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Definition

FinTech, or Financial Technology, as the name suggests refers to a blend of cutting edge technology and every day finance. Think Steve Jobs meets the Rothschilds. The result is a transformation in all corners of the financial sector from online payments to household mortgages, from trade finance to asset management.

In essence FinTech is the natural evolution of finance in a 21st century world dominated by interconnectivity and mobile devices, but unlike the conglomerate led financial world of yesteryear this phase of evolution is being driven by startups. Geeks and venture capitalists are teaming together to re-write the banking code and are shaking up the industry- for the better. Gone is the reliance on high street banks and loan sharks. Now businesses and individuals can raise finance at the touch of a button, through various channels, at highly competitive rates and not at the mercy of the bank manager.

Initially the industry focused on the development of support services like mobile banking. This has impacted hugely on the largely unbanked developing world because now a smart phone can be used as a bank account. In the insurance sector FinTech is used to tailor premiums by gathering diverse data instead of having the applicant fill out a basic questionnaire which excludes many factors. Recently FinTech has spurred innovations in arranging finance for individuals and businesses by removing banks as intermediaries through a process known as crowdfunding.

From wannabe film producers, artists and writers to budding entrepreneurs who believe their idea is the next big thing, crowdfunding is a welcome addition to a desperately narrow list of financing options for even the most viable of proposals. Crowdfunding involves the sourcing of pooled finance from a large crowd where each individual pledges relatively small sums. Some platforms facilitate pledges from as little as $100 whilst for others the minimum pledge is several thousand USD. Likewise the funding targets can vary greatly from a few hundred USD to $1million or more.

Crowdfunding is broadly divided into three main categories: equity, debt and rewards. Each category caters to a different segment- equity for businesses, debt for businesses and individuals and rewards for small scale projects. There is a fourth category known as donation crowdfunding although this is too similar to existing charity fundraising techniques to warrant further explanation. Interestingly the pedestal for the New York Statue of Liberty was crowdfunded in what was one of the earlies examples of the practice. This followed a campaign launched by publisher Joseph Pulitzer in his newspaper The New York World since the City of New York refused to finance construction. The campaign raised $101,091 from over 160,000 donors.

Equity Crowdfunding

Entrepreneurs looking to finance a start-up or early stage business can pitch their idea or existing business to a crowd of potential investors through an online equity crowdfunding platform. Different platforms practice different methods although methods are becoming standardised as the industry evolves. Generally a summary of the business coupled with a funding target and amount of equity on offer is included in the pitch, which is hosted on the platform for a fixed amount of time. Investors can make pledges through the platform in return for shares in the business if the funding target is met within a set time frame. The investors become shareholders in the business. If the funding target is not met pledges are refunded in full to investors although in some cases the entrepreneur is given the option to extend the life of the campaign if the target is near.

Only the most promising proposals are showcased on crowdfunding websites. An entrepreneur cannot simply register any proposal and expect to receive investment. The criteria is usually very strict resulting in more than 90% of all submissions being rejected before a funding round can commence. There are two reasons why most proposals are rejected: Firstly, equity crowdfunding platforms make their money by charging a success fee on funds raised in the event that the funding target is met. Therefore the platform will not get paid hosting second rate funding proposals. Secondly, if most funding proposals do not receive investment this will impact on the reputation of the platform, as will businesses which go on to fail after a successful funding round.

Equity crowdfunding received a big boost in the US in 2015 when the Securities Exchange Commission, the country's financial regulator, adopted rules permitting companies to offer and sell shares through crowdfunding websites. This was part of the wider JOBS (Jumpstart our businesses start-ups) act aimed at making it easier for start-ups and small businesses to raise funds whilst also providing investor protection. Other countries with strict securities laws require funding proposals to be filed with the appropriate authority to ensure some level of investor protection. The UK Financial Conduct Authority, Frances Authorite des Marches Financiers and the China Securities Regulatory Commission are state regulators from just a few leading economies to recognise equity crowdfunding.

Debt crowdfunding

More commonly known as Peer-to-Peer (P2P) and Peer-to-Business (P2B) lending. P2P lending platforms allow individuals access to a pool of non-institutional lenders to seek various types of loans including mortgages, credit card re-financings and even student loans. The creditworthiness of the borrower along with the indicative interest rate is determined using electronic algorithms which are far quicker than methods used by conventional high street banks. A borrowers creditworthiness can be scored in minutes rather than days. The platform acts only to host borrowing proposals and facilitate transaction whilst it is down to the lenders to decide whether or not a borrower is deserving of credit.

Although the proposal is showcased with an indicative rate of interest determined by a computer algorithm, the actual rate of interest is market driven being determined by auction- a greater number of willing lenders drives the rate down and vice versa. Generally the rates of interest are more competitive than those offered by traditional banks and credit card lenders, particularly in countries which have high cost of credit. This does not mean that lenders suffer as a result of lower rates. P2P lending platforms have lower operating expenses than conventional high street banks so these savings are reflected in competitive returns for the lender. There are no expensive bricks and mortar offices to service as these businesses operate online.

P2B lending platforms operate on the same principle except the borrowers are businesses. In both instances the individual loans are made up of relatively small pledges from a crowd. The regulatory framework for debt crowdfunding is similar to that of equity crowdfunding, as is the fee structure. Lenders usually are not charged to use the platform- instead a success fee is are charged to borrowers who raise funds along with in some cases a fee to register the proposal with the website.

Rewards based crowdfunding

Ideal for financing community projects and favoured by artisans, rewards based crowdfunding is the longest established method of crowdfunding given the absence of a requirement for regulatory approval. Instead of becoming a shareholder or creditor the pledger is rewarded with an item relating to the underlying project. An author may choose to reward their donors with an early copy of the book being financed whilst a musician may offer an album copy. This method of crowdfunding is more closely aligned with traditional charity than finance as the true reward is the sense of satisfaction in helping an individual to get their project off the ground.

Ease of diversification

One lesson of the recent global financial crisis is that investors must diversify to reduce risk. Investing in equity and debt crowdfunding proposals carries great risks because start-ups have a high failure rate and loans issued via P2P lending platforms are seldom secured against the assets of the borrower. Investors should never allocate a large proportion of their capital to individual crowdfunded businesses, nor should they invest most of their savings in one asset class. Shares in crowdfunded businesses should make up part of a wider diversified portfolio so as to limit exposure and downside risk.

Fortunately from a fee perspective there are no costs associated with holding a diversified portfolio of shares and debt in private crowdfunded businesses. Unlike when buying shares in public companies such as those listed on a stock exchange, an investor does not have to pay a transaction fee to invest through a crowdfunding platform. The legal and administrative fees are almost always paid by the company receiving the funding, leaving the investor free to commit small amounts of capital to a large range of businesses. In public markets investors can diversify without paying multiple fees by purchasing an index tracker or investing their money with a discretionary fund manager however this leaves the investor with no control over which companies are held in the portfolio.

If the company is successful, exits can take anywhere from 3 – 7 years and usually occur through a buy-out by a larger company or an Initial Public Offering (IPO) where the company issues shares on a stock exchange. This reiterates the importance of diversification across various asset classes. However secondary markets for crowdfunded securities are starting to emerge so for the first time existing investors will be able to list their shares for sale however these markets are expected to remain illiquid.

Around 80% of global FinTech investment is in the US. Outside of the US London ranks as a major hub, with estimates suggesting 40% of the workforce are employed in financial and technology services. Although London lags behind the US in terms of total investment the growth rate is around double that of silicon valley. Reflecting the European lag is the fact that much investment is concentrated on seed / early stage whilst in the US there is a greater financing pipeline for later stage.

What's the catch?

The sector was plagued by skepticism only a few years ago, especially in the US where regulators warned of online security breaches and mass fraud. But that was then. Now these disruptive businesses are past the induction stage and the results speak for themselves. There are a small handful of horror stories despite tens of billions of dollars being transacted through FinTech portals. Deserving companies previously shut out of credit and equity markets are obtaining finance at affordable rates and the most conservative of regulators allow crowdfunding.

The winners and losers:

Who benefits from this structural evolution in finance? If we can agree that capital is one of the driving forces behind any modern economy then the answer must surely be everybody in one form or another. One could argue that traditional banks will suffer but banks themselves are embracing technology in their online offerings, without which their relevance would surely be diminished. The 'financing' side of FinTech is not replacing traditional means, it is instead opening up new arteries which would never had existed without todays technology.

Consider high risk business start-ups in sectors like technology which traditionally rely on seed investment from friends and family before they enter the radar of venture capital. If friends and family don't have deep pockets there is little chance of getting the idea off the ground. Now idea stage businesses can present their funding proposals to angel investors through equity crowdfunding platforms. Many angel investors are sector specific in that they look to invest in familiar areas- some crowdfunding platforms even cater to specific sectors.

In the peer to peer lending space both the lender and borrower benefit from the absence of an intermediary. It is the individual lender who directly determines whether or not to commit capital whilst traditional banks require human resources to allocate funds. Salaried bank employees in turn need relatively expensive offices and workspaces whilst individuals lending through a peer to peer platform require only the interface of a website. It is estimated that overheads as a percentage of outstanding loans for peer to peer lenders are 60-70% lower than those of conventional lenders.

Cautious optimism

FinTech firms are not about to reinvent the wheel. Traditional banks will always have a place in society given their lobbying efforts and the conservative nature of a large part of the consumer base. In a capital economy built on FinTech, where banks would act only as custodians of safe assets and FinTech platforms would match lenders and borrowers, risk and leverage would fall significantly. The role of excessive leverage in the worlds major financial crises highlights the appeal of such a structure.

However the transition will be long term. Peer to Peer loans in the US today are still only equivalent to around 1% of credit card debt. In the near term we can reasonably expect to see FinTech complementing, not competing with, conventional finance. Banks have already begun acquiring FinTech platforms to enhance their own quality of service.

Regulatory developments in the worlds largest economies and growing investment highlight the necessity of FinTech in the 21st century, especially for providing services to small and medium sized enterprises on which developed economies are built. Modern consumers have high expectations when the competition is only a click away so companies must embrace FinTech just to stay afloat. Despite differences in opinion as to the level of impact one thing is for certain: The sector will continue to evolve and bring added benefits to consumers and businesses.