09/03/2016 ACynicsGuideToFintechBullMarketMedium

A Cynic s Guide To

Fintech

Several business models

that are bound to fail and

a few that might have a

chance

A pal working in and around the

VC industry asked me the other
Silicon Roundabout Old Street near the City of London.

week what I thought about

A lot of ntech startups are based here

nancial technology, or as the

unlovely abbreviation has it, ntech. Here are my edited thoughts, from the
point of view of someone who spent many years as a banks and diversied
nancials analyst, and who has some fairly strong prejudices about what
works and what doesnt work in nancial services industry. In my view, the
portmanteau term ntech groups together a number of dierent business
models; I havent included something something Bitcoin in the list because
thats a slightly dierent debate. Heres my partial list

Fintech business model #1. Reinventing past mistakes of the

banking industry because you dont know about adverse

selection

There are a lot of people out there who have expertise in data science, and
who think that the incumbents in the industry dont have sophisticated risk-
based pricing because their technological skills arent up to the task of
identifying risks. These people tend to think that they can go into the credit
cards business, or the payday lending business or even the car insurance
business, and pick up market share from the dumb old banks by using
algorithms! and social media data! and so on.

This is not true. It is true that banking IT is generally terrible, but actually, if
you look into the digital archives of any large incumbent player, you will tend
to nd an extremely sophisticated, cutting-edge algorithmic risk pricing

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system which was thrown away a couple of years ago because it worked great
in testing and then fell apart really badly in the real world.

There are two reasons why ne-grained risk based pricing has been such a
catalogue of failure. First, banks almost never lose money on bad risks. They
lose money on good risks, which go bad. The nature of algorithm-driven
pricing is that you are searching out protable niches, Moneyball style, in the
form of customers which have some set of characteristics in common which
marks them out as statistically better than the average. Unfortunately, this
tends to mean that you get a book of business which has loads of little
concentrations in them youve got all the mixed-race dentists in Yorkshire,
or something. And this, in turn, means that when the world changes, your
risks tend to be very correlated and you lose years worth of prot in one
lump.

And the second is that the customers get to make decisions too. Unless your
system is perfect, its going to make mistakes. And the kind of mistake its
going to make is the kind which ends up with you hanging out an extremely
attractive pricing oer, and attracting customers who have the particular set
of characteristics that your algorithms have identied. But the people who
respond to your oer are never exactly the same as the people that you
modelled. In particular, the market share you gain tends to come from people
who have all the characteristics that your algorithm liked, plus one more
the property of being more than usually price-sensitive. And it turns out that
price-sensitive customers are often signicantly worse risks; theres often a
reason why someones so keen on getting the cheapest deal, and its usually a
reason that isnt in the database you bought.

Im not saying its impossible, but its been tried a lot of times, by very clever
people, and its worked precisely once Direct Line car insurance, and they
were attacking a much less competitive industry than anything that exists
today. The safe way to do nancial services is to keep the segmentation down
to a minimum and let the mathematics of risk pooling look after you.

Viability rating (2/5)

Fintech business model #2. Thinking that a great big lump of

transactions data is more valuable than it is

The real evangelists of Big Data thinking in the ntech industry seem to think
that providing the actual nancial services is a tiresome encumbrance, a loss
leader that you have to provide in order to get access to the true mother lode
of value a load of Big Data. This is, to be frank, incomprehensible.

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Transactions data just isnt that valuable, and in order to get lots of it, you
need to have a very big operation indeed.

Look at it this way the single most developed transaction data analytics
business in the world is Dunnhumby. They have more than a decade of
experience, and they work with the Tesco Clubcard dataset, which accounts
for a material proportion of all the supermarket transactions in the UK over
the last ten years. And they have managed to segment Tescos customer base
into a grand total of eight economically meaningful groupings. Along with
that, they have come up with insights like people who buy carrots also often
buy cucumbers. Dunnhumby is currently being shopped around for sale at a
valuation of about 2bn, and this is most likely the biggest and best such
company that has ever existed. Which is not to say that its not valuable the
thing is worth a couple of billion dollars, after all but its clearly incremental
to Tesco rather than transformational. Its also pretty clear that things like this
make sense as potentially helpful adjuncts to a protable main business, not as
goals in themselves.

Also in this category are people who believe that a combination of Twitters
Decahose feed and a neural net algorithm are going to make them billions on
the stock market, but I dont think we need to lose too much time on that.

Viability rating (1/5).

Fintech business model #3. Hoping that a load of people who

actively mistrust each other will trust you instead

This business model is very common in the wholesale markets version of

ntech. Often put together by a former star IT guy at a major investment bank,
often by someone who got passed over for the COO job because his
understanding of the business didnt match his technical ability. And it usually
involves the creation of a platform which will bring together a fragmented
market, automate the process of collecting dealer quotes, and generally make
forex, derivatives, bond trading or whatever look more like a stock exchange.
Its aimed at disrupting the middlemen.

I wrote a whole chapter in me and @TessReads book about what service it is

which the middlemen provide. If you dont want to buy the book, Ill explain it
succintly here the service that interdealer brokers provide to their clients is
simply that of being middlemen so that parties who really badly dont trust
each other dont have to deal with each other directly. And if they dont trust
each other, then they are really very unlikely to just hand over their position
and order data to a ntech startup.

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This isnt a totally unviable business model. Trading facilities do get set up,
and they sometimes do take o BATS being the most obvious example. But
if you look at the success stories, there is always a lot more n and a lot less
tech to their way of going about things. Getting a trading platform set up is
always a delicate and hugely political business of reassuring all the parties
that they are not going to get ripped o either by each other or by you. Just
having cool technology is never enough its always about building the trust
and relationships. And if you are able to do that, youre going to make money
whether or not youve got good technology.

Viability rating (3/5)

Fintech business model #4. Trying to use someone elses

network and only pay the marginal cost of doing so

On the face of it, this ought to look like a non-starter. All the big and
important nancial networks are owned by the incumbents. You would think
that this would mean that startups would be hard pressed to get access to
them at all, let alone to do so without paying their share of the overhead. This
would make sense, but in many cases it would be wrong.

For starters, regulators are currently very keen on encouraging competition

and entry in nancial services markets. For another, wherever you nd
competing networks in nancial services, you will nd somebody whose
bonus is only dependent on trac and market share, and who doesnt really
care about economic viability of the business that he or she is winning. And
nally, dont underestimate simple inertia, incompetence and general failure
to get ones act together, which are often the most powerful competitive forces
in nancial services.

So there are actually a surprising number of viable business models which

involve undercutting the incumbents for payment services. And although any
business which is, at base, dependent on the industry not getting its act
together is vulnerable to the risk that one day, the industry will get its act
together, this can often involve an acquisition.

Viability rating (4/5)

Fintech business model #5. Assuming that the regulators will be

more inclined to listen to your whining than to the incumbents

Usually a bad idea in nancial services. Regulators basically dont like small
nancial services companies. There are severe diseconomies of small scale in
supervising them, they are more prone to blowing up and they dont do very

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much for your career. And nancial services is an intrinsically regulated

industry where consumer protection is often very rigorous for a good reason.
So the whole Uber idea of just blatantly breaking the law and then sending
out a press release about how uncool and obstructive everyone is being is not
going to go down well. Several ntech startups have already found out that
there is no exemption for tech companies from the money-laundering or
consumer nance laws, and that regulators usually dont care if theyve driven
someone they regard as a rule-breaker out of business. The existence of
nancial regulations also tends to mean that ntech companies need to have a
lot more capital lying around than they would if they didnt need a nancial
services licence.

Viability rating (2/5)

Fintech business model #6. Giving customers a worse service

for a lower price

The only ntech business model I would regard as a proven success story.
Giving a worse service for a lower price is what made the discount brokerage
industry. Whats going on here is that banks love to bundle services and
charge a premium price for the bundle, on the assumption that lots of
customers will thereby pay for a load of expensive services that they dont
really need. Attacking this bundling has often been a good source of
competitive advantage. As far as I can see, something like this is at the heart of
business models like Transferwise most retail clients really dont need
immediacy for their foreign exchange transactions.

Viability rating (5/5)

Fintech business model #7. Getting your act together with

respect to an industry standard where the industry has

conspicuously failed to do so

In principle, it should be impossible to seriously compete against the banks in

international monetary transmission. They all ought to have good networks of
correspondent banks, to be able to handle their nostro, vostro and loro
accounting and so to be able to convert foreign exchange and send payments
via extremely cheap central bank systems. In fact, the correspondent networks
are often lousy, meaning that payments have to take dozens of extra
unnecessary steps, and the accounting systems are reconciled too slowly. Even
the small number of banks that know what they are doing dont feel like
theyre in a competitive industry, so they dont act that way. And this is only
one of a number of areas Apple Pay ought to have been a huge wakeup call
to the banks not because it was a brand new way of making payments, but

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because it was basically the only fully satisfactory implementation of an

existing industry standard. Again, there is a certain degree of long term
business risk inherent in building your company around the inability of the
banking industry to get its act together, but there are lots of very vulnerable
areas here too.

Viability rating (5/5)

These seven business models are the ones which stood out to me in a quick
survey of the ntech industry Im sure there are others. Im also fully aware
that Im being more than a little bit unfair in some areas, for the sake of
making a point. But I dont think Ive been wholly unfair to any of them, and
the broader point is quite important. Fintech is apparently a big priority
policy area for the UK governments industrial policy, and seems to have
attracted a whole load of fairly uncritical support. Actually, a lot of these
businesses are based on repeating old mistakes, and the ones which arent
seem to be based on solving problems that should never have existed if the
world had a fully functional banking industry.

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