Economics

 

21st Century Finance vs. 20th Century Finance

11.16.2017

 

(Part I of a series on the future of banking and finance)

Finance’s 20th century business lines – their go-to money makers – are all in jeopardy of being destroyed. Primarily this is due to finance’s blatant disregard for its customers’ actual needs. This is the result of the industry’s traditional 40%+ profit margins that allow them to make money regardless of customer satisfaction. This all stands to change, and quickly.

 

Which business lines am I discussing?

 

20th Century Finance

 

Savings

First up, and chief among the traditional business lines of financial institutions is savings. That’s right plain ole vanilla savings accounts. This was the seminal spark for banking in the first place; a place to store my gold or notes on gold, or more recently, my fiat notes on, well, an IOU to pay interest on an IOU of tax collections. Savings is the source of all banking and finance wealth. That customers are willing to forego use of their monies and deposit them at a lending institution is the source of lending power. Add in fractional reserve banking – the ability of banks to mint money out of thin air – and you have a viable business.

 

 

Income

While it may seem obvious that savings accounts pay interest, in the just-post-negative interest rate era (i.e. ZIRP and NIRP), money being paid on your savings is also a product of banking and finance, and not just the safe storage of your gold. Admittedly income paid on deposits is a loss leader for banking and finance. After all, they paid interest as an inducement to parking your cash with them. Beyond a banking institution’s creditworthiness and its leaderships’ character, it is interest that leads you to park your hard-earned currency with them.

 

 

Credit

Another gigantic business for 20th century banking and finance is lending money to you in exchange for you paying an interest rate on your borrowings. Banking and finance, in general, can be characterized as “spread businesses.” This means that they pay you x for your deposits, but then turn around and invest your deposits in another asset that earns them, on average, over long periods of time, about 1.03x. This is the spread that they earn on your monies. So long as they evaluate the creditworthiness of those to whom they lend money well then they are essentially guaranteed to mint profits.

 

 

Investing

Banking and finance are also lucrative for promulgating opinions for what you ought to do with your monies set aside for savings and investment. This takes on many forms from investing directly in securities (government, municipal, and corporate, primarily), or indirectly in securities (mutual funds, ETFs). Again, regardless of the performance, banking and finance traditionally make money just by advising you what to do with your hard earned cash.

 

 

Capital Raising

Typically individual investors never really participate in the capital raising function of banks and finance, unless you are lucky enough (read: fat cat enough) to receive shares in an initial public offering of common equity. But banks, especially investment banks, make huge fortunes raising capital for governments, municipalities, and corporations. These securities issuers pay for the bank’s counsel, size of distribution network (i.e. how many people can they attempt to sell your securities to?), and market making after the fact, including ‘research’ by its cabal of research analysts. Again, historically this has been a blockbuster business for banking and finance.

 

 

Trade Clearing and Asset Custody

Though a minor function of banking and finance, they have historically settled trades for buyers and sellers of securities. They also serves as custodians of these assets “for the benefit of” you.

 

 

Trade Execution

To facilitate liquid capital markets, banking and finance have historically acted as intermediaries between buyers and sellers of securities. Not only that, but when there is an imbalance of buyers and sellers, such that securities prices are imbalanced, they have frequently stepped in and served as market makers. This means that they take the opposite side of a trade on behalf of their customers. But they do not always do this for their customers. Frequently they trade their own book of securities, commonly known as proprietary, or “prop,” trading.

 

 

Whew! That is many lines of business, all of which make the banks very healthy profits. But the rise of new financial technologies (fintech) promises to erode, if not destroy permanently these 20th century lines of business. And no one will cry for these institutions. Here are the fintechs and how they are going to change banking and finance forever.

 

 

21st Century Finance – Fintech Thunderbolts and Lightning, Very, Very Frightening (if you are a 20th Century Finance Pro, that is)

 

Big Data

First up of the financial technologies giving headaches to traditional finance is the increasing access to reams and reams and reams of data, and cheaper and cheaper ways of assessing this data in the search for signal amongst noise. You probably know this technology as Big Data. While traditional finance promises to wring important information, and business making opportunities out of big data, in the 20th century they were the only ones that possessed two things: access to financial and economic data, and a large enough operation to be able to afford to look for signal among the noise inside that data.

 

First came the Internet. Then the Securities and Exchange Commission’s EDGAR (Electronic Data Gathering and Reporting), then websites like Yahoo! Finance, then Factset, and now we have sites like Estimize, Seeking Alpha, Thinknum, CalcBench, and others that are democratizing access to large datasets, and analysis of this data.

 

In short, Big Data threatens banking and finance’s credit, investing, capital raising, research, and trade execution businesses. This is because these businesses typically relied on proprietary data gathering, and profit making based on insights contained in that data. But no more.

 

 

Machine intelligence

Next up, in terms of “uh, oh!” for banking and finance is the proliferation of machine intelligence. I do not call it artificial intelligence, because it is still intelligence, it just happens to be the result of a machine. Machine intelligence does some things extraordinarily well. For example, if an activity is highly routinized and takes place in a very limited context then machine intelligence, coupled with machine learning, can quickly usurp an activity. 

 

You may know that cancer diagnosis based on imaging is soon to be taken over by machine intelligence. The reason is that these diagnoses are highly routinized and take place in a very narrow context: the human body. But so too does credit, investing, capital raising, research, trade execution, and trade clearing. Again, if you work in banking and finance and these activities can be done for cents on million dollars, then you are nervous. Extra nervous.

 

 

Robo-advisers

Combine big data with machine intelligence and passive investing products (e.g. index funds, ETFs) and you no longer need a financial adviser. Here is a dirty dark secret of your adviser. They take all of your data when you sit down with them and plug it into their firm’s software to spit out a generic financial plan for you that is basically not any more sophisticated now than it was in the early 1980s. Yet they charge you a small fortune for this service relative to its actual worth.

 

Now, so-called robo-advisers, are changing all of that. You may access them online and they also engage you in a customer questionnaire and they also deliver to you a semi-custom financial plan just like traditional advisers do. However, they do not charge a small fortune for this activity. Not only that, but as their interfaces grow more sophisticated they promise to provide you with better asset allocation strategies. What’s more they do not call you to trade more, or to sell you insurance either.

 

 

Crowdsourced funding

Crowdsourcing is opening up the world of opinion, not just to experts, but to anyone. Much research over the past 80 years demonstrates that crowds arrive at very sophisticated estimates of things. Examples include the possibilities of geopolitical hotspots (a US intelligence agency briefly ran a crowdsourced estimator and shut it down, not due to inaccuracy but because of the perceived poor ethics of handicapping dread events), and even earnings estimates (see: Estimize). In most cases where crowdsourcing takes place – in fact, I am not aware of a counter example – the activity engaged in is more accurate.

 

Now crowdsourcing is being used to raise funds in equity primary markets, in underwriting of credit risks, and in providing earnings estimates. Pretty much any space in which an expert opinion used to be needed and preciously charged for, is now supplanted by the much less expensive and more comprehensive result of a crowd. This directly undermines banking and finance’s credit, investing, research, capital raising, and trade execution businesses. Ouch!

 

Peer-to-peer lending

Above I described how banks borrow from you (i.e. offer savings accounts) and then invest at a higher rate of return, and earn a pure spread. Presumably this spread is earned for the additional due diligence they provide for loan underwriting and for the additional risk that they take on in issuing loans. Enter: peer-to-peer lending which cuts out the proverbial middleman.

 

Ever buy something from eBay or from an Amazon seller? Essentially you have engaged in a peer-to-peer lending activity. After all, you deliver cash to the seller prior to your goods being received. Do you trust this process? Of course you do. The reason is that you have a lot of transparency into the seller in the form of ratings and reviews about the quality of the seller. Additionally, the platform on which you transact backs up the sanctity of the transaction. This is also true in peer-to-peer lending.

 

Now you can serve as a bank. You can lend to those looking to borrow money and now you can earn the higher interest rates that banking and finance traditionally have earned. Is there risk involved? Absolutely. But is it possible to increase the size of the lending pool? Yes. Is it possible to now engage in smaller loans if you are a borrower? Yes. Is it possible to have customized loan contracts that better serve borrower and lender and their financial needs and wants? Yes. And on and on.

 

Peer-to-peer lending looks set to upset traditional banking and finance’s savings, income, credit, investing, and capital raising businesses. Eventually a platform will succeed in promulgating this, all to the dismay of entities that historically have added very little value to matching savers with borrowers.

 

 

Blockchain

You likely have heard something about blockchains Bitcoin or Ethereum being most famous. Rather than discuss them specifically, let’s discuss two huge benefits of blockchain technology: their transnational nature, and their distributed ledgers. Most people think of blockchain as a currency alternative because people globally via the Internet can buy and sell into the likes of Bitcoin and Ethereum. The advantage for businesses and consumers is that they can now transact in a currency that stands outside the traditional financial system. This allows participants to transact, save, and invest globally without the additional risk of a currency tied to a region or government and the issues that they face. In other words, you can transact now without geopolitical risks. This does not mean that blockchain currencies are risk free, just that they tend not to be affected by the same risks as traditional currencies.

 

More importantly, in the long-run, is blockchain’s use of distributed ledgers. What the heck are those? They are a perfectly transparent accounting of every transaction done using the blockchain. This is the source of the word ‘chain’ in blockchain as the ledger is permanent and shows every transaction ever executed using the block. What is more, any transaction into or out of the blockchain must be agreed upon by every member. Why is this important?

 

Think about any contract you have ever entered into. The motivation for the contract was to align your interests with those of another party or parties in the absence of transparency and absolute trust of the other party. Also, the sanctity of the contract is protected by the judiciary. But distributed ledgers mean that every party has full transparency, not just to the nature of the contract or agreement, but to every action that effects the agreement. What is more, only unanimous consent of every member of the blockchain (even if millions of people) allows for a transaction to take place. Said another way, all parties to all transactions agree to all of the rules of the blockchain all of the time.

 

So distributed ledgers are transparent, and thus mostly risk free, in the extreme. Consequently, distributed ledgers are likely to eventually replace any contracting/lack of trust activity in which you currently engage. Wow! In banking and finance this effects savings, income, credit, investing, capital raising, research, asset custody, trade execution, and trade clearing. In short, all of finance.

 

Summary

In conclusion, absolutely every activity that made money for 20th century financial institutions is being undermined by new technologies that are faster, almost as intelligent, cheaper, and more trustworthy. Just when fintech can plant its flag on the back of fallen banking and finance is unknown. But I do know that banking and finance are never going to see the profit margins that they have experienced in the past again.  In future columns I examine likely outcomes for each of the major players in the banking and finance ecosystems: providers of capital to the ecosystem, intermediaries (where most of banking and finance resides), users of capital, and opiners (i.e. analysts who weigh in on the sanctity of various financial transactions).

 

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7 comments

 

7 responses to “21st Century Finance vs. 20th Century Finance”

  1. Skot Kortje says:

    Great article, Jason. Are we to be outright bearish on financial stocks, or do we expect that financial institutions adapt and implement these technologies to a degree that mitigates the negative impacts of decentralization on their revenue stream? The middleman is usually the smartest cookie in the room. And the most powerful.

    • Jason Voss Jason Voss says:

      Hi Skot,

      Your points are completely on target, in my opinion. I think there are two factors to consider: the size of the second derivative relative to time (I’ll explain in a moment); and the degree to which the industry is comfortable cannibalizing itself. Regarding that first point, if the development I describe in this piece happen rapidly, say within 5-7 years, I think it will be very difficult for industry to respond both offensively, and adequately. They can certainly get defensive about it by acquiring their competition. However, there are two mitigating factors that the industry currently ignores at its own peril: customers paying 40% margins are not happy. Banking and finance think that these two things are the same issue and they are not. Because they think the issues are the same they are cutting margins across the board for everything. What they are soon to discover, though, is that customers, yes, are unhappy paying 40%, but that they are also unhappy because finance does not listen to its customers’ actual needs (more on this is forthcoming articles). So unless banking and finance overcome their inattentional blindness then I think they are going to lose.

      Here is an example of how they could lose and lose fast. Right now fintech is being advanced by very small players. This fact is what allows us to imagine scenarios in which banking and finance have time to respond to the fintech existential crisis. But now imagine that either Amazon or Google get involved and back a fintech solution. How does that change your calculus? To me, this is the second derivative with respect to time. If these changes happen rapidly then banking and finance are forever surrendered, just as video stores quickly succumbed to Netflix, and film cameras to digital.

      Regarding the second point above. I think it is probably hard to get an annual bonus at a bank or financial firm by entering into the room and suggesting that all of the innovation at the organization should be to drain the profit margins out of the business. So to what degree are banks and financial firms willing to cannibalize existing business lines in order to compete with fintech? Jamie Dimon announced, for example, that Bitcoin and blockchain were ridiculous.

      In my almost 25 years in the business this is the first time that I can see a clear pathway to the Schumpeter “destruction” side of capitalism with respect to banking and finance.

      What are your thoughts? I would love to hear more from you, too : )!

      Jason

      • Skot Kortje says:

        Hi Jason,

        Thanks for your tremendous reply. Sorry for my tremendously tardy reply… I just saw your comment after reading your second installment of this series. I like your Schumpeter reference, and certainly, you are right about the dearth of management that has the foresight and courage to tackle the threats to traditional finance in a way that acknowledges the eclipse of the finance period as we have known it for hundreds of years. How does the captain of a sinking ship respond? I think your comment above provides some smart insight. Maybe FANG companies gain the upper hand enough to make even more extensive integration of finance with consumer markets. It should be an interesting and transformational time ahead!

  2. Santi says:

    That was a nice summary of how the industry is changing. I kind of miss remittances business, which is the biggest money flow and has already started to change with blockchain technology.
    Also, just reading your comment. One midsize player has started to enter the market just this week. Square implemented payments with bitcoin and CME just announced Bitcoin Futures for the second week of Dec. Things are moving too fast for banking laggards to even realize the game is changing.

    • Jason Voss Jason Voss says:

      Hello Santi,

      Thank you for your kind words and for taking the time to share them. I too saw the news you highlighted. Interesting times we live in.

      With smiles,

      Jason

  3. Brilliant insights Jason. I still see a laid back attitude from traditional banks when it comes to visualizing the threat from Fintech. That is alarming indeed.

    • Jason Voss Jason Voss says:

      Hello M.R.,

      Thank you, as always, for taking the time to share your thoughts, I really appreciate it.

      I too am shocked by the degree of complacency on the part of traditional banks. Jamie Dimon’s comments, in particular, about Bitcoin just seem completely misinformed. I cannot help but think of Kodak, and AOL, and Toys-R-Us – all of which are in different industries – and how rapidly they became irrelevant. Especially in our industry whose real currency is trust, things are going to change fast unless we begin to deliver greater trust and greater value.

      With smiles,

      Jason

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