Forking The DAO - Robin Hood Update

No, this is not science fiction: the Ethereum world really has been rocked by financial scandal, and has less than a month to resolve it.

It's very hard to explain this situation simply to fans of financial scandals who may be less familiar with cryptotechnology.

In essence a bunch of people ('curators') got together and created - or curated - a new type of open association, which they christened a Decentralized Autonomous Organization, and this first example “The DAO". 

The DAO is built on a new type of cryptographic software platform called a 'distributed ledger' or 'blockchain', in this case known as Ethereum. Such ledgers typically have their own virtual currency, in this case called 'ether'. 

The DAO's rules are in written in software code, so it is in fact a computer programme (or application or 'app'). The DAO is designed to be controlled by investors who use their 'ether' to buy DAO 'tokens' that entitle them to vote on the The DAO's affairs - the main issue being how the DAO should invest the 'ether' it raises through selling 'tokens' to investors, who can also start mini-DAO or 'child DAOs' to focus the investments. By last week the The DAO had raised $60m worth of ether at the going exhange rate.

You can maybe see what's coming...

A savvy participant noticed that The DAO would allow any participant to start a 'child DAO' under their own control and drain 'ether' from The DAO into the child DAO without bothering any of the other participants. 

So they did. 

Cue outrage!

The other participants and 'curators' now say this move was an "attack" that exploited a 'vulnerability' arising from a 'mistake' in The DAO's code. As a result, a 'soft fork' has been imposed by the DAO's 'curator' for 28 days, effectively freezing the child DAO and the ether within it. Many of The DAO's participants want to see the soft fork become permanent - or a 'hard fork' (this saga is providing endless scope for unfortunate puns). Yet The DAO web site's makes it very clear that the code is the sole contract governing The DAO (though what contractual significance The DAO's web site has is therefore questionable).  At any rate, The DAO clearly allowed what in fact happened.

It's ironic that the self-styled "attacker" has resorted to lawyers and is threatening court action to protect his/her/their financial gains. But it would be a fascinating case to run, and a real-world judgment on the issues (applicable law, jurisdiction, whether there was a mistake for which relief could be given etc.) could actually be very helpful to the development of distributed ledgers and the applications that run on them.

23 June:

Meanwhile, the parties are battling it out in a cryptographic re-enactment of Robin Hood (or Barbarians at the Gate?). So-called 'white hat' hackers (claiming to be 'good actors') attempted to secure the remaining ether in The DAO in other child DAOs but the 'attacker' joined them as well.

But is either set of participants 'right' or 'wrong', 'good' or 'bad'? Are they not simply competing in any fashion that The DAO allows?

Would you do business with The DAO or its 'children'?

Would you be happy for The DAO or any child DAO to be an investor in your business? 

Watch this (cyber)space!

Further reading:
Frances Coppola has written a great piece for Forbes.
Introduction to the DAO.
Open letter from "The Attacker".
DAO Wars: Hacker Counter-Attacks and Infiltrates the Robin Hood DAOs

Better Services For SMEs: Follow The Data

I was at a 'parliamentary roundtable' on Tuesday on the perennial topic of small business banking reform. A more official report will be forthcoming, but I thought I'd record a few thoughts in the meantime (on a Chatham House basis). 

It still seems to surprise some people that small businesses represent 95% of the UK's 5.4m businesses - 75% of which are sole traders - and that they account for 60% of private employment, most new jobs and about half the UK's turnover. So-called 'Big Business' is just the tip of the iceberg, since only they have the marketing and lobbying resources to be seen above the waves. As a result small businesses have long been a blind spot for the UK government - until very recently - and the impact has gone way beyond poor access to funding. It includes slow payment of invoices, the absence of customer protection when dealing with big business and lack of alternatives to litigation to resolve disputes.

What's changed?

A combination of financial crisis, better technology and access to data has exposed more of the problems surrounding SMEs - and made it possible to start doing something about them. And it's clear that legislators are prepared to act when they are faced with such data. The EU Late Payments Directive aimed to eliminate slow payments. The UK has created the British Business Bank to improve access to finance, as well as a mandatory process for banks to refer declined loan applications to alternative finance providers and improved access to SME credit data to make it easier for new lenders to independently assess SME creditworthiness. The crowdfunding boom has also been encouraged by the UK government, and has produced many new forms of non-bank finance for SMEs, including equity for start-ups, debentures for long term project funding, more flexible invoice trading and peer-to-peer loans for commercial property and working capital.  Last week, the FCA launched a discussion paper on broadening its consumer protection regime to include more SMEs.

Yet most of these initiatives are still to fully take effect; and listening to Tuesday's session on the latest issues made it clear there is a long way to go before the financial system allocates the right resources to the invisible majority of the private sector.

A key thread running through most areas of complaint seems to be a lack of transparency - ready access to data. This seems to be both a root cause of a lot of problems as well as the reason so many proposed solutions end up making little impact. But the huge numbers and diversity of SMEs presents the kind of complexity that only data scientists can help us resolve if we are to address the whole iceberg, rather than just the tip. That's surely one job for the newly launched Alan Turing Data Institute, for example, although readers will know of my fear that it seems more aligned with institutions than the poor old sole trader, let alone the consumer. So maybe SMEs need their own 'Chief Data Scientist' to champion their plight?

The latest specific concerns discussed were as follows:

• despite much regulatory activity, few bank reforms have actually taken effect - and many are being watered down - with the result that the banking picture is worse, if anything, than it was in 2008. Recent fines and scandals reveal little change in culture from that described in the report of the Parliamentary Commission on Banking Standards and most recently in the damning report into the failure of HBOS. In addition, banking is more concentrated (despite a few new entrants); less diverse in terms of ownership structure, competition, regional coverage and financial model; and still only about £200bn or 3% of bank assets are focused on SMEs and GDP producing activities. The trouble is we've known this for some time, but aside from the BBB's activity on access to funding, we still seem unclear on what can be done for SMEs at a regional or local level;

• the recent findings and remedies proposed by the Competition and Markets Authority into business current accounts are widely considered to be weak and unlikely to be effective - try searching the word "data" in the report to see how often there was too little available. The report still feels like the tip of an iceberg rather than a complete picture of the market and its problems;

• austerity imperatives seem to be the main driver for off-loading RBS into private shareholder ownership - the bank pleading to be left to its own devices (not what it suddenly announced to the Chancellor in 2008!) - and trying to kill-off any further discussion of using its systems as a platform for a network of smaller regionally-focused banks (as in Germany);

• bank lobbying has become more powerful - and will become even more so with the merger of their various mouthpieces - we need much more transparency on banks' access to government and the revolving door between the City and Whitehall/Westminster - we should have learned long ago that the interests of large banking groups are not aligned with SMEs (or consumers);

• SMEs lack an effective means of resolving disputes with banks, as the Financial Ombudsman Service has limited jurisdiction; banks refuse to release internal reports related to credit decisions and calling in loans; while the FCA is said to be hiding behind its confidentiality obligations; and banks have too much legal fire power for SMEs to take them on in court - hence moves to take matters into their own hands. The FCA has clearly woken up to this, but it's recent discussion paper shows there's a huge gap to close.

• the financial infrastructure for SMEs appears not to be geographically diverse - it doesn't yet mirror the Chancellor's "Northern Powerhouse" policy, for instance - despite calls for bank transparency on the geographical accessibility, a US-style "Community Reinvestment Act" and clear reporting on lending to SMEs by individual banks (rather than the Bank of England's summary reporting). There's a sense that we should see some kind of financial devolution to match political devolution, albeit one that still enables local finance to leverage national resources and economies of scale. Technology should help here, as we are tending to use the internet and mobile apps quite locally, despite their global potential;

• Some believe that SMEs need to take more responsibility for actively managing their finances, including seeking out alternatives and switching; while others believe that financial welfare should be like a utility - somehow pumped to everyone like water or gas, I assume - indeed regional alternative energy companies were touted as possible platforms for expanding access to regional financial services. My own view is that humans are unlikely to become more financially capable, so financial and other services supplied in complex scenarios need to be made simpler and more accessible - we should be relying less on advertising and more on hard data and personalised apps in such instances.

• Meanwhile, SME are said to lack a genuine, high profile champion whose role it is to ensure that the financial system generally is properly supportive of them. This may seem a little unfair to the Business Bank, various trade bodies and government departments, but it's also hard for any one of these bodies to oversee the whole fragmented picture. As I suggested above, however, I wonder whether a 'data champion' could be helpful to the various stakeholder in identifying and resolving problems, rather than a single being expected to act as a small business finance tsar. 

 In other words, we should follow the data, not the money...

#LOBOs The Wolves That Stalk The High Streets

'Lobo' is Spanish for 'wolf'

Last night Dispatches updated us on the LOBO crisis that's savaging the UK's local government budgets. 

Not only have councils lost the estimated £500 million in instant profits pocketed by the banks who lured them off long term, low rate loans to 'more flexible' terms; but they're also left with higher interest bills that have resulted in more spending cuts or higher borrowing.

Everyone still involved seems to deny there's a problem, of course, but the data speaks volumes and some of the poachers-turned-gamekeeper have been willing to spill the beans. 

It's worth noting that the banks paid commissions to 'brokers' who brought in the business. Whether those commissions were or should have been disclosed is one issue; and whether the brokers also paid a cut to others is another. You'd think that Clive Betts MP (Lab), Chair of the Commons' Select Committee on Communities and Local Government, might include those items on his agenda - assuming he can get past the sad fact that allowing local governments to deal with the banking wolves in the first place was a Labour initiative.

It's also important to note that all of this only came to light through the tenacity of researchers armed with Freedom of Information requests, the results of which were handed to Dispatches. While hunting down any miscreants is an important step, requiring greater transparency on the sources and terms of local government borrowing in future might also help avoid another mauling. 

FCA #Innovation Hub

The FCA has launched an Innovation Hub as part of its plans to support innovation in financial services.

Innovators can submit a request for support from the Innovation Hub, which the FCA will assess against certain criteria and then decide on the type of support it might be able to offer. The assessment criteria are:

• whether the innovation is genuine - ground-breaking or significantly different;


• whether the innovation offers a good prospect of identifiable benefit to consumers (either directly or through greater competition);


• whether the business has invested appropriate resources in understanding the regulations in relation to its own position;


• whether the business have a genuine need for support through the Innovation Hub?

In addition, the FCA has published a Feedback Statement, responding to input received as part of Project Innovate.

Referral Process For UK Small Businesses The Banks Won't Fund

As mentioned briefly before, UK banks have been so hopeless in referring businesses they can't finance to alternative lenders that the government has decided to create a mandatory referral process.

Currently, the largest four banks account for over 80% of UK SMEs’ main banking relationships. Most SMEs only approach their main bank for finance, with around 40% giving up their search if they are unsuccessful.  A proportion of those rejected are viable businesses who simply don't satisfy the risk appetite of the largest banks. The result is that other providers of finance aren't able to help because they are not seeing the need among SMEs, and the SMEs are unaware of the alternatives to their bank.

So the government will use the Small Business, Enterprise and Employment Bill to require the larger UK business lenders to refer any SME whose finance application is rejected (with the SME's consent) to certain designated private sector platforms. Those platforms will then connect willing SMEs with participating alternative providers of finance (ranging from finance companies, to invoice discounting providers to peer-to-peer lending platforms to challenger banks). 

The platforms will need to comply with minimum standards to help ensure that SMEs are in control and properly protected throughout the process. All types of credit products offered by large banks to SMEs will be covered by the referral requirement, although there will be a low threshold below which it would be too costly to refer the funding application. Some businesses may also be excluded for various reasons that would include where the initial funding application was rejected for suspected money laundering. The proposals are also designed to complement and work in conjunction with the government policy to improve access to SME credit data, a process that is happening separately, but in parallel.

In summary, the SME funding referral programme should work as follows:

• SMEs must consent to be referred, and will have their details anonymised. Alternative lenders will only be able to see key information that would allow them to make an initial assessment of whether an SME may be a potential lending opportunity.

• If a lender wishes to explore a lending opportunity with a business, it would need to make contact through the platform and request consent to see that business’s contact details and begin a direct dialogue. Where a lender wishes to make a more detailed credit assessment, it will be able to obtain credit data from the business’s main bank via designated Credit Reference Agencies.

• Platforms will be able to exercise discretion over whether they grant financial and business advisers and other intermediaries access, but the platform must clearly notify SMEs when it is an intermediary that wishes to contact them, and not a lender.

The minimum standards for the referral platforms will be stipulated by the Treasury on advice of the British Business Bank. Standards will include: 

• data protection – to avoid excessive or misleading approaches or credit checks without consent;

• fair access to all SME lenders that agree to terms and conditions regarding appropriate treatment of SMEs contacted through the platform; and

• accountability for alternative lenders who fail to comply with the terms and conditions they sign up to when joining the platform. 

The Treasury will be able to de-designate platforms that fail to adhere to the standards. The FCA will oversee the obligation on banks to share information with platforms, and the platforms’ requirement to give fair access to lenders. Sole traders and micro businesses will be able to complain about platforms to the Financial Ombudsman Service when dealing with designated platforms. 

Further detailed regulation, including the designation criteria that potential platforms must meet, will be set out in secondary legislation following the passage of the Bill.

The FCA and Mobile Financial Services

The Financial Conduct Authority is going to great lengths to deepen its understanding of the retail financial services market. Project Innovate is a case in point, as is the recent (interim) report on how consumers use mobile devices. However, both initiatives underscore the need for non-banks to engage with the FCA far more than they have to date, and to provide a lot more information about how, why and when consumers need or want to use financial services.

It's a bit unfortunate that the FCA has used 'mobile banking' to describe consumers' mobile activities in the financial services context. We need to get away from such bank-centric language. After all, the FCA points out that consumers don't just use mobile devices to check the balance of a bank account, a bank statement or access internet banking web pages. There are many mobile services offered by payment institutions and electronic money institutions, not to mention the providers of credit, investment and insurance services. Each type of service provider is bound by different FCA-supervised rules and regulations when dealing with us, so it's also a little ironic that the FCA is concerned that "consumers may be unclear about their rights and obligations when using mobile banking products and services".

But terminology is a red herring. The starting should be to consider what activities consumers are engaged in when they need to rely on financial services - and whether the required services are sufficiently accessible or useful.

Here the banks' mobile offerings provide a helpful illustration of how financial services can be misaligned with consumer behaviour. The FCA found that consumers are using mobile devices to access major banks' systems far more frequently than the banks estimated they would (50 times more often than visiting a branch and 20 times more often than a web site). This has caused capacity issues and outages in bank IT systems, which the FCA is not happy with. But the FCA doesn't seem to have considered that this over-reliance on mobile channels might also demonstrate how awkward it is for consumers to use bank services through other channels. 

In fact I doubt whether we really need or want to contact our financial service providers' mobile sites at all, other than in an emergency. Nobody, except banks, engages in "banking". We may use a bank's services, but only in the context of a much wider activity, such as buying a house or a birthday present on the way to a party. "Banking" is what banks think consumers are doing, because banks only view the world through the lens of their own products and not consumers' day-to-day activities.

The FCA needs to avoid falling into the same trap. I mean, there are plenty of great examples of seamless online customer experiences out there which the FCA could use as a benchmark.

Indeed, what this report emphasises most is the need for non-banks to engage far more with the FCA, particularly in the context of Project Innovate.

Alas, it may be too late for them to help shape the second Payment Services Directive...

Wolf Attacks On Local Authorities

It's a vicious coincidence that 'lobo' means wolf in Spanish and a 'Lender Option Borrower Option' in derivatives sales jargon (not to mention parallels with the infamous Timberwolf deal and even The Wolf of Wall Street).   

As explained to me by a researcher from MoveYourMoney in December, LOBOs were sold to UK local authorities to provide (very little) additional funding and to replace the authorities' long term, fixed rate loan contracts with terms that give the lender the option to increase interest rates every 5 years, while the borrower's only 'option' is to repay the loan. This introduces huge uncertainty over local authority funding costs that did not exist before.

How big a problem is this? 

Well, this post suggests that in 2009 at least 30 housing associations may have mistakenly replaced stable long term loans with high cost LOBO facilities in return for only small increases in net funding. But responses to recent Freedom of Information requests suggest that the problem goes further back in time. A response from Brent Council, for instance, shows that in the eight years to April 2010, the council agreed nearly £100m worth of LOBOs, with £21m of funding at risk of being 'called' this year, another £20m in 2015 and £35m in 2016.

Brent's last LOBO was agreed in 2010 and the lender has the option to raise rates in 2015. That was a deal for £10m at an interest rate of 6.75%, even though 'Liebor' rates were at rock bottom. The previous LOBO, agreed in 2008, had a rate of 3.95%. There's no telling what the lender might charge next year...

Now why would local authorities agree to LOBOs? Did they understand the value of the long term deals they were giving up? 

There should be yet another inquiry, but I suspect it will reveal the same old problems amongst the usual suspects that were highlighted by the Banking Standards Commission. Banks are only in the market to make money for themselves.

We Need Let The Crowd into Financial Services

What a difference a year makes. At an industry event yesterday none other than Nicola Horlick, a well-known fund manager, confirmed her faith in crowdfunding as way of people putting money directly into the lifeblood of the economy, at a time when bank finance for small businesses is limited. Her own film finance vehicle raised £150,000 by issuing shares within weeks of an initial discussion with Seedrs CEO, Jeff Lynn, about how the crowd might help. A year ago, she wouldn't have given it a moment's thought. 

Of course, Nicola was referring to equity crowd-investing, which is the latest type of crowdfunding to burst into life. People have been donating to each other's projects via online marketplaces for nearly a decade and lending to each other online since 2005. Even the UK government is lending along side savers on peer-to-peer lending platforms. 

But these 'direct finance' marketplaces are no longer simply challenging a dozy bunch of retail banks. The addition of crowd-investing in shares and bonds is a direct assault on the sophisticated world of venture capital, private equity and boutique investment banking. 

Silicon Roundabout has launched a rocket attack on Mayfair.

This trend has raised a few bushy eyebrows down at Canary Wharf, where the paint is still wet on the signage at the hastily re-named Financial Services Conduct Authority. Not everyone at the FCA is excited by the prospect of just anyone being able to put a tenner into a business run by Nicola Horlick. In fact, the 'hawks' down there seem to believe that ordinary folk should content themselves with a low interest savings account, a lottery ticket and a flutter on the nags between visits to the nearest pub. If you can't afford to lose a grand, say the hawks, then you've hit the economic buffers. The banks can enjoy the use of your savings for free, while the government enjoys the betting taxes and the excise on your beer and cigarettes.

And we wonder why the poor get poorer.

You might also wonder, as I did yesterday, how 'the government' might explain to the same person who is banned from buying a share in the local bakery why he is still be free to blow £10 on a drug-fuelled quadruped at a racetrack, or donate it to a band that might go triple platinum and never have to share a penny of the upside with those who backed them.

But that's where you're reminded that the government never puts itself in the citizen's shoes; and there's really no such thing as 'the government' anyway. Just individual civil servants at separate desks in separate buildings, each looking at his or her own policy patch and waiting to be told what to do. Collaboration is not a creature common to Whitehall. In that world, no one at, say, the Treasury snatches up the phone to share a bold new vision for driving economic growth from the bottom-up with the folks over at Culture Media and Sport, or Business Innovation and Skills or Communities and Local Government. 

Or do they...?

At least those in Parliament, bless them, did collaborate in response to the ongoing financial shambles. Julia Groves of the UK Crowd Funding Association quoted some choice words on alternative finance from the report of the Parliamentary Commission on Banking Standards, and I've set out the full quote below (as I have previously). Julia also put it very nicely in her own words: "Wealth is not a skillset." We need to let the crowd into financial services, and we need to keep the 'crowd' in crowdfunding. Let's hope this time the following message permeates all the way to the remaining hawks at Canary Wharf.

"57. Peer-to-peer and crowdfunding platforms have the potential to improve the UK retail banking market as both a source of competition to mainstream banks as well as an alternative to them. Furthermore, it could bring important consumer benefits by increasing the range of asset classes to which consumers have access. This access should not be restricted to high net worth individuals but, subject to consumer protections, should be available to all. The emergence of such firms could increase competition and choice for lenders, borrowers, consumers and investors. (Paragraph 350)

58. Alternative providers such as peer-to-peer lenders are soon to come under FCA regulation, as could crowdfunding platforms. The industry has asked for such regulation and believes that it will increase confidence and trust in their products and services. The FCA has little expertise in this area and the FSA's track record towards unorthodox business models was a cause for concern. Regulation of alternative providers must be appropriate and proportionate and must not create regulatory barriers to entry or growth. The industry recognises that regulation can be of benefit to it, arguing for consumer protection based on transparency. This is a lower threshold than many other parts of the industry and should be accompanied by a clear statement of the risks to consumers and their responsibilities. (Paragraph 356)

59. The Commission recommends that the Treasury examine the tax arrangements and incentives in place for peer-to-peer lenders and crowdfunding firms compared with their competitors. A level playing field between mainstream banks and investment firms and alternative providers is required. (Paragraph 359)."

A Feast Of Anger And Blame

You have to wonder whether the UK's banking crisis will ever end. After months of wrangling, the regulators have finally decided which UK banks are still short of about £26bn in capital (for now). But yesterday's Parliamentary Banking Standards Commission report points to an endless list of more serious problems that won't be solved by simply leeching yet more billions out of the economy.

The members of the BSC must be highly commended for taking on the long overdue job of trying to bring Britain's banks to heel. Volume 2 of the epic report is an invaluable account of their painful journey, made poignant by the fact that, until quite recently, the members of the Commission actually believed in our rotten financial system. The scale of their disillusionment is almost beyond comprehension. What perhaps started as an investigation into fairly specific allegations of corporate malfeasance resulted in one proud British institution turning on another out of a sense of betrayal. 

So, apart from its entertaining descent into the gory details of British banking, the BSC report represents yet another hammer blow to our faith in society's institutions - this time delivered by one of the ringleaders, namely Parliament itself.

Yet the question remains as to just how far along the 'change curve' we have really travelled. Despite the BSC's list of recommendations, we seem to be merely inching our way through anger and blame, rather than understanding and accepting that the world has truly changed and we need to move on.

While the Commission has voiced great support for alternative finance models and eliminating perverse tax incentives, and the Treasury and FCA have made some proposals to improve the regulatory landscape, the rhetoric from the government continues to put banks at the heart of Britain's economic future, rather than a more open, diverse and innovative financial system.

How much more economic mayhem it will take for society to genuinely 'move on' is anyone's guess.

The Future Is Not Behind Us, It Lives Locally

For every old saying there's an opposite. Today's conflict lies in the adage that "those who don't know history are destined to repeat it." Yet "our history is not our destiny." This leaves a fine line between useful historical insight into how the world works and steering solely by what we see in the rear-view mirror. The distinction becomes critical as we lurch ever more quickly from one financial crisis to the next.

So what lessons from recent history will help us move foward, and which should go in the scrapbook? Here are 5 that I think are worth taking forward, in no particular order:

1. Clearly, the Internet is not a fad. Consumers are the winners, aided by facilitators in their battle against our creaking institutions. Yet e-commerce is still only 10% of all retail. And we are still in the 'primordial soup' phase in the evolution of our tools for extracting meaning from the great, chaotic swirl of data. So this trend has a lot more mileage in it yet and will sweep across more service sectors - if you can buy it online and have it delivered it won't be sold in high volumes on the high street. In fact, it might even be made locally...

2. In addition to democratising services, the Internet is also returning the means of production to local communities through e-enabled machines. Remote/home-working is replacing central workplaces and 'factories' are getting closer to customers, requiring a rethink of corporate systems, processes and supply chains. Huge production plants and sole-occupancy office towers will gradually become a thing of the past. High streets may well regenerate to support this trend, or as a result of it.

3. Cities with at least 3 private workers for every public sector worker see the most growth. Give that some thought if you live in a city near the bottom of this chart. This chimes with findings that economies (regional and national) whose public spending exceeds 35% of their GDP struggle to grow. You have to feel sorry for Northern Ireland...

4. The public sector is very inefficient and needs to act locally - public institutions are already being relentlessly affected by lessons 1 and 3 above, and 2 should increase  the pressure. Civil servants really have no alternative but to spend public money more wisely. Meanwhile, we'll help drive down the cost of government by dealing with the government online. Big government offices must surely go eventually. Fortunately, the moves to devolve more power to local government coincide here, but I don't think we should be fooled into thinking that's part of any real plan to future-proof the UK...

5. The UK's financial system is seriously inefficient at allocating money to people and businesses. The fact that we all rely heavily on a few major banks for whom lending to small businesses is not a core activity is part of the problem, but innovation and competition are constrained by our outdated and rigid regulatory framework and the related incentives. Crowdfunding, or peer-to-peer finance, platforms are springing up all over the country, and are increasingly focused on specific sectors, activities and locations.

In short, if I were a civil servant (see 4) based outside the south east of England (3), I would start an Internet-based service (1) that efficiently provides low cost finance (5) to help localise the means of producing stuff using e-enabled machines - or buy my own 3D printer and start renting it out (2). Now. 

Image from KC Anderson.

Labour Is Still Pushing Financial Capitalism

When Gordon Brown (remember him?) repeatedly proclaimed the "end of boom and bust" he was declaring his belief - along with that of his fellow group-thinkers - that capitalism had found a way to become sustainable. But his support for unbridled growth in everything from investment banking to the Private Finance Initiative eventually revealed he was hooked on financial capitalism, rather than the 'real' capitalism of employment and productivity. Look at how ISAs, for example, have become a drain on the 'real economy'.

Ed Milliband has been trying to repair Labour's image with some lipstick apologies here and there, but old habits die hard.

Recently, the party released "An Enterprising Nation", a report by its Small Business Taskforce. To be fair, there are some good insights into the problems faced by small business, as you would expect from the membership of the taskforce. But, surprisingly, the report contains no proposals for short term solutions, or even medium term solutions. One suspects that either the collective intelligence had already fed all those ideas into the government, or the left wing political establishment doesn't grasp the need to foster an environment in which new businesses can start and thrive today.

Academic as they may be, perhaps the worst of Labour's long term ideas is that of a US-style Small Business Administration. It's an idea I first heard from them in November 2011. And as I pointed out then, the SBA programme had already gained a somewhat unhealthy reputation through David Einhorn's book "Fooling Some of the People All of the Time." Heavy application of the Labour lipstick has now branded this idea the "Spark Umbrella" (a nod to the many local German savings banks, or sparkassen, to which this programme actually bears no resemblance).

Basically, the idea is to saddle the UK with 20 lending vehicles, or "Sparks", funded with £10m of public money (naturally) and £90m drawn, no doubt, from the traditional City suspects. Each Spark would fund its lending to local businesses by selling the loans to the "Spark Umbrella" which would in turn finance the loan purchases by issuing bonds to investors eager to package those bonds into  another set of bonds to sell to... anyone stupid game enough to buy them.

Sound familiar? 

The only way not to end up carrying the can for this, would be to emigrate.

But the UK already has an artificial, publicly subsidised channel for small business lending that limits innovation and competition in the retail financial markets. It's run by the UK's major banks. So we don't need another publicly guaranteed channel to crowd-out sustainable private alternatives. 

I mean, who would start a local lending business knowing that the government was about to launch a publicly funded competitor?

The government should foster an environment in which the private sector can generate alternative finance options, not simply create markets that are ultimately underwritten by the taxpayer.

The fundamental flaw in the Spark Umbrella is its reliance on securitisation (or vertical credit intermediation) to try to overcome the riskier nature of small business lending. That model is hugely expensive in terms of issuing and underwriting bonds that are prone to being mis-priced, particularly in riskier markets, as we have seen. It also creates huge scope for moral hazhard, and traditional financial institutions, intermediaries and speculators are likely to be the only potential winners - as Einhorn's book reveals. There is certainly no guarantee that the loans to small businesses will be competitive with other potential alternatives.

Anyone pointing to the US for solutions also has to understand that, like Germany, it enjoys a much more varied set of small business funding options than the UK, as Breedon reported. So it's possible that the SBA won't have crowded-out US private finance businesses in the way that Spark Umbrella would in our bank-dominated market. 

It's also worth noting that Spark Umbrella is purely debt focused, whereas only 3% of UK small businesses finance themselves by issuing shares.  

Of course, we already have a rapidly growing set of alternative financial services platforms that are beginning to solve the problems that the Spark Umbrella will not. Peer-to-peer lending and crowd-investing provide finance to borrowers and entrepreneurs in small amounts directly from many people at competitive rates from the outset, using both debt and equity finance. There is no need to create new markets for these platforms to grow. However, the government has been dragging its heels on the removal of regulatory barriers and perverse incentives, and that does represent an opportunity for opposition parties. 

True, the government has directed some of the Business Finance Partnership funds through peer-to-peer finance platforms. But that funding goes directly into the businesses who borrow - not through countless intermediaries in the financial markets. Labour needs to recognise the difference.

Horizontal vs vertical credit intermediation from Simon Deane-Johns

'Bank' of Dave Goes P2P

I've hugely enjoyed the documentary series tracing Dave Fishwick's valiant efforts to start a small community 'bank' in Burnley high street. 

I say 'bank' because, while it made for good television to say so, Dave didn't necessarily mean "bank" in regulatory terms. His goal was to enable local people to lend to other local people and businesses without profiting unduly. He rightly thought that's what banks are supposed to do, so he was determined to call himself a 'bank' to make the point. And his good-humoured, optimistic crusade has certainly rammed the point home.

While Dave also didn't necessarily set out to launch a peer-to-peer lending marketplace, his path to launch was eerily familiar to those who have done so. The FSA wouldn't speak to us either, prior to the launch of Zopa in March 2005, but was all too keen to discuss the detail afterwards. Fortunately we'd done our homework and didn't have to stop taking money. At least that made for good TV in Dave's case.

Since 2005 a dozen other management teams have also threaded their way through the regulatory maze to directly link savers and borrowers, or investors and entrepreneurs, via online 'P2P' lending or crowd-investing markeplaces. And it's good to see that Dave's journey has led him to adopt the peer-to-peer model on the high street. He may be facing the bricks-and-mortar problems that the online models solve, but at least he's shown there is very real demand for innovation amongst people who still manage their finances by walking around. And the benefits to the 200 local borrowers who are paying a net 5% to local savers are undeniable.

Unfortunately, there are still unnecessary difficulties in structuring these businesses, regardless of whether they facilitate loans or investments in shares or debt. The sources of that uncertainty were summarised here in January 2012, here in February 2012, here in June 2012 and here in July 2012. Industry CEOs and others met policy and regulatory officials to discuss these difficulties at a summit in December 2012, and again last month (as summarised here). The salient points were also explained again in my submission to the Parliamentary Commission on Banking Standards.

However, while it's clear there is plenty of shared frustration and many officials have been supportive in discussions, there is worryingly little sign of actual regulatory change.

We need a lot more war stories like Dave's.

My Legal Alter Ego Has Been At It Again

Image from Parliament.uk

This time he's made a submission 

To the Banking Standards Commission.

He's a poet and he didn't know it.

Towards A Diverse, Sustainable Financial System

It's not every day you get to brainstorm ways to bring diversity and sustainability to Britain's ailing financial system amidst a broad cross-section of officials, economists, entrepreneurs, think-tanks, technology suppliers and advisers. And yesterday's Finance Innovation Lab workshop was a golden opportunity to do just that.

While the Lab will report the output in due course, I thought I'd share a summary of my notes from the breakout sessions in which I participated. These looked at regulatory barriers and lack of financial awareness. Others explored the unfair advantages enjoyed by estalished providers and ways to encourage innovation. We operated under the Chatham House Rule, hence the absence of names or affiliations.

The UK financial system is neither diverse nor sustainable. 

There is plenty of evidence that the UK's financial system is suffering from a lack of innovation and competition, and is unsustainable in its current form. Rates of market entry and exit are low, relative to other industries. Few customers switch and customer trust is lowest for financial services on several leading surveys. The unit cost of intermediation remains high in financial services compared to other retail markets, while management and staff have reaped the benefits of any increased operational efficiencies (even while legacy systems remain prevalent). Banks rely on a huge back-book of deposits on which they pay little or no interest to finance loans to fund trading in financial assets rather than loans to productive businesses. After all, a single giant property loan does more to grow the bank's numbers than lending the same amount of money to thousands of small firms. 

Regulatory barriers

 

Against this background, we concluded that the current regulatory framework, including subsidies and incentives, is essentially designed to both protect the 'financial system' and 'customers' - i.e. to minimise the risk that consumers and small businesses, in particular, will be mis-sold 'products' by unscrupulous suppliers. 

In effect, however, that framework obliges policy officials (Treasury) and regulators (FSA) protect the system as it is, rather than to ensure that it evolves to encourage and accommodate innovation in line with customer requirements. That's because the framework and those who police it are organised in silos according to existing product types and types of suppliers, and not according to types of customers' and their day-to-day activities. 

The customer protection regime mirrors this approach, being organised according to limited sets of product types and types of suppliers, as well as types of promotional and business activities in which suppliers are engaged (not their customers). As a result, the impact of regulation, complaints and potential for changes are all viewed through the lens of existing products and firms, and any actual changes reinforce those lines of distinction. 

The perverse nature of this can be seen in the fact that, if I want to allocate £100 to a project that I'd like to support, it's easiest for me to donate the money, a bit more complex if I want the money repaid with interest (as a loan), very complex if I want to be able to freely trade that right to be repaid with interest (a bond) and the most complex thing of all is to receive an equity share in the project. This discourages diversification and the search for opportunities to get a decent return on surplus cash; and limits the availability of funding to new businesses, on which most new jobs depend.

Hard-wiring the markets according to types of products, suppliers and ways of dealing with them also artificially limits the number and range of suppliers, product types, and the corresponding markets. In addition, taxpayer guarantees and subsidies in the form of savings and pension incentives are aligned with existing regulated suppliers and product types. Therefore, the regulations and incentives work together to enable the suppliers in the regulated markets to charge higher fees, make higher margins, reward staff more generously and pay more for marketing - resulting in less innovation and competition.

The overall result is a financial system that is not designed to evolve in line with the requirements of consumers, small businesses or even big business. It is designed to suit incumbent suppliers - those who play well with the system, regulators and policy officials. Yet there is no single set of policy officals or regulators tasked with understanding how the regulations, subsidies and incentives actually work together as a whole or whether they distort any aspects of the financial system within or outside the regulated areas.

A broad range of solutions were suggested, as you can imagine, and the Lab will report on these shortly, and include them in a submission to the Parliamentary Commission on Banking Standards. However, suggestions included: 

• creating a Parliamentary Select Committee to focus on encouraging financial innovation;

• limits on market share by product type;

• controls on gross leverage; 

•  separate banks' credit creation process from financial intermediation (the process of allocating that credit);

• central bank guidance to banks on how much to lend productive firms;

• levelling the playing field on subsidies and tax incentives/allowances;

• a target of 200 new local banks by 2016;

• publishing details of national banks' regional/local banking activity;

• making it easier to get low risk financial businesses authorised;

• publishing the amount of the subsidies to major banks and oblige them to set aside a proportion of their subsidy for future crises;

• treating payments systems and credit reference data as utilities (i.e. public goods).

Lack of financial awareness

The scale of financial mis-selling across many different types of products and lack of diversification by investors suggests a widespread lack of understanding of financial services. This was seen to be caused by a lack of financial education, on the one hand; and by product complexity on the other. In turn, product complexity is driven by both regulatory complexity and an unwillingness to invest the extra effort required to simplify products and better align them with customer requirements.

The lack of financial education is essentially a failing of our education system. Yet there is little faith that the Department for Education accepts any responsibility for delivering a sound financial education. It's also clear that no other government department sees this as part of its mission. Rather, financial education seems to be a specialist area confined to universities and business schools or professional bodies. It was felt that this will only change with a determined effort by the Department for Education to measure financial 'literacy', collect best practice for teaching it and including those measures in the national curriculum. Measures of success would include improvements in financial literacy exam results, fewer complaints to the Financial Omudsman Service and improved diversification amongst savers and investors.

Removing product complexity requires a commitment to reducing regulatory complexity, the removal of the regulatory barriers to innovation and competition discussed above, as well as incentives that drive both simpler products and diversification, rather than the concentration of funds into a few regulated asset classes.

In short, more pragmatism and less politics should go a long way.

Evidence From Non-bankers On Banking Standards

Here's what some of the non-banks have to say about banking standards (from 17:52).

More Sunlight Needed On Perverse Tax Incentives

Our continuing economic woes seem to reveal a UK Treasury that has lost touch with the fundamental tax and regulatory problems in the UK economy and is unwilling to engage openly and proactively on how to resolve them.

Not only did the Treasury lose any grip it had on the financial system when it mattered most during the last decade, but the rocky passage of the Financial Services Bill and the need to create a joint parliamentary Commission on Banking Standards also reveal that any such grip remains elusive. This, coupled with the UK's bizarrely complicated system of stealth taxes and incentives, demonstrates the urgent need for more transparency and openness in how the Treasury is going about the task of addressing our economic issues.

The latest example comes with the news that the government might revisit the bizarre decision to delay the revaluation of business rates, which are still based on the higher rental values of 2008. The task of setting business rates every five years lies buried in the Valuation Office Agency, an 'executive agency' of HM Revenue and Customs within HM Treasury. So it's nicely insulated from anyone who might complain about the impact of the rather occasional exercise of its responsibility. Instead, businesses have complained to Vince Cable, over at Business Innovation and Skills, and he's bravely (insanely?) promised to do what he can. However, the hermetically sealed nature of civil service silos means the Valuation Office Agency can safely ignore the issue.

Anyone else afflicted by perverse public sector tax issues faces the same problem. 

UK-based retailers are wasting their time by complaining they are disadvantaged compared to international businesses that are better able to minimise their tax liabilities. Not only is this a welcome distraction from the bigger issue of how the public sector wastes money, (which the Cabinet Office has been left to address), but the Treasury hides behind BIS, no doubt laughing-off the complaints as an example of businesses not understanding how the arcane world of taxation really works. The trouble is the Treasury doesn't understand how that world really works either. Nobody does. That was the whole point of Gordon Brown's stealth approach to taxation. But this should be no excuse for the department that's supposed to be in charge. The Treasury needs to take responsibility for understanding and explaining how it all works, including the unintended consequences.

Similarly, the Treasury needs to take responsibility for the fact that the UK's small businesses face a funding gap of £26bn - £52bn over the next 5 years. Here, again, BIS has had to act as a human shield, even threatening to launch its own 'bank'. Yet HMT has allowed four major banks to get away with controlling 90% of the small business finance market while only dedicating 10% of the credit they issue to productive firms. This, despite the fact that small businesses represent 99.9% of all UK enterprises, are responsible for 60% of private sector employment and are a critical factor in the UK's economic growth which has slipped into reverse yet again. Meanwhile, the Treasury continues to resist allowing a broader range of assets to qualify for the ISA scheme, which currently incentivises workers to concentrate their savings into low yield deposits with the same banks that are turning away from small business lending just when it's needed most.

More sunlight please!

It's OK: Banks Are Happy With Their Business Lending Standards

Readers may recall that UK banks are self-regulated when it comes to lending standards.

As a result, we were recently treated to the farce of a self-congratulatory report by the banks' own so-called Lending Standards Board entitled:

"THEMED REVIEW OF COMPLIANCE WITH THE LENDING CODE PROVISIONS FOR LENDING TO MICRO-ENTERPRISES". 

Naturally, this grand tome of fully 6 pages neatly concludes that: 

"...no breaches of the [Lending] Code or management weaknesses were identified and no action plans were requested, indicating that standards of compliance and practice with the requirements of the Code are very good as they relate to micro-enterprise customers."

Not that we would be told about any breaches, anyway, since the Board explains that "As most Code breaches are of a minor nature, public disclosure of all Code breaches with the associated reputational damage would, we believe be a disproportionate response." A puzzling explanation, since you would not think that minor breaches would inflict much reputational damage...

At any rate, the report is so loose and shot through with so many holes that it's a wonder it could all be gathered into a single pdf.

The review only focused on five of the many 'subscribers' to the Lending Code, and only looked at their approach to credit assessment, credit card guidelines and the treatment of customers in financial difficulties. However, only two of the firms reviewed even offer business credit cards.

The Board also "acknowledges that the majority of concerns raised by the SME lobby [you can hear the sniggers] relate to commercial issues, such as [complete lack of finance] cost of credit and security". But the report ignores such concerns, claiming only that customers are warned of the costs up front. Business loans and overdrafts appear not to have been covered beyond credit assessment stage, nor the critical issue of how well firms are handling complaints.

Interestingly, all the subscribers require a current account to be held where loan facilities were sought, but the report rather carefully states that there was "no evidence in the file sampling to indicate that subscribers require the purchase of insurance products as a condition of sanction." Perhaps another PPI-style scandal lurks here?

Of course, the overall point is that it's much easier to comply with lending standards when you're barely making any new loans. Staff need something to do. Indeed, the report trumpets the "close, ongoing management of micro-enterprise accounts" by relationship managers - no doubt anxious to demonstrate the need for their continued employment.

If a further nail were needed in the coffin of cosy bank self-regulation, this report provides it.

Does Ana Botín Have Any Clothes?

In a fawning interview in Monday's Telegraph, Ana Botin, CEO of Santander UK and billionaire's daughter, is lauded for having run a start-up and quoted as saying she will be “accelerating” the expansion of the bank’s small business lending. But does this really justify such fawning tributes, or does the emperor have no clothes?

According to BIS, the stock of lending to UK non-financial corporate businesses was £506bn in December 2011.  The department estimates a potential credit gap over the next five years of between £84bn and £191bn for the business sector as a whole, of which between £26bn and £59bn is estimated to relate to smaller businesses. BIS says bank lending may grow, but the ability of bank lending to increase may be constrained by the ability to raise capital and meet higher funding costs. The big four banks control over 90% of the business finance market, leaving the likes of Santander with very little indeed.

At any rate, the important factor here is not the amount that Santander actually dedicates to small business lending. It's the proportion that its small business lending activity represents of its overeall credit creation. Richard Werner, the economist, estimates that UK banks generally dedicate only 10% of their credit creation activity to productive firms. He says that it's critical to grow that proportion because credit aimed at productive firms is the only signficant driver of economic growth as measured by GDP - which is flat. Credit that goes to consumption only fuels inflation, and credit for the purchase of non-GDP assets simply drives up the prices of those assets. In Germany, by contrast, 70% of banks (about 2000 of them) only lend locally and supply about 40% of SME finance.

Against this backdrop, Santander's claims don't merit much attention at all. To achieve it's proposed 'acceleration' of lending to small businesses, Santander UK suggests it will use some of the £2bn capital allocated to its failed acquisition of 316 RBS branches and some of the £1bn it has drawn down as part of the public subsidy given to banks in the form of the Funding for Lending Scheme. The bank announced £500m additional asset financing last Thursday. Yet its gross business lending only stands at £10bn, even having grown 20% year on year since 2009. “This is net new lending,” claims, the CEO, but then says this represents switching from other banks. So it may not be net new lending to SMEs generally, i.e. funding that is going to SMEs who can't otherwise get it.

So, while she talks a good game, Ana Botin and the bank she runs have no clothes. 

Image from ElaineByrne.