24/2/17: Distributed ledger technology in payments, clearing, & settlement

A new research paper from the U.S. Federal Reserve System, titled “Distributed ledger technology in payments, clearing, and settlement” (see citation below) looks at the rapidly evolving landscape of blockchain (distributed ledger technologies, or DLTs) in the financial services.

The authors note that DLT “is a term that [as of yet]… does not have a single definition”. Thus, the authors “refer to the technology as some combination of components including peer-to-peer networking, distributed data storage, and cryptography that, among other things, can potentially change the way in which the storage, record-keeping, and transfer of a digital asset is done.” While this definition is broader than blockchain definition alone, it is dominated by blockchain (private and public) typologies.


Impetus for research

Per authors, the impetus for this research is that DLT is one core form of financial sector innovation “that has been cited as a means of transforming payment, clearing, and settlement (PCS) processes, including how funds are transferred and how securities, commodities, and derivatives are cleared and settled.” Furthermore, “the driving force behind efforts to develop and deploy DLT in payments, clearing, and settlement is an expectation that the technology could reduce or even eliminate operational and financial inefficiencies, or other frictions, that exist for current methods of storing, recording, and transferring digital assets throughout financial markets.” This, indeed, is the main positive proposition arising from blockchain solutions, but it is not a unique one. Blockchain systems offer provision of greater security of access and records storage, higher degree of integration of various data sources for the purpose of analytics, greater portability of data. These advantages reach beyond pure efficiency (cost savings) arguments and go to the heart of the idea of financial inclusion - opening up access to financial services for those who are currently unbanked, unserved and undocumented.

In line with this, the Fed study points that the proponents “of the technology have claimed that DLT could help foster a more efficient and safe payments system, and may even have the potential to fundamentally change the way in which PCS [payments, clearance and settlement] activities are conducted and the roles that financial institutions and infrastructures currently play.” The Fed is cautious on the latter promises, stating that “although there is much optimism regarding the promise of DLT, the development of such applications for PCS activities is in very early stages, with many industry participants suggesting that real-world applications are years away from full implementation.”

Per Fed research, “U.S. PCS systems process approximately 600 million transactions per day, valued at over $12.6 trillion.” In simple terms, given average transaction cost of ca 2-2.5 percent, the market for PCS support systems is around USD250-310 billion annually in the U.S. alone, implying global markets size of well in excess of USD750 billion.

DLT Potential 

Fed researchers summarise key (but not all) potential (currently emerging) benefits of DLT systems in PCS services markets:

• Reduced complexity (especially in multiparty, cross-border transactions)
• Improved end-to-end processing speed and availability of assets and funds
• Decreased need for reconciliation across multiple record-keeping infrastructures
• Increased transparency and immutability in transaction record-keeping
• Improved network resiliency through distributed data management
• Reduced operational and financial risks

One of the more challenging, from the general financial services practitioners’ point of view, benefits of DLT is that it is “essentially asset-agnostic, meaning the technology is potentially capable of providing the storage, record-keeping, and transfer of any type of asset. This asset-agnostic nature of DLT has resulted in a range of possible applications currently being explored for uses in post-trade processes.”

The key to the above is that blockchains ledgers are neutral to the assets that are recorded on them, unlike traditional electronic and physical ledgers that commonly require specific structures for individual types of assets. The advantage of the blockchain is not simply in the fact that you can use the ledger to account for transactions involving multiple and diverse assets, but that you can also more seamlessly integrate data relating to different assets into analytics engines.

Due to higher efficiencies (cost, latency and security), blockchain offers huge potential in one core area of financial services: financial inclusion. As noted by the Fed researchers, “financial inclusion is another challenge both domestically and abroad that some are attempting to address with DLT. Some of the potential benefits of DLT for cross-border payments described above might also be able to help address issues involving cross-border remittances as well as challenges in providing end-users with universal access to a wide range of financial services. Access to financial services can be difficult, particularly for low-income households, because of high account fees, prohibitive costs associated with traveling to a bank. Developers contend DLT may assist financial inclusion by potentially allowing technology firms such as mobile phone providers to provide DLT-based financial services directly to end users at a lower cost than can (or would) traditional financial intermediaries; expanding access to customer groups not served by ordinary banks, and ultimately
reducing costs for retail consumers.”

Lower costs are key to achieving financial inclusion because serving lower income (currently unbanked and unserved) customers in diverse geographical, regulatory and institutional settings requires trading on much lower margins than in traditional financial services, usually delivered to higher income clients. Reducing costs is the key to improving margins, making them sustainable enough for financial services providers to enter lower income segments of the markets.

Incidentally, in addition to lower costs, improving financial inclusion also requires higher security and improved identification of customers. These are necessary to achieve significant gains in efficiencies in collection and distribution of payments (e.g. in micro-insurance or micro-finance). Once again, DLT systems hold huge promise here, including in the areas of creating Digital IDs for lower income clients and for undocumented customers, and in creating verifiable and portable financial fingerprints for such clients.

The Fed paper partially touches this when addressing the gains in information sharing arising from DLT platforms. “According to interviews, the ability of DLT to maintain tamper-resistant records can provide new ways to share information across entities such as independent auditors and supervisors.” Note: this reaches well beyond the scope of supervision and audits, and goes directly to the heart of the existent bottlenecks in information sharing and transmission present in the legacy financial systems, although the Fed study omits this consideration.

“As an example, DLT arrangements could be designed to allow auditors or supervisors “read-only access” to certain parts of the common ledger. This could help service providers in a DLT arrangement and end users meet regulatory reporting requirements more efficiently. Developers contend that being given visibility to a unified, shared ledger could give supervisors confidence in knowing the origins of the asset and the history of transactions across participants. Having a connection as a node in the network, a supervisor would receive transaction data as soon as it is broadcast to the network, which could help streamline regulatory compliance procedures and reduce costs…”

Once again, the Fed research does not see beyond the immediate issues of auditing and supervision. In reality, “read-only” access or “targeted access” can facilitate much easier and less costly underwriting of risks and structuring of contracts, aiding financial inclusion.


Key takeaways

Overall, the Fed paper “has examined how DLT can be used in the area of payments, clearing and settlement and identifies both the opportunities and challenges facing its long-term implementation and adoption.” This clearly specifies a relatively narrow reach of the study that excludes more business-focused aspects of DLTs potential in facilitating product structuring, asset management, data analytics, product underwriting, contracts structuring and other functionalities of huge importance to the financial services.

Per Fed, “in the [narrower] context of payments, DLT has the potential to provide new ways to transfer and record the ownership of digital assets; immutably and securely store information; provide for identity management; and other evolving operations through peer-to-peer networking, access to a distributed but common ledger among participants, and cryptography. Potential use cases in payments, clearing, and settlement include cross-border payments and the post-trade clearing and settlement of securities. These use cases could address operational and financial frictions around existing services.”

As the study notes, “…the industry’s understanding and application of this technology is still in its infancy, and stakeholders are taking a variety of approaches toward its development.” Thus, “…a number of challenges to development and adoption remain, including in how issues around business cases, technological hurdles, legal considerations, and risk management considerations are addressed.” All of which shows two things:

• Firstly, the true potential of DLTs in transforming the financial services is currently impossible to map out due to both the early stages of technological development and the broad range of potential applications. The Fed research mostly focuses on the set of back office applications of DLT, without touching upon the front office applications, and without considering the potentially greater gains from integration of back and front office applications through DLT platforms; and
• Secondly, the key obstacles to the DLT deployment are the legacy services providers and systems - an issue that also worth exploring in more details.

In both, the former and the latter terms, it is heartening to see U.S. regulatory bodies shifting their supervisory and regulatory approaches toward greater openness toward DLT platforms, when contrasted against the legacy financial services platforms.


Mills, David, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, Timothy Brezinski, Linda Fahy, Kimberley Liao, Vanessa Kargenian, Max Ellithorpe, Wendy Ng, and Maria Baird (2016). “Distributed ledger technology in payments, clearing, and settlement,” Finance and Economics Discussion Series 2016-095. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.095. 

21/2/17: The Future of Finance

Last week I was speaking at a forum on Open Societies in Panama City. My speech covered the key threats and transformational changes in the global financial services. Here are my annotated slides:

24/1/16: Improving on a Poor Base: Dublin in Global Financial Centres Rankings

Based on the Global Financial Centres 2015 rankings, Dublin is currently occupying a rather poorly 46th place - an improvement on 52nd in 2014, but still in a league of relative minnows like Casablanca, Istanbul, Bangkok et al. 

It is worth noting that Dubai is in a respectable 16th place. Of course, one can occasionally hear Irish development agencies staff bragging about how Dubai was always keen on copying Irish IFSC experience… well, apparently they’ve copied it better than we built it. 

Dublin does a bit better when pitched against European counterparts, ranking 11th in Europe alongside other tax havens of Jersey, Guernsey, Gibraltar and Isle of Man. But Luxembourg - a place of similar standing to Ireland on tax and other issues is ranked six place ahead of us.

Sadly, we do not get into top 12 in any (repeat, any) of sub-indices, including the ones we claim such a strong position in: human capital and business environment. What’s up, dudes?! Ah, well, it turns out the world is a competitive place and having Prime Minister who chirps about ‘best little country…’ is just not enough.

So moar diesel… folks… that IFSC engine is purring out smoke… 

3/12/15: Heard of Number26, yet?..

An interesting 'break-in' into Irish banking market via Number26 which uses:

• Fintech platform; and
• German license

to break the Central Bank of Ireland-led freeze on new entrants into the banking market here.

Details are here: http://techcrunch.com/2015/12/02/number26-launches-its-bank-of-the-future-in-6-new-countries/. Surprisingly low margin operation based on fees from transactions, rather than on direct customer charges. Presumably, accounts are insured by German system and are free from the Irish Government indirect tax extraction schemes, such as card duties etc... One, of course, will have to be compliant on Irish DIRT.

Of course, Fintech offers plenty of disruption potential in the sector that is inhabited by technology dinosaurs. Still, for all its promise, Fintech is yet to:

1. Achieve a significant breakthrough into traditional banking and insurance services (beyond aggregators and price optimising platforms) and
2. Deliver a viable (financially) margins model.

These two points mean that to achieve scale, Fintech offers today need deep pockets and customer bases of more traditional services providers, as I describe during this discussion: http://trueeconomics.blogspot.ie/2015/10/161015-financegoogle-2015.html.

16/10/15: Finance@Google 2015

Few weeks back I was taking part in the Finance@Google 2015 conference covering a range of topics from the future trends in Financial Services to more current / shorter-term aspects of the markets for Financial Services (Banking, Insurance and Online Aggregators, amongst a range of other services).

Here are two videos of my presentations:

First: my presentation "Finance at the End of Old Norms" - link here.

Second: my interview "Excuse the Interruption: Financial Expert in the Spotlight" covering a wide range of questions relating to the evolution of Financial Services - link here.

8/915: Five Years of Dodd-Frank Act: Two Posts on Reforms Impact

Five years ago, on July 19, 2010, President Barak Obama signed the most far-reaching regulatory reform of the U.S. financial system since the end of the Great Depression – Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Act has three core pillars:

• enhanced protection of consumers;
• expanded regulatory reach over risk management (including the markets for derivatives), and
• the Too-Big-To-Fail (TBTF) safeguards.

Given its ambitious scope, the Act was designed to shape American response to the Global Financial Crisis, both in terms of addressing some of the underlying causes, and mitigating future systemic risks. Not surprisingly, the passage of the Act was lauded at the time as a historic moment

My first post, covering Consumer Protection and Derivatives regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act is available here.

My second post on Dodd-Frank Act, covering regulation of TBTF banking and financial institutions is available here.

5/9/15: Remittances, Foreign Aid & other Capital Flows

So globally, remittances by migrants are now worth more than double the total flows of foreign aid and more than portfolio flows (financialised investment). In fact, remittances are now second in importance to only FDI.

Source: Economist; H/T: @RonanLyons 

The latter fact is not surprising as remittances already were second largest source of capital inflows for developing countries at the start of the century and even before (see more on this here covering data until 2000). Interestingly, at variance with the above chart, evidence before 2000 suggests that remittances were negatively (though not statistically significantly) correlated with private capital flows. It appears this negative correlation has been substantially reversed in post-2000 period.

Another study looked at the effect of remittances in Sub-Saharan Africa - the world's poorest region overall, where foreign aid is a very important driver of 'official' development. The study (link here) found that "remittances, which are a stable, private transfer, have a direct poverty mitigating effect, and promote financial development. These findings hold even after factoring in the reverse causality between remittances, poverty and financial development." Globally, the same was established based on pre-2000 data (link here).

A 2009 paper ties remittances (positive effect on long-term growth in the receiving economy) to the degree of development of financial services in the economy (a factor that positively reinforces growth effects of remittances) - details of the study here. Which is sort of a good thing, as remittances themselves promote financial services development (see a study covering 1975-2003 period here).

Given Latin America's experience with emigration and brain drain, data on remittances effects in these countries is interesting in itself. More interesting, however, is the following study that looked at links between remittances, poverty reduction, education and health in recipient countries. "The main findings of the study are the following:

1. regardless of the counterfactual used remittances appear to lower poverty levels in most recipient countries; 
2. yet despite this general tendency, the estimated impacts tend to be modest; and 
3. there is significant country heterogeneity in the poverty reduction impact of remittances' flows.

...While remittances tend to have positive effects on education and health, this impact is often restricted to specific groups of the population."

In contrast to the above studies and many others that reference or identify positive growth effects of remittances, a 2009 IMF study found no positive links between remittances and growth (see link here). So, thankfully for us, economists, Economic Ambiguity prevails...

To make things a little better for the case of remittances v growth, another study (like IMF reliant on modern econometric techniques) looked at the causal links between remittances and growth in Latin American countries. The conclusion (see link to the study here) is that "remittances have a positive and significant effect on economic growth in both groups of countries. ...the impact of remittances is more pronounced in the presence of the financial development variable." The latter bit confirms evidence referenced earlier. 

IMF study is also (weakly) contrasted by the 2006 paper (link here) that found that controlling for endogeneity "...remittances exert a weakly positive impact on long-term macroeconomic growth."

One of the common criticisms of official foreign aid is that it fuels corruption and graft. Surprisingly, there is some evidence that remittances too achieve the same impact on key institutions in the recipient country. IMF study (see link here) found that "a higher ratio of remittances to GDP is associated with lower indices of control of corruption, government effectiveness, and rule of law."

In short, there is huge amount of interesting research on remittances... 

2/8/15: Five Years In: Judging Dodd-Frank Reforms

My blog post for @LearnSignal assessing the first 5 years of the Dodd-Frank Wall Street Reform and Consumer Protection Act: Part 1
http://blog.learnsignal.com/economics/five-years-after-the-dodd-frank-act-part-1-consumer-protection-and-derivatives-regulation

17/3/2014: That Ugly Rating for IFSC... Gets Uglier With Time...

It's dog-eats-dog ugly competition going on out there in the broader wider world of the global financial centres. Competition for talent, managers and investors confidence, regulatory efficiency, tax environment, compliance and supervisory quality etc etc etc...

In that competition, Ireland's (well, most Dublin's) IFSC used to be one of the top dogs... 2007-2009 we ranked in top 25, 2010-2012 in top 26-50... Just as Irish domestic banks went through bust to boom cycle (in share prices and capital, if not actual performance and health), the Government has spent extraordinary amount of resources promoting IFSC as being an unrelated entity to the comatose domestic banks.

The efforts, so far, are not exactly paying off. As the chart below clearly shows, our IFSC ranking in the Global Financial Centres Index continue to fall, and fall catastrophically:

As the main rankings table in the latest GFCI report clearly shows (http://www.longfinance.net/images/GFCI15_15March2014.pdf), our 'non-brass-plate' (remember the pivotal point of Government's argument in favour of our tax and regulatory regimes is that they create 'real' activity in IFSC, as opposed to just setting space for brass-plate operations) are now ranked behind such brass-plate domiciles as Cayman Islands (ranked 43rd), British Virgin islands (ranked 44th), Isle of Man (ranked 51st), Gibraltar (ranked 53rd), and so on...

Actually, Dublin is now lower ranked than 'Mighty' Almaty (Borat-the-banker anyone?). Or for that matter tiny Wellington (yep, New Zealand). The minuscule Malta now ranks 67th, just one tiny bitty place behind the 'Intergalactic Centre of Excellence' on Dublin's Liffey shores.

May be, just may be, our IFSC figure heads can figure out that their advanced age and heavy past careers emphasis on politics rather than finance might need to be augmented by younger blood and broader thinking? Or that Irish Government continued insistence on listening to the entrenched insiders might need to be diversified by attempting to hear new voices in global finance?

Here's the list of top 25 world-wide financial centres...

Note two regularities:

1. Of smaller, specialism-driven locations, Swiss are doing their best to stay at the top. Their strengths: human capital, tax system that favours high skills, open society and huge degree of international and internal (meritocratic) mobility. Our weakness: glass ceilings for foreigners, high taxes on skills, transitory human capital and more closed society focused on promoting insiders and taxing outsiders.
2. Of smaller (similar to Dublin) locations at the top, excluding the Swiss, we have indigenously-driven expertise of Vienna, and international-mobility focused Lux and Monaco which openly flaunt all rules about not being brass-plating havens. Their strengths: expertise built over centuries, reputation for regulatory and taxation stability, and extreme affinity for zero or near-zero taxation.

These two models, and may be some hybrids of others, can probably serve us well in regaining 20 or so places in the rankings. To rise further will require more than that.

Likelihood is, however: our arrogance will continue pushing Ireland down the well-trodden road of arguing for more corporate tax optimisation schemes and sending more shamrocks-in-the-bowl delegations of aged men in 'bankers ca 1956' suits to 'rescue' the golden goose of growth that is the IFSC... The steering committees will be meeting, the back doors to various Government departments will continue swing open for insiders, and 'Johnny the Foreigner' with skills and talents will remain a hostage of complex, immovable bureaucratic apparatus of visas, permits, restrictions and costs.

15/06/2011: Few points of the future of FS

This is the presentation I gave at the Roundtable (thanks to all 150+ academic & industry practitioners who came and engaged) on the Future of Financial Services at the Infinity 2011 Conference on International Finance. Slides and few points:
Since I was chairing the event, I had to limit severely my presentation and the core of the event was based on 3 presentations by industry experts and the discussion with the audience - less Q&A, more open discussion.
Consistent with my view, the global financial crisis continues to threaten macroeconomic stability of the global financial and economic systems.

• The core component of the crisis - the crisis across global financial markets has abated due to the efforts of the Central Banks and Governments around the world. But it has not gone away. The system overall remains fragile on the side of liquidity (with quantitative easing rounds now being scaled back and no liquidity traps remaining, holding liquidity already supplied in the system locked away from the process of real lending).
• The crisis continues largely unabated in the sub-geographies of advanced economies and in particular within the banking sector in Europe, Japan and to a much lesser extent - the US. In the US, where balancesheet repairs on the capital side took stronger forms, the crisis in now manifested on the demand side for lending as well as in continued stagnation in the core household asset markets (property in particular).
• The main focus of the crisis has shifted onto debt - with deleveraging of balance sheets being secondary to the need to continue deleveraging households - something that continues to evade the focus of the policymakers.
• A number of large economies are now also experiencing a full-blown or forthcoming sovereign debt crises.

Overall, the duration, the breadth and the depth of the current crisis are so profound that in my view they signal a structural nature of the crisis, leading to a permanent (or long run) shift in:

• Regulatory environments (tightening of regulatory and supervisory systems, higher demand for capital, higher demand for quality capital, etc) all of which, unfortunately, so far, represent no qualitative departure from the already failed model of regulation that led to the current crisis in the first place. In other words, there's 'more of the same' type of a response on the regulatory side that is emerging so far, which does not hold any real promise of change, but suggest dramatic increases in the cost of capital provision, especially via debt instruments.
• The process of re-banking advanced economies - yet to start - will be taking Europe, North America and other advanced economies to a New Normal which will require cardinal rebalancing of the markets for financial services provision. This, in my opinion, will see consolidation of global banking institutions and a decline in their combined market shares, and the emergence of highly competitive and innovative specialization-driven service providers. The latter will be drawing increasingly greater shares of the markets for FS globally and will be largely free from the legacy of the crisis. In this context, the legacy of the crisis that will remain with the sector is the legacy of massive destruction of wealth inflicted onto the clients by the minimal compliance (prudential or suitability tests-based standards) ethos of the pre-crisis investment and wealth management services providers. In their place, the new providers will be adopting (driven by market demand, not regulatory systems) a fiduciary principle-based services ethos, which will put client needs as the main driver of revenues for the sector. Up-selling complexity and risk is out as a business strategy for margins support. Client relationship-building and product-backed client support will emerge as the core replacement strategy.
  
• In terms of re-equilibrating demand and supply of credit, the problem of shrinking pool of savings (due to fiscal austerity-driven tax increases, and demographic aging in the West contrasted with consumption expansion in the New Advanced Economies - NAE) will have to alleviated through new instruments. Debt will remain constrained as long-term process of deleveraging unfolds, equity will be the king, but hybrid instruments (on corporate finance side, less so onr etail side) and some new instruments for investment will have to emerge.
  
• Lastly, the New Normal will be characterized by a drastic scaling back of real off-balancesheet public liabilities (pensions, health and social welfare nets). The age of reduced local (within advanced economies) savings, falling debt levels and tighter global supply of savings (consumption effects in the emerging and NAE economies) will result in reduced ability to finance sustained deficits. This will precipitate emergence of new financing mechanisms (more closely aligned pay and benefits) for public investment, further reducing private investment supply.

The New Normal is already emerging via the divergence of financial services environments across two geographies: the Advance Economies (the "North") and the NAE economies (the "South").
In addition to regulatory pressures of 'Do More of the Same' approach in the advanced economies, and on top of a persistent gap in growth between the advanced economies and NAEs regions, there are emerging gaps in Investment volumes heavily skewed in favor of NAEs, a margin gap and a capital gap (both in terms of quantity and quality of capital, with many NAE banking systems explicitly or implicitly underwritten by solvent and liquid SWFs).

This geographic bifurcation of the FS models will fully emerge, in my view, around 2015-2020 and by 2020-2025 we are likely to see the drive toward convergence of FS across two geographies:
This convergence will be driven, in addition to the above factors, by the rising pressure of competition with 'North' service providers pushing into NAEs to capture higher margins and new markets, and with 'South' service providers pushing aggressively into the advanced economies markets to capture know-how, exercise competitive advantage of relatively cheaper capital available in the 'South' and retaliate against 'North's' competitive drive into their own markets. The end result will be globally lower Returns to Equity (ROE) squeezed on both sides by higher capital requirements and compliance and risk management costs (E-up) and lower margins (R-down) due to lower availability of savings, regulatory costs increases outside capital costs alone and a long-term shift of demand away from high risk high margin products (the shift toward fiduciary standards). Overall risk (sigma) will abate, as global economy settles on a lower structural growth level, further reducing risk premia-driven margin and ability to upsell risk.

In this process of transition to the New Normal, it is, IMO, of interest to have expanded academic and practitioner debate and research relating to the following questions:

13/02/2011: What a Jeopardy champ can do in the world of finance

Here is my article along with Shanker Ramamurthy that was published last Thursday in the American Banker, discussing IBM's Watson super computer system's potential applications in the financial services industry - helping to advance industry thinking on how in the era of "big data" only advanced non-linear analytics can make sense of structured and unstructured data flows to transform it into valuable insights.

VIEWPOINT: New Computer, New Modeling Possibilities
By Shanker Ramamurthy and Constantin Gurdgiev
February 10 , 2011 - p8

Next Monday a new IBM computer system called Watson will battle two quiz-show champions in a game of Jeopardy! There is more at stake here than winning a game. The potential applications of this technology to transform the operations of industries such as health care, government and finance are enormous.

In the financial services industry, integrated risk management is an everyday struggle. Financial practitioners and supervisory and regulatory authorities must make split-second decisions using information coming from all sides: the Internet to corporate and call center channels.

The challenge is to efficiently process diverse data streams and pick out relevant data insights to apply to strategic business and regulatory decisions.

In the banking industry today, data "fuzziness" abounds. Uncertainty exists about the quality of data, assumptions and models that are being used to make judgments. This, of course, clouds the true picture of risk and biases our decision-making, often in econometrically undetectable ways.
Most banks today run risk models on a discrete and disaggregated basis while relying on often subjective assumptions. High-performance computing advances, represented by Watson's capabilities, can rectify this - by providing visibility into concentrations of risks and risk-related activities, as they happen. Simultaneously, it deploys nonlinear analytics in selecting both the statistically and operationally important scenarios.

The beauty of a nonlinear computer that "learns" is that it can analyze a complex set of implied possible scenarios and give answers to the broadest set of questions. This potentially can lead to the emergence of analytical systems that not only report on probabilistically likely events but also identify latent "Black Swan" events and even sense deeper levels of uncertainty.

For example, a legislative decision altering a specific set of financial strategies can have no impact on traditional linear models because the outcomes can be weighted by an extremely low assigned or assumed probability. But in a nonlinear world, such an outcome can still be testable as part of the selection list for reporting. More importantly, it can be made recognizable by the analytic system and, therefore, objectively reportable.

A system like Watson has the potential to get answers to incredibly difficult questions about strategic decisions, risks and market changes that can otherwise be elusive.

For example, it has the ability to create an interactive risk-pricing system using a menu of models that evolve as the system learns, detecting structural breaks in data before analysts can spot them and build them into existing programs.

Of even more significance, Watson will be able to deliver scenario analysis based not just on either event probability or expected loss/gain but also on more complex company objectives.

This can involve analyzing corporate strategy inputs, including non-quantifiable questions, alongside fully quantifiable inputs. Imagine asking a computer "How do I increase my loan book profit margin by 10%?" or "What actions can I take to strengthen my capital reserves, with minimum impact to my asset base?"

At a much deeper level, the nonlinear learning capabilities that Watson pioneers can lead to the creation of systems that are able not only to handle traditional risks and their interactions but also to evolve into systems capable of transforming deep uncertainty into explicit models. Though still some years away, this could mean an artificial intelligence able to sense Donald Rumsfeld's famous "unknown unknowns," converting them into specific models suitable for risk analysis and getting meaningful, actionable responses.

The real-time, decision-making capability that is so sought after in the financial industry will be a crucial, competitive differentiator.

As risk intensifies within interconnected global markets, the complexity and exploding volumes of data will only rise.

Shanker Ramamurthy is the general manager of banking and financial markets at IBM Corp. Dr Constantin Gurdgiev is the head of macroeconomics in the Center for Economic Analysis at the IBM Institute for Business Value.