The Policy Triangle

Plus: Virtu, Adyen, PayPal

Happy Friday and welcome to another issue of Net Interest, my newsletter on financial sector themes. This week we’re talking about regulation. Bit dry, I know, but it’s important so I hope you’ll stay with me! As ever, I’m hugely appreciative when you share Net Interest with friends and invite them to sign up. And please don’t hesitate to get in touch with feedback. Thanks.

The Policy Triangle

“There are no solutions. There are only trade-offs.” — Thomas Sowell

When Bernie Sanders wore mittens to the presidential inauguration last month, rather than gloves, he made a trade-off: hand warmth over manual dexterity. It’s the kind of trade-off we all make, every day.

Policy is all about trade-offs, too. The pandemic response is a stark demonstration. For the past year, policymakers have had to trade public health against the economy. For sure, the relationship is not strictly binary, but in order to optimise overall welfare, policymakers need to make choices. This one is a difficult and highly visible trade-off because it straddles multiple domains; policymakers typically have an easier time managing trade-offs within their specific fields. Those who look after the economy, for example, have bags of experience thinking about how inflation trades off against growth.

When financial regulators think about trade-offs, the one they’ve traditionally wrestled with is the trade-off between financial stability and competition. It arises because banks are special: their resilience doesn’t just impact them and their shareholders; it impacts everybody. As financial crises through the ages have shown, if a bank goes down it can have a huge social cost. And if there’s a force that can chip away at resilience, it’s competition. It may start out innocently enough, but competition often leads towards excessive risk-taking. In an effort to remain competitive, banks can be seduced into relaxing credit standards. Their incentive to monitor loans and maintain long-term relationships with borrowers diminishes, credit gets oversupplied and soon enough you have a problem. 

These dangers are captured in the immortal words of Chuck Prince, CEO of Citigroup, who, on the eve of the global financial crisis in 2007, said“As long as the music is playing, you’ve got to get up and dance.” (And if you haven’t seen it, The Lehman Trilogy does such a good job of bringing that line to the stage.)

Which is why the trade-off is so important to regulators. Actually, for many years they didn’t give it much thought; they simply suppressed competition. That was the case through most of the period between the 1930s and the 1970s. Following the Depression, this wasn’t a trade-off regulators wanted to make.

However, in the 1980s, policymakers began to take a more liberal line. First deposit rate regulation was phased out; then geographical expansion restrictions were lifted; finally investment banks and commercial banks were allowed to combine. In between, many other elements of the financial industry were deregulated in the US and around the world.

At the same time, regulators took a harsher view of collusion among banks. In the mid 1990s, a cartel of the eight largest banks in Austria was found to be in breach of European law for pursuing a highly institutionalised price fixing scheme. They were fined (close to €125 million) and the market became a lot more competitive. 

These days, regulators recognise the benefits of competition. A monopoly may be more resilient, but regulators have been inured to the efficiency benefits that a more competitive market confers. 

However, make no mistake: in a head-to-head stand-off, regulators would back financial stability over competition every time. In fact, only a few financial regulators have a mandate to foster competition at all. And even when they do, as in the case of the UK, it is often subordinated to the primary mission of keeping banks safe and sound. The bank licensing regime that regulators preside over acts as a barrier to entry that can only be penetrated on the basis of higher-priority goals. 

There are plenty of examples of stability winning out over competition:

  • In the heat of the global financial crisis in 2008, two of the UK’s biggest banks, Lloyds-TSB and HBOS were flung together in a merger. With a combined market share of 33% in personal current accounts – two times the share of the next largest player – this was a big deal. The competition authorities found that the merger would result in a “substantial lessening of competition within a market or markets in the United Kingdom for goods or services.” Yet they were overruled: “the public interest of ensuring the stability of the UK financial system outweighed competition concerns.”

  • More recently, in March last year, policymakers were rightly focussed on getting as much aid out to businesses and households as quickly as possible in the wake of the pandemic. It’s easy to forget now, but at the time we were facing a full-on panic. In the US, Treasury Secretary Steve Mnuchin said, “Any FDIC bank, any credit union, any fintech lender will be authorized to make these loans to a small business subject to certain approvals.” For the fintech lenders, though, those approvals were slow to come and most of the first wave of loans was handled by incumbent banks.

  • More broadly, the focus on financial stability creates a regulatory burden which only larger incumbents can bear, to the detriment of competition. In the campaign against money laundering, the global compliance cost is estimated to be $180 billion. Overall compliance costs fall disproportionately heavier on smaller banks; a study by the Federal Reserve Bank of St. Louis found that relative to overall expenses, fixed compliance costs are three times higher for smaller banks than for larger banks. 

  • Last week, we talked about the DTCC, which has a monopoly position on stock clearing in the US. The grief it caused Robinhood put a spotlight on its business practices, and next week’s hearing at the US House Financial Services Committee will likely bring it up again. But no-one is arguing the DTCC should be broken up. Its role in maintaining financial stability is considered more important than the economics of the stock clearing business. 

All of this is just another way to reflect that regulation tends to privilege incumbents in general.

Disrupting the Trade-Off

Policymakers are increasingly confronting a new problem, though: the entry of technology companies into financial services throws their trade-off framework off-kilter. There are two issues. 

First, financial regulators don’t have jurisdiction over technology companies. They have jurisdiction over their financial activities but not over the companies themselves. At the entry level, this works fine. When a company wants to do payments, they need to get a payments license and when they want to do credit underwriting, they need a credit license.

Sometimes, new entrants skate round these rules. Afterpay in Australia is not regulated as a credit provider since it doesn’t impose a charge for the ability to pay; nor as a payment system since it conducts relationships bilaterally between consumers on the one hand and merchants on the other. In response to impending regulatory scrutiny, the company points out that the major card providers got away with it for 20 years. “The dominant international card payment systems...were launched in Australia in 1984 and were not subject to RBA [Reserve Bank of Australia] regulation until 2004.”

But as new entrants get larger, regulators clamp down. Australian policymakers are toying with ways they might regulate Afterpay. And in the UK, the Financial Conduct Authority recently released a review on unsecured credit, in which it proposed not only to regulate Buy Now Pay Later companies more carefully, but to draw retailers that offer it into their credit broking regime. Regulators can’t treat High Street stores as financial institutions, but to the extent they do credit broking, they need to be authorised accordingly. 

Yet as larger technology companies bolt more and more financial services on to their core offering, there’s a case to be made they should be treated holistically as financial institutions. China presents the extreme case. Ant Financial has a host of different financial licenses but, during its aborted IPO roadshow, it went out of its way to convince investors that it’s not a financial institution. It changed its name, asked to be covered by tech analysts and coined the novel term techfin. Last week regulators hit back, forcing Ant to become a financial holding company, subject to all the capital and prudential requirements that banks face. 

Financial regulators have their sights on other technology companies as well. Facebook’s Libra currency project launch in 2019 was greeted with anguish by policymakers throughout the world as a threat to their monetary sovereignty. Facebook took Libra back to the drawing board, changed its name to Diem and plans to relaunch with regulatory approval. It has made a number of revisions to the scheme, but critically it is seeking a license from the Swiss financial regulator, FINMA, where payments licenses come with strict conditions. The organisation will be required to hold capital and maintain capital buffers as if it were a bank.1

In the US, Google and Amazon have dipped their toes into financial services; they each have a payments license and have partnered with other financial institutions to do credit. For now, they’re too small in financial services to be subjected to oversight from financial regulators. Or are they?

Their cloud service providers host a lot of the financial industry’s data. HSBC, for example, put 100 petabytes of data on Google Cloud in 2018 and has since also signed a deal with Amazon’s AWS. In April 2019, bank regulators went in to inspect Amazon’s facility in Virginia but apparently weren’t treated very well. The subsequent breach of Capital One’s data – which exposed the personal information of over 100 million customers – fuelled a discussion over whether these cloud service providers should be designated “systemically important financial market utilities”. If so, they will be up there with the DTCC, under the watchful gaze of the financial regulator.

As the lines blur between financial institutions and technology companies, financial regulators worry that they may lose control. Marlene Amstad, newly appointed head of the Swiss financial regulator, FINMA, asked this week: “Today data is collected, shared and analyzed in a completely different way. There are opportunities and risks. Where does a software company end and where does it start to be a bank?”

The second issue messing up the traditional trade-off between stability and competition is the introduction of a whole new variable into the formula: data. 

Data is core to technology companies’ ambitions in financial services. In many cases, they harness it very well. Ant demonstrated that its credit underwriting was superior to industry standards. And research has backed up that both in China and in Latin America, data-driven credit can outperform traditional bank credit. (Of course I know that banks utilise data to make credit decisions as well, but technology companies boast of broader data sets.) New startups like Upstart and Affirm say that their credit models allow them to approve over 20% more loans than competitors.  

The arrival of ‘data’ on the scene creates two new trade-offs for regulators to negotiate. One is the trade-off between privacy on the one hand and efficiency/competition on the other. Giving providers of financial services access to more data allows them to better measure credit risk, but at what cost to privacy? This touches on an issue we explored in The End of Insurance, where companies like Root promise that “over time we hope that we can replace all correlation-related inputs to our pricing model, such as credit scores, with a fully behavioral pricing model.”

The other is the trade-off between privacy and financial stability. If that data is increasingly available – and legible – it can be harnessed by policymakers to map the overall system with the goal of improving system stability. Anti-money laundering regulations sit on the axis of this trade-off, too. They ask users of the financial system to give up an element of privacy in order to bolster the integrity of the system. Countries will calibrate this trade-off differently, with China no doubt sitting at one extreme (as we discussed in The Politics of Money). 

Just as they don’t have authority over technology companies, nor do financial regulators have a say in privacy or data protection matters. Which makes these new trade-offs more difficult for them to manage.

However, financial regulators are at least aligning with the banks they regulate, after years of tension post-financial crisis. For the past couple of years, bankers have been complaining about the playing field between them and technology companies not being level. Now, regulators are joining the fray. Agustín Carstens, General Manager of the Bank for International Settlements, recently said this:

“Big techs developed extremely rapidly; they entered into financial transactions as a side effect of the huge network they have. With regard to commercial banks they have an advantage and that is that the regulation on the use of information of individuals is different… Big techs are in many markets, they extract information from all those markets, they organise it and then they reflect it in the services they provide. The way information is used there is far more flexible than what we allow banks to do… I feel that in this case traditional banks are tied and fintechs are running around them and attacking them all the time because they are not subject to the same type of flexibility in the use of information.”

The financial landscape is growing ever more complex, its boundaries blurring. At his investor day this week, the CEO of PayPal, Dan Schulman, remarked that “today… we're seeing a collapsing of financial services, shopping tools, payments.” Financial regulators are cognisant of the risks, but can they keep up with the market?

Thanks to Hyun Song Shin for the notion of The Policy Triangle. The Bank for International Settlements’ recent paper on fintech regulation: how to achieve a level playing field is another useful resource. And Xavier Vives’ book, Competition and Stability in Banking explores the traditional trade-off in lots of detail.

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Sometimes the quarterly earnings reporting cadence is just too slow. Virtu, the market maker which wholesales much of the retail trading activity we’re seeing in markets currently, reported yesterday for the December quarter, but then this year happened. Last quarter wasn’t bad; they did $7.1 million of trading revenue per day, up 75% on the prior year. Apparently, “2021 is off to an impressive start.”

Virtu is the only one of the wholesale market makers which pays for order flow to be publicly traded. The largest, Citadel, will be up in front of the US House Financial Services Committee hearing next week at the GameStop trial. Virtu’s earnings call provides a preview. 

They stress that when they pay for order flow they are taking on risk:

“Trust me, things go wrong. And when they go wrong, they end up on Virtu and the other wholesalers’ balance sheet, right? We are providing a guaranteed execution to hundreds of market participants. And if we have an issue, an error, if we've mispriced something, if there's an outage of Wi-fi in New Jersey, God forbid, things along those lines, we still make good on those prices, right?

So we stand behind the service that we're offering to our users. And some days that’s painful. And when the market is unidirectional in a name and 80% of retail investors are buying or selling something, that is painful. But we’re still there. We're still there. We’re always in the marketplace, right? So people need to differentiate it. It’s not just – this is not the easiest business where we’re just kind of clipping coupons. I wish that were the case. That’s not the case.

And they stress the price improvement payment for order flow brings to investors. 

We estimate, as an industry in 2020, that Virtu, Citadel, Susquehanna, Two Sigma and the other firms, UBS, that provide this wholesaling service, provided $3.6 billion of price improvement. Nothing to do with “payment,” but literal price improvement off of the national best bid or best offer.”

Virtu’s CEO, Doug Cifu, explains the controversial practice of Payment for Order Flow well. His only slip-up was to criticise the most popular man in finance, Michael Lewis. Let’s hope Citadel doesn’t do that. 

“It’s no different than the firestorm of innuendo that was created in 2014 with the publication of the book, Flash Boys. But when people really took the time working with us and other great market participants to peel back the onion, it was kind of a big nothing. Really, there was nothing there. There was a lot of smoke. There was zero fire. A guy sold a lot of books and the marketplace didn't really change at all, right?


Adyen is everyone’s favourite European stock, probably because it’s like Stripe, which is everyone’s favourite private company, but it’s public. They reported earnings this week; the animated earnings review is well worth a look. 

Anonymous investor Brosef provides a bearishly variant take. He points out that payments isn’t a winner-takes-all market and it will therefore remain competitive. There’s no network effect in merchant acquiring and merchants prefer to have multiple processors for resilience. He also argues that banks which straddle both the issuance and merchant acquiring side of the market will be able to offer better authorisation rates. 

Adyen is clearly a beneficiary of the secular growth in electronic payments. But not every point in the value chain converges on winner-take-all economics, and it is worth thinking about what Adyen could be worth without them. 


Michael Mauboussin writes in the FT that higher volatility is as much of a contributing influence on valuations as lower interest rates for those companies that have real options in their business. 

PayPal’s super-app strategy represents a large bundle of options. It’s difficult to think of a bundle that could be bigger: an ambition to be the premier destination on users’ phones for everything – financial services, commerce, travel, food, lifestyle, everything.

PayPal’s CEO said at its investor day this week that “We all have like 30, 40, 50 apps on our phones, but we really only use 8 to 10 of them every day or every week. And nobody wants to remember 40 or 50 different passwords or 40 or 50 different navigation systems. Nobody wants to put in all their payment details across every single one of those apps.”

PayPal puts the TAM of its super-app strategy at a staggering $110 trillion. And while it only has a tiny market share of that currently, it is moving in the right direction. The company reckons it has increased the part of the addressable market it plays in by 6x over the last three years. And it is increasing the cadence at which it is rolling out new options within its bundle.


Diem will offer stablecoins pegged to fiat currencies like the USD and the EUR. Coin issuance will be fully backed by reserves, which will consist of cash or cash equivalents and very short term government securities denominated in that currency. The organisation will not undertake maturity transformation nor accept credit risk given the nature of its reserve holdings, but it will take on market/liquidity risk.