(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
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.
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.
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.
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.
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.
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)
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.
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.
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.
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!
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.
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.
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).