Hey, Banks, your fat margin is my opportunity

That is a Jeff Bezos line:

“your fat margin is my opportunity”.

This is standard thinking for entrepreneurs. Fintech entrepreneurs are eying the fat margin lines of business in the banks.

Fintech is more than Bitcoin. Having finished my exploration down the Bitcoin rabbit hole I can understand the context behind the torrent of news about Bitcoin.

However, I am a Fintech entrepreneur, not a Bitcoin entrepreneur. I first look for problems to solve, then I look for technologies that can offer solutions to that problem. Bitcoin is a big part of the solution set, in some cases it will be the core part. But it is only one part. There are so many disruptive technologies changing the Fintech game – mobile, big data, real time web, XBRL to name a few.

However entrepreneurs start with a problem. The problems I am interested in are the ones that leave consumers or small business out in the financial wilderness, with lousy and expensive services or no service at all.

Banks make a lot of money from services to the Global 2000, but these tend to be an efficient market. The Global 2000 have buying clout, so they get great prices and service. There are few “fat margin opportunities” among the Global 2000.

There are lots of “fat margin opportunities” among consumers and small businesses. Consider the spreads on lending or the fees for payments or the fees to manage money. They are massive.

When disruption really hits, the intermediation $$$ gets cut about 10x.That is what an efficient market does. This is something naive entrepreneurs and investors often miss. They see a market that is worth $10 billion today for example. That $10 billion number is official, you can attach a report showing that it is real. So the entrepreneur pitches investors with “if we only get 1% of that $10 billion” we have a great business. True, that would be a $100m revenue business.

However it never pans out that way. The disruptive technology evaporates 90% of that existing line of business. That $10 billion Total Addressable Market (TAM) becomes a $1 billion TAM. Lets call it TAM-Today and TAM-Tomorrow.

However the business opportunity for the winner is actually a lot better than what that entrepreneur is pitching. The winner does not get 1%. In a network effects game (and all digital markets are governed by network effects), the winner is more likely to get 20% or 30% or even 50% of the market. In fact, less than 50% for the winner is unlikely – think of Microsoft, Google and Facebook. Once you get to 50%, it is a short journey to worrying about anti trust as you nudge towards 70%. So the winner in that $10 billion TAM-Today will create businesses with revenues of $500m (50% of that $1 billon post-disruption market size).

Another naive error in Fintech, is to see those fat margins and think “it’s those greedy bankers”. Sure, sometimes there are easy pickings in a market where you simply bid a lower price. However, usually the fat margins are there because it is a fundamentally broken market that is totally inefficient. Those fat margins are needed to cover the cost of that inefficiency.

Consider a simple example. The old banker’s life used to be 3-6-3:

“borrow at 3%

lend at 6%

tee off on the golf course at 3″

That 3% spread included lots of paperwork processing and meetings with the borrower. That all cost money.

In an efficient, automated market that 3% could be 30 basis points. That is the 90% cut to the TAM. 30 basis points at scale is a massive business. If you do not do it at scale at that rock bottom price, somebody else will. It could even be Jeff Bezos as he sees yet another “fat margin” line of business to attack.

Turning a broken market into an efficient market is not simple. If it was simple it would have already happened. That is what great entrepreneurs do – understand the root cause behind a broken market and figure out how to make it efficient (and how to extract the small slice for doing so).

Matt Harris, a VC who really understands Fintech has a great blog called Race to the Bottom, where he says that you have to do 4 things to after these big markets:

1. Be the lowest cost provider.

In my terms, you don’t want some other entrepreneur looking at your business saying “your fat margin is my opportunity”. Or, as the soldiers would say, “don’t leave your rear exposed”.

2. Lock up differentiated distribution.

In other words, negotiate some exclusivity into your channel deals or that new upstart competitor will come to them and underbid you; even if the new upstart competitor cannot be the lowest cost provider they can use dumb money from investors to buy their way into your market. That won’t work for them but it can still kill you along the way.

3. Serve the previously unserved (and ideally previously unserveable).

This is a big part of what I am covering on this blog. It is not just the unbanked in the developing world. There are plenty of people in the West who have been left in the cold by the current financial system. Consider the 25% of Americans who have no FICO score and therefore find it hard to borrow. Or ask a small business owner how much they like using Factoring or pledging their home as collateral in order to get working capital.  Or ask any consumer or small business how much they love playing a lot of money to change currency.

 4. Change the game

If a market is broken you have to fix it. Huge rewards follow anybody who can fix broken markets and make them efficient, but this is harder than launching a social media site. You need to a) understand the root cause of why it is broken and b) have a disruptive technology that you can use to fix that root cause problem.

Identifying these big broken markets is easy. Find out all the places where you as a consumer or small business owner are getting a lousy deal from the current financial system. You won’t lack for problems to solve. Figuring out how to solve them is obviously harder, but as Matt Harris says at the end of his blog:

“All of these are big bets, and none of them may pay off.  But the juice is surely worth the squeeze.”

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