Innovation or Diversion?

FinTech models that challenge the status quo

Innovation is a truly slippery subject. The problem is that hype must first overcome experience: without the benefit of hindsight it’s incredibly difficult to tell a genuinely innovative development from an interesting diversion.

Take eBay, for example. The idea of creating a global online auction house in which people could bid against each other to buy goods was one of the early successes of the internet age. But which aspects of this innovation proved really durable?

In July 1999, less than a year after the company went public, The Economist¹ wrote: “While eBay’s share price may be crazy, it would be wrong to dismiss the company as just another symptom of a mania. There is method in this madness. Online auctions may be one of the most valuable innovations wrought by the Internet.”

That was then. Sixteen years later, in August 2015, The Economist² carried another article on eBay that noted the steady long-term decline in the use of auctions on the site. By last year they accounted for just one in five US transactions: Fixed-Price and Best-Offer sales made up the overwhelming majority.

This in no way detracts from the innovative value of eBay’s online marketplace. It simply illustrates how difficult it can be to predict which aspects of a new product or service will lead to long-term change. The same ‘hindsight problem’ confronts anyone who wants to understand the potential of the technology-based services now spreading through the world of finance to disrupt traditional banking models, for example.

At this stage, we can still only guess at which aspects of FinTech are going to have a lasting impact. One thing that has already become clear from experience in the UK, however, is that auction-based marketplaces for finance are likely to go the same way as auctions on eBay.

Funding Circle, the largest marketplace lender to small businesses dropped reverse auctions from its UK site last September and replaced them with fixed-rate lending in graduated risk bands, citing a number of drawbacks with an auction process that lasted up to seven days.

Auctions may not turn out to be the game-changer, but there are other aspects of the FinTech entrants’ offerings that may well change the way long-established branches of the industry operate. Here are a few top-line thoughts on what they might be:

• Debt syndication: the online platforms that facilitate marketplace lending make it quick and easy for large groups of lenders to form and advance funding to a business or individual. This has some familiar benefits – for example the opportunity for balance-sheet lenders to accelerate their growth by syndicating portions of their completed loans to third-parties, taking a spread on the transaction and liberating capital for further lending.Online platforms such as LendInvest and SavingStream in the UK have successfully applied this model to the market for short-term property loans. This mirrors the effects of securitisation but extends it into areas where in its conventional form it is not practicable.The use of lending syndicates also opens the way for alternative forms of familiar products – for example the ability to discount single invoices as opposed to traditional whole-turnover factoring facilities. Factoring insist on discounting whole sales ledgers (and apply credit limits to large debtors) to diversify their own concentration risk.This enables them to lend safely, but results in an inflexible (and expensive) product that many borrowers do not like: they don’t necessarily want to discount every invoice but find they have to, if they want to discount any. If the concentration risk that threatens a factoring house – as a single counterparty that must accept the entire risk on its own balance sheet – can be dispersed instead across a syndicate of lenders, it becomes feasible to offer a receivables-based source of cash flow finance that meets the needs of borrowers who don’t want to commit to a whole-turnover facility.

• Closely related to this new variety of syndication is the emerging area of online equity book-building for private investors. SyndicateRoom, a UK equity crowdfunding platform, recently became a member of the London Stock Exchange, which allows it to offer its investor members the chance to participate in discounted institutional share placings that they would previously have struggled to access.The first such placing via the online platform has already closed. This broadens the range of opportunities that SyndicateRoom can offer its registered investors from start-ups through to main market IPOs and secondary offerings. If the opportunity to invest in discounted stock market placings proves popular with private investors, this is likely to pose a challenge over time to the traditional business of certain stockbrokers and may well result in mergers between brokerage houses and equity crowdfunding platforms.In both these first two instances, the true value of the founders’ innovation may well prove to be providing ready access for certain types of investor to asset classes they were previously unable to buy – new takes on the old business of intermediation.

• Transparency. Many of the leading marketplace lending platforms in the US and Europe argue that transparency is their “skin in the game”. In effect, they are suggesting that they do in fact take lending risk on to their balance sheet – not by advancing their own money but by staking their goodwill with each loan that they make.Making as much information as possible available to the market about their processes and lending record (many of the leaders make their entire historic loan book available to download) helps them to show they are aligned with their lenders’ interests, the argument goes. If their performance deteriorates, lenders will desert them and their business will fold. This is an appealing idea and one that might survive an encounter with the nasty section of a credit cycle.However, other aspects of these platforms’ approach to transparency may prove more significant in the long term, in particular the fact that they bring the same transparency to small business lending that already exists in debt markets for larger companies: everyone can see what everyone else is paying for their money. When all small business lending is conducted privately between the bank and the borrower, no one can be sure what others are paying. When loans are facilitated through a public online market, they can.

• Credit information and technology integration. Certain online lending platforms, such as Kabbage in the US, which originally specialised in short-term lending to eBay and Amazon merchants for stock purchases, have pioneered the use of additional data sources including eBay sales and seller ratings and FedEx shipping data to inform their evaluation of borrowers’ credit risk. Similarly, platforms in the US are also taking into account information derived from social media, such as Klout scores.These are just some of the more eye-catching examples of the way that near-real-time data drawn from multiple sources will increasingly play a part in credit underwriting. Potentially of wider significance will be developments such as integration with cloud-based accounting software packages, which is already happening. As well as the adoption of “data extraction” tools such as Validis, which is used in the UK by finance providers such as Bibby Financial Services, Liberis and Verus360 to provide near-real-time monitoring of borrowers’ financial health.Access to banks’ application programme interfaces (APIs) by third parties to enable credit underwriting of potential borrowers using their banking data is seen by many in the FinTech world as the holy-grail for tech-based finance providers

There are, of course, plenty of other areas of potential beyond the new online investment and lending intermediaries. New foreign exchange and payments providers are already establishing their challenge to the major incumbents and just over the horizon is the prospect that blockchain, the technology that creates the ‘distributed ledger’ underlying digital currencies such as Bitcoin, will in fact turn out to be a radical alternative to the current infrastructure for clearing and settling securities transactions.

For anyone interested in the thinking of central bankers on how they might introduce a digital currency based on blockchain technology, and the effects this could have on the financial system, a recent speech by Ben Broadbent, Deputy Governor for Monetary Policy of the Bank of England, is an excellent place to start.

The possibilities are huge and exciting. However, the big question that underlies all these tech-enabled innovations is not how elegant or radical the technology itself is, but how profoundly it is able to change people’s behaviour and their expectations. eBay gave the world an online auction house – but it turned out that all the world wanted was an online mall.

Disclosure: The author is a shareholder in Platform Black, a UK-based provider of online single-invoice finance, and in SyndicateRoom, a UK-based online equity crowdfunding platform.