CTO Corner is BITS’s monthly publication covering emerging trends and technologies in the financial services industry.
CTO Corner: FinTech: The Democratization of Financial Services
Dan Schutzer, Senior Technology Consultant, BITS
The financial sector is no stranger to change and disruption, but the explosion of financial services technology (FinTech)2 start-ups is growing and accelerating change at an exponential pace. According to a recent article posted by The Economist , FinTech startup revenues are worth an estimated $4.7 trillion. This CTO Corner discusses this trend toward the perceived democratization of financial services and its implications on the business, security, privacy and regulation of financial services.
• Availability of funding for new ventures;
• Unrest with incumbents and the tightening of credit;
• Digitalization of everything
• Changes in technology, devices, and generational approaches to accessing information
Categories of FinTech Innovation
Although concerns are evident regarding privacy, impending regulation and an inherent resistance to change, innovation abounds in:
• Peer-to-Peer value exchanges enable easier access to capital and liquidity with a reduced role for financial intermediaries
• Data driven intelligence drives improved understanding of consumer demographics and markets, and more efficient and personalized market offerings
• Smart (machine learning) applications enable consumers ability to self-serve
Take-away – Incumbent financial firms need to actively engage with new technologies and FinTech startups to ensure competitive positioning despite security, privacy and regulatory uncertainty.
The financial sector is no stranger to change and disruption (from bartering to coins and paper money, to stocks and mutual funds) but the explosion of financial services technology (FinTech) start-ups is accelerating change at an exponential pace. In the past, changes took place over decades. Now, many occur in a single year or even shorter timeframes. This CTO Corner discusses the resulting accelerated perceived democratization of financial services, which is causing a Cambrian explosion3 of new access and forms of financial products and services, and its implications on the business, security, privacy, and regulation of financial services.
The global acceleration4 of financial service innovation is being driven by a number of factors including:
• Availability of funding – Since 2008 investment in the FinTech sector has tripled and is expected to reach $8 billion by 2018.5
• Unrest with incumbents – Unrest with incumbent financial service firms grew out of the 2007 financial crisis and is slowly recovering on an individual firm basis.6
• Perceived failure to fully address changing needs and changes in technology, devices, and generational approaches to accessing information
o There is a perceived failure to fully address the financial needs and changing attitudes of the millennial generation.7
o The unbanked and under-banked represent a large and growing percentage (over 27%) of the population.8
• The digitalization of everything – The rapid growth of mobile and the digitalization of everything makes possible new forms of communication and interaction previously impractical to implement and/or impossible to cost justify.
The FinTech Revolution
The list of ideas and new products and services coming out of the FinTech revolution is likely to continue to grow as long there is ready availability of funding and successes in the marketplace. Categories of FinTech innovations
These democratic innovations can be placed into one or more of the following four categories:
1. Peer-to-peer value exchanges – These applications have been accelerated by the growth and increasing popularity of social networks (e.g. payments such as Bitcoin9 and Venmo10, lending such as Lending Club,11 Crowdfunding,12 and other exchanges of value and sharing of resources governed by smart contracts13);
2. Applications endowed with machine intelligence – Applications capable of learning and adapting, (such as RIAs14) are driving the automation of all forms of financial services and the growth of a do-it-yourself (DIY) culture;
3. Data-driven services – The explosion of data and advanced analytics for using this data, are leading to individualized tailoring and competitive pricing of financial services (e.g., telematics for car insurance15); and.
4. Blurring of physical and virtual – The promise of networked “intelligent” devices (Internet of Things) is revolutionizing how people live and work, and how financial services might be delivered, increasingly embedded into other products and services (such as smart refrigerators16, and drone delivery17).
• Crypto currencies (e.g. Bitcoin18 ) and Blockchain applications (e.g. Ripple19 )
• Mobile person-to-person money transfer services (such Transferwise, Xoom, WeSwap, PeerTransfer, SendMoney.ph, Worldremit, Remitly, HiFX)20
• Peer-to-peer investment and lending (Upstart,21 lendingtree.com, fundingcircle.com, realtymogul.com, realtyshares.com)22
• E-Auctions enabling a more global return to bartering23
• Automated (robo) investment advice24 – Expert investment advice once available only to high net worth individuals and organizations are now available through the use of robot investment advisors (RIA) to anyone (Betterment, Wealthfront).
• Crowd funding – Raising money without financial intermediaries (Kickstarter, Indiegodo, and Crowdfunder)25,
• Social network-embedded financial applications (e.g. Venmo’s splitting expenses and bills),26
Concerns and Issues
A number of concerns and barriers to the adoption of new FinTech products, services and technologies are contributing to the uncertainty of the times and the likely outcomes of these innovations.
Security and privacy issues – If growing security and privacy concerns are not addressed, they can lead to disillusionment and rejection of new products and services. Financial services companies should take heed from some of the broader backlash to established technology leaders (e.g. U.S. no longer safe harbor for European data27).
• Robo investment advisors and smart networked consumer appliances can be sabotaged or compromised to give false or misleading data and advice. This could create large market impacts and significant financial damages.
• Emerging peer-to-peer value exchanges could turn out to be more vulnerable and insecure than existing financial transaction services (e.g. Mt. Gox28), and the use of public blockchain ledgers could lead to exposure of sensitive personal spending data.
• Increasingly detailed data about our personal lives can be shared with others, leading to annoying sales pitches, embarrassing disclosures, and even loss of personal integrity, reputation, job loss, poor health, and many other negative consequences of material personal damage.
• These issues become even more complex and difficult to address as we increase the rate which new consumer devices and applications are introduced into the marketplace. The speed-to-market pressure decreases the time devoted to testing, and the increased level of automation and transaction speed increases the impact and difficulty of recovering when things go wrong.29
Regulatory uncertainty – The imposition of new forms of regulation and oversight can affect the outcome.
• Currently different segments of the financial services industry (banking, securities, insurance) fall under different regulatory bodies.
o Financial service firms are subjected to differing international regulations and laws.
o This lack of harmonization leads to increased cost and conflicting guidance.
• Governments are pre-disposed to exercise less oversight of start-ups, allowing them room to grow and get established, especially for the more democratizing offerings.
• If these new alternative financial service products, especially those that integrate across various existing segments, suffer highly publicized data breaches, fraud, and other criminal activities, the result could be a sudden rush of crippling regulations that stifle their growth and profitability.
Natural resistance to change – People have a built-in resistance to change that will need to be addressed and overcome in order to gain acceptance for new better methods.30
• Early adopters traditionally represent less than 16% of the population as a whole.31
• Overcoming resistance to change and reaching a critical mass is especially important for services and products whose value grows with increased adoption (network effect32).
• For some applications, there is the additional need to generate simultaneous demand from multiple stakeholders. For example, payment innovations need to generate demand from issuers, merchants, and users, with each influenced by the others.
• Established firms can find it difficult to adopt new forms of financial services for a number of reasons, including channel conflict (the desire to protect the revenue from existing products and services), and the costly and lengthy process of retooling the current legacy core infrastructure to support these new services.33
Incumbent Financial Service firms responses
The financial services sector has a long history of innovation and disruption to the status quo, so our sector is well aware that this period of change and uncertainty can be pivotal, and those who respond and adapt will emerge stronger. Although there are many barriers and uncertainty regarding the success of FinTech startups, incumbent financial firms cannot merely sit on the sidelines waiting until these start-ups succeed in gaining acceptance and market share.
Some responses incumbent financial service firms are taking or considering taking include:
• Build and nurture innovation labs – This would enable incumbents to gain familiarity with and build the technical and business foundation that can provide them a head start in offering similar products and services.34 This can include partnering with FinTech start-ups.
• Fund startups through innovation funds – Though a few banks have begun to invest in FinTech startups (such as Stripe and Klarna),35 this is the exception rather than the rule. Investing and partnering is important to better understand the strengths, weaknesses, needs, services, and business value coming out of the start-up population, and getting a share of those who reach unicorn36 status (companies worth a billion dollars or more).
• Participate in Peer-to-Peer Clearinghouses – Clearinghouses can interface and interoperate with more traditional financial services. Just as banks set up clearinghouses and ATM networks in the past for the mutual benefit of the industry, they should consider new collaborations that could help retain their position of leadership in today’s fast-evolving financial services environment.37
• Leverage the best of Brownfield and Greenfield – Both Brownfield (built on top of existing legacy platforms and businesses) and Greenfield (start from scratch) has its advantages and disadvantages.38 . Greenfield creates more internal conflict and lacks full integration with established businesses, but is not saddled down with having to build new functionality on top of the existing legacy platforms, whereas Brownfield takes maximum advantage of existing market share. Finding ways to leverage the benefits of both would be optimum.
• Support open finance39 – Creating standard interfaces could make it easy and relatively inexpensive to embed existing financial services and products into any application increasing the likelihood that existing financial products and services will be included and embedded into new FinTech start-up services.
• Build a culture that breeds trust – Making pricing more transparent, providing a better explanation of the attendant risks associated with using any financial product or service, and improving security and privacy protection can increase the level of trust and gain marketplace acceptance.
• Learn to think like a disruptive FinTech – Build a vision based upon the premise that the consumer can get everything for free elsewhere. Assume that margins on loans will shrink. Expect that customers will rarely deal face-to-face, primarily interacting through screens. Anticipate creating value through ancillary services to financial products, not by the financial product itself. Examples of new products and sources of revenue include:40
o Bulk buying of items such as new cars in order to secure major discounts for customers and providing competitive loans and insurance in the process
o Creating bank or a joint financial services clearinghouse versions of Amazon/Alibaba, where customers buy the goods online, in the bank branch, or at home, and the goods are delivered to a secure locker in the bank branch, with satisfaction guarantees. When they are in the bank branch, they can get a loan too!
o Envision how existing products can be extended to other uses. Payment cards and banking applications can be used for identity authentication and attribute verification, and access to sensitive documents.
o Help a user keep track of their financial transactions and interface this information with other user databases.
o Incorporation of financial products into various social network services and interactions, such as identity management services, and discount buying with loans, payment plans, insurance, and product guarantees.
Financial services innovation is accelerating globally leading to increased access to financial services, reduced cost, and improved timeliness of existing financial services, along with the introduction of many new disruptive services and products. Although there are many barriers and uncertainty regarding their success and rate of adoption, incumbent financial firms need to actively engage with new technologies and start up technology firms to ensure competitive positioning even though the uncertainty of a number of security, privacy, and regulatory items could greatly influence outcomes. Incumbent financial service firms can take a number of different measures to prepare for these transformational changes, such as building innovation labs, funding start-ups, and moving to open finance standards. Financial institutions should invest in a diverse portfolio of approaches to remain relevant and competitive in this rapidly changing world of disruptive democratization and ubiquitous access.
6. http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article, http://www.theguardian.com/business/2012/aug/09/financial-crisis-anniversary-trust-in-banks, http://aei.pitt.edu/11334/1/1877-1.pdf
7. http://thefinancialbrand.com/43186/millennials-banking-research-facts/, http://thefinancialbrand.com/49848/millennial-geny-digital-payments-banking-communication/, http://thefinancialbrand.com/34480/millennials-desperate-better-fees-convenience/
14. https://hello.betterment.com/affiliate/robo-advisor/?utm_source=Robo-Advisor&utm_medium=online&utm_campaign=roboadvisor_online_sem_aug2014&utm_content=3115&gclid=CjwKEAjw9dWuBRDFs9mHv-C9_FkSJADo58iMjQn5tHinBDOcH6l_sbwUAcD5ujFYUxpNXXlRpKw1txoC8P_w_wcB, https://www.futureadvisor.com/?slp=ra&utm_source=google&utm_medium=cpc&utm_campaign=Robo%20Advisors&utm_content=robo%20advisory&utm_term=%2Brobo%20%2Badvisory&gclid=CjwKEAjw9dWuBRDFs9mHv-C9_FkSJADo58iMdz2p9PPmDmCc4TDH8UygssfuFJ_0Nl4g7p_Vh-ej8hoC8LXw_wcB, http://www.institutionalinvestor.com/Article/3482690/Asset-Management/RIA-Start-ups-Face-a-Complex-World-but-Help-Is-at-Hand.html?LS=EMS1197944#.VdyVYPZViko,http://investorjunkie.com/35919/robo-advisors/
20. http://blog.coinpip.com/startups-changing-the-money-transfer-industry/, https://www.hifx.com/?search=paid&gclid=Cj0KEQjwqZKxBRDBkNmLt9DejNgBEiQAq8XWPh8y2op0JCgKJAZuK4REFv9roUIy0gw3VTGIhNvz4coaAuHo8P8HAQ
23. http://www.business-standard.com/article/economy-policy/cil-to-start-e-auction-for-power-firms-without-fsas-115070400071_1.html, http://www.meetup.com/StartupPot/events/224896708/, http://economictimes.indiatimes.com/topic/e-auction, https://en.wikipedia.org/wiki/Eauction
24. http://www.thestreet.com/story/13256668/4/10-best-robo-advisors-ranked-find-the-best-automated-online-investing-services.html, http://www.forbes.com/sites/robertberger/2015/02/05/7-robo-advisors-that-make-investing-effortless/
28. The Inside Story of Mt. Gox, Bitcoin’s $460 Million Disaster, http://www.wired.com/2014/03/bitcoin-exchange/
29. http://fortune.com/2012/08/09/rogue-it-is-about-to-wreak-havoc-at-work/, file:///C:/Users/dan/Downloads/xo-0006-Putting_the_Kibosh_on_Shadow_IT_Best_Practices_for_Hybrid_Cloud_Management.pdf
33. Digital dawn in banking and the challenge of legacy, http://thefinancialbrand.com/53622/digital-transformation-challenges-in-banking/?utm_content=19745943&utm_medium=social&utm_source=linkedin
34. http://www.americanbanker.com/news/bank-technology/bank-innovation-labs-boon-or-boondoggle-1075406-1.html, http://thefinancialbrand.com/52177/7-of-the-coolest-innovation-labs-in-banking/, https://www.db.com/medien/en/content/5060_5196.htm
36. http://www.businessinsider.com/the-25-FinTech-unicorns-ranked-by-value-2015-7?r=UK&IR=T, https://www.bai.org/bankingstrategies/print.aspx?id=113609fc-d5b1-4338-aabf-14e9fb9b68bd, http://bankinnovation.net/2015/02/banks-need-to-create-a-FinTech-unicorn-every-year/
37. https://www.bai.org/bankingstrategies/Operations-and-Technology/Technology-and-Information/Keeping-up-with-FinTech?utm_source=BSO_Daily&utm_medium=email&utm_campaign=Daily_ENewsletter&mkt_tok=3RkMMJWWfF9wsRovvK3KZKXonjHpfsX86eslXaGxlMI%2F0ER3fOvrPUfGjI4GT8trI%2BSLDwEYGJlv6SgFTrHAMbJr2LgIXBc%3D, Creating the FinTech Dream in Financial Services, in CTO Corner folder, https://www.bai.org/bankingstrategies/Operations-and-Technology/Technology-and-Information/Creating-the-FinTech-Dream-in-Financial-
39. Open bank project http://bankinnovation.net/2015/08/rbs-to-host-hackathon-with-open-bank-project/