The promise of Fintech is to improve financial services by the use of technology. Technology has been a key focus for decades in the financial services industry. Unfortunately, this technology has primarily benefited the industry itself rather than its customers. The cost of financial intermediation has been remarkably steady for 140 years.
Areas for Improvement
Over a period where productivity has delivered massive benefits to retail consumers in such areas as computing and manufacturing, the cost of financial intermediation has remained remarkably steady at around 2% (measured – as recommended by NYU Stern researcher Thomas Philippon – as the ratio of profits and wages in the financial industry as a percentage of intermediated financial assets).
Banking, insurance, wealth management and payments are key areas of focus. The millennial demographic has very little interest in visiting a bank branch, meeting with an insurance or wealth management representative, or printing any form and mailing it anywhere for the purpose of subscribing to a platform or opening an account and transferring funds. If these things cannot be accomplished on a smartphone, the barriers to proceeding are considerable.
Prior generations may roll their eyes and conclude that this is yet another example of genetic decline. The expectations of their offspring are not, however, unreasonable. Flights are booked, cars purchased, houses previewed, funds transferred online – all made possible after entry into the system of credentialed consumers. These credentials have usually been acquired years ago, before the system itself provided the current level of facilities.
Parents of millenials were likely transitioned to an online platform as the institutions evolved. Their expectations have been shaped by where they evolved from and not by what the opportunity is.
There Ought to be a Better Way
Charles Schwab ran a powerful commercial where adult children questioned their parents about their expectations of the wealth management industry. The question was whether or not a refund of fees was offered for poor performance. The answer “it doesn’t work that way” was legitimately countered by suggesting that maybe it should. The Schwab commercial was a little disingenuous – the refund offered is limited – but the principle is a good one.
Robo advising has become a popular growth business and regulatory initiatives have developed – current administration notwithstanding – to compel wealth advisors to operate as RIAs, registered investment advisors, who have a fiduciary responsibility to their clients. The contrasting model of broker dealers is more caveat emptor. Significant conflicts of interest exist in the investment products offered to clients: brokers, as intermediaries, may offer investments that benefit them regardless of performance because the ultimate investment manager offers brokers incentives to do so.
Traditionally, transparency and disclosure has been the means by which brokers avoid liability. Disclosure, however, can be complex and conflicts, while technically disclosed, may be difficult to find and understand.
Insurance is another area filled with conflicts and hidden fees. Variable annuities offer a tax advantage – deferral of capital gains tax until an age certain is reached. The product offers exposure to a wide variety of investments – equities, bonds, domestic and international – wrapped with a bewildering range of insurance features (the pre-condition of the tax benefit) and some very significant constraints on liquidity, usually in the form of minimum investment periods. The harsh reality is that the tax advantage – deferral into ordinary income tax rates – is generally not worth the high expense ratios. The products are impenetrably complex even to sophisticated investors. They are configured to be of primary benefit to the insurance companies who offer them and the brokers who sell them. Millennials should not buy them – very few people should.
Retail consumer loans and small business loans are a key focus for Fintech. Peer to peer lending, popularized by such companies as Prosper, Lending Tree and SoFi, is an industry that has grown rapidly and is projected to continue to do so. The cost of credit can be high, commensurate with risk, but also affords broader access than has previously been available other than through usurious and disreputable lending sources.
Payments is another area that is being disrupted – rightly so. The transmission of cash among the unbanked is a highly regressive tax.
The Right Kind of Regulation
As Philippon points out in the above referenced paper, it is easier to design a more simple system for new entrants to the industry than to simplify the very complex model of regulation that exists for the current incumbents.
So, how are these emerging businesses to be regulated? In many cases, the traditional regulatory bodies have models that can work. RIA models are appropriate and are being adopted. Broker dealers are not all bad and, as a means of accomplishing clearly delineated and transparently explained transactions, can offer high quality services. The cost of those services, however, is being reduced as new entrants undercut the traditional BDs. This is progress.
The principle of payments is not complex: secure transmission. The principle of investment is not complex: diversification and asset allocation. The principle of insurance is not complex: large risk pools and risk transfer to an appropriately capitalised risk counterparts. The principle of banking is not complex: proper risk pricing and appropriate capitalisation. In each case, what is appropriate in terms of allocation, diversification and capitalisation can be reduced to an algorithm.
Complexity has arisen within a secure zone cordoned off by barriers to entry erected in the name of regulation. The problem – financialization – has arisen because financial services have become an industry that serves itself primarily rather than the diverse users of capital outside the finance industry.
Those who live within this secure perimeter pay more attention to their regulators than to their customers. They fear that if the value of the service actually delivered were truly understood, it would not be attractive. And so they obfuscate what is happening. As new entrants emerge to simplify processes and services, the current incumbents will be tempted to acquire them and use their technology not to benefit consumers but rather to reinforce the entry barriers and increase profits to those behind the barriers.
Regulation is needed to secure the custody and transmission of funds and to assure the qualification of and code by which those who are in charge of custody and transmission operate. Regulation is needed to ensure that those offering services concerning banking, insurance and wealth management are acting transparently, both about what they are offering and the price they are charging. Because they necessarily must interact with others engaged in bringing financial services to clients, regulation is needed to govern the manner in which each player interacts with each other. Above all, regulation is needed to assure the ease of entry to new players in the finance industry.
The existing edifice of regulation is largely designed to preserve the status quo and to manage the potential conflicts within that status quo. In other words, much of the existing landscape of regulation is concerned with managing the rules of engagement in an arena most clients would rather not enter.
It is, therefore, a huge waste of time, energy and resources. The great value of the Fintech industry has been to strip away the obfuscation and reveal this truth.
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