The Open Banking Revolution – Where Opportunity Lies, So Does Danger

            The world has moved at a furious pace. A few years ago, most people wouldn’t even want to log onto their own bank accounts online, let alone process payments over the Internet. Now the concept of walking into a bank branch to execute payment or writing and depositing cheques is almost an alien prospect. In fact, when you walk into a branch to process a payment over a certain amount, they most likely will get you to log onto your own online account and just ‘assist’ while you do it.

               Meanwhile most banks have their own ‘banking apps’ enabling you simple access to your account on your phone with entry just through the fingerprint identification on your iPhone. The degrees to which you can perform financial actions will depend on the bank, but at your fingertips on the train to work is the prospect to pay bills, view balances and set up direct debits and standing orders. In our increasingly hyperactive lives the ability to use a spare second to carry out actions which previously required taking time to walk to a physical bank branch is welcome relief. 

                 Additionally, smartphones for several years now have enabled us to make payments using our phones using fingerprint or facial recognition. No longer do we not need to carry much cash, if any, and we now may not even need to carry a wallet at all. Just a phone (and a charger!). Financial decisions and actions are becoming increasingly easy to carry out. You may be forgiven for wondering how much more innovation could improve things. 

But all the above was before ‘Open Banking’ came in. 

Further Details Around Open Banking can be found at https://www.openbanking.org.uk/

           Open Banking was regulation (which came into force in early 2018 in the UK and EU) that required banks to open up their platforms to 3rd party applications ‘safely’. As such it was no longer only each individual bank which was going to be able to provide you digital access to your account and its data. 3rd party ‘fintech’ developers could create applications which hook into each bank’s own API which, with the customer’s permission, would allow you to view details of your account in a separate tool to your Bank’s app, one potentially giving you far more flexibility than that of the bank’s application itself. 

                 The tools developed from it have enabled you to analyse your income and spending on a given account, helping you to bucket expenditure into different categories making it easier than ever to do that budgeting we all find painful to do. Gone were the large excel spreadsheets where you had to download all your account statements to, and attempting to figure out individual payments and the category it should go into. Now you could allocate a given payment to a particular category and your open Banking app will forever allocate similar payments into its given category, allowing you to slice and dice your income & expenditure into different graphs and tables to help you better understand why you’re not saving as much as you thought you should be. 

          But it’s more than that. Because the apps are independent from the financial institutions providing the banking services, they offer the opportunity to connect up to all bank accounts you may have. Suddenly whereas previously you had log into each of your individual accounts with the providers you banked with, now you could view all your accounts in one place - savings and current. Getting an overall view of your finances had never been easier. 

          Separately, whilst not specifically from open banking, other applications began offering services which allowed for an auto allocation of some of your income into a savings account, encouraging generations millennial and Y to save by doing it for them. Some of these worked by using what you spent on a cup of coffee, and putting the change into some form of savings account. That spare change that often got frittered away on nothing was suddenly being used to save for future, sometimes just 25p at a time. 

            As the apps develop and the major financial institutions become forced to provide access, the opportunities it opens up for consumers also increases. Suddenly there is the possibility of being easily able to switch money between accounts, or choose from which account you wish to make a payment from all of them in the one location. The ability to move money around your existing accounts could enable you to optimise the amount you receive on your savings by ensuring you have the majority of your money sitting in the highest earning account at any given time without the need to log into multiple apps or accounts to move it, something which puts off so many people from managing their cash savings effectively. 

             But it has the potential to be so much more than that, a one stop shop for all your financial needs. The opportunity is there for algorithms to be created for the account holder to automatically allocate their savings to the highest interest bearing account, or shift money off a credit card to the one with the best rate ensuring any cash balances for which you get charged interest would be minimised as soon as it appeared. What if not just your bank accounts were connected, but also all your investment platforms – pensions, ISAs, NS&I accounts, share holdings and other investment vehicles – were all not just accessible in the one place, but where you could, despite your provider, shift resources between them in one place. Robo-advisers could not only be programmed to allocate cash between the funds it feels are best placed, but also the money you wish to stay in cash, could be moved to an account with a better savings rate the moment it became available. With the inclusion of a standardised KYC (Know Your Client) across all banks under the same or linked regulatory bodies, there is no reason why automatic account setup couldn’t be done based on information already used to set up accounts in the past. The list of potential for customers is immense, many of whom suffer currently because of the hassles of moving savings accounts or not noticing when the rate they’re getting is much worse than when they signed up for it.

             With every new innovation comes the potential dangers associated with it. Fraud, and especially cyber fraud and theft are increasing year on year. As we move to a more digital society, criminals are looking for more ways in which they can take advantage, be it via identity theft and setting up accounts in your name to accumulate huge debts with, or through direct theft from your accounts by getting access to your account or convincing you to transfer money to an incorrect account than you intended. Push payment fraud alone last year in the UK resulted in £354m of people’s and businesses’ money being tricked into transferring to a wrong account. One such fraud involves criminals sending an email pretending to be your conveyancer at the time of house completion and inserting their account details for the solicitors. While this fraud falls into the more basic category of persuading you to transfer money to a fraudulent account, the bigger risk with the new apps will come through the ever more complex methods by which hackers seek to steal the details of your account to divert funds to themselves. 

            The regulations applied by the Financial Conduct Authority (FCA), and similar European authorities via PSD2, are supposed to mean that your details (security details, login etc.) remain on the bank’s database itself, and that apps have no access to your security details. But if hackers were to gain access to just an app itself which enabled the transferring, payment or setting up of new accounts then there could be a risk they wouldn’t need your individual account details. Many of us are extremely lax when it comes to protecting our own cyber identities, working on the assumption that the institutions providing us with the services have adequate security in place to protect us from all eventualities. Simultaneously we bemoan increased security features which make things increasingly difficult for us to access or do simple items in our own accounts, with attempts to make passwords increasingly more complex one such feature which tests our memories and patience to the limit. As the speed of innovation shows no signs of abating, and the pressure remains on financial institutions to accommodate their clients at the same speed, there is a risk that the servicing of these new Open Banking apps may come at a greater speed than their ability to protect clients from inventive new cyber fraud.

            Additional questions arise over the use of the data consumed by the 3^rd party applications. As with all digital products these days, many companies seek to use the data that flow through their applications for a variety of purposes. Big data is big business and the ability to have millions of financial transactions flowing through your application opens up additional doors for the fintech to build on the data itself for additional revenues. Be it for the use of targeted advertising of financial or commercial products to users, or of allowing marketing companies a deep dive into the data to better understand consumer or saver behaviour, having reams of financial data on tap is where the real benefit lies for the app providers.  Whilst anonymising the data is an obvious first step to help make users feel secure, one suspects more will need to be done to make people fully trust that their data won’t be misused. The Facebook/Cambridge Analytica scandal is still fresh in people’s minds  and any kind of similar scandal with financial data could delay the progression of such applications by years.

          A final consideration is the potential impact on financial institutions themselves. As they seek to keep pace with the 3^rd party applications on offer, it is possible, with their initial larger resources, they may seek to push their own applications to the forefront. Whilst this could promote better quality of apps, and also apps with much better security, it may also be less beneficial for consumers. An app promoted by one financial institution, whilst it could provide the same services in terms of access to all accounts from any other institution, it may also seek to promote its own accounts and investments above others, which may not be in the best interest of the consumer. Additionally there’s the potential impact on the ability of banks to offer good rates for the same amount of time they currently do. In the current climate, banks often offer new “attractive” savings rates to bring customers onto their books. Many of these offers stand only for a limited period until a certain number of customers have signed up, after which it no longer becomes viable to offer such an attractive interest rate to more clients. In some cases these offers may last for only several months or even weeks. In a situation where applications are using AI to determine the best account for savers and automatically moving thousands of client’s money from the previous better account to the new “star” account, these offers may only last a matter of minutes, never mind months. Separately an inadvertent bank run could be a possibility if some banks’ least attractive accounts are suddenly drained by robo investors switching the money from these accounts to those offering a better rate. If this were to take place in great enough numbers, the speed and size of the withdrawals could put smaller banks liquidity at risk.

          There’s many exciting potential benefits which are likely to occur from the shift to open banking. As with everything we’ve seen so far in the ongoing digital revolution, there is likely to be applications to this new era in accessing our own financial data the likes of which we won’t even have contemplated yet. The trick as always, will be to ensure that we balance that ever growing wish for greater financial flexibility with the increasing need for thorough and safe financial cyber security.

I'd be interested to hear your thoughts on the opportunities and risks of Open Banking:

• Any thoughts on what sort of features would like to have in an app that would better help to manage your finances?
• Would you be open to a robo-investor moving your money around and opening new accounts based on preferences you may have selected?
• What concerns you most about the access to information that 3rd party apps may have and the risk to you?

Short Sellers and the Downfall of Woodford

“Greed is Good”, the famous utterance of the fictional Corporate Raider Gordon Gekko in the 1987 film Wall Street. 

“Past Performance is not an indicator of future returns” - the warning message on almost every advert for an investment fund, or “Caveat Emptor” as the Romans would have told us. 

The warnings we’re always told should stoke appropriate research and caution but the want for a “better than average return” so often drives our greed to take advantage before we’re too late to the party. 

And so to Neil Woodford and Woodford Investments and the suspension of withdrawals from his OEIC (Open Ended Investment Company) the Woodford Equity Income Fund and its impact on his listed fund vehicle, the Woodford Patient Capital Trust. A star fund manager known for stellar returns for decades attempting to stop the rot from poor performing investments and the knock on effect of withdrawals forcing him to sell down on his more liquid holdings. I’ve been fascinated with this story, since it came to light a couple of months ago that his fund had begun to get into trouble and that the allocation of non-liquid small cap and unlisted assets was starting to rival his more liquid holdings. 

There’s so many takeaways to be had from this ongoing story:

• Woodford, once viewed as Britain’s answer to Warren Buffett, showing fallibility the Sage of Omaha has never come close to, as his fund is forced to suspend redemptions for fear of being unable to honour those redemptions without closing the fund down completely. 


• How the speed and size at which investors were looking to redeem their money from the fund forced him the sell down his larger cap, more liquid holdings reallocating his portfolio to be made of more illiquid or entirely illiquid stocks effectively changing his overall strategy and making it harder to keep up with the increasing number of redemptions, including Kent County Council’s final blow of wishing to pull its entire £263m which led to the suspension. 


• How Woodford took sizeable holdings in relatively early stage companies (which couldn’t easily be disposed of) in the estimation that some of these would come good when their ‘unique’ product came to market and he could take advantage by making money from of a main market listing. Did his investors really know what his fund’s aim was about? Do most retail investors ever really pay close attention to what a ‘star name’s’ fund is doing or do they just assume it will make them money?


• Or how he avoided breaking the requirement to only hold a certain number of unlisted stocks by listing some of his private holdings on the almost completely illiquid Guernsey stock exchange and entering into an asset swap with his Patient Capital Fund to buy himself some time. This asset swap which gave the Equity Income Fund shares in the Patient Fund in return for some of those illiquid holdings, indelibly linking the fates of the 2 funds even closer together, as when Woodford would be forced to sell down on his Income Fund assets for the redemptions to investors, the Patient Fund itself would now be 1 of those assets, driving its price even further down. 

However the story I want to follow is the ensuing battle now taking place with those seeking to bring him down further and the knock on impact on the companies he sought to invest in.  

A few days after the suspension of the fund came the news that hedge funds were targeting his investments (#link to Times article) by short selling all his holdings based on the list of stocks the Woodford Funds held, which was published on its own website. In the knowledge that Woodford would be forced to sell these stocks to get back on track, hedge funds sought to drive the value of those assets even lower by selling them ‘short’, meaning that when Woodford tries to sell his significantly sized holdings, especially the more illiquid stocks, he would only be able to do so at an even more depressed price, putting his funds (and investors) in an even more perilous place, effectively pushing him closer to the shutdown he is trying to stave off. But of course this short selling also had an adverse impact on the stocks he held, many of which did little more wrong than to be a holding of a fund forced into a fire sale. Woodford in response has now changed his website to only disclose the top 10 shares in each fund, to prevent any such attack from escalating. 

So how is this possible?

Going short on a stock, effectively means for an investor (bank, hedge fund or individual) to sell a share which they don’t own.

How can you sell something you don’t own? You borrow it.

Confused?

Imagine an investor might believe a particular stock is significantly overvalued. If he doesn’t own it, in theory he can’t sell it to realise a profit. But the market does let him sell shares into the market at the current value so long as he delivers the shares on time. He is obligated to deliver those shares to the buyer in 2 days time (the date of settlement), or risk defaulting on those obligations and be sued/fined. In order to ‘cover the short’ he can borrow the shares from someone that owns them and use these to settle on the shares he shorted.

In return for borrowing the shares, the investor pays the owner of the shares a fee for every day the borrow is in place. Eventually when the investor feels that the share price has fallen enough (or he needs to close out his position) he will buy back the shares in the market and return them to whoever he borrowed them from. If the price has fallen over that time, then then he makes a profit based on the difference between the price he shorted the shares at and the cost of buying them back, less the cost of borrowing the shares. If the lender of the shares wishes to get his shares back at any point then the borrower of the shares will either have to buy the shares back in the market to return them, or find someone else to borrow them from. 

So why would anyone be willing to lend their shares for this purpose? There might be several reasons. For example if you’re a long term shareholder, you might just be sitting on the shares and getting a capital appreciation/depreciation as the share price rises and falls, in addition to any dividends. By lending some of the shares out over a period of time, you still remain the ultimate owner of the shares but benefit from additional funding in the charge you make from lending them. This can act as an additional form of revenue from the shares, although you would want the shares back for the purpose of voting rights or dividends should they be required.  Another reason might be a bank which for the purpose of risk management sits long on shares of a given company across its trading books. Similar to how a bank would use cash deposits it receives in to lend out, a bank would want to lend out any stock holdings it’s sitting on to squeeze any additional income it possibly can from the holdings. 

The practice of short selling itself dates back almost as long as the earliest stock markets, with records showing an early 17th century investor attempting to assert pressure on the Dutch East India company by shorting its shares and demanding a greater share of its profits. Many Hedge Funds have long made a success from trying to short stocks which they see as having a poor business model and being overvalued. They look to profit from what they believe to be the imminent fall in the price, once the market realises a correction is due, all the while hoping that any initial uptick is short lived. But some hedge funds have attempted to take large short positions in companies to force their share price down whilst simultaneously speaking out about what they perceive to be bad practices or signs of future downturn or demise, which if other market participants take heed, could itself lead to a downturn in the price creating profit for the hedge fund. A potential self-fulfilling prophesy which, unless the rumours are something the shorted company can clearly disprove, can easily gather a downward momentum forcing that company itself into difficulties if it causes investors, creditors or customers to withdraw their support.   

There’s many famous examples of hedge funds exerting such pressure, none more so than during the 2008 financial crisis. There first Bear Sterns and then Lehman Brothers saw hedge funds take up short positions in the banks as the mounting evidence pointed to poor trading decisions and the ever growing bad assets on the banks books. Short investors such as Steve Eisman of Frontpoint and David Einhorn of Greenlight Capital were vocal in taking a dim view of Bear and Lehman respectively and how these banks and the banking industry as a whole was in dire straits. (Here’s Einhorn speaking for real about Lehman in June 2008on CNBC laying out the issues with Lehman, or of course more entertainingly you can watch Steve Carrell portraying Mark Baum, the Big Short’s fictional version of Eisman, in destroying the banking sector as a whole as set during the crisis while Bear Stern’s stock plummets tothe floor).

In both these cases the outspoken views proved correct as both banks ultimately collapsed to zero, but there certainly a case that the shorting of the stocks by investors such as these assisted in pushing the negative direction of the share price at a much quicker pace than it otherwise may have done. (Ironically, Steve Eisman now works for Neuberger Bermann, the Asset Manager once a part of Lehman Brothers before it was spun off in a management buyout post-bankruptcy.)

          Short sellers don’t always get it right or have it their own way. As with any speculative investment a short seller can get caught out when their negative view is found out to be false and the stock rises, or even if short term large rises in the stock mean they can’t afford to suffer the paper losses in holding out too long for their investment hypothesis to come to fruition. One case back in October 2008 actually saw Volkswagen temporarily become themost valuable company in the world. As short sellers took a negative view on Volkswagen, Porsche, who already owned 31% of the company, took out option positions which effectively gave them 75% of the company. That coupled with Lower Saxony holding a 20% stake of its own meant there was only 5% of free float shares tradeable in the market. With 12.8% of Volkswagen shares being lent out for short selling, the hedge funds and other investors who had shorted the shares were forced into a desperate scramble for the remaining shares on the market to close out their positions. This sudden demand for the VW shares pushed them sky high, rising 82% at one point, and led to the short investors being caught out and losing substantial losses on their positions.

Given the speculative nature in the ability to short shares and the potential downward pressure it can be used to put on even sound companies, why is it still allowed? There are several reasons, one of which is that the ability to short a company provides additional liquidity in a market where it may otherwise be restricted if you could only buy or sells shares that you owned. Similarly, the multi-trillion dollar equity derivatives market relies on the ability to short sell stocks, without which many derivative providers would be unwilling or legally prevented from making a market. There have been times when the ability to short sell has been restricted, such as the limited ban on short selling banking stocks immediately after the Lehman Brothers collapse in 2008, in an effort to prevent a complete run on the global baking system. But any efforts to put a permanent ban on short selling would likely be more detrimental than beneficial.

Which brings us back to Woodford, and his fight against the shorts. Investment decisions in the market has long gone past just buying companies based on the fundamentals, and plenty of investors, such as some hedge funds, will use what opportunity there is to prey on those on the way down. Some of the shorts involving Woodfords Equity Income Fund holdings were placed against his listed Fund, the Patient Capital Trust, further depressing its value. Given the Equity Income Fund’s increased holding in the Patient Capital Trust following the asset swap, it perhaps seems inevitable that in any sell down, the Trust will be forced to be sold to raise money for reallocation into more liquid holdings or further redemptions on reopening, thus attracting short investors. But the Patient Capital Trust and the Equity Income Fund also share some of the same smaller cap investments, opening them both up to investments short sellers deem most at risk from Woodford’s reallocation or redemption requirements.

Will the shorts increase as it becomes more inevitable that Woodford will have to sell certain assets, thus further reducing the proceeds he can make available for any reallocation? The fact that he is now only publishing the top 10 holdings in the portfolio where previously all holdings were available suggests that Woodford feels this also. Hedge Funds spotting an attempt to force Woodford into an embarrassing fund closure by seeking to further depress the value of the stocks he holds before he can sell them. What better scalp to have than to state a part in bringing down “Britain’s answer to Buffett”. But perhaps Woodford’s ongoing difficulties and underperformance over the last few years has instead rather increased focus and questions on some of the underlying companies. FTAlphaville is not alone in shining a light and raising questions on some of Woodfords small company investments with its takedown of BenevolentAI and its questionable current valuation. It’s probably fair to say that a fair number of the small cap companies sitting in Woodford’s Portfolios are just as much one announcement away from a valuation collapse as they are from getting to unicorn status. It’s no wonder short selling investors may have noticed the same.

Time will tell whether Woodford’s can repeat his past record, which got him his name as one of Britain’s best stock pickers, and once again come good with the majority of his picks. But time may not be on his side, as investors push for the end to suspension so they can at least reclaim some of their money and vultures sit at the gates waiting to prove him wrong.