FinTech

The Technology Driving Disruption in the Financial Services Industry

Parag Y Arjunwadkar

• Editorial: Auerbach Publications
• Año: 2018
• ISBN:
  9781351036481
• Edición: 1
• Categoría: Business
• Categoría: Finance

Everything that we know about the world of finance is changing before us. Innovation is happening constantly, despite the protests of the traditional financial industry. With all the new technology that we have today, it is almost mind-blowing to think about the kind of technology that we will have in another ten years or so. The change is going to keep coming, the only thing we can do is get on board with it. This book introduces the basics of FinTech and equips readers with the knowledge to get on the cutting edge of age we live in today.

Chapter 1

Evolution of the Financial Services Industry

The financial services industry has existed since the beginning of human civilization. At the very beginning of human civilization, societies were formed. Societies were based on the principles of mutual trust, transparency, and helping each other. Helping another individual or groups was either out of good gesture or was remunerative. In the initial days of civilization barter mechanism was prevalent, which meant exchanging goods for remuneration of services delivered. The services delivered were in the form of help, a favor or assistance. The help would include helping another individual in his/her times of distress, provide expertise in a certain field of work, assisting in an activity, looking after each other’s children and many more such activities. The barter trade subsequently developed into giving out loans, credits and insurance. The loans and credits were in the form of providing aid (monetary) to an individual in his/her times of distress. The insurance was typically an agreed obligation that the insurer would payback in case there was damage to the property/person in question.

The financial services industry from the beginning of civilization was based on the concept of honoring the commitment to pay in presentment of a mutually binding financial instrument. The payout mechanism in each of these cases was therefore honored by paying in coins, gold ornaments or by giving away large pieces of land. It was not until 300 BC that the first form of “money”/“currency” in the form of a wooden piece came into existence. In the initial days of currency, it was only the royal family who was entitled to distribute these currencies to their patrons, workforce, helpers and generals, as remuneration of excellent services delivered to them. Therefore, an individual was able to claim extraordinary returns for the currencies coming from royal families. It was only during the 19th and 20th century, long after the industrial revolution started, that the term financial services became more prevalent in the United States. The term was commonly used to represent the banking, capital markets and insurance industries. The popularity of the term also could be attributed to the Gramm–Leach–Bliley Act, enacted in 1999, that allowed different financial services companies from the banking, insurance and capital markets industry to merge.

Financial services in the initial days were meant to provide all the services associated with monetary transactions, and most often these transactions would be between individuals or between a corporation and individual entity. Subsequently, the arrangement became complex with the involvement of multiple intermediaries. Adding to the complexity was creation/development of financial instruments that were a complex mix of other basic financial instruments. Soon people started making profits using these instruments and such an arrangement was categorized as derivatives trading or mutual fund investing. Consequently, all such trading was together termed as wealth management or investment banking.

There emerged investors who could invest wisely in these complex instruments and make profits from them. A large number of people in order to make similar profits started investing in these complex instruments in the hope of multiplying their savings. The complex instruments soon sprang up in all the different areas of financial services including lending, taxation, equities, savings, credits and insurance. Each of these instruments had multiple stakeholders putting their bets in for the very same asset. Soon it was a challenge to identify the actual entity to own the underlying asset.

During the 18th and 19th century, central banks were created by countries who would act as lender of the last resort, i.e., they would be the go-to banks to help in case there is run on any of the other banks. These banks who acted as a lender of last resort and were sponsored by the central governments of a country were later on referred as a central bank of that specific country. During the 1930 financial crisis in the United States, even the central bank of the United States could not support honoring a large number of claims, owing to the complexity and size of the claims. This led to erosion of faith in the system and therefore regulatory authorities were introduced who would act as watchdogs to monitor the transactions that were happening throughout. Despite all of this, the system was not able to stop the failure of big banks less than a century later in the United States, leading to a worldwide recession.

In 2008, about 80 years later from the last financial crisis, the financial industry was again on the verge of collapse, followed by the worst recession till date. In 2008, large financial institutions (FIs) defaulted on honoring the claims of their funds due to inadequate capital and high leverage. Soon a chain of defaults from multiple entities who were a part of the investment chain followed. It triggered a wave of huge defaults resulting in the bankruptcy of a large number of banks, central banks and the financial services industry overall. It was around this time that a large number of financial start-ups emerged who would change the ways of conducting financial business. These start-ups were primarily financial services business firms and were causing the disruption using technology. Therefore, the term “FinTech came into existence to represent all of these companies as a group. These FinTechs started by transforming a niche segment of the financial services business and they soon spread into multiple areas of financial business, thus disrupting the entire industry.

FinTech emergence can also be partially attributed to the interest of venture capitalists (VCs) in investing into the financial services industry. The VCs invest in a start-up on the basis of an idea or the proposed future product, and continue investing during the different stages of the formation and buildup of the start-up. The investment is usually done in exchange of equity from the start-up. The investors exit the start-up when it gets acquired or merged or it goes public or decides to acquire another entity. Irrespective of the mode of investing and exits, VCs have ushered in a culture of technology start-ups. A large part of VC investment was focused only on creating technology start-ups until the late 20th century, and helped bring up companies like Google and Apple. In the 21st century, the VCs started focusing on business domains like transportation, retail and the hotel industry. Consequently, unicorns like Uber, Amazon and Airbnb were born. The trend of the post financial crisis in 2008 veered toward investing in start-ups from the financial services domain. With more than $50 billion invested in 2,500+ companies by 2010, and 23+ unicorns, it can be clearly said that the age of FinTech has arrived.

A large part of the book will discuss the disruptions caused by these FinTechs, and how the entire phenomenon has been catalyzed by simultaneous disruptions in the technology. In the end, we talk about the overall ecosystem for FinTechs and some of the success and failures of FinTechs. The book concludes with the author’s viewpoint on the future of FinTechs.

The Evolution of Banks: Temples to Challenger Banks

Banks were the first constituents of the financial industry and have been around since the time the concept of currency originated. The currency itself graduated from a wooden plank to coins and then subsequently in the form of paper bills. Records from ancient times indicate that temples were used to keep the coins in safe custody of priests. The temples were also involved in loaning out the money, and therefore could be regarded as the earliest form of banks. Besides, there were wealthy merchants, who were able to accumulate these coins and were able to lend them to a borrower, albeit with interest. Some of the earlier civilizations started conducting banking through a separate institution housed in buildings. All the government spending and individual financial transactions were handled by these institutions. In some of the other civilizations the kings and royal families became the default banks for the kingdom. It was these royal families who would collect taxes from the people to fill up the kingdom’s coffers. The kingdom would then pay its soldiers, artisans, etc. from the coffers as remuneration of the services rendered. These people in turn would pay farmers and downstream service providers using the coins received by the kingdom. Therefore, the economy usually circled around the kingdom, with the treasury acting as the default bank. The latter form of banking continued for long time, and history has evidence where one kingdom was taken over by another king because the kingdom was in huge debt and not able to pay salary to its people.

In the 17th century most of the European nations have had a more formal banking system with initial banks being formed by wealthy families. The first bank to issue banknotes was the Bank of England in 1695. The bank was originally a private institution, but by 1870 it accepted the role of a lender of last resort or as the central bank of England. The banking system was making great strides the world over and the services offered by banks increased to include operations like check deposits, clearing and investments. In most of the other European countries, central banks were established during the 19th century. The postal saving system was introduced in Great Britain in 1861 to promote saving among the poor and rural communities. Similar institutions were created in a number of different countries in Europe and the United States.

During the same time frame, small banks emerged around the world in the form of society banks, community banks and cooperative banks. These were mutual savings banks created to address the banking requirements of a specific community or group of people. It was around the same time private banks were created by wealthy merchants’ the world over. The trend further continued in the United States, and a large number of small banks emerged. The life span of most of these banks was limited and often marred with robbery and corruption. J.P. Morgan emerged as head of the merchants’ bank in the 1800s and created U.S. Steel, AT&T and multiple other conglomerates through the use of trusts. It was not until 1907 when there was a large-scale run on the bank money, caused because of the collapse of copper trust shares. J.P. Morgan being the largest bank, tried to manage the situation through multiple initiatives, but the incident highlighted the importance of the central bank in managing the situation. The central bank therefore became the primary stakeholder of the banking system in most of the countries and the private/merchant banks were relegated to be operating within the norms set by the central bank. In the beginning of the 20th century, private banks in the United States and the world over were providing savings, lending and investment services to individuals and corporations alike.

In 1929, large numbers of banks in the United States were providing money to traders and investors at 10% margin money. It was all good until the shares of some companies collapsed and there was a run on the banks’ money. The Federal Reserve could not do much to contain the situation and the country plunged into a depression. During the first few months in 1930, 700+ U.S. banks failed. In all, close to 10,000 banks failed. The depression had global impact and many countries significantly increased financial regulation. As an after effect of the crisis, the United States established the Securities and Exchange Commission in 1933 and passed the Glass–Steagall Act, that separated investment banking and commercial banking (Figure 1.1).

Figure 1.1 A run on one of the banks in New York.

Source: https://commons.wikimedia.org/wiki/File:American_union_bank.gif#filelinks.

The charge card industry has a similar interesting evolution history. In the early 20th century, department stores in the United States started providing charge cards made of metals or card boards to their customers as prepaid cards that can be used only in their stores. In mid-20th century, A New York businessman started Diners Club with a vision that the Diners Club cardboard credit card would be accepted at all the restaurants in New York. It charged merchants a fee on each transaction, but assured the merchants that customers with cards would spend more than the customers who did not have one. Soon it started becoming a status symbol for cardholders and they would get a monthly dining bill. These cards required payment in full each month and therefore were more of a charge card, than a credit card. Within a year of its operations, Diners Club had attracted thousands of members, and a couple of years later it became the first internationally accepted charge card. By end of the decade, major companies joined the competition including American Express, Bank of America, Wells Fargo and multiple other banks. Thus, banks and nonbanks joined in this new form of lending, wherein there was a preapproved credit limit for individuals to spend on their charge/credit cards.

As banking systems evolved in multiple countries, international finance started evolving to become an industry in itself. Some of the wealthy families with global business pioneered international finance in the early 19th century, and these families were also pivotal in providing loans to large banks. Subsequently in the late 20th century, a large number of private and merchant banks started becoming global in order to expand their balance sheets and customer base. Some of the large banks were also providing cross-border transactions and investment services. While banks were expanding their operations beyond countries, the international monetary system evolved from the gold standard in 1865, followed by the Bretton Woods system after World War II. One of the primary agreements of Bretton Woods system was to identify the U.S. dollar as a reserve currency, and the only currency in the world to be backed by gold. In 1971, the U.S. government stopped exchanging U.S. dollars for gold because there was very little gold in the U.S Treasury, leading to the collapse of the Bretton Woods system. Following the collapse of the Bretton Woods system, the countries worldwide adopted floating foreign exchange rates. Under the floating exchange rates, countries adopted one of following three methods – (1) using a foreign currency as its national currency – El Salvador uses the U.S. dollar as its currency; (2) a country fixes its exchange rate to a foreign currency – China pegged the yuan to the U.S. dollar between 1997 and 2005; and (3) determining exchange rates based on demand and supply, usually managed by central banks. Owing to the complexity of cross-border transactions and country-specific regulatory requirements, banks now have a separate department/division looking into matters of international finance and cross-border transactions.

For a significant time period, bookkeeping in banks was done using voluminous registers. Therefore, even simple banking operations like depositing and withdrawing money took a lot of time and was prone to manual errors and fraud. It was not until the 1960s when IBM mainframe computers were introduced in the banking world, and this transformed the banking industry completely. Leveraging mainframe and similar systems, core banking solutions and credit card processing and management solutions were developed. The systems automated a large portion of banking and card transactions. In less than a decade most of these systems were built and were deployed across all the banks. It now became much simpler for the banks to maintain their transaction records, and simplified reporting. Therefore, the introduction of IBM mainframe computers brought in automation, speed, transparency and “trust” in the system. These solutions, when developed, required trained professionals to operate, and their usage was restricted to the employees within the bank. The bank branches, which usually had stacks of registers with bank account details, now had information stored in computers. Though the banks were completely computerized and a majority of banking processes were automated leading to faster transactions, but from a customer’s perspective, besides getting the work done faster, there was very little change in the overall experience.

Computerization of banking operations made automated teller machines (ATMs) a reality. ATMs were introduced between the 1960s and 1970s to cater to off-working hours’ cash withdrawal requirement. ATMs in subsequent years started providing additional services like account balance inquiries, password change and altering profile details. Individuals could perform these operations using their own debit or credit cards over an ATM. The major difference between credit and debit cards is that credit cards are debt instruments allowing an individual to withdraw until the pre-approved credit limit set by the bank is met, whereas with debit cards, an individual can withdraw only up to the amount of cash available in the persons’ savings account. The introduction of the ATM was a step toward branchless banking and has become very popular in the decades that followed. Some estimates put the total number of ATMs globally to be over 3 million.

The emergence of the Internet in the 1990s coupled with the invention of desktop computers, altered the way users accessed information. The information exchange using the Internet soon evolved into interactions between business to consumer (B2C) and business to business (B2B). Banks leveraged the Internet to create applications that would enable a customer to do transactions through a website while sitting at his/her home or office. Customer interaction with bank branches was minimized and the user experience was dramatically transformed. The banking functions were directly available to customers online through a website that was previously restricted to bank employees only. Online systems and solutions coupled with ATMs created an ecosystem for branchless banking. Soon multiple “online-only” banks and credit card companies emerged worldwide. Online-only banks and credit card companies would have websites, a network of ATMs and very few branches, thus creating low-cost financial services catering to online-only customers. Consequently “banking anytime” was now possible.

The Internet changed the way customers interacted with banks and banking started moving toward branchless banking. Mobile banking transformed the customer experience entirely by bringing the bank to the fingertips of the customer. SMS banking was the earliest form of mobile banking available on feature phones launched in late 1990s. The success of the iPhone, followed by exponential growth of smart phones led to the inevitability of mobile apps. Most of the banks made their banking applications available through these apps. With the advent of client-side technologies like HTML5 and CSS3, a large number of banks transitioned their online applications to be available across all the mobile devices. Now the customer was able to operate his/her account while travelling, while at home or even outdoors; therefore it can be said that mobile banking made “banking anywhere” a reality. Thus, all three together, ATM, online banking applications and mobile banking applications led to the popular concept of “banking anytime and anywhere.”

Mobile devices are personalized devices and therefore they have been used extensively to store and carry individual’s preferences. The preferences could be – the type of food one likes to eat, the mode of travel an individual prefers and multiple other things. Additionally, modern-day mobile devices have multiple security features like fingerprint authentication and application “sandboxing.” Business intelligence and analytics in combination with user information and enhanced security on mobile devices have enabled banks to launch personalized offering to their customers. All of these technologies have also transformed the loyalty business entirely. Earlier, a large part of loyalty and offers information was routed either directly by a bank or by co-branding the same with a retail store. With mobile devices, it was possible to take the e...