One of the hottest topics in finance in 2019 and 2020 is FinTech. The name, of course, comes from ‘financial technology’ but mixing finance and technology is not new. Finance has always been at the forefront of applications of computer technology. One of my favourite books is “My Life as a Quant” in which Emanuel Derman (2004) explains his Wall Street adventures and the challenges of adapting the latest finance theory (and theoretical physics) to computer-based models that traders can use to identify pricing discrepancies. If it’s always been done, why is there such a fuss being made about FinTech now? To explain, let’s look at a little bit of the history of finance and technology.
One of the best papers in this area is Arner, Barberis & Buckley (2016). They divide the history of finance and technology into three periods: FinTech 1.0 as 1866-1967, FinTech 2.0 1967-2008 and FinTech 3.0 2008 onwards. The distinct feature of FinTech 3.0 is not the use of technology to deliver financial solutions. It is unique in terms of who is applying the technology (Arner, Barberis & Buckley 2016, p.1275). The thing that makes FinTech 3.0 different from FinTech 2.0 is that many of the players are not traditional finance companies. For example, Apple Inc. offers Apple Pay, which allows users to make payments using their iPhone or other Apple device. In addition to established firms like Apple entering the finance field, there are many new ‘start ups’ offering innovative new services. Much of the time, these are right on the boundary of the existing financial regulatory frameworks.
One example that always raises a few eyebrows is the emergence of ‘robo-advisors’. That is, investors receive portfolio allocation and investment advice, not from a real person, but from an algorithm. One of the leading firms in this space is Betterment, which was established in New York in 2008. It currently has $20 billion under management. Of course, customers can speak to a real person if they like. Also, while an algorithm-based robo-advisor sounds extreme, it should be noted that the use of algorithms to allocate investor funds was a major part of FinTech 2.0. The difference was that ‘back then’ the portfolio manager would collect the funds, probably after an account executive or financial planner worked with the client first, and then use the algorithm to make portfolio allocation decisions. Now, investors can gain direct access to the algorithm. This can reduce fees and might even result in better investment outcomes.
For the time being, the most popular service offered by FinTech firms is payments and funds transfers. According to Ernst & Young (2019), 75% of FinTech customers use FinTech for this purpose. The most important innovation in this space appears to be the e-Wallet, which allows consumers to link an account to their personal device (phone) to make secure payments without the need for a credit card. While many people will be wary about the security implications, experts suggest that the IT architecture makes the e-Wallet safer to use than traditional payments methods (e.g. see the advice offered by Fidelity Investments).
In addition to new products and services, much of the fuss about FinTech 3.0 stems from the vast number of new players entering the financial services industry. Most of the new firms are based in San Francisco. According to Forbes (2019), the top 10 American-based firms, their investment capital and their main activity are:
- Stripe ($22 billion), a payments platform.
- Coinbase ($8 billion), e-wallets and trading platforms.
- Robinhood ($5.6 billion), trading platforms for stocks, cryptocurrencies etc.
- Ripple ($5 billion), global settlements network aiming to replace SWIFT.
- Sofi ($4 billion), online loans refinancing.
- Credit Karma ($4 billion), free credit services (e.g. credit scores, tax preparation software).
- Circle ($3 billion), cryptocurrency trading.
- Plaid ($2.65 billion), connects payments apps and services to users’ bank accounts.
- Avant ($2 billion), instant online loans.
- Gusto ($2 billion), online payroll processing.
The payments system, as well as the traditional regulatory frameworks, may face new challenges from FinTech 3.0. In the long-term, once things settle down, we might see more partnerships between traditional finance firms and FinTech operators. This will act to absorb the new innovations into the financial system. In the meantime, regulators will need to be vigilant.
Select one of the FinTech companies in the Forbes top 10 (or top 50). Describe its main activities and explore some possible ways in which the activity could disrupt the traditional payments system or compete with traditional financial services firms.
For those interested in researching this topic further, much of the relevant academic literature is contained in law journals (e.g. Arner, Barberis & Buckley 2016). See Financial Institutions, Instruments and Markets 9e, Chapter 12: Government Debt, Monetary Policy and the Payments System for a discussion of the traditional approach to payments in Australia.