CLOs: Can this story have a happy ending?

By: Arjun Goyal

A new security, Collateralized Loan Obligations, seem eerily similar to the securities that brought down the financial system in 2008. What is it really about?

If the 2008 financial crisis was a movie, we would have the Federal Reserve as the hero, Fannie Mae and Freddie Mac as our villains, and the housing market as our producers. The weapon being used by our villains would be the ominous sounding ‘mortgage backed securities’. To summarize the plot, when the housing market fell in 2007, mortgage backed securities lost most of their value in a matter of weeks, dragging down the banks and financial institutions that held them in large quantities. After large scale capital injections, bailouts and implementation of safeguards for the future (the Dodd-Frank Act), the culmination of the crisis was finally upon us after several grueling months.

The technical name for Mortgage Backed Securities is a Collateralized Debt Obligation, or CDO. Apart from sounding like something that would put you to sleep, it is essentially a security (obligation) that derives its value from debt that has some collateral behind it in case there is a default (just like a mortgage has a house as its collateral). Because of their role in the financial crisis, CDOs and MBS are villains in wider society, and one would imagine that investors would not be putting their money in this. But there is a similar security that has currently hit the market that is eerily similar to CDOs, known as Collateralized Loan Obligations. I think it’s important that we all understand what these securities are, and what its implications could be.

New Kid on the Block: What are CLOs really?

The best way to describe CLOs would be to use the analogy of a pie. Imagine that your favorite patissiere represents the financial institution making the CLO; let’s use Blackrock as an example. The patissier needs to make a lemon pie (our CLO). He begins to make the filling for the pie by combining cream, sugar, egg and lemon extract. In the financial market, these ingredients represent claims to different types of loans. These are largely corporate loans made to firms looking for debt to finance their business. However, just like there are many types of ingredients, there are also many different types of loans. Most CLOs have a combination of low-risk and high-risk loans, with risk being determined by what kind of companies these loans have been made out to. A loan to a stable company with a positive future outlook (as determined by a ratings agency) would be deemed as low-risk, and those made to sketchier, lower credit rated firms are deemed as high risk loans. What one has to note, though, is that high risk loans entail a higher cash flow return for the holder of the obligation, since the interest rates for these loans are risk adjusted (high risk, high reward). Most CLOs also have a portion of the equity of these companies in them, which is the riskiest portion of it since equity-holders are paid last by debtors. However, it is also the most lucrative portion, often yielding returns between 10-20%!

Next steps: Our patissier takes this mixture and whisks it together, pours it in a tart base and bakes it in an oven at 175 degrees Celcius for 20-30 minutes (that’s 350 degrees F for the American Masterchefs out there). And voila, we have ourselves a succulent tart that we can slice up and sell to the public. Blackrock does the same thing: it takes these loans (and equity), combines them together to make them into a single security, or a CLO, and divides them up into tranches that it sells to investors. However, there is a catch.

Sugar in a pie is what makes it great, but too much sugar in it can curdle the mixture and ruin our dessert. High risk loans are just like the sugar, since the high returns make the CLOs have above-average returns, but going overboard on risk means that the security becomes extremely unstable, and defaults on the underlying loans can make the whole thing go under.

To most investors, and myself as well, CLOs sound eerily similar to CDOs and mortgage backed securities. This is the way experts in the industry would put it: CLOs can be seen as a subset of CDOs, where CLOs only contain bank loans made to corporations. What makes CLOs especially popular is the ability for the bank issuers to customize them based on investor demand. Another interesting fact to note is that CLOs also contain leveraged loans from leveraged buyout merger projects, which are often considered quite risky.

Selling like hot cakes

Considering the effect that CDOs and mortgage-backed securities had on the 2008 financial crisis, investors should be running away from CLOs. The reality is quite to the contrary. CLOs have been one of the most popular specialized structured debt instruments in the market, and this is in spite of the fact that a large portion of CLOs is becoming riskier. For example, one of companies whose loans were part of CLOs was Sears. Yes, the same Sears that just filed for Chapter 11 bankruptcy protection.

Still, investor appetite for risk remains unsatiated. James Mackintosh wrote in the Wall Street Journal that “while weaker credit standards mean bigger losses when loans turn sour, they will help magnify market gains as long as the economy stays sweet”. He’s right, and in the current market where deregulation and pro-growth policies have been the norm, investors only see an upside to these instruments. Just last year, leveraged loans hit a value of over $1.5 trillion. Asset managers like Allianz Global and Apollo Global Management have more than 85% of their loans being managed as CLOs (Allianz is at 97%). Cash rich firms like insurance companies, and organizations like Bill and Melinda Gates Foundation and the family offices of Paul Allen have CLOs as fixed income instruments in their portfolios. It’s a crowd favorite.

Does this plot end in tragedy?

The lack of significant difference between CLOs and CDOs causes significant concern regarding the future of the financial system. And in my opinion, it should. I don’t want to use the word bubble to describe this market, though many do claim that we are in the exposition of one, but the unbridled optimism with which investors have been eating up risky debt is extremely concerning. The high liquidity for these instruments is leading to slipping credit standards, and the covenants that are usually put in place to prevent defaults are starting to loosen. Interest rates are also expected to rise, with the Fed having already hiked them three times this year. Since these loans are mainly floating rate loans, investors are expected to continue flocking to this market in bunches. This is worsened by the fact that the Dodd-Frank Act has been under fire with large scale financial deregulation occurring, especially with regards to policies safeguarding CLOs from taking on too much risk.

But many say that the situation in the market is not like what it was when housing bubble was at its peak. The New York Times notes that the CLO market is only about one-tenths the size of the housing market in the years leading up to the 2008 crisis. Additionally, the top level, low risk tranche of CLOs have never defaulted, even in the thick of the financial crisis. Some also say that if the CLO portfolios are diversified in their loans, there is a possibility to minimize risk while maximizing reward.

Nobody definitively knows the effect these securities could have when the downturn is upon us. Yes, we are currently booming and CLOs are flourishing, but the boat might sink when the business cycle takes over and the economy starts to cool again.

I’d like to think that as creatures with strong memory and reasoning skills, we would have learned our lessons. At the same time, I’m not surprised that the allure of profits overcomes this twice-fold. Personally, I’m not too optimistic on the future of CLOs and their effects. I would want nothing more to be proven wrong. The last thing we need is a sequel to The Big Short (I highly recommend watching it to get a better understanding of this market), where a Christian Bale-esque investor reaps profits as the whole world burns down, again. The jury is still out on this story’s ending; time will tell if it ends in tragedy.

Works Cited

LLC.cls-1, J. Z. (2018, March 28). Are CLOs The Next CDOs? Retrieved from https://seekingalpha.com/article/4159460-clos-next-cdos

Phillips, M. (2018, October 19). Wall Street Loves These Risky Loans. The Rest of Us Should Be Wary. Retrieved from https://www.nytimes.com/2018/10/19/business/economy/clo-corporate-loans.html

Fitch Ratings. CLO Asset Manager Handbook. Retrieved from https://www.fitchratings.com/site/dam/investors/US-CLO-Asset-Manager-Handbook.pdf

Kurt, D. (2018, March 30). Collateralized Loan Obligation – CLO. Retrieved from https://www.investopedia.com/terms/c/clo.asp

Bloomberg News. Popularity of collateralized loan obligations widens thanks to demand from rich. Retrieved from https://www.investmentnews.com/article/20180905/FREE/180909976/popularity-of-collateralized-loan-obligations-widens-thanks-to

Bloomberg News. Popularity of collateralized loan obligations widens thanks to demand from rich. Retrieved from https://www.investmentnews.com/article/20180905/FREE/180909976/popularity-of-collateralized-loan-obligations-widens-thanks-to 

Turkish Contagion and Threat to Emerging Markets

By: Arjun Goyal

Is the recent fall of the Lira going to send aftershocks to the vulnerable emerging markets?

There is a certain excitement in the air of a trading floor when a significant story regarding global markets breaks on Bloomberg. I can attest to this feeling, because the news of the Turkish lira slide broke when I was in the middle of a fixed income trading team in Singapore. Turkey’s crisis has been all over the news, and President Erdogan’s controversial statements and his feud with President Trump has scared many investors off from Turkey. What’s concerning is that Turkey’s woes seem to be having severe repercussions on other countries around the world.

Istanbul under Fire

Turkey has enjoyed healthy real GDP growth in the recent past due in large part to the construction boom. However, most companies took advantage of this boom by being financed by debt, primarily foreign debt. In addition to this, Turkey has been running a trade deficit, and like the aforementioned firms, it has also been running mainly on foreign debt. Unfortunately, Turkey’s economic health has taken a tumble. In 2017, inflation rose to 15% even though the central bank set the target rate at 5%. Investors highly doubt President Erdogan’s economic policy measures, and consequently stock market gains have been meager.

High inflation and low investor confidence led to gradual decline in the Lira over 2017, which only made things worse for Turkey. As its currency declined (the Lira is the worst performing currency this year), its financial burden to repay its debts started to mount. To illustrate this, we can take an example of a country which owes $100 in foreign debt, and have a local exchange rate of 10X/$ (10X = 1$). This means that it owes 1000 Xs in its own currency to foreign creditors. However, over time if its currency depreciates to 20X/$, its obligations become 2000 Xs. This is exactly what is happening to Turkey, and so the currency depreciation is making investors worried about Turkey’s ability to repay its debts.

What bothers investors more is that President Erdogan refuses to increase interest rates; he is widely known for calling interest rates the enemy. It seems unlikely that Turkey’s economic condition will improve without a major intervention. Things came to a head when confrontation between Turkey and the United States escalated. The detention of an American evangelical pastor not only increased the geo-political tensions but also prompted doubling of tariffs on Turkish goods. This made stock markets tumble in Turkey, and investor confidence was at an all time low. This, along with the Fed increasing interest rates, led investors to pull out money from Turkey to safer investments in the US and Europe.

All of this has led to the Lira falling 34% to the US Dollar since January. That is akin to being able to afford a Lamborghini in January and finding out in August you can’t even afford the replacement tires. It also means that if you’re not Turkish, there is a chance you may be able to buy a Lamborghini in Istanbul for the price of its replacement tires (before they adjust the prices, of course). This kind of fall is not unprecedented, but it reminds us of the situations in Zimbabwe and Venezuela; one doesn’t need to be too well versed in economics to know that this is disastrous. It also doesn’t help that Erdogan has taken executive control of the central bank (which is usually kept separate from the executive branch of the government), and shows unnerving nonchalance to the matter, once saying while investors had dollars, Turkey had God on their side.

Contagion Alert

Unfortunately for other emerging market, investors have been spooked by the crisis in Turkey. They fear that the current situation might turn out to be like the 1997 Asian currency crisis. As a quick primer, the East Asian crisis started in Thailand with the crash of the Thai baht, and proceeded to spread to countries like Indonesia and South Korea. There was a fear that this contagion would spread further to cause a global economic meltdown.

It is possible that this scenario could be recreated in emerging markets after Turkey’s meltdown. One of the reasons this is a possibility is that banks with large holdings in Turkish bonds would have to slow-down lending because of this credit threat. Consequently, goods and services in countries where these bank operate would become more expensive, and economic activity would slow down. This dampening further scares investors away from investing in these countries (mainly emerging markets due to their higher risk profile), and might even incentivize them to pull their money out from these markets. Precursors to this could be seen after the news broke about the Lira slide.

India and Indonesia

Both India and Indonesia suffered heavily in the wake of the Turkish crisis. The rupee (INR) slid amidst fears of a contagion from Turkey, and broke the INR 70/USD barrier (almost a 2% drop in a single day). However, the rupee had troubles far before the US-Turkey confrontation: it had slid almost 9% in 2018. The Indian finance ministry blamed external forces for this drop, but India’s wide current account deficit has definitely contributed to the slide. It is also important to note that this drop is seen by many traders and analysts as a correction in the value of the rupee, which had been seen as overvalued for the past 3 years or so. But it seems to me the steep decline was triggered mainly because of the fear of contagion, and slide could have been more gradually in a world without the Turkish crisis. To add to India’s problems, it was speculated that the Reserve Bank of India was to raise interest rates to counter this slide, slashing both the Sensex and NIFTY (India’s primary stock indices), and dampening expectations of short-term economic activity.

The Turkish crisis had its ripples reach Indonesia as well, which has already experienced its fair share of economic turmoil. Just like the Indian rupee, the rupiah slid in response to the Turkish crisis, 7% over the year in this instance. Indonesia should be especially worried about its currency depreciation and the Turkish crisis because like Turkey, it too is dependent on large amounts of foreign debt. Spooked investors may spell bad things for Indonesia if the 1997 crisis presents itself in a renewed form. Fortunately for Indonesia, the central bank could salvage some of the damage: the Bank of Indonesia decided to raise interest rates quite quickly in response to the crisis, mitigating some of slide in the rupiah. However, market sentiment in fixed income circles still remain uncertain and mixed regarding the near future.

To Indonesia … and beyond?

The tremors from Turkey are not limited to just India and Indonesia. The MSCI Emerging Markets Index, a good indicator for performance of emerging market, has fallen more than 10% this year. Countries like Brazil, Argentina and South Africa, who rely on foreign investment, are all under threat of investors pulling out their capital. On top of this, all these countries have large current account deficit, which makes these currencies more susceptible to devaluation.

Analysts say that Europe is not safe from this contagion either. Countries like Spain and Italy are large holders of Turkish debt, and the currency crisis puts banks with these investments in jeopardy. If the contagion enters one of these countries, there is a good chance it may spread throughout Europe.

Is this the Tipping Point?

Many economists say that this Turkish crisis is not going to snowball into a larger economic issue, especially among emerging markets. They cite that the factors leading to the crisis are specific to Turkey, and it seems unlikely that other emerging markets would suffer the same consequences.TD Securities strategists say that the Turkey crisis is largely idiosyncratic, although its triggers have been external factors.

However, any volatility from the Turkish crisis does not spell good news for the emerging markets. A full-blown trade war between the US and China, along with sanctions on Iran, have made it difficult for emerging markets to grow at their potential in the recent past. The way current events are shaping up, with interest rates expected to rise in the US and a major selloff in material and tech stocks around the world, emerging markets will still have to face an uphill battle for some time.

As for Turkey, economic salvation will only be achieved when fiscal and monetary reform takes place. President Erdogan’s gusto may have saved him some political capital in his country, but if things keep going the way they are, investors will not flocking Istanbul and Turkey’s only hope may be an IMF bailout. Even so, Turkey has not scared away one particular group of people: shoppers. Nowhere else in the world could you buy a Louis Vuitton bag at 40% markdown like you can in Istanbul right now.

Sources:

https://www.bloomberg.com/news/articles/2017-12-15/erdogan-s-40-year-old-theory-of-inflation-scores-a-win-in-turkey

https://www.bbc.com/news/business-45113472

https://money.cnn.com/2018/08/14/investing/turkey-lira-emerging-market-crisis/index.html

https://www.washingtonpost.com/business/could-turkeys-financial-crisis-have-a-snowball-effect-on-world-markets/2018/08/17/8fdccd88-a16b-11e8-93e3-24d1703d2a7a_story.html?utm_term=.55adcbf841fb

https://www.bloomberg.com/news/articles/2017-12-15/erdogan-s-40-year-old-theory-of-inflation-scores-a-win-in-turkey

https://www.livemint.com/Money/u58y9YWicWYOzBx8NkVGAN/Rupee-hits-fresh-record-low-against-US-dollar-as-emerging-cu.html

Politics and economics: The rupee’s Turkish worries

https://asia.nikkei.com/Economy/Turkey-crisis-pushes-Indonesia-to-raise-rates-again

https://www.marketwatch.com/story/why-turkeys-crisis-doesnt-spell-doom-for-all-emerging-market-currencies-2018-08-14

https://www.express.co.uk/news/world/1002896/tourists-luxury-shops-louis-vuitton-turkey-lira-prices-cheap-turkey-news

https://www.cnbc.com/2018/08/07/turkish-lira-10-year-bond-hit-record-lows-amid-us-sanctions-threat.html

GE gets Downgraded: The Full Perspective On the Decline of the Former Powerhouse

By: Arjun Goyal

General Electric just lost its place on the Dow. Is this adjustment more than just an update to the stock index?

Introduction

The Dow Jones Industrial Average recently lost its oldest and only remaining original member: General Electric. In place of the industrial monolith came the Walgreens-Boots Alliance, the second largest pharmacy chain in America (after CVS). While changes in the Dow Jones are not unheard (as you will see below), the dropping of GE seems to be part of a longstanding trend in the American economy and shows how its key drivers continue to shift and adapt as times change.

What does the Dow Jones Industrial Average represent?

Before we dive into historical trends and large scale economic changes, it’s important to understand the Dow Jones Industrial Average’s nuances. The Dow Jones Industrial Average (called the Dow henceforth) is like any other stock index in the world: it measures the prices of a collection of key stocks on the exchange. In the case of the Dow, it picks 30 key stocks that are being traded and amalgamates them into the index. As prices of these stocks move during the trading window of the day, the Dow also moves them.

It is important to note that the Dow is a price-weighted index, meaning that stocks with higher prices have a higher weightage in the Dow (or that their price changes influence the Dow more than others with a lower price). For example, currently the aviation company Boeing has the highest weightage due to its price of $332.93 (as of July 5, 2018). The cumulative effect of the price changes of all 30 stocks determines the change in the value of the Dow. (Note that the magnitude of change is also determined by a constant known as the Dow Divisor, but it is not too pertinent here)

Generally, investors use the movement of the Dow as a signal of the market outlook at the time. For example, the rapid rise of the Dow a few months ago represented optimism in investors’ expectations of general economic performance amongst most companies.

A common question asked at this point is what determines the 30 companies that are included in the index? Well, the actual list of the 30 companies is determined by the editors of the Wall Street Journal. However, they do not have any stringent guidelines or selection process in making this decision. Their goal is to pick large and successful companies who represent significant portions of the American economy. In doing so, they try to make the Dow an indicator of the overall health of the American economy and the confidence of investors in the market.

What’s the deal with General Electric?

The Dow’s announcement to drop General Electric (GE) meant that the index had just lost its only original founding member. As stated previously, General Electric is to be replaced by Walgreens-Boots Alliance (WBA). While there is a sense of unconscious melancholy around the loss of GE from the index, it triggers 2 important questions: why, and so what?

As the Business Times puts it, while GE may have been an industry leader a decade and a half ago, “it foundered in several key industrial markets in recent years”. Moreover, its move from industrial manufacturing (like aviation, automation etc.) and foray into the financial services space meant that the Global Financial Crisis of 2008 hit the company hard. Due to these hard times, GE posts the lowest stock price amongst the 30 companies in the Dow. As you can imply from the previous characteristics of the Dow, this means that it also has the least influence over the value of the Dow out of all the companies.

GE has recently seen itself under new management, with large cost cutting schemes and streamlining strategies to try and renew and boost profitability. However, these efforts have still resulted in scenarios like when CEO John Flannery warned that they may not be able to pay their 2019 dividend.Safe to say, GE is not looking good. Walgreens-Boots Alliance on the other hand seems to a great replacement in the Dow: not only is it more financially stable and profitable than GE at the moment, its stock price is more than 4 times that of GE.

However, the change represents a larger shift. A switch from GE to WBA shows how much more important the pharmaceutical and consumer goods industry is to the American economy when compared to large, blue collar engineering companies. I would go so far as to say that the loss of GE from the Dow signifies the fall of the last bastion in the reign of industrial manufacturing companies being the drivers of the American economy.

Of course, this observation comes in light of the fact that the Dow is meant to depict a representation of companies that have large contributions to the American economy, and those that have  significant ones the American consumer. An analysis of previous changes to the Dow and a look at the current set of companies can show that the economy has gone from being driven by large industrial manufacturing and natural resource companies, to information technology, financial services and pharmaceutical companies.

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Foreshadowing: CNN Money writes about shifting economy and Dow changes in 1999

Historical changes and their implications

The original 12 companies as part of the Dow Jones formed a very different profile when compared to the 30 companies in the Dow today. Looking at the list, more than half of the companies in it are industrial manufacturing companies, like American Cotton Oil, US Leather, and GE. It’s clear that at the time these companies drove the US economy.

As time passed, this list continued to change; most noticeably, the number of companies that were a part of the Dow increased from 12 to 30 in 1928. However, for a large part of the 1920s and 1930s, industrial manufacturing companies continued to be the dominant force in the Dow. This is exactly why the Dow is called the Dow Jones ‘Industrial’ Average. By the end of 1930s, oil and chemical companies had joined the mix, with the likes of Union Carbide and Standard Oil.

This industrial image of the Dow continued till about the late 1980s, when there was the beginning of a shift. Companies like IBM and Coca-Cola had consistently been in the Dow, while industrial companies began to be slowly dropped. Financial services firms like American Express, Citigroup and JP Morgan soon got added. By 1991, the Dow no longer looked purely like an ‘industrial’ stock index. With firms like Boeing, Coca-Cola, AT&T and Walt Disney booming, the list of companies seemed quite diverse. At this point, the Dow shifted radically. Between 1997 and 2005, companies like HP, Microsoft, 3M, Pfizer, Verizon and Intel were added to the index in place of companies like Bethlehem Steel, Texaco and Union Carbide. By 2009, Bank of America and Cisco were there too, in place of automotive heavyweight General Motors. The large aluminum company Alcoa was also removed subsequently, and Apple, Goldman Sachs, Nike and Visa took their places on the stage.

Yes, it may not be too surprising to see these large industrial companies being considered obsolete in place of the younger innovators. It is after all how economies evolve: agriculture to manufacturing to services. But what’s interesting to see is the extent to which this change has taken place. Companies like GE, General Motors, Chrysler and Alcoa are not small companies at all in spite of their mellowed dominance; they still hold immense amounts of economic importance and are organizations which have stood their own in trying times. Yet, barely any of these industrial companies are being considered as part of the 30 to act as an economic signal.

Future Possibilities

All this may not seem too significant; yes, it’s interesting but you may think I’m making a bigger deal of it than it is. But I feel like this moment acts as a sign to us show us what the future of our economy may hold for us. In the same way that industrialists lost their place on the top in a fraction of the time it took them to get there, it’s not implausible to say that there is a high possibility that the firms on the Dow today may be ousted in a similar way.

In fact, I think it may be even sooner, considering how rapid change has become in this age of innovation and technology.

Another observation I have made looking at the way large companies have evolved with respect to each other since the turn of the century is that while this may be the era of technology, a few years ago it was the banks and financial institutions that were considered the drivers of the economy. It was part of the reason why there was such a personnel influx into the financial services industry, and why the system has become so much more complex, with everything ranging from complex credit schemes to exotic derivatives trading. But ever since 2008’s financial catastrophe, when Bear Stearns and Lehman Brothers headlined the tanking of an industry, tech companies have grown to become enormous, with 7 of the top 10 largest companies in the world being technology companies. We are in a time where the tables are turned, and banks are becoming increasingly (if not completely) reliant on technological companies to run their divisions, whether it is high-frequency algorithmic trading, supply chain management, or risk management. Tech companies may not be the main drivers of economic growth in the country yet, but there is no denying that they contribute a large portion towards it and are going to become the key source of future prosperity.

But what’s next? There’s no way to really know. It may be renewable energy companies or something in that area with the way Tesla has made claims (although I’m not so sure how Elon Musk is going to keep to his lofty assertions), or it may be in a completely different space. But what GE’s news should remind us is that the state of economy is in constant flux and there is no saying when and how quickly it can completely change. The misnomer of the Dow’s name is a clear sign of that: the Dow Jones ‘Industrial’, full of tech and pharma.

Works Cited

General Electric loses place in elite Dow Jones Industrial Average. (1400, January 01). Retrieved from https://www.businesstimes.com.sg/companies-markets/general-electric-loses-place-in-elite-dow-jones-industrial-average

Hall, M. (2018, June 07). What does the Dow Jones Industrial Average measure? Retrieved from https://www.investopedia.com/ask/answers/050115/what-does-dow-jones-industrial-average-measure.asp

Historical components of the Dow Jones Industrial Average. (2018, July 21). Retrieved from https://en.wikipedia.org/wiki/Historical_components_of_the_Dow_Jones_Industrial_Average

Keitz, A. (2018, June 20). General Electric Booted From Dow, Replaced by Walgreens. Retrieved from https://www.thestreet.com/markets/general-electric-booted-from-dow-14626922

Kennon, J. Here’s a Guide to Understanding the Dow Jones Industrial Average. Retrieved from https://www.thebalance.com/understanding-the-dow-jones-industrial-average-djia-357912

The Ins and Outs of the Dow Jones Industrial Average. Retrieved from https://www.wsj.com/graphics/djia-components-history/

The Meaning of the Dow Jones Industrial Average. (2014, July 30). Retrieved from https://www.thesimpledollar.com/the-meaning-of-the-dow-jones-industrial-average/

Why Does the Dow Change the Stocks it Tracks?. Retrieved from https://trendshare.org/how-to-invest/why-does-the-dow-change-the-stocks-it-tracks

 

Building Blocks to the Future: Capitalizing on Blockchain Technology

By: Arjun Goyal

While the most obvious application of blockchain technology is digital currencies, from healthcare to record labels to sports betting, there are a multitude of other industries blockchain technology has to potential to disrupt.

Unless you’ve been living under a rock for the past year, you’ve probably heard of the term blockchain. Blockchain is a technology that has taken the world by storm, with many calling it the next ‘big thing’ in this current age of rapid technological progress. It has become a buzzword, so much so that the Long Island Iced Tea Company (yes, the beverage company) renamed itself to Long Blockchain Corporation and saw its stock rise by 289%.

You might have also heard of the phenomenon investors are chasing called Bitcoin. Cryptocurrencies like Bitcoin have seen a rapid surge in the past few years, especially after the meteoric price rise of Bitcoin in 2017. These cryptocurrencies are all built on blockchain technology; think of it like how apps based on a computer software or how websites are based on the Internet Protocol.

How does it work? Well since blockchain is such a complicated technology, it is extremely difficult to explain this to a layman for full understanding. But I can try to explain it in a nutshell: blockchain is a type of database such that when a transaction or activity occurs, it is recorded on every machine participating on the blockchain network, thus making fraudulent changes to the record nearly impossible, as one would have to make this change on every single machine. What it tries to do is to give the power of storing this information to everyone instead of just one regulating party, creating a decentralized consensus rather than a central party who validates the data. (For a better and more thorough explanation of blockchain, I highly recommend reading this article on our website)

While cryptocurrencies have been the main drivers of blockchain technology, a deeper look reveals so many interesting implementations and applications of this revolutionary technology. 

Music Distribution (Bittunes)

Bittunes aims to revolutionize the way music is distributed in the world. With the key focus of minimizing piracy in the music industry, Bittunes aspires to use blockchain technology to distribute music around the world while making sure that artists get their fair share of money. The founders noticed that a large part of funds were being taken away at the top of the distribution chain, and by the time it reached the artist, the trickle down had reduced the flow of money to a mere stream. They claim that 78% of revenue in the music industry is non-artist revenue, which is a staggering number. With the introduction of Napster and music piracy, this has reduced even more.

Bittunes addresses this problem by doing two things. Firstly, they have created a blockchain model such that a fixed percentage (around 40%) of the earnings earned on the sale of a track goes directly to the artist. With the nature of blockchain technology, participants no longer require a third-party intermediary to facilitate the exchange, allowing transactions to be completely peer-to-peer, thus giving more of the earnings back to the artist. Secondly, they have created an incentive for users to buy tracks rather than downloading them illegally: giving them a percentage (around 20%) of the earnings as well. By doing this, they have made the music distribution market into a pseudo-stock market, where songs may go up and down in value as they are traded.. At the same time, they give the lion’s share of the earnings to the actual artist. The idea is brilliant and naturally has garnered much backlash from music distribution companies. The beta is coming soon, so only time will tell whether their model can upset the status quo of the music industry. 

Data Storage (Filecoin)

Storage in the cloud is not a new thing. With the vast amounts of data we deal with, data storage innovations are in need. Filecoin takes this dilemma and answers it with an ingenious blockchain-based solution.

Filecoin allows users to save their data on other people’s hard drives. Right now, you must be thinking there are some serious issues with privacy and security. But filecoin uses the decentralized security of blockchain to ensure that there are none of these issues. Their software has strong end-to-end encryption that prevents manipulation and an erasure protocol to prevent future leakage of data. But the beauty of filecoin is that it provides an incentive to the storers of this data since access to their storage facilities is contingent on a payment made between the customer and the storer. This price is determined by demand and supply, which ensures market competition.

Filecoin has managed to leverage blockchain technology to create data storage solutions without going through the traditional data storage route. Investors are clearly excited by its prospects, since it raised more than $250 million in its initial coin offering (similar to an initial public offering undertaken by public companies).

Sports Betting (Wagerr)

Wagerr uses blockchain technology to establish a sports betting platform. Yes, this sounds illegal but the online sports betting industry is a $37.9 billion market, and Wagerr aims to provide a more efficient, blockchain-based approach to it.

It uses “blockchain technology to execute betting contracts” in something that they call “trustless betting.” The software verifies results and pays the appropriate party in the wager the amount being bet. Since it is decentralized, manipulation of this data is extremely improbable and the transaction connection created by smart contracts (an extension of blockchain) is very secure.

Another advantage of being decentralized is that it is less susceptible to detrimental issues like corruption and fraud. Wagerr also prides itself in minimizing middleman costs, since its transaction costs are minimal and its app is supposed to be easy to use (even for casual gamblers).

Thankfully for Wagerr and other sports betting apps like it, the outlook on sports betting is changing and executives like NBA commissioner Adam Silver have supported the regulated legalization of sports betting. The development of these blockchain solutions may accelerate this change.

Medical recordkeeping  (Medicalchain)

Medicalchain provides a similar service to Filecoin, except with much higher stakes. It provides a blockchain solution to the storage of medical records of patients in a place where doctors and health practitioners can access them securely.

The encryption and decentralization of blockchain software prevents any chance of manipulation or data loss, and affirms that the health information for the patient accessed by doctors is credible. Its design also implies that no one can access this information without the consent of the patient (again via a smart contract mechanism).

This kind of product would provide a secure, decentralized yet convenient compilation of all health records, and at the same time prevent misuse of health records in cases of unauthorized prescription medication abuse or identity theft. Additionally, Medicalchain also provides an incentive for patients to use this service by compensating them in their cryptocurrency MedTokens when their information is used through the service.

Their ideas are gaining traction in the real world, and Medicalchain has been featured in The Telegraph, Financial Times and also conducted an event at the FT Digital Health Summit.

Going forward

The criticism on cryptocurrencies have slowed their ascent slightly, and the growing holes in their feasibility are allowing the flaws to become more visible. Whether or not cryptocurrencies succeed in the future (as currencies or as securities), blockchain technology is not going anywhere. Its ability to provide decentralization and security in a cost effective and rapid manner means that its adoption into industries is imminent. And we would be myopic to think that their applications are limited to FinTech and cryptocurrencies, as outlined by the article above.

At the same time, it will take time before this technology is leveraged fully throughout the economy. Past experiences with computing technologies are empirical evidence to support this hypothesis, which may occur due to early skepticism or simply the inertia of undertaking such a radical change. But blockchain is definitely going to affect the way we live, and help us continue to pursue increased productivity and innovation in this digital age.

Works Cited

Shapira, A., & Leinz, K. (2017, December 21). Long Island Iced Tea Soars After Changing Its Name to Long Blockchain. Retrieved April 13, 2018, from https://www.bloomberg.com/news/articles/2017-12-21/crypto-craze-sees-long-island-iced-tea-rename-as-long-blockchain

B. (2017, April 12). Why we started Bittunes.. – Bittunes – Medium. Retrieved April 13, 2018, from https://medium.com/@Bittunes/why-we-started-bittunes-3ab0b63bfad4

Filecoin. Retrieved April 13, 2018, from https://filecoin.io/

Wagerr. Retrieved April 13, 2018, from https://www.wagerr.com/

$257 Million: Filecoin Breaks All-Time Record for ICO Funding. (2017, September 08). Retrieved April 13, 2018, from https://www.coindesk.com/257-million-filecoin-breaks-time-record-ico-funding/

Fuller, S. Topic: Sports Betting. Retrieved April 13, 2018, from https://www.statista.com/topics/1740/sports-betting/

Nathan, A. (2017, July 19). Adam Silver Expects Sports Gambling to Be Legalized ‘In the Next Few Years’. Retrieved April 13, 2018, from http://bleacherreport.com/articles/2722453-adam-silver-expects-sports-gambling-to-be-legalized-in-the-next-few-years

Medicalchain. Retrieved April 13, 2018, from https://medicalchain.com/en/

 

The Great Reformation in Finance: A Look into Impact Investing

By: Arjun Goyal

Many assume that the financial industry operates purely for profit but a recent rise in impact investing may prove otherwise.

We’ve all come across that person who cries: “The bankers are a bunch of crooks! They only want to make money, and are out to get your money and run away with it. Finance is a dirty game.” Regardless of the validity of this normative and generalized statement, we continue and most times need to, engage extensively with the financial world by using banking facilities, putting money into investment and mutual funds to save for retirement or earn a return on idle cash, receiving funds for loans and much more. But there is good reason that such an outlook on financial services exists today. The Global Financial Crisis in 2008 exposed the profit hungry dealings of financial institutions that pushed the economy to the brink and then over the tipping point into a rampant recession.

But the industry is trying to make amends, and is becoming more conscious of the impact of its decisions on society and the environment; not only is this a form of an apology, it is also a marked shift in the activities that firms are undertaking to benefit financially. This change has been highlighted by the rise of firms that are undertaking socially conscious investment, or “Impact Investing”

What is Impact Investing?

Most investments are made in order to receive a future financial return on the funds being invested; the idea is buy something that appreciates in value to eventually sell it for a profit. Impact investing takes this return one step further. As the Global Impact Investing Network (GIIN) puts it, “[Impact Investors] are investors who are determined to generate social and environmental impact as well as financial returns”.

Not only does this mean that these investors avoid investing in any company or project that could have an adverse effect on the environment or society, but also that they seek to invest in assets that engage in activities that benefit the environment and society. At the same time, they differ radically from any form of charity since they demand certain financial returns from their investments. It aims at creating mutual benefit for society and firm, and creates a double bottom line: profit and positive externality.

It is important to note that there is a wide breadth of activities that firms in this segment undertake. They can range all the way from only providing credit and equity for these firms to full scale venture capitalism and private equity. A snapshot of this breadth can be seen in this scale from GIIN.

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Why it works?

When I first came across this space, I was quite convinced that it would be a space where returns would be minimal, and much of the investment funds would end up becoming grants with no return in sight. But there are intrinsic properties in impact investing that make it resistant to such outcomes.

The fact that profitability is part of the investors’ bottom line means that investments into entities will be made with in-depth financial analysis and forecasting to ensure future  project strength and longevity. Needless to say, not all companies can receive this kind of capital, implying that there is a pool of high-potential firms receiving capital from which a large number have a high probability of succeeding and creating a lasting impact in the world.

Because the investments are made with the intention of creating profit (in addition to social impact), there is a creation of accountability in the investee companies. With targets of expansion and return being set by their investors, companies need to do all that they can to meet these targets. If they do not, there is a threat of divestment. In turn, they start to work at increased efficiency without the lax that many socially conscious firms suffer from in the status quo.

Here’s another question: Why would anyone invest in this when there are opportunities to receive far higher returns with less risk? It seems to be the opposite of what logic and portfolio theory state.

The fact of the matter is that we live in a time when being socially and environmentally conscious creates a great impression on others; it’s part of the reason why CSR (Corporate Social Responsibility) has become such a massive part of the undertakings of large firms. It’s also part of the reason why wealthy individuals engage in philanthropic activities. Socially conscious investing may not create a high return on paper but it creates a far higher abstract return than most other investments. In addition to creating impressions, it also has a very high ‘feel good’ value. Impact investing allows for investors to not only make money but also feel like they are contributing to making a difference in the world. This positive emotion is a key driving factor for investors today.

Current State and Real-Life Successes

A Financial Times article on the topic of impact investing notes that it has become extremely popular amongst clients of financial services firms; an executive from Credit Suisse stated that clients say, “if I was otherwise going to give my money away, I can take that bucket of money and use it in impact investing’.” Socially impactful business really has become a buzzword in the current market.

Successful firms that currently operate in the market include Arborview Capital, Bamboo Capital Partners, Omidyar Network and Impact America Fund. These firms have enabled and jump-started numerous businesses in the world who are trying to make a difference. For example, Omidyar Network has been able to invest in companies like Khan Academy, a free online education platform that promotes learning, and Project Isizwe, which helps to provide wi-fi to low income communities in South Africa.

Large scale banks have also recognized the allure of combining social responsibility and profit generation: firms like Bain, Deutsche Bank and Barclays have all started to form representations of impact investing funds of their own. All of this commitment to sustainable investing has led to the management of more than $100 billion in impact assets, as of 2017. And that number only seems to be growing.

However, a key question to answer is why the industry is moving towards this trend. Is it all just for appearances, to change the image of the industry (as stated before, impressions are crucial), or has the industry really embraced the idea of being profitable while still bettering the world? I think it’s a bit of both. Every form of giving (most prominently charity) has a selfish element to it, where we aim to enhance our image to society by showing our sacrifice. At the same time, giving also stems from a deep rooted feeling of compassion. Impact investing and socially conscious finance is no different. My view is that even if it may be just for appearances, businesses trying to make an impact are getting the capital they need to continue bettering the world; in the end, that’s all that should matter.

Will it last?

Even with its success, impact investing still has its critics. For example, Forbes writer Jean Case quotes a venture capitalist who stated that “impact investing is like a houseboat; it’s not a good house and it’s not a good boat.” But the truth is that all new ideas have opposer and critics and the ones that survive are the ones that block these out and continue. Impact investing, in my opinion, seems to be a winner.

There are signs backing me up on this. A few months ago, Larry Fink wrote a letter to the CEOs of firms in the financial services industry, addressing to them that while their practices in creating value for their clients have been great for them, they need to start looking at the implications of their investments. He stated that what the industry needed was investments in companies that promoted social and environmental well being, in addition to creating financial return. This is exactly what impact investing hopes to achieve. I also, attended a talk at NYU Stern during Social Impact week where Brace Young of Arabesque stated how there seems to be a strong correlation between long-term financial success and adherence to certain moral and ethical standards; an example of this could be United Airlines, which runs a successful airline business but who’s unethical treatment of customers has recently caught headlines and caused widespread dismay in goodwill for the company.

It seems that the view of the financial world being out to get you and destroy the world for their benefit may be getting outdated. I hope that the new trend can help amplify the impact people in the world are trying to make by giving them the capital they deserve.

Works Cited

Image source:  Bank, David. (2017, November 16). Forbes joins the impact investing parade with boldface-name reception. Retrieved: https://impactalpha.com/forbes-joins-the-impact-investing-parade-with-boldface-name-reception-d560c4382ca3/

Impact Investing. Global Impact Investing Network. Retrieved from https://thegiin.org/impact-investing/

Gilbert, J. C. (2017, October 10). Putting The Impact In Impact Investing: 28 Funds Building A Credible, Transparent Marketplace. Retrieved from https://www.forbes.com/sites/jaycoengilbert/2017/10/09/putting-the-impact-in-impact-investing-28-funds-building-a-credible-transparent-marketplace/#578e61a3e5fa

Ross, A. (2018, April 14). Give your money real clout with impact investing. Retrieved from https://www.ft.com/content/195598c8-334f-11e8-ac48-10c6fdc22f03

Annual Impact Investor Survey (Rep.). Global Impact Investing Network. Retrieved https://thegiin.org/assets/GIIN_AnnualImpactInvestorSurvey_2017_Web_Final.pdf

Larry Fink’s Letter to CEOs. Retrieved from https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter

Netflix: Will it fall like a House of Cards?

By: Arjun Goyal

All eyes are currently on stock’s meteoric rise. But how long will it last?

Perhaps the only thing more volatile than the weather in New York this year has been the stock market. With the Vix–a measure of expected volatility of the stock market–rising to as much as 37 and the Dow Jones crashing to less than 24,000, Wall Street’s boat has definitely been rocked quite violently. However, one stock on the market has been doing quite well, barring certain rare blips, even in this time of turmoil. Netflix.

The online media and entertainment company’s stock has been rising consistently not just this past year, but in the past few years. In fact, it has given more than a 1000% return in the past 5 years, and almost a 25,000% return since its IPO in 2002.

However, in a world of high margin companies like those in energy or emerging technology, or those in financial services, what makes an online entertainment company like Netflix gain so much traction in the market and get such consistent gains, especially in the past year? To examine this, we need to first see what determines stock prices on the market.

Traditional theory on stock prices

The efficient market theory in finance states that the price of a stock represents the true value of the company at the time, since all information about the company is incorporated into the price of the stock. While this may make sense logically, there is certain empirical evidence that brings the validity of the theory into question. In addition to the components of stock prices, the theory implies that it is impossible to beat the market using available information, since the price of stock has already incorporated all information in it. If it were impossible to beat the market consistently using all available information, then large investment firms and funds would not be able to beat the market consistently like they have for so long. This is one of the primary reasons why modern day investors reject the efficient market hypothesis, and why using it to find the rationale behind Netflix’s meteoric rise.

Theory of Value Investing

The alternate theory was formulated by famed investor Benjamin Graham. According to him, prospective investments should be chosen by assessing and analyzing the financials and fundamentals of the company, such as the earnings report, cash flow statement, balance sheet etc. These companies should be invested in if the stock price is undervalued so that returns can be made when the company starts to show its value and the stock price rises to correct itself.

Modern investors like Warren Buffett follow this method of investing, and if done correctly, it has, more often than not, yielded above average returns on investments.

Applying this to Netflix

The theory of value investing seems to be the body of knowledge that should most closely reveal the reason to Netflix’s recent stock price rise. However, as I see the fundamentals of the company (financial and market data that shed light on value), I see quite a few issues with the upward trend of its stock price being in line with the theories of value investing.

2017 was good year for Netflix, since it earned upwards of $550m in profit after tax. However, they earned this amount on a revenue of $11.69b, giving them a profit margin of approximately 5%. In vacuum these numbers seem arbitrary, but we can give them some context by comparing them with the earnings data of Time Warner, a competitor. In 2017, TWC had a net income of $5.2b with a revenue of $31.27b, giving them a profit margin of 16.6%. Even with these basic numbers, TWC has only grown 65% over the past 5 years compared to Netflix’s 1000%. There are more worrying signs for Netflix.

Netflix has an EPS (earnings per share; it represents the annual return on each share) of just $0.4 compared to TWC’s EPS of $2.66. For the financial nerds out there, this gives them a P/E ratio of 210 ( having a P/E in triple digits is a sure fire sign of overvaluation). Netflix also has a negative free cash flow, and does not give out dividends. On top of that, with the Disney-Fox deal, they are likely to face stiffer competition in the online entertainment space. All of this happened to Netflix in a good year. With this information in mind, it seems difficult to find any rational explanation to why Netflix’s stock would continue to go up the way that it has in the recent past.

A wave of hope

By this point, I think we can all agree that Netflix is heavily overvalued based on its current performance, even in light of its prolific performance in 2017. I talked to my finance professor about this, and even without closely looking at the financials of Netflix, he could say that the market valuation of the Netflix stock was ridiculous, and the price was not exclusively based on the current performance of the company. Aswath Damodaran, a professor at NYU Stern and one of the leading experts in company valuations, has also projected that Netflix is overvalued by over 40% (in 2016 when he conducted the analysis).

What makes Netflix such a gainer? Hope. Investors and analysts have high hopes for the entertainment company in the future. While it may not be doing as well as the price may suggest, Netflix’s price represents the expectations investors have in what the company is going to be in the future. And this expectation was built by its growing popularity and is being encouraged by its bold expansion moves.

Netflix posted significant growth in international subscribers in the past few years, and has worked tirelessly to add to its large list of TV and movie offerings. Most notably, it has invested a large chunks of its revenue in developing its own content. And I can say with certainty that a lot of this content is really, really good (House of Cards, The Crown, Orange is the New Black to name a few). With all these efforts, it has been able to stand its ground against its competitors like Hulu and Amazon Prime Video. TechCrunch estimates that by April 2017, Netflix had captured 75% of the online streaming market. While many users (including myself) have subscriptions to multiple services, Netflix is still seen ahead of the pack when compared to Hulu (17%) and Amazon Prime (33%).

All of this translates to the fact that Netflix is trying to be more than just online streaming service, and investors see that. The price rise of Netflix represents investors’ hopes that Netflix will soon be a heavyweight in the entertainment industry, along with Fox, Disney and Time Warner. Its current state is seen as temporary and a stepping stone to reach its true potential.

Will it last?

Analysts and experts have stated that Netflix will continue to rise this year. UBS and Macquarie have increased their target price estimations in the wake of its January performance. But how long will this rapid rise go on?

The truth is that there is no way to know. It is highly unlikely that the stock will continue going up at this rate in the long term. Many say that it is imminent to cool off and correct itself to a more realistic valuation. My personal opinion is that this rise will continue for a while more, simply because Netflix has momentum on its side. However, it seems unlikely to me that Netflix can sustain itself at this valuation for a long period of time. I feel like there will come a time where it will begin to fall. While there may not be a crash (like how the Dow Jones had to correct itself this past month), there are certain factors that I feel will lead to the cool off.

I think a large part of Netflix’s rise has been a self-fulfilling prophecy of speculation by analysts. They expect the stock price to rise and buy more, leading to an increased demand and hence an increased price; this thought process continues to repeat itself. I don’t want to explicitly call this a bubble, but it seems to me that it has similar characteristics. Additionally, there is no saying what may hit the entertainment industry next. Netflix has ridden the Me Too wave in Hollywood surprisingly well, partially by managing to distance itself from Kevin Spacey (a star on its hit show House of Cards). But it’s impossible to guess what may happen next that may affect the prospects of the company. I also think that there will be a point where the addition of new subscribers will begin to hit a slump, and so will the quality of its content.

By no means is any of this stock picking advice, since I am no expert on either stocks or the entertainment industry, even though I wish I was. It just seems fascinating to see how a company that started in 1997 as a DVD sales and rentals business has turned into our go-to late night or binge-watching resources. We will just have to wait and see where its stock goes in the future.

Works Cited

Staff, I. (2016, September 28). Efficient Market Hypothesis – EMH. Retrieved March 05, 2018, from https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

Reiff, N. (2017, May 04). The Greatest Investors: Benjamin Graham. Retrieved March 05, 2018, from https://www.investopedia.com/university/greatest/benjamingraham.asp

Kennon, J. Learn How Stock Prices Are Determined. Retrieved March 05, 2018, from https://www.thebalance.com/how-stock-prices-are-determined-358144

Time Warner Quarterly Earnings. Retrieved March 05, 2018, from http://ir.timewarner.com/phoenix.zhtml?c=70972&p=quarterlyearnings

Damodaran, A. Musings on Markets. Retrieved March 05, 2018, from http://aswathdamodaran.blogspot.com/2016/02/the-disruptive-duo-amazon-and-netflix.html

Franck, T. (2018, March 05). Already up 60% this year, a pair of analysts see Netflix rising even higher. Retrieved March 05, 2018, from https://www.cnbc.com/2018/03/05/already-up-60-percent-this-year-a-pair-of-analysts-see-netflix-rising-even-higher.html

Perez, S. (2017, April 10). Netflix reaches 75% of US streaming service viewers, but YouTube is catching up. Retrieved March 05, 2018, from https://techcrunch.com/2017/04/10/netflix-reaches-75-of-u-s-streaming-service-viewers-but-youtube-is-catching-up/

NFLX Income Statement. Retrieved March 05, 2018, from https://www.nasdaq.com/symbol/nflx/financials?query=income-statement

Image: https://chrislo.ca/category/news/

 

Prize Linked Savings Accounts–the Future of Banking

By: Arjun Goyal

Want to play the lottery with your Savings Account? It’s not as risky as it sounds

Let’s pose a question first. What would you rather have: a certain chance of winning $1, or a 1% chance of winning $100? The statisticians amongst you must have calculated that the expected payoff (average payoff) in both cases would be the same. Some of you may even have inferred that the decision depends on the risk profile of the individual (whether they are risk-loving or risk-averse). But people aren’t inclined to  calculate expected values, or risk profiles, when  assessing questions like this. I asked my roommate this question, and he immediately responded by choosing the latter. The rationale is simple: the second option gives you the opportunity to win an exponentially larger prize even if the chance to win it is low.

This is the same reasoning used by millions everyday, while buying lottery tickets. If they win, the stars have aligned, and their family wouldn’t have to work a day in their lives. If they don’t, they’ve lost a couple of bucks. The odds seem favorable, even if they realistically aren’t. Now, imagine if this psychology could be used to induce positive change, specifically in the personal finance sector. This is what prize-linked savings accounts aim to do.

What are PLSAs?

Savings accounts, in the status quo, yield no more than 0.05% on deposits. This number may be higher in other countries like India or Indonesia, but they are still extremely low. Prize-linked Savings Accounts (PLSAs) put a twist on this by using the effective interest rate in a different way. Rather than allocating interest to each account holder based on a percentage of their deposits, banks pool the interest that would be given out into prize bundles. Then, they enter each account holder into a raffle, with the number of tokens for each holder depending on their deposit in the savings account. A draw is made and the winners of the raffles are allocated to the prize bundle that have been formed with the pooled interest. To make this clearer, let’s give  an example. You have $10,000 in your PLSA, and your friend has $20,000 in theirs. Let’s say that the scheme both of you have enrolled in entitle you to 1 raffle ticket per $50 held in your respective accounts. This would enter 200 tickets in your name and 400 tickets in your friend’s name. Then, the standard procedure of a raffle is conducted, and the winners are awarded the pooled interest from all accounts in the scheme.

It seems quite counterintuitive to think that anyone would want to enroll themselves in this form of a program. Why would anyone forgo a sure interest gain to enter into a lottery where there is a minuscule chance of them winning a prize? The answer to this lies in the same reasoning that makes humans choose the second option in the first problem I posed above. It is deep rooted in the study of behaviour.

 Why does it work?

One of the first reasons people would enroll in programs like PLSAs or lotteries would be due to the availability effect. What this entails is that since there is the availability of a large prize and how certain lucky individuals have won it in the past, people have an unrealistic assumption that they are going to win it. They ignore the fact that when these lucky individuals won the prize, there were millions who did not win the prize.

This fallacy contributes to the near-miss effect. The near-miss effect occurs when an individual does not win the prize. With the notion of an unrealistic probability of winning, they think that even though they lost in this turn, there is a good chance that they will win the prize the next time they enroll. They ‘just missed’ winning the prize, and they will have better luck next time.

The most important part of behavioural psychology that PLSAs tap into is the notion of loss aversion. PLSAs present themselves as alternatives to lotteries, with one key feature: as Steven Dubner puts it, it’s a “no-lose lottery”. While a lottery loss means that one has lost their initial investment of buying the lottery tickets, a loss in the PLSA raffle does not lead to a loss of anything. All the money being deposited remains as is. To anyone this would seem like an extremely attractive offer. Why put money in a normal savings account and earn interest that is close to nothing, instead of putting your money in an account where you have a chance to perhaps buy a new TV?

How have they been implemented?

One of the first implementations of PLSAs was in South Africa. The primary objective of instituting was to increase the savings rate in the country. After publicizing this financial product, the savings rate skyrocketed, and after a while the number of PLSAs were much larger than the number of traditional savings accounts.

Other countries like Argentina, Brazil, Colombia, Iran, Japan, and Sri Lanka, have banks that provide these services. In fact, Iran it is the most widely used method of saving, since it complies with the Islamic Law stating that it is illegal to have guaranteed interest on an asset.

The US, however, have  only a handful of states that have legally permitted instituting these schemes. As of now, 20 states permit banks to run PLSAs, a growing number compared to how many have permitted them in the past.

 What problems have arisen?

As of now, PLSAs seem like a fairytale and the perfect banking option for anyone with cash to store. Unfortunately, the institution of this policy may not be as easy or as beneficial as it seems.

One of the fundamental issues with this policy is the effect it has on state-run lotteries. PLSAs, as called by Dubner, is a “no-lose lottery”. Why would anyone play the traditional lottery instead of enrolling in a PLSA? Sure, the payout of the lottery is much larger. However, the no-loss nature of PLSA, and much more realistic winning chances of it makes it much more attractive. It would draw a very large part of the lottery players away. This is precisely why state-lotteries have sued many banks, including the First National Bank in South Africa, and have often won. They have stated that it infringes on the law that allowsstate-sponsored bodies to run the lottery.

While they seem like the villains, they make a legitimate case for themselves. Lotteries are a large part of the revenue for the government, and drawing money away from said government revenue  towards the private banking sector would severely dry this income stream. This is precisely why the law to give exclusive lottery rights to state-sponsored bodies was put in place. Moreover, if banks would be allowed to run lottery schemes like this, it may provide a precedent that might help to legalize other forms of gambling run by other institutions.

PLSAs may also enforce an exorbitant focus on saving. While this is good in countries where much of the money is out of the system (and stored in physical cash), it may not necessarily be good for the economy since it may reduce spending. A large part of economic growth is driven by consumption and spending, and in developing countries PLSAs may slow this down.

Beating a new path

Still, PLSAs seem to be the way to usher those who have been out of the financial system, into it. They have become popular around the world, and legislation is changing even in the United States in order for these to run.

The real selling point on allowing PLSAs is the effect it has on its users. After a few months of PLSAs being run in South Africa and with its surging popularity, the state sued First National Bank and successfully shut the program down. However, those who had opened PLSAs, did not pull out their money and store it in cash like they did before. They simply changed to traditional savings accounts in the same bank. PLSAs were simply a hook to get them to store their money in their bank.

In addition to this, Professor Benjamin Iverson of  Northwestern Kellogg School of Management also believes that these schemes can help to beat the poverty trap. He states that the incremental interest earned on savings accounts fail to make a dent in their income, but large prizes like those from PLSAs can help them to get out of the trap.

Both of these reasons are incentives for PLSAs to run in developing countries, especially in those with abysmal savings rates. Rather than seeing PLSAs as the competition, perhaps governments can create state-sponsored PLSAs in their respective nationalized banks, which would give them the benefit of having more savings at their disposal, and perhaps increase liquidity in the financial system.

We should make the most of the no-lose nature of prize-linked savings accounts. While it may be playing games with money and minds, and have some setbacks in short run, the long-term benefits it can create would make  many, many people better off.

Works Cited