Welcome to our course on RegTech.
Well, we're going to be talking in
this first module about FinTech Security and Regulation,
and why we refer to this collectively as
RegTech or what do we mean by RegTech and how does this
intersect the worlds of security and regulations
and the context of financial services innovations using technology?
Now, as we think about finance markets in general,
one of the most fundamental aspects of finance is the management of
risk and the element of risk as part of financial industries.
Essentially, banks as institutions
evolved and emerged to reduce or manage risk of one sort or another.
They were vaults then secure places that would reduce risk of theft,
risk of your money being stolen.
They also by pooling returns,
they can help you reduce risk of any particular business going bad, any loan.
You can make a loan to another company,
but if it's peer-to-peer lending and there's no pooling effect,
your risk is higher for the same return.
So, you have better average returns with lower risk with a pooling effect,
and this economies of scale is part of what banks do.
The risks of fraud go down as you're able to better review documents to better
collect data and have more competence in a centralized lending authority.
In Bohr capabilities to do some kinds of insurance or reinsurance.
The whole insurance industry not banks necessarily,
but another ways of reducing risk or reducing cost to society and to investors.
So, a lot of what we do in finance has to do
with management of risk or reduction of risk.
Regulation also plays an important role in reducing risk.
In fact, security like physical security or digital security,
and regulation both are focused on this idea of reducing
risk or managing risk in society and for investors.
So, that's why we have security to reduce risk, risk of crime,
risk of failure, risk of collapse and that's why we have regulation is to reduce risks.
So, there is a common theme here.
Now, risk isn't always bad.
Many times in financial markets people talk about risk versus return.
If you have higher risk you may be able to have higher return.
Lower risk usually means lower return.
So, you can have your money is guaranteed,
you can invest in a one year treasury bond with the US government,
and you will say, "My risk of not getting paid is very,
very low, but the money that I'm going to get on my money is also very low.
But I could lend it to a startup and I might make huge returns,
but I might lose all my money too."
So essentially, one of the things that enables
banks and insurance companies to make a lot of money is
by converting high risk ventures into low-risk products that they'll sell to investors.
They will loan money in more risky areas like small business loans,
and get a high return for that.
So, they'll make a lot of money on their money,
and they will then go to an investor and say,
"We will give you a CD which is guaranteed to
give you X return in a year with a small return."
By pooling high risk investments they can then package that in a way
that they can sell to other investors as low risk investments,
and by pooling risk they're able to get some nice profits.
They also gain profits or benefits from economies of
scale and operations that a bank has a lot more ability to do,
financial services verifications, the loan documents investigation,
thinking about risk, looking at data mining, etc.
They can do that in
a more efficient way than a small business could or an individual investor could.
So, there's some operating economies of scale that also help them to make money.
Investors will make more money if they take on more risk,
but there is some benefit to the pooling and to the operating efficiencies.
So, many investors even when going for high risk investments may seek
some financial service intermediary role
in either operating efficiency or pooling of risks.
So they may put money in a mutual fund,
they may put money with VC investors who
will have operating efficiencies of looking at the startups,
approving documents, doing more services so you can invest in a VC fund.
Or you could say, "You know what?
I'll just choose to be an angel investor and go contact companies directly",
but then you have less pooling and you have less operating efficiency,
and you may make very different returns.
You may have very high returns,
but you may have very high risk as well.
Many times investors will make that trade off.
They will say, "I will take the higher risk in return for a higher profit."
Sometimes through a financial intermediary, sometimes directly.
So, one thing FinTech can do is enable us to have
more opportunities perhaps for pooling or perhaps for
more efficiency and enabling individual investors to do more with
their money by dishing in intermediary third parties in some cases.
But we have to be careful because higher risk does not always mean higher profit.
There's an old saying,
"High risk, high return",
but it's not always true.
Sometimes you can take high risk and have
no return or negative returns that are very, very bad.
Fraud is an example.
Many people go chasing high returns and they think,
"Oh yeah, I'm willing to take the risk."
Well, that risk may be much higher than they thought.
They may not have realized how much risk they were taking.
They may have far underestimated and this could be in many different areas.
Right now we see a lot of enthusiasm for cryptocurrencies,
but we've seen a lot of enthusiasm for stocks,
we've seen a lot of enthusiasm for real estate,
we've seen a lot of enthusiasm for gold, we've seen many,
many different manias or different exuberance levels over
the past several 100 years of people
getting excited about one market or another and saying you can't lose.
Well, you can and so you have to be careful because
it's not bad to take higher risk for higher return,
it is bad to underestimate that risk and not appropriately plan.
So, sometimes the risks are higher and the returns are lower than expected.
Particularly, when there's fraud or misrepresentation or poor information,
lack of ability to understand what somebody is telling you,
and this can lead to financial services meltdown.
Banks and investors not understanding the risks associated
with CDOs, Collateralized Debt Obligations.
You may not know what those are, doesn't matter.
Neither did some of the people buying them,
but their net effect on the overall economy was disastrous.
So it costs you jobs,
it costs you your savings in some cases,
because you didn't understand and neither
did many of the professionals in the finance industry,
how much risk they were taking.
This may also be the case with some crypto-investors who certainly have upside.
No question about that volatility side.
But certainly, more risk than some of them are realizing, they're taking.
Not all, but the risk is real and you need to recognize it.