Tag Archives: machine learning

Telecoms’ troubles

The telecom industry is in a funk. S&P recently said that their “global 2017 base-case forecast is for flat revenues” and other analysts are predicting little growth in traditional telecom’s top line over the coming years across most developed markets. This recent post shows that wireless revenue by the largest US firms has basically flatlined with growth of only 1% from 2015 to 2016. Cord cutting in favour of wireless has long been a feature of incumbent wireline firms but now wireless carrier’s lunch is increasingly being eaten by disruptive new players such as Facebook’s messenger, Apple’s FaceTime, Googles’ Hangouts, Skype, Tencent’s QQ or WeChat, and WhatsApp. These competitors are called over the top (OTT) providers and they use IP networks to provide communications (e.g. voice & SMS), content (e.g. video) and cloud-based (e.g. compute and storage) offerings. The telecom industry is walking a fine line between enabling these competitors whilst protecting their traditional businesses.

The graph below from a recent TeleGeography report provides an illustration of what has happened in the international long-distance business.

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A recent McKinsey article predicts that in an aggressive scenario the share of messaging, fixed voice, and mobile voice revenue provided by OTT players could be within the ranges as per the graph below by 2018.

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Before the rapid rise of the OTT player, it was expected that telecoms could recover the loss of revenue from traditional services through increased data traffic over IP networks. Global IP traffic has exploded from 26 exabytes per annum in 2005 to 1.2 zettabytes in 2016 and is projected to grow, by the latest Cisco estimates here, at a CAGR of 24% to 2012. See this previous post on the ever-expanding metrics used for IP traffic (for reference, gigabyte/terabyte/petabyte/exabyte/zettabyte/yottabyte is a kilobyte to the power of 3, 4, 5, 6, 7 and 8 respectively).

According to the 2017 OTT Video Services Study conducted by Level 3 Communications, viewership of OTT video services, including Netflix, Hulu and Amazon Prime, will overtake traditional broadcast TV within the next five years, impacting cable firms and traditional telecom’s TV services alike. With OTT players eating telecom’s lunch, Ovum estimate a drop in spending on traditional communication services by a third over the next ten years.

Telecom and cable operators have long complained of unfair treatment given their investments in upgrading networks to handle the vast increase in data created by the very OTT players that are cannibalizing their revenue. For example, Netflix is estimated to consume as much as a third of total network bandwidth in the U.S. during peak times. Notwithstanding their growth, it’s important to see these OTT players as customers of the traditional telecoms as well as competitors and increasingly telecoms are coming to understand that they need to change and digitalise their business models to embrace new opportunities. The graphic below, not to scale, on changing usage trends illustrates the changing demands for telecoms as we enter the so called “digital lifestyle era”.

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The hype around the internet of things (IoT) is getting deafening. Just last week, IDC predicted that “by 2021, global IoT spending is expected to total nearly $1.4 trillion as organizations continue to invest in the hardware, software, services, and connectivity that enable the IoT”.

Bain & Co argue strongly in this article in February that telecoms, particularly those who have taken digital transformation seriously in their own operating models, are “uniquely qualified to facilitate the delivery of IoT solutions”. The reasons cited include their experience of delivering scale connectivity solutions, of managing extensive directories and the life cycles of millions of devices, and their strong position developing and managing analytics at the edge of the network across a range of industries and uses.

Upgrading network to 5G is seen as being necessary to enable the IoT age and the hype around 5G has increased along with the IoT hype and the growth in the smartphone ecosystem. But 5G is in a development stage and technological standards need to be finalised. S&P commented that “we don’t expect large scale commercial 5G rollout until 2020”.

So what can telecoms do in the interim about declining fundamentals? The answer is for telecoms to rationalise and digitalize their business. A recent McKinsey IT benchmarking study of 80 telecom companies worldwide found that top performers had removed redundant platforms, automated core processes, and consolidated overlapping capabilities. New technologies such as software-defined networks (SDN) and network-function virtualization (NFV) mean telecoms can radically reshape their operating models. Analytics can be used to determine smarter capital spending, machine learning can be used to increase efficiency and avoid overloads, back offices can be automated, and customer support can be digitalized. This McKinsey article claims that mobile operators could double their operating cashflow through digital transformation.

However, not all telecoms are made the same and some do not have a culture that readily embraces transformation. McKinsey say that “experience shows that telcoms have historically only found success in transversal products (for example, security, IoT, and cloud services for regional small and medium-size segments)” and that in other areas, “telcoms have developed great ideas but have failed to successfully execute them”.

Another article from Bain & Co argues that only “one out of eight providers could be considered capital effective, meaning that they have gained at least 1 percentage point of market share each year over the past five years without having spent significantly more than their fair share of capital to do so”. As can be seen below, the rest of the sector is either caught in an efficiency trap (e.g. spent less capital than competitors but not gaining market share) or are just wasteful wit their capex spend.

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So, although there are many challenges for this sector, there is also many opportunities. As with every enterprise in this digital age, it will be those firms who can execute at scale that will likely to be the big winners. Pure telecommunications companies could become extinct or so radically altered in focus and diversity of operations that telecoms as a term may be redundant. Content production could be mixed with delivery to make joint content communication giants. Or IT services such as security, cloud services, analytics, automation and machine learning could be combined with next generation intelligent networks. Who knows! One thing is for sure though, the successful firms will be the ones with management teams that can execute a clear strategy profitably in a fast changing competitive sector.

Pimping the Peers (Part 1)

Fintech is a much hyped term currently that covers an array of new financial technologies. It includes technology providers of financial services, new payment technologies, mobile money and currencies like bitcoin, robo-advisers, crowd funding and peer to peer (P2P) lending. Blockchain is another technology that is being hyped with multiple potential uses. I posted briefly on the growth in P2P lending and crowd-funding before (here and here) and it’s the former that is primarily the focus of this post.

Citigroup recently released an interesting report on the digital disruption impact of fintech on banking which covers many of the topics above. The report claims that $19 billion has been invested in fintech firms in 2015, with the majority focussed in the payments area. In terms of the new entrants into the provision of credit space, the report highlights that over 70% of fintech investments to date have being in the personal and SME business segments.

In the US, Lending Club and Prosper are two of the oldest and more established firms in the marketplace lending sector with a focus on consumer lending. Although each are growing rapidly and have originated loans in the multiple of billions in 2015, the firms have been having a rough time of late with rates being increased to counter poor credit trends. Public firms have suffered from the overall negative sentiment on banks in this low/negative interest rate environment. Lending Club, which went public in late 2014, is down about 70% since then whilst Prosper went for institutional investment instead of an IPO last year. In fact, the P2P element of the model has been usurped as most of the investors are now institutional yield seekers such as hedge funds, insurers and increasingly traditional banks. JP Morgan invested heavily in another US firm called OnDeck, an online lending platform for small businesses, late in 2015. As a result, marketplace lending is now the preferred term for the P2P lenders as the “peer” element has faded.

Just like other disruptive models in the technology age, eBay and Airbnb are examples, initially these models promised a future different from the past, the so called democratization of technology impact, but have now started to resemble new technology enabled distribution platforms with capital provided by already established players in their sectors. Time and time again, digital disruption has eroded distribution costs across many industries. The graphic from the Citi report below on digital disruption impact of different industries is interesting.

click to enlargeDigital Disruption

Marketplace lending is still small relative to traditional banking and only accounts for less than 1% of loans outstanding in the UK and the US (and even in China where its growth has been the most impressive at approx 3% of retail loans). Despite its tiny size, as with any new financial innovation, concerns are ever-present about the consequences of change for traditional markets.

Prosper had to radically change its underwriting process after a shaky start. One of their executives is recently quoted as saying that they “will soon be on our sixth risk model”. Marrying new technology with quality credit underwriting expertise (ignoring the differing cultures of each discipline) is a key challenge for these fledging upstarts. An executive in Kreditech, a German start-up, claimed that they are “a tech company who happens to be doing lending”. Critics point to the development of the sector in a benign default environment with low interest rates where borrowers can easily refinance and the churning of loans is prevalent. Adair Turner, the ex FSA regulator, recently stirred up the new industry with the widely reported comment that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses”. A split of the 2014 loan portfolio of Lending Club in the Citi report as below illustrates the concern.

click to enlargeLending Club Loan By Type

Another executive from the US firm SoFi, focused on student loans, claims that the industry is well aware of the limitations that credit underwriting solely driven by technology imbues with the comment that “my daughter could come up with an underwriting model based upon which band you like and it would work fine right now”.  Some of the newer technology firms make grand claims involving superior analytics which, combined with technologies like behavioural economics and machine learning, they contend will be able to sniff out superior credit risks.

The real disruptive impact that may occur is that these newer technology driven firms will, as Antony Jenkins the former CEO of Barclays commented, “compel banks to significantly automate their business”. The Citigroup report has interesting statistics on the traditional banking model, as per the graphs below. 60% to 70% of employees in retail banking, the largest profit segment for European and US banks, are supposedly doing manual processing which can be replaced by automation.

click to enlargeBanking Sector Forecasts Citi GPS

Another factor driving the need to automate the banks is the cyber security weaknesses in patching multiple legacy systems together. According to the Citigroup report, “the US banks on average appear to be about 5 years behind Europe who are in turn about a decade behind Nordic banks”. Within Europe, it is interesting to look at the trends in bank employee figures in the largest markets, as per the graph below. France in particular looks to be out of step with other countries.

click to enlargeEuropean Bank Employees

Regulators are also starting to pay attention. Just this week, after a number of scams involving online lenders, the Chinese central bank has instigated a crack down and constituted a multi-agency task force. In the US, there could be a case heard by the Supreme Court which may create significant issues for many online lenders. The Office of the Comptroller of the Currency recently issued a white paper to solicit industry views on how such new business models should be regulated. John Williams of the San Francisco Federal Reserve recently gave a speech at a recent marketplace lending conference which included the lucid point that “as a matter of principle, if it walks like a duck and quacks like a duck, it should be regulated like a duck”.

In the UK, regulators have taken a gentler approach whereby the new lending business models apply for Financial Conduct Authority authorisation under the 36H regulations, which are less stringent than the regimes which apply to more established activities, such as collective investment schemes. The FCA also launched “Project Innovate” last year where new businesses work together with the FCA on their products in a sandbox environment.

Back in 2013, I asked the question whether financial innovation always ended in lower risk premia in this post. In the reinsurance sector, the answer to that question is yes in relation to insurance linked securities (ILS) as this recent post on current pricing shows. It has occurred to me that the new collateralised ILS structures are not dissimilar in methodology to the 100% reserve banks, under the so-called Chicago plan, which economists such as Irving Fisher, Henry Simons and Milton Friedman proposed in the 1930s and 1940s. I have previously posted on my difficulty in understanding how the fully collaterised insurance model can possibly accept lower risk premia than the traditional “fractional” business models of traditional insurers (as per this post). The reduced costs of the ILS model or the uncorrelated diversification for investors cannot fully compensate for the higher capital required, in my view. I suspect that the reason is hiding behind a dilution of underwriting standards and/or leverage being used by investors to juice their returns. ILS capital is now estimated to make up 12% of overall reinsurance capital and its influence on pricing across the sector has been considerable. In Part 2 of this post, I will look into some of the newer marketplace insurance models being developed (it also needs a slick acronym – InsurTech).

Marketplace lending is based upon the same fully capitalized idea as ILS and 100% reserve banks. As can be seen by the Citigroup exhibits, there is plenty of room to compete with the existing banks on costs although nobody, not yet anyway, is claiming that such models have a lower cost of capital than the fractional reserve banks. It is important not to over exaggerate the impact of new models like marketplace lending on the banking sector given its current immaterial size. The impact of technology on distribution channels and on credit underwriting is likely to be of greater significance.

The indirect impact of financial innovation on underwriting standards prior to the crisis is a lesson that we must learn. To paraphrase an old underwriting adage, we should not let the sweet smell of shiny new technology distract us from the stink of risk, particularly where such risk involves irrational human behaviour. The now infamous IMF report in 2006 which stated that financial innovation had “increased the resilience of the financial system” cannot be forgotten.

I am currently reading a book called “Between Debt and the Devil” by the aforementioned Adair Turner where he argues that private credit creation, if left solely to the free market under our existing frameworks, will overfund secured lending on existing real estate (which my its nature is finite), creating unproductive volatility and financial instability as oversupply meets physical constraints. Turner’s book covers many of the same topics and themes as Martin Wolf’s book (see this post). Turner concludes that we need to embrace policies which actively encourage a less credit intensive economy.

It is interesting to see that the contribution of the financial sector has not reduced significantly since the crisis, as the graph on US GDP mix below illustrates. The financialization of modern society does not seem to have abated much since the crisis. Indeed, the contribution to the value of the S&P500 from the financials has not decreased materially since the crisis either (as can be seen in the graph in this post).

click to enlargeUS GDP Breakdown 1947 to 2014

Innovation which makes business more efficient is a feature of the creative destruction capitalist system which has increased productivity and wealth across generations. However, financial innovation which results in changes to the structure of markets, particularly concerning banking and credit creation, has to be carefully considered and monitored. John Kay in a recent FT piece articulated the dangers of our interconnected financial world elegantly, as follow:

Vertical chains of intermediation, which channel funds directly from savers to the uses of capital, can break without inflicting much collateral damage. When intermediation is predominantly horizontal, with intermediaries mostly trading with each other, any failure cascades through the system.

When trying to understand the potential impacts of innovations like new technology driven underwriting, I like to go back to an exhibit I created a few years ago trying to illustrate how  financial systems have been impacted at times of supposed innovation in the past.

click to enlargeQuote Money Train

Change is inevitable and advances in technology cannot, nor should they, be restrained. Human behaviour, unfortunately, doesn’t change all that much and therefore how technological advances in the financial sector could impact stability needs to be ever present in our thoughts. That is particularly important today where global economies face such transformational questions over the future of the credit creation and money.