With the development of advanced technology such as artificial intelligence (AI) and robotics, the world has entered the era of Industry4.0, defined as the production of goods and services using the Internet of Things (IoT) technology. Consequently, the global financial system is also facing a fundamental transformation. If finance is to serve the real sector, then we need major shifts in both understanding and managing how the eco-system as a whole is changing.
The global economy is being stressed simultaneously by what we can call 6G mega-trend disruptors. These include the Geopolitical shift from a unipolar to multi-order system; Geographical shift of the economic and political center from West to East, especially with the growth of China, India and ASEAN; Gender shift as women improve in terms of equality in income and wealth; Geo-climate shift due to climate warming, natural disasters and stresses from human migration; Generational shift as rich countries age and poor countries still have growing young population; and G5 Tech shift as new 5G technology is advancing in telecommunications, computing power and genomics. These profound changes are interacting in combination to produce very complex outcomes, resulting in what we call Black Swan events – those which we thought were low probability but high impact outcomes. At the same time, the legacy problems of the old financial system, such as the growing social injustice, the gap between the rich and the poor, excessive debt and overhang of quantitative easing policies, the lack of trust, complex regulations, the uncertainties arising from shadow banking and cyber-currencies, still remain unresolved.
Seen from a historical perspective, as the world transits from unipolar to multipolar, the old US dollar dominated global financial system (Finance3.0) is seriously stressed, if not broken. The US-initiated trade wars will disrupt also the global supply chain formed under Industry3.0. The new global financial system (Finance4.0), which must adapt to Industry4.0, is still unformed. This paper looks at possible issues that financial policy makers and regulators must consider so that the transition to Finance4.0 will create an efficient, innovative, resilient and sustainable system.
This transition will not be easy, but it is important that we imagine, however imperfectly, what the shape Finance4.0 should look like.
Amidst these disruptions, China, as the second largest economy with the most trading partners, is beginning to move away from the old Western-centric mindset. She is evolving an adaptive, tactical and strategic thinking on the realization of Finance4.0 from its own perspective. At the very least, we should ask the following questions:
My recent article with Professor Xiao Geng, “from Dollar to e-SDR[1] (super-sovereign digital reserve currency)”, has triggered some international attention and comments. The current dollar based and debt driven international monetary system has systemic weaknesses and risks, such as vulnerability to secular recession, market concentration/fragility and social injustice. The international financial non-system, as it is sometimes called, is prone to trade and fiscal imbalances, which have given rise to trade and geopolitical conflicts.
At the heart of the problem lies the growing US trade deficits and net international investment position (net foreign liability), which has already reached 44 percent of US GDP at the end of 2016[2]. Relying on the US dollar may subject the users to trade sanctions, asset confiscation and enforcement action against companies that violate sanctions against US enemies. But in a world of shifting alliances, when US friends can be foes and vice versa, this adds huge uncertainty and risks to holding and using the US dollar.
The advent of encrypted cyber-currency has created Peer-to-Peer (P2P) transactions that change the way payments are traditionally made, because the use of tokens avoids the use of fiat money. Indeed, if the private sector, together with central banks, can co-operate to create an encrypted SDR digital currency (e-SDR), this can be used as a unit of valuation, means of payment or store of value, based on a currency that has been created already officially by the IMF, but not officially encouraged to increase to meet market needs. On such basis, a geopolitical neutral and fair international monetary system can be designed and built. This may be one of options that may frame the implementation of Finance4.0 and its global monetary framework.
Given the profound changes in the environment caused by the global financial crisis (GFC), geopolitical and technological shifts, we are forced to re-think Finance3.0 from its basic principles. In this regard, the work of Nassim Taleb and recent studies on cyber-currency architecture and implications for monetary policy by the Bank for International Settlements, MIT and other scholars have helped to shape my views on the subject.
Section 1 examines the mega-trends that shape the whole financial eco-system. Section 2 reexamines the basic concepts of financial risk, monetary system, financial stability and financial supervision. Section 3 considers relevant policy proposals for the smooth completion of the Finance4.0 transition. Section 4 concludes.
1.1 6G Mega-trends
Under the combined action of six mega-trends (6G), the old pattern of international political and economic order is undergoing complex and profound changes. A single trend would already be disruptive enough, but it is the simultaneous combination of all six trends acting in different directions that make the path of unfolding events so much more difficult to predict.
Geopolitics shift: as the rest of the world has caught up with the United States in economic and political power, the world is changing from a unipolar to multipolar order. Since the America First policy means no more level playing field, conventional policy and business models cannot operate on the basis of “business as usual”. Few countries are will to contribute to global public goods, such as infrastructure, climate change projects, migration and poverty-eradication etc., due to competitive self-interest.
Geographical shift: the world’s military and economic power is also shifting “from West to East”. Asia is still the fastest growing zone (especially China, India and ASEAN countries), growing annually over 5% into middle and advanced incomes, through rapid technological innovation and adaptation.
Gender shift will become more prominent as more women participate in the labor force, increasing their wealth and income, thus changing family and social dynamics. Growing female employment will contribute significantly to the economic growth rate. For example, China’s high growth rate is partly explained by the high female employment rate (about 73%), whereas the Middle East countries were held back by low women participation in the labour force.
Generational shift: developed countries face a serious aging problem, whilst underdeveloped countries face youth unemployment and under-employment. This creates enormous social pressures as the young think very differently from the current aging baby-boomer generation.
Geo-climate shift: climate warming has put tremendous pressure on water resources, food and energy, particularly in Asia and Africa. Environmental pollution and over consumption of forest, marine and other natural resources are creating extreme weather conditions. Severe water shortages create civil conflicts that add to migration from Middle East and North Africa to Europe, creating an enormous political backlash.
G5 tech shift: rapid technological advances in robotics, artificial intelligence (AI), genomics, and quantum computing are disrupting jobs, business models, social culture and politics. How to adapt and use technology effectively to raise productivity and create jobs is a major challenge for all countries.
The old global supply chain has been disrupted by technology and trade wars. Because of robotics and 3D printing, production can be undertaken in consumer countries, without reliance on the cheap-labour exports from the supply chain. This technology-enabled shift of jobs back to the home base puts enormous political pressure for more protectionism and less reliance on imports. Escalations in the bilateral trade war already threatens the Asian global supply chain. By 2020, 3 million industrial robots will be put into use in the world, of which 1.9 million will be in Asia (950,000 in China alone) which means that low-tech employment will be eliminated, threatening the growth strategy of many emerging markets which rely on cheap labor to compete.
Global social tensions have risen from large scale population migration in search of jobs. Refugees from failing states create grave political, social and economic threats to existing orders, as borders drawn in the colonial period become meaningless and unenforceable. By 2050, world population will increase to 9.7 billion, putting grave strain on food, water and energy production.
At the same time, social injustice is intensifying, feeding the rise of populism and social polarization. According to the Credit Suisse 2017 World Wealth Report, 8.6% of the world’s population control 85.6% of the world’s wealth. These social imbalances will break out in the form of social unrest, civil wars and regional conflicts that threaten global stability.
1.2 Evolution of the global financial system
A unipolar global financial system is never completely fair and neutral. The financial system was designed to be complementary to the evolution of the global political and economic interests of the unipolar power. Finance and politics are inseparable. In the early era of Industry1.0 (1700-1870), as Western countries began to become mechanized, they expanded rapidly through overseas colonies in search of new capital and resources. The Swedish central bank and the Bank of England, the world’s first central banks, were established in late 17th century to raise funds for war. Britain’s imperial power was reinforced by the role of sterling, as the colonies had to invest in sterling assets.
But as the United States became a gold producer and accelerated in industrial power, the role of gold and dollars competed with sterling. Thus, in the Industry2.0 era (1870-1945), the United States dollar became the dominant reserve currency. After World War II, the dominant strength of the US economy created a US-led global supply chain and the dollar-centered global monetary system. The United States issues US dollars to pay for cheap products, labor and services from all over the world. The rest of the world was happy to hold US Treasury bonds or to invest in the US through the New York capital markets, because the yields were positive. The Triffin Dilemma, which required the US to increase supply of US dollars to meet global demand for safe, liquid reserves, meant that the US external debt continues to grow through larger and larger current account deficits. This explains why there were always trade tensions with the large trade surplus economies, initially with Europe (1970s), then Japan (1980s) and today with China.
Once the dollar was decoupled from gold, the gold standard system has been transformed into a credit standard system based on growing dollar debt. In the era of Industry3.0 (1946-2007), however, with the rapid spread of automation and IT technology to emerging markets, the US’s relative economic and political power began to decline from nearly half of world GDP in 1945 to currently one quarter.
The arrival of financialization meant that the creative powers moved from manufacturing to services and then financial speculation. After the Volcker shock in the early 1980s to raise interest rates and conquer inflation, his successors began to lower interest rates and encourage financial innovation (mainly through more leverage) that culminated in the subprime financial crisis of 2007. European regulators also failed to see how their banks were heavily embroiled in financial derivatives in the US, whilst being heavily exposed to the property bubbles and credit debt of the Southern European economies.
The solution to the crisis of 2007/2009 was to lower interest rates through unconventional monetary policy, so that the real net asset yield (ROA) approached zero or negative terms. In essence, the United States has successfully transferred its domestic debt burden to savers and foreign US debt holders by printing US dollars. The net US debt position has already reach 45% of US GDP by 2017, whilst gross domestic Federal debt exceeded 78% of GDP.
The major lesson of the 2007/2009 GFC is less about too big to fail (TBTF) banks, but TBTF sovereign debtors, since the governments ran larger and larger debt to bail out their financial systems. Since such debt can be sustained by low or negative interest rates, the loss burden has been shifted to the high surplus countries and the poor through financial repression and asset bubbles.
Who ultimately will bear the losses of excessive financialization?
There are six essential ways of get rid of excessive debt – faster growth through productivity; cutting down consumption (not possible due to current welfare spending system of democratic governments), inflation (which redistributes losses to financial asset holders), increasing taxation (which the rich will object to and are able to avoid through capital flight); debt/equity swaps, so that the creditor has a share in ownership (very difficult in the area of sovereign debt) and finally war, since the winner can repudiate any foreign debt.
The global architecture of Finance3.0 is a top-down dollar based system in which almost all global transactions are written across bank ledgers, but ultimately through the Fed’s books. Herein lies the dilemma of the dollar. If US interest rate rises, the US budget deficit will increase further, attracting more foreign capital and pushing up the US dollar exchange rate relative to the rest of the world. An expensive US dollar makes the debt burden of the US heavier, since US foreign assets devalue, whilst the liabilities remain in dollar terms.
For the rest of the world, a strong dollar sucks capital back to the US, and higher US interest rates increase national interest rates higher due to the credit and exchange rate spreads widening. With over $11.5 trillion US dollar debt outside the US, many emerging markets will suffer currency crises from capital outflows, asset crashes and large devaluations, as Argentina and Turkey have experienced.
Thus, the issue of how to deal with existing and future debt lies at the core of political turmoil. It is easier to blame the creditors, foreigners, immigrants and “unfair” trade deals for many problems that was previously solved by incurring more debt. Finance3.0 is essentially a debt-drug driven system. Economies get high on more debt, but have drug withdrawal symptoms when there is debt burden gets real with higher interest rates.
The solutions for the debt overhang and international monetary system reform are beyond the scope of this paper. But these issues will be explored in subsequent papers.
Finance4.0 is different from Finance3.0, because of the arrival of new technologies such as artificial intelligence (AI) and encrypted cyber-currencies. Any new system must overcome the shortcomings of the previous financial system (Finance3.0) and establish a truly fair and neutral multi-polar global monetary system. To do this, we have to get rid of the mindset of the old Neo-classical free market model and economic theory, which do not address the questions of social injustice and environmental degradation. We should reexamine financial risk, monetary and financial stability and financial supervision from a more neutral point of view, review our mental or worldview blind spots, and solve the legacy problems of Finance3.0, including exit from unconventional monetary policy, excessive debt overhang and excessive regulatory complexity.
At this point, because information technology has advanced at such a fast pace, we need to summarize what is so special about information, finance and technology. These are basically summarized as follows: –
The 2007/09 GFC has shown that there are serious defects in the Western mainstream economic theory and conventional risk models (see Stiglitz 2018). In essence, the way we look at financial risks must be fundamentally changed. The traditional free market theory holds that changes to the current order are essentially incrementally linear, self-balancing, mechanical, perfect and static. Unfortunately, human behavior in reality is dynamic, nonlinear, complex, interconnected and interrelated, and radically uncertain. Conventional economic models, such as the Value at Risk model (VaR) and the dynamic stochastic general equilibrium model (DSGE), are widely used to measure risk, forecast economic growth and related policy options by central banks and policy authorities. These simplified models have mathematical logical consistency by assuming away endogenous (systemic) risks and uncertainty within the system. They cannot fully reflect how the real world operates. Continuing to use these theories and models is just like still searching for keys under the street lights at night, forgetting that the keys may be lost in the dark where we are not searching.
There are giant blind spots in the traditional mode of thinking. Mainstream economics has become such a mathematical and specialized profession, that it has neglected to draw on knowledge from other social sciences, such as history, sociology, anthropology, psychology and even biology and ecology. FT Columnist Gillian Tett called this the “Silo Effect” (Tett, 2015). Because all organizations are fragmented into specialized departments, each specialist operates in a narrow “silo” and does not see the big picture. Each person or department believes that if they get more resources, they can solve the system-wide problem, but they cannot achieve this. Believers in current theory are trapped in “isolated islands”, failing to see the relationship between different parts that interact to form a dynamic picture of the complex whole. Polish-American psychoanalyst/philosopher, Albert Korzyzbski (Korzybski 1947), called this phenomenon “the map is not the territory”, meaning that our mental maps of the real world are often wrong. Failure to recognize this defect by reading the wrong maps means that the decision-makers get their sense of direction and decisions wrong. In a global world of inter-connected and interactive parts, solving one part of the problem does not deal with the issues. A global solution with global public goods and cooperation are called for. But this is precisely what is difficult to achieve because of geo-geopolitical rivalry,
Take for example the question of uncertainty. We make decisions on the basis of what information we have, but a lot of information that we possess is probably wrong or incomplete (partial). Perfect theory assumes that we have perfect information, which is an impossibility in reality. Because different people have different information and values, if two persons cannot know what the other is thinking, how is it possible to assume perfect information for society as a whole? Bounded rationality (rational decision-making under limited information) also cannot provide sound policy decisions because competitors may give strategically false information.
There are six states of information available for decision-making. The first is perfect information. The traditional free market model assumption of information is unattainable in practice. The second is known knowns. Science and research created many experts who know a lot, but many of us, including leaders and policymakers have to consult experts when making decisions, but even experts are often wrong.
Even with experts, the third is unknown knowns. Experts who know a lot, but are often unable to explain clearly to the public (including policymakers), who do not appreciate the importance of such information. The common undesirable situation is where experts know the problem, but cannot decide, whereas the leaders can decide do not know what is the real problem. The fourth is the known unknown. People are aware of the existence of some complex unknown things, such as black holes, but have not yet proven their existence or found out how to measure these unknowns. At least in these areas, we know that we do not know.
The fifth is the knowable unknowns. Using big data technology, we can conjecture, estimate or paint scenarios of what these unknowns may look like to help decision making. Indeed, artificial intelligence and big computing power are able to assist better decisions on how to diagnose medical conditions than human beings, because they can compute massive amount of data and simulations in order to arrive at more precise projections. Finally, the sixth is unknown unknowns. These are the true radical uncertainty. Often, unknown unknowns are things that we cannot imagine, because these unknowns have never happened before and are beyond normal comprehension. You cannot hedge against something you cannot know!
In contrast, conventional models measure risk as volatility. But unknown unknowns are beyond conventional risk, because we cannot measure what we do not know.
Former quant-trader Nassim Taleb has original insights into these questions in his books “Black Swans ” (2008) and “Anti-fragility” (2013). First, “black swan” events are tail risks with very low probability of occurrence, but if they occur, they have high impact or disastrous consequences. Since we have difficulty anticipating the black swan events before they happen, they are almost impossible to hedge against. Uncertainty is therefore inherent in any system.
Second, since we cannot know or measure ex ante what costs or losses will arise from bad “black swan” events, the only way to improve the “anti-fragility” or robustness/resilience of the system as a whole is to radically change the way of risk management. In other words, conventional risk management assumes that risks or losses can be measured and precisely hedged. Black swan events have two possible outcomes: good or bad. Good black swan generate surprising profits that are not anticipated. These are like options that incur low investment costs but yield very high returns). Nassau’s core message is that if we don’t have the good benefits of “good black swans”, we have nothing to compensate against the losses from unanticipated “bad black swans”. In other words, sound risk management must actively encourage investments in more “good black swans”, so that they will offset the negative effects of the bad black swan events.
The best example of such thinking is the way Silicon Valley finances start-ups. If a venture capitalist invests very small amounts in 1,000 start-ups, the success of a unicorn (one that achieves $1 billion in value) would compensate for losses in investments in 999 other start-ups. This is very different thinking from the Basle risk-weighted aspects of bell-shaped capital allocation and pricing of risks. If the average non-performing loan (NPL) loss for small and medium enterprises (SME) is recorded historically as 20%, then the risk-weight of capital against lending to SME should be 20%, meaning the pricing of loans to SMEs would also be 20% higher, thus probably ensuring a higher rate of SME failure due to higher borrowing costs and lower access to capital. This thinking totally ignores the good side of broad-based and diversified SME activities that create more than 70% of jobs and generate a large amount of innovation. A pretense of perfection and precision completely ignored externalities that are difficult to measure.
Consequently, the Nassim Taleb anti-fragility framework goes for broad-based diversification in order not to “put all eggs in one basket”. “One size fits all” average or Bell-shaped statistical risk models have aggravated the financing cost of small and micro enterprises. Baidu, Alibaba and Tencent in China are the outcomes of “good black swans” because by allowing innovation in the business field through technology, China created New Economy value to compensate against losses in the Old Economy.
Supplementing the concept of “black swan”, Michele Wucker has proposed the concept of “gray rhinos” in her 2016 book, which are high probability and high impact risk events. An example is the current unfolding of US-China trade negotiations, which we all know may have huge implications and collateral damage not only to both countries, but also to the whole world.
We now need to go to the heart of the function of financial systems. Former Bank of England Governor Mervyn King, pointed out in his book “The End of Alchemy” (2016), that “The reasons for the present disequilibrium of the world economy are radical uncertainty, the prisoner’s dilemma and trust.” The lack of trust weakens the stability of the financial system and brings about contagion risks. Investor confidence in financial institutions is determined by the latter’s credibility and professionalism. According to the latest report by the Chartered Financial Analysts (CFA) Institute, only 35% of individual investors and 25% of institutional investors believe that their advisers / asset managers always put their clients’ interests first.
According to the CFA Institute, four future scenarios will lead to comprehensive changes in the financial business model: business operations, human resource/staffing model, investment model, and fund distribution model in the financial industry. These will bring about fundamental changes in the financial institutions, industry and the mode of thinking. First, the disruptive impact of financial technology will bring enormous pressure to transform financial institutions. Second, the old economy and the new economy (high tech industry) will coexist for a much longer transition time than anticipated. Third, low interest rates and low growth mean there will be a longer period of deflationary pressure in the future. Fourth, capital investment in new technologies to solve practical problems such as aging will accelerate.
In other words, there will be both institutional, human culture and eco-system changes in the foreseeable future, which requires a mindset change. Bain Consulting predicts that by 2030, automation will have an adverse impact on 80% of workers, resulting in both wage suppression and job loss. Such job insecurity has already aroused populist sentiment, which will pressure governments to take action that will have unpredictable consequences. The US-China trade war is already one symptom of these consequences.
Thus far, the review of the defects of Finance3.0 gives us some clue as to the desirable features of Finance4.0. The system must serve the real sector, which means that Finance4.0 needs to be innovative, efficient, socially inclusive and just, environmentally sustainable and geo-politically neutral in application and operations. These objectives are both mutually reinforcing but may also conflict because technological disruptions, geo-political rivalry and vested interests all may lead to unjust, unsustainable and disruptive outcomes. For any system at any particular time, what may be balanced for a sub-system (such as a nation-state) may cause the system as a whole to be imbalanced.
If the economy and financial systems are eco-systems with interconnected sub-systems, financial supervision should have systematic thinking, with closely coordinated regulatory policies. Andrew Haldane, chief economist of the Bank of England, proposed that a system-wide view of financial regulatory policy consists of four layers of policy: the first is the micro prudential regulation of the individual banks and financial institutions; the second is the macro prudential regulation of the whole financial system; the third is monetary policy that affects the whole economic system; the fourth layer is global financial framework that shapes the global economic/financial system. These four layers of policies interact with and influence each other, and the lack of coordination between them may lead to pro-cyclical or disruptive effects that create current problems such as global imbalances.
The financial system is an ecosystem formed by the interaction and integration of people, organizations and the environment. The people include employees, depositors and investors. Organizations include all financial institutions, asset managers, intermediaries, governments, regulators and civil societies. The environment includes macroeconomic, geopolitics, society and nature/climate which interact with each other. The common element that bonds the financial system is trust. We cannot analyse solve problems in the financial system without system-wide thinking.
The financial ecosystem comprises clear elements such as structure, process, standard, infrastructure, rules and so forth. Amongst these, standards play a major role, because standardization helps measurement and consistency, which means that standards involve units of bookkeeping, reserve currencies, regulatory standards and technical (computer) standards. As the complexity of financial derivatives evolve, the authenticity of data (ownership/accuracy/fraud) is becoming more and more difficult to determine. Standards are of great significance for maintaining system stability. This explains why after the GFC, digital unique product identifier (UPI) and the legal entity identifier (LEI) are being used to set a specific, standardized number for each financial product and market participant respectively to uniquely identify the authenticity of the related financial assets and individual legal persons as owners, borrowers or intermediaries.
For example, blockchain technology helps to track each transaction and each unit of account across distributed ledgers to securely protect ownership, identity and security in the financial system.
From an architectural point of view, the global monetary system is changing from a top-down unipolar system to a flat P2P multipolar system. The current Finance3.0 era is a pyramidal structure dominated by the US dollar, which is the anchor of the Finance3.0 system. At present, the US dollar still accounts for 60% of global trade payments and investment transactions, accounting for more than half of official reserves. In this pyramidal structure, domestic payments are recorded on commercial banks’ ledgers and eventually settled in the local central bank’s balance sheet. But the bulk of international payments will eventually be settled in US dollars and across the Fed’s balance sheet. In other words, the Fed sits at the peak of the global payments pyramid architecture due to the dominant role of the US dollar.
With more stringent sanctions on money laundering, terrorist financing, tax evasion, and “rogue state” trades, including very arbitrary fines due to geo-political reasons, there is growing incentives to avoid or by-pass the current monopolistic unipolar system. Since 2007, with the development of digital money and distributed ledger technology, it is now possible to establish a flat multipolar monetary system. The Peer-to-peer (P2P) multipolar digital monetary network can effectively avoid the economic sanctions driven by geopolitical reasons from the issuing country of reserve currency, which has already been applied in many instances. Much of the current ICO and bitcoin type transactions are driven by the desire to avoid current regulations and oversight. However, there is need to build a politically neutral international payment system without getting into geo-political disputes and conflicts.
With the expansion of the use of digital money, the present monetary system is evolving into a mixed state: the fiat currency system dominated by the dollar still maintains a dominant advantage, but its monopoly position has been broken by increasing use of digital currencies. Strategically, the digital currency business would need to achieve effective segregation between the digital money business and the dollar business through certain institutional arrangements to minimize the possibility of sanctions.
The specific operational mode of multipolar monetary system still needs further innovation and development. At present, regulators should not make too many mandatory arrangements, but should give market participants enough space / time to innovate and compete. Various alternatives option exist. First, it may be possible to adopt an e-SDR as a unit of account and means of payment instead of the US dollar. This is an idea that myself, Geng Xiao, Mathew Harrison and others have put forward. Compared with the US dollar, the e-SDR is more politically neutral. Compared with cyber-currencies such as bitcoin, the e-SDR is backed by the components of sovereign currencies such as the US dollar, Euro, Sterling, Yen and RMB. As the SDR is a basket, its currency value is more stable than individual reserve currency volatility.
Another option is to build a P2P trading currency (Tradecoin) network. Alex Lipton of MIT (Lipton 2017) proposed the idea of a Tradecoin network for facilitating global trade, with the advantage over bitcoin that improves speed in transaction without reduced security. Accounting consistency is achieved through designated validators [either algorithmic or institutional], which can effectively reduce the cost of calculations that slows down blockchain transactions. For example, Visa transactions take only 0.1 seconds, whereas bitcoin transactions may take 8 seconds or more. In addition, Tradecoin value is supported by the physical assets provided by the sponsors, thus maintaining the relative stability of the value of the currency.
A third option is for different central banks to issue the central bank digital currencies (CBDC). Citizens can open accounts directly with the central bank and use the digital money issued by the central bank. The Indian Aadhar system of providing every citizen with a digital identity card, which can have smart chip embedded, means that 1.3 billion citizens are effectively linked in a system through which everyone can deal with everyone else digitally, using central bank money. How the CBDC evolves will profoundly change the role of all traditional financial services providers, especially the role of commercial banks.
The unique feature of cyber-currencies is that they are neither currencies in the legal nor conceptual sense, but they are held out as currencies. Firstly, the marginal cost of production is near zero, since the private sector learnt that central banks can create money at zero marginal cost. Cyber-currencies like Bitcoin is an asset without a corresponding liability, it does not have either an issuer or custodian (since value floats in the Cloud amongst many computers), its value is uncertain and it is totally non-transparent in the sense that ordinary people cannot understand how it Is produced. Tapping into distrust of central banks, tax authorities and governments, criminal elements have levered off the idea of technology to offer what they claim to be foolproof Blockchain tokens or currencies. The reality is that no system is hack-proof, as shown by the losses of many coin exchanges. There is no one to certify that the Blockchain programmes are genuine, rather than as claimed, so that many of these P2P, International Coin Offering (ICO) schemes have been found out to be Ponzi scams and outright fraud, used by criminal elements taking advantage of the Dark Web.
We are not yet able to predict more accurately the outcome of Finance4.0, but a desirable Finance 4.0 system should have the following five characteristics (summarized as 5T), so that these will interact to provide a more efficient, robust and resilient, equitable and sustainable system.
The first is the Time or Demographic time cycle. Financial services should cover all the financial needs of the entire human life cycle such as savings, capital and investment.
The second is Total ROE, or the total risk-adjusted real return on capital that would increase along with the rate of growth of the real economy. Otherwise, returns to savers will lead to financial repression and regressive tax, which will aggravate the polarization between the rich and the poor, increasing social injustice.
The third is Transfer (of Risk and Uncertainty Sharing). Compared with debt financing, equity financing is more conducive to sharing of risks and benefits. Debt transfers asymmetrically transfer risks, because the concentration of risks to Too Big to Fail borrowers make a risk-dominated financial system fragile. Therefore, equity financing should be vigorously promoted to balance the present excessive dependence on debt financing. An equity based system is fairer to society because the largest and more wide-spread equity ownership, the broader the base of risk sharing.
The fourth is Technology + Reform. Technological creative destruction and disruption has profoundly changed market pricing and the distribution of winners and losers, including the impact on competition and vested interests. This requires continuous reforms to the competition rules and intervention by the state to mitigate the transitional impact on losers and those not equipped to deal with technological job disruption, such as the retraining and re-skilling of workers. This essentially means that reforms and innovations in state responses must be continuous.
The fifth element is Trust. Trust is the glue of the financial ecosystem, without which the financial system will either fragment or become fragile and unfair. Trust is vital for financial institutions to act on behalf of their customers, whilst trust in the state (policy makers and regulators) is vital to ensure that the people believe that the state will look after their interest and protect their privacy right and not be subject to crime, fraud and predatory behavior by large firms.
Trust is hard to gain and easily lost. The CFA Institute considers that Trust comes from Credibility + Professionalism. In order for the future financial industry to have high trust, it must be forward-looking, transparent and better serve the society in a more sustainable way. To achieve this goal, the financial industry must have staff with the following qualities: the diversity of cognition, systematic thinking, the ability to adapt to change and the values of serving the public (rather than a few class of elites). In short, financial behavior depends on the quality or trust-worthiness of people. A fundamental problem since the GFC is that loss of trust has no consequences, meaning that the incentive structure is biased towards predatory or unfair practices.
Debasing the currency is debasing trust in financial systems. Central banks and financial regulators who do not safeguard the interests of consumers and investors will lose their trust. This was the fundamental driver of populist sentiment.
All financial systems have four imbalances: maturity mismatch, foreign exchange mismatch, debt/stock mismatch and governance/bureaucratic imbalance.
The first is the maturity mismatch, where a bank-dominated financial system that relies on short-term bank deposits to fund long-term loans is particularly vulnerable to liquidity crises. The optimal solution is to establish long-term financial institutions such as pension, social security and insurance funds that can invest in long-term debt and equity. But we also need new metrics to be able to measure and calibrate different dimensions of fragility and vulnerability to risks and uncertainty. In the area of maturity mismatch, we must have better data on the duration (the average maturity from cash flow) of financial instruments for the system as a whole. Maturity mismatches create liquidity crunches that can seize up an economy.
The second is the FX mismatch, which refers to foreign exchange reserves being not sufficient to meet the needs of trade and capital account outflows. This was one problem that caused the Asian financial crisis. The solution is to enable long-term savings institutions that can hold foreign exchange, so that the country has diversified net foreign assets, rather than being exposed to net foreign liabilities, with central bank foreign reserves as the first line of defence. Macro-prudential FX tools will require better measures of the duration of FX liabilities, including foreign holding of domestic currency debt and equities, which could easily be converted into outflows.
The third is the debt/equity mismatch. The underdevelopment of the stock market and the over reliance on bank financing led to excessive leverage. The solution is the development of multi-level capital markets, especially long-term pension and insurance funds able to take long positions in equity and debt markets as well as broad-based equity markets that provide equity to small and medium enterprises. Essentially, in a world with higher unknown risks and uncertainty, a higher domestic equity cushion is a necessary condition to absorb insolvency shocks arising from inadequate capital.
The fourth is the governance/bureaucratic imbalance. If there is insufficient balance between the state and the markets, with bureaucracies that do not understand markets, then major policy mistakes will be made. The lack of macro perspective and systemic thinking will lead to imbalance of financial supervision and coordination, making the system vulnerable to crises. The solution is to ensure that there is a coordinated overview of system stability, innovation and competition as a whole. Without an eco-system perspective, it is likely that gaps in supervision, imbalances and fragilities will arise. Improving institutional governance, lowering corruption and increasing professionalism and ability to respond to shocks are critical to withstanding future shocks from Industry4.0 and Finance4.0.
A recent table compiled by Zhou Qiong illustrates the different stages of financial development between China and other advanced economies. The US is in a different class due to its very large stock market capitalization (147% of GDP), as well as asset management (193%) and securities fund assets (102%). Europe, China and Japan are still bank dominated systems with bank assets over 200% of GDP, with China having the lowest securities fund assets (10.8% of GDP). The data implies that Europe, China and Japan all suffer from maturity mismatches, which explained why Europe suffered a debt crisis, when the Southern European banks got into trouble by lending too much to real estate.
Nevertheless, such balance sheet tables do not reflect the sophistication of global markets in terms of electronic trading, which has increased the speed and scale of financial flows. Thus in order to monitor and manage such flows would require both flow and stock (balance sheet) data that is mostly unavailable in detail for many financial regulators.
Table 1: Size of Financial Assets in Major Countries, 2016 (% of GDP)
| Stock market share | Bond market share | Banking assets | Shadow bank share | Asset management scale ratio | Share of securities investment funds | |
| US | 147.4 | 205.3 | 90.4 | 146.0 | 193.5 | 101.6 |
| China | 64.3 | 82.6 | 295.0 | 84.3 | 157.2 | 10.8 |
| UK | 130.8 | 203.8 | 495.4 | 279.2 | 354.7 | 57.0 |
| Japan | 104.8 | 254.3 | 196.6 | 93.0 | 82.7 | 30.9 |
| France | 86.7 | 158.8 | 347.3 | 100.5 | 183.3 | 75.6 |
| Germany | 49.1 | 92.7 | 235.5 | 80.1 | 68.7 | 54.2 |
Sources of data: 1. Stock market size data except for UK data from the World Federation of Stock Exchanges and World Bank. 2. Bond market size data comes from BIS. 3. Banking assets data, US data from FDIC; China, Japan data from WIND, at end period exchange rates; Eurozone, Britain, France, Germany data from The State of The Banking Sector in Europe using year-end exchange rates. 4. Shadow Bank size data comes from the Global Shadow Banking Monitoring Report (FSB). 5. The size of asset management comes from BCG and EFAMA. 6. Annual reports of the US Investment Company Institute (ICI).
After the GFC, financial regulation has achieved good progress in several fields: an improved capital adequacy ratio: by the end of 2015, the average core capital adequacy ratio of all global systemically important banks was higher than 11%, double than that in 2009; a liquidity standard was clearly defined; the total leverage ratio was introduced; improvements made in corporate governance reforms, tightening of conduct regulation, and greater supervision over money laundering, terrorist financing, corruption and threats to network security.
But it is also clear that financial supervision needs to be improved within the whole context of macro-prudential supervision. The combination of zero interest rate / negative interest rate policy and Fintech has disrupted the financial system’s net interest margin and intermediation profits. Almost all areas of the traditional financial business have come under tremendous pressure. The pro-cyclical effect of current financial regulations also caused market fragmentation, pockets of illiquidity and de-leveraging even as the real economy needed funding for structural change. Compared with other industries, bankers are micro-managed by excessive regulation, and since they have huge reputational risks and restraints on remuneration, these lead to the loss of bank talent to Fintech and unregulated sectors. Furthermore, banks have large and obsolete legacy information systems that are inefficient and vulnerable to network attacks, failures or interoperability. Network security to hacks and shutdowns create very high operational and reputational risks.
Regulation is becoming more and more complex. Between 2011 and 2015, global regulatory rules doubled in number, but have also become too complex to understand by bankers and by consumers, itself an operational risk. The US and European regulators have begun to roll-back many regulations, including national exemptions for community or rural banks from Basel III rules.
Regulation therefore needs to be adjusted to best fit the rapid changes to the industry and to the changing context at the global and local level. As mentioned earlier, the CFA Institute survey reports show that the business model, human resource staffing model, investment model and distribution pattern will change rapidly in the face of Fintech challenges. In essence, Fintech engages in regulatory arbitrage, as they cover fields and sectors outside finance alone.
Fintech attacks the incumbent industry through speed, scale and scope, with cheaper and more convenient services. Hence, cost pressures will force incumbent regulated firms to merge and concentrate, increasing scale, but also lowering quality of information and scope of services.
In advanced countries, the distrust of financial institutions and government is spreading because of concerns over increasing social injustice, political capture (including intellectual capture), corruption, and rising crime rates. According to the CFA survey rankings in 2018, retail trust in the United States media and government is as low as 26% and 30% respectively. Trust in the US financial industry is at the middle level, at only 44%.
On the other hand, Chinese retail investors have very high trust levels in China’s financial services industry. According to the CFA Institute survey, India and China come first (71%) and second (70%) respectively in trust levels. By comparison, in the other markets, Canada had 51%, 48% for the United States and Brazil, 47% in Singapore, 46% in the United Arab Emirates, 40% in France, 35% in Hong Kong, 31% in Britain and Australia and 24% in Germany.
However much the regulators feel that financial reforms have made the financial system safer, the public still worries about a coming financial crisis. According to the CFA Institute, 54% of institutional investors and 38% of retail investors believe that another financial crisis will occur in the next 3 years. Indeed, all market retail investors’ expectations of crises have increased except in India and France. Part of this anxiety may be due to the fact that if the central banks still try to please politicians to print money through unconventional monetary policy rather than force politicians to apply fiscal and painful structural policies, they would have to face public anger because they are part of the elite that has been captured. Regulators should be bold enough to speak truth to power and to restore trust and common sense in addressing risks and uncertainty.
This brief exploration of Finance4.0 has revealed that we have opened up as much questions as answers. Because of the relative decline of the unipolar order, Asian emerging market countries are becoming new global growth poles, using digital transformation to drive national productivity and growth. It is quite possible that the unipolar power may launch a series of disruptions and sanctions that may delay or reverse the rise of the new multi-polar powers. These can come in the form of dismantling of the old multilateral institutions, such as WTO, or through bilateral tariffs and sanctions on other countries’ financial institutions, enterprises and individuals. Concerns for fairness in the payment mechanism means that alternative payment tools and mechanisms have to be found. This also needs a change in the mindset to establish independent thinking of how to build the Finance4.0 system and its transitional architecture and processes.
From Finance3.0 to Finance4.0 will be a very disruptive and painful transition. The current US-China trade war is only the starting episode of growing conflicts. Finance must serve real sector. It must give priority to people-based and quality growth, underpinned by financial stability. The financial system in the era of Finance4.0 should be innovative, resilient, sustainable, fair and trust-worthy financial ecosystem. But the transition pressures from 6G Disruptions will bring about continuous and complex uncertainty, so it will be necessary at the national level to give the system enough anti-fragility to cope with the shocks and losses of Black swan incidents and grey rhinoceros events.
Because of the great differences in economic, cultural, institutional and population resources in different countries / regions, the path of transition of Finance4.0 for different countries will be diverse. There will be no single or simple best path for any particular country. For China, the Finance4.0 transition should provide the necessary financial support for the realization of the “China Dream”. China has both the reform determination and the wisdom and resources to engage in deep reforms. I am consequently quite optimistic about China’s Finance4.0 transition. We should uphold the tradition of pragmatism, crossing the river by feeling the stones and get facts in search of the right path. In the process of transition, policy mistakes and losses are not such terrible things. The key issue is to recognize mistakes in time and correct them according to the actual situation. In order to establish systematic thinking, the policy formulation cannot be in a sweeping “one-size-fits-all” approach, but must be sequential and calibrated: “tightening the screws” of a wheel in a practical and responsive manner, so that overall, the screws have the right tensile strength to enable the tires to go faster and more stable at greater speed. In a world of profound uncertainty, such pragmatic structural adjustments using an eco-system framework may be the only way to negotiate a complicated world.
At the heart of the transitional debate will be the role of the state in managing and nurturing the growth of value creation in a socially just and ecologically sustainable manner. Should the state be the minimalist provider of global and national public goods, allowing the private sector to drive innovation and value creation through private greed? Or should the state provide not only public goods, but also safeguard order by protecting society from all downsides? The former (Finance3.0) generated unsustainable social injustice, ecologically disastrous consumerism, whilst the latter creates huge inefficiencies, moral hazard and unmanageable fiscal losses.
Getting to the right balance will require the right mixture of different policy tools, not over-relying on monetary policy, as was the mistake of Finance3.0. Of one thing is certain, that getting to Finance4.0 will require more determined and enhanced reforms at the structural levels.
References
Ash Carter (2018), Shaping Disruptive Technological Change for Public Good, Belfer Center for Science and International Affairs, Harvard University, Ernest May Lecture, Aspen Strategy Group, August
Mervyn King (2016) “The End of Alchemy”, Little Brown
Alexander Lipton and Alex Pentland (2017), Breaking the Bank, Scientific American, Volume 318, 126-31 pp.
Andrew Sheng and Xiao Geng (2018), “From Dollar to e-SDR: Innovating the current International Monetary Non-System? Project Syndicate, April
Andrew Sheng (2018a), Competition and Conflict in Knowledge Economies, Asia News Net, August.
Andrew Sheng (2018b), From Owners to Stewards, in Jan Wouter Vasbinder (editor), Disrupted Balance, World Scientific, Singapore.
Joseph E. Stiglitz (2017), Where Modern Macroeconomics Went Wrong, NBER Working Paper No. 23795, December,
Anton Korinek and Joseph E. Stiglitz (2017), Artificial Intelligence and Its Implications for Income Distribution and Unemployment, NBER Working Paper No. 27174, December
Joseph E. Stiglitz (2018), The Revolution Of Information Economics: The Past And The Future, NBER Working Paper 23780http://www.nber.org/papers/w23780
Nassim Taleb (2018), Skin in the Game, Random House
Gillian Tett (2015), The Silo Effect, Little Brown,
Michelle Wucker (2016), Gray Rhinos, St. Martin’s Press.
[1] Andrew Sheng and Xiao Geng, “From From Dollar to e-SDR: Innovating the current International Monetary Non-System? Project Syndicate, April 2018
[2] IMF Article IV for US 2017, Staff Papers, 2018.
The views expressed in the reports featured are the author’s own and do not necessarily reflect Asia Global Institute’s editorial policy.
Distinguished Fellow, Asia Global Institute
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The University of Hong Kong
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