The familiar middlemen of 20th-century banking and investing are giving way to something very different. Are we ready for the opportunities—and the risks?
FROM THE WALL STREET JOURNAL | NOVEMBER 6, 2015
Imagine that you want to buy a home. You might find a real-estate agent to show you around, which is a very 20th-century way of doing things. Or you might go 21st century and use the Web to research prices and available properties and to take a few virtual tours.
When it comes time to buy, however, you will probably revert to procedures that were created in your grandparents’ era. You will assemble financial documents and present them to a loan officer at a bank, who will take weeks to determine what you can borrow and at what rate and then present you with a narrow menu of costly options.
Imagine instead a simple online interface that could generate a tailored credit score for you, taking into account your future earning potential based on your education and location. It would connect you to lenders ranging from banks and credit unions to pools of individuals who want to lend privately at a negotiated rate for whatever duration you agree on. You could shop around, combine different types of financing and arrange a mortgage package that best suits you, all within a few hours.
We aren’t quite there yet, but we may be soon. Over the next decade, the familiar 20th-century modes of banking and investing will give way to something very different. We are on the verge of the Uberization of finance, which will bring multiple new opportunities but also a range of new risks.
The ubiquitous ride-sharing company uses a simple device—the smartphone—to connect people who want rides with people who want to drive them. Uber is a high-tech middleman that is making the intermediaries of the past obsolete. The financial world is one of the most mediated industries on the planet, and that is precisely what is about to change. Uberization also means using vast amounts of data to make those connections feasible.
Technology is one source of this shift, but so is legislation. The JOBS Act of 2012 contained a seemingly innocuous provision making it easier for startups to raise money from investors previously deemed too poor to dabble in such ventures. At the end of October, the Securities and Exchange Commission finally approved the rules, which will go into full effect early next year. As a result, any company or person with an idea can solicit and raise up to $1 million without most of the onerous regulatory and reporting requirements of the past.
So what lies ahead? Retail banking is the one area of the financial world that has undergone tremendous change over the past decade. Bank tellers are now scarce, and many consumers use smartphones for payments and deposits. It also has become much easier to trade shares online.
But core services such as lending money, raising capital and investing for clients still depend on a firm to act as a conduit—and as a choke point. With many promising startups already launched and with venture capital funding new ones every day, here’s a glimpse of what we can expect in the years ahead.
Hey buddy, can you spare a loan?
The most immediate change will be an explosion in peer-to-peer lending. Just as Uber returns us to a world where anyone with a car could offer a ride to anyone with a thumb, peer-to-peer lending is both new and old. Before there was a robust retail and commercial banking system, there were people with money to lend and people who wanted to borrow it. But the current wave of peer-to-peer services takes this much further, into a hypercharged virtual realm where pools of small lenders can combine online to disperse pools of small loans. And they can do it without the friction, cost or heavy regulatory hurdles of traditional banking.
There are already many players in this field, such as Lending Club and Prosper, but most are already a decade old—ancient by tech standards. With less than $7 billion in loans in 2014, they are tiny in the multi-trillion-dollar lending world. Now the sector is showing explosive growth. PricewaterhouseCoopers estimates that it could be a $150 billion business by 2025.
The downside is that peer-to-peer interest rates are higher than at mainstream banks, sometimes well into the teens. The upside is that people who need modest sums (one site caps them at $35,000) can easily obtain funds from small individual lenders looking for a high return. What makes it attractive for lenders is that they can spread their capital over far more loans than any one peer could make to another peer, which reduces their risk.
And the options are proliferating. Venture capitalists clearly believe that nontraditional lending will be a huge market, especially for millennials who, in survey after survey, express distrust and disdain for traditional banks. New companies such as SoFi (which has raised more than $1 billion) are focusing on individual loans at even lower costs and on the student market, helping people to refinance their loan packages. SoFi is also rapidly moving into mortgage refinancing, another area where traditional banks and government have been, to put it mildly, sluggish.
If you build it, they will come.
Lending money to businesses remains a pillar of the financial sector. Yet credit standards, judging by Federal Reserve surveys of loan officers, remain much tighter than before the financial crisis of 2008-09. That may be prudent, but it has had a chilling effect on business creation. The U.S. is now 12th in the world in new business creation, according to Gallup, and significantly fewer new businesses are started today than in the 1970s, when the U.S. population was much smaller.
Loans to large companies are up over the past decade, but lending to small business has contracted, from more than $700 billion in 2008 to less than $600 billion today, according to the Small Business Administration. As for the Silicon Valley ecosystem of venture capital, it certainly doles out funds to dreamers, but it excludes many types of businesses, especially brick-and-mortar ones.
All of this explains why new funding ventures have received such a boost from the JOBS Act. Kickstarter is the most familiar, with Indiegogo close behind. These crowdfunding platforms let almost anyone announce an idea and solicit money for it, usually in chunks of $1,000 or less. No established venture-capital firm or large bank would dole out such small amounts. Their overhead alone, for due diligence and compliance, would mean steep losses on investments that size.
But the new crowdfunding sites remove those layers, and for now they have few of the regulatory burdens or scrutiny. It is the Wild West of fundraising. The most recent success was Oculus Rift, a maker of virtual reality headsets that raised $2.4 million on Kickstarter and then was bought by Facebook a little more than a year later for $2 billion.
The big hitch? A Kickstarter contribution is a donation. When people fund projects on the site, it is out of passion for the product, not any hope for a financial return.
The next wave of crowdfunding, through sites such as SeedInvest and Fundable, will offer equity ownership to those who throw money into the ring. This new model could upend the insular world of venture capital and business loans while at the same time providing new opportunities for small investors. As for a would-be innovator, if you can post an idea online, raise a million dollars for it and (most important) choose how much equity you want to part with at what valuation, why go through the gauntlet of a commercial loan application or make the rounds at the VC firms on Sand Hill Road?
The result is likely to be billions of dollars of new funding, which would spur lots of good ideas—and lots of bad ones, too. The prospect of unconventional new funding sources has already prompted comparisons to 1999, when millions of individual investors joined the IPO craze only to see their shares of Pets.com become worthless. Such risks are very real, but either way, much more money will be in motion.
What’s a broker?
The traditional model for buying and selling stocks, managing a portfolio and handling assets for retirement was to pay someone else to do it. The next model will be to use Web-based technology to do it yourself or to work in conjunction with experts online.
One of the hottest areas of fundraising in the financial world is a panoply of online wealth-management companies offering a range of services. Their assets are tiny today, not much more than $20 billion. But they have attracted attention and funding because they, too, threaten to disrupt the traditional modes.
Betterment, Wealthfront, Personal Capital and other “robo advisers,” though still marginal in terms of assets, have shaken the wealth-management market. Especially for smaller accounts, they offer basic asset allocation and investing services for a fraction of the ordinary fees. Fund behemoths such as Vanguard and online brokers such as Schwab also have developed and unrolled their own digital advisory services.
Then there is the rise of exchange-traded funds, which are challenging actively managed mutual funds, especially those that charge high fees to deliver the same returns as an index. More than 1,500 ETFs now account for $2 trillion in U.S. assets.
Change will also arrive in the way that stocks and bonds are sold. The 20th-century model has already given way to the online world of ETrade and Schwab, but those models are being challenged, too. Newer digital entrants can offer fractional shares of both stocks and bonds. Bond trading in particular is still controlled by a small number of dealers in the belly of traditional Wall Street for high, opaque fees.
Those who profit purely by facilitating simple financial transactions are increasingly hard-pressed to compete when many of those transactions can be done for nearly zero cost. The traditional investment banks are already seeing profits from their trading desks plummet. Bond business for Goldman Sachs was down 33% last quarter, and its rivals didn’t fare much better.
The trend ahead is worse for these legacy firms. If they offer a service that is not easily automated, they can thrive. If not, look out. Why pay a broker a hefty commission if the same purchase can be done online for pennies? Why pay a human adviser who does no more than cookie-cutter asset allocation? Why pay an active mutual fund if it only offers index returns?
The developing financial landscape will include more creative ways to save and invest, more ways to buy and sell stocks and bonds, and more demand for better advice, delivered interactively online.
Stocks aren’t just for them.
For the past century and a half, every bubble that has burst in the equities market has been followed by a long period of retrenchment. Individuals get burned and then avoid exposure to future losses. That happened after the Great Depression and after 1999, and it is happening now in the wake of the financial crisis. Equity markets have gone up and up since March 2009, but retail investors have been largely on the sidelines.
But what if the next wave of stock ownership isn’t just trading your own account, but stocks as a form of affiliation with brands? What if that Starbucks card came not just with a free latte after 10 purchases but a share of Starbucks after 100? And what if the maker of that cool new device, the GoPro of tomorrow, could offer its shares directly to its avid users instead of having to rely on investment banks to dole out the shares?
Several Silicon Valley startups are already attacking the problem. Loyal3 aims to connect public companies to loyal customers who want to buy shares as early as the IPO, while EquityZen and others do the same for private companies. The idea of directly marketing shares to customers is old, but the new wave makes it far easier—at the click of a button—and cheaper. If these novel ways of buying and distributing shares take off, it could turn stock ownership into a more universal phenomenon.
Providing financial services to the less well-off and the unbanked is also an area seeing considerable investment interest and activity. ZestFinance, founded by former Google executives and flush with venture capital, uses big data to offset the inherent risks. It is just one of many new ventures in this field, which promises to open hitherto closed spigots of capital to all classes, not just the middle and upper.
It is easy, of course, to forecast a new world of money in motion and all of the benefits it may entail. These innovations are almost all products of the last five years, after the financial crisis. They might look less promising if the tide suddenly goes out again. A large institution can survive a bad investment; an individual of modest means won’t so easily weather a complete wipeout on a peer-to-peer loan.
Whatever the risks, however, the Uberization of finance is no fad or stunt. Many of today’s startups may implode, as most do, but the spread and democratization of capital—and the proliferation and analysis of data—are irresistible trends. They will offer new opportunities to millions of people, entrepreneurs and investors alike. They also will unlock a vast amount of money, energy and talent, and to that we simply should say, bring it on.