Essay: The Future of Finance is Free!

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The current #banking ecosystem is built on a clear and transparent system of fees. Customers are charged fees based on products, transactions and services. It creates a level playing field of competition whereby a customer can choose the right provider based on perceived value versus fees declared. This model is now under threat as innovation from the online digital ecosystem is merging into financial services.

Fees are like queues.
Or bad hair days.
Annoying things you have to live with.
But what if you didn’t have to… 

#Technology driving competition

#Finance was one of the first industries to adopt technology at a wide scale, particularly information technology and computers (IBM, 2016). Two things in Finance changed fundamentally with the emergence Financial Technology, or #Fintech as it’s now known.

A: Costs went down

How much time does it take to maintain a bank’s ledger on paper? How much time and effort is spent keeping physical records? That’s where we started. Today, paper is on its way out. In all meaningful senses the #banks run on computers now. Computers create efficiencies by eliminating manual repetitive tasks and increasing the speed of transactions. Efficiency saves cost. There is now less of a reason to charge people menial fees for everyday operations and transactions, as they are largely automated and instantaneous.

B: Competition went up

As technology created efficiencies, it also created opportunities. With technological efficiencies, you could undercut your competitors’ fees. With the onset of digital banking, initially in the form of online banking websites, banks could suddenly expand their footprint without bricks and mortar. No longer was setting up more branches and hiring feet on the ground the only solution to growing your business. You could serve customers virtually. Not just your customers, but other banks customers. Not just other banks customers, but other countries too!

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Boy, this new punch card system will show ’em Midwest boys!

From monetary to value exchange

This global competition has sent financial services providers to further and further lengths to optimize their processes through technology. However, there are only certain limits to which costs can be optimized. Therefore new models have been adopted to become more competitive.

The basic building block of any business is a customer relationship. Once a customer relationship is formed, value is created through various services and goods that are sold. In the modern economy, sold has implied exchange in monetary value. After all, you could only find so many squirrel skins, and carrying pigs in your wallet gets old real quick. Given the fact that technology creates cost efficiencies, which drive prices down, and secondarily makes competition easier, there is always someone willing to take the customer relationship for a lower fee. Life insurance for a pork chop, anyone..?

The concept of Customer Lifetime Value was created to project the potential revenue that could be created from a customer over their entire customer relationship (Berger, Nasr, 1998). Therefore companies must balance the cost of acquiring a customer against the lifetime value. Whatever is left between those two figures becomes the earning potential through that single customer. Either you’re making money off Joe, or you’re paying Joe to be your customer. Usually the former. Ultimately then, competition drives up the cost of acquisition as companies go to further and further lengths to secure the earning potential of the customer, and similarly are willing to settle for lower and lower revenue in the form of fees.

In extreme cases,
like with some Fintech startups with truck loads of Venture Capital,
they will literally pay Joe to be their customer for 5 years or more.

Over time, fees become negligible, and the only logical step is to remove them completely. In a world of services that charge no fees, an alternative method for monetization must therefore exist. The concept of Value Exchange has been used in marketing to describe a transaction between a company providing a product and a customer, where the transaction goes beyond a simple monetary exchange (Ballantyne et al., 2003). This concept can be expanded to describe a business model, which is not based on monetary exchange at all. Life insurance for a back rub, takers?!

This type of approach was introduced to the masses in the 1990’s with the free online email service Hotmail. Users received free access to a fully featured email service. In exchange, they were simply exposed to advertising. As more and more users were attracted by the free service, the value of this advertising grew quickly. The model pioneered by Hotmail achieved explosive worldwide growth, making it the largest email service in the world in just two years after launching (Microsoft, 1998). Today it is one of the prevalent online business models used to great success by Google and Facebook, who are using advertising as the main revenue source across their various services and products. Through the advance of mobile technology in particular, financial services have become an increasing target for startups, which are adopting these new online business models.

Mechanisms for value exchange

Typical mechanisms for value exchange are passing the fees along the value chain, gathering customer data for targeted advertising, or monetizing the data itself. Each of these models poses different opportunities and challenges for financial services. The key issue revolves around regulatory approval, and the balance of data value versus data privacy. After all, what is the cost of one’s privacy?

A: Passing the buck

The first of the three models seems to be totally void of fees to a customer. Free ninety-nine, bro!! As it seems, nobody is paying anything. The party will go on forever! An example of this model is Robinhood, the free trading startup, currently expanding into international markets from its home base in the United States. Robinhood takes no commission at all from its customers, providing seemingly free trading. BEAUTY! According to their website, Robinhood states that they simply accrue interest off un-invested cash left in investment accounts. Given today’s zero interest rate environment, that clearly does not amount to any meaningful amount of revenue.

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Suddenly every other way seems crazy

The same example of Robinhood also provides a variation on the value chain concept, by charging clear fees for additional services such as margin accounts. This model, dubbed Freemium, was widely popularized by mobile gaming companies in the late 2000’s. It means the basic service is provided at no cost to any customer, while those customers wanting additional services must pay fees, often at significant cost. The few pay the cost of the many. Who told you life was fair? This model has also become a mainstay of low cost airline carriers, as customers are increasingly paying for items such as food and drink, which were earlier modeled and built into the prices of all tickets. In the case of Robinhood, this is demonstrated in the form of fees for margin accounts, for traders who’s demands cannot be met with a regular trading account that has limits on trading volume and leverage.

Additionally, Robinhood have raised $66 million in venture capital which gives the company “freedom to focus on building an outstanding experience rather than short-term profits”, claims Robinhood (Robinhood, 2016). Which means they can afford to pay their customers to be their customers. This essentially means they are willing to lose money to make money later. While an admirably aggressive strategy, this type of price warfare pushes that later date further and further into the future. Once the business has achieved a sufficient scale, it will become profitable. Today, some investors may be willing to endure several years of revenue drought for a chance at achieving that holy grail: “scale“. Tomorrow, another investor may come along that is willing to go even further. The conditional nature of such strategies make them inherently susceptible to recession periods, where further funding may not be readily available, leaving such companies under threat of depleted cash flows and even bankruptcy. Sorry, didn’t mean to poop the party.

B: Laser-guided ads

The targeted advertising model was largely introduced by the free email services such as Google’s Gmail in particular. Through the capability of it’s famous search engine, and marketplace for bidding on ad placements, Google was able to monetize their email service. Google reserves the right to read the contents of your private and personal emails, and therefore can target very specific promotions against those contents. An example might be an email discussing flight plans to Egypt. The next day you may notice an ad within the Gmail application for a 20% discount on flights into Cairo. Dude, these Google tickets are off the chain!!

The critical element of this model is the targeting.
Finding the dude.

Simply placing randomized advertisements would not attract significant amounts of engagement from users, thus leading users to simply ignore the adverts. Most users have grown accustomed to such exchange in value, and even see the adverts as a useful tool in their daily lives, as opposed to seeing them as annoying adverts. After all, the dude got his tickets with a sweet deal.

This model is now making its way into the financial domain, for example in the form of spend tracking. A customer might receive a free credit card, with an accompanying mobile application for customers to track their spending. This spending data is then used by the company to attract advertisers onto the platform, to provide highly personalized ads. Against a fee, naturally. If a customer often buys groceries from a particular retail outlet, perhaps they would be interested in joining a loyalty program of that establishment. Customers that have just shopped at a sporting goods store may be interested in joining a nearby gym. Just lookin’ out for you, buddy.

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Loot goes beyond savings analytics with in-app offers

This model is being adopted by some so-called challenger banks, which are offering their customers varying degrees of a digital-only bank. Often the service is limited to a credit or debit card, which comes with the companion app. This provides the bank a further opportunity to monetize, by simply charging minute interchange fees for each transaction (Guardian, 2015).

C: Pumping for data

The final model for value exchange that is being witnessed in the financial marketplace is that of direct data monetization. Perhaps the most complex of the models, it is a fine balance between maximizing the value of data gathered, while maintaining a sufficient level of privacy for customers. What kind of data is being gathered? Data about customers, data about their behavior, data about demographics, data about usage patterns, data about correlations, data about trends.

If you own a tinfoil hat, put it on now.

Early examples of data driven business models include Capital One, who recognized the value of detailed customer segmentation in evaluating consumer credit worthiness. In the 1990’s every other bank was using simple models and uniform pricing to offer credit cards. Instead, Capital One used statistical models to create more personalized products based on demographic and credit data (Capgemini, 2014). This was long before Big Data was an established term. Let’s call it Just The Right Sized Data. Trademark.

A more complicated model was introduced by the online providers of classified ads and airline tickets, which have largely replaced traditional channels. In the marketplace model, someone is selling, and someone is buying. Often, the person who is selling will pay a small fee to promote their listing online. Almost exclusively buyers enjoy the service for free. Sometimes marketplace providers will charge a transactional fee from the seller instead. In this approach, there are in fact two distinct customer groups. The more obvious customer group is the consumer of the service. Without this group there is no business model, as their data is the currency the company seeks to gather. Therefore most money and effort is targeted towards this customer group, even though they create no revenues. Hmmph, imagine that. The key is simply to gather enough data to sell. This data is then sold to the real customer, who may use it for any purpose deemed appropriate by the company in agreement. The nature of this secondary relationship may not always be apparent to the happy consumers of the free service. While obvious in the case of airline tickets, could the same be replicated to create a financial marketplace? Wait for it…

The early successes of this marketplace model have come with peer-to-peer lending (“P2P”), particularly in China. Here, the platform connects consumers or small businesses in need of cash flow with investors looking for those elusive 10%+ returns and not afraid of a bit of risk. Currently in China, there are more than 3,858 P2P providers (Economist, 2016). Leading providers CreditEase and Lufax are some of the highest valued Fintech companies in the world today. The data from China also shows that in such volumes there is always a rotten apple or two, with a few lenders running outright Ponzi schemes. If you see gold Lamborghinis, walk away. 

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A sea-side bungalow worth $20M was a gift to the CEO. I need a better boss.

Perhaps a more opaque, and controversial example of data monetization in Finance is that of Order Flow. Oooh, it’s on now! This concept has been widely publicized by the book Flash Boys (Lewis, 2014). Detractors of High Frequency Traders (“HFT”) point to the inherent unfairness of allowing certain market participants to pay for faster access to market and trade data. Whether HFT are a positive or negative market participant is an ongoing subject of heated debate and even academic research (Kirilenko et al., 2015). *cough* CROOKS *cough*. As market intermediaries, HFT are embedded within the financial markets, and there is precious little retail investors can do to choose how their orders are routed. Considering the traditional model was for the broker to pay for execution, it becomes clear that this arrangement may not always be in the best interest of the retail customer. Particularly, most customers will not be aware to any extent of the mechanics and impact of this business model. Seems fair! Said owner of brokerage while being paid by HFT. Totes legit. 100%.

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Dude. Trust me. Duuude. It’s legit. Dude!

A promising and transparent model for data monetization is the Open Banking initiative in the United Kingdom (Open Data Institute, 2016). In theory, all banks would provide a common set of API’s that allow approved third-parties access to aggregate statistical data, but also actual customer data. This data could be used for a multitude of use cases by startups, while making competition more transparent between the banks themselves. A possible use-case of data monetization could be an intelligent fraud detection service, which aggregates data from all banks, and against a fee, provides the banks with suspected fraudulent accounts or transactions. In this scenario, customers would not be aware in any way that such a service and agreement was in place.

Some institutions may not necessarily see data aggregation and open API’s as a model worth promoting, as we have seen developing in the United States. For a number of years, account aggregation services like Mint.com, Personal Capital and FutureAdvisor have been able to carve out a sizeable market for Personal Finance Management, based on API access to bank and fund data. They have used the data to provide added value analysis and recommendations on improving consumer’s personal finances and investment decisions. As witnessed by Bank of America, J.P. Morgan Chase and Wells Fargo temporarily halting API access to such services last year, mostly around concerns in security (Wall Street Journal, 2015).

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Mint sees what you’re doing, and tells you how to save

Yet there is a longer-term challenge for banks in losing the primary customer interactions to these services, and becoming a simple commodity provider. In such a service, there is less opportunity for banks to differentiate on anything else except price. Having a third party such as Mint accumulate as many as 20 million customers in just 5 years is tipping the scale of power away from the banks. We can’t have that, Chip. Gosh darn it! Do something! Such growth stories are attracting more venture capital into Fintech startups than ever before. This massive flow of funding makes a small startup a real contender in fighting for ownership of customers. Given enough scale, such startups might choose to provide their own competing products directly to their customers. Naughty, but I like it!

Value exchange as an agent for disruption

In the modern financial system, short-term interests of shareholders greatly out-weigh long-term competitiveness. One must simply look at Mark Zuckerberg prioritizing his global social mission over the investor’s financial interests, which gathered media attention (SEC, 2012). Another famous example is Steve Jobs, who’s vision caused constant struggle with Apple’s board, leading at one point to him being fired from the company he himself founded. That must have sucked.

Given the rigidity of public corporations, what implications does this cause to financial institutions in the context of a disruptive paradigm such as value exchange? It simply means they will be unable to sacrifice short-term financial positions, in order to explore and trial new business models. Large corporations cannot sustain loss leading business models for extended periods of time, particularly if it means sacrificing existing revenue sources.

This creates an inherent and significant advantage for outsiders with fewer fiscal pressures placed upon them. In fact, it is often the goal of venture capitalists to pursue high growth for years, accumulating great losses, only to achieve a meaningful market share. Therefore the Fintech startup community is primed to adapt to the value exchange paradigm. They will be able to start without any fees, only accumulating meaningful revenue if the concept and business model find enough traction to achieve scale. Through plentiful capital, they will be able to go to extreme lengths to acquire customers at losses for years before turning a profit.

It’s like a game of financial limbo.
How low can you go?
Underground, son. Next level.

An alternative strategy, avoiding high dependancy on such excessive external capital, is being implemented by #Robo-Advisor platform provider Bambu. While the long-term goal is to enable financial inclusion through a direct-to-consumer platform, the company and brand is being built with a scalable B2B model and low cost base. This avoids the typical pitfalls of Fintech startups, that often require years of R&D and licensing to take place before customers can be acquired. Once licensed, Bambu plans to offer it’s platform to non-financial players such as telco, media and internet companies. This approach has been proven in Europe by the marriage of Fidor and Telefonica launching a digital banking app, without a bank involved. Smells like disruption to me!

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Bambu wants to turn Spenders into Savers into Investors

With the consumer offering, Bambu plans to operate in a world of zero fees, and make money through value added services much like the challenger banks. This could include financing short-term loans for consumers to reach their goals quicker, or ultimately find sellers for the very thing users are saving for. An example might be selling a discounted plane ticket to a user saving for their dream holiday to the Maldives. Not only does the dude get his sweet deal, but he can save for it upfront, like a financially responsible person might do. No need to max out the credit cards as per ‘uge!

Through the work of these pioneering companies, new models are being invented, trialled, and proven at an increasing pace. Like we have seen with other disrupted industries, once a model finds footing, entire industries are changed with incumbents left wondering what just happened. Just ask those who doubted AirBnB and Über how they feel now, if they’re still in business, that is. They’re probably still listed in the phone book.

Conclusions

In the last five years, we have seen the emergence of new business models within the financial services industry, often based on an exchange of value rather than traditional monetary fees. Most of these disruptive models are adaptations of successful online businesses in other industries, such as free email services, or websites offering classified ads and airline tickets. Early adopters of value exchange are most often Fintech startups that are looking to disrupt the incumbent institutions with aggressive pricing strategies and improved customer experience.

Some of the most successful growth stories are the peer-to-peer lending companies of China. This explosive growth also showcases the key challenges of the value exchange model. How can regulators approve, track and penalize all 3,858 P2P lenders in China? As the cost-of-entry into the financial markets goes down with the advent of technology, regulators are under increasing pressure to deal with the flow of innovation. Is the answer just do it? Time will tell.

Some markets choose to tackle the challenge head on, like in Singapore, where the Monetary Authority of Singapore has established their own Fintech team to address this emerging segment of the market. Yet for even successful businesses, the challenge regulation poses is one of internationalization. Due to lack of standardization across regulatory bodies in the United States, Europe and Asia, the cost of expanding business into new markets remains high. This can be seen in the highly localized Chinese P2P lending market and U.S. Robo-Advisory market.

From the customer’s point-of-view, the trade off often comes in the form of trust and security. While the low cost or even free service seems tempting, can customers trust these companies with their private data and money? These perceptions will evolve over time, and will have significant regional biases. Millennials in the United States may be ready to invest their life savings with Robo-Advisors, but same formula has yet to be proven elsewhere at scale.

Ultimately the consumer is the winner, as competition drives both incumbents and new entrants to innovate further to provide higher value in exchange for the valued customer relationship. Privacy concerns must be tackled head on to win the hearts and minds of customers. New technology will unleash new opportunities for efficiency and competition, leading to more creative solutions for removing cost while making profit.

In the end, the future of finance is free. Hashtag disruption. Emoji smileyface.

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Rather PAY than give up PRIVACY? Go FREE or go HOME? 

References

[linkedinbadge URL=”https://www.linkedin.com/in/akiranin” connections=”off” mode=”icon” liname=”Aki Ranin”], is Commercial Director at Tigerspike and this article was originally published on linkedin.