By Roy C. Smith
One of the hottest spots in finance today is innovation in various forms of financial services from computer-based technologies, which collectively we now call “Fintech.” From automated trading systems, to alternative payment platforms, to peer-to-peer lending, to “big data” management, the sector has blossomed with a few startup companies hitting it very big and everyone looking for the next one to do so.
The whole idea is that long established financial systems – banking and capital market trading with high fixed costs – can be disintermediated by applying high-speed information technology to extend services and lower the bid-ask spreads for financial transactions.
However, like the “Cleantech” industry that preceded it on the most-hyped list, Fintech has demonstrated over the last several months that while the underlying concept may be valid, execution at the corporate level can be very difficult.
Indeed, stock prices of Virtu (high speed trading), Square (payments), Lending Club (peer-to-peer lending), and Teradata (big data) have lost many billions of dollars of market capitalization in the past six months. While Bitcoin’s “blockchain” distributed database has attracted a lot of attention recently, Bitcoin itself is still trading at only a third of its 2014 high.
Lending Club (LC) is the latest high flyer to fall, having now lost 83% of its market capitalization since the peer-to-peer lending concern went public in December 2014. Some of the drop is attributable to the announcement last week of the forced resignation of its CEO, some irregularities related to a large loan sale and a federal investigation, but the stock price, after an initial IPO pop, had been declining for the past 16 months.
The peer-to-peer financial services model that bypasses banks (with their expensive capital and infrastructure and regulatory costs) is based on earning fee income rather than interest. Bloomberg estimated that the global peer-to-peer market was $77 billion in 2015; a 15x increase in three years.
LC was the largest peer-to-peer lender in terms of loans generated. Its revenues grew at an annually compounded rate of 240% from 2011 to 2015, when they reached $430 million. Though not yet profitable, LC went public in an IPO underwritten by Morgan Stanley, Goldman Sachs and Citigroup at a market capitalization of $8.5 billion.
LC’s business model is simple – it has developed an algorithm for assessing credit ratings online, and a platform for offering loans at appropriate interest rates to online investors. Because of its low costs, lack of regulation and effective technology, LC can offer borrowers rates lower than banks and provide investors with returns greater than money market or midterm bond funds.
Morgan Stanley was especially enthusiastic about peer-to-peer lending, estimating it would account for 10% of US personal and small business loans by 2020. In 2015 US credit card debt was $625 billion, retail credit (auto loans, etc.) $587 billion, and small business loans $600 billion – a total of $1.8 trillion.
But early on, LC realized that individuals and small business borrowers were not flocking to their website as they were expected to.
Perhaps retail investors didn’t trust the algorithm, or found the prospects of other people’s promissory notes too risky – banks were trained to make such decisions, not they.
As of December 2015, the LC marketplace had generated approximately $16 billion in loans since being launched in 2007. Of these, approximately $3.3 billion (21%) were acquired by retail investors, approximately $5.5 billion (34%) were invested in through securitized Trust Certificates bought by wealthy families, hedge funds or institutional investors, and $7.2 billion (45%) were sold as whole loans, mainly to institutional purchasers.
In 2016 LC noted that institutions had purchased 56% of its loans, and that “a relatively small number of investors account for a large dollar amount of loans.” These investors, however, were no different from (or otherwise funded by) the banks and other financial intermediates that LC was supposed to be displacing. To the extent that the yields were attractive on the day they were shopping, they might invest; otherwise not.
Continuing rapid growth, upon which LC depended for its “unicorn” market capitalization, had to come from branching into the institutional field, which meant dealing in securitized products and whole loans, in which LC had little value to add.
After its experience with mortgage-backed securitizations, the market was cautious about what was in the package of loans being offered.
LC’s recent difficulties came from trying to sell deficient loans to Jeffries LLC that it would resell. Jeffries balked, and LC sold the loans elsewhere, but the breakdown of credit standards of the loans being originated was troublesome to the board. Its business model depended on investors trusting the quality of the loans being offered.
LC also planned to invest in Cirrix Capital, an investor in its loans, presumably as a way to boost sales. This move may have been questionable in its own right, but couldn’t survive the fact that LC’s CEO had already invested without telling the board.
These events cast a shadow over the Fintech industry. This stuff takes time for users to trust it, and for service providers to prove themselves honest and reliable. The industry may grow, but the startups in it are as risky as ever. The ones that may dominate the high ground in the future may not have been born yet.
Which may mean that the real Fintech industry will be going on inside the established players already well plugged into financial technology and the enormous IT budgets they require. Companies like Bloomberg, JP Morgan and Goldman Sachs are already identifying themselves as “tech companies” and are investing in (guess what) automated trading systems, alternative payment platforms, online lending, and “big data” management.