and societal organizations more generally which are going to make the shift.

[00:12:55] Ben: Could you give examples of companies that have failed, have been too slow in making that shift? And is it in the core business, or is it taking a different direction?

[00:13:06] Chris: I’m thinking of, for example, the stock market performance of oil and gas companies over the last year, compared to people, specialists in renewable fuels, that’s number one, but we can see the same, look, look at what’s happening in cars, it’s going to happen across the board in a wide variety of different fields where, a classic example was gas turbine manufacturer four or five years ago where the producer, Siemens Mitsubishi, GE had thought that gas was going to become the fuel which is used for electricity supply to compliment renewables. That turned out not to be the case, market value was crippled within the space of a few months when that realization became well understood in the market more generally.

[00:13:50] Ben: It’s interesting you talk about stock market performance because we are seeing this massive push into sort of ESG and impact investing. Do you think this might provide the mechanism by which companies now start to act, i. e. so much of remuneration is sort of dependent on stock market performance. The individuals are through their asset managers now starting to, to change where they invest. And maybe that’s now creating some sort of incentive for CEOs and for corporates to act.

[00:14:20] Chris: I don’t think it’s ESG. I think it’s, I think it’s conventional greed. It’s saying that unless I do something to move my portfolio towards companies that are more fitted to the next few decades, I will lose a lot of money. And that is absolutely to be encouraged. We need to tell, we need the message to get out to asset holders that they shouldn’t, if they want to achieve returns on their investment, they shouldn’t be investing in Shell, they should be trying to find the next Tesla.

[00:14:56] Ben: You said that governments are becoming, I guess, relatively less important in solving this issue than perhaps was historically the case. But what about some of these international agreements? For example, you know, we’ve got Glasgow 2021 coming up, how important do you see international cooperation on this issue being, and then are you sort of more bullish than you would have been now that Joe Biden is in charge and there’s kind of, you know, some leadership again on this issue?

[00:15:25] Chris: I’m not completely certain, to be honest, because I think that governments do tend to follow what they think is possible, they’re not, politicians aren’t leaders anymore. They are responding to the environment in which they’re found. We’re not going to get people taking difficult decisions, but it doesn’t look to me as though the people in charge in China realize that heavily pushing the technologies of the future towards their tech, the technologies are going to take the world towards zero carbon is the right way for their society to move in its own economic self-interest. And once we got to that point, we don’t really have to worry too much about leadership, people taking difficult decisions. Everything becomes a lot easier because it becomes much more transparent, that the world will move towards the low carbon alternatives. I suspect the US government will follow, but it’s now China and India who are going to dominate this discussion, not the US.

[00:16:30] Ben: Your book and your 10-point plan, we didn’t actually cover them, so I’m just going to very quickly run through them. So the 10-point plan is renewable energy generation, improving the housing stock, electrifying the transport system, local energy grids, moving away from eating meat, making fashion more sustainable, changing the technology for fertilizers, steel, cement, increasing woodland, reducing flights and shipping and carbon taxation. That was the 10-point plan. So in that 10-point plan, conspicuous by its absence is nuclear energy. And I just wanted to ask you, is that because nuclear energy is less politically viable after Fukushima, or is it just because renewables are simply better and cheaper, and don’t have that stuff…

[00:17:11] Chris: Cheaper, massively cheaper, and we’ve got places around the world which can generate, which will be generating electricity at around 2, a low 2 US cents per kilowatt hour,$20per megawatt hour. We’ve got in the example of the relatively small number of nuclear power stations that are being constructed around the world at the moment, average prices well above five times that level. So, if you believe that you want cheap energy, nuclear is absolutely not the way to go. It’s not about the ideology of whether it’s appropriate or not. I think nuclear waste storage is a problem that ought to be solvable. I think nuclear power is essentially safe. It’s just vastly more expensive than wind and solar.

We’ve got used to being able to treat clothing essentially as single-use. I’m exaggerating, but we see it, we buy it, we wear our clothing a few times, we then throw it away. We have no concept of the consequences of that chain of actions.

[00:18:07] Ben: How can we use this climate change movement to galvanize social change? So, you talk a lot in the book about how we can use it to improve our wellbeing and to create a fairer society. How can we practically do that?

[00:18:24] Chris: Terribly difficult question and also very difficult to summarize effectively. So, if I may, I’ll just look at one example of the sort of things that society is. I shy away from thinking governments do this, it’s societies that do it often through local democracy rather than the head office, as it were, sitting in the, in the country’s capital sending out edicts about what needs to happen. And this example is becoming increasingly common around Europe in particular, saying that the center of towns and cities should be dominated by pedestrians and cycles, moving cars out of towns. Why is this good? It’s good in a number of ways. It reduces carbon use for example, but it also brings back into public use, public use, spaces which had been effectively neutralized — car parks, roads, which people, which individuals couldn’t use.

[00:19:26] So we’ve begun to build this structure whereby community cooperation becomes possible. Towns without cars are healthier, they’re healthier both in terms of social interaction, you see more people you can talk to, your children can go out and play more, but they’re also healthier in the sense that they tend to demand as to cycle or to walk. And in most places in the developed world, people really do need to get out more, to take more exercise. And these places in general will have better health. I think I quote the example in the book of Utrecht in the Netherlands, which is one of the most pedestrian and cycle friendly places in the world, where the costs of establishing the cycle infrastructure are vastly less than the benefits that have been saved in terms of lower healthcare costs. So just to go back to the, the meat of the question there, city centers, towns that have been given over to public use are inherently more equal than those, those places which prioritize the 50, 60% of the population who can afford to own and run a car in most societies. So, that’s an example of the way in which the low carbon transition can, if properly done, equalize our economic standing. European, American, many, many societies around the world are vastly too unequal at the moment. I think there’s increasing political understanding of this. The carbon transition has to make the move away from inequality happen at the same time as the reduction in CO2 emissions.

I think the best role for the state, being someone who believes in the operation of markets, is for the state to properly price the environmental consequences of what we as individuals decide to do. And that’s, the shorthand for that is carbon price.

[00:21:13] Ben: And do you think that’s the way to build more political consensus? Or to build more, just to act?

[00:21:23] Chris: Yes.

[00:21:24] Ben: Because I suppose now there is a big divide is between the haves and have nots. Whereas even the haves, I guess, want to live in a world where they’re not worried about their children’s future, whereas the have nots, I guess would gladly opt for that and a fairer society.

[00:21:37] Chris: Yeah. Yeah. I think the problem so far has been is that the mission to arrest the speed of climate change has essentially been one sponsored by the well off. It’s often been seen as irrelevant by the people, or counterproductive by the people who are sitting, struggling to survive economically, at the edge of society. If we’re going to take climate change seriously, take the really significant measures that need to be taken, we can only do so with the active support of a very large section of the community, majority of our communities. That hasn’t been the case, and I think pursuing particularly those low carbon moves, which are of direct benefit to the less well off is absolutely vital to the successful transition.

[00:22:33] Ben: And how do you, how do you motivate people to change the way that they behave today? How do you provide incentives? For example, how, how do you, you talked about flying earlier on, how do you, how do you persuade people to take fewer flights? How do you persuade people to, you know, to buy clothing in a more sustainable way? How do you incentivize these kinds of behavioral changes?

[00:22:55] Chris: Well, it’s a whole portfolio of things, isn’t it? In the case of flying, I think what we’re seeing is the beginnings of a movement which says that it is socially unacceptable to fly, particularly to fly a lot. And when the current pandemic is over, I think we will, we won’t see an immediate, if any, return towards the levels of flying which we saw in 2019. That means, for people in Britain who, a large number of who fly to Spain and Portugal for their summer holidays, may decide that they don’t want to do so, or they may decide, for example, to take the train to these places. So that’s moving on to the second point, we do not in general have an alternative infrastructure, a mass market infrastructure that replaces the high carbon ways of doing things. So, we’re beginning to see railway systems around Europe move towards overnight long, long distance trains overnight, when I was a student, that’s the way you got around Europe and we probably need to go back to that, to be honest. This is not particularly attractive. It’s not something which people are going to be that keen about. But I think people increasingly realize that it’s probably necessary for a stable, for a stable climate. So that’s just one example of the way in which society might make, might make it easier. But getting people to restrain their consumption in order for the world as a whole to do better is, is an enormous challenge, I wouldn’t doubt that for a second. And I’m probably too naïve about this, I’m probably too idealistic.

[00:24:42] Ben: During, let’s call it the transition, right? The big transition towards a zero carbon economy, how do we, you know, so, the end state is one that’s desirable and having read your book, I believe now achievable. But how do we sustain society economically and socially during that big transition?

[00:25:04] Chris: Gosh, this would take a long time and it’s, so, if I may use an example of fashion here, we just, just to illustrate the sort of things, which, which are going to be necessary and some of the problems that are going to occur. We’ve got used to being able to treat clothing essentially as single use, I’m exaggerating, but we see it, we buy it, we wear our clothing a few times, we then throw it away. We have no concept of the consequences of that chain of actions. Firstly, no clothing is recycled and that’s got to change, but it’s at the moment probably less than 1% worldwide is genuinely recycled, and it’s not gone up very much in recent years. We need to build an alternative system which produces high quality clothing for longer periods and an industrial structure around it, which allows for rebuilding that clothing as people, as people change, as they sell it to someone else, as it becomes less fashionable. Now, this is a major change to the infrastructure of the clothing industry, and it requires the development of a local refashioning, remaking sector, which, which will provide good quality employment and already does in some parts of Europe. The crucial thing, however, is that we are going to start spending less on clothing and spend, particularly spending less on new clothing purchased from countries in Southeast Asia, where a large fraction of the working population is making clothes for living. So, here the world faces a dilemma. In order to do the right thing when it comes to fashion, we’re going to do pretty terrible things to countries with large sectors where the clothing manufacturer sector is enormous — Cambodia, Bangladesh, and so on and so forth. So we, as a society need to work out how are we going [to cope with that? How are we going to build recycling and refashioning at the same time as ensuring that we’re not pushing large numbers of people back below the poverty line? And I’m sorry, I don’t have an easy answer to that.

[00:27:14] Ben: How do we manage some of these transitions without the active, you know, without the active role of the states and international cooperation agreements and so on?

[00:27:23] Chris: Well, by active role of the state, I’m sorry, I think the best role for the state, being someone who believes in the operation of markets, is for the state to properly price the environmental consequences of what we as individuals decide to do. And that’s, the shorthand for that is carbon price. And I think that’s the most appropriate thing for countries to do, is to say, well, for the world to do as a whole, that anything that emits carbon is going to attract a tax of £100, $100 per ton of carbon dioxide, that would solve the climate change problem within a decade, in the sense that it would push the technologies which are now struggling to get traction in a world of cheap fossil fuels, to the point where they could become genuinely competitive. Is that possible? I think it’s, is a $100 a ton of carbon dioxide possible? Much more so than it was a year ago and in the new US administration we’ve certainly got people who absolutely believe in the importance of this and doing it on a global level. Whether we can get China into that club, I’m not knowledgeable enough about politics, but I suspect it’s more likely than not, because without it, China is going to face carbon border taxes, such as those proposed by President Macron in France. Meaning, for example, everything in sports is going to acquire a tax. It would be better for China to impose that tax than to have it imposed at the border by the European Union, for example.

[00:28:58] Ben: And how would those, how would the carbon tax work internationally? Because if we take, if we take the example of fashion, you can see how a carbon tax on some of these throwaway or fast fashion ranges might, might deter us from buying them. It might make it relatively less expensive to buy better quality, more enduring clothing.

[00:29:15] Chris: Yeah, made from fabrics with a lower carbon footprint, for example. So, we’d switch fabrics, and I’m sorry, Ben, I interrupted.

[00:29:23] Ben: Yeah, no, definitely, switch fabrics, as well. And then I guess the way that we could then compensate the losers, if you like, you know, the massive factories in Bangladesh, it might be by taking some of the money raised to the carbon tax and, and helping those countries in those sectors to, to retrain and built new, more sustainable industries. But that’s only possible if that carbon tax is employed internationally and the, the money collected is, is distributed internationally. Is that possible, do you think?

[00:29:54] Chris: Yeah, I mean, it’s going to clearly be politically troublesome to do this, but imagine that you have a calculation as to the carbon footprint of a pair of jeans made in Bangladesh. You ask Bangladesh to impose, Bangladesh decides that it wishes to be part of the carbon, the global carbon tax, and says right, from now on we’re going to charge at a rate of $100, a ton of carbon dioxide on exports from this country, so that they can go in tax-free to the markets in which those clothing, that clothing is sold. Unless I’ve got this all wrong, that directly provides the financial incentive for countries to do this, so there’s absolutely no question, the actual volume of clothing made in these places is going to fall, although it may require significantly greater labor input, each individual item, rather. So, a very good question, and I’m not certain I’ve got an absolutely robust answer to that.

[00:30:57] Ben: In the book you talk a lot about devolving control to, local authorities and, you know, communities. And you talk about that in the context of energy grids. Why is that? You just think that local politics tends to lead to better outcomes?

[00:31:16] Chris: I think where things are controlled locally, they will generally be done better, and with the interests of local people more in mind. So call that ideology if you want. It is an ideology, it’s a belief that if the elected politician walking down the street, going to buy some bread, meets someone who is affected by his or her decisions, they, the politician, are more likely to take an action, which is responsive to that constituent’s needs. So that’s, that’s at one level, but I’m particularly influenced because I come from the UK where the utility sector infrastructure more generally has been bought up almost entirely now by foreign companies, which have no interest in keeping, in dealing with, addressing local needs, their objective is to return money to pension holders in Australia or Canada or wherever it is. I’ve got a huge gap between the needs of local communities, for example, energy independence and the need to keep that funding and those dividends flowing from the operation of electricity and gas networks in the UK. So that, that feeling is mostly driven by an extraordinary upset I always feel when I come across infrastructure, particularly local network infrastructure in the UK and its resistance to actually refocusing energy generation and energy consumption on local communities. I’ve spoken in generalities there, but just to give you a particular example, I’m part of a group trying to install a battery, a large battery, close to wind and solar farms, which are community owned, 10, 15 miles outside Oxford. That’s proved, that’s proved impossible because although that battery is needed to help Oxfordshire, the county in which Oxford is, develop some form of energy independence, it’s being resisted by the costs, by the people who own the networks, which we have to connect to in order to make this operationally work. If all this was controlled by the Oxfordshire utility in the way that, for example, it is in Germany, or can be in Germany, then we might stand a chance of getting a faster move towards complete decarbonization of energy supply.

[00:33:39] Ben: And do you think the problem of lobbying and vested interest is greater in a centralized system, therefore then, than the decentralized system?

[00:33:48] Chris: Yeah, yeah, as I say in the book, I would like the utilities in Britain to mirror those in Germany, essentially local public ownership. I know it’s much more complicated than I’ve just suggested in Germany, but everything, nothing about the energy system in Britain is controlled or indeed influenced by local societies, local politics or anything. It is all managed, almost all managed by external stakeholders who have no interest whatsoever in the health and speed of energy transition of these communities.

[00:34:25] Ben: There is an exception, though. In the book you talk about the Orkney Islands. Do you mind just talking us through that example? Because I think they would appeal cause we have a lot of like technology listeners and I think that would appeal.

[00:34:35] Chris: Right, okay, well, Orkney is a very, very interesting testbed for a number of different technologies, because it’s pretty remote. Not much of this is not being watched as closely as it should be by the rest of Europe. So Orkney sits, is a series of archipelago off the northeast coast of Scotland. The nearest islands, probably about four or five miles from Scotland extends over a large area. It’s got about population if I remember correctly of 20,000, don’t quote me on that. Enormous resources of wind and also the European Marine Energy Center. So if you want to put a title turbine to try to title turbine, you do it up there. So, most of the time it has a big surplus of electricity. It doesn’t know what to do with it. So, it has scope to use that relatively cost-free energy because the link back to the, to the Scottish mainland is so weak to carry out a variety of experiments that focused on hydrogen, but there’s lots of different things going on at the same time, the hydrogen is used, is stored, put through fuel cells to create electricity when there’s no wind, the relatively few occasions when there’s no wind. There is a school that’s heated by it, there are fuel cell vehicles across Orkney, and so on and so forth. Well, Ireland would like that, the local community can take control of what it does. It’s easier because of the physical separation, but in my opinion, it would be better if communities more generally across countries had the opportunity to do this, to make themselves into independent states, with regard to their energy generation, energy consumption.

[00:36:12] Ben: One of the things I really liked about the Orkney example was it just, it just seems to mirror to me the way in which economies and businesses become networks over time because of, because of the internet, effectively. Because essentially energy can behave like a network as well which there isn’t some central grid, but instead, you know, everybody can sell to the grid or they can be paid to be kind of buying and selling of, of energy.

[00:36:41] Chris: Yeah. Yeah, exactly. So you become, if you can buy the electricity, that’s being, the surplus electricity that’s being generated on your neighbor’s roof by solar panels when you need it, you have a much better sense of the importance of balancing supply and demand, for example. So the whole energy transition thing becomes much more live, much more personal, but we’re not really pushing that very fast in Europe or indeed anywhere else in the world. But peer to peer trading through distributed ledger type systems, not Bitcoin or anything like that necessarily, but distributed ledgers, ought to be a way of enabling ourselves to become more reliant, more aware of the importance of switching to local sources of energy.

[00:37:27] Ben: Can we make this transition within the framework of capitalism? Or do we need some sorts of change to capitalism?

[00:37:37] Chris: I swing on this hour by hour, to be honest. When we’re recording this, as Australia tries to work out how to control the large tech giants, Google, Facebook, et cetera, there isn’t a model for this yet, but what it demonstrates what’s going on in Australia, what it demonstrates is that large corporations, that the tech giants have a degree of authority over the operation of political systems, which is unprecedented, certainly in the last 120 years. We do need to do something about that. We do need to break up the worst examples of this, but if we are going to radically change our energy system, for example, by covering the North Sea with offshore wind turbines, it is almost certainly better in my mind that we use the tools of capitalism to make that as cheap as quick and as effective as possible.

[00:38:37] And so therefore I think we need to keep the large mostly, mostly, today, I think that we need to keep the large companies alive and pursuing profit when you it’s no good asking just to be nice and do good. You have to allow it, if you’re going to allow any form of capitalism, you have to allow it to make profit. That being the case, you need to control the way in which that profit is made and ensure that things that do good for society, make profit. Those which do not, do not. As I go back, if I may, to the point I made earlier, I think the easiest way for the political system to redirect large corporations towards the right ends is to impose a tax on carbon.

[00:39:21] Ben: And then you, you made the point there, which is something we, we observe as well, which is these are big firms because, because they’re subject to increasing economies of scale, you know, through network effects, which is something reasonably new in the history of capitalism, we see this, this phenomenon with kind of super firms and, you know, and you said it yourself, right, which is so big that they can almost have, you know, they can almost challenge the sovereignty of particular states.

[00:39:48] Chris: Yeah, they do, yeah.

[00:39:50] Ben: They do, but the point I was going to make is in a world of super firms, presumably, you know, maybe this is over simplistic, but if you can get those super firms to take climate change seriously, maybe we can, we can move quick on climate change. Would you say that’s…

[00:40:04] Chris: Uh, yeah, once again, I swing between thinking that the climate pronouncement of large firms, Microsoft, Google, whatever, are real, they are actually doing, there’s no question that these companies are doing something. Whether they’re doing it to be good corporate citizens or whether they’re doing it because they think in the long run it will be financially advantageous for them, I don’t know the answer to that, but I’m not certain it matters. I’m just very glad that the large companies have decided that they’re moving in that direction. But just to go back to offshore wind again, if I may, I can’t see a way in which a trillion dollars is going to be put into the North Sea and other windy parts of the world in the next few years, except by using the capital allocation skills of the likes of the large oil companies. So I want to keep Shell in existence and I want Shell to realize that its future depends upon low carbon energy extraction and transformation, not upon drilling holes in the ground. I think that’s perfectly possible, but it has to be driven by a financial motive rather than an ESG motive, for want of a better word. I’ve no love for the amoral large corporation, but I don’t think the world is going to manage to make the transition without the likes of Exxon and Shell being part of it.

[00:41:30] Ben: Presumably, one of the reasons why the book is so positive is because you see this, you see very little kind of opportunity cost through moving to a zero carbon economy, beyond the small sacrifices that we will have to make as consumers and so on, ultimately we can get to a situation where everything is better, right?

[00:41:52] Chris: I think so, everything is better, energy is cheaper, there is more access to goods and services for the whole of our communities, not just the wealthy. I can’t now see a reason not to do the transition. Yes, there are going to be some costs, immediate costs, but look, let’s face it, the world is awash with capital funding wanting things to do. For the first time, certainly in my lifetime, we have central banks trying to pump money into it, that’s a very crude way of putting it, but we’ve got absolutely no shortage of investment capital available at effectively zero interest rates. That’s lucky, because all of it, because most of the costs of this transition involve a capital expenditure now, in return for a reduced cost in the future. That’s what you do. You put up a wind turbine, it doesn’t cost you very much to run in the future. It costs you a lot to put in place the first time, but then you’ve got wind for 30 years from that turbine if everything goes well, unless it’s frosted up, as in Texas last week.

[00:43:02] Ben: So, you’re saying we can get a massive multiplier on this, very cheap.

[00:43:04] Chris: Absolutely, this is, this is 1933 revisited. This is the new deal. This is rebuilding society on the basis of capital and operating expenditure of effectively free capital, which otherwise has nothing to do. And I, I think the world is well advised, whatever your ideology is, whatever you think about climate change, the world is very well advised to spend that trillion pounds on offshore, trillion dollars, excuse me, on offshore wind turbines, at a time knowing that what this will do is it will reduce the cost of electricity for 30 years into the future.

[00:43:46] Ben: And do you think that the transition to green energy or the green new deal can also solve some of the other challenges we see in, in modern economies around, I would say notably productivity?

[00:43:59] Chris: I would like to think so. I would like to think that we will run our societies in 30 years time by 2050 on a higher ratio of invested capital to output. And if everything goes well, that will mean that living standards are significantly higher. I am very, very dubious, speaking as someone who used to do economics, but has forgotten almost all that he ever learned now, as to whether productivity measures that we’re now using are actually effective, but correct in measuring true productivity. But what I do believe is that by applying capital now, we will end up with higher living standards as a result. But there’s also a view of course, that what we call living standards may actually not be really our underlying standard of living. Being able to afford more clothes isn’t necessarily an index of a higher standard of living. Being able to walk down the street or bicycle into town has zero impact on productivity, inverted commas, negative impact on productivity, but will give you a better, inverted commas, standard of living. So I’m just, why I’m putting inverted commas around all of this is all these expressions generated by the economics of the 1940s, 50s, and 60s, and don’t really seem very relevant to the situation we’re facing today.

[00:45:36] Ben: Corona and the future. One of the few positive outcomes of the pandemic has been, that it has been broadly quite good for the environment, right? Because people have been traveling less, we’ve been shipping less…

[00:45:50] Chris: Have we really? You, you tell an owner of a container ship, you ask an owner of a container ship whether there’s more containers being shipped now than there were, I think you might find that the volume of international container trade is close to its high. We’ve got more, more problems getting things out of China than we’ve ever had before, but you, you make the point that there’s less, there’s less aviation there has been lower climate emissions, but the effect so far has been really quite small.

[00:46:24] Ben: So there’s not too much cause for celebration, but I was even going to ask whether you think the changes in people’s behavior are even likely to be permanent, or whether they’re going to, say, catch up, you know, all those people who have deferred their foreign holidays, where they all want to suddenly take them. How much of the behavioral shift do you think will last?

[00:46:45] Chris: Isn’t that a difficult question? I’m not qualified to answer that, really. I instinctively say it won’t last, but on the other hand, I am struck by, for example, in the UK, the increasing strength of the car-free city movement, which I referred to a bit earlier, which could have a significant effect on emissions. I think pointless travel may, whether it be to a meeting with your colleagues for half an hour or whether it’s just because you need a weekend away, to put it crudely, will probably take some time to get back to, inverted commas, normal. Whether any other systematic changes will occur, I don’t know. I think people will work from home more and that’s probably not going to reduce emissions, although it’s unclear, given that we’ve all been sitting at home trying to work in the last few days in unusually cold conditions, and it would have been better to have been huddled up together in an office. I think what has changed is a view that the only significant reason for optimism I believe is that it does now look as though people accept that the world could choose a different trajectory. I’m not saying it will, but people realize that things could be done differently and be maybe more, maybe more flexible in the way that they approach future challenges , and also the fact that the vaccine process, the vaccine development process has been far faster than anybody believed possible. And we can us as an example of what we might want to do on energy with a similar sense of emergency as the consequences of climate change become evermore apparent.

[00:48:27] Ben: A lot of people use the war analogy to talk about COVID. Do you think it will take a war-like approach to solve climate change? I guess, I guess the challenge with the war analogy for climate is around sustaining the level of urgency. We know that climate change is kind of an ever present danger, but how do we stop fatigue setting in? Because sometimes it can seem a bit hopeless? How do we maintain that sense of urgency?

[00:48:58] Chris: Well, the first thing I would say is that the planet is helping us maintain the sense of urgency with every new week, bringing some form of climate-related disaster. The extreme cold in Texas is almost certainly a consequence of a weakening of the polar vortex due to excess heating in some parts of the Arctic Circle. There’s one example of how things are brought back to us, that risks and dangers of climate change are brought to us every day. And there’s more detail today, this week, about, for example, forest fires, another problem that is going to occur in dramatically greater quantities as the world, as the time goes on. So, we need to give people a story and that story needs to be largely composed of optimistic outcomes and optimistic routes to getting the change we require. And one illustration of that is the fact that The Financial Times, which for a long time, didn’t take climate very seriously, now has a separate point on the banner on its website. It’s got foreign news, it’s got markets, it’s got home news, and so on and so forth, and a little section called Climate. In that, the big climate news of the day is being discussed and it’s been discussed usually from an optimistic angle, that is to say the gross rate of electric cars, the number of new technologies for decarbonizing steel and so on, so forth. So, there’s an example of how things that were just presented as apocalypse in waiting are now seen as opportunities for business, not just opportunities, responsibilities of business to do something about, it’s become a little more, every week it becomes more feasible to address this.

[00:50:51] Ben: What happens if we don’t make the transition? Do we still definitely have time in your view?

[00:50:57] Chris: Well, the climate is going to warn us with increasingly large imperatives that action has to take place. It’s not going to get any better as time goes on, the world doesn’t have a choice about doing this. It may think it has, but actually we do need to decarbonize, we will also need probably to geoengineer the atmosphere, and to collect gigatons a year of carbon dioxide out of the atmosphere. There isn’t any alternative. The good thing now is that it’s not necessarily a very expensive route to getting out of, beginning to shade off the rate of growth of emissions is looking a much more manageable task than it even did 12 months ago. Across the major polluting industries, electricity generation, car transport, et cetera, the speed of the transition is, is growing. And there’s every reason to believe that it’s going to be perfectly possible to fully decarbonize the major sectors if we want to. By 2040, 2050. That’s what makes me optimistic, not the fact that the rate of increase of carbon dioxide concentrations in the atmosphere has slowed, because I’m not entirely certain that’s true at all.

[00:52:14] Ben: You wrote a book, it was entitled How To Live A Low Carbon Life; for anyone who’s listening to this podcast who wants to start to make a difference in this area, what would you recommend as a first step towards living a lower carbon life?

[00:52:29] Chris: Well, the first step as individuals has to be taking stock of our carbon footprint and saying, well, I’m going to stop eating meat and traveling by air. For the average relatively well off westerner, someone living in Western Europe, that might well get rid of almost half your carbon emissions, straightaway. Drive an electric car if you can afford to, or get rid of all cars and only car share an electric car would be the next, or improving the heating system in your house. So those are the individual things. I think also being an activist is important. Showing, getting involved in the various movements now that are pushing for faster and faster, decarbonization ranging from extinction rebellion in places like the UK, towards the investor movements, the groups of people who as investors are getting together to try and put more pressure on, on large companies to produce better articulated plans for decarbonization. Go into politics. I think I’d also say that don’t imagine necessarily that the right route is to be an entrepreneur in this field. If you’re an idealist and you think that this is the most important problem the world has faced, you may not actually be the best person to set up a business in this area, because it may be that you’re being driven by things other than economics business logic. What we need in this world is hard-nosed business people who decide to go into these areas because they see profit opportunities, not necessarily because they want to improve their grandchildren’s future.

[00:53:57] Ben: Your book I read it over a few evenings and I found it to be extremely accessible and I guess you wrote it for a non-specialist audience like me. My question is why do you write for non-specialist audiences? Is it because you think ordinary people through ordinary actions can kind of, can crystallize massive change or is it because, or why not write for, you know, for politicians or for CEOs of big companies? Why choose a non-specialist audience?

[00:54:23] Chris: Because I want to be part of the tide that says we can solve this problem. It’s not an unavoidable apocalypse. We have the tools to do something about it. So some sacrifices may be necessary short term in particular, but nevertheless, we can continue to run our societies effectively without massive upheaval. And that’s what I wanted to get across to as wide an audience as possible. I hope it is read occasionally by CEOs and I’ve certainly talked to some of them about it and possibly even politicians, but the main aim is to get the sense across as wide a group as possible that this is a problem we can solve.

[00:55:07] Ben: For every podcast we ask our guests to give us five recommendations. Okay, so I’m going to ask you, first of all, if you would share the title of one of your favorite books.

[00:55:18] Chris: The title of a book that I would really recommend other people might want to read is by a British author called Benedict McDonald called, and the title of the book is “Rebirding. ”There’s a growing movement around Europe and elsewhere, to rewild large areas that have been destroyed by human activities and this particularly is becoming active in Britain now, as people begin to realize that we are one of the least forested countries in Europe, and we really do need to get some nature back across our landscapes. And this is a wonderful book, both because it gives a sense of it’s possible to do, you can get birds, it’s called rebirding, you can get birds back and those have been enormously lost in the UK now, but it’s also, it also does so with logic and numbers, so it makes us an environmentalist consciousness of the importance of keeping bird life going, more so with a sense that it might be financially feasible to do it.

[00:56:13] Ben: Next, a favorite recent article, please.

[00:56:17] Chris: Well, I found this difficult. I read very widely and I can sometimes barely remember what I’ve read from one day to the next. But one thing I would say is that we need new news media, currently television and obviously social media and online media more generally, aren’t very good at getting to the bottom of news stories, whether they be about the environment or about politics, about different countries. And I would heartily recommend a new service which is deep journalism, called tortoise in the UK, slow journalism, tortoise, for its depth of analysis, its robustness, and the fact that it uses numbers, terribly important, but also is written for the widest possible audience.

[00:57:01] Ben: Fantastic. And that’s a subscription service, is it?

[00:57:04] Chris: Tortoise is a subscription service, you have to pay to get involved, but anything worthwhile generally should be paid for and they won’t solve your data to other people.

[00:57:13] Ben: Next please. A favorite thinker or influencer.

[00:57:16] Chris: This is a friend of mine, so I have to confess that. So, I’m pushing the work of Kingsmill Bond, who is an analyst who works for a UK NGO called Carbon Tracker, which is the most effective place in the world for trying to persuade large fossil fuel companies and other people reliant on the fossil fuel industry that their time is limited and they need to get out of their stranded assets as quickly as possible. And what Kingsmill does is bring quantitative analysis, interesting stories, persuasive logic, beautifully written, to this field. So I would recommend that anybody interested in following an author in this area should look up Kingsmill Bond and what he produces for Carbon Tracker and for other sources.

[00:57:59] Ben: Carbon Tracker, okay, so we will share the link to that with our audience. Next, a productivity hack, please.

[00:58:08] Chris: Well, I find it very difficult, I expect to spend a lot of my time writing. I find it very difficult to do so, and I can spend hours just sitting musing about things that I think are related to what I’m doing, but end up with no productivity at all. So my hack is to say to myself, every day, I have to do a certain number of words of writing. I’m failing to achieve it so far today, so I’ll continue to work on it on, continue writing until I’ve got that number done, because that’s the only thing which can persuade me to live by my productivity promises.

[00:58:37] Ben: Literally you will not get to sleep until you’ve hit that number, is that right?

[00:58:41] Chris: That’s the idea.

[00:58:42] Ben: Okay, well, we won’t keep you much longer then [laughter] so you can hit your target for the day. Lastly, a favorite brand, please?

[00:58:51] Chris: Yeah, it’s difficult, isn’t it, because anything that’s very heavily branded tends to have absorbed some of the less good features of capitalism. So, I just wanted to caution in this case, a slightly different sort of company. It’s an online delivery service for local fruit and vegetables predominantly made in the UK. It’s called Riverford. It’s been around for probably 20 years, it’s growing, it’s profited from COVID. It delivers very high quality, fruit and vegetables directly from farmers in the UK to homes. It was owned by a remarkable entrepreneur, Guy Watson, one of the most interesting things he’s done is he’s given the business to his employees, which is something that I think needs to be followed. So for me, the words Riverford produce a very strong, positive brand image.

[00:59:38] Ben: Fantastic, Chris, thank you very much for coming on the Structural Shifts podcast. It’s been an absolute pleasure to talk to you.

[00:59:46] Chris: Thank you, thank you very much.

Making Wealth Management Available to Everyone (#38)

Structural Shifts with Sid SAHGAL, Qiaojia LI, Nikolai HACK, Michael O’SULLIVAN

This week’s podcast is the recording of an actual live event — a 4×4 Virtual Salon — we hosted in anticipation of the launch of our Digital Age Wealth Management Report (which is now out! 🎉). Our guests were Sid Sahgal (Product Manager at Hydrogen), Nikolai Hack (Head of Strategy & Partnerships at Nucoro), Qiaojia Li (CEO at Rosecut) and Michael O’Sullivan (author “The Levelling”, ex-CIO Credit Suisse). We discuss: changing consumer trends; changing technology; new business models and new fitness landscape for wealth managers. We hope you enjoy and, if you listen carefully, you will get access to some unfair advantage! 🤷

Full transcript
Making Wealth Management Available to Everyong

[00:00:02] Ben: Hi, everybody. Welcome to our latest 4X4 Virtual Salon in which we’re going to be discussing the democratization of wealth management. So just before we kick off, I just want to put another date in your diary because at this time next week, so at 12:00 CT, 11 UK time, wherever you are, on the 18th of February, we have another 4X4 Virtual Salon also on the topic of wealth management, and we’re going to be discussing new business models in wealth management, and for that we’re going to be joined by Tinkoff Bank, by Elinvar, by additiv, and so we hope you can join us for that as well — sorry, the one I forgot was Impaakt. So we’re also going to be joined by Impaakt, which is a platform for impact investing data. So, hopefully you can join us for that.

[00:00:57] Okay, for those of you that are new to this format, the 4X4 Virtual Salon is so called because we have four speakers who I’m going to introduce in a second. We cover four topics, which for this 4X4 will be Changing Customer Trends, Changing Technology, New Business Models, and The New Fitness Landscape for Wealth Managers. For each of those topics there is a poll. You can see on the portal there, there’s a poll which you can complete anytime and we will make reference to the poll results during the conversation. And then last, but not least, we’ll take one audience question per topic. So if you have a question, please post your question in the questions portal. Okay, right, so we’re gonna kick off. I’m going to introduce our four speakers.

[00:01:49] I don’t know if this is how it appears for other people, but I’m going to start with my top left, which is Nikolai Hack, who is Head of Strategy & Partnerships at Nucoro. Nucoro, which is based out of the UK, has followed the “make yourself the first customer” route to market. Nucoro launched an automated investment service called XO Investing in the UK and then it now offers the platform to others. Its platform is pretty broad and it allows financial institutions to build a range of FinTech, money management, propositions, everything from automated investments and stock trading to digital wealth management.

[00:02:27] Next, we have Mike O’Sullivan, who I think doesn’t need such a big introduction, because he’s a veteran of the 4X4 Virtual Salons, having appeared last year on the one we did on post-pandemic wealth management. But for those of you that don’t know Mike, he is a former CIO of Credit Suisse. He’s the author of the much recommended book, The Leveling, which is about the world after globalization; and if you’re interested, we also have a podcast episode with Mike on that topic. And then last, he’s also a serial entrepreneur and investor and a board member and advisor.

[00:03:03] Which brings us, I think nicely, to Qiaojia and Rosecut, because Mike is an advisor to Rosecut, and Rosecut is a London based automated investment manager, it’s two years old. It has a very interesting customer acquisition model because it has a freemium service where you can access some of the tools and simulations and content to help you manage your financial affairs. But if you want Rosecut to manage your investments, then there’s a 1% fee for doing so. The average AMU of a Rosecut user is £200,000, so this is not an ordinary automated investment service, this is very much a premium automated investment service.

[00:03:45] And then last but not least, we have Sid, who is Head of Product at Hydrogen. Hydrogen is a banking as a service platform, helping brands embed banking services into their proposition, including wealth management services. And to do that it works with a network of partners including Cross River Bank in the United States and Stripe. Okay, so, right, let’s begin.

[00:04:11] As I said before, the first topic is Changing Consumer Trends and Qiaojia, we’re going to kick off with you, if that’s alright.

[00:04:19] Qiaojia: Okay.

[00:04:20] Ben: I wanted to ask you, how big is the opportunity that gets opened up by using automated investment services to target affluent or mass affluent customers? By how much can we increase the size of the wealth management industry by using automated investment services?

[00:04:40] Qiaojia: Thanks, Ben, for the question and glad to be here. I think this is a very interesting question. Because from the tech perspective, they think everyone wants to invest and everyone deserves to invest, maybe with £1, with £10, and it is made possible in the past10 to 20 years by a lot of the first generation robo-advisors. But if you look down in terms of the slice of the market of various segments, there’s core like high networth, affluent and retail based on The Credit Suisse Global Wealth Report, actually, Mike was part of the key contributors to that. It’s in the UK, 1% of the population, the top of the pyramid, owns 3 trillion of assets and the next segment, 15% of the population, affluent, owns another 3 trillion of assets. And the remaining 85% of the population owns 1 trillion, one-third of either the high net worth or affluent. So, this is why Rosecut sees us as a meat market provider. We want to cater to the middle sort of 3 million. And the second point I would make is that wealth is fluid, right? It doesn’t always stay with the same demographics or same group of people. So, wealth transfer is a big topic these days and a lot of the older generation gives the wealth to the younger children who basically use an app for everything. If they don’t put the money into a Rosecut app, they will put it into a crypto app. So, you know, technology first is kind of how we see to capture these kinds of opportunities.

[00:06:29] Ben: And Sid, I want to come to you next. So digital channels, digital services are, if you like, democratizing access to wealth management and what would be the benefit of that? So, if more and more people can access wealth management, what will be, I suppose, the social benefits?

[00:06:52] Sid: There’s quite a bit of benefits and I think one aspect to consider is that, like Qiaojia referred to there’s different layers or different groups of investors, right? If you consider some of the affluent or mass affluent market I think it becomes easier for them to access like a sophisticated products which weren’t available easier, earlier. So, for example, you’re getting access to like uncorrelated assets, like art or like structured real estate deals or private equity deals or even like wine, and those are all uncorrelated assets which weren’t available to that segment earlier. You had to have a much higher base to start off with. So I think that’s like a pretty big benefit to that segment of the market. For the lower end of the market, for the retail market and investors who are just starting out, I think access to like a brokerage and simple investment tools has really made a huge difference, as we’ve seen with all the recent GameStop and all of the other trading things that are happening at the moment. I think like it’s a mixed blessing, a mixed bag, with how some of these platforms are set up. There are some, like, for example, like, which is a good one, which is focused on building engagement and literacy and community around it, whereas there are others which are built more on like gamifying it and at least in my opinion, they don’t always result in a positive benefit because it’s not really a game. So, I think all these tools are really helping bring wealth management to the fore in front of everyone, but I think we need to be a bit careful on what the propositions are and hope that they lead to positive outcomes for people.

[00:08:56] Ben: Fantastic. So, if I were to summarize what you said, it was slightly caveatic, but basically Qiaojia is telling us that there’s a very large addressable market of people who don’t have access to wealth management, and you’re saying that when they do, they’ll be able to get access to a wider range of asset classes, which will help them to diversify their risk or better manage their portfolios to their risk tolerance and then financial literacy should improve, so it seems like it’s pretty much a win-win situation. So, Nikolai, why is it still hard to convince consumers to sign up for wealth management services? Why is the cost of customer acquisition still so high, for example?

[00:09:36] Nikolai: Very good question. Thank you, Ben, for having me and thank you for being here, all of you. Yes, I think there is a bit of a misconception. I think, especially coming from inside the industry, I think we often think that we need to educate consumers more and explain things better, and explain things more, in more detail, but I’m not so sure that that’s actually what will help us here. If you look at some other examples from, like, I don’t know all the details of fractional reserve banking, but I will still get a mortgage to buy a house, right? Or, I’ll get a consumer loan to buy a car, which rests on that being a thing. Or, if you look at other pieces of technology, at our work we use G Suite and I don’t really know how Google does it, but I can edit a document at the same time as someone else is editing a document, but I’ll still use the product, right? Because it gives me a very material benefit. So, this product is not sold to me on the basis of its functionality, but on the basis of its outcomes for me. And I think we attempt to explain and educate people more, I think we’re actually putting off potential clients more than we are encouraging them. So, what really, I think helps, is if you have a focus on the outcomes instead of the product, I think especially within [inaudible 00:10:55] very guilty of explaining the concepts of investment management, the methodologies, the frameworks, the ins and outs of how it works, but for the average client most of the terminology doesn’t mean much, but they’re also not very interested in the details, they should be interested in the outcomes and what it does for them. They have objectives, goals, and plans for their life and the products we build should only be the underlying rails on which those goals and objectives are achieved. And that’s the winning proposition, I think. Also it means to break down the style of approach between saving, pensions, protection, investing, again, we look at those differently because they’re regulated differently, they have different revenue streams. Again, for the normal, average, especially mass market consumer, it’s quite irrelevant, because they only care about the outcome and they should care about the outcome, we should do the mental bridging in between to get them there.

[00:11:52] Ben: So, Mike, I’m going to come to you next. I want to ask you whether you agree with that statement. Is the way to encourage more people to take wealth management services, to portray their services more in an outcome-based way, rather than trying to explain to them how the mechanics of how the services work? And then the second thing I’d like to get your view on is the question we’ve asked in the poll, where people seem to be a bit split, between whether or not the pandemic has accelerated the democratization of wealth management. So, if you don’t mind commenting on both of those, Mike.

[00:12:33] Mike: I think these are fascinating areas, very apt in terms of everything that’s happening with Tesla, Bitcoin, GameStop, et cetera. So, let me try and react. And to go back to Nikolai, my experience is that that the process and the detail matter when the outcome is negative, right? I always try and design something for when things go wrong, because when you get a negative outcome, as many people who hold GameStop now in the last two weeks have, then you’ve got to go back and question your own decision making process, the marketing, the messaging from your broker, et cetera.

So I think detail and process are important in that regard. Broadly on the idea of the democratization of finance, I’ve got strong feelings in the context of what’s happening with Robin Hood, I would rather term it the democratization of risk, because that is what really is happening, because you have large established places like hedge funds or individual investors who are effectively selling risk to retail investors, effectively that’s what’s been happening with GameStop when we kind of analyze who has won and who has lost, and people are being exposed to lots of different types of risk they don’t know, they’ve never experienced before, illiquidity risk in the case of alternative investments, hurting correlation risk.

So, I rather see this as the democratization of risk. I also think we need to make a very sharp distinction between trading and the volatility of markets which is I think much more of an American than a European phenomenon. And then the idea of wealth management optimizing portfolios, which is obviously more a sane and balanced approach. And think anything that encourages people to have a balanced optimized approach to wealth is good and is useful, and that is in my view democratizing finance. So, I think, I think the idea of democratizing finance is also, someone mentioned financial literacy, and that’s a huge area, obviously being in the EU are beginning to get into this.

And for me, that’s the real barrier. Part of the time I’m involved with something called WEInvest, Women Empowered To Invest, whose aim is to get women to invest more and to invest better. In that project, one of the things we found is that men and women have these glass ceilings to finance and that the finance world talks to them in math and jargon, et cetera, about what should be products and events that are essential to their lives at retirement, but that’s communicated in a way that is obtuse and intimidating. So for me, the democratization of finance is really all about clarity and open and transparent communication.

[00:15:56] Ben: We’ve had a question from Jean Cristof, it’s about gaffers. So, Jean Cristof, I’m going to take it later on when we talk about new business models, if that’s alright, because I think can tie that into a question about aggregating services. So, I’m going to ask the question in this section, if that’s alright, and I would encourage other people to please post your questions, but I’m going to put this to you Sid, because I think Mike is raising a really interesting sort of distinction between the democratization of wealth management and democratization of risk. And my question to you is if we sort of disembody wealth management from the service providers, i.e. you know there’s this big trend towards embedding wealth services in other distribution channels, do you think that we therefore increase the risk of democratizing risk instead of democratizing wealth management?

[00:16:46] Sid: Yeah. I mean, I think there is a possibility, like, for example, if you offer through a brokerage to a provider who doesn’t have ownership of the risk in the book, then he is not going to be too worried about offloading it to as many people as possible, all he’s worried about is customer acquisition or making a cut on that. So I think where the risk sits is a very important sort of consideration, and so is the fiduciary responsibility, like exactly what are you giving to people, and takes the ownership, like when Mike mentioned, when things go wrong? So, I think just simply embedding some of the wealth management products without having a strong team to take on the fiduciary and risk and responsibility is actually going to be a bit harder and a bit more complicated than it seems.

[00:17:54] Ben: And so, in a model where you have banking as a service provider sitting between the regulated entity, the custodian and the customer, how does that play out in terms of risk management then? Who manages the risk?

[00:18:12] Sid: Usually it will be the banking institution, the institution that has the license that will always manage the risks. It’s on their books. They’re the ones who report to the regulators. So either the platforms or the software providers usually don’t have the risk on their books. And so that has been probably one of the reasons why sometimes embedding some of these wealth management services into other platforms takes way longer and way more complex than people think it is.

[00:18:46] Ben: Great, okay. I’m going to switch to the second topic and I’m going to come to you Nikolai again, we’re now going to talk about changing technologies. The question I wanted to ask you is which are the technologies that are most important in your view, in this democratization of wealth management? Do you think it’s analytics and the ability to use the trail of data that people leave as they interact with digital channels to be able to do that whole personalization at scale? So, what was once the preserved ultra high or the high net worth individual being, you know, democratized, so personalization being democratized.

[00:19:27] Nikolai: Yes, absolutely. I think, I mean, if we really talk about core technologies or deep tech, what is it then? I think obviously it’s cloud computing, it’s parallel processing, all the things on which most of the advances lie, and this is in general, of course, but yes, of course, and that brings with it the use of a lot bigger data sets and the extension of that is hyper-personalization definitely, and there especially, I think we can draw conclusions also from what’s happening in other industries, especially with e-commerce, media consumption, where hyper-personalization is the norm right now, where the offer you get is significantly different from what somebody else consumes, especially think about your Spotify recommendations with a curated playlist you get there. For example, you mentioned investing earlier that build in the UK and therefore example, based on an extremely high degree of automation, the platform builds a unique portfolio for every single client and then this portfolio is managed on an individual basis, on a daily basis, potentially; it doesn’t rebalance daily but it could. And that only works of course, because you have extremely capable server farms, in this case, it’s Amazon or Azure on which the proposition is hosted. And then at the moment of when you need to make the calculations to rebalance the portfolios, you just rent a thousand more workers that Amazon gives you at that very second, the couple of seconds it takes.

So based on that, personalization becomes a possibility at scale at very low unit economic cost, of course. I think something else that I’m quite excited about is the context generation through natural language processing and more important actually natural language generation. We work with a firm called Personetics and then there’s Cognitive Investment Technologies, a smaller UK player, they do very interesting stuff where, with the means of, of course sifting through again big data sets you give the client context to what’s happened in the market, how it has affected their portfolio, much like an advisor would, of course, but again, by bringing down the cost through skipping the human element, you are able to have a mass market proposition.

And I think the last one is classical automation and straight through processing along the entire chain, from onboarding investment proposals, reporting, et cetera, and especially their thing is also about the fluidity between the products, as I’ve mentioned before, saving, investing, pensions, et cetera, but also between the channels of self service and the advisor and that that becomes one experience. I think that’s also will be a key in propositions going forward.

[00:22:11] Ben: I’m going to come to you next, Qiaojia, I want to ask you, so Rosecut uses, still it’s human beings that manage the investments. But if we listen to Nikolai, if I interpret what Nikolai is saying, we can personalize portfolios and we can build a bespoke portfolio for everybody that matches their risks and so on, and in addition, it sounds like we’re getting closer and closer to doing the thing that’s much harder, which is, if you like the emotional aspect of wealth management, giving reassurance by using natural language processing and so on. Do you think there’s still going to be a role indefinitely for human beings in the provision and delivery of wealth management services, especially I suppose, for mass affluent and affluent customers?

[00:23:06] Qiaojia: Yeah that’s really a question that’s been debated within the digital community for the past 10 years or so. And I would say first of all, I want to make a distinction between personalized device and personalized portfolios. So I think for financial advice, it should always be personalized to your circumstances, your long-term life goals, your income level, even your wealth personality, am I a legacy kind of a person or to maximize my wealth and pass down to my children in the most tax efficient way, or I’m a freedom type of person who just wants to earn enough.

So in this case, we help you to define what is enough for your personal circumstances. I’m of the view that this is much more important than personalized portfolios. The traditional industry has come a long way from bespoke the portfolio and doing advisory services and frankly sometimes does not actually maximize efficiency or the return for the client. It’s like you are a chef and asking the customer to detect how you cook the meal, it does not always work very well. So, for us, we standardize portfolios with certain customization elements, but not necessarily bespoke or personalized that might really attract the affluent people.

So, this is why our discussion of offering has a standardized element, basically model portfolio, and then let you pick some interesting semantics, very much related to what Sid was saying, that the alternatives can play an interesting role here. So, going back to the personalized financial advice bids, if you think about the different types of client needs, as well as sort of the cost of human advisors, these are the two most important things driving the industry change.

So, people joke about going to see a wealth manager is like going to see your dentist every year. It’s the right thing to do, but it’s painful, and you really don’t see it, you know, private banks throwing, lunch and dinners and entertainment to make it slightly better, but still not everyone wants to sit down to go through a two hour integration of what are your assets, liabilities, and those kinds of topics. So, we actually found a lot of people enjoying a quiet time sitting at home, just going through that step by step at their own pace, rather than being interviewed by a wealth manager.

So, I think a digital service is a great place to capture those kinds of preferences who are sort of incremental wealth to the industry. And second is about the cost of advisors, you know, since RDR there is such a decreased in the qualified advice space and advisors that are retired, basically retired with some of the older kinds. So, if banks can’t make a living by providing bespoke advice to affluent people and then sort of dropping those clients then digital providers can’t either, and this has been evidenced by some of the first-generation robo-advisors having a hybrid model, hiring financial advisors to provide advice on an hourly basis.

So Rosecut’s view is that we, first of all, want to automate as much as possible, to build a beautiful user experience as close to social media experience, but you have the emotional elements, as well. Of course we still have a long way to go. And then use human as insurance. So anything that the automated platform doesn’t do we have the human advisor to pick up the slack and over time with the trend and the learning from those unanswered questions, you patch it up into the system and make it more and more sophisticated.

[00:27:18] Ben: Mike, I want to come to you next because, thank you very much, Qiaojia, because so far we’ve been sort of thinking about the wealth market and we’ve been splitting the demographic almost by how much money they have; are they affluent, mass affluent and so on, but it’s more complicated than that. Because as you said before, there are other demographics you can layer on top, such as women have different preferences, to men younger generations have different preferences to older generations.

And so I wanted to ask you a question that’s coming from the audience. If we assume that some of these robo-advisors, they have a high cost of customer acquisition today, for example, and they target say mass affluent or affluent, what is the possibility to grow with the demographics, whether they slice them in different ways? So they target younger generations who are mass affluent, who may over time accumulate more assets, how do you see the possibility for some of these new entrants to kind of move upstream into high net worth or ultra high net worth, that may be either by targeting a different demographic or growing with their existing demographic?

[00:28:35] Mike: Okay, so I think that there’s maybe two things here, one is the various changing demographics and then the other is the business model and how we capture that. And I think some online banks and online digital new entrants to the digital wealth management marketplace have made a mistake in paying far too much in terms of customer acquisition costs, and you see that in some of the results and some of the grounds they have, at a gross level they push the model of focusing more on the experience of what the theme is, which is sort of high net worth works because you don’t rely on playing odds on social media, there’s an element of kind of professional conduct as well.

So first of all, on the demographics I think in general, the wealth management industry is very poor at demographics and I kind of scold banking colleagues in old banks by saying you go to a supermarket or a shopping center, or go to High Street and look at how well luxury goods companies and retailers target different demographics, and banking doesn’t do that, it’s lazy not to try. And in the future, I think we will have more attention on younger niche over the topic of longevity would be a really big issue in wealth management, pensions, the accumulation of wealth, and then also women as a demographic is an area that banks in my view haven’t given any attention to at all in terms of services.

In terms of business models. I don’t think that digital banks who are currently focused on mass market community move up to the higher end for a whole load of reasons, one is you need to hire bankers with experience to have different products and a different product range and probably a different platform. And I think most of the people in the high net worth space and upwards, they want a focus on them, they want something that’s maybe less hands-on, they want something that’s sleek in terms of the service, but that’s less transactional. That’s a very, very different proposition if you’re a kind of more of a mass banking app. And I think the problem for those companies that they are increasingly going to be encroached upon by what individual banks are doing with their own digital projects.

[00:31:19] Ben: Just then one follow-up for you then, does that mean, do you think we’ll see turn? So, in other words, as customers get wealthier, they’ll switch from robo-advisors potentially to private banks when they demand a different type of service, in person, and so on?

[00:31:36] Mike: I think that will be the case, depending on the extent to which they get wealthy or not, and I think what also will happen is that some wealth managers will become better at IT, so better back office, Nick has talked about some of the solutions, better at reporting, really basic things that many wealth managers don’t do very well. And I actually think that the biggest revolution would be product and access to what I would call kind of the portfolio of the future, which would have more private assets, probably more crypto, and being a bit more international and these are the offering on new and old players. Not many of them have that.

[00:32:22] Ben: Fantastic. Sid, I want to come to you next, there’s a nice segue there because Mike is talking about some broader portfolios that extend beyond some of the traditional assets. And so the first part of the question I want to ask you, so we’ve had two really good questions here, that I want to put to you, the first one is around the role of tokenization in opening up some of those asset classes. I think you briefly touched on that before, but if you wouldn’t mind picking that up again, and then the second part is around gamification.

So, what is the role of gamification in terms of keeping people engaged with wealth management services? Because I always think about banking as having this engagement challenge, which is principally in the transaction-based service, therefore it doesn’t have high levels of engagement and therefore is open to being embedded in channels that have higher engagement. So the two-part question is tokenization and do you think gamification might provide enough engagement to keep people using wealth services for wealth managers?

[00:33:22] Sid: Good questions. I think that tokenization can definitely help, especially with alternative assets and like allocating ownership in a fair and equitable and a transparent way. So, when you’re talking about art, when you’re talking about wine, when you’re talking about obviously crypto is that very thing that originated from, I think tokenization can really help with access to some of these assets which were reserved for the ultra high net worth in the past, and I think that’ll definitely be a trend that takes hold. In terms of gamification, I think there’s definitely room for it.

For me, I think financial literacy is a really important aspect, and like academic research has shown, for example, that in Europe only about 30% of the population has even basic levels of financial literacy, and it’s about the same in the US, and these are affluent, OECD nations. Simple things like time value of money, about saving, about inflation, teaching people about having a savings account and having an emergency fund, just inculcating some of those habits, those basic financial literacy habits can make a huge difference in their financial outcomes.

And I think gamification for positive cases like that is really important. I think you have to be a bit careful where gamification doesn’t become about getting people to trade more, and I think that is that is something that I’m quite worried about, but in terms of increasing the literacy, getting people to save more, getting people invested more in equities, but more as a portfolio rather than like individual stocks, teaching people about those sort of a risk return trade-offs and better financial habits is where gamification can help.

[00:35:26] Ben: Fantastic. Okay, I’m going to switch now to new business models and I’m going to combine my questions, because we’ve had some good ones here also from the audience. So, I think what I’m going to do is I’m going to kick off with you, Mike, if that’s alright. I’m going to ask you, you might argue that wealth management potentially has lower engagement than some other services through which you could distribute financial services, but it has a high level of trust and you can use trust to aggregate other services, but we see very, very few examples of aggregation models in wealth management, by which we mean using the pull of an existing customer base to aggregate wealth and non-wealth services. So, why don’t we see more aggregation models from big private banks, for example? Why doesn’t UBS, for example, aggregate, other services?

[00:36:22] Mike: Yeah, I think it’s a good question. The answer for me lies largely in the area of organization culture. We’re beginning to get consolidation in wealth management in the UK, Western Europe, Switzerland, where we are today, and the logical question is why doesn’t Google buy UBS, or why doesn’t Amazon buy Credit Suisse? Because what we find is the brands, the top level expertise coming to clear out the tech problems. I’m not a tech person like Nick or Sid, I’m kind of a bystander, I see those things happening across the industry. There are big barriers in terms of banks doing tech, there are lots of interests on the part of people inside banks not having tech disrupt their own jobs. In Switzerland, we have an issue with data projects internally that are simply inefficient.

And then I also find that many tech people in FinTech have very logical solutions to what I think are banking problems, but actually what they don’t spend enough time thinking about is the idiosyncrasy of the banking problem and the fact that banking possibly is like to have humans rather than robots vested in their tech problems. And there are lots of reasons why the two don’t meet. I think that the most interesting space would be crypto because that would be, if I can call it tech banking or tech money designed by tech people. So, it’s entirely consistent within the ecosystem, and from Zurich and other parts of Switzerland, lots of people could get in to develop crypto operations, trading, digital assets, so that space is a very interesting kind of proving ground.

But, to come back to your question, there should be a logic in some of the bigger wealth and asset managers who trade quite cheap particularly compared to [inaudible 00:38:38] just being embasked by tech companies or tech entrepreneurs who can potentially cut the banking cost at least in half by introducing a much more rational tech focused approach. Finally, just to not go on too much, I think the disrupter to the industry will be consumer goods companies getting into finance, probably from the bottom up. They will have scale and they’ve already solved the customer acquisition problem. So the question of just starting with a range of sense of the products. So, that’s where the threats are going to come from.

[00:39:29] Ben: Okay, which is a super segue to use, Sid, because your business model is basically in facilitating that, facilitating non-banks to offer banking services or in this case wealth management services. Do you see that already happening? What is the level of demand for embedded wealth management services? And you kind of alluded to this earlier on in one of your answers, but it seems like it might be more difficult than people think. So, would you mind elaborating on that as well?

[00:40:01] Sid: Yeah, so, getting started with a wealth management product is hard. When I had a startup and we were setting up a brokerage, it took us almost two years to get a license, get all the legal agreements, get everything set up. I think having an embedded finance option, like some of the new platforms like ours, which are coming up make it a lot simpler. They abstract away some of the complexity, some of the compliance, some of the security. So I think that whole process can really be sped up. I think there are still roadblocks and those are related to who takes on the fiduciary responsibility, who has the licensing, and that is always going to be a bit of a problem in wealth management.

So, for example, with some of the embedded services that we’re offering, we finding that a lot of financial advisors are calling us about them. They already have the licensing, but they want to have a mass acquisition channel. And so for example, they want to offer like an aggregator or like a small calculator or risk analysis services on their website and that serves as an acquisition tool for them. So, I think in those sort of cases, having an embedded finance solution works well.

We’re also finding that platforms that are starting to take on more of the financial services burden off a particular segment, so for example, like freelancers, for example, there are people who are building like payments services for freelancers, because a lot of them don’t have even bank accounts. So, we’re setting up facilities to have bank accounts, but then why not add an extra feature where you can also allow them to save easily.

So, you know, having an embedded solution, which they can get up and running quickly is like a real value add to those types of companies, as well. So, we’re seeing a mix of both. We’re seeing both financial services providers who want to acquire people cheaply and non-FinTech companies as well, who want to start dipping their toes into offering some of these services to their customers.

[00:42:36] Ben: Thank you very much. Nikolai, coming to you next. I want you to, if you don’t mind, expand on this topic by talking about some of the interesting business models that you see, the kind of customers that are coming to Nucoro, and I want to just frame it slightly by talking about there’s many network type models that Sid touched on there, like can you take a pool of freelancers and help them to build a collective savings pool, for example. So I just wonder, are there other models like subscription services and things like that, that we start to see emerge in wealth management? So, can you just comment on what you’re seeing in new business model types?

[00:43:15] Nikolai: Yes, absolutely. I think it’s a very interesting question because it’s only remotely relative in tech than the business model which is a much more strategic topic and less tactical, and often overlooked. I think there’s a lot of potential for innovation, totally. I think a few models are interesting, and Rosecut is a great example, right? You have this premium entry level model where you can dip your toes in before it even draws you into the actual corporate position.

But generally the move from AUM based models or in performance based models I think which is flat subscription based fees, which is what consumers are by now very much used to, rather than a lot of the other services, digital and non-digital, starting again, as I mentioned before, Spotify subscriptions, Amazon Prime, everything else. I think another definitely related Sid to what you just said, I think the idea of building ecosystems and making connections with other services and selling across the services.

I think of the challenger banks, like Revolut does this natively within their app, they switch another tile and there is insurance, they switch another tile and there will be risk management. They build a lot of these things themselves, but not necessarily, that it needs to be necessary, right? You can still offer this functionality, but rely on someone else who actually will have the capabilities of technologically doing but also from a regulatory perspective, doing it, it will still be the service that you will be the gateway to that service. So building connections with other distributors in not only the direct approach, I think also plays into that.

And there’s also, there’s a bit of a fear and a concern around being commoditized in a way, however, and also coming to Michael’s point earlier, the biggest attack vector comes from the big tech players. And Google will not become a bank, but Google or Apple will be the biggest distribution partners you will have that you can possibly find if you are a bank.

So, overlooking that I think may be a lethal mistake, as well. And then I think it’s also got very strategic and business motivators, holding a flanker brand maybe, or a stock brand, and moving away from and giving up a bit of the brand equity you have potentially, because having an established brand is a great asset, but it can also be a liability if you want to reinvent your offering and reinvent also the target groups you have.

The biggest players doing it right with Marcus by Goldman Sachs or JP Morgan is rumored to launch something in the UK. It varies with a lot of brand equity but still, I think it plays for midsize market players and all of these, I’m aware all of these are harder steps and I think we often are a lot more comfortable to tinker with internal processes and tech and all this stuff that clients already touched, but I think it pays to be bold in applying some of these more strategic transformation points.

[00:46:32] Ben: So, I want to put the next question to you, Qiaojia, which comes from Ian Stewart and he asks which of the incumbent financial institutions are the most progressive and making the most progress in this area? So, kind of picking up on Nikolai’s point, who is taking the risks, so we’ve heard about Goldman Sachs launching Marcus, and now Marcus is also, the platform is also now offered to others. So, Goldman Sachs is potentially taking some risks and being quite progressive in this area. Who else do you think is leading amongst the incumbents?

[00:47:06] I probably wouldn’t say there is one single leader in the space, and we have seen sort of an influx of incumbents trying in this space in the past five years. I think UBS spent a huge amount of money launching UBS Smart Invest. Actually, the head of the program is one of those advisors, so we’ve learned a lot from their experience. Coutts have launched their mobile app with the basic functions a couple of years ago, and sort of piloted a program called Coutts Invest. At the beginning, it was only open to Coutts clients and then eventually was distributed under the RBS and that was invest with £500 to start with benchmarked against — not make that I suspect.

So, I think one of the key things is that people, the incumbents are worried about things like wealth transfer and how not to be left behind with digitization of the service, but they face two challenges. One is a legacy IT system. It takes forever to build something new and then bolt onto the old gigantic machine. So, in the case of UBS Smart, it took them 18 months to do that. And for Rosecut to have a fresh state of art tech stack, it took us six months. So, this is the level of challenge.

And second, in my view, it’s always easier to start evolution. You can be an independent, almost like a single cell creature, and then rapidly iterate your offering along the way, than starting a revolution within an organization, because you always are fighting against people who prefer the old ways of doing things. Another point is that a lot of the times incumbents treat the digitization as a back-office problem. So they see it as an IT project that a bunch of engineers there needs to go to work. At one of the major banks I worked, I really squeezed into the digital offering team out of my normal KPI and tried to contribute a front office perspective. They think it’s an architectural issue. It’s not only an architectural issue, it’s a user experience, client experience issue as well.

So, I think this is where we see happen again and again are the industries where independent, small, scruffy startups eventually over strong the established companies. And this is personally why I made the career switch and trying to figure out independently. But that said, I have not seen, I think Marcus is probably the best example of mostly investment bank trying to get into a more mass markets, and they have a good strategy plan of investing to not make during the saving product and now moving to investing.

[00:50:33] Ben: And what about somebody like Standard Johnson, because they seem to have a similar kind of playbook, with [inaudible 0:50:42] and I think they’ve got this new platform called Nexus, which is a bit like Marcus. I suppose this is open to anybody to answer, but it seems like, Nikolai was making this point, that if you’re a large bank launching a new kind of your own challenger brand is a way of, if you like, transferring some of the brand equity you have into a vehicle where to your point, Qiaojia, you don’t have the problem of Legacy IT and to your point, Mike, you don’t necessarily have the same cultural obstacles to introducing change, particularly around business models. So, is that the best way for an incumbent to face up to this digitalization threat?

[00:51:23] Nikolai: I think one key element there is also from a cultural perspective it’s the only way that innovation on a technological level can work, just because within the organization you have cultural bottlenecks, especially what Qiaojia said, you have a legacy system bottleneck that just prevents you from being able to do any meaningful change at a scale where it makes it a dent in what is the customer outcomes in the end.

I think there are good and bad ways to go about that. I have felt and we do a lot with the innovation labs or the digital arms that retail banks have set up, and that’s also to Qiaojia’s point, it’s also the way of looking at technology as something that happens outside the business, and then somehow goes back into the business and then change happens. But I think it’s great as a channel to introduce innovation, source ideas for innovation, but it’s not what drives true business model transformation. If you want to truly build a digital first proposition the business and the tech has to evolve and be built in synch, and that’s exactly what the challenger brands are doing, it’s what Rosecut are doing, it’s what all of us are doing, we are building a new startup but also a new technology spec.

So, by creating a subunit or an outside unit, I think it’s probably the only way to do meaningful change, it really then has a transformation curve that is not just like a band-aid to what is essentially a very heavy wound.

[00:53:02] Ben: You’re right, because Qiaojia made the point that a lot of banks kind of view digitalization as a back office function. And then on the other extreme, you’ve got a lot of banks that sort of see it as some sort of innovation function, a play thing for a group of people who aren’t really key decision makers in the organization to work with. And it needs to be in the very top of the corporate agenda. And so how do you do that? How do you make it top of the agenda? Do you hire people that aren’t bankers to join the board?

[00:53:31] Mike: Maybe I’ll chip in, the Rosecut experience opened my eyes to how the big banks were with tech and how good a small focused team can be. I’m now going through the same experience, we invest in startup, in terms of me learning what lots of different areas. So I think the decision would be made by the CEO of the large bank. So I think the kind of thing you want to do is to take some of your senior executives, make it clear to them that this is an essential part of their career, that they’re not just being part in operations.

You want to incentivize them. You arguably want this to be geographically remote from headquarters to give it sort of a mental break. I think we need to put tech and banking people together on party, maybe I think have a lot of interactions with customers or potential customers just to make absolutely clear what the problem you’re trying to solve is, and try and do it in that way. And maybe also look at the bankers, tech classes, entrepreneur class, and teach banking to the tech people, as well. So, it’s something I think, in which people have to be very, very invested, but it should pay dividends.

[00:55:5] Ben: And do you think banks can attract the right tech talent? Because if the competition for tech talent is global, because tech is part of everybody’s business, arguably the most important part of everybody’s business, can banks hire that tech talent or should they be using third party suppliers, like Hydrogen and Nucoro, more than they do today?

[00:55:26] Mike: Let me answer that. Tech talent is already very expensive in London and Zurich, tech talent is as expensive as banking talent. I kind of think what you want to hire, just my limited experience, hire project managers who have a taste of both and can actually advance the project, kind of skilled in both languages, but that’s not an expert opinion.

[00:56:01] Ben: Fantastic. And Sid, a question I want to ask you, I’m sorry to keep coming back to you on these questions of embedded banking, but I just think it’s fascinating as a new business model type. I’m just wondering, if banks or wealth managers in this case, don’t control the customer interface, i.e. that’s controlled by other brands, how do they continue to have a profitable business where they have some control over pricing, some ability to upsell and cross sell, or do they have to accept that they’re just balance sheet providers or custodians or whatever, or regulated services providers? What is the role of wealth managers embedded in the banking world? And then if they do have a profitable role, how do they bridge between being a back office supplier and having some engagement and continued role with the customer?

[00:56:59] Sid: Yeah, that’s a tough problem for them and that’s why some banks have not gone down that route of just providing the services, like in the US. You see most of the FinTechs are using only a couple of banks, like Evolve or like Greenberg.

[00:57:19] Ben: And Cross River.

[00:57:20] Sid: Yeah, Cross River. So there’s just like a handful of banks, but none of the big banks. But for these smaller banks, who have a much smaller customer base, for them it gives them access to huge amount of customers, which they would have never had access to previously. So for them it kind of made sense to build like a tech stack specifically for integration for the fintechs, where it’s like a scalable kind of solution for them. So, they’re still making money and they don’t have the customer acquisition costs. So, it can still work for them. I mean, it becomes obviously a bit harder to like cross sell anything, but I think just in terms of the scale that they can access, it’s huge, and it’s worked really well for people like Cross River, I mean their scale has just grown dramatically in a couple of years.

[00:58:19] Ben: Okay, so I actually looked because we’ve got a report coming out and I looked at some of these smaller banks in the US and some of these guys have got return on equity of 40% plus, because as you say, they don’t have to acquire the customer, they’re just providing regulated services, but it doesn’t seem to me that that would work very well for an incumbent with the kind of cost base the incumbent has.

So this is a question to anybody to answer, is an incumbent, therefore, with a large customer cost base, excluded from participating in embedded finance, or is there a way to kind of leverage the brand to make it such that if I’m using a third party service, I still would want the service from a given institution. In other words, is there a way to still differentiate when you don’t control the customer channel? And how is that possible? Is that a tech question?

[00:59:16] Sid: I think there just one aspect I’ll give, one example, which is like the Apple card offering, for example. Goldman Sachs was still involved in that, but they weren’t at the front of that brand offering. But what they were able to do is they were able to take on some of the risk assessment off their clients and that worked out poorly in some examples, but you know, people were able to see that they were able to get cards much easier. It also gave them access to a huge channel, as well.

So I think there are some possibilities of being embedded and still having the visibility and some control on the proposition that you’re offering. But it becomes challenging. I think now a couple of the banks are trying to offer banking to Google as well, and they there have been some deals that have happened over there. But they will just be in the background in that case, but it’s a huge customer acquisition channel for them.

[01:00:25] Ben: Does anybody else have a view on that? Because it seems to me that implicit in what you’re saying with Goldman Sachs Apple tie up is you have, if you like, two premium brands. Is it just about building brand? Do you think there’s a tech answer to it, I suppose is another way of putting it. If I can build sufficient, contextual information and I can serve up relevant offers and content and so on, even if it’s through somebody else’s channel, can I still carve out some differentiation that makes me more than just a commodity supplier of regulated services? And I’m curious to know if you think that’s a tech challenge, brand challenge, or whatever.

[01:01:01] Qiaojia: I’ll chip in a few of my observations. On the tech side, I think it’s really challenging because of the legacy system and the executive team may not have the courage to put in a couple billion and do a complete overhaul. But what other things they could have done is to really sort of reshape the sort of incentive system.

One thing that a power banking colleague put to me in terms of the private banking model, she described it as a hair salon model. You know, every advisor has their own desk and has their own support and look after their own group of clients. So it started with a bad habit of banks, I’m talking about specific power banks, poaching each other’s high producers and paying them a lot of money and hoping to attract the book. But overall it’s not a very structured effort of growing the organization together. So, this is one thing to think about, how to incentivize team effort, rather than rewarding lone wolves. This is something that we can think about.

And second is that when you face regulatory pressure and margin compression they you race up to the top of the pyramid and dumping your smaller clients to slow regulatory pressure, then rather than doing the reactive thing, it’s more important to be really clear who you are focusing on. It doesn’t mean if you are a big bank you should be just thinking, okay. I’m catering to everyone, have a tiered offering, like some of the British banks with retail, affluence, and then high net worth and ultra high. You really need to think about how you’re going to do that. Maybe outsource your lower tiered clients to some partners and then focus on the most important segments that you have the right skill and expertise for.

So, UBS went through the process of, well, let’s try to dab into affluent, no actually we should just focus on ultra high and a lot of banks feel like they focus on ultra high now, but there are only so many ultra highs in the world. Like you can even slice down the target market to entrepreneurs or certain industries or just really have a good view of what you can do, and a more organized effort and reinforce your brand in that. So, yeah, this is a non tech perspective.

[01:03:43] Ben: And the cultural questions again, so Mike, you seem to have strong opinions on culture. Is that possible, moving from the hair salon model, outsourcing customer management, all these things, again, to be quite alien, it seemed to me, when I speak to private banks, to be quite alien to their thinking, because they still think that they are in control of the customer and the fulfillment of those customer needs.

[01:04:14] Mike: That’s been enforced by the individual bankers. They will jealously guard their clients. I think, just to go back to your original question, which was I think if you have a high cost base, can you put in place some of these changes? My response to that would be ask why you have a high cost basis, is it a defunct business model, is it the wrong blend of bankers, that kind of thing. When you end up in that situation where you have a competitive margin, outsourcing tech might be a solution, but the real problem lies elsewhere, lies with core management, maybe institutional cultural issues that are very, very deep seated.

I think you’re going to see if you walk into a wealth manager in say Switzerland, they all look the same from the outside. People who meet you all look the same, to the extent that it’s become a bit of a party and that maybe tells you that means cultural elements are very, very strong and that trying to change them will meet a lot of resistance.

[01:05:33] Nikolai: Maybe to add something there, because also coming to your point, Ben, I do think certain elements or changes is met with a lot of skepticism. What I find interesting is that a lot of times it’s very difficult for them to articulate what is actually the value that clients see, a lot of them don’t really know actually. Is it because a rather trivial element like customer service team, for example, on the middle office side, for example, it might be that it’s very important for your clients. Maybe you don’t see it as important at all.

It may be other elements, maybe it is for the status symbol of what the brand represents, or it is the user experience with a personal relationship with your advisor. It might be a very wide range of things. A lot of times they don’t know. And I think that’s the starting point, first figure out what is it actually that your clients like and see as the value to add, then maybe actually only have a discussion around that, not doing all the things that you think are necessary to do.

[01:06:35] Ben: I think that brings us to I think probably the last question that I’ll ask, which comes again from the audience, it comes from Christopher, and it begs the question, what is the ultimate role of a wealth manager? What underlies his question, because he asks are technology solutions sufficiently so advanced that a wealth manager can outsource the entire thing to a technology ecosystem? And then what would be the USBs that remain? So, if I’m a wealth manager and I’m in charge of the brand, can I source everything else from an ecosystem of tech providers, from FinTech providers, et cetera.

[01:07:20] Mike: I think at the very high you can’t, and at the high end what some banks are beginning to do is to bring corporate finance bankers into relationships with families and family offices and that kind of stuff can’t really be commoditized, because I think at that level clients want security and they want the client to know them intimately, and you can’t do that remotely, you can’t do that with technology. That kind of advice networks are finding the business of clientele, that’s not something for which bankers offer a solution. I think also for senior bankers, they often play a partner role. So, at the very top end I don’t think that’s possible. I agree with Nick and Qiaojia.

[01:08:28] So, if I interpret that correctly, you’re saying that beyond the people that serve the ultra high net worth individuals, the family offices, whatever, everything else theoretically could be, because you’re saying ultimately it’s a question of scale and lowest unit cost, and access to networks.

[01:08:44] Mike: I think most of it could be, obviously as you go down the scale, I think you also want to think about content and education. Content is not something the banking industry does very well. Most banks keep an account with Twitter, no bank I know does research on TikTok, so I think there is actually a huge scope there, not to make things more efficient, but make things a bit more clear and more entertaining, as well.

[01:09:23] Ben: Okay, interesting you say entertaining. Absolutely the last question and then we’ll wrap this up. How do you make wealth management more entertaining? I’d like to get everybody’s views on that.

[01:09:39] Nikolai: Just one example I have, my girlfriend is learning German at the moment and she uses Duolingo to do this, it’s a very popular language app on the iPod. So, there is a daily lead, basically every evening before 12:00 she would go online and just rush in some sessions to improve her score for that day to end up, among the top 10 of her league.

I think there is a lot of literature around what are the best ways to learn a language, the most efficient ways to memorize vocabulary, a lot of theoretical approaches to that. The app sold it in a very different way, a very compelling way to get in maybe 10 more words or something. I think we don’t have to reinvent the wheel with wealth management, but to draw inspiration and insights from other sources, at least a starting point, because we’re a bit behind, others are ahead of us.

[01:10:57] Ben: How would you gamify wealth management without introducing democratization of risk, to Mike’s earlier point? It seems to me you can’t gamify a portfolio because then you’re changing risk, so is gamifying what aspect of wealth management, savings, because that seems external.

[01:11:20] Nikolai: You’re totally right, it must be different levers, not only the risk lever. But then you have, again, we see approaches like that already, like roundups, we see one sets a goal and we see visually how that goal materializes on a map and I think it’s more tangible. I think there are ways that are not risk taking.

[01:11:43] Ben: Maybe there’s an intergenerational play, parents or grandparents helping children, grandchildren to save, to invest sensibly and so on, which might help with the intergenerational, risk of attrition.

[01:12:01] Sid: I think a social aspect can be very huge, especially for the new generation, and I think we saw that with some of the Reddit boards and stuff, but that can be harnessed in a more positive sense where you have peers and maybe some interesting people who are talking about finance, talking about investments, and you’re kind of working with a group to kind of solve your financial problems. I think that is going to be some of the new kind of FinTech platforms that we’re going to see in the future. I’m already starting to see some of those they’re just starting to get funded now.

[01:12:42] Ben: Perfect, great. So, we’re almost out of time. So, I think all that remains is to thank the four of you very, very much for taking part in this discussion, to thank everybody who has listened to this either live or the recording, and then also just to remind you that if you enjoyed this, next week, we’re going to be double clicking on the new business model aspects of wealth management, and we’re going to be joined by Elinvar, Impaakt, Tinkoff and additiv to that discussion. So thank you everybody for participating and taking part in this, and see you at the next4X4 Virtual Salon. Thank you very much.

Capitalism without Capital and after COVID (#37)

Structural Shifts with Stian WESTLAKE, co-author of ‘Capitalism without Capital’ book.

Our guest is Stian Westlake, co-author of ‘Capitalism without Capital: The Rise of the Intangible Economy‘ and we discuss the implications of an economy built increasingly on intangible assets, even more so in the post-pandemic world. In this podcast, we discuss the four S’s that explain how intangible assets behave differently than tangible ones, why we’re not seeing more economic growth or higher productivity right now, even though intangible assets are more scalable, what governments need to do to mitigate the increased income inequality that’s occurring in part due to the rise of intangible investments, and more. Stian serves as the Chief Executive of the Royal Statistical Society. Previously, he served as an advisor to three British ministers for science, innovation, research, and higher education. He also led the policy and research team at Nesta - UK’s National Foundation for Innovation.

Full transcript
Structural Shifts with Stian WESTLAKE

Sometimes there are things that are very easy to measure at the big picture, but they get harder to measure the more granular you get — and intangible investment is definitely one of those things

[00:01:30.26] Ben: Stian, thank you so much for coming on the Structural Shifts podcast. We’re really delighted to have you on. I think there are a few structural shifts as profound as the one you’ve been investigating, most notably through your 2018 book, “Capitalism Without Capital”, which is the shift from a tangible to an intangible economy. This is a phenomenon which has been playing out over the last 40 years in developed economies, and which, as we’ll discuss, has likely been accelerated by the pandemic. It’s also a phenomenon, which, although it might seem slightly esoteric, is at the roots of or contributing to some of the biggest changes we’ve seen in society, such as inequality, as well as in business, such as the rise of big tech platforms. So if it’s okay with you, let’s start by just defining what we mean by an intangible economy. So, do you mind just kind of setting the scene and telling us the extent to which investment has shifted from tangible to intangible assets?

Stian: Yeah, of course. If you think about what the economy used to be like 40, 50, 100 years ago, the majority of the stuff that businesses, that governments invested in were stuff you could see and touch — what economists would call tangible capital. So, it was machines, it was factories, it was vehicles, it was buildings — all these kinds of things. One of the things that we’ve been noticing is there has been a really slow but pronounced change over time, such that now the majority of investments that businesses make — buying an investment, I mean, something that you incur a cost upfront, and it delivers you a benefit over time — most of the stuff is stuff that you can’t see or touch, things that you can’t stub your toe on, as it were. It’s things like investing in r&d to create new ideas, new patents, things like investing in marketing, advertising, customer understanding to build brands, it’s things like employer training. And it’s stuff that has this kind of fuzzy idea of things like organizational development. So if you think of a company like Apple, one of Apple’s competitive advantages is its remarkable supply chain. Now, the supply chain includes some things that you can touch — it includes factories — but Apple doesn’t own them. So those are to some extent tangible. The stuff that really creates value for Apple is these privileged relationships, the expectation of doing business, and their access to these suppliers, which allows them for example, to get products to market at volume, fast. These things are investments, they’re costly to acquire, they deliver benefits over time, but they’re very different from the world where your investments were the machines and the factories or the land that you grazed your cattle on.

For most of history, tangible assets represented a much bigger slug of the economy, than the investment in intangible assets. And about 10 to 20 years ago, depending on the country, those two lines crossed.

[00:03:59.18] Ben: The book is full of brilliant graphics but one of the ones that really stands out is the one that shows the acceleration in investment in intangibles and the point at which it crosses over. So intangibles now represent or comprise a larger proportion of overall business assets than tangible assets.

Stian: Yeah, that’s right. So if you think of these as a percent to GDP, so in relation to the size of the economy, for most of history, tangible assets represented a much bigger slug of the economy, than the investment in intangible assets. And about 10 to 20 years ago, depending on the country, those two lines crossed. The intangible line has been moving up and up and up, slowly but steadily for decades. They crossed. If you look in rich countries now, the intangible investment represents roughly 15% of GDP of national annual output, and tangible assets more like 10–11%. One of the nice things about these slow but steady changes is you can be pretty confident that these things are reliable. We have so much data on this. This is a change that’s been going on for a very long time.

[00:05:06.17] Ben: You say we can be confident in the reliability of the data. But, I mean, you used the term ‘fuzzy’ for some of these intangible assets earlier on. And that sort of suggests that there might be things that are quite difficult to define, and therefore quite difficult to value and capture on a balance sheet or in economic statistics, GDP statistics.

Sometimes there are things that are very easy to measure at the big picture, but they get harder to measure the more granular you get — and intangible investment is definitely one of those things in that national accounts do a kind of okay job of representing this.

Stian: So it’s a really good question. And it’s one of these things that have traditionally not been very well captured in either economic statistics — the kind that governments put together — or in business statistics, the kind of thing that your accountants would put together. And one of the interesting parts of this work, my co-author, Jonathan Haskell, along with many other economists, have really spent a lot of the last 20 years trying to work out ways of measuring this intangible investment at the level of the economy. And they used surveys, they’ve used fascinating historical data sets; it took quite a while to get a handle on this stuff but the results are pretty conclusive that this intangible investment is growing. Where things get tricky — you mentioned company accounts — sometimes there are things that are very easy to measure at the big picture, but they get harder to measure the more granular you get — and intangible investment is definitely one of those things in that national accounts do a kind of okay job of representing this. Nowadays, most countries will record their r&d investment and record some of their human capital investments. But corporate accounting standards don’t recognize this stuff. So, you will find very few intangible assets on a balance sheet. And I guess one of the interesting aspects of this is if you look at the job of people who try and value businesses with a lot of intangible assets — such as sell-side investment analysts, people who work for hedge funds or other investment funds; it’s really interesting, there was a whole bunch of research done on what these guys spend their time doing when they’re on CEO calls, CFO calls, and someone managed to code all these conversations. It turns out that most of these things are actually asking about intangible assets, to try and understand the value of whether it’s supply chains, whether it’s the r&d going into the new product line. And there’s a kind of an interesting opportunity here if you’re involved in investment because this stuff is harder to value — and if stuff is harder to value that’s good for the people whose expertise lies in valuation.

The reason why we should care about the change to intangible capital is that from an economic point of view, intangible capital behaves differently. And the four S’s are the four ways in which it acts differently: scalability, sunkenness, spillovers, and synergy.

[00:07:19.18] Ben: It’s true, I never… I suppose I had thought about it, but not like that exactly, which is it’s kind of an arbitrage opportunity there because I suppose superficially, things like return on capital might be understated, or profits might be understated because so much of this stuff should be on the balance sheet, but it is an expense to the p&l. And then, you know, just having a better understanding of the things that are not recorded in annual accounts or in the annual report potentially gives you an edge.

Stian: Yeah. And I guess, you know, if you think about the way things have always worked in, say, on the sell side, when you look at sectors like pharma. So pharma is a sector that has always been heavily based on intangible assets. The value of GSK is kind of the value of its pipeline of drug ideas. And I guess, if you’re an analyst in that sector, what you’ve always done is basically, you’ve done a bunch of valuations of what you know to be the product pipeline with some kind of option value based on what you think the individual capability of the firm is. And I guess in an economy where intangible capital gets more and more important, more of the task of investment analysis is going to look more like the pharma investment analyst or even a kind of an analyst of the VC house.

Intangible assets have a lot of spillovers, and that means that a company that makes them can’t always be sure that it will get most or even any of the benefits of an investment that it makes. […] It’s much harder to control those spillovers than it is with tangible assets, […]. And so, managing those spillovers becomes a really important part of what successfully managing business looks like in an intangible economy.

[00:08:30.22] Ben: Definitely. You talk about the four S’s of intangible assets. Do you mind just running us through it? Because I think it’s really critical that we understand the properties of intangible assets. And since they behave differently, that then, in turn, means that economies behave differently, and so on. Do you mind just telling us about the four S’s?

Stian: Yeah, totally. If you take away only one thing from the book, this is the thing to take away from it. So the reason why we should care about the change to intangible capital is that from an economic point of view, intangible capital behaves differently. And the four S’s are the kind of four ways in which it acts differently. The four S’s are scalability, sunkenness, spillovers, and synergy. So I’ll just quickly give an example of what I mean by each of those. So scalability: if you compare an intangible asset to a tangible asset, a tangible asset, you can only get a certain amount of use before you need to kind of invest in more of those tangible assets. If you own a fleet of taxis, if you want to carry more of a certain number of customers, you need to buy or lease more taxis. If what you own is an algorithm for dispatching private hire cars like Uber, you can scale that if not infinitely, then arbitrary. You can scale that across a very large number of taxis and a very large number of cities. So valuable intangibles go a really long way. And one of the implications that means that we can go on to talk about is that if you’re a big company with some valuable intangibles, you can get very big, you can create a lot of value.

Stian: The second S we talked about — sunkenness. So sunkenness refers to the economists’ idea of sunk costs — the fact that sometimes once you invest in something, you can’t recover the value of it. And that’s very much more true for intangible assets than tangible assets. So if you own, for example, an office building — a tangible asset — and you go out of business, you can very often sell that office building, you can recover quite a lot of the value from it, even if you’re in a distress sale. If you own a patent, you can sell patents but patents are very often worth almost nothing to anyone apart from a small number of providers. A brand of a company that’s gone bust is not worth a lot. As we can maybe come to talk on later, that’s got some really important implications to how you finance businesses that have a lot of intangible assets because debt investors do not like sunk costs.

Stian: The third S is spillovers. The idea of spillover is, intangible assets have a lot of spillovers, and that means that a company that makes them can’t always be sure that it will get most or even any of the benefits of an investment that it makes. So, there are classic examples all through the history of tech, but Xerox PARC — kind of one of the foundational stories of Silicon Valley — they invented almost every foundational computing technology, every desktop computing technology you can think of. They make no money from it. Most of the value was captured either by Apple, by Microsoft, or by a host of other companies. It’s much harder to control those spillovers than it is with tangible assets, where we’ve got a set of very clear rules around them, they’re kind of physical, they’re kind of easier to keep tabs on. And so, managing those spillovers becomes a really important part of what successfully managing business looks like in an intangible economy.

There is a lot of productivity growth, at the moment, it’s just not evenly distributed. So, if you run one of these companies that can benefit from the synergies and the scale of intangibles — i.e. own a bunch of valuable intangibles, you can scale them across a really big business, and you can combine them in ways that make it very difficult to compete with you. 

Stian: And then the fourth S — synergies — is this idea that intangible assets seem to be especially valuable when you combine them in the right way with other intangible assets. So, a classic example we talk about in the book is the EpiPen — the epinephrine injector for stopping allergic reactions and anaphylactic shock. And what we talk about in the book is how that isn’t really a typical pharmaceutical invention. In fact, it’s based on a drug with a patent that expired over 100 years ago. But one of the things that EpiPen’s owners have very effectively done is they’ve combined a whole bunch of intangible assets from the design of the injector, to their very privileged supply chains, to the various legal moats that they put around things to even the brand name — the recognizable brand name — of the product that you kind of want to be able to recognize when describing in an emergency. And together, all of those things, all of which are kind of intangible assets, combine to create a big competitive moat around the product, but ultimately kind of very profitable, very value-created product for them. And these synergies exist, you know, between talent and intangibles, between different intangibles. And again, it means that if you’re a company that has a bunch of these valuable intangibles, you can create a lot of value for shareholders.

[00:12:59.01] Ben: Fantastic. So I think the four S’s give us a really nice framework to dig into some of these other topics, right? So I wanted to move next to growth. You talk about the scalability of intangible assets, right? So if the economy is made up of more intangible assets, and those intangible assets are more scalable, why don’t we see more economic growth or, you know, or higher productivity growth than we do at present?

Stian: So that’s a really good question. It’s something that really ever since we started working at this, we’ve been wrestling with, and it’s a big subject of our follow-up book, which is coming out later this year. But I guess one of the things here is that there is a lot of productivity growth, at the moment, it’s just not evenly distributed. So, if you run one of these companies that can benefit from the synergies and the scale of intangibles — i.e. own a bunch of valuable intangibles, you can scale them across a really big business, and you can combine them in ways that kind of make it very difficult to compete with you. Those businesses, as far as we can see, are very profitable, their profitability is growing, they make a lot of money for their shareholders and their employees, and they’re kind of seen as iconic businesses. So, you know, your classic dominant internet platforms, Google and Facebook, and whoever would be examples of that. But, you know, we see this in other areas as well. So, you know, Domino’s Pizza — a classic example of a business that looks very old fashioned, but has totally killed it in terms of developing a very powerful internet platform. So you have a world where some businesses, because of the intangibles are doing really well. And one thing that we’ve been looking at is the fact that in an economy like that, because of these spillovers, you create kind of perverse incentive for the rest of businesses. If intangibles have quite a high spillover and if some firms are really good at getting the benefit of those spillovers, the rationale for investing, for your kind of laggard businesses, your runners up in industries is plausibly much less.

there’s been a ton of research over the last kind of 20 years now, looking at that gap between your so-called leader firms and laggard firms. And basically, in every country, in every industry, that gap is growing. And really, interestingly, it’s growing the most in the industries that have the greatest number and that have the greatest proportion of intangible assets.

Stian: You know, if you’re in a traditional — if you imagine a very tangible-based economy like an industry like, I don’t know, running a laundromat, let’s suppose the best laundromat has the best washing machines and the best building; if you run the second best and the third-best laundromat, you can catch up in due course. You can borrow money from the bank, you can buy better machines, it’s kind of pretty obvious what you need to do to catch up because you can visit the other businesses and look at what they’re doing. There you would expect to see over time the gap between the most productive, most profitable businesses, and the least, would shrink because you can just copy. Now, if you’re in an intangible economy, those dynamics change. Imagine you want to compete with Uber. Okay, you can try and develop your own dispatching app but the scale effects are such that you’re going to be up against vast fixed costs, it’s very unlikely you’re going to be able to compete with the huge amount of money that Uber can pour into their development. And because of scale, you won’t be able to kind of amortize that across a large business. Okay, so you say, “Okay, well, I’ll come up with some new product feature that Uber hasn’t come up with.” Let’s suppose you’re an absolute product development genius, and you come up with something. In this economy, because of the synergies and because of the spillovers that we talked about, you might not be very well advised to do that, because Uber could quite simply copy it, or, you know, they might buy you, which would be kind of a good story for you but in terms of the dynamic, your business goes away, and therefore the leader business grows more powerful. So, rather than the world of laundromats, where catching up with the leader is about copying, it’s about acquiring probably mass-produced tangible capital, where you can probably get a bank loan for it, in the intangible economy, it’s much harder to catch up like that.

Stian: And I guess this comes back to your original question about what might be going wrong with productivity. If you can imagine an economy where the best businesses are doing really well, they’re generating a lot of money for their shareholders, they’re being really productive but there’s huge disincentive for a large chunk of the economy to invest and to catch up. In aggregate, that could come to an economy where productivity growth is actually pretty slow. And in terms of the evidence for this, there’s been a ton of research over the last kind of 20 years now, looking at that gap between your so-called leader firms and laggard firms. And basically, in every country, in every industry, that gap is growing. And really, interestingly, it’s growing the most in the industries that have the greatest number and that have the greatest proportion of intangible assets.

One of the issues of spillovers is businesses will invest less than is socially optimal in R&D. If you’re in a world where you want more R&D investment, but businesses won’t do it, that probably means you need governments or research institutes to do it. Again, that’s quite a judgment-based process, so you’re sort of saying you’ve got to trust people in positions of authority to do this kind of thing, which is particularly challenging in today’s political circumstance. So that’s a real dilemma.

[00:17:23.07] Ben: Do you think there’s another thing at play as well, which is, in the world of tangible assets, economies of scale were eventually subject to diminishing returns, right? Whereas in the world of intangible assets, you know, where we have network effects, you could argue that a lot of times, you get just increasing returns to scale. You talked about Uber — I guess the more customers you have, the more drivers you can attract, the more drivers the more customers, and you get these virtuous self-fulfilling feedback loops, meaning that you get increasing returns to scale, whereas in the past that almost wasn’t possible in economic terms.

Stian: Yeah, that’s definitely true. And I think those network effects you talk about are a really important part of this kind of scalability of intangible assets.

[00:18:07.18] Ben: Do you think we should be using more antitrusts? So you talked about Facebook and when I think about Facebook, I think, you know, the initial platform was super successful, had very strong network effects, it delivered a lot of utility to its customers. But since then, you know, it’s copied features from other people like Snapchat, it bought Instagram. And I just wonder, you know, should we be using antitrust to stop the big platforms from getting even bigger through copying and m&a, for example?

Stian: Antitrust and competition policy clearly become very important in an era of intangible assets because of this kind of tendency of the best companies to do really well. The flip side is, I think a lot of the old rules become a lot harder to apply. So, traditionally, we’d look at an economy, and also we’d look at an industry and we’d say, if the kind of concentration ratios are above a certain level, then that’s a problem and we need to break up the leader firm or we need to block acquisitions. That becomes a lot harder in this kind of economy, I think, for two reasons. Firstly, because these synergies because there are so many crossovers between different types of assets, it becomes a lot harder to define an industry. So, for example, you know, are Facebook and Google in the same industry? I mean, on one level, they’re clearly not — one is a search engine, one is a social media site. But, you know, if you’re an advertiser, they might look a lot like they’re in the same industry. So it becomes a lot harder to make those distinctions. I think the other thing is that, you know, the kind of silver lining of scalability and spillovers, is that although businesses can thrive and grow and their dominance can get entrenched, the flip side is, when things go wrong, they collapse very quickly and your rivals can grow up very fast. So the kind of optimistic vision of competition in a world of intangibles doesn’t look like a market where there’s kind of, you know, seven or 17 or 70 competitors all in the same market. It might be a market where you have people who temporarily look a lot like very dominant, almost monopolistic players, but where there’s a lot of competition almost across industries, and where you have enough dynamism, enough opportunities for startups, that people like Facebook and Google occasionally get dethroned.

[00:20:29.04] Ben: I agree with that. I think there’s not enough documentation of negative network effects. Because, you know, on the way up, it’s exponential; potentially, on the way down, it can be exponential too. Are you saying that competitive or antitrust policy is difficult to execute, therefore, we shouldn’t try? Or are you just saying that we need to find new sort of yardsticks for anti-competitive behavior? Because similarly, you know, it’s difficult to look at concentration; it’s also difficult to look at price because so often these platforms lead to lower prices because they’re monitored indirectly.

Stian: I think the short answer is, it’s probably the latter of your two things. It’s more that we need to kind of come up with new ways of analyzing this new way of looking at it. And that’s really tricky because one of the nice things about the world of 20 years ago, if you were a competition regulator, your job — I don’t want to say it’s easy; it was a difficult job — was quite rules-based. There were ratios and there was a whole academic infrastructure of how you would think about the concentration ratio in a particular sector, although a lot of judgment needed to be applied to that. That was kind of some yardsticks. I think if you’re looking at this kind of thing now, it becomes much harder. And in the same way earlier that we were saying that to be a sell-side investment analyst, scale becomes more important and the job becomes harder. I think that’s also true if you’re a competition regulator, which I guess where that takes you, if you’re to say, “What does this mean for politics or for public policy?” is a really unfashionable position. Basically, it means you need to spend more money on people who’ve been derided as bureaucrats and pencil pushers, more money on their analytic ability, and be more willing to at least consider innovative approaches to how you do those kinds of things.

We shouldn’t use the intangible economy as an excuse to give up on doing just the basic stuff to make society fair.

[00:22:14.20] Ben: But it all becomes a bit less objective, doesn’t it? Because in the same way that… You know, a sell-side analyst you could sort of test in advance their ability to understand the company accounts, or you could test civil servants’ ability to understand a legal framework, or similarly, you know, financial information. It’s very difficult ex-ante to understand or to kind of determine how good people are going to be at those jobs, right? How much to pay them and so on, right?

Stian: Well, it becomes much more judgment-based. And one of the things that we know from, there’s, I think, a whole branch of Management Science, looking at this kind of thing, that if it’s harder to measure performance in these jobs and more discretionary and more judgment-based, that typically leads to higher salaries, and it’s a more costly process to run.

[00:23:03.07] Ben: But I think in the world of antitrust if decisions are taken more based on judgment, then I suppose they’re more open to legal challenges and so on.

Stian: Yeah, you’re absolutely right. I mean, it’s really interesting. We see that across the piece as a result of intangible, so it’s not just… I mean, we can come on to talking about this a little bit later, but this is also an implication of spillovers, for example. We are probably in a world where one of the issues of spillovers is businesses will invest less than is kind of socially optimal in stuff like r&d. If you’re in a world where you want more r&d investment, but businesses won’t do it, that probably means you need governments or research institutes to do it. Again, that’s quite a judgment-based process, so you’re sort of saying you’ve got to trust people in positions of authority to do this kind of thing, which is particularly challenging in today’s political circumstance. So that’s a real dilemma.

[00:24:00.21] Ben: Do we need stronger IPE protection? Because I guess that’s, again, a double-edged sword, which is, what’s the right balance to anything?

Stian: So I guess the things we’re trying to balance, the spillovers of intangibles would suggest that you want kind of tough clear IPE rules because you want to make sure that the stronger your IPE rules, the more the incentive to own IPE and to invest in it are. Now, the problem, the thing that complicates that is the synergy between intangibles. So, if you take a product like Spotify — it’s a great example of something born from the synergies of intangibles, because you’ve got music rights, which are kind of one intangible asset, you’ve got the software, and the network, and the customer insight that Spotify has. By combining those, they’ve created a really valuable product that many of us are very happy to use. Now, suddenly, what people at Spotify have always told me is that if the music rights industry had their way, if they had tougher IPE rules and kind of more political influence that Spotify would never have been allowed to get off the ground. They would have been sued and out of existence in their first year or two. Now, I guess that’s the kind of great example of if your IPE rules are too strong, you don’t have a problem with spillovers so people will very happily make lots of music because they’ll make lots of money from it. But you’ll never get an innovation like Spotify, because it will always get crushed. So, I guess this comes back to what you’re saying. You need to strike the right balance between the two.

One of the ways to tackling inequality in an intangible economy, surprisingly, is through a very tangible asset — it’s through housing. It basically means that making it easier to build housing, making it cheaper for people to move to places they want to move in, becomes even more important.

Stian: I guess one interesting — if we sort of say, well, what’s the current failure mode of IPE rules? I suspect there’s probably quite a range of IPE rules that would work okay. What doesn’t work okay is a set of rules where there’s a huge amount of opportunities for special-interest lobbying where things get very distorted. So I guess the US patent system is kind of notorious for this, where you’ve got specific jurisdictions where a lot of patent lawsuits take place because they’re particularly pro-rights holders. I think the East Texas courts for patents seem to be like that. Similarly, in the US, you’ve got quite a lot of uncertainty. So you might have come across the copyright lawsuit over Pharrell Williams and Robin Thicke’s song “Blurred Lines”. So there was a huge lawsuit where the estate of Marvin Gaye sued Pharrell Williams and Robin Thicke for basically creating a song that seemed very much like a song that Marvin Gaye had written. And what was really interesting about this case, is that Pharrell Williams says he actually set out to create a song that was inspired by the Marvin Gaye song, but didn’t breach copyright. And it turns out, you know, there is a whole industry of forensic musicologists who would advise you on whether your song breaches copyright or not. And what was interesting is, in this case, the case went to court and I think it was a jury trial, weirdly; the jury just came up with a totally unexpected ruling in favor of the Marvin Gaye estate, even though everyone thought what was going on was kind of probably okay, with the result that the music industry is still talking about this. They’re saying, “Oh, well, you know, in light of this trial, what are we allowed to sample? What are we allowed to be inspired by? So that’s a kind of example of where an unexpected, quixotic interpretation rule is especially damaging. In the same way that, you know, if your business owns a factory, and it is possible to repossess that factory, sort of, you know, 5% of the time based on the phase of the moon or something like that, it would create a lot less incentive to invest in fixed assets.

Stian: So I guess what that means, probably matters less about precisely how strict the rules are, as much as making sure they’re clear. It also means that if you’re a government, you need to spend quite a lot of effort resisting the efforts of either rights holders or lobbyists to make little exemptions and carve-outs in the rules in their favor. Having been on the other side of the table working for the government on IPE policy, it’s really difficult to do that. IPE lobbyists are really smooth, they’re very kind of effective, they’re very highly paid. So that’s a challenge.

[00:28:17.19] Ben: Okay, I want to move on next to inequality. Let’s start with the inequality between people, right? So you’ve already alluded to this that where you have the right skills, the payback is going up, remuneration is going up. What are the kinds of skills that are most in-demand in an intangible economy? The most valuable.

Stian: Some of them will be the skills that are probably obvious — the tech skills; if software and algorithms are really valuable, the ability to code, the ability to manage teams of coders, or the ability to kind of manage big scientific projects and research projects. Those are clearly going to be more important. But that’s probably obvious, everyone knows that. The things that may be a little bit less obvious, is that in a world where the spillovers really matter, where it’s really important to combine synergies, the ability to bring those things together, also matters a lot. And those are often kind of soft skills. They’re often skills of hustle and entrepreneurship or social skills, things like the famous reality distortion field that Steve Jobs was famous for creating. Those things potentially become even more important in an economy like this. The other thing that I guess is potentially troubling about this is a world where who owns these assets and who has the right to use them is less clear. You could be in a world where political influence or even soft social influence becomes more important — whether that is retired politicians taking on high-profile jobs, whether it’s Instagram influencers, those general soft skills probably become more financially valuable than they were worth 40 or 50 years ago.

[00:30:02.09] Ben: Who loses out? What skills are less valuable, less solicited in this new world?

Stian: Well, one direct effect is that in some cases, these intangible assets directly relate to making some more routine jobs even more routine than they already were. Kind of the proverbial example here is, say, working in an Amazon warehouse, where, compared to a traditional warehouse job, intangible assets allow you to be more monitored, they generate a quicker work pace, which I think most people say this makes these jobs less enjoyable and less well-paid than they would otherwise be. So there’s a kind of direct effect there. But I guess there’s also an effect where if what you’re seeing is social status, social privilege, educational opportunities become more important, the flip side is that the pain of not having those things gets higher. So, you know, if you are more socially excluded, if you’re in a place that doesn’t have these job opportunities, it’s kind of not surprising that you will feel more left behind and that your sense of social exclusion — which, you know, there has always been kind of a divide between the big city and the kind of small town or the countryside; that’s always been there culturally. But the fact that cultural divide gets kind of underpinned now by an even bigger economic divide, is kind of… You can see that playing out in our politics and our current society at the moment.

[00:31:24.22] Ben: We definitely see that bifurcation of society in things like the Brexit vote. 14–52. Are we seeing, do you think, in a way, more losers than winners? I mean, relatively speaking, right? Because, you know, we don’t see massive rise in unemployment but what we do see is potentially a big bifurcation in the quality of the employment and the remuneration of employment. And I’m just wondering, you know, since we can see inequalities rising, is that because, you know, there are increasingly a small number of winners, if you like, or big winners, and then the overall population is tending downwards, in a way, in terms of, you know, real income?

Stian: Yeah. I mean, I think it’s always hard to say what’s ultimately driving inequality, because you can always, even if you have an employment system that’s creating a lot of inequality, you can always tax, you can always redistribute to generate more equality afterwards. I guess the kind of an optimistic way of looking at this is that this intangible economy, as well, is generating some of these superstar jobs that are really prestigious and really highly paid. It also generates a lot of jobs that are potentially more satisfying, more fulfilling for people to do than your kind of traditional job 50 years ago — even if they’re not as highly paid. So, you know, there’s a lot of jobs in the creative industries that are not particularly highly paid but all the research that has been done on well-being suggests that people actually like doing these jobs much more than potentially some jobs in traditional manufacturing. So I wouldn’t be totally pessimistic, but it’s definitely something that we need to be aware of this bifurcation between these elite jobs, and the kind of more socially-excluded mass.

[00:33:09.24] Ben: What do we do about inequality in this way? Because we have, I suppose, a small number of superstar firms, a small number of superstar individuals earning, sort of excess rent, if you like, or whatever. Excess returns on their skills? Is the answer to tax that and redistribute it? Or is that an industrial age policy idea that doesn’t hold someone in the digital age?

Stian: I don’t think we should give up on tax redistribution yet. I think that is pretty important and is still worth doing. And, you know, for all the people who talk about international tax-avoiding companies, I think there’s still quite a lot of low-hanging fruit there. In a country like the UK, you can just employ more tax inspectors. And, you know, we kind of under-invest in that. There is probably a low-hanging fruit in just basic compliance. So we shouldn’t use the intangible economy as an excuse to give up on doing just the basic stuff to make society fair.

Stian: I guess what you then get is, I think there have been some interesting angles where aspects of the intangible economy maybe exacerbate unexpected problems of inequality. So, one thing that there’s been a ton of research on looks at the cities that do really well out of the intangible economy — researchers were both in the US and in the UK. One thing that’s really interesting, if you take the Bay Area, Northern California, a great example of a place that’s been very successful because of intangible assets; not just computers, even before that. And what research shows is that once upon a time, housing in and around the Bay Area was pretty cheap. It was easy to build more housing when you needed to, and therefore the cost of renting or buying a house nearby was kind of somewhat affordable. And what that meant is if you had people making a lot of money in, say, San Francisco, that money somehow got spread around, because it was easy to move from a poorer part of the US to San Francisco, even if you didn’t have high skills, and you could take a low-skilled job but because you’re in a place where there were lots of people making a lot of money, you would get a pretty high wage relative to what you would have got had you stayed where you were.

Stian: And what people like Enrico Moretti, an economist who looks at these things and documents it, is that that’s kind of changed because it’s become much, much harder to build new houses in places like San Francisco; it’s definitely true in the South-East of England as well. And what that basically creates is that creates a really hidden unfairness because if you grow up in a place where there aren’t a lot of great jobs, and for whatever reason, you’re lucky enough to have a good education, to have the skills where you can take advantage of the intangible economy, you probably have a high enough salary to make it worthwhile moving to London or San Francisco. You can afford the crazy rents, your landlord will suck up a lot of money. But it just makes sense and you can grow there. But if you aren’t in that position, you’re stuck where you are. So, the old world where — and it’s very unfashionable to talk about money trickling down or trickling out — in the old economy, it did that much more than it did now. And the real barrier, one of the real barriers was rent. So I guess what this means is, one of the ways to tackling inequality in an intangible economy, surprisingly, is through a very tangible asset — it’s through housing. It basically means that making it easier to build housing, making it cheaper for people to move to places they want to move in, becomes even more important.

[00:36:38.08] Ben: Yeah. So, I guess you can’t have social mobility without geographical mobility, or it’s much harder.

Stian: Well, it’s interesting. I mean, there was a very widely talked-about book a few years ago by David Goodhart, who talked about the idea that the world was divided into somewheres and anywheres and the anywheres were the kind of Metro elite who kind of went from New York to London and just kind of didn’t care and somewheres were kind of rooted in Pittsburgh or Grimsby or wherever, and kind of loved their city. But I think there’s another way of looking at that, which basically says, it’s not that people who David calls somewheres are unusually in love with one place and hate moving; it’s that we’ve made it so that even if they want to move, they can’t afford to, so mobility has become something that only the very privileged who are going into these high-paying jobs can ever hope to do. And in a world where a lot of this intangible economy is happening in particular places, that’s a very damaging burden to inflict on a country.

[00:37:41.21] Ben: Yeah, and I think you probably have great statistics on this but it seems to be also that the intangible economy maybe doesn’t throw up as many jobs as the tangible economy. And a lot of the job growth is in what we might call proximity jobs. And therefore, we’re sort of holding back the growth of those types of jobs by, again, not allowing geographical mobility,

Stian: Yeah, you’re totally right.

[00:38:05.08] Ben: It’s becoming more and more difficult for traditional lenders — you know, universal banks, corporate banks — to lend to corporates because it’s really difficult for them to get enough comfort over that kind of loan, where it’s made in the absence of collateral — you know, physical assets that a company can pledge to the bank in order to secure that loan. And I think, again, there’s another brilliant graphic in the book, where you show that, you know, despite everything we talked about the growth of intangible assets versus tangible assets, actually, the lending is going up against tangible assets versus intangible assets, which just seems perverse. Right? So is that the root of it? This absence of collateral?

Stian: Yeah, that’s right. So, I mean it’s been called ‘the curse of collateral’, the fact that banks, ideally, want assets that they can take a charge of if a business fails. That is the way debt finance works and most businesses in the economy rely on debt finance, most financial institutions provide debt finance. You know, if we talk about stock market or venture capital, those are modes of finance that apply to a very, very small minority of businesses. So, there’s a kind of real challenge here. On the one hand, how do you develop institutions to provide more equity-based finance to a greater range of businesses? But also, how do you make a rule system that doesn’t discriminate against that because obviously, the first rule of financial structuring for a business is that debt interest is tax deductible, but payments to shareholders are not. So, you know, you’d want to finance a business with that.

[00:39:45.17] Ben: So okay, there’s a lot to unpack. So the first question is, you know, should we change that? Should debt not be tax deductible?

Stian: The kind of wonkish answer, the ideal world answer is, yeah, you want to change that. You want a world where debt finance and equity finance are placed on the same footing. And, as I said, this is quite wonkish. This is something where economists and tax policy wonks have come up with 1,000,001 proposals for exactly how you do this and all the things like equity tax credits. The problem is this, politically, would be a really hard thing to do. I mean, if you were to try and change the economy like this, you’d immediately have the private equity industry up in arms, you would create a lot of challenges for the banking system, it would be a big change. So, you’ve got to think not just about what’s the ideal end-state, but also what’s the institutional basis for it and how do you get there without totally causing lots of unintended harm to the economy.

[00:40:45.20] Ben: Exactly. Because you then form policy in a vacuum away from all the subpart dependencies. But maybe a better question might be, then, how do we get more VC-type capital flowing to the economy?

Stian: So I think that’s a really good question. Germany is an interesting example here because if you look at the way German banks do business lending, they very often will take equity warrants in small businesses, which is effectively like a way of making your debt finance more equity-like. And one of the effects of that is, if you look at, say, a British small business lender — you know, British High Street bank making loans to small business — almost invariably, they will look to take charge on the owner’s or director’s house. And that caters to the idea that the owners own their own house, which is obviously quite an assumption anyway. So it kind of skews you towards lending to a certain type of person. Now, that’s basically a way of getting tangible collateral, in a business that’s mostly intangible because a house is kind of pretty tangible. Now, in Germany, probably partly because homeownership rates have always historically been much lower, and more people rent in Germany, banks are gonna have to find a way around that. So these equity warrants is something that they’ve always done. Now, it means the banks end up doing more due diligence into the businesses because you need to understand more about how the businesses work. But I guess, they figured that’s a worthwhile cost, because the upside of these equity warrants is quite high. So, I guess that’s one example of it being done well. I mean, if you look on the fringes of the venture capital sector, it’s really interesting to see different types of more kind of growth-oriented venture capital branching into more markets and I think it’s really interesting from that point of view. So, I think we’ll see a gradual growth there. But this is really hard. This is a 10-year project, and will probably require governments to get behind it, too.

[00:42:40.18] Ben: Now, a lot of these intangible businesses have become a bit better understood. And, you know, so you see people lending, for example, or putting debt into businesses that have SaaS revenues, or you see people putting debt into businesses where they understand the mechanics of a game, for example — you know, they know the points of which a game is going to get large pickup, and they’re happy to invest to allow the games provided to invest in paid advertising on Facebook or whatever. So I think maybe the idea that debt no longer works is perhaps too simplistic and maybe just debt needs an upgrade.

Stian: That’s definitely true. And I guess, obviously, you know, as anyone involved in that markets will know, some lending is against collateral, but actually, you know, a ton of debt is lent against cash flows and expectations of cash flow. But I guess, to your point, what that does, it requires a greater understanding of what those cash flows look like. And, again, this is another one of these things, where it advantages the smart money. If you can understand these streams of cash flows and get enough certainty to be able to lend against them, then knowledge is unusually valuable.

[00:43:49.14] Ben: Something that’s only really occurred to me lately, since I started a business, which is, if I invest capital on the stock market — this may vary jurisdiction to jurisdiction — I face a capital gains tax of x, right? And that capital gains tax is the same as if I take a much more risky stance of investing in a business that creates employment, generates intangible assets with spillovers. So do you think we need a separate treatment of people, depending on where the gains from capital come from?

Stian: That’s really interesting. We’ve got some kind of limited examples of that already. You know, there are some tax breaks for providing risk capital either in the UK — things like the seed enterprise investment scheme, venture capital trusts, and so forth. So, that principle is there already, but it’s a really interesting question. I think, broadly speaking, you know, if the spillovers are good, then ways of subsidizing those — whether that’s through direct funding or tax breaks — it seems like there’s a strong economic case of that.

[00:44:54.06] Ben: And then the last question I wanted to ask you in this section was really around the role of government here because you’ve probably seen it — you know, there’s Mariana Mazzucato. In her diagram where she said the constituents of the iPhone and how many of them were spillovers from government fundamental research. And I’m just wondering, you know, there’s been, I would say, a reduction in government fundamental research in lots of countries, right? Because, you know, there was this sort of ideology of that crowding out public, private sector investment, and so on. But do you think we should maybe shift the balance there and the debate and push more money towards fundamental research?

Stian: I think there’s definitely a really strong argument saying the government should be funding more things like r&d, because they have these spillovers. If you just leave it up to business, you will get less of that than you would otherwise get because businesses can’t be sure they will internalize the benefits. And I think one of the really important things that kind of Mariana’s book really made the case for that in a kind of very powerful way, which is really important. I think there’s a lot of questions on how you do that, what the best way of doing that is, and particularly doing it in a way so that businesses also invest alongside because obviously, what wasn’t told in that story of the iPhone, is that alongside lots of fundamental research, there was also a ton of often quite unrewarding r&d done by businesses, whether it’s gonna join Magnetoresistance, which is how you got the kind of hard disks that these devices rely on, to the actual turning these things into useful consumer-friendly products. All of that requires a lot of investment as well, which often has quite high spillovers. So, public investment, yes, we absolutely need more of it. And it’s quite well that a lot of governments, I think, are moving in that direction. It also becomes even more important to work out how it may not mesh well with what businesses want to do.

[00:46:44.17] Ben: So many people talk about this sort of K-shaped economy, where everything that was analog is really suffering and everything that was digital or intangible is kind of accelerating. And I’m just wondering, is that a too simplistic read of the situation? I wanted to start with how intangible assets fare during the lockdown, for example, because I’ve read a piece that you wrote on Medium where you made this somewhat counterintuitive argument that actually intangible assets might not be faring as well as you might think, during a lockdown.

Stian: Yeah, absolutely. I mean, I think the pandemic was very interesting from the point of view of what you said for the intangible and the tangible economy, because when it started out, I think there was a huge focus on whether we’ve got our tangible asset response right, the way I would describe it. So people sort of say, you know, “Can we build enough hospitals? Do we have enough ventilators? Do we have enough factories making personal protective equipment?” And you know, everyone was very impressed when in Wuhan they built this huge new hospital, and we would say, you know, “Will the UK be able to cope? Will the US be able to cope?” And then we built the Nightingale hospitals, this is great. Wow. So this was all about tangible assets, you know, physical things. But I think what people kind of rapidly realized is that, actually, that wasn’t the real challenge and it wasn’t the thing that people struggled with, because actually, what people came to realize was really important was what you could call intangible assets. So, first and foremost, it was, “Can we develop vaccines that are effective? And can we put in place the supply chains to get them out there?” Both classic intangible asset problems. “Can we put in place tests and trace systems?” Test and trace systems are made up of software, they’re made up of processes, they’re made up of data? You know, those were classic examples of intangible assets. And some countries did them really well and some countries did them maybe not so well. And I think if you look at the differential mortality rates in different countries, it was, in some ways, the intangible response that really, really explained the bigger gaps much more than the tangible assets. So, I think that was kind of one interesting aspect of how the focus changed. I guess another really interesting question here is the move on what many people’s part remote working has done. So, certainly, in the UK, the latest statistics, 35% of people are now working entirely remotely. The historical figures for that before the pandemic struck have been less than 5%. So, that’s a really big change. And of the 65% who are not wholly working remotely, a fair chunk of those people are doing some remote work. So although this isn’t the majority of the population, it’s a really big chunk of people, it’s a really big change.

[00:49:38.17] Ben: And what happens to spillovers in the world of remote work? Because, you know, I think, again, it was in the same article, which I very much recommend to people — it’s on Medium — which is you talk about how during Prohibition you could trace a reduction in the number of patents because people needed to meet in bars to come up with some really brilliant creative ideas. And I think there’s some element of that, which is, you know, even though, ostensibly, we’re still interacting with our colleagues in a very collaborative manner, it’s different, right? It’s different if you’re remote, and you can’t go for a beer or coffee, whatever, and have those brainstorming moments, those moments of serendipity. Is it your hunch that this is going to lead to fewer spillovers.

Stian: So I think this is the $64,000 question. So, no one really knows and I think, to some extent, it’s probably up for grabs. It’s almost certainly true that it’s going to have some effect on spillovers, because you’re not getting these, as you say, these casual interactions that maybe some ideas depended on. The question is, you know, to what extent can we replicate them? To what extent, maybe, can a lot of remote working work well? And to what extent can we come up with ways of doing more remote working that gives you just enough of what you need? I mean, there was that famous saying, where, I don’t know who said it, but it was, “50% of my advertising works, I just don’t know which 50%.”

Ben: Oh, yeah.

Stian: It’s probably the same. You kind of think, well, you know, there’s probably some really important part of the time you spend in and around the office with people but it might actually only be 10% of that time. And the question is, can you work out what that is, and focus on that more effectively? So I think if we can do that, there’s a huge benefit, because remote working is incredibly good for productivity. But you know, it’s a big forced experiment.

[00:51:34.29] Ben: Well, I think the thing is the experiment is going on for a very long time now. So I’m sure people are starting to codify some of those things that there’s moments of serendipity and putting them into the way that we do remote working. Because in the beginning of the pandemic, it was very much kind of everything just moved to Zoom. And now I think people are realizing, for example, that, you know, just doing things synchronously through Zoom is not great, and Slack sometimes can be a better medium, for example. I think people are sort of now adapting the way they do remote working.

Stian: I think that’s totally true. And it’s interesting, you know, there are some industries that have been doing this for longer. So, you know, huge parts of the tech industry have been very comfortable with aspects of remote working and having remote development teams, as you say, using asynchronous communication and text communication much more than video conferencing. And I guess the real question is, can we work out the lessons for that? And can we scale them up quickly? Because that could be really valuable.

[00:52:28.15] Ben: You started to talk about San Francisco earlier on, and I had to hold myself back from delving into that. But on a few podcasts ago, we had Ian Hathaway on, and he was talking about his idea that, you know, smaller and smaller cities, if you like, can learn from San Francisco to some extent — you know, replicate the playbook. And I’m just wondering, does that diffusion of the magic of Silicon Valley happened faster now? Because maybe that was less important than it was to be in physical proximity?

Stian: Yeah, I think this is a real opportunity for anyone that wants to compete with Silicon Valley to make the most of it, partly because it’s about getting new norms in place that will help these areas. So, if we can get more comfortable with remote hiring, if we can get more comfortable with remote VC funding — something that’s often driven proximity — then this is a sort of an opportunity, as you say. There’s a kind of two-year window where some of these new practices could get trenched and people could realize their worth. That’s a huge opportunity to make a step-change. I mean, I guess the other dimension talking about San Francisco — San Francisco has kind of an interesting story. So, you know, I worked in Silicon Valley at the beginning of the 2000s. And San Francisco wasn’t really a part of the Silicon Valley ecosystem back then. The idea that this one big city is kind of the epicenter of tech is, as far as I can see, kind of something that it’s the kind of last-decade phenomenon. Silicon Valley for a very long time was just kind of the suburbs of Palo Alto and Mountain View, and places like that. And so, there’s kind of an interesting question. Well, you know, maybe the move to really core cities — maybe we might take a step back from that. So I definitely think it’s a lot to play for. You know, if you’re a city leader, or you’re someone who wants to kind of build a cluster somewhere other than San Francisco or New York, or London, then this might be a big opportunity for you.

[00:54:35.14] Ben: One of the things I thought was interesting in that article you wrote is you said that a tangible asset during lockdown doesn’t get used, right? And therefore, the productive capacity of that asset is kind of frozen. And then once things get back to normal — whatever that normal looks like — it then becomes productive again. What you said about some of the intangible assets is they degrade much faster in the absence of being used, right? And again, it was something that I thought was quite interesting because I think there’s been this assumption that everything intangible is benefiting and everything tangible… You know, you wouldn’t want to be an airline. And it was just a more nuanced kind of view of tangible versus intangible assets.

Stian: Yeah, you’re right. I mean, there’s this kind of question we were thinking about what’s the economic cost of leaving an asset, a business unused for a while, and we were speculating that maybe for a very physically-intensive business, that cost was lower. So it was easier to kind of mothball a factory and turn it back on, again, than it is to mothball an advertising agency and turn it back on again. But that’s very speculative and I think that’s something that I don’t think anyone knows the answer to that. So, there’s lots of real-time economic puzzles kind of going on right now.

[00:55:51.10] Ben: Okay, and this is the only political question I will ask you, which is, do you think that the pandemic is kind of giving a backdrop, or a unique set of circumstances in which somebody like Joe Biden could introduce a massive set of policy initiatives — a new deal, if you like? Because one of the things that we’ve talked about, every sort of policy initiative we’ve talked about: we’ve talked about some really difficult politics around it. For example, you know, opening up planning restrictions, I’d imagine is a very difficult political thing, changing the tax relief on debt would be a very difficult thing politically to introduce. So, does it give the pretext for more ambitious political maneuvers?

Stian: I think there is definitely the need. You know, there is a platform of policies that would be really great to put in place, whether that’s more investment in r&d, planning reform, making sure that we create opportunities for people to take on these new jobs, investment in education. There’s definitely a need for that. I think the really difficult thing is that in an age of populism, all these things get harder to do. So I talked to you earlier about when we were talking about the competition policy, that really actually what you need is, you know, more bureaucrats, more pen pushers, and to give them more power. Now, that is a pretty hard sell in the age of queueing on and, you know, ramp and populism in most countries. So you have this kind of weird situation, the need for this kind of institutional reform is greatest at a time when the political dynamics push you in the opposite direction. You know, if you want to sort of say, “Let’s spend more money on r&d, because that will lead to good business opportunities and create economic growth and more jobs.” What does it mean, when you say, “Invest more in r&d”? It means you’re going to tax people more, and you’re going to pay that money to kind of liberal elite scientists. That’s the kind of paradox and I think it’s really interesting to see different people trying to negotiate that in different ways.

[00:57:53.25] Ben: And you don’t think that the pandemic gives kind of enough political capital to unlock the paradox? So you think it’s not as simple as that?

Stian: It might be, you’re right. You’re totally right. Maybe the pandemic will give the opportunity to do this. And maybe it’s the kind of thing where even if you can’t do the big push, you can get some of the way there and that will still make a difference. It’s definitely tricky, because the politics and the policy push in opposite directions.

[00:58:23.04] Ben: Would you mind sharing with us one of your favorite books?

Stian: A really interesting book I read recently, is a book called “The Hungry Empire” by Lizzie Collingham. And what’s fascinating about it is it’s basically a book about the history of the British Empire seen through the history of food. And what’s so interesting about this, it obviously speaks to a lot of issues around global history, around race, around the relationship between Britain and the rest of the world, all of which is super topical at the moment. But it does it through a prism that I think will be really interesting to anyone who’s interested in technology, in kind of economics, in kind of the business of how the world works. It’s a long way from technology, but in some ways, it’s a book that’s very much about technology and a lot of issues in the world today. So, it gets a strong recommendation from me.

[00:59:12.19] Ben: Okay, I’m gonna read that, and, for the listeners, we’ll share the links to all of these on our website. So the next one, a favorite recent article.

Stian: For me, I think something I would absolutely recommend here is the work of Enrico Moretti on cities. We talked a bit about it earlier, but he wrote a great book called “The New Geography of Jobs” and a few articles based on that where what he looked at was the way that we live in a world where great cities, dynamic cities are increasingly economically important. But one of the problems that we have is that the ability to live there, to afford to pay the rent there or move there is unequally distributed because we make it harder and harder to build in these cities. And he effectively made the case that it is totally kind of countercultural range where we like to talk about somewheres and anywheres but he talked about the fact that actually what lies at the heart of our problem is the fact we’ve made it harder to move. And this is not something that people actually want. There’s not something that makes people happy. So to me, it’s a very important and topical article right now.

[01:00:15.02] Ben: And then, the next one is a favorite thinker, somebody whose essays and articles you regularly turn to.

Stian: This may be — I don’t know if all of the people you have on say this, but I’m addicted to the blogger Scott Alexander, who used to write Slate Star Codex. He’s now gone on to Substack and the new version is called Astral Codex Ten. You may know, he’s a US-based psychiatrist, he’s kind of very involved in the rationalist community. He writes about technology, economics, psychology, about kind of almost anything. He has an absolutely incredible writing style. Everything he writes is an absolute breeze. But he does it with a kind of an incredibly good nature. So a strong recommendation from me.

[01:01:04.17] Ben: This is exactly why we ask these questions because I confess to not knowing Scott Alexander.

Stian: It’s amazing.

[01:01:11.03] Ben: Okay, the next one: a productivity hack, something that enables you to operate at scale in the intangible economy.

Stian: This is a very weak productivity hack because I’m very bad at it, but I do try and do 10 minutes of mindfulness meditation at the beginning of every day, and I’m probably the worst meditator in the world but either because of some kind of placebo effect or because it’s useful, it does make me feel a little bit more on top of things.

[01:01:39.28] Ben: Okay, and then the last question is a favorite brand.

Stian: My surprise favorite brand I think it would have to be Bovril. I rely on Bovril for my protein needs. It keeps me going in home working, kind of always have a mark of it on the go. It’s a remarkably nutritious food. And it’s got a retro appeal in the sense of it’s something that was very big 100 years ago, but has kind of come back into popularity in an age of high protein, low carb eating.

[01:02:09.29] Ben: Yeah. And I think it’s something that’s quite polarizing. So it’s good that you’ve taken a slightly controversial position there. That’s good.

Stian: I’d like to think so.

Ben: I guess many people that listen to this will not know what Bovril is. So that’s gonna be interesting to see and googling.

Stian: Yeah. A very affordable, a very accessible product as well.

Ben: Great. Stian, this has been an absolute pleasure. Thank you so much for coming on the podcast and sharing your insights around this structural shift from the tangible to the intangible economy.

Stian: Thanks so much, Ben. It’s been a real pleasure talking to you about it.

A Long View of Banking Industry Disruption (#36)

Structural Shifts with Marc RUBINSTEIN, former hedge fund partner and author of the Net Interest newsletter.

We sit down with Marc Rubinstein, a former analyst and hedge fund manager who currently authors Net Interest — a weekly insight and analysis newsletter on the world of finance. Each note of his newsletter explores a theme currently trending in the sector, whether it’s FinTech or economics, or investment cycles — and today, you are going to hear about a little bit of everything. Marc and Ben Robinson discuss the history of equity research and where it’s at now, whether current regulation is tilted too far against banks, the twofold challenge facing challenger banks, the past and future of embedded banking, the four key differences between investing in private companies versus public, the potential financial services game-changers that could happen this year that people are not talking enough about, and more. 

Full transcript
Structural Shifts with Marc Rubinstein

There’s a lot of overlap between what a very, very good equity analyst does and what an investigative reporter does.

[00:01:26.21] Ben Robinson: So, Marc, thank you so much for agreeing to come on the Structural Shifts podcast. We’re a really, really big fan of Net Interest and so, we feel very, very privileged to have you on the show. If you don’t mind, can we start by you just briefly introducing yourself and giving us a short summary of your career so far, just because I think that will be relevant. I think we can use parts of your career to frame some of this discussion.

Marc Rubinstein: Sure. Well, no, thanks, Ben. It’s great to be on. I’ve been in the realm of financial services for 25 years. I started as an equity research analyst, analyzing banks — I spent 12 years doing that — I spent 10 years investing in banks as a partner of a hedge fund exclusively focused on financial services, stocks globally, publicly-traded, long and short. And then since 2016, I’ve looked at financial services out of sheer interest. It’s something that it’s difficult to shake off. And so that’s basically it in a nutshell.

[00:02:22.07] Ben: Good. Okay, so we’re gonna pick up on different aspects of that. But I wanted to start with the equity research part because one of the newsletters I’ve most enjoyed — I mean, they’re all brilliant, but one of the ones I’ve most enjoyed just because it had personal resonance for me because I was once an equity researcher — was the one where you talked about the history of equity research. If you don’t mind, maybe you can just talk a bit about how sell-side equity research works, because it’s kind of a strange model where, you know, fund managers have access a lot of times to internal research, but yet they source it from a third party; that third party doesn’t charge directly for that research. So it’s kind of a strange model. So if you don’t mind just talking about sell-side equity research, and also how it’s changed, right? Because I think, you know, if I were to put it crudely, it’s gone from a really well-paid, really highly-solicited job to something which is not that anymore, right?

Marc: So, I started out as an equity research analyst in the mid-’90s. And I was not particularly familiar with it as a professional opportunity. It wasn’t something that I, at college, realized that it’s something that I wanted to do. I wanted to go into finance and I participated in a graduate training scheme at a bank — Barclays Bank — it was an investment banking subsidiary of Barclays at the time; and went through various placements across the bank, not dissimilar to the way graduate training programs work today. I do need to say though, any listeners that have watched the series industry, it was nothing like that. But I ended up in equity research and spent, as I said earlier, 12 years there. Now, the way equity research was conducted then was very, very different from the way it was conducted prior to that, and the way it’s conducted today. Equity research emerged in the 1960s, 1970s as an add-on to the core brokerage business that brokers offered their clients. At the time, commissions were very, very heavily regulated and the only way to compete was through ancillary services. And so, brokers offered equity research as one of those ancillary services. They gave it away for free. It was a marketing device in order to attract brokerage business. And that was the case when I entered as well. At around the time — so, we’re going into the ’90s, into the late ’90s and early 2000s — another side of the investment banking business was booming, and that was M&A — an equity underwriting. It’s very topical now to go back 20 years and look at the tech boom of ’99–2000s, given the conditions we’re currently seeing today. But the way it worked back then is that companies would want to IPO and they would choose their investment banks, not dissimilar today. And one of the features that they would look for in selecting their investment bank was the quality of the research that that investment bank produced. And so, rather than exclusively being an ancillary business to the trading business — which was the case, historically — increasingly research became an ancillary business to banking, as well. And as a result of that, equity research attracted a new revenue stream and was, therefore, able to grow. And in the late 1990s, this business of equity research grew, costs increased, a superstar culture emerged.

The markets are not efficient, and Signal and Zoom are great recent examples of that. And to the extent that they’re not efficient, research does have value and those inefficiencies typically emerge the lower down the market cap curve one goes.

Marc: The piece that you referenced, I talked in there about a telco analyst who worked at Smith Barney in New York, called Grubman, and he wrote on telco stocks like AT&T, and he was coerced by his boss, Sandy Weill, who was the Chief Executive at Citigroup, to rethink his view — it’s kind of a euphemism for upgraded to a buy — on one of the stocks under his coverage. The 2000s came along, Eliot Spitzer, who was the Attorney General in New York, took a view that actually there was a massive conflict of interest at play here and he tried to dismantle that construct within equity research. The problem is that the cost base was still there and the cost base didn’t have now a revenue stream to attach to. And so, you had like an orphan kind of wandering around looking for kind of a foster family; this cost base was looking for a new revenue stream. For a short period, it stumbled upon proprietary trading. So, the period between 2001 probably, 2006, 2007, investment banks built very large prop trading businesses, internally, and equity research was a feeder mechanism for some of the ideas that they would put on. And then, the financial crisis happened and that business disappeared as well. Ultimately, that was also dismantled by regulators through Volcker amendment to the Dodd-Frank Act of 2010.

Marc: So, throughout this entire history, you’ve had this kind of valuable resource — inherently, experts looking at companies and issuing investment recommendations through the process of research on those companies. Yet, in and of itself, it was a business that found it very difficult to reflect a model that was able to pay it sufficiently. Which brings us to today and you’ve had another bout of regulation — this was in Europe about three years ago — in 2017, you had MiFID II, which required an unbundling going all the way back to the ’60s, where this process started, where research was ancillary to trading, regulators in Europe came along and said, “Actually, there’s a conflict inherent in this as well.” Certainly in the degree to which it paid for by institutions, and yet again, the business has gone through a kind of an identity crisis. And that’s really where we are today.

[00:08:35.08] Ben: If you like, it’s been sort of hammered by three waves of regulation, right? So, first, Eliot Spitzer, then Volcker, now MiFID II. One of the things that’s changed is you said, I think in your newsletter, you talked about how much Grubman made, right? I think he made like $50 million or something in the space of a few years, which would be unheard of now. So, you know, payback has gone down. But the other thing that’s notable is the amount or the volume of equity research, which has dramatically changed. I mean, you talked about go-to Credit Suisse, an investor meeting, they were like, you know, hundreds of analysts there. I remember, you know, going to SAP investor meetings, there would be 100 plus analysts in the room. And so, clearly, we went from a situation where there was oversupply — do you think we’ve tipped to the opposite situation where there’s a lot of undersupply, particularly of smaller cap stocks?

Marc: For sure there is an idea that there’s an undersupply research out there, that a lot of it is being certainly a shakeout within the industry. Now, it was arguably overpaid, to begin with — and certainly Grubman, did he merit the millions of dollars that he accrued? Probably not, almost certainly not. Possibly not from a compensation perspective, but from a resource allocation perspective to the industry, we may have under shored on the other side. And it’s not dissimilar. Maybe the analogy here is the media, is the press and actually there’s a lot of overlap — and I draw this out in that piece — between what a very, very good equity analyst does and what an investigative reporter does. And there’s a public service here, there’s a public good here. You know, certainly what the research analysts were doing — so Wirecard, very well-known fraud. Interestingly, the credit, rightly so, for uncovering that fraud has gone to a journalist, Dan McCrum from the Financial Times. But there are other cases, and certainly, there were a couple of analysts. Some of them didn’t cover themselves in glory, but there were a couple of analysts who also got that right. And there’s kind of a public service to looking independently, without being influenced by the companies themselves and the management of those companies, nor by other constituencies, for putting out independent research on companies, for doing their job.

[00:10:49.16] Ben: It’s interesting that you call that public good, because it suffers from the same shortcomings of a public good, in the sense that it’s difficult to exclude access to that research once it’s in the public domain. And it doesn’t stop you from consuming. In many ways, it does have the properties of a public good, which means it suffers from the free-rider problem and in general, sort of under-provision.

Marc: Absolutely right. And in addition, it’s difficult before the fact to know if it’s any good or not. Clearly, the analyst report that said that Wirecard was a fraud, after the fact we know was very, very valuable research. The report, which would have arrived on the same day, on the client’s desk which said, you know, Wildcard is a great company and it’s got huge upside — again, after the fact we realized it’s got negative value. But at the time, the decision rests on the recipient to discern between those two. And that’s not easy. And it’s not easy as well, to know ultimately, where the value is, in this. There’s a lot of noise out there.

[00:11:53.12] Ben: I want to come back to Wirecard in the context of, you know, bank regulation, and whether it’s a level playing field. But just on this idea of, you know, perhaps under-provision of research. Do you think that creates arbitrage opportunities? So, for example, do you think it’s now easier to create alpha investing in small-cap stocks? Because there’s a high return on doing that research yourself, whereas before, that was not the case.

Marc: I think, yes. So actually, just recently, there’s two companies called Signal — Elon Musk tweeted quite recently that one should be buying Signal, he was a big proponent of Signal; readers picked up the wrong Signal. Actually, early on in the pandemic, the same thing happened with Zoom, there were two Zoom companies. The point here is, you know, the markets are not efficient, and Signal and Zoom are great recent examples of that. And to the extent that they’re not efficient, research does have value and those inefficiencies typically emerge the lower down the market cap curve one goes.

It’s incredibly difficult for any investor to change their mind.

[00:12:57.18] Ben: There’s a quite high proportion, certainly relative to, in the past, small caps that no longer have any sell-side equity coverage, right?

Marc: Yeah, that is right. And it’s not great, either. Now, the flip side is that some of it has shifted over to the buy-side themselves. That was a trend that was already in place from the institutional perspective. But what we’re now seeing because of the ability to share ideas more freely, through the internet and platforms like Twitter, and also dedicated platforms, like Sub-Zero, and the ability for individual investors or smaller, emerging institutional investors to get access to infrastructure — maybe they can’t afford Bloomberg at $24,000 a year, but they can afford other apps and other facilities — more research has been generated. And you know, actually, this brings us back to the model, it is quite interesting. So, the old research model was ‘we’ll give it away to everyone for free and we’ll attract some revenue dollars through trading commissions’. More recently, post-MiFID II, that translated into, ‘we will just service, say, the top 100 customers who are prepared to pay for it’. There’s a trade-off now between generating thousands of dollars from 100 customers or via the internet, particularly where the market might be individual investors who… And whether this is cyclical or secular or not, at this stage, I don’t know. But certainly, retail engagement in the market is increasing. They’re not going to pay thousands of dollars for institutional research but the quality of what’s available on the internet is very, very high, and maybe they’ll pay $20, $30 a month, and tens or hundreds of thousands of those… You know, there’s a good newsletter writer called — there’s a number of good newsletter writers out there, but a number of them, they offer, in my view, institutional-grade research, particularly in the technology space, and they charge $10, $20 a month for it. But they have hundreds of thousands. And I actually would be interested to see their p&l against a traditional equity sell-side research business, given lower costs and broader reach.

[00:15:21.13] Ben: I was actually gonna highlight this as a second arbitrage opportunity, which is one might be there’s more potential to make money from small caps than there was in the past, but the other one is, I think — you know, I don’t want to suggest that this is the model for Net Interest, but a bit where you can almost crowdsource almost as good or maybe even better, in some cases, research from the internet, which is, you know, the sort of the bottom up, you know, kind of organic production of research to fill the gap. Because, I agree, and you see the same thing also in investigative journalism and other content areas, which is, you know, your choices are either to pay a subscription for the FT or to subscribe to newsletters, right? Because these things are sort of mushrooming. And, you know, I mean, that’s another phenomenon in the way that you’re embodying, which is you publish your newsletter on Substack, and in some ways, you’re kind of contributing to this gap that’s been left as equity research has become or is provided to a lesser extent than it was in the past.

Marc: Yeah, I think that’s right. And, you know, it comes from just this, I don’t like the word ‘democratization’ that people use, but it certainly plays into our theme. You know, clearly, the advantage that… And I remember when I was an equity research analyst, it was at BZW, which you mentioned, which was a subsidiary of Barclays. And I was looking at Swedish banks in 1996. They kind of emerged from a crisis, they’ve been re-privatized, they’ve been re-IPOed, and there was kind of a recovery theme in a way. And I stumbled upon — it was kind of the early days of the internet, we had access to the internet, but what was on there was difficult to find. There was no search, it’s kind of the days before Google. And I kind of stumbled across a document written from the Central Bank of Sweden, the Rik Bank, which provided very interesting data on kind of banking volumes. It was faxed to me by somebody in Sweden. I literally, I was working at home, it was a Saturday, I was working at home. I couldn’t read it because it was Swedish. Google translate didn’t exist. I ran around to my local bookstore, bought a Swedish-English dictionary, translated this thing, put out a piece of research on this finding that actually loan growth in Sweden, based on this data was greater than anybody anticipated. And it was it. I stumbled across something purely informational. And clearly, the friction to getting that information now is just non-existent. Everybody has all of the information all of the time hence, there’s no arms race in place to get new sources of information. Kind of alternative, dangerous nets. But you know, that’s all done. What’s happening now is the same thing is happening to analysis. Now, people, again, through the ability to meet in the market square via whether it’s Twitter or any other kind of platform, there might be a great analyst who’s based in… I mean, I know there’s a great equity research analyst, who I read called Scuttleblurb, he is based in Portland, Oregon, far from Wall Street, and there are people just all over the world in India, in small towns in England, all over the world, all analyze it. So, they’ve got the base level of information and the degree of analysis they’re doing now is institutional grade, and it’s accessible.

[00:18:50.08] Ben: It was just before the financial crisis that you switched from being a sell-side analyst to working for a hedge fund, if I’m right. Presumably, that was a great time to have the ability to go short on banks. And I just wondered, you know, when you were living through it, how evident was it in advance of the crisis that it was coming. Could you presage that, you know, we were gonna have this big crash, or was it really as sort of sudden and unexpected to you as it was for the people that weren’t as closely following that?

Marc: It’s a really interesting question. It would be easy for me to say yes. I would say the way I would finesse it is yes, we saw elements of it. But it’s important to remember, somebody once said, ‘causes run in packs’. There’s never a single cause. I think it’s lazy analysis. And I see it and often politically motivated for people to say the financial crisis was caused by x — and x typically correlates with one’s political inclination. X could be, you know, greedy bankers, or x could be people borrowing too much or x could be sloppy regulation or x could be too much leverage at the banks or whatever it might be. There’s a whole range of reasons. And ultimately, it was the confluence of lots of those things that happened to create the crisis. Although we — me and my colleagues — identified some strands of it to have predicted the degree to which it all coalesced, you know, in kind of, you know, let’s say, October 2008, I think that was difficult to predict. But that’s never… There’s complex reflexivity to it. It happened, I remember watching, I vividly remember watching the debate in Washington around passing the torpid. It was controversial. And I remember specifically it went down. But because it went down, the market went down, and so, reflexivity because the market went down, then when it came back for another reading because the market had gone down, incentives have shifted. Predicting kind of reflexivity in advance is difficult. Having said that, the worst things we saw. So back in, you know, we were short. I mean, back in 2006, we were short some subprime companies. I went back through my — I’m not a Facebook user anymore but when I canceled Facebook, I downloaded all of my posts, and there was one post in July of 2007, where I cautioned about an impending financial crisis. We were short, Fannie and Freddie, and all the rest of it. Just an observation about investing broadly, and, going into more detail on the crisis, but investing broadly, it’s incredibly difficult for any investor to change their mind. And I think there were a number who were negative; a lot stayed negative beyond March 2009. But the fascinating thing to me is those that there were kind of negative, and then they switch positive. And just taking a step back away from financial services, but generally, investors’ ability — the very, very best investors, their ability to adapt to changing conditions like that, continually, it’s very, very difficult. And I think, you know, history is littered with investors who have got two or three calls right, but to be able to retain an element of persistence, through those changing dynamics, it’s very, very difficult.

[00:22:38.06] Ben: Yeah, I think it could be a rabbit hole but I would argue almost that potentially the greatest of all investors, Warren Buffett, has not been able to adapt this strategy to some extent to the digital age, because he’s still buying sort of, you know, asset-heavy companies with a lot of supply-side, economies of scale, and so on. So I think it even happens to the best when there’s a paradigm shift.

Some of the consternation of bankers right now is that tech companies are getting away with stuff that they just wouldn’t be able to get away with.

Marc: True. And to our conversation earlier about small cap, large cap, I mean, certainly, his performance hasn’t been as good in the recent past, compared to prior periods in his history. And he’s got longevity, very difficult to compare him to any other investor, because I’m not sure there’s any track record out there that’s as long as his. But he made the point recently — he actually made it ’99 — he made the point, there’s a great quote in ’99, where he was talking about if he had a million dollars to invest, you know, he’d crush the market because of his ability to access small cap, but it could be a reflection on your point as well.

[00:23:36.10] Ben: It might be both because you actually wrote another great newsletter about the curse of managing too much money — it becomes harder and harder to achieve a return on much bigger sums.

Marc: Yeah, exactly. That’s another curse — I call it the Zuckerman’s curse. Gregory Zuckerman, who’s a great writer, has written a number of books about — he’s written two, in particular — hedge fund managers. And they’ve been published. Clearly, he’s been attracted to them because of their profile, and their profile is a function of their performance. And therefore, there’s a direct line between them showing good performance and him writing a book. Actually, there’s more nuance to that. It’s not them having good performance, is them having good performance and being big enough for him to notice. One of my favorite investors out there is Hayden Capital. A guy called Fred Liu, based in New York, was up 222% last year, but he’s small, nobody knows of him. And the curse is that over a certain size it’s difficult to sustain that performance on an ongoing basis. Actually, it’s worse than that because typically, after a good year, the money then comes in. And investing isn’t mean reverting but certainly, there’s an element of… It’s only as difficult to sustain very, very good performance across multiple time periods.

[00:25:05.17] Ben: Do you know what Zuckerman’s next book is about? Just so we know in advance.

Marc: That’s a good one. I feel bad because I’ve read them all. I mean, they’re great books. It’s the writing on the wall.

[00:25:20.11] Ben: I’m gonna ask you, a bit like the financial crisis question I’m gonna ask another question, which is gonna be, I think, impossible for you to answer in retrospect, without any sort of cognitive biases, and so on. But you wrote another newsletter, which I really, really liked, which was called “The End of Banking”. How obvious was it now, in retrospect, that post-financial crisis, financial services was just not going to be the same again, right? Because their profitability is not the same. It doesn’t represent anywhere near the same size of, you know, as the composition of the index in which it sits. And so, it just seems like the financial crisis in a way was like, you know, the peak. And you know, maybe as you said, this may be cyclical, it may be that in the future, it becomes as big as it was and as profitable as it was. But certainly, it seems much more structural, for the reasons I think we can talk about now. But when did it become evident to you that the sector becomes structurally less sexy in a way?

Marc: I’ll be honest with you, it took me a long time. My mental model — I mentioned Swedish banks earlier — my mental model was that banks — and this has been true historically, and in my working memory through the Swedish banks, they went through a period of crisis, they’d be recapitalized, they’d come back to the market. Typically, they’d be a lot more conservative and so, underwriting would be tighter. They would then generate huge amounts of capital and then recover. There was a singularity inherent in the industry. They would crash, they’d be recapitalized and then recover. And that was my mental model. I remember at the time being told — we talked about the tech boom from 20 years ago, ’99–2000. We’ve talked about that already. I remember in 2010, 2011, a strategist who’d experienced the tech boom — I mean, I experienced a tech boom as well but I wasn’t directly involved in it — I remember a strategist at a bank saying to me, “The market has to cycle through a generation of investors to forget what happened, to forget the scars of the previous crisis for any kind of return to normality.” And I didn’t believe it. I said, No. You know, so I was sanguine about the extent to which the market recovered. I underestimated a number of things. I underestimated one, how low-interest rates would stay for how long. Two just the… You know, and I often think, actually, for the investment banks, worse than 2000 for them, and their long-term from a strategic perspective, worse than the experience they suffered in 2007–2008m how well they performed in 2009, hurt them longer term from a strategic perspective more, because the backlash was then huge. It was kind of the political disgust, they made so much money in 2009, and that increased the scope of regulation, which muted them for many, many years after that. So, I underestimated regulation, and then we can talk about disruption. It’s difficult. I’m not sure I underestimated that but that was clearly another factor.

[00:28:45.28] Ben: Maybe let’s unpack those things because I think interest rates, I think, you know, we won’t know for a long time if this is a structural or a cyclical factor. But it seems like the re-regulation of the banking is a much more structural thing. As is this one other thing which I don’t know if it’s permanent or not, but you talk about it as governments inserting themselves into the cap table of banks. This idea that they become almost like an arm of government in some ways, right? Because, you know, particularly during the COVID crisis, you know, that we used the direct funding and also, you know, they just don’t have the same control they used to have over capital allocation. So, again, I don’t know if that’s a structural or a temporary phenomenon, but certainly, one of the things that’s been so weighing on bank valuations. But the re-regulation part, I think is probably much more structural. And the question I wanted to ask you about that is, you know, I think we could probably talk about regulation in different buckets. So part was about making banks safer, part was about some introducing more transparency, but the part that I think is now looking a bit kind of controversial in a way is all the regulation is aimed at introducing more competition to banks. You know, so, a PSET, for example, almost seems like that was mistimed because I think what the regulators perhaps hadn’t appreciated because the lag, was that there’s just been so much new competition from non-banking players, right? So I wonder almost in hindsight whether regulators would still introduce some of the regulation they’ve done to introduce more competition into banking because it seems like almost now, not necessary. And potentially unfair. You know in your last newsletter, you talked about that letter from Ana Botín to the FT. And, you know, some of that I thought was quite justified, some of that criticism of recent regulation and the absence of a level playing field. So, it’s a long question, but do you think almost like some of the regulation are tilted or was too far against the banks?

Marc: Yeah, I think it is. I think it’s a truism that regulators typically fight the last battle. And not just regulators. I think it’s a response to, you know, I mentioned earlier, you know, my mental model for the period after the financial crisis was dictated by the last battle, which was the Swedish banking crisis of mid-1990s. So for regulators is the same. They are very, very focused on fighting that battle. And equally, I think it was a truism that whatever the cause of the next financial crisis, it was never going to be the same ingredients to the one in 2007, 2008 to 2009. By the same token, we’re not talking about a financial crisis, here. We’re talking about as you put it out, a playing field. But certainly, the combination of low-interest rates, and a playing field that’s not level was very, very negative for the banks. And there was a degree to which maybe regulators understood that, maybe they didn’t. If they understood it, certainly there was no political motivation to circumvent it, because there was this culture about wanting to punish the banks. But you’re right, you know, this point about they insert themselves, the role of any chief executive of any company, pretty much exclusively is capital allocation. And from an investor’s perspective looking at banks, if they don’t have the capability to manage their own capital allocation because regulators can come in… I listened to a debate recently, between some sell-side analysts, and market participants, and representatives from the Bank of England. And the view of the Bank of England — and I don’t think they’re unique here. I think it’s a view of many regulators that prevented their banks from paying out capital, in March of 2020 was only temporary. But you’ve spoken about scars and the degree to which scars can be left, and from now on, any investor that is investing in a bank understands that at any point, particularly given the capital framework that was put in place to protect banks from unknown. I mean, clearly, a pandemic was an unknown, but that’s what capital is there for. It is there to protect against the unknown. It is not there to protect unknowns, except for a pandemic, or unknowns except… All unknowns, whatever they might be. And so, even with that in place, for them to come in and say, “Actually, we’re going to take charge here of capital allocation” that sends out a very negative signal.

One could have made an argument 10 years ago that banks have got more data, more valuable data. I guess Amazon has got shopping data, Google has got search data, Facebook has got social data, and some overlap between them. Banks have got financial data, and what data is more valuable than financial data? And yet, they’ve been restricted, rightly, from their ability to monetize that.

[00:33:26.20] Ben: Plus, they’d already introduced regulations to ensure that there were more buffers, that you had to protect against losses earlier in the cycle. And so, to some extent, it was almost like a double hit on their ability to allocate capital, right?

Marc: Exactly. Exactly. So we’ll see the extent to which… There’s a view out there that we haven’t seen the worst, that maybe over 2021, when things begin to recover, small businesses will see unemployment. And there’s a view out there. The other thing is, again, a competitive point of reflexivity. Back in March, the regulators didn’t anticipate — to be somewhat fair to them — the degree to which monetary policy would come in, and fiscal policy would come in, but once they had come in, there was a degree of caution that was maybe unwarranted. And again, they might argue, who cares. We’re hurting some bank investors here, but who cares? But ultimately, from the perspective of a bank investor, there’s some long-term issues here. And actually the ultimate bank stop, and it worked in 2009 is that investors, the private sector bails out the banks, the private sector puts more money in because it knows that actually, at this point in time, we can draw a line and that future returns for that bank look positive. It would have been difficult actually, for that to have taken place in 2020, given what had gone on before it and given the things we’ve discussed about regulatory intervention. I think it would be very difficult. The banks have raised capital in the private markets, and that would have been very negative.

[00:35:19.18] Ben: Do you think maybe things might change from here? This is where I wanted to bring in Wirecard because the banks are so heavily regulated now and so closely scrutinized that a lot of the scandals and fraud and impropriety is happening outside of the banking sector in tech companies or shadow banking or areas of shadow banking. Do you think at some point that the regulator is now going to change the direction of, or at least move its focus to all of those companies that are doing banking, but aren’t banks?

Marc: Whether it’s going to happen or not, I don’t know. And actually shadow banking, I mean, I said earlier, I’m going to contradict myself now talking about fighting the last battle. But some of the ingredients of that last battle were in the non-banking sector, were in the shadow bank. Subprime companies weren’t regulated and in the US, different regulatory requirements for thrifts, such as Washington Mutual, who played a game of regulatory arbitrage, choosing to be regulated by one regulator rather than a broad financial services regulator. The investment banks weren’t regulated as banks. Lehman Brothers was regulated separately from… And as a result of the crisis, Goldman and Morgan Stanley became bank holding companies and became regulated as a bank. So shadow banks, this kind of regulatory arbitrage was going on anyway. But you’re right, is going on now. And these payments companies, to all intents and purposes, what a payments company does is not dissimilar to what a bank does. And we saw that with Wildcard, actually. And hence, you know, you mentioned Ana Botín’s FT piece. Some of the consternation of bankers right now is that tech companies are getting away with stuff that they just wouldn’t be able to get away with.

Nobody wants a mortgage, they want a home.

[00:37:23.05] Ben: in every sense, right? In the sense of the same scrutiny, but also, you know, they don’t even have the same level of capital, for example, to do the same business. It’s not just more scrutiny, it’s not just the supervisory level blame for this; it’s actually an operating level blame for this as well.

Marc: Yeah, that’s right. That’s right. That’s right. And the issue here is not about financial stability, per se. It’s about the specific issue that Santander has, and Unicredit has mentioned it, and Jamie Dimon at JP Morgan has hinted at it as well, which is about data. And one could have made an argument 10 years ago that banks have got more data, more valuable data. I guess Amazon has got shopping data, Google has got search data, Facebook has got social data, and some overlap between them. Banks have got financial data, and what data is more valuable than financial data? And yet, they’ve been restricted, rightly, from their ability to monetize that. And I think the issue now is we’re seeing this convergence of data and this degree of consternation about the degree to which the playing field is not leveled.

[00:38:43.00] Ben: And the PSDs bit as well. It’s not just that they have to share data if the customer says that’s okay, is that they’re sharing data with companies that already have, in some ways, an advantage because they’re already more embedded in our lives, right? So, you’ve made the point many times in your newsletters, if you control distribution in the digital age, you know, you’re in a much better position to create network effects and to reduce the cost of customer acquisition and so on, than if you’re a balance sheet provider. And so it’s almost like, it’s a double whammy of sort of thinking you need to introduce more competition and forcing banks to share a really valuable asset with those people that are already better positioned to capitalize on data and distribution anyway.

that combination of Goldman Sachs’ back office, banking as a service infrastructure, with Apple’s consumer-facing distribution and brand value, could be a bigger competitor to JP Morgan than Chime or any kind of startup, FinTech, challenger bank.

Marc: Yeah, that’s right. And banks, certainly some of the starter bank, some of the challenger banks are trying to exploit that idea about distribution. But they don’t have the distribution right now, and that’s obviously an issue for them.

[00:39:41.03] Ben: I’m really pleased you mentioned challenger banks because one of the things I wanted to ask you is, you know how people are talking about this COVID economy is k shaped, right? And the idea that everything digital is booming and everything analog is suffering or faring really badly. And to some extent, you’ve seen that in the world of financial services and FinTech. You know, you talked about Square — which we’ll come back to in a second — as a company that’s really shot up and really found more customers and been able to benefit from the crisis. But challenger banks notably haven’t. What do you put that down to?

Marc: Well, some of them have, actually. So you’re right. I did write. Some of them have. Chime in the US has done very well through this period. But others haven’t. I think the biggest challenge, singularly, that these challenger banks face is their ability to acquire customers cheaply — and the right customers. There’s some question mark as to the quality of those customers, let’s say. And actually, to be fair to the company, the company has provided disclosure in the past as to what the unit economics are, on a customer that pays its salary account into its Monzo account, as distinct from a regular customer that maybe saw their friend has got Monzo, downloaded the app, and maybe actually isn’t even an active user. I guess a problem — maybe is why it’s different from other digital industries — is that there’s a life cycle perspective, whereby the customer becomes more profitable when he’s a little bit older. And yet, digital adoption tends to take place when they’re younger. So the challenge for the challenger banks is twofold. One is, as I’ve mentioned, it’s the ability to acquire customers cheaply. But the second, linked to the ability to capture revenue from them, is can they turn a millennial into — can they extract profitability, which is equivalent to what a typical bank customer profitability might be? Or do they have to wait until that customer gets a bit older, and kind of hits that profitability level, which would be typical in a lifecycle process.

[00:42:11.04] Ben: Let’s talk about customer acquisition cost, because I agree with you, the unit economics are really hard to manage, if you’ve paid loads and loads of money to acquire the customer. It costs a lot to acquire the customer. And then, the lifetime value is somewhat held up — in my view, at least — which is, you know, the ability to sort of upsell and cross-sell customers is hard in banking because we don’t actually spend very much time on the banking apps. And so, we still have this thesis that it’s gonna become much easier to embed banking and other channels than it is to build a really, really profitable banking business going forward. Because, you know, if you consider social channels, for example, or e-commerce channels, we spend a lot of time on those channels. And if you can introduce banking at the point of sale, or if you can introduce banking in a social way, then, you know, first of all, we have a low or even negative cost of customer acquisition, but then you also have the ability to generate very high lifetime value, because you have the customer spending a lot of time on the app, and therefore, you have a lot of surface area in which you drop-sell and cross-sell. Where do you stand on that whole embedded banking discussion?

Marc: Yeah, I think that’s right. I think that is right. I think one of the reasons why payment has been the most successfully penetrated area within financial services by startups and digital propositions is exactly this point that the frequency of payments is infinitely higher than the frequency of mortgage application. So that is right. And I’ve thought about this in the context of insurance, as well as banking, but in both cases, nobody wants a mortgage — there’s no tangible benefit, there’s no tangible value in the mortgage itself. Nobody wants a mortgage, they want a home. And secondary to that is the financing of it. And equally, nobody wants a checking account. Ultimately it is a payments mechanism and they want some facility to serve multiple jobs. One is to preserve their payments. One is as a store of liquidity. One is maybe as a conduit into savings — longer-term savings. But the tangible value of the thing itself is low. And, as you say, therefore, the appeal of embedded finance is very, very high. Now there are issues around regulation, and from a business perspective, the ability to scale, but from a consumer perspective, it makes perfect sense.

[00:44:51.15] Ben: And do you think this is, therefore, the biggest threat to banks over the long term which is, you know, it becomes easier to embed finance in channels that have engagement, than trying to create engagement in banking channels, and therefore, as you’ve talked about this sort of split between what we might call distribution financial services and the, I guess we could call it the manufacturing financial services becomes even more pronounced, and therefore, you know, profits go one way and the other becomes more and more of a utility over time.

Marc: It depends. So, one of the features of banking is that each market is distinct. There’s a path dependence because we’re going back hundreds of hundreds of years, banking has evolved very, very differently across different markets. You know, a mortgage in Switzerland is very, very different from a mortgage in the UK, for example. So Russia is an interesting case study. Sberbank, the biggest bank in Russia, has brand value that banks across countries in Europe and in the US would envy. They have phenomenal brand value. Sberbank itself has launched a marketplace where… Everything we were discussing earlier, it knows it’s got the data and it’s got the brand value. So it’s got the data and the brand value. So, it’s offering a marketplace to its customers via its app. So that’s one approach. Everything we’re nervous about big tech companies in the US and countries in Western Europe, everything we’re nervous about them achieving, Sberbank itself might be achieving that and is in competition to the tech companies in Russia because it’s forging its own path there. So that’s one market. It’s a bit different. But you’d be right elsewhere. You know, I often think about that. I’ve written this in one of the newsletters that Goldman Sachs plus Apple is probably the biggest competitor — that combination of Goldman Sachs’ back office, banking as a service infrastructure, with Apple’s consumer-facing distribution and brand value, that combination of both of those could be a bigger competitor to JPMorgan than Chime or any kind of startup, FinTech, challenger bank.

[00:47:18.01] Ben: Listening to you, it seems there’s a tendency to conflate retail banking with banking in general, because, you know, trust is so important. And as you say, once we move into wealth management, then you just don’t see the same level of tech or FinTech disruption. Once you move into wholesale banking, you know, you don’t see the same level of tech and FinTech disruption. So I wonder, you know, are we guilty sometimes for talking about retail banking, as if it’s whole banking? And then the second point would be because you’re such a student of financial services, I wonder, do we also fall into the trap of thinking that these things which look so disruptive, have actually played out many times before in different guises? Because I was reading your newsletter about Visa before and it’s almost in a way that, was Visa not embedded banking in a way? So I wonder, are we also guilty of thinking these are bigger trends than they really are and they happen quite regularly over the course of history, in cycles?

Marc: Yeah, it’s such a good point. I think 100% I agree with that. And there’s nothing new under the sun. A lot of what we’re seeing now we’ve seen before in various guises. So you’re right, I did a deep dive on Visa, recently. It’s a fascinating story. The founder of Visa, Dee Hock was so far ahead of his time in thinking about payments and the way in which payments simply reflect — just to give some context, we’re talking about the 1960s, where, you know, computers were the size of buildings, and he was thinking about payments. And most of the payments at the time were done on paper that was shuttled between banks. And he foresaw this system whereby payments were — he didn’t use the phrase ones and zeros, but he talked about alphanumeric data — simply alphanumeric data. He has written about all of this. So, Dee Hock, the founder of Visa, is 92 years old today. He founded Visa in the late ’60s, let’s call it 1970. He was CEO until 1984. And he wrote a book in ’99 that was re-issued in 2005. And he questions the need for banks. He says, “If it’s just alphanumeric data, why do we need banks, and the payments?” And he, at the time, knew nothing about crypto, knew nothing about digital currencies. But presently, he talks about a global currency, he talks about payments just taking place directly between consumer and merchant, much of the functionality that Bitcoin potentially offers — or crypto more broadly potentially offers today. And he was talking about this in the ’60s and ‘70s.

Marc: Just to come back to your question, similarly, equally, he allowed JCPenney, which went bankrupt last year, it kind of came out, it went through a bankruptcy process in 2020, has come through with that now. But back in 1979, it was one of the three biggest retail merchants in the United States. It was so big, he said, “Well, let’s introduce embedded finance, let’s bring it straight into the Visa ecosystem”. But even before that, interestingly, it was companies like JCPenney, that actually invented the credit card in the way now that… So now we think about kind of Shopify, and everything that Shopify is doing with Stripe to embed finance at the point of sale in merchants. This was a big merchant’s… I guess, what’s changed is that you don’t have to be big anymore, that because of these providers, because the cost of everything has gone down — the cost of storage, the cost of underwriting, the cost of everything has gone down — it’s become more accessible for smaller companies to offer these things that the big companies have been offering since the 1950s and 1960s. So yes, there’s nothing new under the sun. The same with challenger banks. AG was a challenger bank that merged in the UK with a not dissimilar model to the model of many challenger banks today, 20 plus years ago, 25 years ago. A lot of these models have appeared before and one of the things that I try and do in that interest is look back through history — as you said — as a student of financial services, to learn from them and apply them to the situations we find ourselves in today.

[00:51:54.04] Ben: Having said that, there is nothing new under the sun, I just want to get you on digital currencies, because actually, it does seem like something which is more transformational. If you don’t mind, can you briefly just describe what digital currency is because, you know, one of the things that, you know, when we talk about digital currencies, people get, I suppose, a bit confused about is, you know, if I were to pay you some money now, and I would just transfer it to you, that’s in a way digital money. So what’s the difference between just an electronic transfer of Sterling versus digital Sterling?

Marc: There’s three types of digital money broadly. One is crypto. So, basically, it’s got its own infrastructure and its own coin. So, like Bitcoin. Two is we can talk about stable coins, which have their own infrastructure. So Facebook looks like it will launch any week now, actually, its own stable coin. It’s got its own infrastructure, but it’s stable in the sense that it’s not its own coin, it’s a US dollar or some other currency. And then the third type is a Central Bank Digital Currency, which is, the central bank maintains the infrastructure. It is also an existing currency — call it the US dollar. So these are the three types. And the difference is… So, if we’re talking about your question referred to Central Bank Digital Currency, the difference is, you know, if I give you a 20£ note, it will have a serial number on it. So, when I’m talking about a digital currency when I’m paying you online, it won’t have that serial number on it. So basically, I’m digitizing that 20£ note. I’m digitizing that 20£ note such that if I was to pay you 20£, it would have a serial number attached to it, such that the regulators, the central banks could then audit the trail of that currency the way they do with cash right now through a digital system.

[00:53:56.06] Ben: But isn’t that the most important point for Central Bank Digital Currencies, which is about that ledger? And therefore, it really goes into the question the extent to which you need banks to intermediate. Because if you can have your wallet directly with the central bank, if the central bank can disperse money to you directly, does it to some extent take away that role of banks as creating money supply? Because I suppose, to the earlier question about, you know, if we are going to see an increased split between the distribution of manufacturing financial services, and the central banks kind of rising up to take a bigger share of the manufacturing — or I don’t want to call it manufacturing, but if the balance sheet aspect of financial service because more will just sit directly on their ledger. Does that again squeeze the traditional banking sector?

Dee Hock, the founder of Visa wrote a book in ’99 where he questions the need for banks. He says, “If it’s just alphanumeric data, why do we need banks, and the payments?” And he, at the time, knew nothing about crypto, knew nothing about digital currencies. But presently, he talks about a global currency, he talks about payments just taking place directly between consumer and merchant, much of the functionality that Bitcoin potentially offers — or crypto more broadly potentially offers today. And he was talking about this in the ’60s and ‘70s.

Marc: Yeah, absolutely. And one of the reasons why the central banks are being so cautious in rolling out Central Bank Digital Currencies — everybody’s looking at China — China is trialing Central Bank Digital Currencies right now. They’ve suggested that those trials will continue up until Beijing Winter Olympics in 2022. So, we’re not going to see anything launched until at least then. And that’s in China. And similarly, Europe and various other central banks have said that they’re still studying it. And one of the things they’re studying is exactly that, is that what would differentiate between retail central bank digital currency, and wholesale. And one extreme would be retail, which is the picture you paint, which is that you and I have an account with a central bank, the same way that UBS has an account with the central bank, or Barclays has an account with a central bank. We have an account with a central bank and are therefore able to conduct ourselves without the need for banks.

[00:55:48.18] Ben: Because I can just send you money through my wallet to your wallet, right?

Marc: Exactly. And it’s insured. The way bank deposits are currently insured. All they do at wholesale, and actually, they maintain the role of banks. And again, it goes back to this idea of path dependence. It is quite interesting. Dee Hock, when he thinks about Visa, he’s got this framework for looking at the world. He says, you know, “To understand anything, you have to think about the way it was, you have to think about the way it is, you have to think about the way it might be. And you have to think about the way it ought to be.” And when he was thinking about Visa back in the early ’70s, and say today, actually, he’s made this very clear in his book, that Visa had been created through his kind of organizational principles. It’s not a panacea, and he lists in his book, and I quote him in my recent piece, some of the issues, some of the drawbacks some of the flaws in the Visa model. And to come back to what we were talking about, the point applies here as well, is that there’s a path dependency that, you know, maybe on a blank sheet of paper, we can devise this phenomenal new financial system. And they did that in China. You know, China didn’t have credit cards, they went straight from cash. So they didn’t need credit cards. They went straight from cash to a digital wallet, and you cut out the middleman. That’s very, very difficult when you’ve got vested interests that are cultural, political, data, that when people are used to a certain way of doing things as they are in Europe, in the US, you might be right, from a blank sheet of paper, if we could devise a financial system, we do it like this. But that’s not, to use Dee Hock’s framing, that may be the way it ought to be but we can’t neglect the way it has been and the way it is. And therefore, it probably won’t pan out like that.

[00:57:49.16] Ben: I was going to ask you this question at the end, but I feel I need to sort of preempt it now. Which is, you talked about Libra. And I just wonder, you know, if you look ahead at 2021, what’s the most potentially game-changing thing that’s going to happen in financial services that people aren’t talking enough about? It feels like that might be Libra, because, in a way, they’re going to roughshod over all those vested interests and introduce something that’s going to potentially have the adoption of every Facebook user, which is I don’t know how many billion people and it’s kind of outside a single country jurisdiction and it just seems massive. I’m wondering, you know, are you going to write a newsletter on Libra? Because it just seems such a big phenomenon?

Marc: Yes, I agree. I think it will be a big story for 2021. Riding roughshod. Interestingly, they already watered it down. So initially, they put together a consortium, which included financial service companies, there was a backlash from regulators. And so, they watered it down and the result today is something a little bit different. But I agree with you 100%. I think it’s gonna be a big story of 2021.

[00:58:54.13] Ben: But it’s still a currency that might be used to intermediate peer to peer and other transactions. You know, and even all the vendors that sell through Facebook, right? Within the Facebook network, you might have a currency that sits independently of any fair company, or is that not?

Marc: So again, I mean, anything I would say, the regulators do still have the capability to insert themselves. And we saw that too in Brazil, WhatsApp, which is part of Facebook launched a payments mechanism. And they spent a lot of time preparing it, launched it, presumably at launch they’d had the approval of the central bank because they’d spent a lot of time preparing it, but nevertheless, the central bank once it saw it, changed their minds and shut it down. So, regulators still do have this power, which is, I guess, classic disruption. Bitcoin has been operating at the margin and interestingly it never really became a payment coin. So, Coinbase, which is going to IPO this year, started out as a payments system for Bitcoin. And there’s a book that was released in December, called Kings of Crypto, about the story of Coinbase. And in it, they talk about hiring somebody in order to acquire merchants that will accept Bitcoin. And they did a great job, he got all these merchants, he got multiple billion-dollar revenue companies, lots of merchants, all lined up to accept Bitcoin. But consumers didn’t want to spend their Bitcoin. And so, they pivoted to a broker and Bitcoin became less of a payment mechanism, and more of an asset class, more of a commodity. But clearly, that can change. But as I said, it’s tangential, classic disruption. So they operate margin, and it can become mainstream.

[01:00:58.23] Ben: Yeah, if I understand what you’re saying, Libra, first of all, you know, whatever way in which it’s envisaged that it will be used might change because the use case is different from the one that was a bit like Bitcoin. I want to move on to a different topic now, which is private versus public investing. Because, you know, to get to the latter part of your career, I think one of the things that you’re doing now is you’re doing some angel and private investing. I just wonder if you have any interesting observations about the difference between investing in public markets versus investing in private companies? And I suppose we’ll come back to it as well. But you know, I think it’s relevant because companies seem to be staying private for so much longer than in the past. And it’s almost like being an expert in private investing is a more important skill set than it was historically, we could potentially argue. So I wonder if you’ve got observations around that.

Marc: Yeah. So, interestingly, three months ago, I might have agreed with your point about companies staying private for longer. I think what we’ve seen recently through the rise and the emergence of SPACs…

Ben: You’ve preempted that because I was gonna ask if the SPAC is the vehicle to get companies from private into public markets faster?

Marc: Yeah. I think yes, they are.

Ben: Let’s break this down into three sections, if you don’t mind. So, first of all, maybe everything we’ve got on the data shows it’s changed yet, but why weren’t companies staying private for longer? Because it must have been because it was difficult to realize the value in public markets. And how do SPACs do that? Why would a SPAC or a company taken to market through a SPAC, have a higher valuation than a company that would have gone through an IPO process?

Marc: Yeah. In the short term, maybe that’s an inefficiency in the market. Long term, it’s not clear that the mechanism through which one comes to market has a bearing on one’s long-term valuation. But having said that, there are some structural differences in the process. The key one here being that when, through the IPO process, management is not allowed through SEC guidelines to provide any projections on the future. And coming back to what we were talking about earlier, in terms of equity research, one of the roles, one of the jobs that equity research analysts used to fulfill was to provide equity research at the time of the IPO. Now, it wasn’t always independent, which is one of the issues why it was shut down. But there was a service provided nevertheless. Now, that’s not allowed. So now, what will happen is the company will provide its own filing and the institutional investor will have to peruse that filing, do their own due diligence, do their own work in order to take a view, but they’re given no steer as to what the projections are.

[01:04:08.23] Ben: Do you mind, just because I’m not sure everybody knows what a SPAC is. I mean, I love the phrase that you put in your newsletter, you said, “The SPAC is a bit like the wardrobe, is the portal to Narnia, complete with unicorns on the other side.” So what did you mean by that? If you don’t mind just spending a minute on what it is because it’s such a new phenomenon. Maybe many people don’t know what it is.

Marc: Sure, that’s fine. So a SPAC is a Special Purpose Acquisition Company. And what it is, it’s a pool of money that is raised by a sponsor. Typically, a well-known sponsor will raise several hundred million dollars in cash. And the purpose of the cash and the role of the company that the cash sits in is to do an acquisition with a private company, to find a private company — hence the analogy of Narnia. So public investors clearly are restricted to investing only in public companies. But if they were to buy a share in a SPAC, it’s just a pool of cash. If they were to kind of hand some cash to the sponsor, the sponsor will then go through the wardrobe, into the land of the private companies and find a private company to merge with, bring it back out. And then, all of a sudden, you now, through the merger process, have got a share in a private company.

[01:05:31.21] Ben: That is a great analogy, by the way. That’s superb to describe what a SPAC is.

Marc: And just to finish off what I was talking about earlier, the difference is — and it’s slightly arcane, it’s kind of regulatory — but the merger process enables the company to provide projections. So the guy on our side of the wardrobe, when the sponsor comes back out with his private company, can say, “Well actually, in 2022, ’23, ’24, these are our projections. What do you think?” And at that stage, he can either kind of roll with it, or he can sell because maybe it wasn’t what he wanted as a public market investor, so he can sell but he’s kind of got that right.

[01:06:14.17] Ben: So you think this sort of recent last 20-year phenomenon, with more companies staying private, is maybe addressing this fact? Because it does two things, essentially, if I understand rightly. Firstly, it reduces a lot of the friction and the cost of going public because I can’t remember how much an IPO costs, but it’s a lot, right? You pay your fees, I think it’s like four or 5% that you pay to the investment bank?

Marc: It could be even higher, actually. Yeah.

[01:06:35.04] Ben: So yeah. So there isn’t that big cost, there isn’t the sort of, you know, I don’t know how many months it takes to IPO. But it reduces the friction, the cost, the time to go public plus also through being able to share projections with the market. Arguably, and I think this is the bit you’re talking about, there isn’t the data, but arguably, it enables you to achieve a higher valuation. Because I guess there are two reasons why people stay public for longer, right? One, they didn’t feel they could achieve the valuation that they deemed appropriate in the public market, or they were just put off by the time and the cost and the friction.

Marc: Yeah, that’s right. And also the third reason is the private market was rich with capital. So, why would they…

Ben: But that bit hasn’t changed, has it?

Marc: That hasn’t changed. But you’re seeing even in the public… You know, interestingly, recently… So Lemonade is a FinTech, it’s an insurance company that was founded on a kind of a digital platform. And it was SoftBank. So the SoftBank vision fund is one of the biggest venture capital backers out there, it was an investor in Lemonade. It went public in July of 2020. Actually, recently, already in 2021, it’s raised fresh capital in the public markets, at a valuation much, much higher than when it went public in the summer. Typically, normally — and that’s an unusual occurrence — in the public markets, normally, that would take place in the private markets to be a funding round, even six months after the last one. It’s more unusual in the public market. There was kind of a convergence between… I mean, maybe it’s cyclical just because of where valuations are. But it feels as it was kind of convergence between some of the behaviors that were typically the case in private markets and in public markets.

[01:08:23.10] Ben: I suppose you could argue companies like Tesla wouldn’t achieve a richer evaluation on the private market than they could in the public market. But do you think also, there’s some of the stuff that couldn’t IPO because it didn’t come under the same level of scrutiny would do so through a SPAC?

Marc: Yeah, I think that’s right. I mean, some pushback about SPAC is people have talked about as being a SPAC bubble. And, you know, inevitably, there’ll be a lot of poor companies that are coming through that wardrobe, sneaking through that when the, you know, as Buffett says, when the tide goes out. Yeah, we’ll say who’s swimming naked.

[01:08:59.29] Ben: I think probably we’ve run out of time to talk about Robinhood, and that whole phenomenon of the gamification of the stock market investing. But I just wonder if you had any other observations just from your practice as a public and a private investor. You know, the kinds of things you look for in companies that you didn’t historically, or whether it’s very similar.

Marc: It’s really very different. It’s very, very different investing in private companies, from investing in public companies. For one, probably four key differences. One is the level of transparency, which is much higher on the private side than on the public side. Two is — and this is an interesting point — two is volatility. So, a lot of people inherently don’t like volatility. And I think one of the attractions of private market investing is that they only get revalued when there’s a funding round. And so, kind of right now it’s not an issue, because, in the markets, we’re only seeing upward volatility with everything getting up. But I think there was a kind of a degree of, think back to March, April of 2020, when there was a lot of not such good volatility in the markets. I think there was a degree of comfort around private holdings, which, you know, whether it is Robinhood app, or whatever broker one is using, one’s not seeing kind of the daily volatility of valuations in private holdings than they are in public. That’s a big behavioral difference. The third difference is the structure. It’s very, very important as a private investor to be comfortable with the structure of the holding. You know, when you buy a share in Apple, it’s a share in Apple. It’s pari-passu with all the other shares in Apple. That’s not necessarily the case with private companies. Well, they are different classes of shares so it’s something that as an ex-public investor gone private, I suddenly have to learn about. And the final point is just that you’re in the room. I mean, I can write a newsletter about Jamie Dimon at JP Morgan, he may or may not read it, he may or may not do anything about it…

Ben: I think he subscribes to that, doesn’t he?

Marc: Probably he won’t do either. But it’s just a great experience being involved in a private company.

[01:11:31.05] Ben: Yeah, I think is that last point, which is, you know, you have the ability to make your own weather in a way, right? Because I always thought, for me, that’s the key advantage of angel investing, which is, you don’t just sort of invest the money and hope for the best. You can actually get involved and materially affect the return on that investment that you make.

Marc: Yeah, exactly. Exactly. Exactly.

[01:11:51.10] Ben: One question I wanted to ask you, which is the big downside, obviously, of private investing, is liquidity. And it just amazes me that we haven’t seen more people enter the space for the secondary market for private investing. Why do you think that is?

Marc: There are some crowdfunding platforms in the UK — it was one crowdfunding platform in particular in the UK — was Seedrs, which offers secondary trading of its companies that is crowd equity, crowdfunded for. But probably is difficult, actually, because of the fact that, coming back to the point about structure, different classes of shares. You know, I did another newsletter on fixed income markets — electronic trading and fixed income markets — which is much less developed than electronic trading in equity markets. The reason being is there are multiple fixed income instruments out there. Whereas there’s only one equity for most companies, there’s only one equity. And it’s the same here with private, there’s two different classes of shares with too many different terms. But there’s no standardization.

[01:12:53.08] Ben: So, I have two quick follow-on questions for you. One is, what’s getting you really excited beyond Libra looking into 2021?

Marc: I think what’s happening in embedded finance is fascinating. I think what’s happening broadly, just the acceleration we saw in 2020 around digital, I think what’s happening broadly, through payments mechanisms, and beyond payments, not payment as the hub. It used to be that the checking account was the anchor product for most banks, or potentially, the mortgage actually, increasingly is becoming payments. And that I think has all sorts of implications, whether it’s around crypto or Libra, or embedded finance. It’s basically the common theme across all of those things.

[01:13:40.06] Ben: And then the last question I wanted to ask you, which I think is gonna be difficult, you may have to come back to us, which is, what’s the best book that’s ever been written about the financial services sector?

Marc: Liar’s Poker.

Ben: Yeah, that would have been my pick. Yeah. Okay, good. So if anybody hasn’t read Liar’s Poker, you really, really should. Great. Marc, thank you so much for coming on the podcast. It was a great discussion, and I really appreciate you taking the time and keep up the good work with Net Interest which is awesome. And if you didn’t subscribe to Net Interest, you really should. One fantastic deep dive into an aspect of financial services every Friday. So subscribe. Marc, if people want to subscribe, where do they find it?

Marc: Yeah. So is the page.

Ben: Thanks so much again.

Marc: Thanks, Ben. Great to be on. Thank you.

Sequencing the World’s Regulatory Information (#35)

Structural Shifts with Manos SCHIZAS, Lead in Regulation and RegTech at Cambridge Center for Alternative Finance

Our guest is Manos Schizas — Lead in Regulation and RegTech at Cambridge Center for Alternative Finance at the University of Cambridge. We discuss how regulatory change is accelerating so fast that people alone can’t deal with it and how does the technological solution addressing the problem looks like. Can technology solve this problem at scale? How much innovation are we seeing thanks to machine learning? And we also discuss about the Regulatory Genome Project, a recently launched long-term project that aims to sequence the world’s (financial) regulation, allowing developers and firms to build own applications on top of the platform. Before joining the Cambridge Center for Alternative Finance, Manos also served as a regulator with the UK’s FCA.


It costs something in the order of 4% of turnover for a major financial institution to comply with regulation.

Ben: Manos, thank you very much for coming on the Structural Shifts podcast.

Manos: Thanks for having me on the show, Ben.

[00:01:22.05] Ben: Maybe let’s start by you talking about your background because I think it’s useful for our listeners to know that you’ve seen this interplay of finance, tech, and regulation from many different angles. So, if you don’t mind, Manos, just tell us kind of, you know, how you started off in this world?

Manos: Sure. So, I first got involved with writing and reading about regulation back in 2008. At the time I was a very, very junior lobbyist at an association for accountants — the ACCA. And because I had their access to finance brief, inevitably, around that time, I had to feed into the discussion around Basel III, and the implications for financing of small businesses. But before long, I was talking and writing primarily about FinTech and regulation. At some point, I made the jump over to, I guess what I thought at the time was about the dark side. So, I joined the FCA — the UK regulator — I spent some time there leading their work, at the working level, on things like crowdfunding or their approach to small businesses, surprisingly, political and fraught topics. And then, I moved on to a London-based RegTech startup, where I was their Head of Regulatory Content Operations and also had the product brief for a short period of time. And then, of course, the rest is history. I joined the Cambridge Center for Alternative Finance, where I lead their thought leadership practices, as well as their applied research program on RegTech and machine-readable regulation.

The pace of change and the volume of data has really long outstripped the ability of firms to just throw humans at the problem — human brains and human bodies.

[00:02:53.10] Ben: We’re going to come back to the Regulatory Genome — the project that you’re working on — but before we get there, I think we should zoom out and talk a bit about the whole terrain of regulatory compliance and why it faces so many challenges? So maybe let’s start from the point of view of a regulated financial institution. Why is it so time-consuming and expensive for banks and other financial institutions to comply with regulations?

Manos: Well, alright, let’s start from the top line if you will. It costs something in the order of 4% of turnover for a major financial institution to comply with regulation. Again, that’s turnover. That’s not, you know, breaking margins, that’s not profit. It’s colossal amounts of money on a global scale. And why does it cost so much? Well, I guess, there hasn’t been a time in very recent memory when financial services weren’t heavily regulated. But since the financial crisis, in particular, there’s been an explosion in regulation, that has seen the amount of regulatory notifications rise, I think about seven or eightfold between 2008 and 2018. So, I guess the key point is, the cost is driven primarily by how demanding the regulatory framework is and the pace of change. Now, it’s not the same for every part of the regulated sector. So, a tier-one bank will probably recognize the pace of change as I describe it, whereas let’s say, you know, a smaller asset manager might not, but by and large, there’s been an explosion in regulatory requirements. At the same time, there’s also been an explosion in the sheer amount of data that firms hold, not just the ones that they have to hold for regulatory purposes, but the ones they hold for commercial purposes. You know, only recently — I think it was HSBC — one of the major banks was creating a data lake that was in size exactly the same size as the entire internet had been four years earlier. It gives you a sense of perspective of what we’re talking about. The pace of change and the volume of data has really long outstripped the ability of firms to just throw humans at the problem — human brains and human bodies.

Manos: There’s also other elements related to the way you manage institutions like that. So, you know, many of these major firms are matrix organizations where it’s actually, in the time of change, quite easy to lose visibility as a senior manager of why you’re complying the way you’re complying, what exactly the outcomes you’re achieving are, and so on and so forth. And at the same time, regulators are hardening their stance on the personal responsibility of senior managers. You know, you’ve got senior managers regimes in the UK, in Singapore, in Australia, in Hong Kong, and in an increasing number of jurisdictions. So you’re in this kind of the opposite of a sweet spot, if you will, or the sweet spot for vendors, where the key decision-makers are facing increasing scrutiny on a personal level, and at the same time, are losing visibility. So if you’re a vendor, this is a good time to come in and try to sell them technology.

[00:06:12.08] Ben: What about if we look at it from the point of view of regulators because it sounds a bit like, you know, listening to you, the regulators are really driving the agenda here — which I guess is true to an extent — but the regulator doesn’t control the pace of technology change, which is driving innovation; and the regulator also only can really affect its jurisdiction. And I think one of the things that’s become more apparent over recent years is there’s a lot of competition between jurisdictions to attract new financial institutions and also new FinTech companies. And so, does the regulator also see the need to do things differently in this space?

Manos: Sure, I guess there’s two types of regulations depending on where they come from. So, there are rules that are fundamentally quite harmonized across the globe. AML, for example, prudential requirements — at least in banking and insurance. And for those, the rules come down from Mount Olympus, from the G20. They cascade through the standard-setting bodies and then finally into national regulators. Now, if you are a regulator working in that kind of subject matter area, then your key concern is, am I fundamentally compliant with international standards? And have I found the most efficient way to comply with them? AML is the usual example here because if you’re not compliant, that’s a big problem. The whole country can get graylisted or blacklisted, and you just don’t want to be there as a regulator. But you know, even when the stakes aren’t that high, regulators want to know that they are compliant with international standards. Then there are other areas of regulation which are closer to the matter of technological change that you mentioned earlier, where good practices are bubbling up from the bottom up. So areas like, I don’t know, cybersecurity, data protection — you know, there is no single unifying force or no single cascade of standards from the top. But everyone wants to know how they compare to the jurisdictions that they see as competitors. So, if you’re in Malaysia, you’re the Securities Commission, you will look at what MAS is doing in Singapore. If you are in the UK, you’ll be looking at what the Europeans are doing post-Brexit. Pre-Brexit, obviously, you just have to comply. So this process of regulatory benchmarking is actually one of the factors driving regulatory change internationally. When at the CCF, we surveyed regulators from 111 jurisdictions around the world. They told us that nearly every exercise of review of regulation in relation to FinTech had involved some benchmarking exercise. And, in more than half of these circumstances, it was the benchmarking exercise that had prompted regulators to change how they do things.

if anything, regulators are under more pressure. So when we say something like, you know, the pace of regulatory change has increased sevenfold since the financial crisis — well, you know, firms’ compliance budgets have not increased sevenfold. But regulators’ budgets have not increased at all, not in real terms anyway.

[00:09:11.06] Ben: What about COVID? Has that had much of an impact on the pace of regulatory change?

Manos: Well, that’s what our research tells us. So, we have just come out of a significant project to basically carry out a rapid impact assessment of COVID on the FinTech and RegTech industries, as well as the regulators responsible for them. And obviously, what you hear from regulators is that COVID fundamentally changed the way they approach some areas of their work — not just their rulemaking, but also their hands-on supervision. But I guess what regulators tend to see here is some megatrends that have accelerated — so trends towards you know, more or less material financial services, more online banking, more app-based financial services and so on and so forth, but also greater demand on their resources, so that they can do more with fewer touchpoints with industry. And then, of course, COVID also came with some of its own, if you will, pathologies. So, regulators told us, for instance, that they were much more aware and worried about fraud in a COVID environment where a lot of things have had to be put on the cloud or have had to be done remotely at relatively short notice, or where firms have had to deal with stuff that previously were very closely held in-house on a remote basis. So, of course, the focus of regulators has had to change.

[00:10:48.17] Ben: So, Manos, if we were to try to summarize what you’ve told me, you’re saying that the pace of regulatory change is accelerating to the point where financial institutions can no longer just throw, you know, human resources at this problem because it’s an exponentially changing situation so it requires a technology solution to it. But would you also argue that the regulators need to be putting more technology at play here? Because presumably, they also want to know how regulations are changing and being implemented, and they want to make use of the data to make sure that they’ll keep up with the potential rates of innovation, put that to good use in terms of financial inclusion and everything else. So would you say that the need for new technology applies to both the regulated and the regulators?

Manos: Yeah. I mean, if anything, regulators are under more pressure. So when we say something like, you know, the pace of regulatory change has increased sevenfold since the financial crisis — well, you know, firms’ compliance budgets have not increased sevenfold. But regulators’ budgets have not increased at all, not in real terms anyway. And so, regulators find themselves in these very interesting challenges wherever there’s this use of data involved. Like, to give you a simple example, the first touchpoint with technology around regulation and compliance for most regulators is reporting. And if you talk to an emerging market regulator — not the poorest countries in the world, necessarily; just, you know, significant emerging markets — they will say, “You know, firms report data to us and by the time we’ve validated the data and made sure it’s not garbage, it’s three months old.” Now, let’s go back to that COVID discussion we just had. If you had three-month-old data on the robustness, the financial stability of firms, as a regulator, it would be useless. It’s a snapshot from a completely different world. So you can see how COVID can really create an issue for regulators there and waken some of them to the challenges. But even if you think of more normal times, you know, the FinTech revolution has created a very big fringe of very small, very marginal firms that fly sometimes under the radar of regulators, and sometimes just above. And so, for instance, when the FCA took over payments, for instance, the population of firms that they were supposed to supervise more than doubled overnight. Now, their resources did not increase at all. So, what exactly do you do when faced with a situation like that? You have to find some way of prioritizing your human resources. And the only way, really, to get to a point where you can do that is to invest in technology that allows you to prioritize better by getting insights more cheaply, more efficiently, where the risks are proportionately smaller.

in the AML space, every year there’s a new estimate of what percentage of the illegal flows of funds are actually intercepted by AML controls. And it’s usually always in the low single digits. So, you know, you have to keep wondering, like, is this really the best we can do?

[00:13:49.05] Ben: That’s happening, is that not? So, we are getting thousands of new entrants into this space, new technology companies, new RegTech companies are entering this space to solve these challenges that regulated companies have, and regulators have. I was reading before this podcast that I think collectively, over $10 billion of new venture capital has gone into this space in the last 10 years. So, are we solving this problem at scale?

Manos: Well, it’s interesting. I mean, obviously, throwing more firms at the problem doesn’t necessarily solve anything. It is a good indicator of how valuable the prize is, I guess, for whoever wins the race. Just to be clear, just the number of RegTechs really depends on how you define this sector. So, you know, you will hear estimates from 800 all the way to the 2000 number that you quoted, but the amount raised is almost always estimated the same way because most of the fundraising is concentrated in a handful of large firms. So, this is one of the first things I think we need to keep in mind in the context of this discussion. You will hear about RegTech growing very fast as a sector, and all of the success stories, but the typical firm in the RegTech sector — we did our own research on this — has raised somewhere in the order of $1.5 million. Now, it sounds like a lot of money if you give it to me to buy a car or a house even. But how much runway does it buy a technology company? Like, less than a year. And to put it into further context, how long does it take from the moment, let’s say someone at the bank shakes your hand and says — well, they can’t shake your hand anymore, but you know, looks you in the eye virtually, and says “I love your product, we will definitely buy it” and the moment when you first see any money from them? Usually about 18 months. So, you have to put these two numbers together, like, how much runway do they have versus how long it takes for them to actually convert prospects to paying customers. So, most of this sector isn’t particularly successful financially. And so, the sector is kind of ripe for consolidation. Quite a few of these people are competing in very, very crowded segments. Also, of course, in our own research, what we’ve seen is that there was a golden era of new market entry between let’s say, 2013 and 2017. And the pace of market entry has slowed since then, quite significantly. So, this sector is now growing more from the center than from the margins — so, big firms getting bigger, as opposed to new firms joining.

I’m skeptical about the pace at which we can move towards machine-readable and machine-executable regulation, where we treat regulation as code.

Manos: Now, to your question, though, the actual question was, you know, are they solving this problem? I think the first thing to bear in mind is that the sector has been around for like 20, 30 years, depending on how you define it. So, you know, you had regulatory intelligence applications 20 years ago, you had BPM and GIC applications 20 years ago; they’ve evolved since then, yes, but the fundamental kind of offerings were already being imagined at the time. What firms are now much better able to do, I would say, is, first of all, they can scale a lot faster and deal with smaller institutions because their services can be delivered through the cloud and by APIs. It’s much easier for them to work together, so, hooking up different applications via APIs is now much more realistic than it used to be. And so, what that means is that ideally — and we’ll have to come back to this point — you know, no one firm has to build everything, end to end your entire kind of compliance factory. So, that obviously helps. But there are areas where RegTech has yet to make a significant impact. If you try to map where most of the effort has gone — AML, reporting, risk particularly on the prudential side — between those three areas you’ve probably captured 80–90% of the activity that we’ve seen; probably a lot more if you count it by funds raised. And then there are other areas, notably on conduct, for instance, that are kind of less tangible and quantitative areas of compliance, where, you know, you don’t see the same level of success. And, of course, even where the RegTech sector is making inroads — good on them — you still have to ask yourself, how much success do we have to show for it? So, in the AML space, every year there’s a new estimate of what percentage of the illegal flows of funds are actually intercepted by AML controls. And it’s usually always in the low single digits. So, you know, you have to keep wondering, like, is this really the best we can do?

[00:19:02.21] Ben: And listening to you, it sounds a bit like, you know, even though lots of money has gone into this space, and accepting that, you know, most of it has flown to a few big firms, rather than the long tail of smaller suppliers, it sounds like there’s still a lot of duplication of activities in this space, and also potentially, like, there’s not complete coverage of the regulatory space, i.e. people keep shooting, I guess, for the areas with the largest addressable market. So, would you say that they’re two of the challenges that still persist, that the RegTech community is still duplicating a lot of its own efforts, as well as, you know, perhaps don’t have complete coverage yet of all the areas of regulatory compliance?

Manos: Absolutely. And I’m not sure that any one firm has a particularly good overview of its entire competitive environment, just because so many people are trying this and many of them are still under the radar unless they’ve done two or three funding rounds and you start seeing kind of headlines about them. But I think it’s also important to say that compliance, in general, involves a colossal duplication of effort. If you think about it, the regulations are the regulations. They are what they are. But there’s thousands of financial services firms, each developing their own mapping of rules, you know, against their own internal systems. And you think, “Well, how much of that is duplicating effort? And is there really a business reason to duplicate this for each firm to do it on its own?” Because compliance in itself does not confer a competitive advantage. Being able to manage risk better does. Being able to understand customers better does, of course, so there are some things that firms will always want to keep close to their chest. But compliance in itself does not. So the duplication is quite substantial and not very rational.

[00:20:54.08] Ben: In terms of technology change, you mentioned cloud, you mentioned APIs? What about AI? Because it seems to me that one big area of potential improvement here is to train models… You know, you can imagine this particularly in the case of financial crime, for example, where, you know, many actors contribute information about financial crime and one provider can train the best models and can give the best predictive analysis about where financial crime might arrive, or stop financial growth based on patterns seen in the past. So, are we seeing much innovation and headway being made thanks to AI in this space?

Manos: We are. And I guess we’d better because the amount of processing power we can leverage these days is colossal. So, you know, in the first AI spring, in the ’50s and ’60s — I’m not reminiscing, I wasn’t there — back then it would take about seven minutes for a computer to parse one sentence or one paragraph worth of text. And now we can do, like, billions of them in the same amount of time. You know, obviously, that helps. Having said this, applications of AI mostly end up with a trade-off. So, think of it a little bit like an industrial process, where, because at the end of the day, most of the applications of AI that you’ll see in compliance come down to statistical models. You’ve got error rates, you’ve got false positives, you’ve got false negatives. And the whole kind of quality assurance process is around saying, “Well, how many false positives and false negatives can we tolerate?” And particularly, like, “How many false negatives can we tolerate?” Because that’s where you get fined or put in jail. And so, usually, what happens is firms, certainly in compliance, are very, very reluctant to accept that there will be a consistent level of errors in a compliance process, particularly around things like AML. And so, you know, many will seek a level of certainty that is just not possible. Some of them will tolerate redundancies and duplication, just to make sure that they are covered. And particularly in the larger firms, often you will have a duplication internally. If you’re a tier-one bank, there is actually a decent chance that you’ve licensed software that duplicates things you’ve built in-house, that you have licensed software from two different people that overlap. So, the strategy around incorporating AI in this area is still not fully fleshed out.

to get from the messy regulatory language to something that humans can work with, you have to have some kind of mental map of what regulations are out there, a kind of taxonomy of regulatory obligations and concepts. That’s one side. And you have to have a corresponding mental map of what the firm looks like — what matters to the firm. So a firm doesn’t see itself as a collection of compliance obligations. It sees itself as a collection of products and functions and locations, and yes, even processes and controls and policies, and so on, and so forth. So, you have to have both of those maps, and then get them to talk to each other — so create linkages between the two sides of the equation.

[00:23:41.02] Ben: What about this whole area of machine-executable regulation? So, you know, certainly, I’ve been reading about a lot of companies that are working on, you know, basically turning regulation into code, which can then be executed by the machine. And this seems, you know, at least prima facie, like, this is the most elegant solution to this problem, right? Because if regulators can put out very precise regulations, and they can be turned into code, not only can that code then be executed immediately, but it will be executed exactly as the regulator intended to be executed. So that seems like the holy grail here, would you agree? And do you believe that this is realistic and that we’re making progress in this direction?

Manos: I mean, it is the holy grail. And it’s interesting because it’s one area where software developers and lawyers kind of lead in the middle. Both sides think like machines. They want very precise and consistently worded inputs and outputs. But in reality, most regulation doesn’t work that way. So, the hype around machine-readable, machine-executable regulation is what it is because some of the earliest use cases for RegTech and SubTech are around reporting. And reporting use cases involve heavily standardized data — I say heavily standardized, but if you see them upfront in their raw form, they’re not always that good but they involve much more standardized and much more quantitative data, more structured data as well than most other RegTech use cases. So, if you’re only really interested in reporting and adjacent use cases, actually machine-readable and machine-executable regulation will happen. You know, it’s already happening in some domains, and it will happen in most others. Enormous amounts of money, enormous amounts of attention, and standard setting effort has gone into those. But then there is a lot of regulation where this level of standardization, of quantification and of structure just doesn’t exist, partly because that’s not how it’s been designed and it’s very expensive to redesign it from scratch, but partly because regulators want it that way, or legislators want it that way.

Manos: So, to give you an example that’s close to my experience: let’s say consumer credit regulations in the UK do not include any indication of what criteria somebody should meet in order to get a loan. Not because they couldn’t come up with, you know, a good sense of what credit worthiness looks like, but because legislators and regulators want firms to have the flexibility to come up with their own answer to the question. In other cases, the point isn’t flexibility, but responsibility. So, very often, what the regulator wants is for the onus to be firmly on the firm to find a way to reassure the regulator that the outcomes are as the regulator expects. And so, you can imagine a situation at the limit of this road towards machine-readable, machine-executable regulation where the regulator just releases their code and they say, “Okay, plug this in, connect it to your data lakes, and out will come compliant outcomes.” If something goes wrong, who’s to blame? The only person left to blame now is the regulator. That’s not a very comfortable place to be, certainly not if you’re an independent regulator. Like, if you become a sandwich between industry and government, that’s the sort of thing that would end up with the regulator being crushed. So, there will be a natural resistance in some areas of regulation against this level of mechanization. But even in reporting where this is supposed to work well, you know, if you hear the noises coming out of some of the kind of leading regulators in the world — not least the FCA here in the UK — what you will hear is that there’s enormous amounts of data standardization that needs to be done before the promise of even that use case — which is the most promising RegTech use case of all — can be fulfilled. So I’m skeptical about the pace at which we can move towards machine-readable and machine-executable regulation, where we treat regulation as code.

Treating regulation-as-content where we say the regulatory language is what it is and the job of RegTech isn’t really to turn it into push-button executable code, but rather to turn it into workflows and business rules.

Manos: Now the opposite, which does work, but is more human in the way that it does work, is treating regulation as content where we say the regulatory language is what it is and the job of RegTech isn’t really to turn it into push-button executable code, but rather to turn it into workflows and business rules. And so, the idea is that to get from the messy regulatory language to something that humans can work with, you have to have some kind of mental map of what regulations are out there, a kind of taxonomy of regulatory obligations and concepts. That’s one side. And you have to have a corresponding mental map of what the firm looks like — what matters to the firm. So a firm doesn’t see itself as a collection of compliance obligations. It sees itself as a collection of products and functions and locations, and yes, even processes and controls and policies, and so on, and so forth. So, you have to have both of those maps, and then get them to talk to each other — so create linkages between the two sides of the equation. If you’ve done that, then effectively you can get either one application or multiple applications talking to each other by APIs to do this interesting kind of relay of regulatory content. So regulatory content comes in, it gets labeled according to where it has to go, what it’s related to, and then it’s passed on to the appropriate application, to the appropriate subject matter owner with an instruction that implies what kind of workflow is expected afterward. So, that’s messier, it’s more human, but for the same reasons, it’s bulletproof. Eventually, someone will make sure that the system works. Whereas end-to-end machine-readable and machine-executable regulation will usually break down.

[00:30:19.28] Ben: You know, if we think about the idea of machine-executable regulation as being… You know, if we were to be on the Gartner Hype Cycle, it would probably say machine-executable regulation in brackets for reporting, right? And then it would be somewhere quite early in the hype cycle, because, you know, this is probably being hyped, and we’re going to go to the trough of disillusionment. Where are we with the alternative approach, which is, you know, using, I guess, AI and classifiers, and so on, to be able to classify regulatory text at scale, and to serve it up, as you said, into workflows. So this seems like the more promising approach and where are we in the hype cycle with that kind of bridge?

Manos: Just before we move on from machine-executable regulation, I think the key moments in the hype cycle for that, you know, probably, the key moments would have been the FCA and bank of England’s digital regulatory reporting pilot. So that was definitely a hype point in the hype cycle. And if you’ve read all of their lessons-learned reports, you actually feel yourself sliding down the hype cycle. It’s hard to read those and think, “Oh, this was this was a slam dunk.” But then you look at things like, you know, ISDA’s Common Domain Model that basically gives you a way of making both machine-readable and machine-executable a lot of the contract terms around derivatives. And you think, “Well, that’s quiet there. But actually, that seems to be working reasonably well.” And the whole kind of cause of machine-readable and executable regulation has been given a new lease of life with the Saudi-led G20 sandbox, which really is focused on these types of applications. So, you know, I think we’ve still got some time of hype left in the machine-executable side of things.

Manos: But as you said, I think there’s a lot more to be said for regulation as content and the other side or the less ambitious kind of side of RegTech. And there, I guess, the level of maturity is very good. So, when we looked at the market last — you can probably name something in the order of 25 to 30 platforms or tools that are in the regulatory intelligence space, that are really making significant headway in organizing regulation, according to their themes and topics and using things like natural language processing and machine learning to automate that so that they can read rule books at scale. Now, where you want to go eventually is that there’s one kind of virtual front end to every rule book in the world. We’re not there yet. But equally, I think, as long as you’re thinking of private standards only, we’re not that far either. I mean, there’s very significant work done and you can already name three or four firms that are way out ahead of anyone else — I won’t name them here. Now, what you don’t have, though, is some way of reconciling all these proprietary standards into one language of regulation. And that’s quite hard for someone on the purchasing side because what it means is, if you’ve done a lot of work to onboard one of these suppliers and mapped all of your internal systems and controls and processes to their dictionaries and their map of compliance, what then happens if you want to change the supplier? You know, or what has to happen if you want to onboard some other compliance application that needs to talk to that first one, but just doesn’t know the language? That’s the bit that we don’t yet have a very good answer for and there’s no clear kind of commercial incentive for firms to create that.

[00:34:18.08] Ben: Which is the segway into the Regulatory Genome Project, because that is at least partly a public good, right? And it’s aimed at solving exactly this problem of creating common standards and interoperability, right? At the level below commercial applications.

Manos: That’s correct. So let’s start with a little bit of background on the Regulatory Genome Project. So, at the CCF, we were approached in 2017 by what is now Flourish Ventures and was then part of the Omidyar Network with a very specific use case. So these guys were impact investors, they invested in FinTechs mostly in emerging and frontier markets, that were kind of mission-driven to improve financial inclusion. And what they said was, “Look, our portfolio is doing quite well. But one of the things that usually get in the way of growth and manifests itself in the kind of growth plateau at a time that is not really helpful for our firms is that if you want to grow beyond a certain point, then you have to expand at least on a regional basis.” So let’s say you start off in Kenya and you want to cover all of East Africa. Very reasonable. So, when the firms reach that stage in their development, it’s actually quite hard for them to grow because different markets, even within the same region, even if there’s a certain level of integration, have different rules. And so, a lot of time and money, and lawyers fees have to go into making sure that you get market entry just right from a compliance basis. And there’s no obligation for regulators to be consistent with each other or to make life easy for you.

Manos: So, they came to us with that question, saying, “You know, you have access to resources at the university, you know, cutting-edge research on NLP, you know, machine learning engineers — isn’t there something that you could build, that would pass regulation across jurisdictions and make it comparable?” And we thought at the time, well, look, this is a nice applied research program. Of course, we would be interested in looking into this. But what we found as we went along and created a pilot application and tested it, and saw they worked reasonably well, we thought, well, we’ve only covered one domain in this area. We came up with an AML model. We’ve only covered one domain and anyone we tried to take this to as a potential user would say, “Well, what about this other area of application?” So they might say, “Okay, AML good. What about cyber? Or payments, great. But what about insurance?” And it seemed to us that we were going down this rabbit hole of mapping out all the regulations in the world in order to create this one product.

Manos: Obviously, there was also a kind of existential question — you know, the university isn’t really a RegTech vendor, we didn’t want to be permanently in the business of building applications. And it’s a busy space out there, right? Other people have done this longer, and they know this better. So, we thought, what is it that we feel is really needed? Is there a public good that our research can produce? Now, that is consistent with the mission of the university. And so, we thought of an analogy to, I guess, the life sciences. And, at the time, because we were dealing with people who had been involved in the Human Genome Project, it kind of triggered this thinking of, is what we’re trying to build really kind of parallel to the Human Genome Project? And is this pilot application we built, something analogous to an application like 23andMe? And then, from that kind of thinking became the genesis of what we now call the Regulatory Genome Project.

even if you’ve already gone quite a way and had a lot of success in implementing RegTech within the organization, the appeal of interoperable applications and open standards, I think, should be quite significant.

Manos: So, we basically thought we need to find a way to fund and resource and guide a long-term project that maps all regulation. And then, to make sure that it’s available to people truly as a public good, we have to not only make the marked-up rules, I should say — the classified rules — as open data or as near as open as we can make it, but also, we need to find a way to release some of the pent-up innovation out there, by allowing developers and firms to work on this map of regulation, this global map of regulation, and build their own applications. And that way, we don’t have to be, you know, the guys who build everything. We can tap into the creativity and technical skills out there.

Manos: I think what’s really important also, just to bear in mind is the skill sets on the two ends of this journey are just very different. So, building a map of regulation requires a certain amount of technical expertise in the areas of regulation, it requires very strong ties with regulators — which the university has. Whereas, building applications on what we call ‘the right-hand side’ of this journey requires very different skills and a deeper understanding of how the institutions work internally as organizations. So, what does it mean to keep the machine kind of running? And so, to expect somebody to cover all of that is actually quite hard. That means that most people who have innovative ideas in RegTech, either coming from one end or the other end, can’t really deliver the whole thing. So, I guess this is a long way of saying that the key principles behind the Genome Project are, first of all, regulations should be available in machine-readable form as a public good. This is stuff that firms are required to know, by law. They’re made with public money. There is no reason for it to not be open data in a machine-readable format. That’s principle number one. Principle number two is, all of this information must be available to developers in such a way that people can build applications around it. And finally — and this is a key point — both the representation of regulation and the resulting application need to be interoperable. You need to have one common language of regulation. It’s true, different jurisdictions regulate in different ways so, you’ll never get to the point where you say, “Well, this requirement in Brazil is exactly equivalent to that requirement in Mongolia.” But what you do have in the middle is a kind of regulatory Rosetta Stone that can map regulations from any given country against a common framework. Think about, I don’t know, the Dewey Decimal System, right? If you go into a library and you’re a librarian from anywhere in the world, of course, the books are going to be different, but you know that nonfiction is going to be there and you know that life sciences are going to be there. So, that’s the level of interoperability we want to get to.

[00:41:27.18] Ben: And how do you get there? How do you sequence the genome of regulatory information?

Manos: So, let’s get as practical as we can. So, it starts with a paper exercise — I mean Excel exercise — whereby you create almost a hierarchical list of regulatory concepts and obligations. You usually do it by domain. So, you might say, “Here’s my taxonomy of AML concepts and obligations, here’s my taxonomy of cybersecurity, and so on and so forth.” And you know, some of these taxonomies are what you might call horizontal — they cut across the entire financial services industry, so the two examples I gave just now — some of these are vertical. So you might have payments, for instance, insurance, crowdfunding, which was one of the areas of the Center’s particular attention and expertise. And what you do is you create these hierarchical lists of obligations. So for instance, you might say, I don’t know, let’s say you’re dealing with investments, right? You might have client categorization and within that, the definition of an accredited or professional counterparty. You know, perhaps not the best example, but the point is that you always move from a higher level, more general obligations or families of obligations, to more specific ones. Now, at the end of each of these branches, if you will, you will have an end node. You will have the most detailed level of classification of regulations that the genome can manage.

Manos: Now, in theory, there is no limit. You can keep making them more specific, and more specific, and more specific. But remember, the genome as a public good is about making regulations comparable across jurisdictions. So there is a natural stopping rule. You want to stop at the point where the regulatory requirements at the end node are still comparable internationally. So, for instance, client categorization, yes, that’s comparable. You know, the distinction between professional slash accredited investors and more ordinary retail investors, yes, that’s comparable. But if you go all the way to saying, you know, ‘treatment of local authorities for the purposes of client categorization’, you are getting now so fine to the weeds that you’re going to draw blanks for most jurisdictions. And then for everyone who’s subject to MiFID, you will just have this note that says, actually, in most cases, these people are retail clients. So you can guess what the stopping rule is. You go as many levels down as you can until you reach a point where international comparability is compromised. So, that’s how you build that.

Manos: Up to this point, you’re still kind of in the paper world. You can still be doing that in Excel. But then, once you’re happy with the structure you have created, then you can start using machine learning. And machine learning relies basically on collecting large amounts of data from a diverse sample and teaching the machine that a specific example corresponds to a specific node. So, for instance, let’s say you have rules around credit worthiness assessments of consumer borrowers in different jurisdictions. You basically say to the machine, “This is a credit worthiness assessment-related obligation. This is as well. This is as well. This isn’t.” You repeat that over and over and over again until you can train basically a statistical model — which lives as code and we call ‘a classifier’ — so that model can now take in unfamiliar text, and take a stab at what category it fits into. So the next time around you feed regulatory text that you’ve never seen before to the same classifier, and it can say what the probability is that it is about credit worthiness, and you set yourself a cutoff and you say, “Well, if it’s above, let’s say, 70%, 80%, we’ll mark that as a one.” And so, what that does is, if you try to imagine now the machine-readable version of the same regulatory document, that paragraph or that piece of text now carries a tag, an electronic tag that says, “This corresponds to this type of obligation.” And any other application that knows the universe of tags that you’re working with — your taxonomy — can now read this and say, “Oh, okay. I know that this paragraph now is about this.” And that’s how you might be able, for instance, to run queries via an API; you might say, “Can you bring me all the text that’s tagged as credit worthiness assessment?”

[00:46:13.17] Ben: How difficult is the tech there? It sounds almost like, you know, provided you train the classifiers with enough data, then the results will get better and better and better. So, would you say it’s more of a challenge to get the data than it is to get the tech, or am I oversimplifying?

Manos: It’s a good question. I mean, I don’t want to downplay how difficult it is to get the tech. Like, the colleagues who we have working on this are obviously at the top of their game. Having said that, the technology comes with its own significant challenges. What do I mean by that? You know, there isn’t an enormous amount of regulatory tax out there. Now, this may sound really funny bearing in mind what I said earlier.

Ben: Yeah, the sevenfold increase you mentioned earlier. Yeah.

Manos: That’s true. But, you know, from a machine learning point of view, if you look at what kind of corpora people are working with to train machine learning models, they will usually use, you know, all of Twitter for the last three years, or, you know, the entire text of Wikipedia, or the entire internet if it comes to that. So, you know, in comparison to things like that, the amount of regulatory text out there is not enormous. And so, a lot of the challenge is around making sure you have enough samples to actually build good models. The other thing I guess, which people need to appreciate is that the returns to just having more samples start to diminish reasonably early. So, you know, the models don’t get exponentially better as you double or triple the amount of data you have access to.

Manos: Where this becomes really challenging, is, first of all, when you look at really new or niche areas. So, let’s say tomorrow, you know, one of our regulators came up with a very, very specific type of obligation in relation to making, let’s say, AI auditable. So it says, “If you implement any AI applications as a firm, you have to make sure that they are auditable by a regulator — whatever that means. You know, in the early days, only one regulator will have any references to that. So your sample is going to be tiny, right? That is a problem because it means your model runs the risk of having blind spots and you have to find ways of bootstrapping the small sample that you do have, in order to make sure that the classifiers work. I’m not saying that’s not possible, and obviously, my colleagues are working on things like that, but it is challenging. And it’s also challenging when you look at non-English techs because if you create a classifier for AML obligations written in English, that’s going to be completely useless if you’re reading documents in Spanish. But the problem is, if you want to replicate that process in Spanish, your corpus of documents now becomes a lot smaller. And Spanish is, you know, a major global language. Try doing that in Japanese, try doing that in less widely-used languages, that are not the language of business for many people. That is another major issue in that area. But I guess the final issue will always be with these things — and I’ve already mentioned it once already — is that, at the end of the day, there will be errors. And there’s a question of, you know, how much liability should the parties accept for these errors, and who does it sit with?

[00:49:45.07] Ben: If we move beyond the tech and the data — although I think this is a bit related to the data — to this idea of the chicken and egg problem because it’s not difficult to foresee a time when the genome exists and therefore if you’re a RegTech provider, you would build any new RegTech application on the genome because you then don’t need to do all of the mapping of taxonomies yourself. You can just query the public good, right? But between now and then, you’ve basically got to convince software providers to build on the genome, you’ve got to convince regulators to work with you, you’ve got to convince commercial users to use it. So, how do you go about building that ecosystem around the genome to make it successful in the first place? Or, in other words, how do you solve that chicken and egg problem?

Manos: So it’s a fair question. I mean, there is a place you can start, obviously, and it depends on where your relative strengths are. So if you look at other initiatives that have tried to kind of force some level of convergence within industry, they would usually have some strength in one area or the other. Now, if you’re talking about the university’s areas of expertise, obviously, because of our work in capacity building with financial regulators, that for us is the obvious place to start. So we’ve got very strong links to financial regulators around the world and we also know that they have a very strong use case around regulatory benchmarking. So, remember what we said earlier in this podcast that regulators are always checking their homework against the guy who sits next to them. And so, these benchmarking exercises are big painstaking things — expensive, very slow. I remember one regulator saying, “You know, if I had a tool that could do this, I would have nine months of my life back on just the last project.” Which was quite intense but I sympathize with that.

Manos: So the first people to reach out to are regulators. But regulators being involved gives confidence to financial services firms. And not just confidence in the quality of the taxonomies and the classifiers because frankly, regulators will never pull out a big rubber stamp and saying, “I approve of this.” But what a firm can see is that if this is good enough for the regulator to use for their own use cases, then, you know, maybe this is good enough for us as well. I think — you know, as far as industry is concerned — this standard-setting process is also an opportunity to influence in the direction of the common good, in the sense that, of course, you know, no regulator is going to go to a consortium of firms and say, how should I write my AML rules? But giving them the tools to compare against their peers, will usually give you, as a result, better regulation, because people will now have an evidence base on which to say, what is common practice? What is good practice? How do different things correlate with market outcomes or consumer outcomes? So, from an industry perspective, even though you can’t just lobby these people in a crude way, they have been given tools whereby, internally, they can come up with better outcomes for things that you care about. So that’s another reason why industry really, you know, ought to care about creating something like this.

Manos: And then, once you’ve got a few major banks, a few major fund managers, a few major insurers on board, as well as a developer platform through which you can access these assets, then, as a developer, it becomes quite reassuring to know that you can build on this standard because you’ve got the sense that whatever else happens, there are some people who are already on board, and will use applications or will build applications against that standard. So, your investment, your one-off investment in mapping all of your internal systems to this common denominator set will not be wasted. And, as a developer, that can be quite attractive, because the alternative is that every time you onboard a new major client, you have to do all sorts of ad-hoc fixes, so that your systems talk to theirs, which is, you know, expensive work that you’re not always going to get paid for because the client, as far as they’re concerned, it pays for the actual result not for the path you have to walk in order to make sure you can service them.

[00:54:16.15] Ben: So you’ve just launched the Genome Project, and you just started to try to recruit new members, new consortium members — the private sector, the regulated users of the genome. First of all, how is that going? And secondly, if I were a large financial institution, and I had, you know, significant resources to invest in RegTech, and as you say, already had many, many existing RegTech applications and suppliers, what would be the case you would make to join the consortium?

Manos: It is true. We have been in conversation with a number of major financial institutions starting with some of the larger ones, as you might imagine, for obvious reasons, which are now starting to yield results in the form of potential collaborations. Now, that activity is not going to end anytime soon, because, at the end of the day, you want as much of the industry onboard the consortium as possible. But once the first step of recruiting firms is significantly under way, then the work begins to build out the rest of the genome, and also to recruit developers and make sure that you raise awareness of the benefits of your platform and to build the kind of tools that will help developers build applications against the genome. So, there’s a significant kind of technology roadmap, there’s a significant business development roadmap, as well as, of course, the semantic roadmap whereby we’re actually creating the genome itself. So this is just the beginning. But we’re already seeing some of the first successes. Similarly, on the regulatory engagement side. So, you know, we’ve had our first few workshops with individuals from the regulatory community who are willing to dedicate their time to review and make suggestions to improve the various taxonomies. And so, you know, I’m quite confident that if we’re speaking again this time, next year, a significant percentage of financial regulation will have been mapped — and come 2022 we’ll be in a position where people can actually start building applications.

[00:56:31.28] Ben: If I’m a bank and I want to make this case internally — because I presume there’s a price point to join the consortium — how would you convince me, practically, that it makes sense?

Manos: Yeah. I guess it’s always a very different conversation when you’re dealing with a major financial institution that actually has done a fair amount of work in the RegTech space — and pretty much all of them do. If you speak to tier one bank, they have been bombarded with proposals from RegTechs, and even from potential consortiums as well. And so, I guess the way people will usually respond this — you know, why do I really need this sort of thing? I’ve already got fairly mature solutions in-house that I’m reasonably happy with. So where is the real kind of long-term strategic value?” And I guess there’s three layers to this. The first one has to do with how procurement works effectively. It’s great that you’ve got the supplier that you’re happy with. That’s amazing. However, what it also does is it locks you in because you’ve invested a significant amount adjusting your internal systems to fit with theirs, and particularly adjusting at the semantic level — so, making sure that all of your other applications speak the same language as the vendor and can map to the same taxonomies. Now, that’s usually a significant sunk cost. And so, a firm that wants to move away from a supplier relationship doesn’t actually have a lot of good options, because they’ll have to take on the cost of doing this all over again if they onboard somebody new. And it’s very unlikely that they’ll be able to get a startup, for instance, to do that work because the startup just doesn’t have the cash and the runway with which to do it. So you end up in a situation where you’ve got a significant supplier lock-in. And it shouldn’t really be the way that a major financial institution runs compliance technology. So, that’s one part of the answer.

Manos: The other part of the answer is that usually, even when you do have really good applications, they tend to be limited in scope. So they will either be limited to a few domains that they were originally built on. So let’s say, you know, anywhere in Europe or anywhere in firms that deal with Europe in any way, people will have built ad-hoc systems to deal with MiFID compliance, for instance. You can’t then repurpose that to deal with some new type of securities law that comes in 10 years down the line. If you’re lucky, maybe you have architected that way but most people will not have. So the benefit is that dealing with a kind of de facto standard, like the genome, as and when it becomes available, builds some longevity into the applications that you do build. And obviously, it’s not just scalability across domains. It’s also, are you able to serve jurisdictions that are not in the magic circle of jurisdictions that suppliers usually target? So if you think about what most applications can deal with, they can deal with EU, UK, US and Canada, Australia, Hong Kong, Singapore — that’s your magic circle. Beyond that, you know, here be dragons in many cases. So being able to have that same level of scalability and functionality beyond those core jurisdictions is a huge benefit.

Manos: And then finally — and I think this is the more where interoperability really comes into its own — is when you deal with suppliers or partners to whom you have the cascade regulatory obligations, or with which you are tied together in a compliance pipeline. So I’m thinking of things like, for instance, product governance, where the producer of a financial product and the distributor of a financial product are tied together in a set of obligations around, for instance, identifying what the target market of a product is, identifying any applicable risks, understanding what kind of uses the clients are supposed to have for these products, reporting on whether it is sold and distributed in the way that was envisaged. Now, all of that requires that information flows between two very different firms — you know, the distributor might be a huge bank or it might be an IFA; the producer will usually be a very substantial financial institution — but they can be very different is what I’m saying. Similar things happen, for instance, when you cascade obligations in the area of cybersecurity or cyber resilience, where the two organizations — the supplier, the vendor, and the buyer — are actually very different organizations. So, if you need their systems to talk to each other, you need some common denominator to map them against each other. Otherwise, you risk, again, that kind of lock-in that we talked about earlier with regards to suppliers. So, I think the bottom line here is even if you’ve already gone quite a way and had a lot of success in implementing RegTech within the organization, the appeal of interoperable applications and open standards, I think, should be quite significant.

[01:02:03.05] Ben: Let’s assume that you build this, it gets wide usage, you overcome the chicken and egg problem, then we can imagine the network effects — the flywheel of network effects — will really start to kick in. And you know, then you’ll be able to level the playing field between regulators, regulators will get better feedback to make better regulations, there’ll be fewer barriers to entry for new vector companies. And so, you’ll see this unleashing of new RegTech innovation. Firms will be able to comply with regulation more cost-effectively, more quickly. Would you describe that as the end state, the kind of collective good that will be created, or is there anything I’ve missed?

Manos: So, no, I think you’re mostly there. I mean, what I would expect to see if this whole thing works properly, is that in the end, there is a marketplace where firms can engage developers to work on the genome — you know, they don’t need to involve any of us in any way. But also, regulators can start writing regulation that is as machine-readable as possible. So, for instance, right now, there are standards like a common torso for writing machine-readable documents at the document level. You know, you can do a lot better than that if you have a common standard for what is in an AML document or what might be in a cybersecurity document. At some point, once you’ve reached critical mass, you’ll start to penetrate a lot more deeply into how regulators do their work, and also a lot more deeply into how people build applications. And that, to me, is what success will really look like — that people start considering your standards at the outset of building their tools and applications.

Ben: Manos, thank you so much for coming on the show. It’s been great!

Manos: Thanks for having me! A real pleasure!

Digital Assets are Coming of Age (#34)

Structural Shifts with Adrien TRECCANI, CEO of METACO, the foundation of digital assets

Bitcoin is the best performing asset in 2020. There is growing institutional interest in crypto and broader digital assets. Tokenization is poised to be a huge market opportunity. In light of all this, we’re inviting you to a masterclass on all things crypto. We’re sitting down with Adrien Treccani, CEO and co-founder of METACO — a provider of security critical infrastructure for financial institutions that enables them to safely enter the digital asset ecosystem. Adrien is a leading software engineer specialized in high-performance computing and financial engineering and an advisor to banks, hedge funds and associations on distributed ledger technology. So today, you are going to learn about the difference between cryptocurrency, digital currencies, stable coins, you’ll hear about the evolution of blockchains, what will happen to commercial banks if we start seeing Central Bank-issued Digital Currencies, and more.

Full transcript


The next step is for the trusted companies on the market — which are the banks — to actually get in and start offering professional services around the management of digital assets. And for that, infrastructure is needed.

[00:01:24.17] Ben: Adrien, normally, on Structural Shifts we don’t do a whole lot of bio. We don’t cover a lot of biographical information, but I think it might be useful in this case. So, should we start there? How did you first enter the crypto space?

Adrien: You know, Bitcoin started in 2008 when the first paper was published by this anonymous creator called Satoshi Nakamoto. And then, for a few years, it was only the playground of, let’s say, libertarians, anarchists, passionated software engineers, and cryptographers. But, let’s say around 2011, a lot of people started getting in either for speculation purposes or because of passion for the new technology and innovation. At this time, I was doing my Ph.D. You know, when you do a Ph.D., you have a bit of free time. I don’t like to say it, but you still have some free time to look for things which are not strictly speaking related to your Ph.D. research. One of these things was cryptocurrencies. I was completing my Ph.D. in mathematical finance with a specialization in high-performance computing and Bitcoin was not so far away from what I was doing. So, reading articles about it, I saw an opportunity to speculate or invest. I did not believe in Bitcoin initially. Like, I think, everybody, initially I saw a scam or something which I could not really understand. But after a month of looking around for information, and also missing out on incredible growth opportunities — I think Bitcoin tripled while I was just looking at it — I started investing a little bit and therefore, also getting into the details of blockchain. And this is only years later, in 2015, I realized that something had to be done to support the growth of the ecosystem. The industry was not ready at all to offer massive services around cryptocurrencies, tokenization, and all of these new use cases that are appearing today. In particular, we were still facing a lot of platforms getting hacked, losing most of their coins; investors like myself losing a lot of money in these horror scenarios. And so, I thought that the next step was for the trusted companies on the market — which are the banks — to actually get in and start offering professional services around the management of digital assets. And for that, infrastructure is needed and Metaco — my company — is specialized in offering such infrastructure.

cryptocurrencies have these incredible opportunities that you no longer see on any of the markets

[00:03:41.23] Ben: And you always saw that as being the opportunity you would pursue? Because I can’t remember when we first met, but you’ve been in this space for a very long period of time and you’re an expert. And you could have done anything, right? I mean, you could have set up an exchange, you could have been a trader — why did you start a custody platform?

Adrien: I could have been trading. That’s a good point. I have these several years in the hedge fund industry as a trader, and I think cryptocurrencies have these incredible opportunities that you no longer see on any of the markets unless you do high-performance frequency trading. And so, I think that would have been a possibility. However, at that time, the markets were not sufficiently developed, if you think in terms of market depth, about liquidity, to implement many of the strategies that today would be actually very interesting to study. I missed the opportunity at that time and that was also for me a way to get back to software engineering. And discovering Bitcoin when I was doing mathematics and finance allowed me to get back to programming. And so, when I was the victim myself of losing bitcoins, having one of the exchanges I was using that got hacked and then a second exchange that I was using got hacked, I really thought that the opportunity was in building the infrastructure of this new ecosystem. And today, well, I’m not saying that since we founded the company in 2015, we had this exact precise business plan. In fact, we slightly pivoted in 2017, but we always had this ambition to provide institutional solutions for digital assets.

[00:05:18.11] Ben: Is custody, do you think, the biggest missing piece in the institutionalization of digital assets?

Adrien: Well, I think custody means slightly a different thing with digital assets than it does in traditional banking. When we think about custody in traditional banking, it’s often about storing pieces of paper, and potentially, you know, having corporate actions and not doing much about it. When we say custody in the crypto ecosystem, what we mean is much more than that. It’s obviously key management, the management of these — what we call — secret keys, which secure the assets, but it’s all of the interaction with the blockchain or the distributed ledger. It’s not just about storing and moving assets, it’s also about interacting with smart contracts and corporate actions, managing the whole lifecycle of digital assets — things which are much more dynamic than what one is usually used to with custody in traditional banking.

We’ve seen this big trend of central banks speaking about creating not just physical cash, but getting into digital cash — what is called today, a CBDC. The principle behind it that you can store and transfer a currency peer to peer, from person to person, with no intermediary is something that we see today indeed central banks are moving to.

[00:06:13.12] Ben: Many of the listeners will have different levels of understanding of all these different terms. So, if you’re okay, to maybe just take a step back and just maybe see if we can define and come to an understanding of some of these terms, and then we’ll delve in a bit more deeply. So, can we start with what the difference is between a cryptocurrency and a digital currency — or a central bank digital currency?

Adrien: Yes, sure. So, I would say that Bitcoin created this new way or proposed a new way of dealing with assets. These new ways to think about the solution were, there are less central parties. You can completely decentralize the payment network or currency, and make sure that there is no single point of trust — you don’t have a CEO, you don’t have a chairman or a company or a government that has full control over the assets or its infrastructure. And so, Bitcoin was the first to provide a scheme that actually works and that has been verified now for almost 10 years. However, what was invented by Satoshi Nakamoto in this context can be reused for many new applications. Some parts of its invention can be reused in different contexts and sometimes, almost exclusively, everything that is invented can be reused for other assets. When we speak about digital assets, we generally think about taking the blockchain technology that he invented in this context, extracting some parts of it, and using it for different asset classes — let’s say securities like equities, fixed income, and whatever, bonds or loans, real estates, arts; you know, anything that you think could benefit in being tokenized or put in a digital form on the blockchain.

Adrien: Then once you’ve gone through this tokenization process, your asset benefits from the same properties as Bitcoin itself. It can be stored and transferred efficiently, it can be divided into small particles, it can be controlled through what is called a smart contract so, sort of automated software, which can simplify the application of contractual clauses. What we’ve seen recently is that this technology could potentially also be used by more traditional assets like currencies. We’ve seen this big trend of central banks speaking about creating not just physical cash, but getting into digital cash — what is called today, a CBDC: Central Bank-issued Digital Currency. I’m not saying here that they would use exactly the same principles as Bitcoin. I think that the Bitcoin blockchain or the Bitcoin technology will not be adapted for that, it will not scale enough, it would be too open or too transparent in different ways, but the principle behind it that you can store and transfer a currency peer to peer, from person to person, with no intermediary is something that we see today indeed central banks are moving to.

[00:09:04.10] Ben: At the moment, I can pay you in Swiss francs, I can make an online transaction, it’s digital, right? So just again, what would be the difference, then, between just a digitally-exchanged Swiss franc and a digital Swiss franc?

The idea of the Central Bank-issued Digital Currency is that you can have a direct link between you and the Central Bank, but it is now digital rather than physical

Adrien: Well, think about the difference today between cash and something that you hold on your bank accounts. When you have cash, it’s guaranteed by the Central Bank that you will have some purchasing power tomorrow. So, if you have this banknote in your wallet, then tomorrow you should still be able to buy your bread in the morning with this banknote. Because it’s backed directly by the Central Bank, this claim, this promise is made by the Central Bank itself. Any other entity in between, an intermediary, I don’t know, defaulting, going bankrupt, could not break this promise by the Central Bank. I’m not saying that this is perfect. Of course, the Central Bank, we’ve seen many examples where they hyperinflate the currency and potentially, even though it doesn’t go bankrupt, you still lose all the purchasing power that you’re supposed to have and you start having packs of banknotes that are worth nothing, that are good to light the fire, for instance. But you know, this is still a claim that is direct between the consumer and the Central Bank.

Adrien: Now, if you think about banking money, that’s very different. In fact, when you have money in your bank account, this is not a promise by the Central Bank, this is a promise by this intermediary that is your commercial bank. If this commercial bank goes bankrupt, if it wants to apply special fees on every transaction, any model, any business model or risk that this bank is facing, potentially, you’re going to be subjected to it. It’s not a direct claim or a direct connection between you and the Central Bank. So, this whole chain of intermediaries, which sometimes is much more than just one commercial bank — it can be multiple commercial banks, it can be payment processors, it can be custodians in between — this whole chain could be completely reduced to a direct link, similar to what you have with the cash, but in a digital form. And so, the idea of this CBDC, this Central Bank-issued Digital Currency, is that you can have an equivalent direct link between you and the Central Bank, but it is now digital rather than physical, and you can use it to process transfers on the internet as efficiently as you would with Bitcoin — probably much more efficiently than you would with your bank transfers where sometimes you cannot transfer during the night or off business hours, sometimes you cannot transfer outside of your country, or it takes multiple days, it can be very expensive depending on where you send the money. With the CBDC, the promise is that it would be relatively similar to Bitcoin, you could send this money anywhere, anytime, frictions would be minimal, and you would have the guarantee that even if there is a complete collapse on the financial industry, as long as the Central Bank is relatively stable, your purchasing power should remain the same.

[00:11:54.15] Ben: In the event that we do see Central Bank-issued Digital Currencies, what becomes the role, then, of commercial banks?

I wouldn’t be surprised if in the future, we start seeing fine art, Picasso paintings being tokenized, so you, as an investor can finally invest in it, even if you’re not a billionaire, through tokenization, and that you can start diversifying your portfolio in many different classes of assets, that today you don’t have access to.

Adrien: Well, I think it may change dramatically. I don’t think banks will disappear. In fact, you know, some people expected that post offices would disappear when the internet was adopted. This is not what happened. In fact, Swiss posts in Switzerland are louder than ever. They just had to restructure to find new business models, new opportunities. And we see that what they used to do may have changed slightly, but it’s still relevant. I think the same is going to be true for cryptocurrencies or Central Bank-issued Digital Currencies. I believe that banks will still be relevant. If you think about it, even today with cash, you have the ability to store cash under your mattress. Now, do you do so when the amount is relatively large — let’s say if you store more than a couple of thousands — are you going to put that under your mattress, or are you going to put that in a vault somewhere and potentially with a bank? You probably will do that with a bank. Even though you don’t have to, it’s just an option, at some point, you realize that you prefer paying a professional third party that knows what it’s doing, has all of the measures, the infrastructure, the processes than doing it by yourself saving a few hundred bucks per year, but potentially being fully compromised. And I think the same thing is going to happen with digital assets. Even if you have the option to work with the Central Bank directly, it would be a very practical option to have for small amounts, you know, fast transactions to not be fully dependent and reliant on the commercial banks and payment processors. But in general, when you want to work with a trusted third party that removes some part of your fees and your anxieties, and you will get back to working with a bank. And this is pretty much our assumption also with Metaco. You know, we could see a future where banks completely disappear. In fact, we could go one step further and think about a situation where even central banks disappear and are replaced by Bitcoin, Libra — which in a way is a central bank — Ethereum, etc., and where commercial banks simply are no longer relevant. I think that’s not gonna be the case. And our approach at Metaco is that most investors in these cryptocurrencies and digital assets, will still want to work with a trusted partner that knows what they’re doing, that advises them — and for that, infrastructure will be needed.

[00:14:17.06] Ben: Do you foresee that everything will go digital or crypto and therefore they just have to find a new role than the new decentralized financial world? Or that there’ll be a little bit of a bridge between the old and the new?

If you think about a world where some of the regulations adjust to this new digitalized ecosystem, decentralization, I wouldn’t be surprised that new competitors that would never have considered getting a banking license due to the costs and, you know, frictions could suddenly become relevant and capable of operating a regulated business in this field.

Adrien: I think the transition is going to be very long, first of all. So, even though we speak about tokenization as being a hot topic today, I think tokenization is going to take years to become a new standard, and that is going to take even more years until the legacy approach is completely replaced by tokenization. Now, whether it’s going to be fully replaced at some point, I wouldn’t be surprised because if you think about it, everything is digital today, except monetary considerations. Everything can be digitalized: information, communication. You no longer send telegrams, right? You use the Telegram application, which is a messaging app; you use WhatsApp, you use Facebook; storing pictures — you used to print them — well, you no longer print them, you keep them in a digital form. So, what’s missing today is the notion of money or value of equities, which is partially digitalized but it’s still in a very centralized ecosystem, which doesn’t give you as an investor direct control over what you own. So, I wouldn’t be surprised that in the future, we start seeing fine art, Picasso paintings being tokenized, that you, as an investor can finally invest in real estate, even if you’re not a billionaire, through tokenization even if you’re not a billionaire, and that you can start diversifying your portfolio in many different classes of assets, that today you don’t have access to.

[00:15:59.23] Ben: One more question on the role of banks. So, what about things like issuents? Do you think that they just become custodians or do you think they keep some of their historical roles in, for example, issuing new securities?

Adrien: I think they will keep this role, however, they will be facing more and more competitors coming from IT. So, security firms, IT firms, or, you know, some of the big techs today: Google, Apple, Facebook, Microsoft of this world. If you think about this, it’s already the case that Apple is getting very strong in payments. Alipay, obviously, and many of these other protocols are getting traction to a point that you can ask whether banks and payment processors are going to remain relevant in this field. So, I think yes, banks are gonna keep this role and are probably going to be natural service providers in this field. However, they’ll start facing competitors that they don’t see today on the market. A big part of the reason they are still so strong in this market is because they’re protected by regulations. If you think about a world where some of the regulations adjust to this new digitalized ecosystem, decentralization, I wouldn’t be surprised that new competitors that would never have considered getting a banking license due to the costs and, you know, frictions could suddenly become relevant and capable of operating a regulated business in this field.

[00:17:16.10] Ben: So it seems that a lot of the promise of digital currencies, cryptocurrencies, Central Bank-issued Digital Currencies, is about democratization, is about making everything to do with finance cheaper, easier to access, having less friction. So, is that where you see the benefit? Do you see that finance becomes open to everyone because you don’t need a bank account — you can diversify your assets for, you know, very small holdings? Or do you think it’s something bigger? So the reason I ask that is because, on the way here, I re-read the classic article by Chris Dixon, “Why Decentralization Matters?” And for him, it’s much more than just democratization. It’s about introducing new, better incentives for digital commerce. Do you see it as big as that?

Adrien: I see it even bigger than that. It’s much more than finance, it’s much more than payments. It actually can have dramatic consequences, in my opinion, in a good sense. But beyond this obvious industry that is finance, one example is governments today or the way we operate a company. Let’s start with this simple use case. Today, a company, if you’re in Switzerland, you create your company, you say, “Oh, I’m going to inject 100,000 Swiss francs for the capital, I’m going to be the shareholder of this company, I’m going to be subject to specific laws that have been established. I can set up a shareholder agreement.” All of these things, if you think about it, they are arbitrary. It happens that through history we’ve defined that this is the way it should be in a country, and every country will have a different way of operating with companies. But in the end, it’s nothing more than a series of contracts. And all of these contracts can be fully digitalized on the blockchain. This is exactly what these so-called ‘smart contracts’ are about. They’re not just for tokenizing things. They’re also for digitalizing companies where you can have an algorithmic Board of Directors, shareholders that can vote, you can pay dividends to anonymous shareholders that you don’t know anything about, except that they hold a part of this abstract company. You can take decisions and vote as a Board of Directors, not because you all meet in the same room, and you have the law of Switzerland backing you, but because you just vote with your token, in a smart contract on the chain. So, a company is something, if you see it this way and you do the abstraction that is nothing more than a set of contracts, I see a future where this simple concept may be completely digitalized and even the government here would become less and less relevant in regulating and controlling how companies operate.

Adrien: That’s just a tiny example, but if you push this further, you can start thinking about many laws that exist today, and are enforced by the centralized governments. You know, we have a centralized government, we speak about democracy, but in the end, there are a bunch of people that vote to elect legislators, legislators create laws that do not always reflect what do people want, these laws are then enforced by judges and courts that may even interpret the law in a different way than it was written, which was different from what the people actually wanted — and you end up in a system where you have dozens of intermediaries and a very centralized system for politics, for law, for justice. And I can see a future where blockchain and smart contracts can be used to create new incentives where many of the laws that we have today become irrelevant because they are already backed by some form of smart contracts, and the protections that the law offers us today can be enforced by algorithmics, by codes, by programming, and you no longer need to have armies of lawyers, judges, courts, and politicians creating laws because it trades into code running on the blockchain. So, that’s, I think, a very exciting future, obviously very disruptive — I’m not sure regulators will be happy about it, because it takes away some of their power — but I think it also can create a world with much more certainty, where, when you sign a contract, which in this case is digital on the blockchain, you’re not fearing that law may change in the next two years, or that the courts may interpret your contract in a different way, that the counterparts in the contracts are maybe dishonest. You agree on a contract, you don’t ask the lawyers and the judges to agree with you. You just code it in a specific way and you get the two parties of the contract to agree and to let the blockchain execute it with no ambiguity.

[00:21:32.25] Ben: You mentioned Libra, right? When we think about Central Bank-issued Digital Currencies, they are decentralized to a point, but they’re not completely decentralized, because you still have, I guess, one per country, one per nation-state. Whereas, it seems that Libra is trying to do something which is truly global, right? So, do you think that Libra is therefore the best medium of payments that could be or a better form of that?

Adrien: I think the ambition of Libra is very different from the ambition of a central bank. You know, a central bank, by definition is central. Why would a central bank aim for decentralization when even its name includes the word ‘Central’, you know? A central bank wants centralization, it wants all of the power to decide on what’s best for the economy. Then, we can debate whether it actually does what’s best for the economy and I would argue that it does not. But I think there are as many opinions as there are economists on the market. The point is, a central bank is not here to decentralize. It is here to provide a service which is systemic to the economy. I’m pretty sure, although this is obviously a market that is immature today, that any platform that a central bank deploys for Central Bank-issued Digital Currencies like a digital Swiss franc, is going to be rather centralized than decentralized. What is going to provide as a benefit is that it’s probably going to be peer to peer. So, you will have the ability to store and transfer these Swiss francs person to person with no intermediary — but through Central Bank, of course — however, I don’t expect that they will build and provide an infrastructure which is maintained by dozens or hundreds of thousands of different users or companies. I think this is not necessary for what they aim to do.

Adrien: However, Libra has a different ambition, which is to provide a neutral platform, which can host, then, a lot of different initiatives. It could potentially be used by a central bank to issue its coin on the Libra network, it could be used by a private company that wants to issue its coin — whether it’s a currency, a stable coin, or whether it’s a commodity token or something else — on the Libra platform. So, I see Libra more as infrastructure or as really an open platform than it is about providing money. Of course, one of the main use cases of the Libra platform is for this consortium of private slash public companies or entities to jointly control and potentially issue a stable coin. The Libra Foundation or Association is responsible for managing these stable coins for different currencies that they announced and this can look very much like what a central bank would do. But to me, it’s just a specific use case that they could have achieved with this Libra platform. And I wouldn’t be surprised that in the future we’ll see hundreds of new use cases like this one on the Libra platform the same way we see so many different applications of smart contracts on Ethereum.

[00:24:28.13] Ben: To pick up on that, you introduced the term ‘stable coin’. What’s the difference between cryptocurrency, digital currencies, and stable coins?

Adrien: So a cryptocurrency, at least if you think about Bitcoin and the ones that get a lot of inspiration from Bitcoin, a cryptocurrency is a fully decentralized currency. And by this, I don’t mean just that the blockchain — which is the ledger that stores every transaction and wallet and balances — is decentralized, I mean that the currency itself is not controlled by any central party. So, who is responsible for creating new bitcoins on the network, managing the monetary policy of Bitcoin? Well, it’s no single person. It’s actually the whole network itself that has to agree on the terms of the next bitcoins to be created in the network. And so, the management of Bitcoin itself is therefore fully decentralized. What it means also is that there is no central party that can decide whether it would make sense to create more bitcoins today or less bitcoins today. It’s fully algorithmic. This is very different from what the central bank does. If you think about the Central Bank, it looks at the economy, it looks at the exchange rates of the currency, and based on this, it will decide, “Well, should we print more Swiss francs? Or should we print less Swiss francs?” This will be a dynamic politically-based, in a way, or economics-based decision process that defines how many Swiss francs are in circulation. So, that’s very different. This is how the central bank is capable of keeping this stable, because depending on the status of the economy, it can decide to print more or print less, so that the purchasing power and the exchange rate with other currencies is relatively stable. With cryptocurrencies, you cannot do that, because they are fully decentralized, nobody controls them, so they cannot adjust to the exchange rates. This is why you see Bitcoin rising so much or Bitcoin crashing so much, suddenly. It is not adjusting to the demand of the market. So, that’s the main difference between cryptocurrency in the traditional sense and a stable coin. A stable coin is generally managed by a central party, or has, at the least, if it’s not managed by a central party, some form of algorithmic pegging to the value of something that is stable in the economy.

[00:26:52.03] Ben: Let’s also talk a bit about blockchains, the underlying ledger. So, do you see that the Bitcoin blockchain will always exist? Or do you think that gradually, these blockchains will evolve and become more scalable, more composable over time? So, is it just the first generation or is it a blockchain that will continue to exist, that has continued relevance? How do you see the evolution of blockchains? And how many can there be at any one time, since, you know, to be secure, it needs a lot of computing power?

Adrien: I think that the alternatives that you propose are not necessarily mutually exclusive. If you think about Bitcoin, I agree it is a first-generation blockchain, by definition. It’s the first one that was launched and that actually survived. Now, it is also true that is not going to be the only one and that it’s already outdated from a feature point of view. The feature set of Bitcoin is very limited as compared to many new distributed ledgers and blockchains that exist on the market. At the same time, this is also the main value of Bitcoin, it’s its stability. It’s not changing every week, it’s pretty much the same code and the same algorithm that is running now for more than 10 years. And this is because of the stability that people and investors have so much trust in it. You know that it’s not going to break because of a new bug that nobody knew about, that was brought during an update or in some new feature implementation. You know that you’re facing the same thing as the last 10 years. So, if it was robust until today, there are good chances that it’s going to remain robust in the next 10 years.

Adrien: If you think about alternatives like Ethereum, Tezos, and the many other ones that exist on the market, their goal is not exactly the same. It’s really to innovate. And they do innovate. In many ways, they do much more than what Bitcoin can do. But at the same time, it’s also a risk, because if you’re an investor, if you’re using that in production, and there is a massive update of the platform, what are going to be the consequences on your code? Could it be that a bug is introduced, a security risk is introduced? You never know, really. And I think this is why, as an investor, you may want to also favor these stability components — and this is also why we see Bitcoin being so dominant on the market in terms of market capitalization and traction. It’s certainly not because it has the most use cases. I think that Bitcoin is pretty much nothing more than a stable deflationary — or ultimately deflationary — cryptocurrency that is therefore a good investment opportunity. It doesn’t do much more than that today, it can be a great payment protocol, but not much more. Whereas Ethereum provides all of these so-called smart contracts, which can simplify contractual relations between investors and you have an infinite degree of flexibility: you can program any arbitrary software running on the Ethereum platform which you cannot do with Bitcoin. So I think that today, the question is more, “What do you want to do with these cryptocurrencies?” If what you want to do is revolutionize the future, replace what I call, you know, companies being digitized, you can’t do that today with Bitcoin; you have to go with a more modern platform. However, if what you want is you’re looking for a form of digital gold, something which has gained trust over the years and that has shown to be something that is attractive that people like to hold, and that tends to keep its value to some degree, then I would prefer investing in Bitcoin for that. It’s really its main value proposition.

At this stage, we are at the beginning of this industry, where you still have a lot of competition — healthy competition in a way — you have a reasonable amount of different ledgers that are all credible, but you have still a very strong dominance with Ethereum for smart contracts and Bitcoin for cryptocurrency.

[00:30:21.02] Ben: If we assume that the end state or future states where we have decentralized apps, decentralized companies, or maybe digital autonomous companies, decentralized apps, decentralized finance — so we have, you know, a tendency to have a very large number of companies, and apps, and so on, the opposite of centralization. Underneath it, we still have the force for centralization of the blockchains themselves, right? Or not? Because, I suppose the subsequent question is, you know, how many blockchains do you think we’ll end up having? The permissionless ones.

Adrien: It always depends what you call centralization. You’re saying that we have decentralization that is the blockchain. It’s a bit like saying it’s centralized because we’re all on the same planet. You know, we all live on planet Earth. Of course, at some point, you have a centralized standard, if I could say, or a relatively central standard. Now, it doesn’t mean that this standard is centralized itself. If you think about Bitcoin, sure, it’s a very centralized standard. So the specification of how Bitcoin works is now agreed over by thousands of users, thousands of companies. However, the Bitcoin network is maintained by these thousands of users. So, if you want to change anything, you can’t do it by yourself. You have to convince thousands of other users. I think that this is actually a very strong value. This is the network effect. The network is more valuable as you start growing its user base, the network that it can reach. Would you use Bitcoin if you knew that only a couple of people on planet Earth would agree that you send them to them and that they sell a piece of bread to you? No. You like having Bitcoin because you know that there are millions of people that hold some, potentially you can go to a supermarket and buy a piece of bread with it. Maybe not everywhere, but this is starting to happen. And clearly, Bitcoin has value. You can exchange it for Swiss francs or something else quite easily.

You have this triangle, that you can’t get everything at the same time. You can’t get decentralization, security, and scalability at the same time. If you want two of them, you’re gonna have to sacrifice part of the third one.

Adrien: Now, having the fragmentation with dozens of blockchains, actually, in a way hurts the system. It’s great in the sense that it creates competition between these initiatives, and therefore, through competition, they have to improve to keep their momentum, keep their dominant position. However, at the same time, when you want to do something concrete — let’s say you’re a bank and you want to create a new asset on the blockchain — you immediately start asking yourself, “Where should I do that?” On Bitcoin, on Ethereum, on Tezos, on any of these other, you know, hundreds of blockchains. And therefore, whichever decision you take, is going to make some people happy, and some people unhappy, because not everybody agrees on the same standard. So, it’s always this trade-off between competition is a good thing but if you have too much competition and no standards, then it limits the innovation also. And I think at this stage, we are at the beginning of this industry, where you still have a lot of competition — healthy competition in a way — you have a reasonable amount of different ledgers that are all credible, but you have still a very strong dominance with Ethereum for smart contracts and Bitcoin for cryptocurrency.

[00:33:22.23] Ben: In the current internet era there’s a tendency for heavy concentration at the app level. I think the opposite is true in the crypto world, which is the concentration is at the protocol level. If concentration is at the protocol level, is the hardest thing, then, getting those protocols to scale? Because I remember you’re the first person I ever heard talking about sharding. So, can you talk about some of the ways in which these protocols are starting or the mechanisms that people introduce to try to get this whole infrastructure to scale better? And use less electricity?

Adrien: So, I think that’s multiple different issues. So, the first one is, I don’t know if it’s a theory, but it’s at least a very strong observation. You have this triangle, that you can’t get everything at the same time. You can’t get decentralization, security, and scalability at the same time. If you want two of them, you’re gonna have to sacrifice part of the third one. So, you could, for instance, like, Bitcoin has pretty good security, pretty good decentralization, but then, the scalability is not so good. Or you could say, “Well, I’m gonna centralize”, which is what we have today. You know, if you think before Bitcoin, we had these very centralized payment processors like Visa, MasterCard. And you can say, “What matters for me is security and scalability, so I want to be able to process thousands of transactions.” However, then in this case, it’s not going to be so decentralized. It’s going to be very centralized, actually. And having these three properties at the same time is very difficult. So, when we speak about ways of scaling the blockchain, sure, we can do much better than what we do today, but we have to be aware that this cannot be infinite. We cannot reach hundreds of thousands of transactions per second or millions of transactions per second, keeping the same level of security and decentralization. You will have to start, you know, sacrificing some of these properties.

We should not see energy consumption as the devil. It’s part of any successful industry, and I would tend to argue that securing value, which is probably the most important thing today, in a globalized free market, being able to secure wealth, secure value and purchasing power is arguably much more important than many services we pay so much for in terms of electricity

Adrien: Now, what we see happening is the capability to indeed use sharding techniques where potentially part of the network validates some kind of transactions, and the rest of the network validates other kinds of transactions, and therefore, because you don’t have every single computer of the network validating every single transaction, then you can maybe double it or triple it, depending how you shard, how you allocate this subset of operations to each of these maintainers. Now, I don’t want to get into the details, but this is typically one sacrifice because now rather than having all of the users checking everything, you only have part of the users checking some things. One could argue that in many cases, this is sufficient — and I think it may be the case that it’s sufficient for many applications — but by definition is obviously less secure than everybody looking at everything. So this is one of these trade-offs.

Adrien: Another way of scaling is to not have every transaction written on the blockchain. Of course, when Bitcoin started, it was the assumption that, you know, everybody could write a transaction on the blockchain, or at least some people believed that. I don’t think Satoshi Nakamoto himself believed that. He wrote something in one of his, I think, messages or maybe in the white paper that suggested he was aware that this would not scale forever. But clearly, it was realized at some point that you could not scale what you write on the chain, forever. You would have to, at some point, decide to write transactions outside of the chain. And so, what we see today as a possible way to scale is to say that small transactions, fast transactions that require really high frequency, but maybe do not need to be secured to a point where you write everything on the chain, they could be processed more centrally between two parties using cryptography. So, in a way, it would still be relatively secure, no way for an intermediary to steal the funds or to break the chain. But you would only rise the settling transaction, the clearing transaction on the chain after you have reached a point where the risk that you have of chain is maybe too high for your tolerance.

[00:37:16.08] Ben: Is that how you see permission and permissionless blockchains coexisting? So, just again, for the benefit of our listeners, can you define what the difference is between permission and permissionless?

Adrien: Yeah. Permissionless ledger is like Bitcoin. It is a ledger that can be used and maintained by any user. If you have an internet connection, not only can you use Bitcoin, but you can also maintain it, you can be what is called a miner — so somebody that’s going to protect the network actively — and you don’t have to ask anybody; you don’t have to ask the government, you don’t have to ask your bank. You can just participate in maintenance and use it however you wish, like any other user on the system, without any permission. That’s what we call a permissionless ledger. Now, of course, not everybody is happy with this solution. If you think about banks, for instance, they don’t like the idea very much that they would start issuing securities and have to have processes to apply compliance logic on something which is, in some way, out of their control. So, in the last five years, or maybe more than that, several initiatives have been launched to create things that looked very much like Bitcoin or Ethereum but that are not controlled by any internet user. They are controlled by a subset of pre-approved users. That could be a consortium of banks, for instance, where you take a consortium of 10 banks, and each of the 10 banks knows which are the other banks of this consortium. We can verify, therefore, that only just 10 banks are maintaining and protecting this network and potentially accessing its information. So, this is a permission ledger, a ledger that is not accessible by anybody.

[00:39:00.14] Ben: And so, you could see a situation where a consortium of companies or banks might do supply chain finance, for example, in a permission blockchain, and then write the resulting transactions into a public or permissionless blockchain.

Adrien: It could be the case. I think we’ve seen quite a few projects going that way, where a permission ledger is used a bit like intranet — you know, like, before the internet, we had more intranet — so it’s used a bit more in a private context. And when you want to settle or when you want to get back to a more public standard, you would operate on a public chain. I’m not a big believer in permissioned ledgers, to be honest. I think that although in some use cases, they have a strong value proposition, in general, they are not so much more than a very secure database. You could, in fact, implement a permissioned ledger with some SQL database with additional layers on top of it, checking the integrity of data and making sure that multiple parties have ways to audit the contents. And so, I sometimes am a bit doubtful that this can establish itself as the new standard for digital currency management. However, in some cases, we’ve seen interesting applications. In particular, when you have natural consortiums for specific applications, if you look at a specific supply chain, it may be that indeed, you don’t need to open up to the rest of the network, you just want these specific dozens or hundreds of parties to be involved. And why would you then go on a public chain where you have to pay fees, where everything is public, and therefore you have privacy leaks, and where you’re not in control — so, it’s harder to apply your governance logic on top of it. In these cases, indeed, using a permission ledger is an interesting alternative.

Cryptocurrencies in general are becoming much more legit. And we see it concretely happening with regulators opening up everywhere in the world and reputed banks moving in this field, also.

[00:40:49.00] Ben: We’ve talked about how blockchains can become more scalable. Another objection that people raise is that, you know, they’re so wasteful in terms of… You know, because trust is achieved through mathematics, and mathematics is done by computation, these need an awful lot of electricity, right? So, there are ways — proof of stake and so on — that are emerging where we don’t necessarily have to burn a whole lot of electricity to create the trust, right? So, do you mind just talking about some of those emerging techniques?

Adrien: Yeah, sure. But, before I speak about these imaging techniques, maybe there is a philosophical question, which is, do we actually care? If you think about this, governments use a lot of electricity too, and we’re not arguing that we should remove all governments on planet Earth, just because they turn on the light when they get to work. Banks use a lot of electricity. Gold mines, when you’re mining gold, you use a lot of electricity.

Ben: And there’s also, we can put electricity on a renewable rail.

Adrien: Of course, I think we’re getting there in the future. We may have actually a very efficient way for, if you think about, some of these renewable energy factories, however they do it, that don’t know exactly how to store the electricity, they don’t want to sell electricity at the wrong time during the day. Well, they could actually use this electricity to mine Bitcoin when it’s not profitable to sell it on the market and rebuy electricity later. So, I think we should not see energy consumption as the devil. It’s part of any successful industry, and I would tend to argue that securing value, which is probably the most important thing today, in a globalized free market, sort of economic system, being able to secure wealth, secure value, purchasing power is arguably much more important than many services we pay so much for in terms of electricity. You know, if you ask me, I’m a bit of a libertarian so I’m quite open-minded about this. But if you ask me, if you want to save energy, I’d say maybe fire a third of the government. Maybe a third of the administration today is not so necessary. If you think about it, we have all of these laws that are no longer relevant and that need to be implemented, that need to be monitored. Let’s save energy! You know, fire some state employees. Or maybe some banks are no longer so efficient, so we can fire some personnel in the bank. So, I know it’s a bit hard to say that, but the energy consumption is not something we should necessarily avoid. We could argue that having the most secure blockchain on the market today — that is Bitcoin — has a price, an electricity price, but this price may be the right price for the service it provides.

Adrien: Now, you’re right that there are some new initiatives. It’s been quite a few years already that what is called proof of work — proof of work is the main mining algorithm on Bitcoin, which is so energy-consuming. There are new initiatives to replace this proof of work algorithm with more modern or let’s say different ways of securing the blockchain. And although I doubt very much that Bitcoin will adjust to it — because again, the main value of Bitcoin is that it doesn’t change so much — we already know that other chains like Ethereum or Tezos have moved or will move to such a new way of securing the blockchain. Now, it’s not perfect either. It may be more ecological, you may use less electricity — actually, significantly less electricity — but it has other security weaknesses that it introduces, that we don’t know much about and it’s not clear that it’s actually as secure and as neutral that the Bitcoin system is. So I think it’s good for innovation, but I would not be so convinced that this is the way everything has to go. I think Bitcoin remaining the way it is, it’s actually a very strong value proposition.

[00:44:37.25] Ben: Because in its essence, if somebody has a larger stake then somebody else has more say over the blockchain, is that right? So it’s not as equitable or not as fair.

Adrien: Yeah. But, you know, in this proof of stake modality, which is this alternative to proof of work that uses less electricity, if I want to make it simple, the richer you are, the more control you get. So if you’re rich in terms of coins and cryptocurrency, you’ll have larger control over the network. And the assumption here is that it’s very hard for somebody to centralize so much that it has a lot of control over the network by becoming very rich. Well, this assumption is correct. If you look at history, and the billionaires of yesterday that now are worth more than 100 billion or 200 billion, you may wonder if this assumption of relatively decentralized coin distribution is valid. Of course, there are ways to counteract on that, you can create counter incentives for cheaters or abuses of the system, but is it going to be perfect? I think nobody can know for sure until this is concretely implemented.

Adrien: Now, if I want to be honest, proof of work is not perfect either. So, this existing Bitcoin protocol that secures with what is called mining, it is heavily electricity consumption is not perfect either. There is also a degree of centralization, the reason being that as soon as a company emerges and makes profitable business rounds of mining, it’s going to grow, it’s going to hire more people, buy more hardware, and is going to concentrate a lot of mining around its factory. And what we see today is that China is one of the main miners. It has several of the largest mining factories, and electricity price is one of the key drivers of where you would like to establish such businesses. Some countries naturally attract mining, other countries naturally reject or repulse mining because it’s too expensive and not profitable. And even though mining is interesting in the sense that, in theory, anybody could just turn on its computer or laptop and start contributing, and therefore creating very decentralized networks, in practice, your laptop is so weak or is so bad in comparison to professional miners that it has become unrealistic to compete with professional miners, unless you heavily invest in professional hardware. And that means that most people will not do it, and therefore centralization also appears.

[00:47:05.12] Ben: And is that centralization of mining becoming a problem? Does it make the network vulnerable?

Adrien: By definition, having excessive centralization always means it makes it more vulnerable. At one point it becomes really vulnerable is hard to say. I think we’re far from that. And even though it is relatively centralized today, it still is an oligopolistic control. And the interesting property of such protocol is that even if you have a miner that represents, I don’t know, 5% of the total mining power, and therefore, one could say has 5% of the mining power, he cannot do anything by himself. He would need to align himself and have a handshake agreement, or a contractual agreement with up to 50% of the mining power — so many other parties on the network — to finally reach a point where this is potentially dangerous for the network. What we’ve seen in the past that this sort of centralization event can happen. There were multiple times in the history of Bitcoin, where mining was so centralized that the top two out of three miners, were almost able to control the network. What we’ve seen is that naturally, without trying to enforce new rules or change the protocol, the network itself got so afraid by this amount of decentralization, that it fragmented by itself. So, some of the contributors of these mining pools, you know, these mining companies, decided to switch and move to different companies, because they didn’t want to be potentially parts of excessive centralization, that would hurt the trust and the security of the network, and presumably the value of the coin because the value of Bitcoin heavily depends on how much you trust it.

[00:48:49.10] Ben: So we’ve come a long way. So, you know, initially we had this, you know, in for me, of being a place where criminals did business, right? And then we had this sort of, Bitcoin boom. I remember Jamie Dimon said that Bitcoin was worse than tulips. And then, it just seems that, you know, as time has gone on, more and more institutions have entered this space. A lot of the negative reputation has disappeared so, I think most people recognize that it’s not a place where exclusively criminals do business. And it seems like in the very recent past, there have been a number of key masters, right? So, people like Paul Tudor Jones writing that letter where he said he was going to invest in Bitcoin, he saw it as a reputable asset, and the OCC saying that banks can now act as custodians and Renaissance Capital now being able to trade futures. Do you think we’re reaching some sort of tipping point where Bitcoin moves from an edge case niche financial product to something which is truly in the mainstream?

Adrien: I think there is no doubt about it. The only thing that’s missing is the regulatory approval in some countries — actually in many countries — and the ecosystem and infrastructure to build up so that the banks or the institutions that are moving in this field, have the technical capability to do so. What we see — our company Metaco is well-placed to know about this market because we’re in discussion with dozens of banks pretty much everywhere in the world — and we see the demand is very, very strongly increasing. It’s generally a demand that needs to start building today to be productive or operating in a couple of years. So, it’s not something that is so responsive. You’re speaking about large companies, large banks, or even smaller banks, but that have a lot of other considerations — the regulatory aspects, the risk, the reputation. The market is moving now and it’s a given, at least to me, that what we knew about Bitcoin — five, six years ago, it was the preferred currency of the dark web Silk Road markets to buy drugs, weapons and pay hitmen — is very far away now. And Bitcoin criminality, of course, is always going to exist the same way that you still use dollars for terrorism financing and money laundering or whatever criminal act — or Swiss franc or any other traditional currency. Bitcoin is not going to be an exception. Of course, there will be criminal activities with Bitcoin. But Bitcoin is becoming much more of a legit currency. Cryptocurrencies in general are becoming much more legit. And we see it concretely happening with regulators opening up everywhere in the world and reputed banks moving in this field, also.

[00:51:42.10] Ben: Did you ever have any doubts that cryptocurrencies and blockchain would become a mainstream phenomenon?

Adrien: I personally never had doubts about it, otherwise, I would have probably sold my coins multiple times in the last seven years, as the market crashed — which happens regularly. I think for me it was clear, and it still is clear. What I could never have been 100% convinced is whether Bitcoin would be the winner, or Ethereum, or something else. I’ve also made a lot of wrong bets on some of these other currencies that I did not invest in, because I thought they would never succeed. And actually, those things can be worth more than a billion today. So, nobody really knows, I think Bitcoin is here to stay and I think it’s going to be a very, very strong new asset class on the market as it becomes more mainstream. I’m pretty sure that the other smart contract platforms on the market, like Ethereum, are here to stay. They have this very strong network effect today, where they’ve almost established themselves as standards. So, a big question has always been which of these cryptocurrencies are going to survive? But I think we’re very close to having a concrete answer to that question today.

We, at METACO, focus on infrastructure, and then we work with regulated partners, which are banks, in making sure that they have the most solid and professional infrastructure to protect their assets, to start tokenization use cases, do anything that is related to the blockchain.

[00:52:53.27] Ben: I just want to maybe finish off by talking a bit more about Metaco itself. So, you recently raised a 17 million Swiss francs series A round in the middle of the COVID-19 pandemic. So, that would seem to indicate that this space, again, is hot and becoming mainstream. But can you just talk a bit about why you’re different from some of the other companies that provide custodian infrastructure? Do you think it’s because you’re principally on the side of the banks and the financial services companies?

Adrien: Yes, indeed, we’ve gotten through a Series A financing round, where we raised 17 million. To be fully transparent, we started the fundraising before the COVID. But, you know, it doesn’t change much about the outcome, which is, you know, raising funds takes more than six months.

Ben: And it was a larger raise than you were initially seeking, right?

Adrien: Oh, absolutely! We aimed to raise 8 million, we ended up with more than 20 million on the table and we settled at 17 because we didn’t want to get into a lot of negotiation about new valuations, reducing dilution, etc. But it was a very successful round. To be honest, it was not the easiest period to close such a round. It is clear that a lot of venture capital funds on the markets stopped any discussions they had not just with us, but with any company on the market because they had to focus on their existing portfolio of companies that maybe may have been suffering because of the period. I think we’re getting back to normal now but we’ve been extremely successful in also the companies that we brought as shareholders. You know, Standard Chartered Bank is one of our shareholders, Zuericher Kantonalbank — it’s massive players in the banking sectors. Standard Chartered is a global custodian, Zuericher Kantonalbank is one of the most reputed banks in Switzerland. We brought a company called Giesecke+Devrient, which is one of the security giants that is supporting central banks everywhere in the world, and that is also very much focused on Central Bank-issued Digital Currencies, which is one of the reasons for the investment in Metaco. So, incredible investments and opportunities opening up with these different new partners and shareholders.

Adrien: I think as a general comment on the company, we are very special in the sense that we are specialized engineers in cryptocurrencies, in blockchain, in security, and obviously in software engineering, but we don’t focus so much on regulated services. We actually don’t want to become a regulated company. We focus on infrastructure, and then we work with regulated partners, which are banks, in making sure that they have the most solid and professional infrastructure to protect their assets, to start tokenization use cases, do anything that is related to the blockchain. And so, for that today we have the chance of still being very much of a startup. We are agile, we can take decisions very fast, very efficiently, depending on the market conditions. But, at the same time, we’re backed by extremely solid companies, we have a lot of liquidity and that gives us all of the opportunities to scale not just in Switzerland, but in Western Europe, Germany, and Singapore, Southeast Asia, and in North America.

Ben: Fantastic! Adrien, thank you very much for your time!

Adrien: Thank you, Ben!