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Robert MERTON£ºOn the Role of Finance Science and Financial Innovation in Development of the Chinese Capital Markets

ReleaseTime£º2017-02-17    Views£º427




    Thank you very much.  Thank you to SAIF for inviting me to take part in this consequential event.  Before I get into my remarks, a little housekeeping.  As you see, we have no slides on the screen.  Fortunately for me, and I hope for you, you each have copies of the slides with you.  I hope you do in both Mandarin as well as English.  So you know, sometimes old-fashioned technology is useful, even in the modern days.  

    The second point is I don¡¯t usually use slides anyway when I speak.  The role of these slides for you is that if you hear something this morning of interest, you now have a copy to remind you of what was said, and even a place to make some notes.  So, these slides are not exemplary of the kinds you would use if they were on the screen.  So, that¡¯s the first.

    The last housekeeping is to make clear I come today to show you some ideas, not to tell you, and certainly to tell China, what you should do.  I come to this country, to Asia, about four times a year, but that doesn¡¯t qualify me to give advice of what you should do.  So in the sprit of everything I say this morning, view this as showing you things.  If you find something interesting, it¡¯s yours.  You get all the credit, and you must also take all the responsibility for it. 

    So my topic today in this session is about finance science and financial innovation, and how it impacts capital markets.  I should start by simply saying and reminding ourselves that a well-functioning financial system is essential for economic growth.  It¡¯s not a sideshow, it¡¯s not separated from the real sector.  This idea that there¡¯s a real sector and a financial sector is a dichotomy, only exists in old macro textbooks.  In the real world, they are inextricably linked to one another and they have profound effects. 

    My colleague, Robert Solow at MIT long ago showed that economic growth was not driven by population growth nor by frugality and saving, but rather by technological progress.  You can have all the technological developments in places like MIT where I am, or the University of Chicago where Mr Rajan is, or here in China - but unless that technology is embedded in the economy in a scaled way, you¡¯ll never see its benefits for growth.  The financial system is key to performing the function of getting that technology into the economy and widely adopted in an efficient way.

    So, I remind ourselves this is a mainstream issue for the morning.  The topic I¡¯ve chosen about finance science is financial innovation is the process by which you make the financial system better.  The drivers of financial innovation are finance science, technology, and need.  If there isn¡¯t a sense of need, nothing gets done.  So, those are the three drivers for the implementation of financial innovation.  So, that¡¯s where I go this morning. 

    I think it¡¯s appropriate in an event sponsored by SAIF because its role, which is known globally, is one of research in finance, teaching or education in finance, and providing the knowledge base and advice for policy.  So, it seems that this would be appropriate for the occasion.  Now, let me say briefly what I¡¯m going to talk about before I do.  The first thing I¡¯m going to do is going to take you back to a long time ago, oh it doesn¡¯t seem that way to me.  I¡¯m going to take you to another country, my country, the United States.  I¡¯m going to take you back to the 1970s. 

    The purpose is to show you the impact of crisis because the 1970s, as you see, was a huge period of crisis in the United States, in my judgement at least as big as the 2008/2009, but we don¡¯t want to get into which one is more.  I want you to see what happened there in response to crisis, and use that perhaps as a base and as a learning experience in thinking about the crises that we all face and will face in the future, and certainly ones that you faced here in China involving the financial system. 

    Having done that, I¡¯m going to move from the old 1970s quickly to the present.  I¡¯m going to address and apply sort of a case study, an example of using finance science and innovation to address what I think is a topical issue here, the issue of things like capital controls and other stability measures, which certainly can have their valid purposes but often have unintended and costly consequences. 

    I want to show you in real time how you can actually address those unintended costs and still sustain the policy.  That¡¯s innovation in the present.  Then I will move to innovation to the future looking ahead.  There, I¡¯m going to talk about the interaction between financial innovation and technological innovation; a buzzword today for that is ¡°FinTech¡±, looking at that aspect in the future, and I¡¯ll have some observations. 

    Then finally in my remarks, I¡¯ll talk about a methodology and approach called project management, if you like, on how you can go about effectively implanting large-scale changes to the financial system.  I have in mind changing the whole retirement system or changing whole sets of markets large scale, how one as a practical matter can go about doing that.  I call that the ¡°North Star¡± approach. 

    So, that¡¯s my agenda.  How far I¡¯ll get, I don¡¯t know.  I was looking around for a clock; I don¡¯t see a clock.  That¡¯s very dangerous with me because we might be here for two hours otherwise.  So I will look at you professor, but it may be too late.  So, let¡¯s get started.  If you have the slides, you might want to turn, I¡¯m not going to give you pages, to the first event which is ¡°Major Financial and Economic Crisis¡± of the 70s.

    On this page, I just quickly list a series of shocks that all impinged on the United States really in the 1970s.  In no particular order of importance, we have the fall of Bretton Woods.  For more than a generation, currencies around the world were fixed under conditions established in 1944.  So, people didn¡¯t even have to think about currency exchanges rates because they were all fixed.  Suddenly in the 1970s, they were all let go.  This was a big shock of risk, particularly in terms of going across geo-political borders.  A whole generation had no experience even with how to deal with that. 

    What else happened?  We had the first oil crisis.  Oil went from $2.50 a barrel to $14.  We didn¡¯t know the number, but we had a second one by the end of the 70s; again, pretty much unprecedented.  What else happened?  Well, double-digit inflation.  Can you imagine that?  Over 10% in the United States.  We hadn¡¯t seen that since the Civil War in the middle of the 19th century, over 100 years.  There was no experience of dealing with that. 

    What else did we have?  9% unemployment.  Now think about those of you who think about policy, yes, we have not even a little higher unemployment in 2008/2009, but we didn¡¯t have double-digit inflation.  I won¡¯t ask our central bank governor who¡¯s here, but imagine you were the central bank in the United States or EC or around the world where you took the policy decisions that you did, could you have done that in a 10% inflation environment?  I doubt it. 

    This thing was called ¡°stagflation¡±.  I¡¯m not an expert in that area, but I did ask a Nobel Laureate for whom I have great respect today, ¡°What happens if stagflation comes back?  Do we have a cure?¡±  At least this one person said, ¡°No, we don¡¯t know what to do¡±.  So, let¡¯s hope it doesn¡¯t come back. 

    So we have high unemployment; high inflation, the inflation not seen since as I say for over a 100 years.  What else did we have?  The stock market in real terms fell by 50% in 18 months from 1973 through to the end of 1974.  We had double-digit interest rates.  That¡¯s kind of a joke since in the last period, we¡¯ve had interest rates of practically zero.  Now, what else?  Well, we had no money for housing because we had some regulations that put a ceiling on interest rates.  If you could get 10% full faith and credit of the US government, 5% in a bank account didn¡¯t look very attractive. 

    So this list and I go through it, I¡¯m not going to go through each on the list, it¡¯s to show you how many major shocks hit the United States at one time where we hadn¡¯t had experienced for a long time.  Now what I want you to see is what was the reaction of that, what actually happened in the United States in response.  If you have the notes, flip to the next page. 

    There was a wave of financial innovation, that hasn¡¯t been seen since, that took place at that time.  There is no question, at least in my view, that its implementation was driven by these enormous increases in risks in the economy that had to be addressed.  So we developed for example, the first listed option market.  What are options?  They¡¯re insurance, financial insurance.  That¡¯s one way of dealing with risk. 

    What else was developed?  Financial futures, financial futures for currencies to deal with the fact that now currencies were risky; financial futures to deal with stocks; financial futures to deal with the varying interest rates.  Imagine 10% interest rates, what that would mean in terms of volatility and flexibility.  Those all came in. 

    We created the first electronic stock exchange, money market funds, the first index funds were created.  I could talk about any one of these for the rest of time.  I won¡¯t.  So if you don¡¯t get all the individual pieces, you don¡¯t get all the lyrics, listen to the tune of this.  We created international diversification in stocks, Paul Samuelson introduced that, and a major insurance company TIAA-CREF for the first time in this period.  Prior to that, international diversification in stocks was just not done. 

    We got rid of the cartel in commissions where institutions had to pay the same rates as individuals.  That created the framework to have institutionalisation investment.  Very importantly, we created a national mortgage market.  Ever since that time where we got a base of funding of residential housing in the United States, that base was global; not just banks and savings and loans, any entity could provide the funding from around the world, and they did and they do.  In the four decades since that development, there has always been mortgage money in the United States, unlike in the 1970s when there was none; no matter how good a credit you were, you could not get the money. 

    That benefit, which came in as a consequence of these events, has been paying dividends, that innovation, as have the others, to the United States and the rest of the world since.  So not only are these innovations a response to crisis, as a response after the crisis was done with, they continued to provide benefits to society and have continued to do so.  This seems to have been forgotten in the dialogue of the last eight to ten years.  It¡¯s important because in terms of the experience here you face, sometimes, often even, the response to crisis is to cut back, slow down, say ¡°No, we can¡¯t innovate or in fact we should undo innovation¡±. 

    Maybe sometimes that¡¯s the right answer.  There¡¯s no automatic answer.  What I want you to see here in the face of these enormous shocks to a large country, the response was the opposite; not because it was coordinated in the sense of government, but these were the private sector with the benefits of government together creating all these markets - not to get rid of risk, you can¡¯t get rid of those risks, those are part of the economy - but rather to manage it, to share it in much more efficient ways. 

    So, that¡¯s the lesson for this.  One, it can be done; two, sometimes the best response is actually to move faster on innovation and not cut back.  Again, and this is not an advertisement for SAIF but it¡¯s true, making judgements from these really well-trained professionals, it¡¯s not something that someone from the seat of their pants just making generalisations can give you the answer.  You have to make judgements, and they¡¯re big. 

    So moving from that, so that¡¯s sort of my punch line for it is to do it, and the fact that this innovation provided long-lasting benefits.  Just as an aside, one of the innovations of that period is the interest rate swap, very simple contract and concept.  Now, there¡¯s something around US$500-600 trillion notional amounts of swaps around the world today.  The interest rate swap overnight eliminated the largest risk in banks - good banks, banks that were behaving themselves, banks that were serving their customers, but who had huge interest rate dispatches between depositors and borrowers.  The biggest risk in banks everywhere was interest rate risk; this was eliminated overnight. 

    So with that, that¡¯s enough for the past, I better get moving forward or I¡¯ll never get anywhere.  So, let¡¯s move to the present.  There are some other things in the notes that I won¡¯t talk about because we¡¯re running behind time, but the one I want to show you today has to do with the issue that I know is a big one here in China.  You have decided to take steps, and in fact even before the crisis, of which what might call broadly capital controls, the controls of capital flowing in and out of the country.  I¡¯m not going to give an opinion on whether capital controls are a good idea or not here.  I don¡¯t know enough, and that¡¯s not the issue. 

    But what I want to show you is something I think we can all agree on, and that is if we can reduce the cost imposed by capital controls, costs that were not intended but are a consequence of the way capital controls are typically implemented, if we could get rid of those costs, everybody would say that¡¯s better I hope.  We can have a debate whether we do capital controls, but everybody would prefer capital controls be there. 

    So here¡¯s the suggestion, and I take an extreme way to do it.  First of all, what is the old major cost of capital controls?  If you have capital controls, then if they were complete - you understand I know they¡¯re not complete but I¡¯m saying is if they were complete - that means what?  All the risk of the country, enterprise, industry has to be borne by whom?  The people in the country.  Because if you have capital controls, you can¡¯t broadly diversify, you can¡¯t take money out and you can¡¯t bring money in.  How expensive is that? 

    If you look at the chart, this is the only thing you really need to look at, the chart there that shows the chart of risk versus return.  I hope for this audience, that¡¯s a familiar kind of chart.  This shows how much average return for how much volatility that you take.  That straight line is going from no risk, again essentially a riskless return, up through higher expected returns with no risk.  Okay, that¡¯s those familiar curves.  This is like the ¡°capital market¡± line, if you want some jargon.  

    But this is just the menu of risk versus return.  Now, you see there are three lines in that picture.  The top one happens to be the top line is the menu of risk return benefits if you are globally diversified, you hold the World portfolio.  The steepness of that line shows you the amount of additional reward as an investor you get or as a country you get from taking on the additional risk. 

    So clearly as an investor, you like that to be steep, you like to get lots of reward for the amount of risk you take.  So, you can see the risk/reward if you held the world.  Now for the period of about 20-odd years from 1993 to 2015 - it¡¯s not important what years, it¡¯s just an example - we looked at what the realised risk/return was for China.  That¡¯s the lowest line there, that¡¯s actual.  It turned out that China did not have a high reward to risk benefit in its stock market.  You know, that happens; some countries happen to do better, some do worse, usually not much under anyone¡¯s control.  But you can see that if you only invested in China, you would get much lower reward per unit risk.  That¡¯s the cost. 

    Now, that¡¯s not a good measure because that¡¯s what happened after the fact, and we all make decisions beforehand.  China, as it turned out, underperformed expectations.  Well, so you shouldn¡¯t close out the costs because nobody knows what the future is actually going to be.  So what I¡¯ve constructed is a third line which is labelled ¡°expected¡±, and what it is is given what happened to world, in other words how World did, what would you expect China would have done had it done just as expected, not overperformed, not underperformed? 

    That¡¯s the line that¡¯s relevant, and you see here it¡¯s the middle line.  That¡¯s the estimated costs of not diversifying, of putting all your eggs in China, as big as China and diverse and as growing as China.  Do you see that it¡¯s much lower?  So for any level of risk, the amount of expected return is lower, a vertical line.  But for any level of expected return, the horizontal line, you have to take more risk if you only invest in China.  That difference is not going to short-circuit the numbers, it¡¯s just you see the picture. 

    If you want a ballpark, just don¡¯t take this number as precise, even close, of how big the number costs to China was had it been completely that way, it¡¯s about 300 basis points a year, 3%.  Now to put that in context, my understanding is NCSSF is now your sole for the retirement system because I think you brought all the provincial ones in.  If your NCSSF were a retirement horizon, the regeneration, 24 years, so that¡¯s a short generation, 3% doubles your money.  So, you¡¯re talking about magnitude.  3% as a cost means that if you had that 3%, you would have twice as much of a return in a fund in a generation than you will have if you follow that policy. 

    I¡¯m trying to give you a sense these are big numbers, so it¡¯s a big cost.  Does that mean that you shouldn¡¯t do it?  No, because you have to ask yourself why are you not doing it if you don¡¯t do it.  But first, you have to see that it was costly, all right.  Now why would you have capital controls, why would you restrict?  There¡¯re several possible reasons. 

    One, the first one typically is you¡¯re worried about instability, capital flowing out, capital flowing in, disruptions, that¡¯s not good.  A second one is governance, it¡¯s a longer term.  If all your shares are owned by foreigners because everybody is diversified, and they own vote them, it¡¯s a country not China but a country let¡¯s say like Canada, it¡¯s such a small part of the world portfolio, that would mean that no Canadians would own very little Canadian stocks, and you¡¯d have a governance outside of the country.  Most countries would not put up with that.  So that¡¯s a second reason, for keeping it inside. 

    A third one, which I don¡¯t say has credibility, is the idea that if it¡¯s for the pension of the workers, shouldn¡¯t the money be invested in the companies the workers are working in?  That¡¯s the third reason.  Now I¡¯m not going to defend these three, I¡¯m reporting them.  But certainly, you can recognise the first one.  So someone will say, ¡°Look, I¡¯m sorry but for stability we¡¯ll just have to pay the price of the 300 basis points¡±.  Again, I¡¯m not debating that; that¡¯s your decision, not mine, you know more.  However, what if we could get rid of the 3% cost and you can have your capital controls? 

    So here¡¯s the thing, how about you do the following thing?  You have your institutions hold all the A shares, and you can by extension individuals, but let¡¯s just deal with it, you know, your CIC, your own sovereign wealth funds, the big pension funds, reserves, big institutions hold the A shares.  But you want to diversify.  So what you do is you have those institutions enter into a total return swap, which is nothing more than the exchange of returns, no cash changes hands, in which those institutions swap or pay out or agree to pay out the returns on China A shares and in return receive the returns on global equities, a diversified World portfolio. 

    A very simple contract to understand.  You¡¯re A shares, say I¡¯m going to pay the return on the A shares; and in return for that, I get the return on the World.  No money changes hands.  It¡¯s a pure exchange of risk.  If you look at the chart, what¡¯s the economic outcome for NCSSF or CIC or any other, you¡¯re still holding the shares.  But what is their return?  They pay out the return in those shares and they receive back World, they end up with a diversified holding. 

    Everybody see that?  So, do you see your institutions get diversified?  But what about the policy implications?  You could still have capital controls.  Why?  This is an exchange of risks.  There is no investment moving in and out.  The only time money goes in and out is say periodically every three months or every six months, whenever the terms of the swap are settled.  So, one party pays what it promised and gets back what it was promised.  That is the difference. 

    Now, let¡¯s look at the nature of that.  First of all, look at the size.  It¡¯s predictable because you know it¡¯s going to be every three months or every six months, so it¡¯s not a surprise.  If you do this, when does money go out of China on this contract?  When does China pay out?  When does CIC pay out?  When does NCSSF pay out?  Only when the Chinese stock market does better than the World.  Those are good times for China.  Those are times you don¡¯t need capital controls, you don¡¯t need stability in that sense.  This is good times. 

    When does money flow in?  When China¡¯s stock market underperforms the World.  It actually is better than just capital controls because when the money flows in, the worse that the Chinese stock market did relative to the world, the more money flows in.  So, it¡¯s a right-way contract.  China pays when China has the ability to pay, and China receives when China has the greatest stress. 

    By the way, this isn¡¯t unique to China; it¡¯s the nature of the contract.  So first thing I want you to see the flows that come from this contract are actually stabilising, not un-stabilising, and predictable, not the amount but when it will happen.  You get more when you need it, and you pay more when you don¡¯t.  Now I don¡¯t have the time or we¡¯ll never get there, but I give you in the notes there, analyse a little further because you know, you say ¡°Okay professor, nice idea on the scale of all China, could you ever really do this in the real world?¡± 

    Well I¡¯m going to go out on a limb, I don¡¯t see the tree but I know I¡¯m going out.  I¡¯m a teacher ,but I¡¯m telling you that if you said to me tomorrow let¡¯s do this, and I don¡¯t mean as a little experiment, I¡¯m talking about a huge size, I think even I - and we know you have many people that are much better at it - even I could get this done starting tomorrow.  Why?  The contracts, the swap contracts are well-understood and used around the world large sized.  You don¡¯t have to worry about new legal things, you won¡¯t have to worry about it.  Those contracts have been adjudicated over decades.  So well-known contracts, well-known institutions; it¡¯s all the same institutions, so you don¡¯t have to change that. 

    Now someone will say to me, ¡°Wait a minute.  If China did that with all it¡¯s A shares or large amounts, who is big enough to be the other side?¡±  The answer is I know it¡¯s there.  Why?  If China has too much China in its portfolio for a well-diversified, right, which it does, what¡¯s true about the rest of the world?  It has too little because it adds up to the World.  So you have too much, the rest of the world has too little. 

    So I know whether it¡¯s Norges Bank in Norway or pension funds in the Netherlands, I know that there¡¯s demand for those shares if they¡¯re provided efficiently, effectively and without things like expropriation risk and high costs.  All of that could be done by this structure. 

    So there¡¯s natural demand, you don¡¯t have to pay big premiums to get this done because they want the shares as much as you would want to diversify.  By the way, you don¡¯t have to worry about counterparty risk, you don¡¯t have to do this with Goldman Sachs or Deutsche Bank.  You all know there¡¯s people in this room, I can see them, how to price a swap on a traded security like shares.  That is not rocket science.  If you don¡¯t want to do it yourself, you can hire - let me not name a firm - there are plenty of firms who for a relatively small fee will calculate what the swap is worth, and the two counterparties can agree that that¡¯s the price they¡¯ll do it at.  So you don¡¯t need to go through an intermediary.  You can do it directly.  You can put 42 sovereign wealth funds in the room - there¡¯re more people in this room that you would need - and say, ¡°You all have these, you have too little A shares.  We have too many.  Let¡¯s set this up as an efficient effective way¡±.  You don¡¯t have credit risk, you don¡¯t have counterparty risk.  Swaps naturally have relatively little. 

    Okay, so let me just say look at all the other things that this does.  It allows you to have local governance; it keeps the capital stabilty, capital flow stabilty control; and even has local investment.  Now, it won¡¯t provide any investment funds.  What it does is provide efficient risk sharing, 300 basis points a year.  So whether you think capital controls are a good idea or not, I have no comment on.  But I do think that getting rid of the negative impact, your untended impact of those, is something that almost everyone can agree on.  Again, I really mean it, you could do this - and I say tomorrow it might take a little longer - but you don¡¯t have to go out and create a huge infrastructure to do it.  It¡¯s a pretty simple story for people to understand.  There¡¯s no fancy mathematics stuff here, and it uses all market-proven technologies. 

    Well looking at the time, I think I better move faster here.  That¡¯s my present, and I hope that¡¯s hope a present - pun intended - to bring here in the consequences that I know these are issues that you¡¯ve been thinking about, the trade-offs.  I¡¯m just saying if I can come up with a simple idea like that which is practical, I¡¯m sure if you put a little more effort in it, you could make it much better.  Okay, so this is just to tease you and encourage you to take a look at this because it¡¯s really doable.  This is not hypothetical. 

    Now let¡¯s move a little bit further, farther in time, and we¡¯re now up to technology; and by that, I mean computer technology and so forth, Silicon Valley, whatever you want to call it, and financial innovation, and the two of those coming together in terms of the future and what are their implications, ¡°FinTech¡±.  What I want to say here is if you listen to the stuff that comes from Silicon Valley, they say to the people in financial institutions ¡°We are coming to disrupt you.  Banks and others, your competition is not another bank; it¡¯s Google, we are going to disrupt you¡±.  The question is, you know, like most things, there¡¯s some truth to that.  How much and where?  And yes, I believe in those parts of the financial systems that are processing, by that I mean clearing and settling on exchanges, payment systems, things of that sort, yes, I think it¡¯s going to be quite disruptive.  It already is becoming that way. 

    So if I was running an exchange where my franchise is clearing and settling, centralised clearing and settling, bit coin technology having nothing to do with its application to currencies can be used for doing clearing and settling in a decentralised way and become a substitute for an exchange.  So if I was running an exchange, I¡¯d better start thinking about that.  Either I do it myself to get ahead; there¡¯s some exchanges already announced they¡¯re doing that; but whatever, yes, I think that¡¯s real. 

    But let me tell you the place where I think that FinTech is going to run into a lot of headwind, and that is in the area of activities that I call ¡°inherently opaque¡±.  What does inherently opaque mean?  You all know what opaque means, there¡¯s transparent and opaque.  Inherently opaque means something that¡¯s opaque and you can¡¯t make it transparent.  Let me give you an example from medicine. 

    I want to have a knee operation - I don¡¯t, don¡¯t worry, not unless I fall off this podium, okay.  I want to get a knee operation.  I go to the surgeon in the hospital and I say, ¡°Make it transparent¡± because transparent, then I can see it, understand it and make a decision, I¡¯m willing to go ahead¡±.  So, what does the surgeon do?  The surgeon gives me every scientific study on this knee surgery he¡¯s planning to do.  He lists all the tools in the operating room.  He has line by line, they¡¯re going to put me on the bed, they¡¯re going to do this to my skin, line by line what he¡¯s going to do to me on the table. 

    That¡¯s full disclosure, that¡¯s transparency, right.  Think about it.  Does that help you to make your decision?  Remember if you have that knee done, that¡¯s going to affect you the rest of your life.  This is not just a minor thing.  If it¡¯s done right, great; if it doesn¡¯t go right, it¡¯s going to be pretty awful.  The point is I don¡¯t care what your education is, it¡¯s still opaque.  You can¡¯t tell from what I¡¯ve told you. 

    RSCC would say it¡¯s fine, you¡¯re fully disclosed, people can make decisions.  But reality is you can¡¯t.  It¡¯s inherently opaque.  In fact, most things that involve judgement, including surgery, are inherently opaque because you can¡¯t make judgement transparent.  When you have opacity, what¡¯s the only way you can make it into an activity?  Trust.  I use medicine here because it¡¯s important to all of us.  But two, how many times have you heard ¡°You have to find a doctor you can trust.  You have to find a hospital you can trust¡±.  Why?  Because you can¡¯t understand it, you can¡¯t see it, it¡¯s not transparent what they¡¯re doing and they can¡¯t make it so. 

    So, the only substitute when there¡¯s no opacity is trust.  There is no second choice, and this also applies to crises.  So solutions in crises where you say let the banks take care of themselves, unless the banks have trust, they can¡¯t do it.  Because certainly, that¡¯s why we have crises, opacity. 

    So getting back to the theme, does technology create trust?  Well, no.  Look, as I was saying to someone last night, I have a phone, I can¡¯t say which, you know, it¡¯s okay Google, but you can make up your own name.  From my phone, I say okay Google.  I¡¯m ready and I say, ¡°Okay, what should I do about my knee?¡±  It answers all the questions rapidly, you know, within 30 seconds.  I could ask it who was the President of the United States in 1933, but I asked it this.  Now, it¡¯ll give me an answer.  Now suppose it said, ¡°Well, maybe you should just cut your knee off¡±.  I don¡¯t mean to be gross.  Would you do that?  Of course not. 

    Why?  Well, it¡¯s pretty serious, you don¡¯t know what the model was or the data that that advice was given on and why it was given.  You don¡¯t trust it.  Now if you did trust it, if you went to the best hospital, the best doctors who you do trust and they said for you to survive, that¡¯s what you¡¯re going to have to do, and you get a second and third opinion to increase that trust, and that¡¯s when you might do it.  But not because someone tells you over a vehicle in 30 seconds.

    The same thing with investing, serious investing, not games playing, not entertainment.  Would you really take your family¡¯s money and yours, your retirement money and because something over a machine told you to do something, put your money in it?  The point I¡¯m trying to make is that most of the focus in FinTech on the tech side is delivery, low cost processing.  But unless it can create trust, the only alternative is it will work for things that are transparent because transparent is the substitute for trust.  I don¡¯t have to trust you if something is transparent, I can see it.  But for much that we do in finance, advice and so forth, both in products and individual advice, is inherently opaque. 

    So my prediction is that those entitles have the ¡°trust asset¡±, that are trusted by whatever reason, whether it be government, private sector, individuals, family, whatever, that asset is going to be needed by FinTech, the tech part of FinTech, in order to get implemented.  So instead of it disrupting and taking business away from such entities who have the trust asset, it¡¯s actually going to enhance them. 

    Why?  Because if I have trust, however I got it, now people will deal with trust, the technology will allow me to bring my asset and apply it to more people or to apply it deeper to individual people because I can do it faster, quicker.  Well of course, what I¡¯m responsible for, it¡¯s my thinking, the basis of the trust that I have with my counterparts, my clients, that they¡¯re depending on it. 

    So what I would predict to you is you will see it, and actually I¡¯m already seeing it in the United States.  Financial advisor firms, pure ones, so you can see them, not the complicated banks and so forth for the moment, not that they aren¡¯t going to have to do it too, but it¡¯s different, all right.  Advisor firms in the United States are partnering with FinTech Silicon Valley companies to bring the technology in to allow them to deliver their trust, their services, trusted services downscale to smaller size people. 

    I can¡¯t afford with my current technology to take too small an account, it¡¯s too expensive.  But if I can leverage myself through the technology to deliver that trusted information in a low cost way, I can go down to smaller and smaller groups of people and economically deliver it.  So, I could extend myself to a bigger pool.  I¡¯ll actually expand not contract, as a result of the technology.  Technology is not going to disrupt me in the sense to put me out of business, it¡¯s going to leverage me.  

    Much like in entertainment and in sports, what have you seen?  Because you can do everything by video and so forth around the world, high definition, music or whatever.  Everybody can see Manchester United playing soccer anywhere in the world.  You can even go to a room where they have grass or it smells like you¡¯re on the field.  You¡¯ll see it better probably than you would see it from the stands.  That allows Manchester United, as an entity, and its players to expand itself around the world.  They¡¯re only playing in one place at one time.  But with technology, they¡¯re able to go all over the world.  

    So, what happened?  They get a $100 million contracts.  Unfortunately, a lot of second and third level teams paid a price and that always happens.  I¡¯m convinced that that¡¯s the direction we¡¯re going in finance.  If you have the trust asset, you¡¯ll grow.  If you don¡¯t, or you¡¯re just trying to just complete on the sides, there is disruption.

    That¡¯s my message, but now I want to expand a little more because I think this trust thing, first of all, let me remind you about trust.  Trust is not - you know, usually when you say ¡°trust¡±, you think trustworthy.  I¡¯m going to do what¡¯s in your best interests.  That¡¯s important, but that¡¯s not sufficient.  I trust my children with my life, my family with my life, and make a decision for me.  Maybe I shouldn¡¯t but I do.  But I wouldn¡¯t let any of my children near me with a scalpel to do the operation because they don¡¯t have the skill. 

    So trust is both trustworthy and competence, and you need both to have trust.  So, I believe this is key.  I also believe this is a way to understand one of the big fallouts of the 2008-2009 crisis.  I don¡¯t think anyone would question that as a result of 2008/2009, the big recession, trust has been lost in the financial industry.  It¡¯s been lost in the providers and it¡¯s been lost in the regulators, the government people that overdo it.  It¡¯s been lost both in terms of trustworthy, i.e. you only have to see things like sadly Wells Fargo, okay, but it¡¯s also been lost in competence.  Managers of big institutions didn¡¯t even understand the risk they were taking. 

    That¡¯s incompetence, and it extends to the regulators.  You hear about regulatory capture, that suggests that they¡¯re not trustworthy.  You hear about regulatory incompetence, they didn¡¯t understand the things that they were regulating.  That¡¯s incompetence.  So I believe there¡¯s no question that has been a shock to the system, and there¡¯s empirical evidence to support this.  Since 2008/2009, in the retail sectors at least in the United States in extensions, there¡¯s been an enormous shift of investing by retail away from active management into index funds.  The biggest beneficiary in the United States has been Vanguard.  They¡¯ve been taking in a quarter of a trillion new money every year, a quick 250 billion new money. 

    What is about Vanguard?  Is it suddenly people don¡¯t believe that active management can do better?  Maybe, I don¡¯t think so.  They¡¯ve always been saying that.  Do they know it¡¯s lower cost?  Yes, they¡¯ve always known it¡¯s lower.  What is the difference?  Active managers are opaque, therefore you have to trust them.  If you¡¯ve lost trust, then you can¡¯t use them, but you still have to invest.  So, you go to a strategy that doesn¡¯t require trust.  That¡¯s indexing.  Vanguard is a wonderful company, but you don¡¯t have to trust it because it doesn¡¯t do anything.  It makes no decisions.  It¡¯s transparent.  So, I point this out to you as reasons. 

    How much time do I have left?  10 minutes.  Okay, I think we might almost make it.  So I want to leave this with you.  I¡¯ve talked here in China about this the last year, in insurance associations and so forth, and in the Geneva Association around the world, and I¡¯ve had good resonance.  You know, trust always sounds like apple pie and a good thing, and it is.  But this is a case where actually building trust is the best business activity.  It¡¯s a value enhancer.  Because that¡¯s where you know, you always have competition in technology.  You build a better bitcoin, someone will better than one that.  It¡¯s a very very competitive element.  Trust is something that¡¯s harder to overcome, and therefore that¡¯s where a lot of the value is. 

    That means for regulators, for institutions and for those in the business, you should have focus on how do I create more trust.  It would take a much longer time than I have to get into that, but I can assure you there are big and serious things to be done to try to develop that.  I¡¯m trying underscore this is better for everyone, than the most capitalist value maximising entity, this is in my view the way to go.  I think that it has a big influence on how you run your businesses, how you organise them, how you regulate them.  If we can create a trust triangle, providers, regulators and customers, usually we think between the provider and the customer, what you have between the provider and the regulator, if we could get trust there, which is missing sadly in many places, you¡¯ll do much better because the providers really do know an awful lot about the business they¡¯re in. 

    They can help the regulator.  If you step back, regulator and provider or not in conflict.  They can be when people are bad or stupid; and we can all agree, fools and knaves we don¡¯t want.  Yes, fools and knaves exist in academia, in the clergy, in politics and in finance.  But that¡¯s not the foundation.  The foundation is regulation is there to make the system better for the users.  The providers want things better for the users because that¡¯s their industry.  So they¡¯re both on the same side of the table fundamentally, and we shouldn¡¯t forget that.  We have policemen because we do have bad people, but not everybody is bad and we don¡¯t run things as if everybody is a crook.  It¡¯s too costly. 

    So, that¡¯s why I wanted to focus on trust.  I think this is the guide to where you¡¯re seeing things are going to go.  You¡¯re going to see lots of exciting things.  By the way, a lot of value creation.  We¡¯re going to be able to do it, and I built them, and the only reason I¡¯m saying this is so that you understand it exists.  I built retirement systems that can be run at very low costs that are customised for every individual, and I never even have to talk to the individual.  I ask you for no information.  It can be run completely, okay.  I only put that as a teaser to say this is not a dream for 10 years or 20 years from now, this is today.  It¡¯s only going to get better.  So there¡¯s a great opportunity here, let¡¯s not lose it. 

    Finally, the last eight minutes, seven okay, I¡¯ve got to talk about the last thing in your notes.  This is about implementation.  I will only say that what I¡¯m about to say is I actually did it, and that doesn¡¯t mean it¡¯s right, but I¡¯m trying to say I actually used this to implement a large retirement system design and so forth.  This is how do you go about if you¡¯ve made a decision, you want to make major revisions in your financial system, change the retirement system, change the way markets and so forth, something big, how can you go about doing this. 

    Now the first thing I would do is - see if this doesn¡¯t ring with you - if you were going to design, let¡¯s say, a new retirement system, what¡¯s probably the first thing that you¡¯d think of doing, government or otherwise?  Go out and find out what¡¯s best practice, right.  You go around the world, you see what¡¯s been done, and you pick the different pieces and you call it  ¡°that¡¯s best practice¡±. 

    I will say one thing here unequivocally, best practice is not good enough.  Sorry.  Now don¡¯t tell anybody, but when I drive in Massachusetts, I¡¯m a conservative driver but I drive very fast.  So when I¡¯m driving on the turnpike, the autobahn, I look in the rear-view mirror.  I¡¯m kind of looking there because I want to see if there¡¯s anybody that might interfere with my trip.  Suddenly, I realise I¡¯m driving at 30 metres a second looking in the rear-view mirror.  Now if what¡¯s in front of me is the same as what¡¯s behind me, that works, right.  But if there¡¯s a change in front of me, it doesn¡¯t work. 

Okay.  That¡¯s my metaphor.  If the world is unchanging, if the technology of how you do things in finance is unchanging, then looking at best practice - which is the past even if it was just done - because it exists, is already a legacy.  It¡¯s the past, just like that building I passed at 30 metres a second.  It¡¯s the past; it¡¯s behind me.  But I don¡¯t think any of you would agree just look at FinTech the whole thing, the way China has changed, the rest of Asia is changing, the institution, the one thing we know is not true is that what¡¯s in front of us is the same as what¡¯s behind us.  If you were bringing in a phone system in a new country with no phones 20 years ago, would you have put up telephone poles the way they are in the United States, which at the time was the best way?  Of course you would have known, even though it hadn¡¯t been built yet, about digital technology.  You say, ¡°Hey, the world¡¯s going to change.  Yes, US was best practice, but the world has changed¡±, and you wouldn¡¯t reproduce it, it wouldn¡¯t build itself that way today before you¡¯ve got to rebuild it. 

    So I don¡¯t know how many metaphors to give, but you get the point.  If you have change, if you¡¯re making changes either because technology changed or because the country is changing.  GDP has grown.  You¡¯ve gone from an agrarian economy to an industrial economy, that changes your retirement system.  The family as a retirement system doesn¡¯t work as well because people don¡¯t live and stay on the farm.  They move away, and that won¡¯t work.  Not that it wasn¡¯t a good system, but it won¡¯t work in the new environment.  That¡¯s change.  When we have change, best practice is not good enough. 

    So what you should do is when you have a project, you bring together the best team you can, and say ¡°Design the best solution you can imagine that¡¯s feasible.  The best one, no constraints, no regulatory constraints, no ¡®is it being done now?¡¯, but it has to be feasible.  It¡¯s not, you know, we¡¯re not making silly assumptions you can do it.  Design that best design¡±.  That¡¯s the unconstrained best.  That¡¯s Nirvana.  Write it down, get agreement on it.  Everybody reach agreement.  This is where we would love to be unconstrained. 

    Step 2, look at where you are now.  That you can do.  Those are two well-defined projects.  The best you can do without constraint, and where you are now - two points.  Those are big projects, but they¡¯re well-defined.  This is where you are, this is where you would dream to be.  Nirvana and where you are.  Then the implementation is first, be sure you get agreement where you want to go.  Once you¡¯ve done that, your mission statement is to get as close to Nirvana as you can.

    What if it¡¯s like a retirement system and has to work tomorrow as well as 20 years from now, you don¡¯t have the luxury of waiting.  Then the view is tomorrow we¡¯re going to do the best we can under the constraints of the day.  Nobody can fault you if you do the best job possible in a given day.  But you make it good, ¡°This isn¡¯t good enough, this isn¡¯t what we want to do.  This is just the best we can do tomorrow.  But by the way, this is where we¡¯re going¡±.  That¡¯s a very different message. 

    That¡¯s the first benefit of it.  People who may not be happy with the state of affairs right now because it¡¯s a pretty crummy system, if you¡¯re doing the best you can, and you can show them where you¡¯re taking them this is a good place, you can get buy-in.  You can get people to agree.  So, that¡¯s one advantage. 

    What¡¯s the second advantage?  Big projects don¡¯t just have three people with pizza boxes, three partners starting something up with an app or a computer, and they work together and that¡¯s it.  Big projects - people come, they go, a new person joins you.  When you have Nirvana, and you have where you are and you have a mission statement, you can orient that person, ¡°This is where we¡¯re going, this is the mission, this is where we are¡±.  It¡¯s very practical.  Because in real big systems, people are coming in and out.  If you don¡¯t have that anchor out there, you don¡¯t know where you¡¯re going.  I don¡¯t even know which door to go out of this building unless I decide where I want to go first. 

    Third advantage, and I live through this in my little exercise, with the retirement, because I started implementing retirement well the first was in 2005.  That means I went through 2008/2009 like the rest of you.  That was a bit of a distraction.  You would agree?  Well if you want metaphor, that¡¯s like a storm.  You¡¯re on your way to go somewhere.  A storm comes.  You¡¯re on your ship, all you care about the storm is keeping the ship above water.  You don¡¯t worry about any long-term goals.  You just want to survive.  That¡¯s sensible.  But when the storm finishes, where are you?  Who knows.  You¡¯ve been blown wherever you went to survive.  

    That¡¯s the first order.  But now, where do you want to go?  You want to go where you wanted to go.  If you have that anchor, if you have Nirvana, where people have agreed where you want to go, that¡¯s like the North Star at sea without GPS.  You find the North Star, and that tells you where to reset your course.  Without that, you¡¯re at sea and you start over. 

    So what I¡¯ve tried to describe, and I know I have to quit, I hope you at least hear this as a teaser.  Take the approach best practice is not good enough.  Don¡¯t put all the constraints in, take the constraints out.  Then if I¡¯m doing something now and I say, ¡°Oh, there¡¯s a regulatory constraint right now.  They won¡¯t let us move towards Nirvana¡±.  I go see the regulator.  I say, ¡°Look, you agree you want to get this to a good place.  We¡¯ve all agreed we want to go to Nirvana.  That¡¯s key.  Can I show you that this regulation is keeping us from going there?¡±  I think the regulator is going to say, ¡°Thank you for showing that to me.  If that makes sense.  Of course, we¡¯ll change it¡±.  Regulations are not Avogadro's number, they¡¯re not a fixed constant of nature.  They¡¯re created by us with a function, that this is a practical way, so the regulator can see and trust that the reason you¡¯re asking to change the regulation is not counter public policy, counter to it.  Yes, time¡¯s up.  Thank you very much for your time.  Have a great day.

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