No technology can completely eradicate fraud and human deceit, but I believe technology can make operations more transparent and systems more accountable.
To illustrate this point, let’s look back at the mortgage crisis of 2008. Here’s my take on why things got out of hand:
- Traditional banks make loans the old fashioned way: they take money from people at certain rates (savings deposits) and lend it out the community at a higher rate. The margin constitutes the bank’s profit. As the bank’s assets grow, so do their loans, enabling them to grow organically.
- Large investment banks bundle assets into securities that they can sell on open markets all over the world. Investors trust these securities because they are rated by third party agencies such as Moody’s and Standard & Poor’s. Buyers include pension funds, hedge funds, and many other retail investment instruments.
- The rating agencies are paid by investment banks to rate them. Unfortunately, they determine these ratings not so much by the merits of the securities themselves, but according to the stipulations of the banks. If a rating fails to meet the investment banks’ expectations, they can take their business to another rating agency.
- If a security does not perform as per the rating, the agency has no liability! How insane is that?
- Most surprisingly, investment banks can hedge against the performance of these securities (perhaps because they know that the rating is total BS?) through a complex process that I will not get into here.
Investment banks and giant insurance firms such as AIG were the major dominoes that nearly caused the whole financial system to topple in 2008. Today we face an entirely different lending industry, thanks to FinTech.
What is FinTech?
FinTech refers to a financial services company (not a technology company) that uses superior technology to bring newer and better financial products to consumers. Many of today’s FinTech companies call themselves technology companies or big data companies, but I respectfully disagree. To an outsider, a company is defined by its balance sheet and a FinTech company’s balance sheet will tell you that it makes money from the fees, interest, and service charges on their assets—not by selling or licensing technology.
FinTech is good news not only for the investors, borrowers and banks collectively but also for the financial services industry as a whole because it ensures greater transparency and accountability while removing risk from the entire system.
In the past four to five years a number of FinTech companies have gained notoriety for their impact on the industry. I firmly believe that this trend has just begun. FinTech companies are ushering in new digital business models such as auto-decisioning. These models are sweeping through thousands of usual and not-so-usual data sources for KYC, AML and Credit Scoring.
Whether or not these technological advances are revolutionary is open to debate. However, these FinTech companies are definitely creating their own niches. We have seen success stories in debt consolidation, student loans, commercial real estate, residential mortgages, small business loans, franchise loans . . . one new company even offers wedding loans! The by-product of this trend is a fragmented ecosystem of FinTech companies that are good at doing very specific things. Only time will tell whether any of these firms go on to become the next Goldman Sachs. But already a new market of innovative financial products has entered into mainstream finance. As their market share grows these FinTech companies will gradually “de-risk” the system by mitigating the impact of large, traditional, single points of failure.
And how will the future look? A small business might take its next business loan from Lending Club, OnDeck, Kabbage, or DealStruck, instead of a traditional bank. Rather than raising funds from a venture capital firm or other traditional investor, small businesses can now look to Kickstarter or CircleUp. Sales transactions can be processed with fewer headaches by Square or Stripe. You can invest your money at Betterment or Wealthfront and not have to pay advisors who have questionable track records outperforming the market. You can even replace money with bitcoin using Coinbase, Circle, or another digital-currency option. These are the by-products of the FinTech revolution. We are surrounded by a growing ecosystem of highly efficient FinTech companies that deliver next-generation financial products in a simple, hassle-free manner.
Admittedly, today’s emerging FinTech companies have not had to work through a credit cycle or contend with rising interest rates. But those FinTech companies that have technology in their DNA will learn to ‘pivot’ when the time comes and figure it all out. We have just seen the tip of this iceberg. Technically speaking, the FinTech companies aren’t bringing anything revolutionary to the table. Mostly it feels like ‘an efficiency gain’ play and a case of capitalizing on the regulatory arbitrage that non-banks enjoy. Some call themselves big data companies—but any major bank can look into its data center and make the same claim. Some say that they use 1,000 data points. Banks are doing that too, albeit manually and behind closed walls, just as they have done for centuries. FinTechs simplify financial processes, reduce administrative drag, and deliver better customer service. They bring new technology to an old and complacent industry.
Is there anything on the horizon that can truly revolutionize how this industry works? Answering this question brings us back to 2008 as we try to understand what really happened. I can’t help but wonder: what if there was a system that did not rely on Moody’s and S&P to rate the bonds, corporations, and securities. What if technology could provide this information in an accurate and transparent manner. What if Bitcoin principles were adopted widely in this industry? What if the underlying database protocol, Blockchain, could be used to track all financial transactions all over the globe to tell you the ‘real’ rating of a security.
Of course, I am oversimplifying! There is a long way to go but we are on the right path. Stay tuned for more.