The friction of the old versus new models of finance

Everything is moving from C2C via B2B to P2P.  I hate all those TLAs, but it puts the context of what’s occurring in our world quite nicely.   The core of this change is articulated best by the bitcoin community who believe we do not need a trusted third party to exchange value these days.  The technology is that trusted third party.  In code we trust.

Image from Binary Wasteland

But it goes further than this, and it hits at the core of why digitalisation is disruptive in banking.

The truth is all financial services are now being transacted direct, person-to-person, person-to-business, business-to-business through a networked connection.  Or it can be.

• Loans are easily made one-to-one through peer-to-peer lending.
• Small business funding can be conducted easily through crowdsourcing.
• Payments can be made via mobile or net direct.
• Global transactions can be processed through code, without banks or SWIFT involved.

Now there is a downside to all this,, as the real role of banks as trusted intermediaries is that they guarantee these movements of value will be made securely and are guaranteed.

Where are the guarantees with these other technomediaries?

Well, they do cover the bases.

Default rates at Zopa and RateSetter have been 0.69% since launch, and 1.5% at the higher-risk SME lender Funding Circle.

Zopa (P2P lending): 

Reducing lending risk

At Zopa, if a borrower misses a repayment, a collections team chases on your behalf. But if a borrower reaches a point where they are behind on their loan repayments by at least 4 months, we’ve created the Safeguard fund to step in and give you back your money, including interest owed. It’s funded by a contribution from the fee a borrower pays when their loan is approved. As you can see, there’s a buffer on top of what it expects to pay out.  The Safeguard fund has covered all bad loans since it launched. This means not a single lender has lost money on loans covered by the fund.

Funding Circle (SME lending): 

Lending to businesses: what’s the risk?

Every business on Funding Circle has been assessed by our experienced credit team. They are established and creditworthy and have typically been trading for around 10 years.  However, it’s still important to remember that with lending to businesses, there’s an element of risk that some may not be able to fully repay their loan. If this happens, the loan becomes what’s known as a bad debt.  The bad debt rate is currently: 1.4%

M-PESA (P2P payments): 

You thought the funds held in M-PESA were held (and used) by Safaricom

The funds are deposited in several commercial banks, which are prudentially regulated in Kenya. In addition, the funds are held by a Trust and are therefore out of reach from Safaricom, which cannot access or use them. In the unfortunate event of Safaricom going bankrupt, the creditors of Safaricom would not have access to the M-PESA funds.

In other words, all of these new models are protected and secured against risk, as far as prudentially possible, as these new models would not work if they weren’t.  That’s the issue with bitcoin right now.  It’s not secure or protected, and that’s why the banks are getting interested in how to work with it.  However, that removes one of the main reasons for creating these new models: removing the high cost third party intermediary.

And this is where it gets most interesting, in that banks have traditionally been a high cost trusted intermediary because:

1. They built a model of organisation of the physical distribution of paper in a localised world;
2. The model is predicated upon manual processing and human services; and
3. The company is focused upon achieving the highest shareholder return and hence purely profit motivated.

In the new P2P world:

1. The model is one based upon the digital distribution of data in a networked world;
2. The model is predicated upon digital processing and automated services; and
3. The business, as a result, is focused upon achieving the lowest cost processing and hence cost motivated.

This is where the friction of the old model and new model collide, and where we are seeing the greatest innovations amongst the fintech startup community.  The challenge is how the traditional community step up to this new model, and is why we saw the headlines from Lloyds the other day regarding branch closures and commitment to digital.