Finding Genius

by Kunal Mehta

  The more data companies can collect, the more refined their algorithms become. Kenneth Lin, CEO and founder of startup Credit Karma, which offers free credit scores and related services, has said that “data is a powerful driver making innovation go forward, especially in financial services. If I know a lot about you, I can tailor the message and experience [and] help [you] get to a better place.”8 In VentureBeat’s piece “Credit Karma: Believe the Hype for ‘Artificial Narrow Intelligence,’” Credit Karma’s CTO Ryan Graciano said the company uses “data in production, for ad hoc analysis, for data science and modeling, and for online prediction, across all of our products and platform.” To understand a sense of magnitude, Graciano said that their data set is increasing at the rate of over 1TB per day and his team builds one thousand new models every month to analyze 120 billion observations. If companies such as Credit Karma and Betterment did not have data for their individual users, their solutions would be one-size-fits-all. Ingesting customers’ data empowers them to provide custom solutions, while cheaper, faster computing power democratizes access to custom solutions, typically reserved for those willing to pay steep prices.

  Incumbents have been working on artificial intelligence as well. JP Morgan, for example, has been forthcoming about its focus on this technology. In the bank’s 2017 Annual Report, they wrote:

  “Artificial intelligence, big data and machine learning are helping us reduce risk and fraud, upgrade service, improve underwriting and enhance marketing across the firm. And this is just the beginning…. We also need to be more forward looking in many other areas. Doing so will create a better and stronger system — not doing so will actually create additional risk. Following are a few examples: Almost all risk and control functions (think Anti-Money Laundering, Know Your Customer (KYC) and Compliance) could be better performed if we worked with the regulators to streamline what we do and use advanced techniques, like artificial intelligence and machine learning, to improve the outcomes. The same is true for fraud prevention and customer service.”

  JP Morgan has $11.4 billion in their technology budget and has been putting it to use for initiatives such as its 2016 launch of COIN (Contract Intelligence), a machine learning solution that sifts through loan agreements in seconds compared to the 360,000 hours lawyers and loan officers were spending annually. This frees up significant time for lawyers and loan officers to focus on more important tasks. Similarly, many startups are leveraging operational efficiencies by automating more, a feature that has enabled startups to keep their teams streamlined. Startups are also able to keep costs low (because they maintain minimal brick and mortar presence) and employ fewer people (because less human interaction is required), leading to efficiencies that enable startups to pass on some of the savings to consumers.

  3) Hybrid Model

  As prevalent as automation has become, being able to speak with a human can be comforting to consumers. Money is personal and people need to have full confidence that their money is safe. Thus, fintech startups are often creating an online-first approach with the ability to reach human representatives. Brian Hirsch extols the values of a hybrid process that can be automated or manual as he believes it is smart to “have the ability to flip a switch and return any part of automation into a manual process to get consumers to convert. The more informed a transaction needs to be, the more you need to have that type of system in place” — such as for large purchases like mortgages where consumers might need more hand holding. This focus on the customer experience pays dividends in customer conversion as well as customer satisfaction and loyalty.

  4) Transparent and Mission-Oriented

  Fintech startups are marketing themselves as transparent and morally aligned with consumers. A well-stated mission in addition to clear, transparent pricing are major selling points. Hirsch believes that millennials want to see that the companies they support “have heart and care as an organization because not every financial institution does that.”

  Millennials are demanding these multi-faceted changes in the financial industry from enhanced technology to more personalized solutions. According to The Future of Finance Part III, millennials want more transparency, streamlined and automated processes, and 24/7 access. According to their 2015 survey, 33% of millennials do not think they will need a bank by 2020 and 50% are hoping fintech startups challenge and surpass banks. Millennials crave a change in the financial ecosystem. That being said, many others do still trust the incumbent financial institutions, indicating that these institutions will continue to exist for many more years to come.

  Disruption and Innovation in the Financial Services Industry

  Disruption looks different in the financial services industry compared to other industries where the top 10 companies are more susceptible to being displaced. For example, in the last two decades, Amazon has upended the retail industry to become one of the top players in the space; however, this type of complete upheaval is much harder to achieve in the financial industry. Large financial institutions, such as Goldman Sachs and JP Morgan, are able to hold onto their reins more tightly due to regulations, deeply entrenched customer trust, brand awareness, and their immense scale. It is also much easier for consumers to switch who they buy goods from than change their bank or insurance policy, which tend to fall into the “set it and forget it” category. Due to these factors, it takes much longer and is much harder to have a full flip of market leaders in the financial industry. However, this market is still highly attractive to entrepreneurs and venture capitalists because it is a massive market with plenty of room for new fintech startups to grow. Every major publicly traded bank in America has a market capitalization of billions of dollars. If a fintech startup even captures 1% of the market, it can still become a billion-dollar company. As of Q1 2019, there are 41 VC-backed fintech unicorns (companies valued at over $1 billion) globally that have a combined value of $154 billion.9 It is not a winner-takes-all market.

  Incumbent financial institutions have often viewed the new class of fintech startups as forces of disruption rather than forces of innovation they could benefit from. Last century’s innovations primarily advanced financial institutions’ offerings.10 In contrast, these new fintech startups are aiming to seize market share from incumbents. PwC’s Global Fintech Report 2017, Redrawing the Lines: FinTech’s Growing Influence on Financial Services, found that 88% of legacy financial institutions are worried about losing market share to startups.

  In the last few years, financial institutions have been realizing that innovation is vital and that they need to embrace it to remain competitive. Banks are debating whether it makes more sense to build or to buy innovative products from an efficiency and cost standpoint. Employing the former strategy, Charles Schwab launched Schwab Intelligent Portfolios in 2015 to compete with robo-advisory startups such as Betterment, Ellevest, and Wealthfront. Goldman Sachs launched Marcus, a consumer-friendly brand which offers personal loans and savings products that allow consumers to open an account with no minimum deposit. In 2017, over 30 banks, including Bank of America, Citi, Capital One, JP Morgan, and Morgan Stanley, unveiled Zelle, a person-to-person money transfer solution to compete with Venmo and PayPal. These solutions have been incredibly successful as they have all reportedly processed or managed tens of billions of dollars. They have succeeded because they were able to simultaneously create a friendly brand separate from their core brand and leverage their massive resources to market their solutions and scale. Part of their success can also be attributed to the strength of their products. Marcus offers higher interest rates on their savings account compared to many of their competitors and Zelle does not require users to download a separate mobile app and provide their bank account information, offering users a sense of security.

  Investing in or acquiring fintech startups is also a viable strategy. In the last six years, CB Insights reported in “Where Top US Banks are Betting on Fintech” that the top 10 US banks by total assets have invested almost $4.1 billion across
81 disclosed rounds of funding into startups. One such investment is PayPal’s 2018 strategic investment in Tala. Regarding the investment, Siroya says: “PayPal has had a lot of learnings in this category and can help us accelerate our creation of new products. We’re seeing real opportunities to partner with financial institutions. So now it’s just a matter of how we think about our road map and theirs.” Strategic investments such as PayPal’s are a win-win for both financial incumbents and startups. Financial institutions need innovation and data-driven technologies, which startups can offer. Fintech startups need capital, data sets, and customer acquisition channels, which incumbents can offer. These relationships will prove particularly crucial to startups in poor economic conditions as incumbents have the ability to cushion their startups with capital if they are hit badly. Startups can also use incumbents’ data from previous downturns to prepare themselves. Without this capital cushion and data, startups are much more likely to struggle and not survive an economic downturn.

  Financial institutions are beginning to recognize these synergies and view fintech startups as possible partners. 82% of incumbent financial institutions expect to increase their number of fintech partnerships in the next five years, according to PwC’s Global Fintech Report 2017. In 2017, 45% of financial institutions were partnering with fintech startups globally compared to 32% in 2016. As a result, some fintech startups that were once solely direct-to-consumer are now creating business-to-business arms to integrate with these partners. However, integration is often not easy due to legacy technology deeply embedded in banks’ infrastructure. As a result, PwC reports that financial institutions are working to update their legacy systems with more of an emphasis on data analytics and mobile, or they are building new solutions while also maintaining their older solutions on legacy systems.

  Brian Hirsch recommends that fintech startups retain an advisor who comes from an incumbent financial institution to help startups navigate relationships with large financial institutions. A potential concern is whether the Chinese wall can be properly observed if a bank invests in a competitive startup. When putting together the deal, information rights is a key aspect that all the involved parties should discuss; but ultimately, it depends on trust. As financial institutions are making more investments and acquisitions in the space, it remains to be seen if banks are more likely to roll up startups with their other offerings or create a “financial supermarket” with an assortment of financial products they have acquired.

  Challenges Facing the Financial Industry Today

  There are two major challenges the financial industry as a whole is grappling with: the regulatory climate and data security.

  Fintech startups have a leg up on traditional financial institutions because startups can build themselves from the ground up already compliant with current regulations and stay nimble so they can adapt to new regulations as they arise. Incumbents, on the other hand, are weighed down by layers of bureaucracy accumulated over time. Startups can also build systems with the most up-to-date security, a task that is significantly easier than patching a legacy system. Matt Harris points out that it is more time consuming and expensive to work within the boundaries of compliance and that it requires a higher standard for a minimum viable product, but believes it is essential that fintech startups adhere to regulations from the outset; otherwise they risk getting shut down. Brendan Dickinson says Canaan will only invest in startups that fully understand and operate within regulations:

  “We have a fundamental thesis at Canaan that fintech is not a ‘move fast and break things’ industry so you need to understand, respect, and work within the rules set up by regulators. Like other heavily regulated industries, if you break the rules, you’ll go to jail and get shut down. We’re less likely to fund people who don’t have a point of view on how they’re going to work with regulators or what the regulatory regime is in their market.”

  David Klein believes that building compliance into company culture is key. He says:

  “From day one, we have considered ourselves to be a financial institution more than anything else. Most fintech companies actually want to think of themselves as a tech company first and a finance company next — maybe because of valuation or because it sounds cooler. But the truth of the matter is, if you think you’re a tech company more than you are a finance company, you’re likely not going to have the culture of discipline you need to build a sustainable set of controls that’s required for a company that operates in a highly regulated space. It’s really important to ensure that you are perfectly compliant and have all the controls in place because at the end of the day you are a financial institution that has a lot of responsibility to consumers and accountability to regulators.”

  Regulations serve as a limiting force for how fast fintech startups can grow compared to startups in other industries, but regulations are essential for consumer protection. Klein believes that there is an opportunity for the industry to build an intermediate regulatory framework that would allow fintech startups to be innovative and achieve scale with less friction: “The way you would do it is make regulatory compliance and capital requirements proportional to the risk your company places on the broader system. So, if you’re an early innovator in finance, you have to meet a minimum set of requirements, but beyond that, the requirements are commensurate with the risk you are taking on as a business, and the risk you are putting on the system.” In a similar vein, Brian Hirsch believes that financial regulations should be predicated on how large startups are and how long they have been operating. He believes there should be an intermediate step of partial regulations for fintech startups, such as “if the startup is 95% compliant on all these standards, it’s good. Then, every year or so as the startup hits certain thresholds in size, it needs to meet more standards. There needs to be some sort of construct that allows for a certain number of non-critical mistakes.”

  Incumbents have an advantage in scale and power as they can use lobbyists to help them pass regulatory bills in their favor. For example, the New York Times reported in 2013 that bank lobbyists heavily influenced legislation that would roll back part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, with some sections of the final bill reflecting lobbyists’ suggestions verbatim.11

  A major set of regulations impacting fintech companies is the European Union’s General Data Protection Regulation (GDPR), which came into effect in May 2018. GDPR requires companies to put controls in place for consumer privacy and regulates how companies collect and use consumer data with the goal of putting power back into consumers’ hands. The new regulations impact not only companies that are based in Europe but also any company that has the data of European residents. As a result, many companies, including financial institutions worldwide, are implementing company-wide GDPR policies instead of having different policies for their consumers in Europe and for their consumers in the rest of the world. Fines for not complying with GDPR are potentially massive: either 4% of annual revenue or up to €20 million, whichever is higher.

  In addition to regulatory compliance, security must also be a top priority. Security breaches tarnish brands and consumers are becoming increasingly aware of data breaches. They want financial institutions, who are responsible for important consumer data (e.g. social security numbers), to be trusted partners. The Equifax breach in 2017 affected over 147 million people, prompting numerous articles about how consumers can protect themselves. Therein lies the problem: the onus is not supposed to be on the customer. It is up to companies to protect their customers’ data. Otherwise, they risk losing their reputations, customer loyalty and trust, and ultimately market share. Securing data is only going to become more difficult once quantum computing becomes viable because the speed at which hacks can occur will accelerate dramatically. As Hirsch puts it, “when we get to the age of quantum computing, all bets are off. There will be a transition period where bad people will get control of the technology faster than all financial systems are able to
implement what needs to be implemented” to protect consumers’ data and their systems from being breached.

  On the flip side, Hirsch believes that “privacy is important but I think many consumers are willing to give up some level of privacy for a better deal. I just think there has to be transparency.” For example, he believes a fintech startup could present consumers with two choices: if consumers allow the startup to access and use their data, they are presented with a certain price; otherwise, without the data they could be presented with a slightly higher price. This scenario provides full transparency to consumers and empowers them to make the ultimate decision about if and how their data is going to be used. Siroya echoes the importance of transparency around data, explaining that Tala is “incredibly transparent about what data we ask consumers permission for. Customers have to explicitly go in and give us permission — we’re not just taking that information without them knowing.”