Payments, processes, and economic fluidity…

The global payments and transaction processing system has historically been dominated by banks, centralized processors (such as SWIFT), or networks such VISA or Mastercard. More recently, a number of specialized entities such as Worldpay (which had its origin as a unit of RBS) have begun to encroach.

However, as Izabella Kaminska, a columnist for the Financial Times recently pointed out (Why transaction laundering is turning into a huge financial blindspot- FT Alphaville, March 17), the rise of “FinTech” has begun to cause a level of fragmentation and loss of control which raise serious questions about the ability of payment processors and banks to adapt.

This is because, whereas major banks and their peers (while not perfect in terms of systems and compliance) are now truly paranoid about understanding who their conventional customers are and the source of funds which pass through their accounts (with a number of them having suffered huge fines and reputational losses as a result of prior negligent or complicit behaviour by their staff), they have increasingly used third parties as a source of retail and SME client acquisition.

As a result, they have, in effect, delegated much of the “KYC” and screening or “onboarding” process to supposed specialists, who promise to improve efficiencies and cut acquisition costs. In doing so, not only have they added another layer of complexity, but unless they and their regulators are able to understand and manage an ever evolving economic environment, they run the risk of stifling the sorts of creativity, innovation and adaptation which generate new businesses and economic growth.

All of this begs the question, as with any process with multiple layers, of whether it has vulnerabilities and weaknesses which can be exploited. In this case, the so-called “gig economy” and the rise of platforms such an AirBnB or Uber, has led to a rising number of micro-businesses, each of which seeks access to the payments system, while the number of websites that purport to sell often intangible goods or services has also proliferated. There is, of course, nothing inherently wrong with this, but it is worth asking whether banks, with their legacy systems and circumscribed processes, are truly capable of adjusting to a world in which the very definition of what is a “business” or what it means to be “employed” has become fluid.

The regulated entities currently at the top of the chain, namely the banks, have delegated much of their risk management obligation to a diverse and usually unregulated ecosystem, which may rely wholly on algorithms to screen for potential fraud or criminality. One could argue that a properly-constructed algorithm may be more effective than a fallible human being, even if there will be circumstances in which a more comprehensive due diligence “overlay” is needed. It is all a question of judgement and balancing the risks, rather than being dogmatic that there is only one “correct” approach.

And clearly there are reasons why insurers and reinsurers should begin to think about this issue in some depth. After all, D&O and E&O insurance covers form the core of most Financial Lines business units; so, if the nature of the risks and their sources are moving and mutating, it begs the question as to whether historic pricing and loss experience data remain relevant.

While, at Awbury, we have no direct involvement in underwriting such products, nevertheless, we aim to remain “ahead of the curve” in understanding and assessing emerging risks, as they can have a material indirect impact, even if they seem tangential, and in themselves potentially offer new avenues to explore in terms of our own product development. In a “connected” world, understanding the nature and consequences of complex systems is essential to minimizing the risk of being caught unawares and unprepared.

The Awbury Team


Compliance, complexity, and crisis…

Although we are approaching the 10th anniversary of the start of the Great Financial Crisis, its effects linger in many areas of the financial arena, let alone monetary, fiscal and economic policy.

Banks are still being fined by, or reaching settlements with shareholders, customers, regulators and governments; with the amounts involved in the billions of US dollars, or equivalent- all of which depletes capital, damages franchises and affects valuations.

So, the question has to be posed: have we really learnt anything that can minimize the risks of a repeat?

To try to counteract the perceived risk of malfeasance and to placate regulators and customers, banks and other financial institutions, including (re)insurers now spend a remarkably large proportion of their costs on “compliance” and “know your customer” in all their many guises. The processes established are considered essential to survival, even if there are now signs that some of the regulatory burden may be lifted. The paradox is that, in doing so, and because much of the work can become “formulaic”, they may well be diverting resources from areas that may become the source of the dangers to come.

Yet, even if that occurs, can it really be said that behaviours have changed? Of course, banks have been convenient and “soft” targets, because they depend upon on governments and regulators for their very existences. Lose that banking licence and you are out of business. And there are many equivalent scandals in the non-financial corporate world that provide ample evidence that banks are not such outliers after all.

Nevertheless, the concern lingers that it is only a matter of time before another crisis erupts- and it will almost certainly be from an unexpected quarter, because the obvious causes are exactly that.

Banks and (re)insurance companies are notoriously opaque when it comes to what is actually going on within their business models; and their complexity often creates a dissonance between the reality of their risks and economics and the constraints of the regulatory and accounting standards to which they are subject, which tend to be “one size fits all”, or barnacled with accretions that make a mockery of the supposed desire for transparency and comprehension.

As a result, regulators, have repeatedly tried to improve transparency by requiring periodic publication of so-called “Pillar 3” disclosures, which are intended to provide the reader with sufficient detail and granularity of data that trends become more easily discernible and “the market” enforces discipline by increasing an institution’s cost of deposits or capital, or the spreads on its debt.

Such efforts are laudable. However, the nature of the data are such that a fairly sophisticated understanding of banking or (re)insurance is required, which then leads to the further question of whether there are sufficient independent and objective “observers” who will be both willing and able to be “enforcers”.

And, as we said above, the next crisis, when it occurs, will almost certainly have as its origin factors that no-one will have foreseen; or, if they have, they will be derided as “paranoid”, or misguided. This means that one should remain vigilant at all times about indicators that a tipping point or Minsky Moment has been reached, and that the next cascade of economic and financial damage has begun.

In our opinion, looking too much in the “read view mirror”, while at the same time focusing on information that is both complex and unlikely to highlight new risks, too much time and effort is devoted to appearances and too little to actual risk management.

At Awbury, while reviewing required disclosures for potential signals and trends, we believe that we have to remain vigilant about the overall economic environment, as well as attuned the appearance of new signals of stress.

The nature of our business model is such that we believe firmly in radical transparency, and providing clarity not obfuscation with our clients and partners; because ultimately all effective businesses are built on both trust and a proper alignment of interests. Pretending one has a “magical black box” rarely ends well.

The Awbury Team


So, which particular EU tail risk do you prefer…?

So, which particular EU tail risk do you prefer…?

In the current environment in which all sorts of “truths, half-truths and untruths” are being promulgated, and rhetoric can become very intemperate and irrational, it is usually worth pausing for a moment to re-examine whether or not the risks that one is supposed to worry about (Brexit, Russian irredentism, North Korea, the Great Wall of the Rio Grande) are the ones that matter.

Therefore, even though “markets” are often wrong in terms of signaling risks or outcomes, it is worth paying attention to factors that may seem obscure, but indicate that all may not be well. So far as the EU is concerned, there are a number of topics to cause concern about “tail risks”:

– Greece continues to struggle with austerity and “compliance” with the measures imposed on it by the “troika”, which increases the probability of another “Grexit” crisis
– With the candidacies of the so-called “mainstream” parties of the left and right in turmoil, the odds of a victory in the Second Round of the Presidential elections due in early May for the far-right nationalist Marine Le Pen have begun shortening
– Italy is “too quiet”, yet nothing has actually been solved, in terms of political and constitutional arrangements, nor in addressing the sclerotic banking system, choking on its non-performing loans

And the whole point about “tail risks” is that they have a tendency to be somewhat more probable and extreme than any model can forecast, no matter how many Monte Carlo iterations are performed! Yet, currently, bond yields, spreads and volatility remain remarkably low, as if everything will ultimately sort itself out through the usual “Euro-fudge”.

We would not be so sanguine. As recent events in the UK and the US have shown, it is becoming rather dangerous to assume that the old, post-WW II neo-liberal Western consensus still holds. There is too much metaphorical and literal bomb-throwing going on in too many places, both within and outside the EU, for anyone to be able to comfort themselves that all will be well.

So, it is telling that what many would regard as a really obscure indicator, the differential between so-called CDS-2014 and CDS-2003 contracts (i.e., contracts that include a payout based currency redenomination risk and those that do not) has recently doubled from 20 to 40 basis points in respect of Italy; and from 3 to 24 basis points in respect of France, as pointed out by Marcello Minenna of Consob, the Italian securities market regulator. Now, we admit that this is truly arcane; but the message it conveys is that there are those in the markets who are concerned that the risk of certain countries deciding to or being forced to exit the Euro is rising, especially when Le Pen has made it clear that she favours “Frexit”, while a majority of Italians believe that the Euro is a “bad thing” for the country.

Perhaps the broader point to be made is that human beings, while they can contemplate the possibility of extreme events occurring, find it very difficult to believe that they actually will. And yet history is sadly littered with the bodies of those who could not accept that they would be the victims of a bad outcome.

Of course, we would not characterize the likely consequences of Grexit, Frexit, or Italexit as humanitarian disasters (although the Greeks might argue that they have already experienced that within the EU/Eurozone), but any one of them would increase the risk of existential turmoil within Europe, and its vulnerability to predation.

At Awbury, we try to make a habit of always asking the “but what if…?” questions, because we wish to avoid the risk of being prey! We would suggest that there are secular changes under way that bear close observation and analysis.

To be continued…

The Awbury Team


Narrative Fixation, or Narrative Pluralism?

We recently wrote a post entitled “Let me tell you a Story”, in which we pointed out that, because human beings are always trying to make sense of the world they inhabit, they like to create stories and narratives.

In this post, we thought we would develop the point a little further in reference to the work of Edward Fullbrook, who has undertaken extensive research into the ways in which how narratives are defined and approached affects outcomes, because of the impact that has on an individual’s or group’s ability to reason.

It can be very tempting to state that there can be only one correct answer, theory or narrative to explain a particular phenomenon or outcome. However, with the possible exception of mathematical proofs, that is often not the case; and the way in which narratives are created and, more importantly, promulgated is actually critical in many areas of enquiry, as is the availability of language sufficient to describe them.

As Fullbrook pointed out in a seminal paper (Narrative Pluralism, published in 2007, and to which the post is heavily indebted), when quoting Wittgenstein: ”The limits of my language mean the limit of my world…and what we cannot think we cannot say either”.

So, in constructing a theory or a narrative, if our approach is self-limited (a so-called “narrative fixation”), it is highly likely that the value of what we describe is also limited, and probably not representative of the messiness and complexity of reality. It is somewhat ironic that the ability to integrate thoughts and impose some form of order is much admired in many economic circles (think of all those “models”!), when a far more effective approach would be to accept that “narrative pluralism” (i.e., considering more than one approach) is likely to provide a richer and more useful, albeit “messier” outcome. After all, economies such as those of the United States are incredibly complex and complicated. One only has to consider the wasteland created by neoclassical economics through the mechanism of the Great Recession to understand that fetishizing one approach over another is dangerous, and moves theory into the realm of ideology.

And when narratives or theories become hegemonic in, say, the area of financial regulation, they can become exceedingly dangerous; because they tend to constrain the ability of those affected to challenge their validity and point out that “the Emperor has no clothes”. For example, US GAAP or IFRS could be regarded as “hegemonic” in their own geographical spheres; yet by requiring conformity with a particular approach to what are often complex realities, they often impose behaviours or actions that may have no economic or business value. Add to this the human tendencies towards herding and imitation and one has the makings of a self-referential, closed “system”, in which the heretics are declared anathema.

Yet consider Werner Heisenberg’s (yes, that Heisenberg) comment that: “What we observe is not nature, but nature exposed to our method of questioning”. We try to make the observations “fit”, when any observation only reveals one facet of a more complex reality. The heretics and the thinkers who do not kow-tow to the naked Emperor should be celebrated. The dangers of becoming too satisfied with a particular narrative or theory because it has proven “accurate” in a particular set of circumstances are very real- debacles such as Long Term Capital are sufficient evidence of that!

At Awbury, the team tries to avoid accepting that there can be only one “right answer”, because doing so runs the risk of “fitting” the narrative into some comforting framework, when we should be challenging our assumptions and testing them frequently for their continuing validity.

And one final thought: Karl Popper showed that no amount of verification and inductive support can ever truly prove a theory- each remains vulnerable to refutation and replacement. The history of scientific discovery provides ample evidence of that reality.

The Awbury Team