Money Out of Thin Air

Promises only bind those who believe them

Photo by engin akyurt on Unsplash

The saying goes like this,

Loans create deposits

It might not sound like much, but this is how money is actually created. You’d think it would be printed as paper bills by a central bank or minted into coins. Not anymore, to a large extent. Paper money and coins are indeed “money”, but they make up only a small percentage of the reserves available in the economy. Let me try to break it down to you in a simple example.

I Promise to bay the bearer, etc.

When a bank grants you a loan, it basically credits your bank account with the loan amount, 10 000 dollars for example, and records a liability of the same amount on its balance sheet. You can withdraw this amount in cash or use it to buy a car. Or a piano. Or groceries. It is real money.

Now you might be a dreamer and believe in equilibrium, that in the grand scheme of things, banks use only the cash deposited by people, as loans to debtors. Well not really.

Banks are allowed to lend much more than the liquidity or capital at their disposal. That’s a net creation of money.

Out of thin air.

And don’t bother with the liability side, the minus amount in dollars recorded on the bank balance sheet. It cannot be used to fund anything. It cannot be withdrawn in cash. It is just an accounting entry on a balance sheet account. A reminder of the debt you own the bank. Nothing more. A promise if you will.

The bet at hand

The bet at the heart of the game is that loans will allow debtors to create enough value in due time to pay them back, through their hard work or the rise in value of their property or investments.

This bet kind of works out when the economy is fine, but not so much when banks lend money without decent credit controls, to people they know damn well cannot repay the loans.

It works even less when bankers are convinced that dot com compagnies of the early 2000s or the real estate market of the late 2000s have more value in them than what they are truly worth, and end up massively lending to people who are investing in such assets.

The bet is off in this case, quite obviously, since the debtors cannot create value out of thin air, be it called dot com or sub-primes.

The promise

In the end, this is how most of the money circulating in the economy is created. Legally. A number credited on an account, which retains its value as long as the promise behind it trustworthy.

And as we say in France, in a tongue in cheek expression, promises only bind those who believe them.

Can you believe that?

Let the board sound


On that moment when you start walking on water

One of the major traps in fintech is implementing the requirements of a financial institution without questioning the value it is expecting from them. Many times, the client would be describing how he or she operates a given business process in the system being replaced rather than the functional value expected from that process regardless of the platform. Many times, what the client does in a system is actually a workaround for a gap in functionality and you don’t want to be implementing workarounds and accumulating technical debt in the platform you are delivering to him.

Many years ago, I found myself in a meeting room somewhere in the UK, surrounded by representatives of the treasury, operations and finance departments of a humongous financial institution, trying to come up with a proper design for their treasury business processes to implement and automate in our platform. At some point, we stumbled on a concept we had never encountered before, the FTP, or Fund Transfer Pricing, which only started gathering interest by the end of the 2000s, after the sub-prime crisis had washed international finance ashore, a very recent topic back then. It felt like the client was speaking a different language and the meeting was reaching a dead-end when the senior architect suddenly rose to the challenge. He asked a simple question with his typical French accent.

“Why do you do it?”

Sometimes the most basic question can yield the most effective answers and this one proved it right. The client ended up explaining what he actually wanted to do rather than how he wanted it to be done. For the less experienced consultant that I was back then, it felt like magic. A very complex business requirement was unraveling, bit by bit, with every question the senior architect was asking. The guy was walking on water that day, and even the client was amazed by his magic: He went into the meeting not knowing a thing about FTP but still managed to save the day and get out of it with a clearly described business requirement which we could design into the platform. And all he did was ask questions. The right questions. That was my first true lesson into requirement gathering and design, my Fintech 101 moment if you will. It was very humbling, and I remembered thinking I could never pull off something like that.

I would however get a shot at it, some years later, when I found myself in a meeting room somewhere in northern Europe, in the middle of winter, surrounded by half the treasury department of one of my clients, trying to come up with an elegant design for their banking book accrual P&L reports. Fintech 101 was far away in time and I had done enough mistakes by then to have learnt a few tricks of the craft. It felt like walking on water to me and I like to think the client felt the same magic. But nothing is less sure…

Let the board sound


On being cornered and the way out

Or when you think they expect you to be the intergalactic expert.

Many years ago, I found myself in a meeting room somewhere in the middle east, in the middle of summer, surrounded by half the finance department of one of my clients, trying to come up with an elegant design for the accounting schema to configure in the platform we were implementing for them.

They were having trouble projecting themselves in the new system and at some point, a very senior stakeholder asks a very precise and arduous question on the amortization of bond premium and discount and the expected impacts from an accounting perspective if my memory serves me well. I was young. I was foolish. He was an intergalactic expert on the topic. I was not. Here you go. Cornered!

And lesson learnt.

Photo by pixel2013

Fast forward nine years. I found myself in a meeting room somewhere in northern Europe, in the middle of winter, surrounded by half the treasury department of one of my clients, trying to come up with an elegant design for their banking book accrual P&L report to configure in the platform we were implementing for them.

They were having trouble projecting themselves in the system and at some point, a very senior stakeholder asks a very precise and arduous question on the amortization of bond premium and discount and the expected impacts from an accrual P&L perspective if my memory serves me well. I was older. I was wiser. He was an intergalactic expert on the topic. So was I. I had nine years to become one.

The next question nearly got me cornered though. Arbitrage swaps this time … 

Fortunately for me, I had realized by then the vacuity of trying to become an expert on every topic l might encounter some day in my career, especially as an architect. My job is ensuring consistency and sound design of the delivered solution, front end to back end across all the business processes in scope and through to the integration with the IT landscape of the client. Consistency, not expertise. And for that, you need to be knowledgeable on many subjects but it would take many lifetimes to become an expert on all of them. Beyond the reach of mere mortals.

I mean where would you start… The finance industry is an ever changing one and when expertise on funky derivatives and hybrid products was sought after in the 2000s, banks moved back to cash products in the aftermath of the Subprime crisis. Then came new norms and new processes: EMIR, Dodd-Frank, Basel III, MIFID, SFTR, FRTB. Affirmation platforms, LIBOR transition and so on. Even project and development methodologies have drastically changed in recent year, from a waterfall approach to Agile, SaFe and DevOps. Besides, the platforms at hand are huge enterprise wide modular software and expertise on them can only be, well,  modular.

So intergalactic expert? No. But you can become the next best thing by mastering a basic skill: asking the right questions and be honest about your limits.

Broadly speaking, as a FinTech professional, clients do not expect you to come up with answers on the spot, or devise a solution out of thin air as much as they expect you to understand their requirements first and foremost. You can always rely on your subject matter experts when you are out of your comfort zone, expertise is their job and they would be more than happy to oblige. However, not understanding the requirement in the first place makes the point moot. And for this, what better than to ask questions? Try to understand what the clients are talking about, use the board to draw your understanding of it, get their feedback on the result, ask more questions, rephrase to make sure you got it right and do not be afraid to say you are not an expert on a given subject. 

In many cases, you are not expected to be one. 

Or maybe just on asking the right questions…

Let the board sound


On FinTech and a bit of fun in a post for once

Or how to explain what you do as a fintech professional to people who have no clue about technology and/or financial institutions, without quoting The Wolf of Wall Street.

Photo by Timisu

The average tentative involves you saying that you work in fintech (that’s financial technology) and having then to explain that your clients are mostly banks which rely on complex technologies and heavy computing power to operate, which will not make sense to most people because, well, why would you want a data center and cutting edge software to track the account balances of your customers and run your accounting, there’s Excel for that, but heeey, nooo, it’s investment banks and funds we’re talking about, not retail banks, you know, the type of banks which trade complex financial products which require heavy math and intensive computation to be valued and processed, and it goes sideways from there on because, well, you find yourself compelled to provide an example, so you try to explain what an option is, a contract which conveys its owner the right to buy or sell an underlying asset or instrument like an Amazon stock at a specified strike price prior to or on a specified date, and that the math to value it was only developed in the 70’s by Black, Scholes and Morton, which sparked a boom in the trading of options which has not waned ever since, and by the time you start explaining the Black-Scholes equation and the fact that it relies on the volatility of the price of the underlying, what underlying? Well the Amazon stock remember? No? That’s exactly my point: they are either completely lost or completely bored. At this point, you can always try to rely on your wingman, the Wolf of Wall Street, because that’s the closest most people will ever get to a trading floor and I do not blame them for not trying harder, it is an acquired taste.

If this long explanation still sounds obscure to you dear reader and possibly fintech professional, just know that a retail bank is the one you go to to open a bank account and get a credit card and it caters mostly for individuals whereas an investment bank is the place where options and other financial instruments are traded, on a trading floor. 

And for those who have never seen one, a trading floor can look and sound like a high-tech fish market, a bit toned down maybe, no fish smell, less decibels, but a fish market still. People selling stuff to other people, trying to agree on a price, managing their stock while keeping an eye on the market and the competition. There you go. It might not be entirely accurate, but it has the merit of demystifying the place. 

At this point of the reading, you might want to realize that we have still not explained what it is that a fintech professional actually does. I personally work in delivery, that’s implementing complex financial software solutions at investment banks and hedge or mutual funds. But it is not about me, it is about you dear reader/possibly fintech professional.

So the next time they ask you about your job, and unless it is alright because you like the way it hurts, swallow your pride, give The Wolf of Wall Street a break and say you work in IT, full stop. 

And point them to this post.

Let the board sound


A proxy to the rather opaque USD/LBP unofficial rate

In the aftermath of the default of the Lebanese government on its debt on March 19th in 2020, the Lebanese pound reached abysmal lows versus the US dollar. Up to that point, the Lebanese government, or more precisely the Banque du Liban, had always followed a policy of strict pegging of the local currency to the US dollar, at a rate of 1507.5 LBP for a Dollar, to instill confidence that investments, typically in bonds, will retain their purchasing power in US dollars when they mature. This rate had been constant since 1997. The Lebanese pound intrinsic weaknesses started to unravel around October 2019 and the peg to the US dollar started to fall apart.

The unofficial FX rates on the local market have surged in the past months, reaching values as high as 15000 LBP per USD according to sources. These sources rely on polls from exchange houses and currency changers on the local market. Given the relatively small size of the Lebanese money market and its opacity, the local unofficial FX rate could benefit from a proxy on international marketplaces with a high enough correlation to allow a coarse evaluation of the fairness of the unofficial FX rate, and identify under or over valuations of the Lebanese Pound.

Lebanese sovereign Eurobonds (Bonds issued by the Lebanese government in a foreign currency, in this case USD instead of LBP) might be a good proxy for the specific case at hand with the following assumptions:

  •      The currency had been successfully pegged to the US dollar for decades  before a first default and an economic downturn.
  •      The country has successfully issued Eurobonds in the past decades, until a first default

When investors buy such a Eurobond at par (at 100% of the face value of the bond, quoted as 100 on fixed income markets), they are expecting full repayment of the principal amount at maturity. In the case of the Lebanese Eurobonds, the investors are expecting full repayment of the principal in USD from an issuer whose domestic currency is the LBP. In other words, they trust the central bank to keep the Lebanese Pound pegged to the US Dollar on a rate close or equal to the current peg rate, allowing the Lebanese government to easily finance itself in USD to repay the principal at maturity.

If the Eurobond is bought at a heavy discount, for example 20% or 30% of the bond face value, it means that the investors foresee a higher risk of default, which in the case of sovereign Eurobonds is due in part to the weakness of the domestic currency. In other words, the investor does not expect the central bank to have the means of enforcing a peg of the Lebanese pound to the USD and hence, the Lebanese government of easily financing itself in USD to repay the principal.

At the time these lines are being written, the Lebanese Eurobonds being considered are quoting at around 12 or 13. One could argue that this price can be seen as a “recovery rate”: the investor accepts to pay 12% of the face value of a Eurobond because it does not expect a scenario worse than a 12% repayment of the principal. The value of every dollar of principal must be reduced by 88% for the investor to incur a loss, having bought the Eurobond at 12% of its face value.  For an issuer like Lebanon which had successfully pegged the domestic currency to USD for decades at 1507.5 LBP per USD, it can be said that the value of every 1507.5 LBP of principal (one US dollar at the time the bond was issued) must be reduced by 88% for the investor to incur a loss, or that the central bank has to sustain an 88% downturn of the USD/LBP rate for the investor to incur a loss, at which point 1507.5 LBP is worth 0.12 USD.

Hence the proxy: USD/LBP black market = USD/LBP peg * 1/Eurobond price = 1507.5 * 1/0.12 = 12562.5. This value is very close to the unofficial FX rate quoted by different sources on the local Lebanese market.

To ensure the soundness of the idea, I have back tested the values of the black-market FX rate for the past year against the price of a Lebanese Eurobond, ISIN XS0250882478, as quoted on the Luxembourg exchange. It is an eight-year Eurobond maturing on April 12, 2021, which makes it old enough to have been issued at a time when the USD/LBP peg was effective and maturing around a year after the first bond default following the economic downturn of the Lebanese republic. This ISIN was suspended on the Luxembourg exchange where the values were taken shortly before its maturity.

USD/LBP rate computed from Eurobond prices versus USD/LBP unofficial rates

In the figure above, on the day of the bond default in March 2020, the bond price used as a proxy gives a USD/LBP rate much higher than the black-market value. This is probably due to the fact that an economy has a given inertia due in part to capital restrictions and other measures imposed by commercial banks and the central bank of Lebanon on depositors to avoid a bank rush and to try to control the FX rate to a certain extent.

Starting July 2020, the curves seem to be much more correlated. In fact, the correlation (Pearson) is computed as 0.771 on the values of both curves between July 29 and March 31. The gap towards the end of October 2020 could be explained by rumors on the formation of a new government by the nominated prime minister, which drove the local unofficial rate down through a relative increase of the confidence in the Lebanese Pound. This gap has persisted until right before the bond maturity, where we see a correction. It could also be due to other biases linked of the exchange where the Eurobond prices were sourced.

Further steps are planned, to refine the findings on this proposed proxy. They include running a back testing exercise on another Lebanese Eurobond and using quotes from a different exchange, for example, USD/LBP rate based on Eurobond XS0471737444 maturing in 2024 and quoted on the Frankfurt exchange.

Let the board sound