New technologies are disrupting the financial services industry, like they have in many other markets, whether Wall Street is ready for them or not. From peer-to-peer lending and robo-advisors to bitcoin and crowdfunding, financial technology or fintech is smashing old business models on its way to crowning new rulers in the world of money. And there is no turning back.
“Fintech is not only the future, but it is here,” said Amy Gutmann, president of the University of Pennsylvania at the April 3 launch of the Stevens Center for Innovation in Finance at Wharton. The business school is planting an official stake in the ground by establishing a center dedicated solely to fintech. “We have an incredible history and heritage in finance, but I think the best way for us to honor the history of the school is to leverage it for the future,” added Wharton Dean Geoffrey Garrett, at the event. (Garrett also wrote a LinkedIn post about the event.)
It’s helpful to think about fintech companies as fitting into any of three main business verticals — lending, asset and wealth management, and payments, according to David Klein, CEO and co-founder of CommonBond, which he said allows his firm to provide lower cost student loans. Layer on top three technology horizontals — front-end, middle ware and back-end — and pretty much any fintech company will fall into this grid, he said during a panel discussion among fintech disruptors and regulators at the launch event.
CommonBond fits into the lending space. Klein’s own experience with hefty student loans led him to found a company that he said offers lower interest rates and improved customer service. The firm, he added, can offer a better deal by underwriting the loan risk, which the federal government does not do. It also has lower operating costs by not having any physical stores, unlike banks. “We don’t have bricks-and-mortar locations and we underwrite so that has allowed us to lower the rate of interest for students going to school or refinancing,” he said.
Like Klein’s company, Square Capital is focused on meeting the unfilled needs of the end user. There are 30 million small businesses in America and 24 million of them are sole proprietorships — think of the food truck, shoe repair shop, nail salon or beauty parlor — according to Jackie Reses, head of Square Capital. If they want to expand, many of these small businesses face big hurdles in getting loans from a major bank, which typically ask for volumes of paperwork and guarantees. “It has become a total crimp in U.S. economic growth,” she said.
Access to financing is the lifeblood of any business, which uses funds for things such as working capital, inventory purchases and emergencies. If a flood closes down a shop for a few days, the impact could be severe. “Most businesses have only 17 days of working capital in their bank accounts,” Reses said. “Any unusual occurrence that happens could really put an end to a business.” At Square, 70% of its sellers can’t get capital anywhere else.
“Most businesses have only 17 days of working capital in their bank accounts. Any unusual occurrence that happens could really put an end to a business.”–Jackie Reses
“The mission of Square and Square Capital is to bring small businesses into the financial ecosystem,” Reses continued. Since the introduction of its first product, the Square Reader, a white dongle that plugs into a smartphone to let anyone accept credit cards, Square has expanded into a broad suite of products. “Our whole ecosystem is built around the idea of listening to the pain points and issues that we hear … and building tools that help small businesses,” she said. As such, “we really changed the risk paradigm of who is allowed into the financial system.”
The small entrepreneurs’ needs guide the strategies of Square Capital. “We start with the framework of what job we’re doing and what’s the help wanted,” Reses said. “I don’t sell loans. I help small businesses solve their cash-flow problems.” If Square just focused on matching what competitors were doing, it would end up offering a ‘me too’ product. Such a way of doing business is “very backwards-looking, not forward-looking,” she added.
Two Phases of Cryptocurrencies
There’s another thing that seems backward to the folks at Square: the idea of a currency issued by a country. Founder Jack Dorsey thinks such a system feels “antiquated,” Reses said. “In a multi-country world that we live in, there’s no reason why a nation-state should actually control the movement of that capital going forward.” One way to wrest control of money from a central authority like a government is to switch from using fiat, or hard, currency to cryptocurrencies. Square’s Cash app already makes it easy for users to buy cryptocurrencies — with a simple swipe.
Cryptocurrencies have the power to change the lives of people in countries with substandard, inadequate or corrupt financial systems. “What we’ve seen in the last 10 years is the birth and growth of an open source monetary system that allows those people to opt out for the first time,” said Robby Gutmann, CEO of New York Digital Investment Group, a digital asset management firm. For example, cryptos could preserve the income of a taxi driver in Venezuela who has seen the bolivar sharply devalued.
Robby Gutmann said the crypto world falls into two buckets. The first pertains to the use of cryptos, which he said is expanding albeit slowly. The second relates to investments in cryptos. Over time, he believes, the two will converge. He also identified two phases for the cryptocurrency. It is currently in phase one where it functions as a “bridge asset,” he added. Cryptos can’t be used directly to buy most goods and services; they still need to be converted into hard currency and vice versa. Phase two comes when local currencies are replaced by cryptos, he said.
Gutmann said it is hard for him to imagine the developed world mass-adopting cryptocurrencies. The existing financial systems work well for most people and so there’s less motivation to change. Any change also needs the participation of banks and institutional investors. But for developing nations, cryptos could solve some tough problems and thus be more quickly adopted.
“What we’ve seen in the last 10 years is the birth and growth of an open source monetary system that allows those people to opt out for the first time.”–Robby Gutmann
Regulators Are Moving
Regulators are taking notice. The Securities and Exchange Commission, for one, is becoming more proactive instead of reactive, said Elad Roisman, a newly appointed commissioner. The SEC sees lots of interest in cryptos. “We have this burgeoning asset class, incredible interest by a whole new generation of investors, [which is something] I’ve never seen before,” he said. “Our job is to help facilitate [growth], but at the same time ensure that investors have enough information to make informed decisions and if there are bad actors, we’re finding them.”
Instead of waiting for new laws to be minted that apply to these new technologies, the SEC gets guidance from history. “We have found a way to find decades-old laws and Supreme Court cases and apply them to new technologies and new assets,” Roisman said. For example, to determine whether a crypto is a token or a security, it looked at the Supreme Court case SEC v. Howey in the 1940s. The ruling in the case defined a security: It is an investment of money in a common enterprise with a reasonable expectation of profits based on the efforts of others.
Roisman said the SEC has also offered guidance through periodic reports. For example, he pointed to a 2017 report that classified tokens offered by “The DAO” as securities and thus must comply with federal securities laws. The SEC also set up groups like FinHub where regulators, innovators, developers and entrepreneurs congregate to learn from each other. “We have continually brought in people with … financial and technology backgrounds to inform our policy-making decisions.”
But Klein said there’s still a big regulatory gap that makes it hard for startups to scale like the incumbents. For example, CommonBond can’t compete with big banks when it comes to access to capital. Banks have a source of cheap capital in the form of customer deposits — it pays very little interest to the bank customer and turns around and lends the money out at a higher interest rate. Companies like CommonBond cannot get capital this cheap to lend out. It has to offer higher rates to savers to lure them away from banks, which enjoy their trust because they’ve passed stringent government requirements.
“We have this burgeoning asset class, incredible interest by a whole new generation of investors, [which is something] I’ve never seen before.”–Elad Roisman
“In our space, if you’re a very big bank — who has what I believe to be a pseudo-government sponsored monopoly on capital — then you get access to big capital at a low cost consistently over time in a way that nobody else does,” Klein said. “So when innovative players who are smaller and truly thinking about the customer first, what’s their access to capital? What’s the cost of capital and how sustainable is that over time?”
Klein said this dilemma leads to a bigger question: “Are we going to have an intermediary regulatory frame that allows smaller innovators to make the jump, or bridge, to true long-term scale?” Right now, on one side are smaller players operating in a “hodge-podge of state-based regulatory noodle soup” and the other side are banks that meet a “very high bar” of capital and liquidity ratios and other compliance measures, he said. There’s nothing in between. “I would propose having an intermediary solution that allows innovators to bridge to scale.”
But until the regulatory framework gets there, the best scenario is for startups and incumbents to work together since they each want what the other has. “Unless and until we get to that point, I believe there is an opportunity for incumbents to take the best of both worlds, partner in some capacity [with disruptors], and make finance better for the end consumer,” Klein said.