In this issue of The Institutional Risk Analyst, we ponder the world of fintech, a term everyone in business and finance knows but few can define with any particular detail. There are many companies that claim to be fintech firms, or at least have some components that have these characteristics, but there are very few that we can point to as being truly revolutionary.
The term “fintech” is a contraction of two words -- “financial technology.” In a recent paper published by the University of New South Wales, Douglas W. Arner, Jànos Barberis and Ross P. Buckley note that the term fintech “refers to technology enabled financial solutions” that have evolved over the past 150 years. They continue:
“It is often seen today as the new marriage of financial services and information technology. However, the interlinkage of finance and technology has a long history and has evolved over three distinct eras, during which finance and technology have evolved together.”
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The largest strides in the use to technology in the world of finance came many decades ago, when sending physical mail was supplanted by the telegraph and later the telephone. In the 1970s, when the first computers were introduced to banking, the time required to process financing transactions began to fall dramatically. Then, as today, what computers do best is count.
Just as the invention of electricity changed industrial processes, the advent of computers to enable automated reconciliation tasks forever transformed finance. Fifty years ago, when some of today’s leaders in the consumer finance sector first entered the business of lending on residential homes, getting a mortgage could take months as data was assembled and validated. Payments were made using checks, which were then manually reconciled and presented to the originating bank.
When this writer worked at the Federal Reserve Bank of New York in the 1980s, there were three shifts working 24 hours a day, five days a week, processing cash and checks across the banking system. Airplanes flew bags of paper checks around the country to be processed by the regional Federal Reserve Banks. It is interesting to note that, decades later, the Federal Reserve System still has not extended the hours of the FedWire to evenings or weekends. As we noted in our previous comment ("The Fed Takes a Baby Step Forward in Payments"), the Federal Reserve Board is only slowing bringing the bank-centric payment system in the US up to current technology.
Yet despite such impediments, the evolution of technology is changing the way in which finance operates. Obtaining a mortgage today takes just days instead of months. Perhaps the biggest single task in the process is validating the information obtained from the borrower, including checking for fraud. The actual task of documenting the loan and the collateral has been greatly accelerated to the point where it is normally done in days or even hours.
A great many of the advances in lending today are more incremental than revolutionary. Eliminating mistakes and the attendant legal and regulatory risks that process faults inevitably create is perhaps as important as speeding the volume of loan applications through the system. Mortgage lenders, for example, profit by making more loans, but making a single bad mortgage can wipe out the profit from hundreds of good loans.
Last year, the average time it takes for homebuyers in the United States to close on home purchases was 47 days across all loan types, according to mortgage software company Ellie Mae. But there is natural tension between the desire for more sales and the imperative to avoid costly mistakes. Removing the possibility of mistakes in the loan underwriting process has become perhaps the single biggest goal in the mortgage industry, but is also important across all consumer loan categories.
Enhanced productivity with fewer errors is the common goal of any lender facing consumers. For example, many consumer loan vendors provide tools to speed the validation of employment (VOE) by eliminating the transmission of personal financial data through email or fax. Lenders are able to complete more loans in less time. The laborious process of manually reviewing borrower-provided employment data has been replaced by an entirely deterministic process.
Other technology providers focused on mortgage lending offer secure environments to assemble and validate all of the information in a loan file, focusing activity within a common digital workspace. Again, the object here is to improve the time required to complete a loan, reduce cost and also avoid errors and fraud that can result in costly credit events. All of these changes are important, but they are hardly revolutionary. Do the companies providing these banal tools deserve nose-bleed valuations? Hardly.
As the benefits of technology to all aspects of credit and payments have become increasingly incremental, the hype surrounding the use of technology in finance has soared exponentially. Private equity funds and established companies tout the payback from fintech as though we were all witnessing the invention of electricity or silicon-based computing. But in fact most changes seen in finance today are incremental at best.
One of our favorite examples of the ambiguous benefits of what we know as “fintech” is the payments company Square, Inc. (SQ). Touted as a “disruptive” provider of payment processing for retailers small and large, Square in fact is an overlay of off-the-shelf tools and functionality that operates atop the legacy world of banking and payments. We owned the stock early on when it traded in single digits, but got out when SQ touched $100 per share.
Despite the millions of words written about the disruptive aspects of fintech, companies like Square simply provide modern software that sits atop legacy banking systems. Today Square’s equity trades at almost 70 times forward earnings. This is not to say that evolution is unwelcome or without worth, but the value claimed by many "fintech" firms is an exaggeration. The Sell-Side hype surrounding fintech was largely responsible for the rise and fall of SQ, which today trades in the $60s.
Lest we forget, payment processing is a legacy bank monopoly jealously protected by the Federal Reserve System and other central banks. Much of payments today follows a linear process map that harkens back to the days of paper before the invention of the telegraph. Fintech companies such as Square are not so much providers of new technology as they are the newest players among commodity payment providers such as Visa (V) and Mastercard (MA).
There is nothing “new” about payments companies such as Square or PayPal (PYPL), they are simply more nimble than big dumb banks. But the banks will figure it out. There is nothing really new under the sun when it comes to technology, only new packaging and hype in the world of media and investments. Just as today's automobiles are merely evolutions from the original horseless carriages of a century ago, much of FinTech today is merely an evolution of existing technology.
Virtually every fintech company we have examined over the past five years represents more a progression from existing tools rather than a fundamentally new process or technique. The next evolutionary step from computers enabling old, linear production processes such as lending will be data-centric applications. In the meantime, maybe it is time for us to stop writing terms like fintech with capital letters and focus instead on how “new” uses of existing technology add value for lenders, investors and consumers as measured in dollars and cents.