Those of us who have thought about the future of capital markets have envisioned a world where investor preferences and asset characteristics can all be expressed in code, and a smart matching engine can execute trades that maximize the efficiency of the market without unnecessary human involvement. It is now over a decade since the inception of online lending—the inspiration to apply this vision to loan financing—but this vision is not yet fully realized. However, at this time, we can explore how the concept translates to today’s capital markets environment, how forward-thinking lending companies such as Kabbage are using technology to optimize their treasury processes, and how automation and human intelligence can combine to bring the aforementioned vision to reality.
In its early days, there were over 35 million users of America Online (AOL) according to the company. That number consisted of people periodically dialing into their accounts: “going online” at a particular time of day, emailing or IM’ing someone, then signing off once they finished — typically on a conventional landline. Today, not so many years later, we walk around with pocket supercomputers, always connected to a vast world of information through wireless networks. For the sake of comparison, there were approximately 1.2 billion daily Facebook users in 2016.We don’t “go” online anymore; we just “are” online.
This is transforming nearly every aspect of our lives, from how we shop, communicate, hail a taxi and entertain ourselves, to how we work, learn, invest and manage our finances. Just as massive, distributed computing power and persistent connections are transforming our personal lives, they promise to transform the accumulation and distribution of capital. We spend a lot of time thinking about this at Orchard. What do you call this next phase of always-connected financial services, this idea of persistent connections and the development of technology that provides new ways for capital to find its highest and best use?
Phase 1: Bringing Your Financial Life Online
When thinking back over the last couple of decades of technological progress, on the surface, the ways that we interact in our personal, professional and financial lives have changed dramatically. Indeed, most of us can barely remember what it was like to live and work in a world without email or social networks, or without real-time access to a seemingly infinite amount of information, near-instant global communication and productivity tools that simplify our lives. In financial services, though, many of the advancements to date have simply used technology to mirror in the digital world the same products and processes available in the physical one. That is an important step in innovation, but only the beginning.
Phase 2: Connected Capital
In financial services, the next wave of technology is just starting to take form and make use of this idea that we are “always on” and “always connected.” I call this phenomenon “connected capital.” Connected capital involves products, behaviors and experiences that are not merely online versions of offline practices, but rather are fundamentally new ways of interacting and transacting, enabled by abundant connectivity, computing power and access to data.
Companies building solutions in this area will aim to integrate with nearly every aspect of our daily lives and will design products and services that require minimal effort on our part to operate and manage. This will require us to truly reimagine the way we choose to interact with technology and, possibly more telling, how technology may choose to interact with us in the very near future.
Innovations such as online banking, peer-to-peer lending, marketplace lending and the like have been important steps in the history of financial innovation. The terms “online lending” and “non-bank lending” have enjoyed widespread use but somehow do not tell the full story. The distinction will not be bank versus non-bank, or even offline versus online, now that being “online” is mere table stakes and “traditional banking” has become a retronym.
The dividing line in a world of connected capital will be between the firms who merely utilize technology to deliver a traditional product in an online setting versus those who leverage the power of an always-connected world to deliver experiences that never could have existed before.
It is no exaggeration to say that online lenders have revolutionized lending. They achieved this by providing a better customer experience than retail banks, at lower interest rates than credit cards, at a time when credit was hard to come by for many consumers. Now that a few well-capitalized banks such as Goldman Sachs have finally started getting into the game with their own online personal loan offerings, the competition is heating up. Touting the same technology-driven customer experience introduced by online lenders but with loans funded by low-cost, federally insured deposits, these formerly ‘traditional’ lenders are taking a page straight out of the disruptors’ playbook. Using the advantage that access to low-cost capital provides, they have targeted a primary revenue source of most non-bank, online lending models, namely fees, for their own brand of disruption. How might this affect a borrower’s choice of lender in the future? Will the disrupted become the disruptors?
How Do Borrowers Choose a Lender?
The matrix above provides a useful framework for visualizing the factors that weigh in a borrower’s choice of lender. By comparing various lenders on these dimensions, it is possible to make predictions on their relative advantages and disadvantages with regards to attracting and retaining high-quality customers. On the vertical axis, we plot the value dimension, classifying factors into economic or emotional. While pricing is obviously of crucial importance to would-be customers, qualitative aspects also bear on any decision. On the horizontal axis, we plot the temporal dimension, classifying factors into short-term and long-term. For example, a customer’s business relationship with a lender can last many years, and borrowers will want to weigh factors that may impact them from the time of application to loan maturity.
Emotional Factors
In addition to purely economic interests, a borrower’s choice of lender takes into account various experiential and emotional components. At the outset of a relationship, borrowers will certainly prefer a lender who offers an efficient, pleasant, and intuitive customer experience during the loan application and origination process. For example, most small business owners would greatly prefer filling out OnDeck’s online application—connecting their accounting software to provide financial data and receiving a decision in minutes—to the process of walking into a bank branch, filling out forms, faxing hundreds of pages of financial statements, and receiving a decision in weeks. A better user experience has fueled the rapid growth of innovative online lenders over the past several years.
In addition to ease of use, customers also place importance on the overall reputation and trust level of a financial brand. People and businesses want to know that the data they provide to a lender will be well cared for, and many want to trust that the company they are conducting business with has their best interests at heart. In this regard, the comparison of newer online lenders with more-established banks is less straightforward. Banks’ reputations are still hurting from the aftermath of the Great Recession and suffer from a general perception of unpopularity with the general public. Large institutions are still working to regain their customers’ trust. In particular, customers who are digital-natives may be more likely to place their trust in a technology-focused company with a customer-friendly persona. At the same time, some customers may worry about the corporate longevity of the more recently launched online lenders and may take comfort in established banks with a long operating history and clear regulatory oversight.
Economic Factors
In a lending business, there are essentially two types of revenue for lenders: fee revenue and spread revenue. Commonly, fee revenue refers to amounts paid from borrower to lender corresponding to various situations. Across credit products, there exist front-end fees, such as application fees, origination fees, or membership fees, and there are back-end fees, such as late payment fees or over-limit fees. In practice, the manner in which lenders apply these fees varies between lenders and product types. The table below lists some typical examples, though it is by no means exhaustive. A massive variety of products exists in the wild.
There are many fees across a variety of loan products, and even within the online lending space, there is significant variation.
Spread revenue is another key mechanism by which lenders make money. This refers to the difference (“spread”) between their cost of capital and the net interest yield from borrowers. While this is a core component of traditional lending businesses, a “pure marketplace” lender who never holds assets on balance sheet and sells all loans at par would not have this revenue line. Instead of earning interest, the interest payments flow through to investors, and the originator generally takes a servicing fee. For example, LendingClub’s 2015 annual report shows net interest income as less than 1% of total net revenue for 2015, while fees represent 97% of revenue. By contrast, net interest revenue accounted for over 46% of J.P. Morgan Chase’s 2015 net revenue.
Goldman Sachs’ new foray into online, small-dollar consumer loans is funded in a highly traditional way, using low-cost, federally insured bank deposits. GS Bank, acquired from GE Capital earlier this year, offers savers interest rates from 1.05% to 1.85%, resulting in significant capital Goldman can use to lend to consumers. Given the opportunity to earn such significant spread revenue, Goldman has opted not to charge origination fees and has emphasized this in its competitive positioning.
What’s Next?
With Goldman Sachs having recently launched its long-awaited online consumer lending platform and other large banks likely to follow suit, it will be interesting to observe the interplay between these institutions and their fintech counterparts. While some imagine banking’s entrance into the space will be a sputtering failure, and others are fearful that the disrupted will become the disruptors and well-capitalized banks will put today’s online lenders out of business, the truth is likely somewhere between these two extremes.
Competition will be fierce, and there will be winners and losers, but a future where lenders are focused on building trusted brands and improving the customer experience will only benefit borrowers in the long-run. Borrowers have come to expect that the processes of applying for a loan will be conducted online regardless of whether or not they are applying at a bank or one of the new non-bank, online lenders. Taking a step back to consider the economic and emotional motivations behind why borrowers tend to choose a given lender will help organizations position themselves for success in the future.
As we near the conclusion of a long election season, this is the question on so many people’s minds. Every candidate for office runs on a promise that, should we elect him or her, we will feel better off in the course of a few years (generally in time for the next election). Many candidates also trade on the premise that right now, you might feel worse off (presumably because that candidate is not yet in office). While this simple question may lose its meaning amid the cynicism of political realities, it does contain a compelling implicit premise. Whereas observations made over short periods of time are subject to noise that may cause us to draw incorrect or perhaps overly narrow conclusions, reflecting on progress over a longer period allows us to focus on the most important trends, developments, and outcomes. This concept is a useful lens through which to evaluate the progress of an industry that has seen accelerating innovation and adoption over the past eight years: the financial technology industry in the United States.
In 2009, millions of Americans watched the inauguration of President Obama after an election that took place right in the middle of the deepest recession in a generation. In fact, during that campaign, which now seems quaint by today’s standards, both candidates took a break from campaigning to attend recovery-package talks in Washington, even issuing a joint statement on the need for both parties to cooperate on a plan. Regardless of which candidate you may have supported, many people watched that inauguration with a sense of hope, that perhaps over the next presidency, we would emerge from the depths of the crisis a stronger and more resilient nation. Whether we are in fact stronger today is clearly an unresolved issue, but one particular area of our economy has seen inarguably significant activity. Over the past eight years, financial technology (or “fintech” for short) has exploded in popularity, as innovations have become accessible not only to large financial institutions but also to consumers and businesses of all sizes. Let’s examine some of the innovations that have been part of this wave.
Mobile Banking
Not long ago, most conventional banking operations required the customer to be physically present in a retail branch. In the past eight years, much has changed, primarily due to the near-ubiquitous penetration of smartphones. In 2009, USAA released the first mobile check deposit feature in its iPhone app, with other major banks following suit in subsequent years. Today, consumers conduct a variety of banking transactions on the go, including check deposit, money transfer, bill pay, and even applying for certain types of loans. This shift has changed the customer experience and also altered the physical landscape of banking, coinciding with the net closure of branches across the country.
Source: St. Louis Federal Reserve
As mobile connectivity obviates the value of physical proximity, barriers to switching have been reduced, and some traditional depository institutions have struggled to adapt. While mobile banking has had an impact on how people bank over the past eight years, the capabilities in most apps basically just mirror the operations one might conduct in a branch. If large financial institutions want to maintain their centrality in customers’ lives, they will need to introduce innovations that uniquely take advantage of the mobile platform and go beyond those branch-based basics.
Online Lending
In 2009, the entire lending industry had just been turned inside out. After the collapse of the sub/near-prime mortgage market, record high credit card losses, and amid plummeting consumer confidence, Americans deleveraged in a big way and lost trust in traditional lenders. From the ashes of crisis came innovation and the desire to apply a new model to lending. At the time, the nascent industry of “peer to peer” lending had started to gain momentum among a small group of enthusiasts borrowing from and lending to other people on websites such as LendingClub and Prosper. In 2009, those two sites facilitated just $60 million in loans. At the same time, some companies began conducting commercial lending online as well, using the power of web-based tools to simplify the application process and attempt to make better credit decisions. OnDeck Capital, a leader in this market, launched in 2007. Today, LendingClub, Prosper, and OnDeck have made over $32 billion in loans to consumers and businesses online, and the ranks of innovative online lenders have since grown to include literally hundreds of firms, poised to facilitate a meaningful portion of our nation’s economic activity. While online lenders have meaningfully improved the customer experience for millions, they will now be challenged to maintain their advantage against large banks with access to low-cost capital and to continue to grow their businesses while navigating a complex and sometimes uncertain regulatory landscape. The latter point may very well be a focus in the next presidential administration.
Retail Investing
Online investing for individuals in 2009 was where online retail banking is today—electronic and convenient—but only just beginning to make use of the opportunities offered by a population carrying over 200 million always-connected pocket supercomputers. The rise of online brokerage took place in the first so-called “dot com” boom of the late 1990s. While these online brokers, such as E-Trade, TD Ameritrade, Scottrade, and others, offered low-cost and convenient trading of a variety of investment products, this was only the first step in a fundamental transformation of how people plan and manage their investments. Over the past several years, various companies have offered entirely new models of investing. Robo-advisors such as Betterment and Wealthfront use algorithms to manage custom-tailored investment strategies in an automated fashion. Companies such as Quantopian, Motif Investing, and Covestor provide a platform for people to develop sophisticated investment strategies and then make them available on a marketplace for others to follow. Even the aforementioned online lending platforms began as a way for individual investors to access a new and untapped type of fixed-income investment through fractional loan investing in consumer debt. For wealthier “accredited” retail investors, various web-based platforms like Prodigy Network, iCapital Network, FNEX, PeerStreet, and many others offer easy access to more esoteric investments, such as commercial real estate, private equity, managed futures, and hedge funds. While obvious advances have been made in the automation, availability, and cost-efficiency of various investments, we may see in the coming years more successful attempts to merge the best elements of machine-based and human-based investment advice to deliver strategies that are more closely tailored to individuals’ personal circumstances. As with online lending, the next president has an opportunity to affect these developments by advocating for more regulatory certainty and a framework that contemplates adoption of leading-edge technologies such as artificial intelligence.
Institutional Investing
One of the major trends in technology more broadly has been the consumerization of enterprise technology. What this means is that while once upon a time, advances adopted in big companies trickled down to consumers, that stream now often flows in reverse. People are becoming so accustomed to personalization, mobility, and thoughtful user interfaces in their personal applications that they are now bringing these concepts into professional settings. In 2009, while smaller individual investors could begin to access a wealth of capabilities online, many investors in RIAs, hedge funds, and other investment vehicles had to subsist on phone calls, manually-generated spreadsheets, or client-access websites that were last designed in the late 90s (and looked like it). Over the past several years, companies such as Addepar have worked to bring modern, data-rich, and highly-capable user experiences to larger investment managers and their clients. Simultaneously, several alternative asset classes, such as online lending, have now become large enough to be institutionally viable, providing large investors with greater product diversity. This influx of institutional capital has also helped industries such as online lending mature into significant asset classes. Although the breadth of capabilities to which institutional managers now have access has certainly grown, the next challenge will be in how such firms continue to differentiate themselves and maintain their fees, when so much can be commoditized. Additional challenges in the next presidential term involve how best to adapt decades-old securities laws to a rapidly evolving financial landscape.
Payments
One of the greatest areas of financial technology innovation in the past eight years has involved the systems, mechanics, and convenience of payments. Eight years ago, transferring money to a friend online was difficult, expensive, or nearly impossible. Today, individuals can simply send money using apps such as Venmo, which was acquired by PayPal, and payment features offered by banks, such as Chase Quickpay, have also gained widespread adoption. Venmo handled $3.2 billion in payments in Q1 2016 alone. Developers of online and mobile applications have also been positively affected by the transformation of payments. In 2009, integrating credit card acceptance into a product was a major technology project and lengthy undertaking involving paper, faxes, and obtuse compliance procedures. Today, developer-friendly payment platforms such as Stripe have streamlined the process and have facilitated billions of dollars in payment flow. While the payments landscape is dramatically more convenient and streamlined than it was eight years ago, the lion’s share still takes place on ‘rails’ that are decades old and lag the rest of the developed world in settlement time, security, and flexibility. It remains to be seen how and when newer technologies might enhance or replace the ACH network, as well as the impact that decentralized, cryptographic protocols such as blockchain might have on payments.
Looking Forward
Over the past eight years, we have witnessed a wave of financial technology innovation in the United States, which has benefitted consumers, businesses, and the economy at large. Nevertheless, many of the promises of technology remain unrealized, and there is ample uncharted territory for innovation. For instance, many financial firms still offer products that put their interests in opposition to those of their clients. And, for all the benefits of mobile technology, most financial service providers are still behind the leaders of other industries in terms of fully tapping the potential of an always-connected world and, crucially, in gaining their customers’ trust to do so. There are also major challenges to be solved in the political realm, and it is often difficult for regulators to keep up with an environment that is changing so quickly, balancing the mandate to protect consumers and the broader economy while also being supportive of innovation. When this election season finally comes to a close and the next inauguration takes place, our new president will inherit an economy that still bears many of the scars and uncertainty of the great recession, with a population divided as to the benefits of recovery and a path forward. We hope the next president will be supportive of the role of financial technology in promoting access to credit, efficiency, transparency, and ultimately playing its part in fostering the growth of a stable and robust U.S. economy.
Nearly each week, we see another data point in the ongoing transformation of American retail. Once-bustling malls are becoming ghost towns. Department store sales are trending monotonically downward. Stalwarts of commerce are performing far worse than the market overall. The common thread running through these stories is the effect of near-zero switching costs on economic decision-making, something that has transformed many an industry, including retail, and is beginning to transform financial services as well.
Department store sales have consistently decreased since the turn of the millennium, according to data collected by the U.S. Census Bureau.
Mobile devices account for a rapidly increasing proportion of Black Friday sales, according to data collected by IBM.
The appeal of malls and department stores lies in their ability to offer many goods and services in close proximity. For decades, this gave stores or departments with close physical adjacency a natural competitive advantage over their far-flung counterparts. The “switching cost” of driving or otherwise transporting oneself to a location outside the mall or department store was a meaningful barrier to competition and perhaps a misinterpreted indication of customer loyalty.
The transformation we’ve observed in retail consumer goods parallels the change currently taking place in financial services. Banks built vast networks of physical branches and introduced an impressively wide array of consumer and business financial products — the often-referenced “financial supermarket.” Implicit in this strategy was the concept that a customer using one of the bank’s products would want to use that same bank for other financial products as well. The switching costs of evaluating another bank’s products, rates, and services provided a formidable barrier to competition. Just as in other retail markets, banks may have mistaken customer inertia for customer loyalty.
Today, consumers or businesses can evaluate multiple competing providers of financial services from the comfort of their laptops, smartphones, or tablets. A wave of new entrants to the market have used technology to promote their offerings to would-be customers and differentiate themselves with potentially better rates, friendlier customer service, or ease of use. There are even aggregators such as Bankrate, Lendio, Fundera, and LendingTree, which allow prospective borrowers to compare multiple loan offers at once!
The number of physical bank branches per capita in the United States has steadily decreased since 2009.
The volume of loans issued by online marketplaces has grown dramatically in the U.S.
The physical switching costs of adopting a new financial solution no longer involve traveling to a new bank branch, but rather navigating to a new website. Even the administrative switching costs are no longer particularly high, as personal financial management and business accounting software are able to integrate data from a variety of sources into a single user interface.
The Internet has demonstrated its ability to reduce switching costs across a variety of industries, resulting in greater consumer choice, lower costs, and improved customer experience. As customers have more options, providers of products and services have a higher standard for customer acquisition and retention. This incentivizes them to offer better products at better rates and to consistently raise the bar on customer service. Companies who embrace this thinking will be rewarded with brand recognition, market share, and customer loyalty for years to come.
To Order Chaos 