The financial services sector is under threat and on the top of the list of potential victims are the banks. No one loves their bank. In a world where people tattoo brands like Harley Davidson, Netflix and Apple, why is it that there are no bank logos on body parts?
If banks launch a new product, do people call up their friends, arm of a posse of disciples with camping chairs and a basket of sandwiches, and camp overnight outside the branch waiting desperately for it to open so they can storm in and fondle the new service?
Do people sneak out of the office early on a Friday, head straight home, storm through the front door and log into their bank accounts so that they can binge-watch the educational video on internet banking?
Do people spend hundreds of dollars on hipster leather biker jackets with their bank logos emblazoned on their backs?
I think not because banking is as enjoyable as sucking on Gandhi's dusty thong. The Millennial Disruption Index reports 71% of millennials would rather go to the dentist than listen to what banks tell them. That is a monumental kick in the nuts of the banks. Millennials would rather lie flat on their backs, open their mouths and have sharp needles and drills perforate the soft vulnerable skin tissue around their teeth than interact with their banks.
You do not need to be Alan Turing (the genius that cracked the German Enigma code) to decipher the takeaway of this nugget of information. Banks suck and technology is going to drive many of them out of business.
Why has traditional banking not captured the hearts and imagination of the average man? The answer is simple. In 2008, banks lost their biggest asset and that is trust. They lost the trust of their clients and technology companies moved rapidly to fill the gap. Since the financial crisis, the number of financial technology or fintech companies has increased exponentially. They are moving aggressively onto the turf dominated by the traditional banks and cherry-picking the most profitable segments.
Before 2008, banks were mildly successful in incorporating technology into their services via online banking and call centers- most of which were located in New Delhi. After the crisis, regulators tightened the rules in an already over-supervized market.
The regulators did not realize that the crisis was not caused by the lack of regulation in the banking system but the lack of regulation in the shadow banking system- the opaque world of non-bank financing and derivative structuring.
Response in the U.S. to the crisis was the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009. This Act ran over 2,300 pages (War and Peace boast 1,225 pages) and is used as a natural anesthetic in sleep clinics. It shored up bank balance sheets by raising capital requirements and risk management metrics and requirements. It also provided a laundry list of prohibited activities which meant that banks now had to spend an inordinate amount of time hiring lawyers and compliance officers to ensure the new rules were not broken.
The technological innovation that most banks had embarked upon before the crisis was put on the backburner. Banks also stopped lending to riskier small businesses, the entities that most need financing, and increased their lending to large less risky companies that didn’t need the money.
While banks were obsessing over compliance, tech companies were entering a phase of mega-innovation. Consumers were exposed to a world of hailing a taxi from their phones, being pampered with same-day delivery on Amazon and being able to order 50 assault rifles on Craigslist without ever having to leave their swastika filled bunkers.
Tech companies share an obsession with customer satisfaction. Banks do not share this obsession. How often have you gone to the bank teller and asked to do a withdrawal and her response is as if you had thrown a dead platypus on the counter?
Post-crisis, a gap opened between what people expected from their banks and what was being delivered. How is it possible, in a world where I can download the Joshua Tree album on Spotify while I am plucking my eyebrows, it is not possible to open a bank account without physically going into a bank branch?
Technology companies identified this gap and started to fill it with sweet sweetness. As of 2019 Facebook boasted numerous banking licenses and was experimenting with its own cryptocurrency. Amazon was experimenting with student loans. Alibaba was running one of the largest money market funds in the world and WeChat (the Chinese version of WhatsApp) was doing 820 million wire transfers during the Chinese New Year. If you trust Facebook with photos of your newborn baby, will you not trust them to handle your finances?
Cryptocurrencies, blockchain, and crowdfunding have now made possible a life without banks and the world is rejoicing. If you want to transfer money or pay accounts, crypto accounts allow you to do so. If you want to borrow or invest money, you can go to crowdfunding sites like Moneytree or Lending Club. If you want to buy and sell stocks or mutual funds, you can do so through apps like Robinhood. If you are looking to execute a more complex cross border tax-driven structured transaction, you may need a bank but how often does that come up - Mr. Rockefeller?
In this blog, we will explore how fintech is upending the financial services sector. At the core of this disruption is the desire for disintermediation. Financial companies are classic middlemen. You want a loan, go to a bank. You want to pay your lights and water, go to your bank and pay. If you want an insurance contract, go to your insurance broker. If you want to buy and sell stocks, you go to your stockbroker. As people become more informed about the limited value these intermediaries offer, they look for ways in which they can bypass them and go straight to the source. Disintermediation is the Robin to Batman's Fintec.
Four Major Trends in Fintech
Trend 1: Burn Down the Branches and Dance on the Ashes
Banks are inefficient monsters. Have you ever wondered by banks pay you 2 percent on your deposits and then lend money to you at 20 percent? If you can buy something at 2 and then sell at 20, you should be minting money.
The reason why they are not is that banks have astronomical overheads. Maintenance of the branch network of traditional banks is one of those costs. Other costs are associated with complying with new regulations. The third is related to litigation. This is especially true in the U.S. where angry customers are suing their banks after realizing that these banks had "stolen" from them.
This is reverse bank robbery. The romantic days of Bonnie and Clyde and bank robberies are far behind us. People realized that the banks themselves were the robbers.
Trend 2: Just Click Enter
Credit is the lifeblood of any economy. Bank regulation has slowed down the credit process. Some glaciers move quicker than banks in the awarding of credit lines.
According to a report from McKinsey on traditional banking, the average "time to decision" for small business and corporate lending is between three and five weeks. Average "time to cash" is nearly three months. Magellan circumnavigated the world faster.
These turnaround times are becoming unacceptable. Digital banks have embraced the digital-lending revolution, bringing "time to yes" down to five minutes, and time to cash to less than 24 hours.
Trend 3: Robo-Advisers – Anything is Better than a Human
Can machines be trained to be better investors than human beings? To answer this question, we will make a quick list of what humans do well and a slightly longer list of what they do badly.
Humans have opposing thumbs and therefore can grab small objects such as pens, lego toys and in the case of Donald Trump, a big bucket of KFC.
Now let's look at the weaknesses of the average homo sapien. Experts say that the average human being uses 8 percent of their brain. I know people who use considerably less. Humans are not able to process large volumes of information quickly. They get flustered and they are prone to distractions. This is especially acute in the male species when exposed to human matter such as cleavage or any form of silk underwear.
Humans are prone to emotions such as fear, greed, and stress – also in the face of the aforementioned cleavage. When stressed, cortisone floods their bloodstream and parts of the brain turn off.
Lack of sleep results in diminished brain activity. If you withhold water from the human for more than three days, his brain cell function is impaired. Humans are ill-suited to making rational decisions about money and finance because nothing evokes these negative emotions more.
Computers do not have these same emotional limitations. They are not easily distracted, they are quick, they do not need to go to the bathroom and they do not need to rest over weekends. They are perfect employees. The hardest part is to get someone smart enough to train them to think and operate in the desired fashion.
In the world of investing there are two important trends - a move towards passive investing and a move towards algorithmic or black-box trading. Both trends lever off the strength of machines to make better investment decisions. We will look at each trend individually.
Passive investing – The Present and the Future
To understand passive investing, you need to understand its arch-nemesis - active investing. Active investing is the process of relying on human beings to make investment decisions. In the world of equity investments, active management is also referred to as stock picking. It is the ability to select stocks that go up in price and avoid stocks that go down in price based on rigorous and intensive fundamental and technical analysis.
It stems from the belief that the human is smart enough to beat the market. Beating the market means consistently delivering returns that are superior to the market or the benchmark. That benchmark could be an equity index or it could be a cash reference such as LIBOR.
The greatest active manager to walk the face of the earth is Warren Buffett. Over his career, he has delivered annual returns of 5 percent above the Standard and Poor's 500 Index. This 5 percent per annum may not sound like much but when you annualize it over decades, the difference is like comparing Attila the Hun with Mary Poppins - although some conspiracy theorists say that Mary could have been packing some heat in that carpetbag.
Buffett, however, is an outlier. Average stock pickers do not outperform the market because it is just too bloody expensive. They have MBAs from Harvard and 250 grand in student debt that needs to be serviced. Salaries, however, are just one of the expenses. You need to add the cost of software systems and support staff, computer hardware, corporate travel to meet the management of companies they want to buy, and fen Shui consultants who charge thousands of dollars for telling you to move the chest of drawers away from the bay window.
All these costs need to be recovered from the investors in the form of fees. When you deduct these fees from performance, most funds deliver returns that are below the market. Buffett, in addition to being a genius, also runs a lean shop. He spends $3.22 on breakfast at McDonald's, does not own a computer, uses an abacus instead of a calculator and is notoriously frugal. Save the pennies and the pounds will look after themselves.
Investors are starting to better understand the weakness of active investing and are migrating to passive. Passive investing works on the maxim that if you cannot beat the market, just buy the whole market.
But how exactly do you buy the whole market? If you are looking for some Standard and Poor’s 500 Index action, you need to buy 500 stocks. Let's assume that the average price of each stock is 50 dollars. That means that you need to fork out 25,000 dollars - an amount of money that most investors do not have.
Then there is the problem of weighting. Not all stocks have the same weight or importance in the market. Apple, which costs north of 200 dollars has a higher weight than Zions Bancorp. Other stocks cost a lot more than 50 dollars. One share of Buffett's company Berkshire Hathaway costs close to $300,000 (before the coronavirus scare). This discourages the average mortal from buying the market. But that was before the invention of the ETF.
Vanguard, under the wise stewardship of the late Jack Bogle, was the pioneer of passive. Jack recognized early the benefits of structuring shares that could replicate the performance of a specific market or sector. Enter the exchange-traded fund or the ETF which has grown into a multi-trillion dollar industry.
The ETF is beautiful because it runs on minimal human intervention. Instead of a highly paid Ivy League-educated polo-playing Kennedy related fund manager picking stocks, you pay Vanguard to hire a pre-pubescent kid in a hoodie to program a computer to buy and sell stocks based on their market weighting. Passive investing is not robo advising in the strictest sense, but it is a useful entry point into the world of machine investing.
Algorithmic or black-box trading also takes us closer to the world of the robo-adviser. An algorithm is a process or set of rules that define a decision-making operation. This is best understood with an example. This example exists in real life. Names have been changed to protect the identity of the participants, the majority of which are minors. No dogs or small animals were hurt in any of the transactions.
Once upon a time in Mexico City, an algorithm was created by a young genius who has a canny resemblance to the late great Kurt Cobain. He took a well-known principle and found a way to use technology to exploit the money-making opportunities it offered.
In the world of finance, there is a discipline known as corporate finance. Typically populated by lawyers, accountants, and MBAs (a fun bunch of guys), their job is to work with corporate clients to assist in corporate actions such as financing and the acquisition of other companies. Why would one company acquire another?
The most common reason is to allow the acquirer to grow their business. In 2017, Amazon wanted to make a strong push into groceries and attack the dominance of Walmart. Amazon did not want to grow this business organically so they looked to partner with an important player already in that market. They ran a beauty pageant and the winner, on account of a convincing performance during the swimsuit contest, was Miss Whole Foods. She was wholesome, healthy, with no genetic modifications and a strong aversion to hormonal intervention.
This was where Amazon confronted its first hurdle. The existing shareholders in Miss Whole Foods were perfectly happy in her. She had delivered strong and consistent returns. If they sold all their shares to Amazon, where would they put their money? Miss Whole Foods is one of a kind gal and not easily replaced. Jeff Bezos, the intrepid chief executive officer of Amazon and one of the wealthiest men in the world, realized that he would need to find a large juicy organic carrot, cover it with lactose-free, sugar-free and gluten-free ranch dressing, and wave it in front of the Whole Foods shareholders. Bezos would need to offer a price that the shareholders could not refuse.
This is where the corporate financiers come in. Working in stealth mode, they would need to calculate that premium. Markets are notorious gossipers. The financiers would therefore need to work with the utmost discretion.
I grew up in South Africa in the 1980s in a conservative Calvinist environment where you were taught that politics was sacred and sex was dirty. When pornography was unbanned in the 1990s, I would sneak into the pharmacy and try to get that magazine off the shelf, to the cashier, and into my leather duffel bank without the cashier even noticing. This same skill is required in corporate finance.
The majority of the shareholders agree to the size, shape, and taste of the carrot. Amazon now needs to announce this to the market in the form of an Edgar filing to the Securities and Exchange Commission. This dissemination is done electronically at a specific time to ensure that everyone receives the information at the same time and no one person or organization is favored.
When the news breaks, investors feverishly read the announcement and then decide how the market will react. The typical reaction is that Whole Foods stock will spike up and trend towards the price offered by Amazon. Investors who were endowed with colossal speed-reading skills and nimble fingers will try to buy the stock before it spikes. This is where the computer comes in.
My mate, the Cobain look-alike, has spent years teaching his supercomputer to find these opportunities. He wrote an algo that is designed to analyze every single Edgar filling and look out for keywords - like "acquire", "target price", "merge", “synergies". When the machine finds these words, a trade opportunity presents itself. The machine does this in nanoseconds while the human does it in minutes.
In addition, he has placed his servers on the floors of the stock exchanges so that he can reduce latency. His computer (called Breogan - character in the Lebor Gabála Érenn, medieval Christian history of Ireland and the Irish) executes the trade and then a human watches the trade evolve and then manually unwinds the trade after running its full course. The average holding time for a position is 56 seconds and the fund has been able to deliver spectacular returns.
The fund employs physicists, actuaries, and computer scientists. He even hired a Ph.D. in meteorology. Weather specialists are exceptionally skilled in finding trends and patterns in large data sets. This fund spends an inordinate amount of money on software - server's switches, data, and network connections. The last time I heard he was looking at ways to use lasers to transmit information but was coming up against some interesting challenges from Mother Nature. Clouds, apparently are the Lex Luther to lasers Superman.
Robo-advisors, as the name suggests, are robots that act as investment advisers. They are trained by way of algorithms to look for keywords in the profile of the investor and design a portfolio that is best suited to meet their investment goals. Not only can robots be trained to act more effectively than humans, but they can service a wider range of people. This is vital in the democratization of financial services.
The cost structure of the financial services sector caters to the middle and upper markets. It is not geared towards the lower market which is in most need of the assistance. Banks lend money to people who don't need it. Financial advisers swoon over millionaires and billionaires who often know more than the advisors. The masses are marginalized and are caught up in a virtuous cycle of poverty from which they are unlikely to escape unless there is a major overhaul of the status quo. Robo could be part of that solution.
Trend 4: Upending Insurance – The Ugly Cousin of Finance
The selling of insurance is the biggest scam since snake oil during the California gold rush. The product is awesome but the way it is sold is the capital of Dodge. There are good reasons for this.
No one likes to buy insurance. It is not an impulse buy. No one is filled with joy and satisfaction when the policy on their car needs to be renewed. We don’t want insurance but we know that we need it. It is prudent to transfer specific risks to a third party, but prudent does not sell.
Insurance companies know their product is unsexy. They, therefore, need to inject it full of collagen and silicone and dress it up in an underwire bra and leather mini skirt. The job of selling insurance is as attractive as sitting in a toll booth in the middle of a dark tunnel surrounded by incontinent bats. To sweeten the deal, insurance companies need to incentivize these salespeople.
I have friends who sell insurance. They spend half their time traveling to exotic locations to attend insurance "conventions". All expenses are paid by the insurance companies. We are talking about three to four trips a year to ski in the Swiss Alps, desert camps in Dubai, island hopping in the Mediterranean on private yachts, and private game reserves in the Serengeti.
As Transparent as a Texas Hold’em Champ
When you buy an insurance policy, you have no idea how much the policy cost and how much goes to the broker.
The controversial billionaire hedge fund manager Ken Fisher said in an interview with Steve Forbes, the founder of Forbes magazine, that if you put $1 million into a retirement annuity- a product frequently peddled by insurance brokers - you are "paying" the broker enough to put his kid through private school. Fisher says that his salespeople would earn 1/30th of that amount for a 1 million investment in his fund. This is a little crazy.
One strong trend in fintech is disintermediation. Fintech is not about making changes for the sake of making changes. It is about disrupting industries and disruption can only take place is the existing model is flawed. A flawed model is one in which the needs of the customer are not being fully met.
Insurance stands out like the Harlem Globetrotters in a Tokyo subway. Take the example of Uber. I know that this is not a financial services firm but it serves as a good example. When Uber started, I was living in Latin America - a region where public transportation is riskier than jumping into a phone booth with an ill-tempered spitting cobra.
In Mexico City, taxis are a fantastic mechanism to separate your wallet, cell phone and important bodily organs from your person. Uber was a revelation and within a handful of years, Mexico City became the place in which Uber completed the most number of trips per day. Uber worked because the existing taxi system did not. It was unsafe, taxi drivers would only take you to where THEY wanted to go, and taxi meters were often "modified" with a little button known as a "diablito" - the little devil. The driver would tap the diablito with his foot and the fare calculation would accelerate.
Insurance is broken because premiums are not based exclusively on the risk of the policy. The premiums are heavily influenced by the commissions paid to the broker. Tesla was the first car maker to sell directly to the public by cutting out the middle man. In 2013, Ping An, Tencent, and Alibaba joined forces to launch Zhong An, China's first truly digital insurer. The company underwrote over 630 million insurance policies and serviced 150 million clients in its first year of operation. Zhong An aims to reshape traditional insurance by applying internet thinking across the insurance value chain from product design to claims servicing. The online model is based on lower operating and distribution costs. Big data and analytics support ensures accurate product pricing and risk control. It also facilitates disintermediation.
Finding what is broken in the finance industry is not difficult. Make a list of all the things that piss you off about your bank, stockbroker, pension company, insurance company, and financial services company. Then find companies that are working tirelessly to solve these pain points, or start your own company that will focus on filling these gaps.