In this era, cash is no longer king. Even in a recession, there is no guarantee that cash will ever reign supreme again due to the efficiency and influence of alternative payment mechanisms. Visa is not only the world leader in digital payments, but also the current gold standard of payment processing. With its processing networks providing secure payments around the world for over 200 countries, 44 million merchants and 17 thousand banks and financial institutions, Visa is positioned to grow along with ecommerce.

Within its industry, Visa maintains a secure hold on the market, with a 50.6 percent share, which is more than double its next closest rival, American Express, with 22.9 percent. Visa also has 328 million credit cards in circulation within the United States as of 2016, which is more than MasterCard, with 192 million, American Express, with 57.6 million and Discover, with 58 million, combined. There is a lack of potential usurpers in the market due to the high barriers to entry as a result of costs like infrastructure, getting the proper software and building an extensive merchant network that requires a large amount of capital.

Visa has also done a great job of maintaining its market lead by actively working alongside peers who utilize the Visa network. In July of 2016, Visa and PayPal announced a partnership that allows Visa debit customers to move money instantly through PayPal accounts while PayPal received incentives for the increased Visa card spending volumes. Visa also collaborates alongside IBM’s Watson through their Internet of Things (IoT) platform to reach thousands of IoT client companies. New options such as Apple Pay and Google Pay work on top of existing Visa networks and therefore, are simply not competition.

Unlike competitors such as American Express and Discover Financial Services, Visa is purely a payment facilitator and not a lender. While this difference may seem insignificant, it means that Visa is not exposed to the rising delinquency rates from “double dipping,” or collecting interest. on loaned interest, if the US or global economy falters. Because it is the transaction middleman, Visa can withstand recessions better than its peers due to the lack of lending risks. As a payment processor, Visa’s business appears to be far more stable.

Visa can be expected to continue to grow and Visa’s CFO claims that many governments are very interested in taking cash out of their economy. There is no doubt that a cashless future will provide speed, certainty, security, reliability and cost savings through the use of the Visa network rather than check or wire transfer. It is primed to be the leading credit card network for years to come.

Currently, Visa is in a perfect position. With regulations banning Visa in China recently lifted, Visa seems poised to target every corner of the world. While Visa relies on developed nations for the bulk of its revenue and profit, it operates in more than 200 countries worldwide. This diversification is beneficial in that Visa can somewhat circumvent the negative effects of a recession in the United States or any major developed country by leaning on the purchasing-dollar growth in emerging-market countries, which could be unaffected by a global slowdown.

In addition, Visa is a multi-platform company. While plastic cards are what Visa best known for, its services can also be seen on tablets, laptops and phones. Visa invested heavily in next-generation technology to appeal to a younger generation and this investment already seems to be paying off. Visa also continues to expand, as seen in its relatively recent buyout of Visa Europe. By expanding into Europe, Visa increased merchant reach by 40 billion, boosting its cards in worldwide circulation to around 3 billion and bringing its global payments volume to about $6.8 trillion annually. In addition, Visa’s recently released analysis of foreign travelers’ spending during the group stage of the 2018 FIFA World Cup found that roughly one in every five of the purchases with Visa used contactless payment technology, boding well for the future of Visa’s investment in the area. In the stadium themselves, the share of contactless payments was 54 percent.

Digital research firm eMarketer estimates that mobile payment apps that do not use a traditional financial institution — dubbed peer-to-peer payments systems — will process $120 billion in transactions this year, up 55 percent from the prior year. That figure is forecast to double by 2021. According to the Nilson Report, merchants paid card issuers $43.4 billion in Visa credit card interchange fees in 2017, up from $25.9 billion in 2012. This increase is largely due to the ongoing shift in consumers using cards to make more of their purchases and the introduction of more high-cost cards with generous reward programs.

This current economic environment has been beneficial to Visa as the relatively low interest rate has kept the federal funds target rate low and below its historic average, encouraging consumers to use their credit cards. As long as the Federal Reserve continues to keep interest rates relatively low, Visa will benefit. There are also other events that will provide a tailwind for Visa. The U.S. Supreme Court decision in favor of big card companies will help Visa continue to charge high fees and hinder upstart payment companies who might pose a threat to Visa.

Like every other company, Visa also has problems. While Visa seemingly has an impenetrable moat, blockchain disruptions loom. As of now, it’s hard to judge the exact nature of a potential threat to Visa from Bitcoin and other digital currencies, but given the astronomical rise in Bitcoin, Ethereum and other cryptocurrencies over the past year, Visa stock owners would be wise to take this into account. Blockchain-based payment systems offer several advantages over credit cards such as better security from hacks and lower marginal transaction costs. While it currently is not a threat due to the lack of credible oversight, regulation and slow transaction processing, blockchain technology could prove to be the future in a cashless world.

Despite potential road bumps in the future, Visa seems prepared to fully take advantage of a cashless future.

Microcredit, a concept spearheaded by Nobel Peace Prize winner Mohamed Yunus, received widespread admiration as a substitute for government poverty alleviation solutions. Based around the idea of social collateral, where borrowers are grouped together to assume joint responsibility for the repayment of a single loan, Microcredit boasted very high repayment rates and promising results. At first glance, these figures may seem impressive. The statistics however, are a distortion of reality; the reality is a context where microfinance has made underwhelming progress in reaching the goals it set out to achieve.

 

Microcredit is the solution to the unavailability of credit to the poor in developing countries. The poor often have low creditworthiness, stemming from little wealth and assets to serve as collateral, which makes banks perceive them as high-risk borrowers. Credit’s inaccessibility to the poor is then worsened by the already existing gap in credit in developing countries due to poor infrastructure, low investor and business confidence and poor regulation to support such credit markets. This is because the poor have no substitute for banks as the credit market does not allow for the growth of such substitutes. Consequently, these two phenomena have translated into a shortage of credit, with the few issuers of credit being very selective with those to whom they lend their money. The absence of credit constrains investment that will yield additional income and accumulate wealth, breaking the cycle of poverty. The innovation of Microfinance is the alternative to conventional money lending institutions: it does not require collateral, it provides small amounts of money and it initially sets low interest rates. It is a lending system catering to the poor.

 

Creativity, to the capitalist mind, is synonymous with opportunity. Over time, commercial banking concepts have seeped into the microfinance system, distorting its mission. Mohamed Yunus, the pioneer of Microfinance himself, was appalled at the “mega profits” that some microcredit banks enjoy. When a bank is righteous enough to give money to the poor, financial sustainability becomes hard to achieve with a heavy outflow of funds that cannot be offset by relatively smaller inflow of funds. Soon, the banks have to turn to private investors to ensure that the fund pool is adequate. Over time, as the prominence of private investors grows, the motive to fix poverty is overpowered by the desire to maximize profits to keep investors satisfied.

 

This explains the monstrous rate of interest Banco Compartamos, a non-profit organization turned for profit bank, set between 75 percent to 100 percent, as a higher interest rate means larger profits for banks. Ironically, banks are now focused on ensuring that borrowers can make payments on time, gradually shifting their focus to the richer of the poor: a form of segregation based on the ability to repay. The overall effect is that the microfinance is now selective, as the elements of inclusion have now dissolved from its model.

 

Common belief dictates that microfinance facilitates the development of small-scale enterprises. A Department for International Development (DFID) funded review showed that money given to the poor is used primarily for consumption. It claimed that “the microfinance craze has been built on ‘foundations of sand’ because ‘no clear’ evidence yet exists that microfinance programs have positive impacts.” Atkinson and Messy show that education is an important determinant of financial literacy in all countries under the Financial Capability Survey funded by the World Bank Russia Trust Fund. Since a majority of the people receiving these loans are poorly educated, their financial literacy levels correlate to their poor level of education. As a result, they cannot be expected to divert their money into investment. Consequently, from the poor’s perspective, consumption becomes the only form of expenditure; it is often the case that they spend most of their income on consumption, so it seems sensible for them to spend this extra money on consumption as well.

 

The constraint to development arises when the people are still expected to make repayments for the loans that they have borrowed, which they do by recycling their loans. Bearing in mind that they have not generated an income making source through investment, they must now cover the expenses of the interest repayment, which can be appallingly high in some cases. The interest repayment then becomes an additional cost, so the people end up worse off than before. This rise in institutional debt burdens not only adds to the existing anxiety of the poor, but it also translates into an increased direct financial cost to the poor.

 

However, for the sake of debate, let us assume that the typical microcredit proponents assumption is correct: microcredit does promote the development of enterprise. In this paradigm, enterprises originating in developed countries focus on operating in the primary sector. As the Prebisch-Singer Hypothesis dictates, primary products have little value addition in comparison to secondary and tertiary sector products, so the potential earnings that these primary sector business owners can make in relation to business owners from higher sectors would be lower, yielding relatively little additional income. One may wonder if these business owners can develop niche market catering enterprises. Realistically, this is not true because product development in niches requires research and innovation. Even if these business owners want to serve market niches, their incomes do not support the upfront costs of research and innovation. With enterprise development constrained, microfinance proves yet again that it fails to make substantial improvements to the quality of life of the poor.

 

Proponents are also quick to point out that microfinance empowers women, since its approach is focused on women who are believed to make better expenditure decisions than men. Out of a sample of 120, a study by Aminur Rahman from the University of Manitoba, showed that 70% of the funds that women receive are used by men in a village in Tingail region, Bangladesh. The problem is the conservative impression of a typical family unit prevalent in developing countries, where decision making revolves around the male figure assuming the lead role in the family. As a result, women become facilitators of the transfer of funds from the bank to the lead male figure in the family. From this point, the same cycle of inefficient fund allocation occurs.

 

Research also points out an increase in pressures applied on women who obtain these loans. Vanu, a woman from the site in which the study was carried out, narrates a story of a woman who hung herself after defaulting on a microfinance loan. This is because of a cultural bias that associates a negative reputation with a woman who defaults on a loan balance, which does not exist with men. Rahman also puts forward the notion that microfinance initiatives focus on women because of their positional vulnerability. Interviews with local workers employed in a microfinance institution under the scope of the study testifies that women are considered passive and submissive, which translates into better compliance with the institution. Here we see that microfinance institutions divert from their public transcript, or the promise made in its mission statement to empower women, to view women as an item of exploitation. This glaring defiance of microfinance to achieve its objectives is once again a testament to how microfinance falls short of the objectives it tries to achieve.

 

Microcredit, in theory, sounds like the ideal solution to poverty. Practically, however, it fails at eliminating poverty and improving the quality of life of the poor. Despite claiming to promote enterprise development and gender equality, microfinance has contributed little to promoting enterprises that add value and generate large income streams that create wealth, and to empower women, who still serve as pawns to dominant male figures because of cultural issues that microfinance cannot solve. With corporate influence in the microfinance system, objectives of microfinance institutions are now focused on profit, compromising on the reach of microfinance to the poor.

 

Policymakers will now have to look at other substitutes for poverty alleviation. Experts point to cash handouts, implemented in African countries that have brought significant improvements in quality of life, as a substitute for microfinance. Practical implementation could entail the government’s issuance of “handout cards” to the poor, with designated amounts of money for each essential item of expenditure, such as food, healthcare and education. These balances can only be utilized at government-approved centers such as hospitals and public schools, for example. In a real world scenario, this would mean that when an individual spends money at a government approved hospital, the individual produces this card and the cost of healthcare would be deducted from the funds allocated for healthcare. Such an approach would restructure how a household conducts its expenditure, while ensuring that handouts by the government are not diverted into other areas, ultimately enhancing the quality of life of the poor. However, the ability of developing countries to invest in technology is a question to which the answers are uncertain.

 

With so many unanswered questions, the undeniable truth is that research on microfinance and any possible substitute has barely scratched the surface; the potential areas for discussion are plenty, and the unchartered waters of exploration are many.

 

In 2004, a technology startup looking to raise capital through an Initial Public Offering (IPO) decided to forgo the traditional route, instead using a novel method colloquially known as the “Dutch auction”. Here, investors bid for the stock to dictate the price of the initial offering. The company priced at $85 per share, well shy of the $135 share price the tech giant desired—raising a mere $1.67 billion with a $23 billion valuation.

Today, that company—Google—is worth well over $700 billion.

Startup founders look toward the widely-regarded failure of Google’s unconventional IPO route as affirmation to not challenge the system. A “conventional” IPO takes place when companies wish to raise money from the market. A “lock up”’ period of 90 to 180 days prevents principle shareholders from selling stock into the market initially. Underwriters from investment banks set the price and support it in case the stock begins to crash. This traditional method reduces volatility in the price and allows for a company to raise capital for future investments and expansion.

However, Spotify, which went public in April 2018, made waves as the largest company to ever pursue a Direct Public Offering (DPO). A more decentralized process, this kind of listing allows existing investors or employees to directly sell shares to the public. The company being listed also does not issue any new shares. The most widely reported difference between the DPO and IPO was the elimination of the middle man, the underwriter. Headlines across the country surmised the doom of the investment banks as more technology companies would pursue direct listing to save on underwriting fees. In reality, Spotify’s choice to pursue a DPO was nuanced and done with advice from some of the world’s best financial advisors.

The ensuing concerns about what this would mean for the investment banking industry is understandable–IPOs are incredibly important to the entire industry. Equity underwriting is one of the most lucrative fields on Wall Street. This is especially apparent during the underwriting of an IPO, when banks receive roughly seven percent of capital raised. In 2017, the United States’ five largest investment banks made over $20 billion in equity underwriting. Large companies vying for the largest pool of expertise and research often employ five to seven different underwriters. For this reason, the elimination of IPO underwriting could easily have drastic effects on the industry as a whole.

Had Spotify pursued a traditional IPO, each of their Wall Street underwriters would have earned tens of millions of dollars in fees. In reality, the banks were not entirely removed from the equation. In the company prospectus, Spotify disclosed that advisory fees of $35 million would be shared between Allen & Co, Goldman Sachs, and Morgan Stanley. This price did not include the underwriting fees that total 13 to 15 percent of bank revenue.

Many concerns over Spotify’s use of direct listing came from beliefs that the technology sector would follow suit. Over the next two years, a new wave of some of the decade’s most notable startups will go public, raising billions of dollars for their businesses. According to Dealogic, 2018 tech public offerings have already raised more than all of 2016 and 2017, combined.

Investor consensus is on pace to make a sharp turn in 2018 with both Spotify and Dropbox holding their prices after going public, while Snap and Blue Apron’s 2017 IPOs saw price collapses. This bullish attitude towards the market is urging big names to go public. Uber’s CEO has made clear plans to go public in 2019. Lyft began posturing for a public offering after speaking with investment banks. In what is likely preparation for a future IPO, Airbnb executives began adding independent directors to their board.

Technology IPOs are critical for the innovation landscape. Money raised upon floating shares to the public can be returned to employees who start new companies. Some capital is returned to venture capitalists, who use it to invest in the companies formed by ex-employees. Public offerings in the technology sector are so critical for this very reason.

Given the critical nature of tech IPOs, companies within the sector spend a significant amount of time preparing for their listings. Spotify’s choice to pursue a direct listing was a calculated move tailored to the company’s strengths. Most companies listing shares publicly do so in an effort to raise interest-free capital for future investments and acquisitions. Spotify, on the other hand, did not issue shares and raise new funds in an effort to keep existing stakes at their value. The company, instead, allowed existing shares to be traded. This situation is impossible under an IPO, where companies float new shares on the market. Raising capital is the principal reason for the vast majority of companies going public, a barrier to the direct listing process.

While Spotify’s DPO circumvented underwriters and reduced cost, it also removed many of the tasks that are key for soon-to-be-public companies. During an IPO, bankers and executives travel around the country visiting institutional investors and advertising the company they represent. Underwriters also speak with their firms’ largest trading partners, agreeing to buy and sell the shares at a price that earns these partners profits. These services don’t occur for a DPO. Spotify was able to eliminate this process due to publicity. Spotify is unique in its incredible brand recognition across the world. The company had no need to gather the support and guarantee of institutional investors to pick up the stock price due to its prominence throughout households. Other companies potentially going public in 2019—including Slack and WeWork—simply lack the appeal and prominence of Spotify, giving value to the underwriters in their public listings. Spotify’s ability to eliminate underwriters was unique given its incredible brand recognition.

Spotify’s unconventional motivation was another factor that distinguishes it from other technology companies. As previously mentioned, the company did not intend to raise capital from this round. Instead, Spotify wished to increase liquidity and reduce volatility for its investors.  As a result, the DPO investors and employees alike had the opportunity to immediately sell their shares. On the first day of trading, there were few sellers and buyers. Over time, groups became more comfortable with the listing, and the initial volatility of the stock price fell dramatically as more investors and employees sold. In the scope of a traditional IPO, this would appear to be a failure: large blocks of shares were not moved to institutional investors, and the price was volatile in early hours of trading. Yet, in Spotify’s scope, this IPO was ideal. The company’s share price increased from $48.93 to $132.50 privately to between $136.51 and $169 publicly. In just two days of public trading, over 600 percent more Spotify shares traded hands than after ten weeks of private trading.  Spotify increased investor and employee liquidity through this move, which was in line with the company’s motivation for the public offering.

Since the birth of the IPO, companies have been characterized as successful based on whether they ticked a series of checkboxes—none of which Spotify touted during its public listing. Within the technology and banking sectors, IPOs play a critical role. The introduction and success of Spotify’s DPO resulted in some reactions that the tech industry would shift to this new model, cutting out the underwriters. The reality is that the number of private companies with name recognition, no need to raise money, and a desire to give investors liquidity can be counted on one hand. Spotify’s path to public trading was a unique event tailor-made for its situation. Those worried about the downfall of Wall Street equity underwriting should not fear–Dropbox’s pursuit of a traditional IPO in March of 2018 resulted in shares trading up 40 percent. Evidence of a resurgence of tech public offerings is abound, and–thankfully for the banking industry–the DPO is no substitute for an IPO.

Automated Investment Advice        

New start-ups in the wealth management industry, such as Betterment, FutureAdvisor and Wealthfront, are changing the way that investing is being done. Rather than a do-it-yourself approach, or meeting with an investment advisor for face-to-face financial planning, automated investing platforms offer investors a low-cost way to invest capital, design a portfolio and rebalance the asset mix using software that is accessible from any device connected to the internet.

According to MyPrivateBanking Research, the automated investing market will experience significant growth from the current $14 billion in assets under management to $255 billion by 2019. Further, automated investment services are expanding globally. For example, Australian start-up, Stockspot, is getting first-mover advantage in the space, offering automated portfolios of Australian Securities Exchange exchange traded funds (ETFs).

How Automated Investment Platforms Work

Automated investment platforms use software to determine an investor’s level of risk tolerance and investment goals, and then uses algorithms to select and manage a personalized portfolio for the investor based on their individual needs. After an account is established, the automated software platform automatically rebalances the portfolio as needed.

Automated investment platforms use a step-by-step process in working with investors. For example, the system used by start-up FutureAdvisor helps investors determine which existing investments should be sold, what new investments should be purchased and why. The tool also allows investors to reject some of the recommendations, in which case FutureAdvisor will reevaluate the remaining investment recommendations.

There are three main advantages of using an automated investment platform. The first is that it automates the process of tax efficiency. For example, Betterment uses ETFs and municipal bonds, tax efficient buying and selling and tax smart dividend reinvesting as ways to embed tax efficiency into a portfolio. The more sophisticated automated platforms continuously harvest tax losses, that is, the selling of a security that has experienced a loss. By realizing, or “harvesting” a loss, investors are able to offset taxes on both gains and income. With automated software platforms, the sold security is automatically replaced by a similar one, maintaining the optimal asset allocation and expected returns.

The second advantage of automated investment platforms is that they automate the process of trading and transactions. This disciplined approach avoids market timing and avoids irrational and emotional decision making that is characteristic of human investors. Automating the buying and selling of investments can help reduce the irrational tendencies of investors who try to time the market.

The third advantage of an automated platform for investing is that the system automates portfolio management. Taking the investors risk tolerance into account, the automated platform puts the portfolio on auto-pilot and sends reminders when a human touch is needed.

Smart Beta

One of the approaches to automated platforms for investment management is to offer the client the best returns for the lowest risk. “Beta” is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes based on measures such as volatility or dividends. The use of “smart beta” by automated investment platforms is linked to a desire for portfolio risk management rather than only investment return. And automated investment platforms that follow a smart beta investment strategy seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility. Generally, smart beta emphasizes weighting schemes based on fundamentals or market inefficiencies and can add greater diversification and improved returns over time.

In response to the success of start-ups in attracting assets under managements, Schwab, Vanguard and Fidelity have entered the field. For example, Schwab’s automated service for consumers uses “Intelligent Portfolios,” which are heavily weighted toward smart beta ETFs. Schwab’s “Intelligent Portfolios” combine cash allocations with a mix of market-cap and fundamental index ETFs.

Fees

Automated investment platforms using smart beta strategies may cost less than active management, since there is less day-to-day decision-making for the manager. However it will, at the very least, have higher trading costs than traditional passive management in an index fund (which minimizes those costs) and is a pricier option.

It is not uncommon for financial investment advisors to charge 1-2 percent annually or more via the loaded investment tools they may recommend. As history has shown, this is a steep fee to overcome in order to beat the performance of a passively managed index of the market. While there are different automated platforms and fee structures, most fees range from 0.40 percent to 0.60 percent of assets managed.  For example, Future Advisor charges 0.50 percent for their investment services and others have flat rates.

Do Automated Investment Services Have a Future?

The automated investing space is new and evolving. As yet, most entrants in the field are not profitable. Instead they are relying on significant venture capital funding. Still, the industry is growing with several companies already having over $1 billion assets under management. The ease in which new investors can open an account and have a portfolio selected, rebalanced and monitored for tax consequences is an attractive option for many investors just beginning the process of accumulating wealth through the stock market.

This article was featured on the DBJ Instablog on Seeking Alpha.

As the United States economy struggled to avoid complete collapse in the height of the financial meltdown, leading players in the regulatory arena, as well as those in Congress, pushed for a solution that would prevent any future downturn from escalating to the near catastrophic levels of 2009. That solution emerged in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which passed Congress on party lines and was signed by President Obama on July 21, 2010.

Dodd-Frank formed a key part of President Obama’s plan for economic recovery. The law significantly overhauls the American financial regulatory system, creating a new Consumer Financial Protection Bureau, limiting risky trading, implementing a new regulatory regime for credit agencies and insurance companies, among others. The law is arguably the biggest push for financial reform since the Great Depression, and given its length and breadth, has generated substantial opposition.

One of the most controversial provisions of Dodd-Frank is the Volcker Rule, named after former Federal Reserve Chairman Paul Volcker. The rule would ban most forms of proprietary trading, which prevents financial firms from profiting directly from trading on the market, as opposed to profiting through commissions. This rule is significant in that it can potentially prevent some of the dangerous behavior that helped cause the financial collapse. Because of the ardent opposition by banks and the limited financial resources appropriated to regulatory agencies, the Securities and Exchange Commission and other financial regulators have requested additional authority to prosecute violators and impose penalties.

But Republicans in Congress see the Volcker Rule as an unwarranted and harsh crackdown on financial activities necessary to promote healthy economic growth. Chairman of the House Financial Services Committee Jeb Hensarling (R-TX) said previously in a statement that the final version of the Volcker Rule “is just the latest example of Washington’s regulatory overkill that ends up hurting more than it helps.”

In this new Congressional session, a bill to delay the Volcker Rule failed in its first attempt to pass the House of Representatives when Republicans used a procedural rule requiring a two-thirds majority to speed up its passage. That effort failed 276-146, but ultimately, a new attempt under regular order passed by a simple majority of 271-154. While twenty-nine Democrats voted with a unified Republican caucus in support of the bill, its passage into law is doubtful given fierce Democratic opposition in the Senate and a likely presidential veto. “One day into the new Congress,” said Senator Elizabeth Warren (D-MA), one of the leading proponents of financial regulation, “House Republicans are picking up right where they left off: trying to gut Wall Street reforms so that big banks can make more risky bets using taxpayer-backed money.”

The controversy over the Volcker Rule and Dodd-Frank in general stems down to a difference in political viewpoints between Democrats and Republicans on how much regulation is necessary to prevent a future financial collapse. Democrats cite the need for increased reforms and requirements on big banks in order to safeguard consumers and prevent large financial institutions from growing to be “Too Big to Fail” and bringing down the economy in the event of bankruptcy. Republicans, on the other hand, believe these increased regulations hamper financial growth and economic recovery, and they point to deregulation as necessary to promote growth. Political consensus on this fundamental difference appears doubtful, but smaller bills have previously garnered bipartisan support, indicating the possibility for compromise in the future.

The Dodd-Frank Act is one of the most sweeping pieces of financial reform legislation ever to become law, but only time will tell whether it will have the fortitude to resist sustained attacks from the financial industry. Furthermore, many believe it has not gone far enough to prevent a future financial collapse, a reflection of the legislative process as well as sustained opposition from Republicans. Now, with a wholly Republican Congress and only two more years left in President Obama’s second term, the future of many of President Obama’s initiatives remains uncertain. As the economy approaches full recovery from the financial collapse, the impetus for additional regulations will undoubtedly diminish, as legislators move beyond the financial collapse. The debate over Dodd-Frank and the Volcker Rule will surely continue beyond 2017, and as partisan politics heighten as the 2016 election season begins, President Obama’s record will become a key component of the campaign.

 

 

Passing on savings to the customer has always been a cornerstone of Walmart since its foundations. Walmart founder Sam Walton’s legendary thrift (even executives flew coach class and shared hotel rooms on business trips) was put to work in crafting this new business model. This model, first implemented in 1962, relied on volume of transactions rather than margins to get ahead of competitors. Now, over half a century later, the fact that Walmart has an annual revenue of around $421.8 billion worth of goods throughout the world is a testament to the viability of such a retail model.

Throughout its meteoric rise from Bentonville, Arkansas to the farthest reaches of the world, Walmart’s constant message has been for the customer to “save money” in order to “live better” and has provided unremittingly low costs in every market it penetrates. But while this tactic allowed the company to grow to a market cap of $245 billion, it has also made Walmart notorious for one of its primary cost-cutting measures: the maintenance of low employee wages. Walton once wrote, “No matter how you slice it in the retail business, payroll is one of the most important parts of overhead and overhead is one of the most crucial things you have to fight to maintain your profit margin.” In setting sales associate’s wages at 3% below market, Walmart is continuing on Walton’s legacy of cost-cutting.

Though this practice has led to over $15 billion in earnings for the current fiscal year, it has also led to several employee strikes and national media attention. While noted economist Ernek Basker and others have argued that the expansion of Walmart into any given community brings a net financial benefit to community members as gains from low prices outweighs the cost of slightly diminished local wages, the fact remains that to many Americans, the word “Walmart” is as associated as much with low wages as is low prices. Recent spates of bad press in the media, coupled with several largely unsuccessful attempts by Walmart employees to unionize, has garnered the corporate giant a negative societal reputation it cannot seem, despite its $2.1 billion advertising budget, to shirk. Once minor, these public relations problems can no longer be ignored as the United States’ economy continues its slow progress back to pre-crash normalcy and Walmart—which bases much of its business model on demand for inferior goods—will now have to compete against higher quality suppliers as well as online markets. In order to expand or simply maintain its existing market penetration in the developed world, Walmart will have to look to the past and imbibe two other maxims of Sam Walton.

Walmart was once the retail leader in supply chain management but has since lost that title to ecommerce giant Amazon. Although Amazon’s $74 billion in revenue for 2013 is dwarfed by Walmart’s revenue of $473 billion, the market caps of these two companies ($134 billion and $246 billion respectively) imply a much more bullish outlook for Amazon’s growth potential. But Walmart does not have to play the role of a sprawling, established retail giant—it should leverage its current resources towards the continued expansion and development of its ecommerce platform. In 2013, Walmart’s global online sales grew 30% to $10 billion and similarly spectacular growth is expected for 2014. Canadian markets have been an epicenter of online sales growth for Walmart, with a 145% increase in online revenue in 2013 alone. While Walmart has been pressing e-commerce throughout the developing world, this growth in Canada should be an indicator to Walmart executives that the company also has the ability to break into developed markets. Walmart’s position in American and Canadian markets has recently been less stable than it once was; demand for food and basic consumer goods continues to show a steady rise, but there has been a relative dropoff in sales in stores where merchandise is the primary offering. An emphasis on e-commerce could allow Walmart to reclaim former position as a market leader in merchandise sales.

Walmart still has the edge over Amazon as far as profitability goes. Gross annual profit margins for the online retail giant have been quite weak: -0.65% as of June 30, 2014. Walmart’s profit margin, by comparison, consistently hover around 3.5%. This profitability advantage, coupled with an advantage in sheer revenue, confirms that Walmart can leverage its cash to make strategic investments in areas such as ecommerce. Walmart, however, will have to act on this advantage now or risk losing it in the face of new economic developments. Just as Sam Walton once invested in the latest computing technology to maximize his corporation’s productive efficiency, so should today’s Walmart executives use their economic largess to become leaders in e-commerce.

Regardless of how much Walmart is willing to invest in the future of its online sales component, it will inevitably have to address worker satisfaction and wages—a flashpoint that has become an endemic public relations and employee retention issue. In finding a solution to the issues of low wages, Walmart could look at Costco Wholesale Corporation. Walmart’s business model is often compared to that of Costco’s, with pundits such as Forbes’ Rick Unger arguing that “the time has come for Wal-Mart to take a lesson from Costco and consider the potential upside of treating employees like human beings.” However, calls for higher wages and better employee benefits ignores the innate differences between how the two stores of the two companies are run. At Costco manpower is focused almost exclusively on checkout and security while Walmart distributes employees across the store to directly aid in the shopping process. As a result of Walmart’s policy, each store has to hire many employees. In fact, Sam’s Club, a Walmart subsidiary, has in fact tried this business model, operating on a membership payment model with far less employee-customer interactions. Today, the 632 Sam’s Clubs in the United States still lag behind Costco in a crucial metric: “Costco’s sales on a per-store basis were much higher as it generated nearly as much total revenue with one-third fewer employees. Consequently, profit per employee at Costco was $13,467 compared to only $11,039 at Sam’s Club.” It is clear from the relative failure of Sam’s Clubs that an alternative store and business model is not the optimal way forward for the company.

Instead of trying, at an enormous financial and restructuring cost, to remake itself into a second-rate Costco, Walmart should focus its efforts on incentivizing employees by giving them stake in the company. Sam Walton was known for his emphasis on promoting the idea of Walmart as a shared corporate venture throughout the chain of command. By giving employees equity options and stock benefits, Walmart executives would be welcoming its over 200 million employees into the veldt. Though unusual in the retail industry, shift towards an equity compensation plan would not be unprecedented; Starbucks has, since 1995, given all of its fulltime employees the option of purchasing company stock at a discount each fiscal quarter. This policy may be the reason that Starbucks has, as a corporation, managed to escape media and national scrutiny despite the fact that its average wage of $8.79 per hour is even lower than Walmart’s average of $8.89 per hour. Walmart has already adopted other employee incentivizing programs such as one that allows some fulltime employees the opportunity to obtain a discounted college degree at one of several online universities. However, if Walmart develops a comprehensive employee discount stock-purchase programs in a way that doesn’t hurt the bottom line, the morale and company image could be radically improved.

With 11,000 stores under 71 banners in over 25 countries, Walmart has an unprecedented tactical avantage over its competition. While some pundits see the business model Sam Walton created as outdated, exploitative and unworkable, the current successes of the company are largely the effects of Walton’s policies. Current Walmart executives can boost profit margins, relieve employee and media tensions, and expand into new e-commerce markets by following more closely the tenets of their founder. Walmart has the assets necessary for expansion into new markets, regions, and sectors. By looking back to the past, Walmart might find its path into the future.

 

This article was co-published by Seeking Alpha on Jan. 7, 2015.

Bankers at the world’s top investment banks closely monitor “league tables” with the same dedication as avid Premier League soccer fans.  The usual suspects lead the pack. At the top of the mergers and acquisitions (M&A) table are storied franchises such as Morgan Stanley, Goldman Sachs, JP Morgan, and Bank of America. Colloquially known as “bulge brackets,” these public financial institutions offer a full suite of financial services ranging from capital raises and asset management to advisory and market-making.

Closely on their heels, however, are drastically smaller, “boutique” firms. These specialized practices, known to few outside of Wall Street, offer a much more narrow range of services and often specialize in M&A advisory. This new crop of banks with streamlined business models, deep rolodexes, and niche focuses are giving traditional industry players a run for their money.

The Wall Street landscape, as we knew it a few years ago, has changed. In the aftermath of the recent financial crisis, new regulations, overall risk aversion, and operational inefficiencies are reining in once highly profitable practices such as fixed income and proprietary trading. The age-old model of being a financial jack-of-all-trades has proven to be a burden. If prominent banks are to regain their competitiveness, they will have to focus on their core strengths instead of striving to mimic market leaders. Market dynamics will force bulge brackets to shift resources away from low-margin, weak-demand services and product offerings and will ultimately lead to a more diverse industry landscape.

Boutique banking on the rise

Managing directors at leading boutiques such as Evercore, Centerview, Greenhill, and Moelis & Company are overwhelming ex-bulge bracket veterans who have chosen to set up their own shops in pursuit of higher compensation and career independence, among other factors. Given their wealth of experience and industry expertise, heads of elite boutiques have been well-positioned to capitalize on the wild ride in M&A over the past decade. According to the Financial Times, M&A volume tripled between 2003 and 2007, plummeted during the crisis, and has since strongly rebounded. During this volatile period, several boutiques went public and since then have seen sky-rocketing returns on their stock (see index). Wall Street has not been so fortunate. Over the past year, shares of bulge brackets experienced returns that can only be described as anemic, 4% year-over-year versus 17% for the leading boutiques. In the first quarter of 2014, boutiques advised on roughly a third of all announced M&A deals according to Dealogic estimates.

The beauty of these independent advisory firms lies in their simplicity. They typically earn their bread by closing deals and receiving a commission-based advisory fee. About half of the revenue goes towards employee compensation and a quarter towards overhead, leaving a wide operating margin. There’s no need to worry about Basel III, FASB 157, risk-weighted assets, or a long string of expensive lawsuits.

And boutiques will certainly have no problem competing with bulge brackets for the newest crop of young talent. According to Glassdoor figures, the leading boutique investment banks offer analysts compensation that’s on par with bulge brackets, and in certain cases are even higher. Though analysts may give up the opportunity to develop a broad network of industry professionals in a more structured work environment, they often play a more integral role in the actual transaction process than they would at a larger institution. With firms such as Centerview and Evercore directly competing with the likes of Goldman and Morgan Stanley for big name clients, top college graduates are increasingly making the switch to boutique banking.

Wall Street’s dilemma

The post-financial crisis economy has not been kind to big banks. On May 19th, Swiss bank Credit Suisse pleaded guilty to tax evasion in the United States and will incur a fine of $2.6 billion, in addition to increased regulatory oversight. These costly criminal charges come only a month after Bank of America reported critical accounting errors that led to a delay in a highly anticipated share buyback program, much to the dismay of shareholders and BoA employees.  Around the same time, Barclays, a British bank, saw several of its top rainmakers leave amidst poor compensation. It effectively renounced its ambitions of becoming a top global investment bank, announcing sweeping layoffs in its U.S. investment banking operations. Deutsche Bank, long recognized as an industry leader in fixed-income trading, stubbornly clings on to its foothold in fixed-income and currencies despite a sharp cyclical downturn, cumbersome regulations, and general risk aversion towards exotic, but profitable investments. The recent spate of negative press has not only sent share prices tumbling but has also battered credibility just as banks were beginning to rebuild confidence with clients.

However, the strong recovery in corporate finance has Wall Street excited. M&A revenue for 2014 is forecasted to reach $16 billion, up 5-10% from the previous year. Several factors are at play here. After years of hoarding cash, large corporations are ready to take advantage of the restabilization in the economy, strong equity markets, and relatively low interests rates to make strategic acquisitions. Private equity firms also have a record amount of “dry powder,” funds they raised but have yet to deploy, and are ready to take on unprecedented levels of leverage in the hunt for attractive acquisition targets. According to proprietary interviews with C-suite executives, banks are readily offering cheap credit lines and a host of amenities to solidify existing relationships with clients. With multiple banks lined up in the hopes of landing the next mega-merger, corporations will have plenty of advisors to choose from.

Despite the optimism, the latest research from strategy consultancy Oliver Wyman and Morgan Stanley suggests big banks will need to work more smartly to win a spot at the table. Bulge brackets are smothering their clients with excessive and ineffective coverage. Corporate executives have noted that most of these outreaches amounted to nothing more than generic pitches and product peddling. This inefficiency can be traced back to the siloed nature of many financial institutions. The research departments, product groups, and deal teams often operate independently with limited communication across the various functions. In order to provide truly effective client coverage, banks will need to internally employ multilateral efforts to gain a deeper understanding of client needs.

A more level playing field

Banking is ultimately an information-based profession. M&A advisors, therefore, are paid based on who they know, what they know, and how well they negotiate. The emergence of innovative technologies that effectively use the wealth of available online data have begun to chip away at the first two ways investment bankers add value. First, who you know does not really matter anymore. Simple LinkedIn searches and a few minutes on Google can get you the contact information of virtually any influential corporate decision-maker. Second, the infamous “pitch-book,” one of the first sets of presentation materials prepared in a transaction process, has become commoditized as financial analyses have become cheaper and the preparation process easily outsourced. While it does indeed take years of hard work to become an industry expert and a menace at the negotiation table, technology has undoubtedly leveled the playing field for bulge brackets and ambitious up-and-comers.

Where Wall Street still excels and will continue to dominate is actual financing. Regardless of how prestigious or talented the new crop of boutique firms become, they will not have the same level of access to capital markets or have such an enormous balance sheet to leverage. This is Wall Street’s value proposition. Bulge brackets will continue to excel at complex transactions that require access to significant financing or capital markets. However, it is difficult, though not impossible, to demonstrate that complex financial institutions with many moving parts and regulatory obligations can necessarily provide better advice than a lean boutique shop staffed with industry veterans. To borrow a concept frequently used in management consulting, banking incumbents must adopt an 80/20 mentality towards their offerings.

But perhaps we are only scratching the surface of a more fundamental issue with how investment banking is done today, one that is more philosophical than operational. What was once a straight-laced, buttoned-up industry has transformed into a high-flying, glamorous profession. While there are certainly many bankers on the Street who truly have the interests of the client at heart, it appears that the urge to one-up rivals in prestige and earnings has led to poor decision-making, irrational deal-making, and risky trades. This begs the question of who bankers really serve today: shareholders or clients? When J.P. Morgan stood before a U.S. Senate hearing, he spoke these famous words:

I should state that at all times the idea of doing only first-class business, and that in a first-class way, has been before our minds…The banker must be ready and willing at all times to give advice to his clients to the best of his ability. If he feels unable to give this advice without reference to his own interest he must frankly say so. The belief in the integrity of his advice is a great part of the credit of which I have spoken above, as being the best possession of any firm.

Though spoken nearly a century ago, J.P. Morgan’s words get at the heart of why independent advisory firms are beating out bulge brackets. Decades of consolidation, keeping-up-with-the-Joneses, and profit chasing has left many firms bloated and unable to live up to the mandate of “doing first class business in a first class way.” Unless broad structural changes are made, Wall Street will continue to lose market share to smaller, more nimble boutique shops.

 

All over the Street, in every investment bank, on every trading floor, hysteria reigns. Phones are ringing, clients are calling, screens are blinking, and traders are yelling. “We appear high!” is a phrase I’ve gotten used to hearing most mornings. At Morgan Stanley the trading floor is so expansive you can almost see everyone in the room when standing. The fluorescent lighting and high ceilings accentuate the floor’s vastness even more. Oh, and there are monitors. So many monitors.

Now take the elevator up to the 40th floor, and the chaos of the trading floor fades into serenity. I enter the waiting area, and notice the immaculate, wood-finished walls, the panoramic view of the city, and the beautiful spiral staircase adorned with pristine portraits of prominent leaders from Morgan Stanley’s past. But what business does a twenty-year-old Dartmouth intern have making a trip up to the executive suite?

“I want to meet the CEO,” I said to the associate sitting next to me, earlier that morning.

Trying to find the perfect words to express my interest, I crafted an email and sent it over directly to Mr. James Gorman’s generic corporate email account. On the off chance he said yes, I did not want my fellow Dartmouth wintern, Jimmy, to miss out, so I invited him to come along. No more than five minutes later, I received a reply. The Chairman and CEO of Morgan Stanley invited us to stop by his office later that afternoon. I was shocked by the quick response, and even more shocked that Mr. Gorman wanted to see us that same day.

I spent the next hour researching and drafting questions I would ask, trying to demonstrate that this wintern had done her homework and was prepared to share her “groundbreaking” wintern perspectives. I tried to develop opinions on the firm’s new ROE target and the effect the firm’s summer acquisition of Smith Barney would have
going forward on the municipal bond market, a market in which I am clearly an expert.

When the time came Jimmy was unfortunately nowhere to be found. I knew I could not risk being late for Mr. Gorman, so I de-linted my suit jacket, put on my “sophisticated” glasses, and headed upstairs on my own.

As I walked into the executive suite, I was overwhelmed as I thought about all the monumental conversations and decisions that must have occurred in these rooms. Was this the place where John Mack had received the phone call from Henry Paulson urging him to sell the firm? Or where Tim Geithner advised him to merge with JP Morgan? Was it here that the decision to turn the bank into a bank holding company was made? And as I’m sure John Mack had to spend some nights at the office during the financial crisis, was that the closet where he kept his spare suits? History surrounded me and all I could do was smile at this opportunity.

I entered Mr. Gorman’s office and to my relief, the extensive Google searching was for naught. I was not expected to provide my hazy understanding of the firm’s strategy, nor did I feel obligated to try and impress Mr. Gorman with my overly specific and rehearsed questions. I realized I wasn’t just speaking with the CEO of one of the world’s top investment banks; I was sitting face to face with a father of two, a brother to nine, and a mentor to over 55,000.

We began talking about his upbringing in Australia and shared stories about our respective siblings. He described the university system in his home country, noting that his college courses were very career-focused, the exact opposite of the liberal arts education I am receiving at Dartmouth. He was interested in what drove my decision to attend Dartmouth, and while I do love many features of the College on the Hill, I admitted that the predominant reason was that my sister was a freshman there at the time.

I wanted to learn as much about Mr. Gorman’s life as I could in the short time we had together so I shifted gears and asked to hear more about the road he travelled on his journey to becoming CEO. I learned about his underlying passion for managing people, which appeared to motivate his progression from law to strategy consulting, and eventually to Wall Street. He expressed the aspects that ultimately drew him towards firm management, such as the importance of setting defined goals and designing appropriate strategic steps in order to achieve those objectives. I was fascinated by his unconventional career path, which stood in stark contrast to the typical Wall Street CEO, who rises through the ranks as a banker or trader. Despite a six-year stint in a senior management role at Merrill Lynch and a successful career at McKinsey, consulting for financial services companies, Mr. Gorman was relatively
new to the Street when he joined Morgan Stanley, and had been a lawyer in Australia earlier in his career. As a young adult who cannot be sure what her business card will read in five years, I found it refreshing to hear that there is no single formula for success.

I could sense that Mr. Gorman had to get back to his busy day, so I candidly asked him, “what is one piece of advice you could give me as a young woman who is planning to embark on a career in finance?” He stressed the importance of remaining in decision-making positions in my extracurricular activities at Dartmouth and emphasized how these would best prepare me to succeed in the years ahead if I had any desire to take on management roles at some point in my career.

 

Photographed by Craig Schneider
Photographed by Craig Schneider

 

He revealed that I was one of only a few people who had been in his office, and I left feeling fortunate to be interning at a place where even the most senior leader of the firm finds it worthwhile to connect with the individuals at the very bottom of the totem pole. I returned to my desk and it seemed like everyone had heard about my encounter. People were excited to hear that their CEO had made time to connect with an ordinary intern, truly embodying the flat and transparent structure that Morgan Stanley values so greatly.

I went to find Jimmy to share in my excitement and to find out why he had not made it upstairs. Regretfully he explained that he was sitting with a trader in CMBS and had not seen the invitation. “It must have been a pretty cool trade to blow off the CEO!” I joked. However, a few days before the end of our internship, Mr. Gorman was gracious enough to make time to sit down with Jimmy as well.

To those who say you have to sell your soul in order to succeed on Wall Street, I have to disagree. The amount of spirit, character, compassion, and generosity I’ve experienced in such a short time at Morgan Stanley has been incredible. While Mr. Gorman’s gesture was a unique and special opportunity, it was also a symbol of a culture of mentorship. I feel very fortunate to have worked in such a supportive environment and I hope that someday I will have the opportunity to pay it forward.

From a tourist’s perspective, Argentina is a relatively relaxed country. From the wine bodegas in Mendoza to the languid city life in Buenos Aires, it is difficult to imagine the underlying resentment towards the government and the decline of their economy. However, once you have walked the sidewalks in the city or experienced enough rainy days to notice the crumbling infrastructure, the angry graffiti on the building walls, or the constantly changing prices on restaurant menus, today’s problems become apparent.

Inflation is not a new problem for Argentina. Historical inflation rates have hovered around the thousand percentages, but the government has always found a way to stabilize the economy. Argentina has encountered quite a few inflationary cycles in their economy, each which led to new policy controls that aided in the short run, but did not provide long-term anti-inflationary effects. Other changes took effect in the 1990s, from liberalization and deregulation of all of their markets to a new tax system. With less government regulation, prices began to stabilize according to the market, and the public had the option to use any type of currency they pleased. Inflation stabilized to an average of 0 percent by the 1990s, with the inflation rate fluctuating with the economy.

These new policies worked until the end of the 1990s. Poorly planned liberalization strategies, where the government sold sectors of their economy for less than half their value, led to worse working conditions and thousands of layoffs. 2001 saw one of the most turbulent times of Argentina as protests mounted to an all time high in the Argentizo which ousted President de la Rue and had the government fumbling through 3 other presidents before Kirchner stepped into power. The economy managed to pick up around 2003, but the economy has rapidly been declining since.

Argentina’s inflation today is at a ten-year high of 30% and the government’s expansionary monetary policy may be to blame. Government subsidies, such as holding household electricity costs constant (though they are still expensive), after the 2002 crisis have caused a need to print more pesos to finance these projects. By injecting so many extra pesos into the economy, the value of the peso decreased. Investors withdrew their money from Argentina due to uncertainty about Kirchner’s policies and fear of inflation. In order to prevent this capital flight, beyond the $21.5 billion capital flight happening in 2011, President Cristina Kirchner banned citizens from withdrawing US dollars from the bank. She has also tried to limit imports, vacations, and online purchases (Porsecanski 2014). Former finance Secretary Daniel Marx explained, “Those problems are related to the speed of inflation and the exchange rate in an international context that is more complicated” (2011). Argentina’s Mercado Abierto Electronico system estimated that these policies have diminished the amount of currency officially traded by 50%, as compared to 2010. These bans have only allowed the black market exchange for US dollars to flourish.

The government’s attempt to curb and hide inflation in the country has become apparent with the differing values of the official peso and the “dolár blue,” the black market exchange rate for the peso. The “dolár blue” rate reflects how much the citizens think the peso is worth, it is based on the economy and “Wall Street.” This also highlights the effects of the government’s attempt to decrease the supply of US dollars in the market (which increases the value of the dollar). In the span of one month (January to February 2014), the official rate had changed from around 6.5 pesos per US dollar to 8 pesos, a 23% decrease in the value of the peso. The “dolár blue” has jumped from 10 pesos per US dollar to 12 pesos, a reduction of 20%. Local newspapers have speculated on the apparently more stable value of the “dolár blue”, which demonstrates the ineffectiveness of government policies versus market forces in Argentina. 

The increase of government intervention in economic policies has led to their economic decline, with a bill approved that allowed the government unlimited access to the central bank’s reserves. This granted the government the ability to print money as needed for their endeavors, contributing to the country’s inflation. Kirchner has also seized private industries, such as the oil company YPF, in order to stabilize oil prices for citizens. This has only led to unnecessary increased government expenditures. The government has attempted to diminish their restrictions, by allowing individuals (but not businesses) to withdraw US dollars from the bank. Nicolás Titaro, a company treasurer in Buenos Aires explains, “Great, we can buy dollars now…We just need salaries that let us.” The government’s poor timing with their policies has only increased the ineffectiveness of their macroeconomic strategies.

Fears of inflation have reverberated throughout the economy, from the value of their pesos to some of their most important exports. For instance, in the agricultural sector, farmers have been refusing to sell their soybeans. They understand that their soybeans have a more stable value than the pesos they could receive for selling the soybeans. The US Department of Agriculture explains, “Unless a mechanism becomes available for producers to convert soybeans into assets that can retain their value in the current inflationary environment, limited selling is likely to continue.” This could become a problem, as Argentina is one of the world’s top soybean exporters and soybeans are one of Argentina’s main crops.

Stagflation could be the end result for Argentina unless the government can finally admit to the actual value of their dollar. There needs to be more responsible government actions, privatization–but in a socially conscious manner. Free market forces can do wonders for the economy, but also harm minimum-wage workers. The government needs to allow market forces to dictate the economy, while ensuring the protection of the lowest rung of workers.

The continuation of the decline of the peso can only mean an even smaller dollar reserve and decreased leeway for the government to pay back international debts and enact new policies. In the long-run, Argentinians can expect a lower standard of living as price increases diminish their purchasing power. The lack of transparency from the government will only lead to increased demand for US dollars and rapid devaluation of the peso, as no one, not investors nor porteños have faith in the Argentinian peso.

Federal Reserve Board Building

Since the beginning of the great recession, the Federal Reserve has increased its transparency of monetary policy, created new tools for controlling short-term interest rates, and has maintained its dual mandate of fostering maximum sustainable output and employment with stable prices. The recent rise in the monetary supply and the increased size of the Fed’s balance sheet has been alarming for inflationary hawks. With an enlarged balance sheet, the federal funds rate may no longer be the most effective method for the Fed to control short-term interest rates. Two new tools: the interest on excess reserves held at the Fed, and the overnight reverse repurchase program could serve as a way for the Fed to directly control short-term interest rates and affect a larger number of market participants.

Traditionally, the Fed indirectly manages the federal funds rate in order to control short-term interest rates. The federal funds rate is the rate at which banks lend to each other for overnight loans in order to secure the amount of reserves required by the Fed. Since 2007, the Fed slashed the federal funds rate target from 5.25 percent to below ¼ of a percent in order to encourage lending and business investment during the recession.

After reaching the lower bound on the yield curve, the Fed created new tools in order to continue its expansionary stance on monetary policy. The Fed introduced three rounds of quantitative easing, consisting of purchasing millions of long-term treasury bills and mortgage-backed securities every month, in order to decrease medium- and long-term interest rates. The result of these purchases is a drastic increase in the size of the Fed’s balance sheet, which recently crossed $4 trillion and will likely continue to rise to a peak of about $4.5 trillion.

Former Fed economists, Brian Sack and Joseph Gagnon, recently published a paper proposing that the Federal Open Market Committee should stop targeting the federal funds rate as its benchmark interest rate, and instead use the reverse repurchase program in conjunction with setting interest on excess reserves at the same level.  Since 2008, the Fed has pumped $2.5 trillion into the economy by purchasing bonds on the open market. However, the traditional system will not work unless the central bank pulls out most of this money. This liquidity in the system will present a major challenge when the time comes to raise short-term interest rates. There is also economic evidence that a greater amount of liquidity in the financial system allows it to operate with less risk and greater efficiency, and therefore the Fed might not want to decrease its balance sheet even in the long run.

For monetary policy in the future, Sack and Gagnon have proposed that the Fed set short-term rates by directly controlling the interest on excess reserves rate and the reverse repurchase agreement rate. The interest on reserves (IOR) is a rate the Fed directly controls, where the Fed pays interest to banks that keep excess reserves at the Fed. The Fed’s control of interest on excess reserves gives the Fed ability to control interest rates even if there are abundant reserves in the market. By raising the interest on reserves rate, the Fed could counter inflationary pressures by increasing the opportunity cost of lending, which would incentivize financial institutions to keep their excess reserves risk free at the Fed.

Another short-term interest rate setting program is the reverse repurchase facility (RRP), which is an open market operation where the Fed sells a security with an agreement to repurchase the security at a specific time in the future at a certain price. The difference between the repurchase price and the sale price, including the length of time between the transactions, implies a rate of interest paid by the Fed on the cash invested by the counterparty institution. The RRP “interest rate” basically sets a floor on the short-term interest rate, since no market participant would be willing to lend under the risk-free rate provided by the Fed. In order to counter inflationary pressures, the Fed could increase the price of the repurchase, which would increase the opportunity cost of lending with an interest rate near or at the RRP interest rate.

Unlike the federal funds rate, the Fed can do reverse repurchase agreements with non-banks, which extends the Fed’s control to a broader set of market participants.  Therefore, the Fed will have access to over 140 financial institution and counterparties including corporations like Fannie Mae and Freddie Mac. One positive implication of this plan is that the Federal Open Markets Commission would have the ability to control financial conditions by directly setting the short-term interest rates. This would increase the Fed’s flexibility, since it could adjust its balance sheet to achieve its own economic objectives without having to be as concerned about the consequences of liquidity and indirect interest rate impacts like the Federal Funds Rate.

The Fed should use the reverse repurchase facility as its policy instrument and it should maintain the interest rate paid on bank reserves at the same level of interest. The Fed would be able to leave a large amount of liquidity in the system on a permanent basis, which should reduce risk and increase the market’s financial efficiency. Sack and Gagnon believe that the optimal solution would be achieved by setting the RRP rate in concomitance with the IOR rate. This would hopefully give the Fed sufficient control over short-term interest rates and also allow the Fed to influence broader market conditions in order to foster maximum sustainable output and stable prices.

The research on this policy is very new, and the Fed will need to complete more research on the effectiveness of using these two new tools in synchrony with each other. In the future, the Fed might no longer use the federal funds rate as its main policy tool, and the interest on excess reserves and reverse repurchase facilities could be the future determinants of United States monetary policy.