Fintech and crowd funding, inflating the next bubble?

"Everyone wants to be on board the next Uber – financially, if not literally."
Andrew Cornell, Managing Editor

The payments news site Pymnts.com recently sketched out the market, citing TechCrunch research suggesting alternative lending, built around disruptive technologies, could be a $US1 trillion industry.

According to consultancy Accenture in a new report titled “The Future of Fintech and Banking: Digitally disrupted or reimagined?” investment in financial technology (fintech) companies grew by 201 per cent globally in 2014, compared with 63 per cent growth in overall venture-capital investments. Accenture called the sector a “hot ticket”.

There were billion-dollar initial public offerings in December for Lending Club ($US9 billion) and OnDeck ($US1.3 billion). In the first two months of this year, venture-capital investors committed $US340 million for lending tech startups in 17 deals. According to the CrunchBase data Pymnts used, the average deal size was $US23 million, up from $US14 million for similar deals in 2014.

This is an exciting area. The incumbents – banks and other conventional financiers – are facing increased regulatory scrutiny and costs while, being often huge organisations, they can struggle with legacy systems and cultural inertia. And everyone wants to be on board the next Uber – financially, if not literally.

A UK Treasury report into alternative lending also had some quite extraordinary growth projections: the British Association of Chartered Certified Accountants argued it would only take the alternative lenders four years to rival today's banks for lending volumes if their current growth rates are maintained.

Major banks including RBS and HSBC acknowledged “crowdfunding” and P2P (peer-to-peer) lending are emerging as stronger competitors to traditional banks.

Presumably not only conventional taxi drivers but Uber ones will soon be passing on stock tips about the next big fintech disruptor.

The obvious question then is whether these new valuations and the intensity in the sector represent a bubble or at least the signs of one. Though often backed by great insight and innovative technology, a lot of these disruptors remain small with limited revenues and tiny market shares.

The UK Treasury report laid out four broad caveats, of note to lenders, investors and borrowers:

• A lack of minimum standards of due diligence or disclosure. In particular, the reporting requirements on borrowing businesses may be lower than for listed companies
• Investor over-optimism, particularly if due diligence or disclosure has been poor
• Problems with technology, IT security or the Internet
• A potential lack of regulatory experience or, with regard to loan-based crowdfunding, lending experience in crowdfunding firms.
  
  

These are by no means fatal caveats but they highlight that, just like during the dotbomb phase of the turn-of-the-century tech revolution, many of these potential disruptors won't survive.

At JPMorgan's recent Financials Forum on innovation and disruption (and BlueNotes will shortly publish forum participant Matt Boss' take on disruption) disruptors were broken into three categories:

• A large number of entities offering solutions with small individual impacts around the edges of markets
• Entities delivering a product solution, potentially either for a gap in the system or a better solution (P2P lending is an example)
• Those reinvesting the whole process or proposition (UK's Atom Bank for instance).
  
  

These are all valid niches for pioneers but the reality of pioneers is most don't survive the first winter. Then there are those innovators who create a special bit of kit or an intriguing technology but offer a solution for a problem yet to be identified.

The challenge for investors – and incumbents – is to identify those disruptors which have seen a genuine gap in the market and offer a real solution.

Then there are the often ignored 800 pound gorillas, the major companies already operating either in different sectors but with a value proposition for financial services, whether that be Google or Facebook or a retailer, or indeed existing players.

Google has just poached Morgan Stanley's chief financial officer for a $70 million sign on while PayPal's chief executive has decamped to Facebook. In both cases the assumption would be the destination companies want to be more serious about financial services and payments in particular.

But equally this highlights one of the enduring features of industries facing disruption or looking to disrupt: the contest is not simply adversarial with rivals engaged in a duel to the death.

In Australia, the most disruptive play in financial services in the last two decades has been the arrival of mortgage origination in the mid-90s via, most notably, John Symond's Aussie Home Loans and his raucous “We'll Save Ya (from the banks)” marketing line.

The emergence of that disruptor realm – non-bank brokers selling mortgages which were parcelled up and sold via securitisation – is widely regarded as having sliced around two and half percentage points from bank mortgage margins.

There are no stand-alone originators from that period left today. Aussie is owned by Commonwealth Bank, RAMS by Westpac (after collapsing in the financial crisis and being dismembered) Wizard was bought by GE Capital which then on-sold it while others have shifted their business models.

So in this case of massive disruption, the incumbents, the major Australian banks, responded by reshaping their traditional businesses, adopting securitisation more widely themselves (and this element of the model was actually developed by Macquarie Bank) and eventually buying some of the disruptors.

We are already seeing this play out in the latest wave of disruption, especially in payments with the giant international schemes Visa, MasterCard and American Express hoovering up innovative businesses as fast as they can.

The lesson is as disruption plays out, the incumbents respond to disruption and can disrupt themselves. For every Kodak there is a Kyocera, the Japanese tech giant which transformed itself from a traditional pottery company to a high tech conglomerate.

Incumbents can not only buy in innovation but learn innovative cultures, allowing them to better create their own. Many staid old companies now have their own “skunk works” or innovation divisions, living in black-skivvied quarantine away from the suits and LV handbags.

Critically too, newly emerging innovators and disruptors tend to be product or segment specialists – crowd-sourced and P2P lending at present is focussed on the higher risk segment of the market where traditional funding is harder to obtain.

Meanwhile the incumbents in this space are either moving up the value chain, looking to offer a borrower a deeper and longer relationship, or making the decision not to compete for reasons of price and risk.

It's very topical to talk about China but in this case it's worth quoting Chinese premier Li Keqiang quoting an old European proverb, from his speech at Davos this year, “when the wind of change blows, some build walls, while others build windmills”.

That's not to say disruptors can be ignored. Some might become the next Apple. My former employer Fairfax missed the opportunity to buy disruptors in the classified advertising space and has barely lived to regret it.

But this is a hot market. The investment propositions being offered are now being layered upon one another, such as a pilot crowd funding platform using Bitcoin, in itself disruptive cryptocurrency. Bitcoin company Safello, established barely two years ago but known for its compliant approach to Bitcoin, has partnered with leading crowdfunding platform FundedByMe to raise funds.

P2P, crowd sourcing, cryptocurrencies, payments innovations, all are potentially remarkable technologies and investments. But at the valuations going at the moment and what history tells us about disruption cycles, the one disruption guaranteed is to the wallets of investors with many propositions.

As well as a period of great disruption, this is also a period of extraordinary liquidity, fantastically low interest rates and very little regard for risk premia.