Money Illustration
Illustration by Sebastien Thibault

Fintech at the Crossroads

Technology’s rapid disruption of incumbent financial systems has start-ups thinking big, and big banks thinking like start-ups. But will consumers ultimately come along for the ride?

When it comes to innovation, the finance industry usually moves along like the proverbial tortoise: slow and steady. But sophisticated computer algorithms have come along and strapped booster rockets to that plodding reptile, rocketing the industry into the twenty-first century at blinding speed. Recent studies of alternative finance around the world underscore the rapid growth. The Asia-Pacific online alternative finance market, including peer-to-peer lending and crowdfunding, grew 323 percent in 2015 to $102.8 billion, led by a fourfold increase in China to $101.7 billion, according to the study, “Harnessing Potential: The 2015 Asia-Pacific Alternative Finance Benchmarking Report.” Another study, “Moving Mainstream: The European Alternative Finance Benchmarking Report,” noted that the European alternative finance market grew 144 percent in 2014 to €2,957 million.

No one is watching this amazing transformation more closely than Robert Wardrop, ’96 (EXP-1), the executive director of the Cambridge Centre for Alternative Finance at the University of Cambridge. At Cambridge, Wardrop is focusing on European economies and collaborating with three other universities that contributed to the above studies of global alternative finance markets: Graduate School at Shenzhen, Tsinghua University and the University of Sydney Business School, both studying Asia; and Chicago Booth, studying the Western Hemisphere. “These new forms of alternative finance are growing quickly, and this growth is beginning to attract institutional investors. Alternative finance, at least in some European countries, is on the cusp of becoming mainstream,” Wardrop noted in the European report.

Indeed, alternative finance is at the heart of the recent surge in fintech—a term covering technological innovations in finance, especially the software algorithms that bring buyers and sellers together without introducing a middleman. Five or so years ago, the fintech industry’s challenge was to convince institutional and retail investors that fintech ventures were a legitimate asset class to back. Investors climbed on board—in a watershed moment in December 2014, San Francisco–based peer-to-peer lending company Lending Club notched an IPO that valued the company at $5.4 billion.

Today, the main impediment to the fintech boom has shifted from persuading investors to onboarding consumers. “The challenge to growth going forward is much more about convincing high-quality borrowers that they can trust this channel of financing,” Wardrop said. For all the gaudy numbers and talk of disruption, fintech has reached something of a crossroads.

From ATM to Robo-adviser

Technology’s ability to remove middlemen and change the way consumers interact with and manage their money goes back to the advent of ATMs in 1984. “ATMs were one of the first innovations facing the consumer directly rather than consumers having an intermediary,” said Mark Ernst, ’86, executive vice president and COO of financial services technology company Fiserv, based in Brookfield, Wisconsin.

 1997 brought e-bills, allowing consumers to view and pay bills online. Just over a decade later, mobile banking made it possible for people to take care of those transactions and payments from their smartphones. Online shopping and banking have conditioned consumers to expect easy, fast, and cheap transactions, paving the way for the explosion in innovative financial technology all around us.

Today, fintech has developed well beyond mobile banking, allowing the rise of nimble, nonbank entities that use sophisticated tools to connect borrowers and lenders at a fraction of the interest and fees charged by banks. 

“Banks have so much overhead. They have legacy computer systems that cost them hundreds of millions in maintenance alone,” said fintech entrepreneur Guillaume Piard, ’15. “A bunch of geeks can slam together a new technology that will be leaner, smarter, faster."

A bunch of geeks can slam together a new technology that will be leaner, smarter, faster.

Guillaume Piard

Here Come the Disruptors

For example, consider a liquidity gap in Asia, the manufacturing center of the world. Suppliers there often source US or European buyers but then have to wait 90 days for payment. “There are supply-chain breaks all over the place,” said Jerry Dimos, ’09, regional vice president at Fairway, Kansas-based C2FO, which helps connect suppliers to working capital. “The further away they are from the United States, the more fractured and inefficient the financial system. How do these guys even make any money at all? The answer is not many do.”

That’s where capital exchange markets like C2FO become valuable in helping businesses, particularly small- and medium-sized enterprises, stay afloat. “We are enabling the supplier to signal to the buyer that they are in need of cash,” Dimos said. 

Investors recognize that there’s a major consumer and business market that technology will disrupt, and they want to get involved. That’s good news for entrepreneurs in the space, who seek to reduce the friction between borrowers and lenders. Entrepreneurs such as Piard use their business experience and Booth education to put the “fin” in fintech.

Piard’s path from designing portfolio products at Lehman Brothers to founding a fintech start-up might just be a perfect snapshot of the industry’s transformation in progress. Once Lehman collapsed, Piard found himself moving in the direction of legal and regulatory work, crafting 70-page legal documents such as bilateral contracts and advisory materials, and advising banks. “The industry was getting tougher and tougher,” Piard said. “Banks were still trying to squeeze out as much revenue as possible. It just wasn’t fun anymore.”

New York–born, Chicago-reared Piard returned to the Windy City at 32 to earn his MBA at Chicago Booth. Trained as a physicist and interested in working in consulting or energy, he stumbled upon fintech a year into the program. His interest stemmed from a quest for personal finance advice that fit his budget. Unable to find any suitable existing options, he began designing and coding his own tools. When he discovered the fintech industry working to create solutions to the same money-management questions he was trying to solve, he realized the financial tools he was creating for himself could become entire companies. He started reading everything he could get his hands on about the industry. “When I discovered fintech, it was shocking,” he said. “It was an epiphany.”

Working with the Polsky Center for Entrepreneurship and Innovation, Piard developed the idea for his fintech start-up, Evest.fr, a robo-adviser in the spirit of investment services like New York–based Betterment and California-based Wealthfront. In the summer of 2015, Piard moved to Paris to launch the company, soon meeting and joining forces with quantitative analyst and web developer Hugo Bompard, who became Evest.fr’s cofounder and CTO. Still in its nascent stages, Evest.fr, which now has five employees, plans to double its staff over the summer, around the same time it publicly launches.

These days, Piard is busy in negotiations with a retail financial distribution partner in France. “Every morning I know I’m going to have a ton of problems. I wake up with no idea how I’m going to solve these problems, but I know I’m going to do it,” he said. “There’s a sense of urgency that has been evaporated when you speak with big corporate partners. It doesn’t make me want to go to the corporate space.” 

Banks Thinking Like Start-ups

It’s that sense of urgency that’s waking up banks to the fact that they must get involved in fintech themselves. The 2007–10 financial crisis crushed consumers’ Microchip Illustrationtrust in banks and led regulations that reined in banks. The 2010 Dodd-Frank Act increased compliance requirements in the United States and made it more costly for US banks to lend to certain groups. In the United Kingdom and European Union, the European Market Infrastructure Regulation (EMIR) created new risk management standards and greater reporting requirements for trade, and the Alternative Investment Fund Managers Directive (AIFMD) tightened regulations on investment fund managers. The European Union deployed the Capital Requirements Directive IV (CRD IV), a legislative package including tighter restrictions for banks and investment firms. Since the financial crisis, Fiserv’s Ernst said, “Consumer financial services are far less profitable to most banks than they used to be.”

Like fintech start-ups, banks are using technological innovations to reduce costs. For instance, the average in-person transaction at a bank branch costs $4.25 to complete, but that cost drops to $1.25 when the transaction is made at an ATM, and falls even further to just $0.10 per transaction when done through mobile banking, according to data from Javelin Strategy & Research.

Couple that cost effectiveness with shifting consumer expectations created by mobile technology advances across all other industries—the “Uber-ization” of consumer experiences—and the shift is inevitable. “The real emerging story is how expectations in mobile and real-time are driving consumer expectations,” Ernst said.

Banks shouldn’t think of themselves as financial institutions, but really data analytics companies.

Randall S. Kroszner

Big Banks and Entrepreneurs Come Together

That’s why banks have fired up the jetpacks and become more active in investing in such technologies. Three years ago, banks would have been circumspect about working with start-ups, said Dan Roberts, ’10, managing director and head of capital and liquidity management at Barclays. “These days we are much more open minded to working with smaller start-ups. It gives us access to some great ideas, and even if we don’t develop products with the people we are working with, we see a benefit in skills transfer.” 

Increasingly, big banks are developing or partnering with institutions to create their own fintech accelerator programs. At Barclays, for example, an accelerator program out of New York; London; Cape Town, South Africa; and Tel Aviv, Israel solicits ideas from start-ups working in machine learning, lending, digital banking, trading, cyber security, data analytics, payments, cryptocurrency, insurance, and wealth management.

In 2013, Citibank’s Citi Ventures launched its first fintech accelerator program in Tel Aviv, and in 2015, JPMorgan Chase partnered with the Center For Financial Services Innovation to create an accelerator program for fintech start-ups specifically focused on B2C mobile products for the bottom 60 percent of US consumers. 

“The banks are the most-interested investors,” said Dimos of C2FO, which received funding from Citibank for its working capital exchange market. “There’s a big push for small and medium-sized enterprise (SME) financing since the financial crisis,” he said. “Some solutions are taking the existing banking model and digitizing it.”

“Banks shouldn’t think of themselves as financial institutions, but really data analytics companies,” said Randall S. Kroszner, Norman R. Bobins Professor of Economics and former Federal Reserve governor. “Firms that have a lot of data about people are going to be entering finance, and banks better be prepared for that. Otherwise banks might not be around for very long.”

Kroszner noted that tech giants such as Google and Amazon have the infrastructure to one day collect data on purchasing habits and other activity that could help them determine whether a customer is a good credit risk, putting them another step closer to being financial institutions. 

From Near Collapse to Explosive Growth

In the twenty-first century, money in the United States began moving outside of deposit-taking institutions such as banks and into money market funds, hedge funds, finance companies, and other financial firms. The amount of assets held outside banks steadily grew until the Great Recession, in 2008, when money began getting moved back into banks. 

Now, however, that recent trend has reversed, with more money again moving outside of banks. According to data from the Financial Stability Board, assets outside of banks hit new highs in 2013: $25.2 trillion in the United States and $75.2 trillion globally.

As a result, since 2010, an estimated $50 billion in private equity and venture capital has gone into the fintech industry, according to Investopedia data, with nearly $14 billion in funding going to fintech start-ups in 2015, up from less than $3 billion in 2012. The question on the minds of many investors, innovators, regulators, and consumers is whether the bubble is apt to burst sooner or later. The answer is not so simple. The reality is that the traditional role of banks will need to shift. 

“Globally the big challenge in the payment space is that the banks still have a lock on the movement of money,” Wardrop said. “Until that layer gets decoupled from banks, there’s this huge incumbent legacy structure that leaves banks controlling the tolls.” That’s increasingly why fintech players such as C2FO are gaining traction, by giving not just big businesses but also SMEs much-needed access to capital in order to grow. “We are trying to solve a big problem with a simple solution,” Dimos said. “The technology is only a part of it. There’s a whole ecosystem that surrounds it.”

The Question of Trust

Just as the fintech industry appears poised to hit warp speed, caution flags are appearing. In early 2016, investors saw a surge in defaults among subprime consumer borrowers, the market fintech start-ups usually serve. Those jitters, coupled with the stock price performance of fintech darling Lending Club (at press time, trading for about one-third of its IPO price) are giving investors pause. Indeed, the United Kingdom’s Elevate Credit withdrew its IPO in January in light of market conditions for fintech firms. 

The conditions that led to fintech’s rise won’t be in place forever, said Robert Rosenberg, ’97 (XP-66), adjunct associate professor of entrepreneurship. “An era of historically low interest rates will come to an end someday, and this will have a major impact on many online business models,” said Rosenberg, who also is director of entrepreneurship programs at the Polsky Center for Entrepreneurship and Innovation, which—in partnership with Cambridge Judge Business School—is surveying alternative finance in the Americas.

Fintech will also face more regulations going forward. “Fintech has many fewer regulations because these enterprises are specifically not banks—they don’t take deposits, which absolves them of much overhead and reporting,” Rosenberg said. That’s changing: in May 2016, the Securities and Exchange Commission launched new investment crowdfunding rules.

 “You are playing with people’s money,” Wardrop said. “This notion of the trust of the general public is underestimated in fintech.” The breakneck pace of innovation in this sector has been disconcerting to consumers. “By a margin of two to one, the general population believes the pace of innovation is too rapid,” according to the 2016 Edelman Trust Barometer. Consumers’ fears of privacy and security breaches proved to be of greatest concern in both financial and online services, Edelman found.  “This skepticism is clearly manifested in the perception of specific industries, in particular the financial services sector, where there is a gap of more than 20 points between the elite’s trust in the sector and the general population’s.”

Meanwhile, consumer trust in banks, especially local banks and credit unions, is recovering. According to the latest Chicago Booth / Kellogg School Financial Trust Index, the American public’s trust in banks in December 2015 reached its highest level since the financial crisis. Trusting alternative finance could have huge benefits for consumers and enterprises, as technological advances streamline access to money for all. “The structural changes brought about by the digitization of the finance industry have the potential to flatten the provisioning of finance to both individuals and businesses around the world,” Wardrop said. Increasingly frictionless finance bodes well for fintech, especially as consumers gain confidence in alternative finance solutions. “Consumers need to be able to trust who they are dealing with,” Ernst said. “When you are dealing with people’s money, things get really emotional really fast.”

—By Jane Porter