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An explosion of start-ups is changing finance for the better
THINK of banking today and the image is of grey-suited men in towering
skyscrapers. Its future, however, is being shaped in converted warehouses and
funky offices in San Francisco, New York and London, where bright young things
in jeans and T-shirts huddle around laptops, sipping lattes or munching on free
food.
A wave of financial-technology (or fin-tech ) firms, many of them just a few
years old, are changing the ways in which people borrow and save, pay for
things, buy foreign exchange and send money. In doing so they are finding and
mining rich seams of profit, challenging the business models of existing
institutions and inflating a bubble of excitement among investors that
technology and the internet are about to change banking for good.
Much of this may sound like hype, particularly to those whose memories take in
the unmet promises of internet banks at the height of the dotcom bubble, or
that go back earlier still to the statements of Bill Gates, the co-founder of
Microsoft, that banks were dinosaurs. Yet the growth rates of some of these
start-ups seem to warrant the excitement.
Take Xoom, a San Francisco-based firm that is little more than a decade old. It
specialises in sending small amounts of money across borders. By collecting the
money online, and using technology to minimise fraud, it is able to undercut
the fees charged by traditional money-senders such as Western Union that have
huge networks of agents to collect and distribute cash. Its stock has more than
doubled since its IPO earlier this year, valuing the company at more than $1
billion, a heady figure for a firm that reported revenues for 2012 of just $80m
and a net loss for the year of $5m. In an echo of the valuation methods used
before the bursting of the dotcom bubble in 2001, its shares are priced not in
relation to its profits or even its revenue but to its extraordinary growth.
In Britain similar buzz surrounds Wonga, an even younger firm that specialises
in making short-term loans at eye-popping interest rates. The firm is
controversial: it occupies the same market as payday lenders. The Archbishop of
Canterbury, no less, has said he wants to use church credit unions to compete
it out of existence. But Wonga is growing fast thanks to slick technology and
clever algorithms that analyse masses of data, including how much time
customers spend on its website. This allows it to reach credit decisions in
seconds. The time taken between a customer applying for a loan and receiving
the money in their bank can be mere minutes.
Some in the industry think Wonga will be valued at more than 1 billion ($1.5
billion) when it comes onto public markets. Its profit margins make that seem
plausible. In 2011, the most recent year for which its financial information is
publicly available, the firm produced a pre-tax profit of 62m on revenues of
185m.
The excitement around these companies and others has venture-capital (VC) firms
tripping over one another to find the next Wonga or Xoom. I get two to three
calls a week from VCs, says Michael Kent, the CEO of Azimo, an online
money-sending firm based in London.
Several factors have converged over the past few years to produce the upsurge
in fin-tech firms. First was the financial crisis, which damaged trust in
banks. It also precipitated several years of record-low interest rates, which
pushed savers to look for better returns where they can. That has benefited
peer-to-peer lenders such as Lending Club, an American firm that provides a
platform on which investors can lend to borrowers and that recently passed the
$2 billion mark for loans originated.
Shape of fin to come
The rise of cloud computing, a term for software and services delivered over
the internet, has also slashed barriers to entry for technology firms. This is
true across many areas of business but it is an especially potent force in
financial services, which is a digitised industry in which most money exists as
bits and bytes in computers rather than as notes and coins.
Globalisation also helps. Sonali de Rycker, a partner at Accel, a VC firm, and
a director of Wonga, points out that the company initially got started by
outsourcing much of its programming to developers in Kiev, the Ukrainian
capital.
The spread of smartphones has also boosted tech start-ups by enabling the
emergence of new ways of making or receiving payment. Firms such as Square in
America or iZettle in Europe produce cheap credit-card readers that plug into
smartphones and allow merchants to accept card payments. Their costs are low
partly because customers already have sophisticated computers in their pockets.
The emergence of big data , a term used rather loosely to describe computer
software that can analyse masses of information for patterns or correlations
that people would not otherwise spot, is another factor. Number-crunching has
helped firms such as Wonga and Zestcash, an American start-up, transform the
way credit decisions are made.
Yet for all their promise, fin-tech firms still face formidable barriers. Chief
among these is winning the trust of their customers. It is not a huge leap of
faith to order a book online; it is a larger one to entrust your savings or the
management of your financial life to a new company that seems to exist only on
your computer screen or smartphone. Samir Desai, the chief executive and
co-founder of Funding Circle, a British peer-to-peer lender that specialises in
financing small businesses, says his biggest challenge is raising awareness
among borrowers. Less than 1% of businesses have heard of peer-to-peer
lenders, or even know that there are alternatives to banks, he says. As
expensive as banks branch networks are, they provide advertising that money
cannot easily buy.
Another challenge comes from the limits of their business models. Peer-to-peer
lenders such as Zopa (with which your correspondent has deposited 50 in the
name of research) are not able to offer their savers the security of insured
deposits or a guarantee that they can withdraw their money when they want it.
This makes them much less risky to regulators since they cannot suffer from
bank runs, but less useful to customers who want long-term mortgages as well as
instant access to their cash. Fin-tech firms will take lots of business from
the banks in coming years. Replacing them is another matter.