Sustainable finance and Fintech – Research & Practice Plenary Session @ FINEXUS Conference

Time and Venue: Wed, 17 Jan 2018, 17:30 – 18:30. Aula KOL-G-201, Univ. of Zurich
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Summary. The fintech sector has the potential to increase the funding opportunities for innovative SMEs in the low carbon sector, which the traditional banking sector is not prepared to invest in. Building on the experience of several leading experts from industry and academia, this session discusses recent examples of successful applications of fintech in sustainability projects along with emerging issues that remain to be addressed regarding systemic risk, governance, confidentiality, and traceability. In particular, the session will try to identify the aspects of fintech that can contribute to closing the gaps between finance and sustainability as well as critical aspects of fintech that could jeopardize financial stability.

Panelclick here for speaker biographies:

  Veronica Garcia Heller (CEO, BitLumens)
Moderator
  Richard Olsen (CEO, Lykke)
Speaker
  Nick Beglinger (CEO, Cleantech21)
Speaker
Claudio Tessone (Professor, UZH)
Speaker

 

Background information and policy discussion.

Fintech and opportunities for low-carbon and circular economy. Fintech is emerging as a core disruptor of every aspect of today’s financial system. It covers everything from mobile payment platforms to high-frequency trading (HFT), and from crowdfunding and virtual currencies to blockchain.

On one hand, this technology is an opportunity to bypass traditional banks and classical funding channels in particular for sectors that are perceived as high risk or subject to unknown exposure. Among these sectors, two are of specific interest in the context of this conference. One is the green energy sector in the face of the transition to a low-carbon economy. Indeed, there are many official initiatives at the international level to promote the low-carbon economy. For instance, the EU Commission has committed to the 2030 Climate and Energy framework[1]. Another one is the sector revolving around the emerging concept of circular economy, in which the digital transition is crucial and fintech, in particular, can play a pivotal role. Again initiatives such as the European Commission Circular Economy package[2] will lead to financing needs that may not be fulfilled through traditional channels.  Regarding both the green sector and circular economy there is a perception of uncertainty because these are fields in which investors do not feel confident about and on which the traditional banking sector does not have enough knowledge to assess risk and value instruments. Therefore, one possible view is that the fintech sector could compensate for this underprovision of funding. In particular, the blockchain technology in principle allows even small companies, which currently have no access to the bond or equity market, to issue tokens and finance themselves.  

Fintech and financial stability. The development of blockchain projects for small companies makes possible to establish financial contracts with each other in a decentralized fashion without the need for financial intermediaries. This possibility comes in principle with a number of potential advantages in terms of better bargaining power and lower transaction costs. However, the dynamics of the market share of actors in the information technologies sector is often self-reinforcing, leading a rich-get-richer phenomenon and a concentration of bargaining power in the hands of very few actors. Hence, there are growing concerns about a possible bubble in the fintech, similar to the dot-com crisis of 1999. Market players wonder which of the business solutions promised in many of the ICO will be delivered in time or delivered at all.

Moreover, an entire stream of work in financial networks (see the sessions of this conference on financial networks) have highlighted how a decentralized network of financial contracts can lead to undesired effects in terms of systemic risk (Battiston ea. 2016[3]). In particular, introducing derivative contracts in a network of bond obligations can lead to a new kind of systemic risk known as default ambiguity, i.e. it is mathematically not possible to determine who is in default because contracts set up in a decentralized fashion can lead to sets of inconsistent claims (Schuldenzucker ea. 2017[4]). This is relevant to the context of fintech because it means that a network of smart contracts entails the risk that we understand poorly. The relevance of these issues is demonstrated by the interest of financial service providers. Remarkably a recent report by Depository Trust and Clearing Corporation (DTCC) Exploring How Technological Innovations Could Impact the Safety & Security of Global Markets[5] has highlighted that:

  • “assessing the impact of fintech developments on financial stability must be done on a case-by-case basis, taking into account how each individual application may affect the various dimensions of systemic risk. It is too early in the fintech revolution to fully understand whether these innovations are systemically beneficial or harmful.”
  • “DTCC has developed an original framework to enable industry participants to analyze how specific fintech applications may impact financial stability. The framework covers a wide range of critical factors, including concentration and interconnectedness risk, fragmentation and substitutability of services and automated decision-making processes.”

Finance is a set of technologies. Fintech allows extending this set. Disruptive changes are expected from the modern application of technologies from the fields of data science, machine learning, network science in combination, in particular with cryptography and the blockchain, the ‘Internet of things’ and artificial intelligence. Novel applications of a number of technologies could make the current wave of changes unlike any we have seen before in the world of finance. More efficient, accessible and less vulnerable financial system is promised by the fintech innovations. At the same time, by creating new markets and blurring the boundaries between financial services and adjacent industries like retail and telecom industries, technology-enabled innovations bring a new set of risks to the financial system and may lead to significant unpredicted negative events. Minimizing the risks and maximizing opportunities of new innovations is essential to maintaining a healthy financial system that benefits society at large.

Overall, advantages and risks of fintech and blockchain, in particular, could be summarized as follows (partially based on DTCC report):

Advantages:

  • New level of transparency offered by the blockchain technology: Increased control for regulators and policymakers
  • Diversification of credit and liquidity risk within the financial system
  • Increased competition and lower fees attract new clients and offer services in places where it was not possible to do before
  • Disintermediation of incumbents: Some fintech applications tend to shift the traditional hub-and-spokes topology of financial networks towards a more decentralized structure, which is typically associated with lower concentration risk and higher resilience
  • Fintech could reduce concentration of businesses and make it easier for small companies to enter the market

Potential issues:

  • New level of anonymization offered by the blockchain technology can be used for illegal trades, guns and drugs sales, etc.
  • Exacerbating cybersecurity threats or amplifying third-party risks
  • Lack of banking experience could create systemic vulnerabilities in periods of market stress: small fintech companies offer financial services without having proper understanding about how the financial system works
  • Increased risk of interconnectedness and financial complexity
  • Excessive level of the automated decision-making processes (smart contracts)

Fintech and Sustainable development. The UNEP report. Several specific issues were highlighted in the recent UNEP report Fintech and Sustainable Development – Assessing the Implications[6]. Among them:

  • “How can we mobilize domestic savings at scale to enable long-term investment directed at long-term sustainability of the real economy through investment in sustainable development innovations and in resilient and sustainable infrastructures?
  • How can we best collect, analyse and distribute financial system and real economy information for better economic decision-making, better regulation and better risk management?
  • How to best remove barriers for scaling the resulting ‘fintech for sustainable development’ innovation portfolio given their significant impacts if deployed widely and deeply?”


Further the same UNEP report emphasizes that although the technologies involved are not all new, it is the combination of them – the speed, the breadth and depth – that gives fintech the potential to disrupt the system as a whole.

Blockchain investment services.  Initial coin offerings (ICOs) are a new way for small and intermediate companies to raise capital which they could not do using traditional investment channels. The idea of ICO is that a startup creates a digital coin (token) using the potential of the Bitcoin or Ethereum blockchain and offers this coin for investors worldwide. In the world of fintech ICO is often considered as the analogous of the traditional IPO. The main difference is that instead of stock share that one would own after an IPO, ICO purchase gets investors the ownership of a new type of coin or token, which can be used in projects for different use cases rather than just represent a security. Due to the novelty of this capital raising scheme and the difficulty of its regulation ICO is possessed as a very convenient way for young companies to attract investment even without having any successful track record. Investing in a digital currency is extremely high-risk: almost 99% of all ICOs fail[7]. This fact can be partially explained by the lack of sufficient regulatory level and control from the government side. According to Forbes[8], “In recent months, ICOs have become the target of growing scrutiny in many jurisdictions, including China, South Korea and the United States.” ICOs were called in many different ways: from “revolutionary new way to get funded”[9] to “pyramid schemes”[10]. Only in 2017 almost 4 billions of dollars were invested in 235 initial coin offerings[11].

Digital currency footprint. Despite all promising advantages of blockchain there is a side effect of its adoption and utilization. The so-called Proof-of-Work (POW) protocol which underpins the most popular cryptocurrency Bitcoin makes the maintenance of the system extremely energy inefficient. Even a tiny fraction of a bitcoin sent over the blockchain requires so much energy, as a typical household in a week[12]. Alternatively, the blockchain system emits around 18 tons of CO2 per one generated bitcoin[13]. The source of the problem is in the cryptographic principles of the system which guarantees the security of all transactions: each new block has to be verified by all computers competing in the mining process which causes excessive amount of energy spent for each block. The irony is that the blockchain technology embodied in Bitcoin was designed to address inefficiencies in the financial system but it turns out to generate inefficiencies in the physical world.

However, there are several alternative concepts of the blockchain technology which are supposed to overcome these existing problems and move the adoption of cryptocurrencies on the next level. For example, the second biggest blockchain platform, Ethereum, proposed Proof-of-Stake (POS) protocol as the alternative of the POW used for Bitcoin. Several similar concepts are under investigation but none of them has been fully tested so far.

Aims and scope of this session. In the context of sustainable finance, it is crucial to integrate climate and transition risk factors in current financial risk metrics and there is a hope that fintech can significantly facilitate the transition to the sustainable and green financial system. Building on the experience of several leading experts from industry and academia, this session discusses recent examples of successful applications of fintech in sustainability projects along with emerging issues that remain to be addressed regarding systemic risk, governance, confidentiality, and traceability. In particular, the session will try and identify the critical aspects of fintech that can contribute to closing the gaps between finance and sustainability as well as critical aspects of fintech that could jeopardize financial stability.

Clean Coin and Internet of Things. One approach that will be discussed in the session is the Clean Coin project supported by Climate KIC, WWF and South Pole and the main goal of which is to “… analyze the question of what makes a [crypto] coin clean, how a digital currency has to be to make sense from an environmental viewpoint” (Beglinger[14]).

Combining the idea of Internet of Things (IoT) with the blockchain approach naturally leads to the concept of a ledger of things, i.e. a distributed system to handle transactions of any kind among smart devices. This idea is pushed forward by some companies such as IOTA, although their idea still seems far from the global adoption.

Bitlumens will also be briefly discussed in the panel. Bitlumens brings power and water to women farmers without a bank account and in places without the power grid while using the blockchain and internet of things (IoT).

Bitlumens is supported by the UNFCCC (United Nations Framework Convention on Climate Change) and tackles carbon mitigation by offering photo voltaic (PV) systems to get access to lighting and water in places where there is no power grid or proper access to water. The payment of the hardware is made in installments by using Bitlumens tokens (BITL). The system also allows microfinance and remittances in digital and fiat currencies while using the blockchain. Our goal is to generate both a financial return as well as a positive measurable social and environmental impact. Bitlumens first pilot is running in Guatemala and the main challenge remains on the absence of a global regulatory framework to develop start-up blockchain related projects.

Lykke is another company which exploits some features of the blockchain technology. From their website: “Lykke is building a global marketplace for the free exchange of financial assets. By leveraging the power of emerging technology, our platform eliminates market inefficiencies, promotes equal access from anywhere in the world, and supports the trade of any object of value. The Lykke Exchange is fast and secure. Users receive direct ownership of assets with immediate settlement from any mobile device. Richard Olsen, founder and CEO, is a distinguished pioneer in high frequency finance. He has been laying the conceptual foundations for Lykke for most of his professional life. The company was established in Switzerland and received initial seed funding in 2015. Company shares are issued as colored coins redeemable on the Lykke Exchange. Our software is open-source and non-proprietary.

 

[1] https://ec.europa.eu/clima/policies/strategies/2030_en

[2] http://ec.europa.eu/environment/circular-economy/index_en.htm

[3 http://www.pnas.org/content/113/36/10031.abstract

[4] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3043708

[5] www.dtcc.com/~/media/Files/PDFs/Fintech%20and%20Financial%20Stability.pdf

[6] http://unepinquiry.org/publication/fintech-and-sustainable-development-assessing-the-implications/

[7] https://blockgeeks.com/guides/why-most-icos-will-fail/

[8] https://www.forbes.com/sites/cbovaird/2017/10/18/is-bitcoin-benefiting-from-the-ico-crackdown/#5fe70e8333a5

[9] http://mashable.com/2017/06/18/ico-explained/#WMhkT_s865qu

[10] http://mashable.com/2017/09/04/china-bans-icos-bitcoin/#_R0X3W1HOmqz

[11] https://www.coinschedule.com/stats.html?year=2017

[12] https://motherboard.vice.com/amp/en_us/article/ywbbpm/bitcoin-mining-electricity-consumption-ethereum-energy-climate-change

[13] https://docs.google.com/spreadsheets/d/1PpLk7tHnSX6VSRcceZgjTuBV140BqOKRaARiP5eUo5k/edit#gid=0

[14] http://www.climatechangenews.com/2017/12/15/bitcoin-reforms-proposed-curb-soaring-carbon-footprint/