Global fintech startups raised $8.3 billion in the second quarter, boosted by a record 25 mega-deals each topping more than $100 million, according to a report by CBInsights. Amias Gerety, a partner at QED Investors, an early stage venture capital firm that focuses on the financial services sector, recently spoke to Knowledge at Wharton to share his insights on fintech investments, the hype around the blockchain, the path for cryptocurrencies and why cybersecurity is the main risk facing the world today.
Before joining QED, Gerety was the acting assistant secretary for financial institutions at the Treasury Department under President Obama. He was also the deputy assistant secretary for the Financial Stability Oversight Council, which was established by the Dodd-Frank Act after the financial crisis.
An edited transcript of the conversation follows.
Knowledge at Wharton: Your firm focuses on investing in the financial services sector. What areas in particular are you most interested in and why?
Amias Gerety: As a firm, we’re pretty broad-based. Other firms might have a sole partner or maybe two partners focused on financial services. We have 12. Most of our investing is in the U.S., in the U.K., and in Latin America, particularly Brazil and Mexico. So we do have the ability to cover really broad portions of the fintech ecosystem.
One of the ways that we organize ourselves is that we try to be very hypothesis-driven. So there are different areas of expertise that we have. We’re obviously all constantly learning new things. And given that we start to develop hypotheses about areas that we’re most interested in, and as companies come in or as we reach out, we usually have a good sense of which of the partners at QED should be the one to chase this opportunity or to evaluate whether it’s the right opportunity for us to partner.
Personally, I spend a lot of time now focused on this idea of operational transformation, digital transformation inside of financial services, and where technology is going to make a difference. I also spend a lot of time looking at mortgage and alternative home equity — different things in the transformation and how people think about owning and renting property. Those are probably the two biggest areas, but we’re always looking opportunistically at exciting things that we haven’t thought of.
Knowledge at Wharton: What are some of the hottest fintech trends that you’re seeing?
Gerety: One of the really interesting things that we’re seeing in fintech is that it’s easier than ever to build a consumer-facing fintech company. And that has pretty interesting implications. One of the implications is that you’ve seen some really fast-growing consumer-oriented fintech companies that are generating really high valuations really fast, and the pressure on those from a competitive perspective is really high. That’s both exciting, but also a little scary, given how fast these companies are growing.
… The other thing that is really interesting as an implication of this is that there are a lot of infrastructure-oriented companies that are gaining a lot of value and becoming more interesting. People sometimes call it ‘the middleware for fintech.’ How do you interface between a new fintech that’s going to serve small businesses or consumers and the bank that needs to provide deposit or payment services? Things like that.
Knowledge at Wharton: So you’re seeing a lot of applications like, for example, blockchain in these startups?
Gerety: Honestly not. I would say that blockchain is in a classic hype cycle, where people got very excited that blockchain was going to solve everything — then [they get] very disappointed. … When I get pitched a blockchain company or a company that uses blockchain, I [listen for a bit] and then I say to them, “Why don’t you repeat your pitch without using the word ‘blockchain?’ Because the truth is, I’m not technical enough to know whether blockchain is the perfect data architecture for any given function.”
… When companies pitch me, I often get them to focus on what is the business problem you’re solving. If you can tell me that actually you believe — because you’re a technical expert — that blockchain is the best way to help you solve that business problem, I’m certainly not against looking at companies like that.
“I would say that blockchain is in a classic hype cycle.”
But I think oftentimes the architectural and technological choices overwhelm the focus on the business problem. That’s starting to sort itself out, and people are getting a lot more focused on those functional business models, which is, “What is the problem you’re solving, and how are you solving it?”
Knowledge at Wharton: In other words, you’re saying that blockchain is not necessarily the path for every single database-oriented company or startup.
Gerety: Well, it’s certainly not necessary. One thing that we know is that at the level of the computer science, a decentralized architecture with any consensus mechanism will be slower than a centralized architecture. That’s just if you have one entity making one step and one entity making 10 steps. The entity making 10 steps will be slower for just the basics of the database.
Now that doesn’t mean that there aren’t really large potential benefits — embedded cryptography being an embedded benefit, programmable database entries. Some of that is just about using more modern features. … Certainly there’s the embedded audit trail feature that a lot of people get excited about.
There are a lot of reasons to be excited about the blockchain applications, although I tend to isolate them from a functional perspective and say, “Embedded cryptography — that sounds great. Why does that add value in this business process?” Or “A smart contract — why does that add value?” Let’s focus on that, rather than on whether those two things are tied together into a blockchain.
Knowledge at Wharton: Do you think that it makes more sense for big companies to use the blockchain technology, maybe on a permissioned basis, rather than startups?
Gerety: It really depends. I do think that for financial services applications, it is much more likely that where it works, it will work on a permissioned, consortium-basis first. What’s the most successful blockchain project in history so far? It’s bitcoin. And bitcoin is a decentralized, permissionless, consumer-oriented financial services application. So in that sense [at least], that would certainly contradict my thesis that we’ll get really sustained value in permissioned, consortium-based [applications] before we get the other.
But ultimately, all of these blockchain-oriented businesses have at their heart an argument about networks. And when you have an argument about networks, at your heart you’re talking about a collective action problem. Now I think we both know that if you solve a collective action problem, you will create value. So then the question is how does any given user interface design, database architecture, or functional insight allow you to solve a collective action problem and get a large number of disparate groups to work together on a common purpose?
That’s a central problem in business history, and certainly many of the blockchain projects that we see are making an argument about why their particular solution will solve those collective action problems. But in my view, the real value comes from whether that collective action problem gets solved, not by any particular choice in the technology architecture.
Knowledge at Wharton: How do you feel about cryptocurrencies, now that you mentioned bitcoin?
Gerety: I’m pretty bearish on cryptocurrencies. One of the questions that I often ask people is, ‘when was the last time that you transacted in yen?’ Because I can tell you right now that if I had a hundred million dollars in yen, I could liquidate it into dollars tomorrow and not move the market. But that still doesn’t give me any particular incentive, even as a frequent business traveler, to transact in yen. And by the way, many of the businesses that I interact with would be glad to transact in yen.
So the idea that we need another currency, over and above the currency that we have, I think is still a little bit unproven. Most of the time that you see people getting excited about bitcoin, it’s either for speculative purposes, or there’s something going on in their life — perhaps it’s international drug trafficking – or perhaps it’s simply distrust in their home country government that means that they fundamentally distrust the international system of finance or the local system of finance to which they have access. I think those are the major tailwinds behind bitcoin’s rise.
“I’m pretty bearish on cryptocurrencies.”
While I have real sympathy for the people of Venezuela where cryptocurrencies can protect against runaway inflation combined with complete breakdown in trust between their government and the Venezuelan people, for example, it’s still true that that’s a very difficult thing for a venture capital firm to invest in. Every financial transaction that goes into and out of Venezuela is going to be subject to a very complicated legal regime, including U.S. and international sanctions and local government efforts to impose capital controls – not to mention litigation in courts as different parties fight for control of that country, and as sanctions and other regimes take place.
As a firm that takes compliance with existing laws very seriously, it’s hard for us to be super-long on the question of cryptocurrencies. I will say that personally I am flat bitcoin. I own none, but I’m theoretically short. I don’t think that the value that we’ve seen there is going to be sustainable. I think there will be cryptocurrencies that are truly anonymous that will become more valuable than bitcoin over time for the very purposes that have driven bitcoin’s value so far. But it’s very early. It’s very hard to tell how those things will work out. And as an investment firm, we find that it’s not really worth our time to chase those ideas.
Knowledge at Wharton: Putting on your regulator hat for a second, do you think that cryptocurrencies are a destabilizing force in the financial system, or do you think that while it’s imperfect, it is the future of money?
Gerety: I really don’t think it’s the future of money. I don’t think that insights around database architecture change the fact that money is fundamentally a project of states, and it’s a project of governments. So the ultimate thing that happens, the ultimate thing that gives a dollar value is the fact that if you conduct economic activity inside of the United States, you incur tax liability in the United States. And those tax liabilities are denominated in dollars. And failure to pay those tax liabilities will land an actual, physical human being in an actual, physical jail.
There’s nothing digital or made up about that value chain. It’s a little bit attenuated, but that is the underlying power of the dollar, and the fact is that there’s a ton of economic activity in the United States, and the economic activity of the United States is fundamentally governed by U.S. law. That’s how money works and has worked in history.
Now, it’s possible — certainly there are many people betting on this — that other power arrangements could facilitate money. But in the history of the world as we know it, monetary arrangements are features of state power, not primarily features of commercial power. And so that’s why I don’t think it’s the future of money. I don’t think that bitcoin or anything else is likely to sever that.
So that’s on the one hand. I think that there are still lots of interesting things that can happen. There will be lots of people who will experiment, and I think that there’s lots of room to run. But in terms of what we think of as money, people often forget the link to state power, and state power is really important.
Knowledge at Wharton: What qualities do you look for in startups to invest in?
Gerety: There’s an adage in venture which is, ‘Team and TAM [Total Addressable Market]. A great team with a big market.’ I would say that at QED we tend to be a little bit more hypothesis-driven. We tend to start from the idea that the future is here, it’s just not evenly distributed. So we can already know today what some of the big trends are that are going to play out over the next three to five years. And we try to think … what are the types of companies that are likely to succeed in that world? And then try and back great teams that are pursuing that vision.
My partner Matt Burton when he’s coaching founders often [tells them], ‘You can’t convince anyone of anything.’ What you’re doing when you’re looking for funding as a founder is trying to find a partner who basically already agrees with you, who already shares the vision that you have. Sometimes that person hasn’t articulated it in their head yet, and so you can help crystallize a set of thoughts that makes sense to them. But the idea that you have to persuade someone to give you money, rather than find someone who’s going to be a great partner, I think often gets founders into the wrong pattern.
Knowledge at Wharton: I’ve heard you say at a conference that you try to look for problems that need solving, and sometimes there isn’t a company addressing those problems. And so you sometimes approach people and ask them to start a business. Are you still doing that? And how successful have you been?
Gerety: We’ve done that a bunch, and it’s an interesting challenge, in fact. … Maybe the best recent example of this is just over a year ago, we started a company called Wagestream in the U.K. We saw in the U.S. a number of companies that were starting to give people advances on earned wages. And this is just a transformative benefit relative to payday lending.
“The real value comes from whether that collective action problem gets solved.”
Payday lending has the idea that because you receive a regular wage, I can give you a loan today. The payroll advance idea is the wages I’m going to advance to you are already legally yours. So this is not a credit relationship between the company and the consumer. This is a credit relationship fundamentally between the lender and the employer. So the credit risk associated with that is dramatically lower, which means the price is dramatically lower. It’s a powerful model that’s starting to emerge, and there are a number of fast-growing companies focused on this in the United States as well.
Knowledge at Wharton: Last fall, you said at the American Enterprise Institute conference that software is eating the world and that the most important financial stability risk we face is cybersecurity. You further said that we are not sociologically prepared for the severity of cybersecurity risks we face if we had the cybersecurity equivalent of 2008. Can you explain what you meant and do you still believe this is the case today?
Gerety: Yes, I really do. The thing to highlight is the idea that we are not really prepared for the potential there. So most people, when they think about cybersecurity in their daily lives, think of things like data breaches. But data breaches are actually not particularly material in terms of what could happen. Partly this is because we have a financial system that in the main has pretty good insurance against the average data breach. So if your credit card information is stolen, most consumers will find that they will get a new credit card and that any fraudulent purchases that have been made in their name do not inure to their disbenefit. So they are protected from that kind of fraudulent purchase.
Now there are, of course, real problems associated with identity theft, and depending on the severity of any particular identity theft case, you can have really disruptive elements in your life. But if you compare that to a data integrity attack where we literally don’t even know who owes what to whom, that is just very, very different in terms of the systems, protections, and the preparation that we have as a society [to handle it]. So this is really scary. It’s a tremendous financial stability risk, and it’s something that I know people in all the regulatory bodies are very focused on. But it’s also not clear what the right answer is.
There’s a lot of effort on information-sharing [among entities concerned with cybersecurity.] There’s a lot of effort on cross-industry cooperation. There’s a lot of effort on trying to game out what could happen. Industry has been very cooperative. There’s also a lot of effort put into making sure that both small entities and large entities are engaged.
[Step back for a second and consider the U.S. regulators’] response to the financial crisis. We put a lot of policies in place to respond to that. I think we’ve made the financial system much stronger than it was, but there was an overriding idea at work. The overriding idea was capital — that if you really have financial reserves against the risks that you take, you will be better off. There are other things, too, but that was the overriding idea.
With cyber, we don’t have as strong a grasp on what that overriding idea might be that could actually prevent a real catastrophic cyber incident. That’s why I think everyone should be worried about it, and unfortunately I’m not in a position to solve that problem. But it’s an important thing to keep on people’s minds.
Knowledge at Wharton: What do you think about fintech companies applying for the national bank charter from the OCC?
Gerety: It really remains to be seen what’s going to happen here. One thing [I tell companies] is if you are going to become a bank, you might as well become a bank. The OCC fintech charter is an effort to create something that’s not quite fish or fowl. So it would be a national lending license. It’s unclear what it would mean from a payment systems perspective. Obviously, there’s a big debate about how we should treat industrial loan companies.
I tend to think there’s a line between banking and commerce that is worth policing. But the best way to see innovation in banking, if an innovative company wants to be a bank, is that they should really embrace the idea that they want to be a bank. And that means taking deposits and making loans, or taking deposits and providing other financial services.
“Data breaches are actually not particularly material in terms of what could happen.”
There’s a set of regulations that come along with that, and a set of standards too. But I think that’s the right way to do it — walk through the front door, rather than try and come along the back. Now I think there will be others who see value in the fintech charter that the OCC is trying to put together. It’s too early to tell what the outcome will be there, partly because there’s still litigation, and partly because we just haven’t seen anyone publicly apply or be granted one. So we don’t really know the shape of what that fintech charter looks like.
But we have a long history of banking regulation. There are some pretty special things about being a bank in the U.S. system, and I think that companies that want to have access to those special rights and privileges — it’s worth at least knocking on the front door and inquiring whether that’s right for you or your company.
Knowledge at Wharton: How about partnerships, because we’ve seen a lot of those go on between fintech companies and incumbent banks, especially community banks.
Gerety: Yes, I think that there is a lot of room for value in partnerships. We often joke that the end point for any fintech is to become a bank, be bought by a bank, or find a sustainable business partnering with banks. And certainly that third category, [is where] we’ve seen more activity than either of the first two categories. So we think there’s a lot of room.
Banks have tremendous advantages in terms of cost of funding, and tremendous advantages in terms of risk and compliance controls. And there is a lot to be gained [in partnering with fintech startups to improve the] user experience, nimbleness, and ability to design products that are new and really fit the lives of consumers or small businesses. There’s a lot of value to be gained from putting those two [strengths] together, and partnerships can be a really valuable way to do that.
Knowledge at Wharton: What do you think are things that the fintech firms are not getting about regulations? And what are regulators not getting about fintech?
Gerety: Many fintechs forget that actually doing things the right way, building systems that are built to do things the right way, should be a source of sustainable competitive advantage for them. They could actually embrace that more. So that is what fintechs need to keep in mind when they think about regulation.
[As for] regulators, … don’t focus on what the most advanced academics are doing. Focus instead of where is it actually hitting industry, where is it actually making a difference? If regulators can take that perspective, it will both narrow the universe for what they have to track, and it will mean they are keeping track of the things at the frontier of what’s really being implemented. … That’s a perspective regulators can take advantage of — focus on what’s happening today, what’s happening tomorrow and next year, and not what might happen in 10 years.