Can Challenger Banks break the massive bank concentration in the UK?

david-vs-goliath

The UK has one of the most concentrated/ consolidated banking markets in the world with the top 5 banks accounting for 85%market share.

By contrast, the big banks only account for about 44% in America and 25% in Germany.

The question is, does this level of concentration & consolidation make it harder or easier for challenger banks? This post seeks to find out which of these two theories is correct:

  • Theory 1: Big banks will remain dominant. Their size enables them to crush any attacker
  • Theory 2: The digital only challenger banks will win because the game has changed.

We segment the market into:

The Big 5 universal banks

The big traditional challengers

The new digital only challengers

The challenge from retail players

Current account innovators

Altfi Lenders moving into Deposits

SME Banks

Niche challengers

The Big 5 universal banks in their castles

Everybody knows them – a walk down any UK high street shows their dominance. These are the barons in their big castles, with huge moats populated with crocodiles and plenty of boiling oil to pour on attackers. They seem impregnable. Consumers may grumble, but maybe they will always need a big solid bank to fall back upon.

Approximately 27% market share goes to Lloyds and a further 18% each to Barclays and RBS with HSBC and Santander taking 12% and 10% respectively.

The other narrative goes like this –  the barons in their castles have lost the plot and suffer from bunker mentality and are “too big to manage”.  Their innovation teams report back from sponsored hackathons and innovation challenges to business units that then get back to business as usual. Their business reality is about managing dividend cover ratios, buybacks and stress tests, not delighting customers.

Investors also know these Big 5 very well. Apart from crashes around various crises, such as the Global Financial Crisis in 2008, the Eurozone Debt Crisis in 2011 and Brexit in 2016, their stock holds up as long as they keep paying high dividends and passing stress tests. There is no sign as yet of investors viewing the challengers as a serious threat.

The big traditional challengers

These are the landed gentry in their manor houses. They are minor compared to the Big 5 but 3 of them have meaningful market share, more than 1%:

  • Nationwide
  • TSB
  • Coop Bank

Virgin Money has the new brand, but is really Northern Rock under the skin. Clydesdale and Yorkshire are innovating with the B account, but this article in the Telegraph shows how hard it is to win over new customers.

They all seem like smaller versions of the big guys, which is not a game-changer.

In this category, Metro Bank is the one to watch. When Metro Bank opened for business in spring 2010, created by a US entrepreneur called Vernon Hill, it became Britain’s first new high street bank in over 150 years. It has retail branches – called stores – open 7 days a week and outside normal banking hours. The model was largely based on a similar venture created by Hill in the US, Commerce Bancorp (acquired by TD Bank in 2007), which gained the nickname of “McBank” as Hill applied his knowledge of the fast-food chain business to the bank. Metro Bank has also been a talent incubator; Metro Bank’s co-founder Anthony Thomson left in 2012 to set up rival Atom Bank.

During 2015 it looked like the game was turning to the challengers as per this report from KPMG:

“Britain’s challenger banks outperformed the Big Five lenders by notching up an 18% hike in profits in 2015, but new research warned the “tide is turning” in a tougher year for smaller players.

Total pre-tax profits for so-called challenger banks – such as – rose by £194 million to £1.28 billion in 2015, while the Big Five were left nursing a combined profits drop of £5.6 billion.”

The new digital only challengers

These are the insurgent “neobanks” using ladders & tunnel & battering rams to break into the mighty castles.

In 2013, the Bank of England created a simplified two-step process with lower capital requirements, in order to introduce more competition.

The digital challenger strategy is mostly to appeal to mainstream but younger consumers – the Millennial strategy.

We sorted these challengers by amount raised:

Bank Total ($m)
Atom 166
Starling 70
Tandem 35
Monzo 18

Atom’s last round was from BBVA which pioneered buying Fintech Neobanks with Simple. So we can expect a big challenge into the top 5 from “the other big Spanish bank in the UK”.

We see two distinct strategies. One is to build a new tech stack from scratch. The idea is to be able to offer a genuinely new service rather than a new UX on top of an old core banking system.

The other is to outsource the back end to proven banking software vendors. The idea is to focus on the UX layer, so that they can innovate faster. Most digital only banks adopt this approach; you see surprisingly Traditional Fintech below the hood.

Monzo is the biggest proponent of the DIY from scratch strategy.  The technology used is classic for a digital startup. It is mainly open source: Linux, Apache Cassandra, Golang and PostgreSQL relational database. There is a team of 16 people working on this.

The challenge from retailers

Asda, Tesco, Marks & Spencer and Sainsbury’s have all launched banks. The logic makes sense as they have brand recognition and physical high street coverage, yet without a major presence they don’t suffer from innovators dilemma.

Like all banks, they suffer from cyber attacks.

The Post Office also has the brand recognition and physical high street coverage.

These retail store challengers use traditional old school technology. Their advantage is simply being able to monetize their real estate in multiple ways – and that is a big deal.

Current account innovators

While most challenger banks focus on deposits and loans, which is highly regulated, many other ventures focus on the current account (checking account for American readers). This is a big area for innovation and there is no reason why in the digital realm a current account must be bundled with deposits and loans. The innovators we see in this category are:

  • Tide. Tide focusses on SMEs. They offer a fully featured current account and business MasterCard, plus SME-oriented finance apps, accounting capabilities and and online community.
  • Think money. They also offer MasterCard as part of their current account. They differentiate via tools to help  customers manage cash flow (ego tracking incoming like salary, benefits, pension so that there is enough pay all the regular bills. Once the bills are taken care of, the rest of the money is moved over to the customer’s “card account” for discretionary spending.
  • Soldo. They also offer prepaid debit card (MasterCard) and a mobile app. They focus on family spending, budgets and cash flow. The company says it does not intend to compete with banks, but will rather complement their services. It plans to seek formal partnerships with banks and co-branded arrangements. Soldo holds an electronic money licence and is regulated by the FCA.
  • Loot. Loot is a  mobile banking service aimed at students or what it calls “generation Snapchat”. They also offer a prepaid Mastercard account. The card is linked to a money management app that lets people track their spending and gives them insight into where their money is going.
  • Pockit. They also offer a prepaid MasterCard and focus on the underbanked, who rely on cash in the absence of bank accounts.  Pocket says it takes two minutes to open an account – without any credit checks.
  • Ffrees. It offers a no-frills account (and a debit card) and does not carry out credit checks. Ffrees describes itself as an “Unbank”, with their November 2016 launch of their new U Account. They claim to have opened 10,000 accounts in 3 months from a young demographic. We covered them in their earlier incarnation here.
  • Lintel Bank. They do position as a full service bank and are still waiting for a licence. They focus on migrant workers and students via prepaid current accounts, money transfers, personal and SME loans, and mortgages.

AltFi Lenders moving into Deposits

Our thesis at Daily Fintech is that the P2P Lending is the new Deposit Account. As an investor, you put in more work, take a bit more risk (less if you put in the work) and get a much higher return than you would from a deposit account. This is still only for early adopters – such as Hector Nunez who we profiled here – so there is still a lot of room for intermediaries to package it up for consumers in a way that is easily accessible.

Funding Circle raising $100m signals that P2P Lending is alive and well.

Zopa, which claims to be the world’s first P2P Lender is taking this thesis to a logical conclusion by applying to become a bank. This gives them a big interest rate arbitrage opportunity. They can borrow via deposit accounts from investors and lend via overdraft alternatives, while laying off most of the balance sheet risk to the market. This will be worth watching.

Other AltFi Lenders moving into Deposits include:

  • Together Money. This was created by Jerrold Holdings Group, which unites Auction Finance, Blemain Finance, Cheshire Mortgage Corporation and Lancashire Mortgage Corporation.Their focus is on residential and commercial mortgage loans to niche market segments underserved by mainstream lenders. They have applied for a banking license.
  • Paragon Bank. This banking subsidiary of a well-established specialist finance provider, Paragon Group, was launched in early 2014.
  • OneSavings Bank. This is a rollup and rebranding of a number of financial services businesses owned by US-based private equity firm JC Flowers. Constituent companies include Kent Reliance (residential mortgages and savings products), Interbay Commercial (commercial mortgages), Prestige Finance (secured loans), Reliance Property Loans (property financing) and Heritable Partners (development finance).
  • Masthaven. This mortgage specialist recently received a banking licence.
  • Hampshire Trust Bank. They were founded in 1977, but moved into the banking space in 2014, following the arrival of new owners.
  • Coombs Bank. They are still waiting for a licence (site is “coming soon”. It is backed by S&U plc, a provider of consumer credit and motor finance created by Derek Coombs.

SME Banks

Our thesis at Daily Fintech is that SMEs have been like the middle child – neither Consumer nor Enterprise, so Banks did not serve them well. This leaves a big window for new ventures such as:

  • Shawbrook Bank. Formed in 2011 via the merger of Whiteaway Laidlaw Bank, Link Loans and Commercial First, Shawbrook is a publicly traded specialist lending and savings bank that focuses primarily on SMEs. You could also put them in the Altfi moving into Deposits category.
  • OakNorth. They focus on the needs of high growth ventures.
  • British Business Bank. This government entity is active in encouraging lending to UK SME and has done a lot for P2P Lending.
  • CivilisedBank. They go to the SME rather than asking the SME to go to them (as they don’t have any branches). A network of local bankers working in their local communities come iPad equipped to your office. CivilisedBank hopes that this differentiated strategy will lead to a lower Customer Acquisition Costs than either retail branches or hoping for automated inbound conversion.
  • Aldermore. The company was founded in 2009 with backing from private equity company, Anacap, and did an IPO in March 2015.
  • Wyelands Bank. They were previously known as Tungsten Bank and before that as FIBI Bank. This is an example of buy & repurpose rather than build. Instead of building a bank and applying for a new license, you buy an existing bank and change it to suit your needs. The site is in coming soon status. The investor behind Wyelands Bank is Sanjeev Gupta and at the time of the acquisition from Tungsten, the planned focus was to provide funding to supply chain and trade financing firms (i.e. similar to Tungsten focus).

Niche challengers

  • Hampden & Co claims to be the first private bank to launch in the UK in the last 30 years.
  • Templewood Bank wants to be a new independent merchant bank (awaiting a banking licence).
  • Lintel Bank targets migrant workers and students (awaiting a banking licence).
  • Monese targets expatriates and immigrants. It is also in the current account innovators category, claiming a 3 minute mobile account opening and a simple a monthly charge of £4.95.
  • Monizo targets freelancers. They clain to offer real-time insight into how much tax freelancers need to pay (which is critical to financial planning for freelancers).

Daily Fintech analysis.

The two theories are:

Theory 1: Big banks will remain dominant. Their size enables them to crush any attacker

Theory 2: The digital only challenger banks will win because the game has changed.

We incline to Theory 2, but with a twist.  Consumers know they lack for choice and they lack engagement with the big banks. The traditional analog scale of the Big 5 does not help them win the digital scale game – which is about UX and network effects. Their scale makes them slow and hard to manage.

So the Big 5 are ripe for disruption by smaller and more agile competitors, but not by the current challengers. 

Our analysis is that the challenger banks will be acquired by non-bank players and new foreign entrants. They will have the deep pockets and balance sheet to enable them to win. The challenger banks will find it hard to compete as standalone entities, but via the M&A route they will be a success for investors and founders.

What could trigger a tipping point?

For all this Cambrian explosion of activity described above, all these ventures together are still a rounding error compared to the Big 5.

Most of the ventures profiled are quite happy with a small piece of the pie, as it is such a large pie. However, a tipping point matters because it is about Customer Acquisition Cost (CAC). Despite the oft repeated data about how much Millennials distrust traditional banks, it still costs a lot of money to persuade them to part with hard-earned money.

There is no magic silver bullet functionally. Everybody offers a frictionless mobile UX with personalization based on big data. That is the price of entry.

The trigger will be another catastrophic event like the Global Financial Crisis of 2008. As catastrophic event usually don’t follow the last one, the next one will be something new; the best guess currently is some form of mass cyber attack.

N26 and the German small banks

The digital challenger bank to watch in Europe is N26, from Berlin.

The German banking market is much less consolidated or concentrated than the UK.

The Grossbanken – Deutsche Bank, Commerzbank & HypoVereinsbank – mostly focus on Corporate banking and are publicly traded. Then there are about 500 independent, local “Sparkassen” or “savings banks”, with a market share around 50%. There are also about 1,450 independent, local  “Volksbanken” or “Raiffeisenbanken” (translation = Cooperative Bank) with a market share of 25%.

Yes, in Germany about 75% is from small banks, which is almost a mirror image of the UK.

The question is, does this make it harder or easier for N26?

These tiny banks must rely on outside firms for technology. The Daily Fintech prediction is that at least one digital challenger bank will switch from B2C to B2B or B2B2C and offer their capability via these locally dominant small banks. That company can come from anywhere. So our take is the N26 will have a hard time competing against lots of small local banks partnering with new neobanks that pivot to B2B or B2B2C.

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Prevention & pay per outcome could be the key to Healthcare InsurTech post Trumpcare

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An apple a day keeps the doctor away. With the ever-rising cost of healthcare, the ROI of one apple a day looks pretty good. 

Welcome to pay per outcome disruption coming to healthcare Payers (Insurance companies) and Providers (doctors etc).

Nobody knows what Trumpcare will look like, but some direction of travel seems clear. Please note that this is not a political blog, please refrain from any comments like that; one cannot ignore politics when looking at Healthcare InsurTech, but our focus is the business of technology not politics.

So far we know this about the Healthcare InsurTech market:

  • It is huge (about 18% of GDP in America)
  • It is broken (ask any consumer and most doctors)
  • It is dominated by America (so what President Trump will do is critical)
  • There can be no meaningful change at the Insurance level without breakthroughs in health technology; thankfully we can see a lot of that.
  • Regulation (and therefore politics) has a massive impact, but not even politicians can change the big secular trends around technology and demographics.

The one trend that seems clear is the move from pay per procedure to pay per outcome. Consumers aka patients aka citizens/voters want this and many medical practitioners want this, but it’s a wrenching change for payers and providers, so one can expect plenty of resistance from incumbents. The most logical extension of pay per outcome is the perhaps apocryphal story of the Chinese Emperor who paid his doctor when he was well, not when he was sick, on the basis that when he was well the doctor was doing his/her job right.

Prevention may include an apple per day, but that is only a simple starting point.

A move towards prevention and pay per outcome will disrupt the U.S. healthcare business. As healthcare is about 18% of GDP, there is a lot at stake. Payers and providers will have to transform themselves to meet this emerging reality. The driver is the same as the democratization of wealth management. As investors get more information, they can make more informed decisions on their own. The same is true with patients. The strategic response from incumbents and startups is to deliver new services that improve convenience while lowering cost by leveraged big data to provide personalized solutions.

The fundamental shift is to rewarding prevention at least as much as for fixing a problem. Which brings us to the corporate self-insurers. People talk about the grand vision of insuring healthcare for all consumers/citizens/patients, but that requires a political will and is hugely complex. However, within the domain of a single large company, it is a different story.

These numbers add up. According to some estimates the

total number of employees among all Fortune 500 companies is over 26 million.

Whatever direction the politics takes us, the trend towards an increased focus on the healthcare consumer seems clear, simply because the tools are there to deliver that. Whether we move to Health Savings Accounts (HSAs), or providing tax credits (similar to what employers currently get), or mandates for the whole population, the focus will be on ensuring quality of outcome for consumers.

In this post, we look at 4 of the companies positioned to do well from a general trend to an increased focus on the healthcare consumer and pay per outcome:

Accolade

Omada Health

Sharp

Boundlss 

 

Accolade

 

Accolade describes itself as a healthcare concierge. Its customers are large, self-insured companies—as well as health insurance providers—that want to see their employees and their families make better use of the healthcare benefits they provide. People can call on the service for personalized help navigating health plan benefits, evaluating care options and other questions, all from a single point of contact. The company says its services reduce costs by 5 to 15 percent, while improving insurance usage, health outcomes, and patient satisfaction.

Their CEO, Rajeev Singh, expressed it well in a recent interview in Xconomy:

“If you’re a wealthy person in this country today, you go get a concierge doctor and you pay $35,000, $40,000 a year for that concierge doc. They are your central point of navigation. Anything goes wrong with anybody in your family, you call them and they fix it. This is fundamentally the democratization of that idea.”

Accolade recently raised $70 million in new capital from Andreessen Horowitz and Madrona Venture Group, among others, bringing the total venture capital raised by to $160 million.

Disclosure: I have an indirect financial interest in Accolade.

Omada Health

Omada Health  focusses on prevention related to obesity, which the company describes as an epidemic and pegs as a $500 billion a year cost for employers, insurers, and consumers/patients.

Their product name – Prevent – says it all. Prevent is a digitally-based lifestyle intervention that helps individuals reduce their risk for obesity-related chronic diseases such as diabetes and heart disease.

When people sign up for Omada, they receive a wireless, digital bathroom scale, pedometer, resistance band, and tape measure. Customers are also paired with health coaches and are given a proprietary health-related curriculum and connected to a like-minded online peer network.

Omada operates on a pay-for-outcomes pricing model and has been tackling the obesity epidemic with a lot of scientific evidence, published in its own clinical two-year study in the Journal of Internet Medical Research.

Their last funding round was a $48 million Series C in September 2015 led by Norwest Venture Partners. Its strategic investors include two Omada customers and health care leaders – Humana Inc. (NYSE: HUM) and Providence Health & Services, as well as prior investors US Venture Partners, Rock Health, and Andreessen Horowitz, and new investors GE Ventures and dRx Capital.

Sherpaa

Sherpaa is a New York City-based digital healthcare service that offers a back to the future relationship with your doctor – ye olde family physician. In their words:

“Sherpaa is your own personal primary care doctor, online. You use Sherpaa doctors for issues a primary care doctor or urgent care center would treat. Just subscribe, fire up our app, communicate, and get care. Our doctors diagnose, order tests, prescribe, treat, refer if we need to, and check in until you’re all better.”

They make two statements that few patients/consumers would argue with:

– Communicating with your doctor should be as easy as communicating with your friends, family, and co-workers.

– A consistent doctor helps you best.

Boundlss

Boundlss, from Australia, offer staff wellness programs to improve outcomes for Insurance carriers, corporates and individuals. They offer an AI powered chatbot personal coach called Loyd who can make customized wellness suggestions.  The platform connects to over 150 wearables and apps already tracking health metrics for a user, which it no doubt leverages to makes its custom suggestions. (We covered them earlier in this post)

Health insurance is all about data.

Buying Health & Life Insurance today is like filling in a form to tell Netflix what movies we say we like at that moment in time – versus what movies we actually watched recently. You fill in a snapshot report of your health, with blood samples and other tests run by a doctor and the premium is set. The fact that you later put on 40lbs and developed diabetes – or gave up smoking and alcohol and ran a marathon and reduced your blood pressure – impacts Insurance risk but is ignored by Insurance companies today.

Wearables and in-home sensors (such as in bathroom scales) could change all of that and revolutionize health and life insurance by a) personalizing insurance and risk and b) changing the delivery of healthcare by augmenting the intelligence of healthcare workers through cognitive computing linked to this avalanche of data and c) improving health outcomes by engaging patients with personalized but automated coaching.

Our premiums would go down as we became healthier. Becoming healthier would not only make us feel better, it would also save us (and our employer) a lot of money.

Imagine an exchange like this over chat bot:

  • Patient: I am not feeling well.
  • Healthcare worker: I can see why; your xxx vital sign does not look good. I suggest you do yyy right now and let’s schedule some time so I can run some more tests.

Wellness programs

We see an increasing trend for digitally savvy wellness programs to partner with insurtech ventures. For example, Limeade partnered  with Accolade.

Outside the US, VitalityHealth, originally from South Africa, is an insurance carrier that was early pioneer of wearables before they were called that. They have expanded globally through partnerships; they moved into the UK, with Pru Health and China with Ping An. In the US they have the novel strategy of partnering with 6,000 gyms; they can track actual attendance from a swipe of their membership card.

Australian insurer Medibank has partnered with loyalty program flybuys, offering bonus points for fruit and vegetable purchases. In addition bonus points can also be accrued for every 10,000 steps made a day, measured by linking up your Fitbit device. Like Vitalit Health they have has also partnered with local gyms via its GymBetterprogram.

Healthcare is massive and massively complex

Fixing something as big and complex as the healthcare business was never going to be easy. There is no simple Uber like app to fix this and many early VC funded attempts hit issues such as 23andMe, Theranos and Zenefits. The prize is still big but it will be like scaling Everest – very, very hard and it takes time. For example, it takes many years for an innovation like Telemedicine to go mainstream, but when it does it will be a game-changer and with almost ubiquitous high bandwidth, it is inevitable if not imminent.

Two big hurdles face the data driven healthcare changes:

  • Hurdle # 1: PreExisting Conditions. One lasting legacy of the Affordable Care Act (aka Obamacare) is that consumers cannot be denied coverage based on a pre-existing condition. That is a problem if the wearables data shows we have a new condition that could have been present but indetected at time of application. We want our Insurance to go down when our health improves, but we don’t want it to go up when our health declines.
  • Hurdle # 2: Data Privacy. Privacy regulation varies by jurisdiction, with Europe tending to tougher than USA; but even in USA in some States you must communicate to consumers if you use factors such as gender, age, zip code in pricing.For wearables and in-home sensors to impact Insurance premiums, policyholders must be willing to share data with the Insurer. This may be an area where Millennial attitudes to privacy (it’s done, put a fork in it) may rule. Or there may be consumer and regulatory backlash as the data is so sensitive. The companies will need to prove that their aggregated anonymous data cannot be reverse engineered to create Personally Identifiable Information (PII); any hacker that breaches that will create a reputation crisis, so it has to be really secure.

These are real obstacles, but entrepreneurs treat obstacles as something that defines their action list. They find a way to solve those problems. Given the scale of the opportunity, somebody will surely solve them.

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Fintech is entering the third wave and this will be a wild ride

 

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Disruptive change typically goes through three waves:

Wave 1: Everybody says that this is revolutionary. This is the initial hype wave. The basic ideas are right, but the timing is way off.

Wave 2: Everybody agrees that this is evolutionary. This is when realists point out that change takes a lot longer than the original promoters of change led us to believe and this leads to the Wave 1 ideas being discredited.

Wave 3: Everything changes. Some incumbents fail, some transform and thrive and a new power structure emerges with some new players.

The Internet went through these 3 Waves

Wave 1: This is revolutionary. From about 1994 to the peak of the bubble in late 1999.

Wave 2: This is evolutionary. From mid 2000 to around 2004. After the dot com bubble burst, everything digital was declared dead and the only tech was enterprise tech and that needed to be incremental and very low-risk. Remember Intranets and brochureware websites?

Wave 3: Everything changes. From 2004 to today, when the search and social era of GAFA and BAT emerged. The change envisaged in Wave 1 took longer than forecast, but the eventual impact was far bigger than even the most wild-eyed visionaries had forecast.

The 3 Waves look like this in Fintech:

Wave 1: This is revolutionary. After the Global Financial Crisis in late 2008 to the Lending Club IPO in December 2014 and an acceleration in VC funding in 2015.

Wave 2: This is evolutionary. This is what we saw in 2016, when Bitcoin became totally discredited and the bellwether Fintech stock, Lending Club, blew up. The key belief in this wave is that incumbents control the pace of change. Nobody debates that change is needed and change is good, but entrepreneurs are told to knock politely on the doors of the incumbents and sell technology to them.

Wave 3: Everything changes. From 2017 onwards. This post explains why.

 

Why Fintech is a big deal and will meet a lot of resistance

Financial Services is a big % of GDP, of employment and of corporate profits. Many big companies, that are not labelled as Financial Services, make a lot of their profit from Financial Services. By some estimates, Financial Services accounts for as much as 40% of corporate profits in the Fortune 500.

This article on Bloomberg does a good job describing how finance came to dominate-the US economy and you could write a similar story about the UK and Switzerland.

Almost all of this can be digitized and is therefore susceptible to disruption.

In short, there is a lot of money at stake.

That also means that a lot of money is spent to persuade people that nothing will change and the status quo will remain. Perception does impact reality (aka mindshare leads to marketshare).

However, this is PR. The reality is that incumbents can no longer dictate the pace of change. They can benefit from change or be hurt by change, but what they cannot do any longer is dictate the pace of change.

 

Why incumbents can no longer dictate the pace of change

Imagine Blockbuster saying “we will decide when and how streaming video will roll out”. Or Kodak saying that about digital photography or Borders saying that about book retailing. Disruption does not happen like that, particularly if it is Big Bang Disruption.

Straws in the wind indicating change

You can wait until the change is obvious, or you can try to get ahead of the herd. To do the latter, you need to get comfortable with incomplete data that I call “straws in the wind”.  It takes guts to see a few straws blowing about and bet that this is caused by an invisible wind, but that is what the best early stage investors do. The signs of change are far from obvious, but “the answer my friend is blowing in the wind”. We see 5 of these straws in the Fintech wind today:

  • Wells Fargo fake accounts scandal. This was what happens when organic growth slows because of a secular wave of change and managers pile on the pressure to maintain the illusion of growth.
  • Funding Circle raising $100m. This indicates that P2P Lending is alive and well. P2P Lending is a disruptive model where banks don’t dictate the pace of change.
  • Lending Club stock recovering. Since the ouster of the CEO in May 2016, the stock has recovered from a low of 3.51 to around 5.50 which is an annualized return of over 100% (which makes it one of the best performing stocks of 2016). Of course you can also measure from the peak (bad) or from the pre IPO early stage days (very good). The key point is that the P2P Lending bellwether is alive and well. Disclosure, I was fortunate to buy some shares at 3.51 after writing this post. You can get insights like this in your inbox every day – its free and all we need is your email.
  • Defections from the R3CEV blockchain consortium. This indicates that a bank-led consortium may not dictate the pace of change in blockchain deployment. An analogy would a consortium of camera makers doing something with digital photography. Looking at past waves of disruption it is much more likely that a startup harnesses the pace of change that consumers want and that individual banks figure out how to transform themselves for this new reality.

 

Expect a lot of PR that it is business as usual

During the evolutionary wave, the incumbents see an opportunity to slow things down and control the pace of change.  They do this through both acquisitions (buying and closing down a competitor or changing how they operate) and PR.

The PR works, because people have an instinctive reaction to believe that the status quo will remain. Banks have not fundamentally changed for hundreds of years, so it is really hard to imagine a world where Banks are not at the center of Financial Services.

For example, read this view by Goldman Sachs that the third wave of Fintech will be all about “partnerships between big banks and startups.  

I don’t mean to pick on Goldman Sachs, but I think this is PR and not reflective of reality. Some incumbents will make the transition after Big Bang Disruption and I think Goldman Sachs will be one of them. From personal experience of selling technology to them, I know that they were Fintech before it was called that and that they fully understand the level of disruption that is coming.

Partnerships between Banks and Tech Startups are real and a key feature in how Fintech evolves, but what is different this time is how the world has changed from Traditional Fintech when Banks controlled the pace of change.

Today , both Banks and Tech Startups need a reality check before a real partnership can be negotiated.

 

Partnerships require a reality check by both parties

When Banks and Fintechs first date, it is a Venus and Mars story. If the relationship continues, it goes through three levels of maturity:

  • Level 1: Incomprehension. The other party just looks strange and it is hard to imagine a productive conversation. Whether the emotion is fear or disdain, the reaction is the same – inertia. Banks seek to overcome the incomprehension problem by funding Accelerators and Hackathons.
  • Level 2: Funding. Banks take minority equity stakes in Fintech ventures through their Corporate Venture Capital (CVC) unit. This is the level that most relationships have reached. Funding while still in Incomprehension mode is clearly dangerous.
  • Level 3: Strategic. This is where the relationship drives needle-moving revenues and profits for both parties. This may or may not include an equity relationship; the strategic relationship comes first.

As Fintech entrepreneurs and Banks seek strategic win/win relationships, they will move beyond Level 2. The Corporate VC wave of funding into late stage Fintech that we saw in 2015 was a classic sign of an overheated market. The real win/win deals will be at Level 3 and equity will not be a primary feature of those deals; they will be straightforward revenue share deals. Big Banks will have to gain the trust of entrepreneurs who might worry that Big Banks want to learn from them and then build in house or buy a struggling competitor. In other words, Big Banks could be competitors or partners. Smaller Banks don’t have an option to be competitors; they are partners that entrepreneurs can feel comfortable with.

A real partnership only happens when both parties have a clear answer to one strategic question:

  • The one question that banks need to answer is where in the stack do you want to excel? Do you want to be a platform for consumer-facing businesses? Or do you want own the customer experience? Both are great strategies, but it is a choice – it’s very, very hard to be both.
  • The one question startups need to answer is do you want to market direct (B2C) or via channels (B2B2C)? The answer can be “both”, but only if the startup is getting real traction in B2C. Without that, startups are really doing B2B, meaning they are selling technology to Banks (aka Traditional Fintech).

The difference between inevitable and imminent

During wave 2, realists point out the difference between inevitable and imminent. This has killed many startups. They understood what change was coming and how to position for it, but underestimated how long it would take – and that means running out of cash and that is the end for a startup. That is one reason startups are so hard. However, that is no consolation for incumbents. They face a relay race where the runners who give up exhausted can pass the baton (IP & team) to a new runner. Investors lose money on one runner and invest in the next one.

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The dabbawalas in India point to future e-commerce and payments

dabbawala

If you spend any time in India, you will often be told that home-cooked food is far better than restaurant food. As the restaurant food is so delicious, this is hard to believe, but it is true.

In Mumbai, India, 200,000 workers get fresh home cooked food every day. In this relatively impoverished city, workers get better food that is totally customized to their individual needs than the most pampered workers in Silicon Valley and other wealth hubs.

Investors and entrepreneurs who have spent $billions on food and grocery ecommerce should take serious note of how this is done.

Policy makers might also pay attention as this is good for the environment and for jobs.

The future of e-commerce is mobile. The future of payments is also mobile. So these two worlds of e-commerce and payments are converging around mobile phones and Internet Of Things devices. We see this convergence in companies such as Uber, Amazon, Alibaba and Paytm.

 In short, it is time to take note of what Mumbai’s dabbawalas are doing.

Once again this illustrates our theme of First The Rest then the West – that countries formerly known as emerging aka the rest of the world are leapfrogging the West thanks to not being invested in legacy technologies, processes and models.

Dabbawala 101

A dabbawala (aka tiffin wallah) is a person in Mumbai, India, who collects hot food from the homes of workers in the late morning, delivers the lunches to the workplace and returns the empty boxes to the worker’s residence that afternoon. They are also used by meal suppliers in Mumbai, where they deliver cooked meals from central kitchens to the customers and back.

Dabbawala translates to lunch box delivery person. “Dabba” means a box (usually a cylindrical tin or aluminium container aka tiffin) while “wala” is a suffix, denoting a doer.

These tiffins have become fun gifts in the West. Some parents use them for their kids lunch box.

Hot VC sector

The food and grocery delivery space has been hot. For a good analysis in 2015, read this post on Techcrunch by a VC. VCs put in more than $1 billion in 2014 with a big acceleration in 2015. A few successful IPOs such as Just Eat and Grubhub/Seamless led to a rash of similar ventures.

There has been a cooling in 2016 as some ventures inevitably failed and VCs focused on a few late stage deals. However, the window is still wide open with the online penetration % in low single digits.

The first generation was simply an online ordering layer (replacing phone orders with online orders). The second generation of restaurant marketplaces includes behemoths such as Uber and Amazon that compete on logistics through a network of independent couriers. The logistics network creates a powerful moat and a correspondingly higher commission around 25%.

It is this second generation, competing on logistics, that should be studying the dabbawala network. Actually they probably already know about it and understand its disruptive power (and would prefer if it stays in Mumbai). It is the third generation that will use the ideas behind the dabbawala network to create a new wave of digital cooperative network.

Indian frugal innovation

The dabbawala network is a good example of what has been termed “jugaad” in India which translates to “frugal innovation”. This became fashionable to study in the West around 2011 when big companies and universities (such as Santa Clara and Stanford) strove to understand how to reduce the complexity of a process by removing nonessential features. This becomes critical in serving mass market consumers at razor-thin margins without reducing quality.

Also in rich countries

Switzerland could not be more different from India – a tiny country with a high GDP per person.  Yet we see a dabbawala network operating here.

The appeal of fresh, delicious, nutritious food cooked with love and care is universal.

Better for the environment

The packaging wastage around today’s e-commerce (big disposable cartons) upsets a lot of people. If this upsets wealthy people who are influential this can damage the bottom line of the e-commerce marketplace. The dabbawala tiffins are reused every day.

Pave the cow paths with proven digital innovation

The dabbawala network started in 1890 with 100 delivery people (it now has about 5,000). So this was hardly a tech startup. Yet one Silicon Valley mantra is to “pave the cow paths”. This means adding innovation to whatever is already working.

There are 5 tech innovations that are already proven which would add a digital layer to a dabbawala network to make it massively scalable:

– QR code to replace the unique ID stamped into the tiffin.The current system is well thought-through and would translate easily to a QR code.

dabbawalla-7

– ChatBot UI for service inquiries and exception handling. Lets say you want to change the the location to your friend’s office or cancel for a few days next week when you are travelling.

– Mobile payment at delivery time (with auto routing of payments to the cook and the delivery person).

– RFID sensors in the tiffin so that the whereabouts can be tracked automatically (your phone pings you to say that lunch is in the lobby and getting into the elevator).

– fully electric cheap cars and scooters for delivery (cannot rely on trains in many countries and many delivery people will object to pedal powered bycicles).

Delegate don’t micro manage

Ordering takeaway food online rather than by phone increases efficiency, but adds to the tyranny of choice. What shall I eat for lunch today that is a) delicious b) nutritious c) avoids any dietary or religious prohibitions? How much nicer to have somebody who really understands all those needs decide for you and occasionally surprise you within those constraints.

For a lovely movie about the romance of this, watch The Lunchbox.

Put in more MBA terms, it is surely better to delegate this task rather than to micro manage it.

Digital Cooperative Future

The dabbawala network grew in an era and culture where/when men worked for pay and women cooked at home. Today, those roles could be reversed or both could be working and the cooking is done by somebody else.

The Gig Economy is the new normal for a large % of the population. The only question is, do we have a power law society (with the lion’s share of the economic value of these networks going to the network operator) or a bell curve society where the broad mass of people get most of the benefits of these digital networks? The latter is the vision of a digital cooperative future. Many of the blockchain startups envisage a future like this, but the beauty of the dabbawala network is that it does not require any technological breakthrough.

Look at the dabbawala network in the context of recent digital innovation compared to Uber:

  • Each dabbawala is required to contribute a minimum capital in kind, in the form of two bicycles and a wooden crate for the tiffins. This is like an Uber driver owning their own car.
  • Each dabbawala is required to wear white cotton kurta-pyjamas, and the white Gandhi cap. Rich people will pay more if their Uber driver looks like a chauffeur and that branding also helps the network operator.

Here is the fundamental difference with sharing economy network. Each month there is a division of the earnings of each unit. This is a cooperative, not simply individuals using a common system and brand.

At a human level, this enables the connection that people make with their postman or Fedex or UPS driver (or going really far back, the guy delivering milk). The same person comes every day. For humans who like humans, this is more appealing than drone delivery.

Doorstep services is not just for food

This is why Uber got into food delivery. If you have a logistics network, you can use it for anything. This is simply a networked, free agent model of Fedex and UPS. Entrepreneurs in India have figured this out. For example, Anulom uses the Aaadhar unique ID and the dabbawala network for the paperwork around rental service agreements. This earned them a tweet from the Prime Minster, Narendra Modi.

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Parsing Lemonade PR to see if P2P insurance is game changer or a mirage

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One of our 2017 Insurtech Predictions was:

#2 P2P Insurance does not (yet) live up to its promise.

We will see many drop out, leaving one or two well positioned to win big in 2018 and beyond. The term P2P Insurance will fall into the slough of despond.

Today we dig deeper into that subject.

A lot of the InsurTech innovation we see can be coopted by the incumbent carriers relatively easily. Knowing how to build a compelling digital user experience is not enough to create a moat and sustainable advantage. So a lot of people are looking at P2P insurance as the disruptive game changer. 

Ever since Lemonade did their $13m Series A funded by the hot hands of Sequoia Capital just over one year ago, there has been a lot of speculation about whether Lemonade will prove this model to be a game-changer or whether the whole thing is a mirage.

Now that Lemonade is releasing some information, we take a look at what we can learn about the whole sector.

P2P insurance 101

P2P insurance, sometimes also called reciprocity insurance, reduces the inherent conflict between insurance carriers and their policyholders. Policy holders are given more control in return for taking reciprocal risk (i.e. paying out to other members). Peers control decisions that are traditionally made by the insurance carrier, such as:

  • forming their own risk pools for deductible coverages
  • making decisions about the proceeds of the pool
  • allowing peers to adjudicate their pool’s claims.

Variants of P2P insurance

  • By country: Both regulations and social networks vary widely by country, so it is natural to see entrants from so many countries.
  • By risk type coverage: some go after automotive, others move into new insurance needs related to the sharing economy. Other examples are liability insurance, household contents insurance, legal expenses insurance and electronics insurance. Which one gets traction first is still unclear.
  • Broker model: a part of the insurance premiums flow into a group fund, the other part goes to a third party insurance company. Claims are firstly paid out of this group fund. Claims above the deductible limit are paid by the insurer. When there is no insurance claim, the policyholder gets his/her share refunded from the group pool or credited towards the next policy year. If the group pool happens to be empty, a special insurance comes into force.
  • Carrier model is similar to the broker model, except that as the peer-to-peer provider is also the carrier. If the pool is insufficient to pay for the claims of its members, the carrier pays the excess from its retained premiums and reinsurance. Conversely, if the pool is “profitable” (i.e. has few claims), the “excess” is given back to the pool or to a cause the pool members care about. Peer-to-Peer insurers take a flat fee for running the operations of the insurance enterprise. The fee is not dependent upon how many (or how few) paid claims there are. The carrier model can be launched by incumbents or full stack, regulated InsurTech startups.

Social and affinity networks

Trusting your peers is critical to the model, so Social and affinity networks will play a key role. The trust is not based on personal relationships, more to do with affinity. To take one example, window cleaners need insurance and if you are a window cleaner you and your peers understand the risks better than any insurance company can as long as you all have access to the same data.

In the broker model, the only requirement is that all group members must have the same type of insurance. In the carrier model, the only requirement is that the group members have something in common, such as being members of the same club or profession or believing in the same charity.

Some P2P Insurance Players

You can see from this list why analysts focus on Lemonade. Most others have not raised much. One that has – Huddle Money from Australia – positions more broadly as a P2P Bank.

Name Country $m Raised
Huddle Money Australia 6
Friendsurance Germany 15.3
Lemonade USA 60
Besure Canada Undisclosed
TongJuBao China Undisclosed
PRVNI Czech Republic Undisclosed
insPeer France Undisclosed
PeerCover New Zealand Undisclosed
Riovic South Africa Undisclosed
Guevara UK Undisclosed

There are many others. This thread on Fintech Genome is where the list is being crowdsourced.

Now for the case for a game changer presented by Tigger and the case for mirage by Eeyore. Note for those who did not grow up with Winnie The Pooh stories, here is the cast of characters:

– Tigger is the excitable cat, full of enthusiasm for every new technology which will surely change the world for the better and do it right now.

– Eyore is the old grey donkey who thinks it is all rubbish, that all this change will only end badly or won’t happen at all.

– Winnie The Pooh is a humble “bear of little brain” who somehow gets to the right answer by asking good questions. We all want to be that insightful bear, but in the tech world the market is the only judge of what works or does not work.

First, lets look at what information Lemonade actually released.

Lemonade’s recent PR 

  • A ‘world record’ for the speed of paying a claim. The company claims that at seven seconds past 5:47pm on December 23, 2016, Brandon Pham, a Lemonade customer, hit ‘Submit’ on a claim for a $979 Canada Goose Langford Parka. By ten seconds past the minute, A.I. Jim, Lemonade’s claims bot, had reviewed the claim, cross referenced it with the policy, ran 18 anti-fraud algorithms on it, approved the claim, sent wiring instructions to the bank, and informed Brandon the claim was closed.

The case for game changer by Tigger

  • P2P Insurance fundamentally aligns the interests of the insured and insurer, breaking the win/lose basis of traditional insurance.
  • Affinity networks lead to organic customer acquisition, reducing CAC.
  • Millennials are under-insured and a natural target for renters insurance.
  • Lemonade is a great UX that is personalized & relevant, with a new backend that was built from the ground up (not a new UX on a 30 year old legacy system).

The case for mirage by Eeyore

  • Risk assessment is hard and no UX gloss can change that.
  • There is nothing new about mutual business models.
  • It’s just some social marketing and incumbents can easily copy that.

Our take

I incline to the Tigger game-changer case. Possibly that is me being an entrepreneur and thus having an optimistic mindset, but I also think that the combination of deep-pocketed Reinsurance and full stack new Carriers using a new model and new social techniques and new UX and new anti-fraud technology stands a very good chance. It is still really early in this game, but Lemonade are making all the right moves. A few more thoughts:

  • Quick payout is a big win for consumers. Doing that on big claims may require reducing settlement latency via a blockchain network. So they are smart to focus on really quick payouts on really small claims that do not have that dependency.
  • Loss leaders are a normal way to get early traction for well-funded startups. You cannot glean unit economics from that PR story about one claim to payout thatr was done in seconds.
  • Their PR story does not match the focus on renters insurance. Maybe they had a PR deadline and this was a story that fit, but this seems like a misstep. Or maybe the PR story about instant payout will give their anti fraud tech a real stress test as the bad guys swoop in. Maybe that was the real audience for their PR?

Two horse race at moment

Friendsurance, out of Germany, started earlier, in 2010. Their investors – Horizons Ventures – are not as famous as Sequoia Capital, but a quick glance at their portfolio and the people behind them like Li Ka-shing (the richest person of East Asian descent in the world and the 11th richest person in the world with an estimated wealth of US$26 billion) generates a lot of respect. Expect a move into Asia by Friendsurance given the credentials of the Horizons Ventures team – but not in any hurry as Germany is a very big market on its own and they will be passported into the rest of Europe.

For discussion, please go to this thread on Fintech Genome

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Back to the future of P2P Lending, we interview one of those peers

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The founding idea of both Lending Club and Prosper was Peer To Peer (P2P) Lending. Along the way, professional intermediaries aka Institutions got into the act and we started referring to Market Place Lending or Altfi. P2P Lending means no other intermediaries – just Lender + Borrower + Platform. The imperative to scale fast, to keep equity investors happy, forced the platforms to get capital from professional intermediaries. Something was lost in this transition. Professional intermediaries add fees and also tend to be less loyal as they see their job as moving money around fast to protect their investors. 

Hector Nunez is a good example of those original P2P retail investors. He has been investing in notes on Prosper since the early days. In an ironic twist that tells a lot about Fintech in the capital markets, Hector also has a job as a doorman at 75 Wall Street in New York City, which used to house trading rooms and now has been turned into apartments (in the new FiDi or Financial District of Manhattan). Hector was one of the early investors in Prosper loan notes and turned his $5k original stake into $138k over 10 years. This is a track record that most professionals would envy. See later for how this translates to IRR.

So it made sense to get Hector’s take on some of the big shifts in this market.

What is the difference between retail and institutional investors?

Our thesis is that three things separate the retail investor from the institutional/professional investor:

  1. Access to tools, techniques and data. Fintech is democratizing the tools, techniques and data that used to only be available to professional intermediaries. This is a work in process. Some tools are still only available to professional intermediaries, simply due to how they are priced, but this will change as new players come into the market. Techniques can come from books, blogs, forums and online courses. Platforms give access to data to encourage investors. So it is only tools that are lacking and entrepreneurs who build these tools know that this is primarily a pricing decision and that selling to 100 retail investors at 1c is the same as selling to one Institution for $1 and may be easier. We asked Hector about some of these tools.
  1. OPM (Other People’s Money). Institutions invest OPM. Retail investors invest their own money. To invest well you have to be a) contrarian and b) right. It is hard to be contrarian when you invest OPM – you have explanation risk. Retail investors have no explanation risk. When they are contrarian and wrong, they only have to explain it to the mirror and learn from why they lost.
  1. Concentration. One Institution can lend a lot of money and that is a quicker way to scale a platform than persuading lots of retail investors to use the platform. One retail investor might be able to deploy $300k while an Institution can easily do 100x that i.e $30m (but that $30m can also disappear equally fast as Institutions tend to be more trigger-happy). Getting 100 retail investors to deploy $300k or 1,000 to deploy $30k certainly takes longer, but it gives the platforms more long-term capital. One way to think about the retail investor is like a bank depositor who takes more risk and does more work for a much higher return.

Hector explains how he invests

I asked Hector to explain his investing approach:

Prosper gives borrowers credit grades (“AA,” “A,” “B,” “C,” “D,” “E” and “HR”) in which the investor sees and gets to invest in the loan the way she/he sees fit. In my case, I’m investing in only 2 grades (“B” and “E”). I have other grades but those are the ones that are in beta mode or that I ceased to invest in. Because there are only 3 or 5 years terms, it takes that long to purge the grades that I’m no longer interested in investing. Now one can argue that this is the disadvantage in retail P2P lending in that once something goes wrong, there’s no essential bail out. I would argue that this is actually beneficial because it teaches me to stay away from certain kind of loans with certain kind of attributes. As opposed to “jumping ship” early and probably not learning exactly why the loan went south. So I set a fixed amount of notes in 3 credit grades that I’m going to invest in and that number is 200. diversification is key and that by having 100 loans (notes), the investor is almost guaranteed to have a gain.

Agile Investing and IRR

Institutional/professional investors focus on IRR (Internal Rate of Return). It is a metric that shows performance. Hector, like most retail investors, does not obsess about IRR because he is not selling to investors.

What Hector is doing – and other retail investors work in a similar way – is what I call agile investing. Like agile programming, you start small and add more and refine the approach as you get market feedback (what you win and what you lose).

In Hector’s words:

Here’s what I started with: 5K which 10 years later (this upcoming March) is currently @ ~$138K. Please note that this includes both my trial and error loans as well as my lower interest loans. I started with 5K, then I put in an additional 10K, then 15K, another 30K and then another $20K. Throughout this process I’ve taken out then put some funds back in so overall, my principle is ~$80K and the rest is in excess of principle.

If Hector was running a Fund and pitching OPM for money, he would track all of those inputs and outputs to calculate IRR. That is how intermediaries work and IRR is a useful tool. However, what Hector is describing is how individual investors work which is to experiment and put more into what works. This is what I call “agile investing”. Note that “individual investors” could mean people with a lot of money to invest – think of Family Offices and Prop Traders.  So this maybe the new mode of investing that the micro asset managers use (see later for follow/copy/mirror model investing).

Ceiling?

I asked Hector what kind of “ceiling” he sees for this way of investing.

I cap off 200 loans for each grade that I’m investing, because I believe there is a point where too much diversity negates gains and losses. Also, years ago, Prosper imposed a percentage limit on both retail and institutional investors which affects the monetary amount that I could invest in. Currently it is @ 10% for the 1st 24 hours. In other words, when a borrower posts his/her loan on Prosper, any investor could only contribute (invest) to 10% of the borrower’s total loan within the 1st 24 hours of the borrower’s loan. After that, the cap is lifted and the investor could invest any monetary amount. I only invest to the 10% limit so monetary wise I’m also capped. So my overall monetary ceiling is currently @ ~$400K and my overall note ceiling is currently @ a little over 500 which includes my beta loans. Once, I reach those goals, I will then have to branch out into other platforms i.e Folio and apply my tried tested and proven strategy on that platform.

Hold to maturity or trade on secondary market?

Prosper announced in September 2016 that they were Closing Down Their Secondary Market for Retail Investors. Prosper had been running a secondary market via FOLIOfn since 2009.

This is the sort of tool that Institutions have taken for granted for a long time.

The old fashioned idea of a bond was to hold it to maturity, collecting interest along the way and many Institutions still like to work this way.

I asked Hector for his take on this:

“Personally I’m not affected by this move as I never had plans on selling my notes on Folio. Remember, we had Folio as an option to sell and I knew it and I never bothered to look at Folio to sell my notes. And in that aspect, I believe I was a typical investor and part of the reason why I think Prosper and Folio parted ways. Remember, if loans default, there’s still a chance we can recoup our losses via the collection agency which work on our behalf (as opposed to losses in the stock where there is no chance of recouping). With Prosper there’s a chance that the collection agency can recoup some if not all your principal with the interest (all for a small fee of course which the agency automatically takes from the funds recovered). I did create a Folio account but that was as a security blanket which I would have put in use had the majority of my investment soured. As the story went, it never did.”

Cross platform investing

Institutional investors are strong on diversification. Hector agrees, but has a slightly different take:

“I believe in that old cliche that you should not put too many eggs in one basket. I am all about cross platform investing. Should one platform go south, you have another to pick you right up; however I only believe that to a point. My belief is that too many investments would cancel themselves out leaving the investor with little financial movement either way (gain or loss).”

Hector is referring is what Institutional Investors call “closet indexing”, when investors diversify so much that the end result is very close to an index (which you can buy for very little from somebody like Vanguard).

One way to diversify is to go global. I asked Hector whether he would consider investing outside America, via platforms in those countries. Hector was clear on this front and his logic was interesting:

No and as of now I don’t have any plans on doing so. There are a couple of reasons why. First, I must complete my investment goal on Prosper before I step on to a new Market. I will make an exception with Folio because I already have an account and I’ve been doing my research with them for quite some time. Second, I trust the American market more than international markets because I feel that I have a better pulse on the US market than that of another country. Probably this is because I live in the US. My strategy relies much on understanding their personal financial background in the context of some event that makes them need a loan. Example: A person could be asking for a loan because he/she may have psychological issues and need their medical expenses paid off and the borrower has a pretty decent financial history while another person may be asking for a loan for a vacation and have a questionable financial history. I would lend to the person in medical need not because of what the borrower is going to use my funds for but rather because of their proven financial track history.

Hector ends with what all good investors have – humility and a learn it all attitude rather than a know it all attitude:

Believe it or not I’m still learning on Prosper and still letting my “beta” notes play.

Can I follow/copy/mirror Hector?

One theme that we have been exploring on Daily Fintech is the emergence of Micro Asset Managers enabled by the follow/copy/mirror model:

  • Copy and mirror trading platforms like eToro, Zulu Trade, Darwinex.
  • Thematic investing marketplaces that allow new micro-managers to emerge by creating their own financial product (equity based), and actively manage it; like Motif Investing, and Wikifolios.
  • Even social research platforms like StockTwits are stepping into this space by offering Follow functions and rankings of the subscriber micro-managers.

This is an alternative to either passive low cost index tracking or high cost active hedge funds. The idea is simply to follow/copy/mirror an investor who is investing their own money. This allows a passive investor (who does not want to work hard at the investing game) to follow/copy/mirror the active investor (somebody like Hector) who gets some share of the upside. That active investor does not need to gather or manage investor’s assets, so they do not need to charge an AUM fee. This is a game-changer in the massive asset management business.

Hector was eloquent that IRR % was more important than total funds under management:

I believe that the amount of money one has in investment is not the sign or bar of performance rather it is the rate of return. A person can have a million dollars in stocks and come out at years end with 1.1 million and another investor could have 100K and turn a profit of $20k and it is the latter investor that I would be most impressed with and try to emulate.

The follow/copy/mirror model is working today in VC (Angel List) and in Public Equities and in FX, but I am not aware of anybody doing it in Fixed Income/Lending. Hector is the sort of investor I would like to follow/copy/mirror. I asked Hector for his take on this:

I welcome you and any potential retail Prosper investor to follow my lead. I could give you or anyone nice fundamental tips in getting started as well as giving you warnings and recommendations. If you or anyone wishes to get started, please let me know.

It will be interesting to see if the Lending platforms start to offer this or if some other platform specific to the follow/copy/mirror model offer a cross-platform capability.

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The $14 trillion mortgage market disruption game is about to start

mortgage-house

At $14 trillion (total debt outstanding, USA only), the mortgage market is about 14x bigger than either Auto Loans or Student Loans (each about $1 trillion). Yet the mortgage market has so far remained relatively immune to disruption and has been a mainstay of bank profits. We believe this is about to change. 

 In this post we look at the players in the market and the forces driving disruption, plus one wildcard disrupter. Our analysis mostly focusses on USA, but we touch on other markets such as China.

Mortgage players

We see 6 types of player – Banks, Altfi/MarketPlace Lenders, Technology Enablers, GAFA & BAT, Quicken, StartUps.

Banks

Wells Fargo dominates, with JP Morgan Chase, Bank of America and US Bank all having major market share.  This is changing as big banks flee the market after all the troubles caused by the Sub Prime mortgage blowup in 2007/8. Look at this chart from the Mortgage Bankers Association:

screen-shot-2017-01-04-at-09-41-31

Between 2007 and 2014 the commercial banks share went from 74% to 52%. Out of that 22% drop, 2% went to Credit Unions (i.e. small banks), but 20% went to Non-Banks.

TL:DR, this market is opening up and big banks losing 22% is a disaster for them.

Altfi and MarketPlace Lenders

So far, this has been the dog that did not bark yet story. SOFI has been the most aggressive about moving into adjacent lending segments, but they have not yet been big players in mortgages. Lending Club recently moved into Auto Loans but has so far steered clear of Mortgage Lending. So the 20% that went to Non-Banks came from somewhere else.

Technology Enablers

National Mortgage News has a great article on what it took to make a fully paperless mortgage transaction. The technology enabler, DocMagic, is worth keeping an eye on and there will be other tech enablers. Mortgage processing going paperless is one of the key drivers for disruption that we look at below. 

GAFA and BAT

GAFA (Google Amazon Facebook Apple) and BAT (Baidu Alibaba TenCent) like massive markets that are ripe for disruption. Mortgage lending qualifies. So what are they up to?

So far, this is another dog that did not bark yet story. However, anybody entering this market must figure out how they will play with them when they do enter the market.

  • Amazon. This is not an adjacent market for them and there are no signs yet, but given the famous Bezos line – “your fat margin is my opportunity” – it must be on their radar screen.
  • Facebook. They are a natural for P2P Mortgage Lending (see below) but no sign of them entering the market yet.
  • Apple. “Siri, get me a mortgage” is still in the realm of science fiction.
  • BAT are all in the Finance business, but with no clear focus on mortgages.

In China, the one to watch in mortgage lending is Pinganfang. This is a real estate e-commerce platform, helping home buyers to get mortgages. It is a collaboration between PingAn (a financial holding company with a historical focus on Insurance) with a major property developer in China called Shum Yip Group. They pitch it as “Real Estate + Internet + Financing”.

Quicken

Quicken Loans is already a major player in mortgage lending and as a tech-centric player we expect them to benefit a lot from the coming disruption. This is a leading tool that the family uses to plan and manage finances, so it is natural for consumers and business owners to turn to them when the biggest financial decision that a family makes comes up, it is natural to turn to Quicken.

StartUps

This thread on Fintech Genome has some interesting ventures and a great discussion of the issues. Please go there to comment.

Its more about Fin than Tech

Big players such as GAFA may be waiting for clarity on three things all of which have some political risk (aka “what will Trump do”):

  • Interest rate policy
  • What happens to Fannie & Freddy?
  • Bank deregulation

Three Forces driving Disruption

  • Going Paperless. This enablers new entrants without a lot of back office processing capability. Look at the company doing the mortgage in theNational Mortgage News has a great article on what it took to make a fully paperless mortgage transaction. They are small. Going paperless will eradicate one of the benefits of scale. New entrants can come in and Community Banks can compete better with Big Banks.
  • Big Banks exiting after SubPrime blow up and nervous of more big fines. This is where Bank deregulation could reverse the trend.
  • Consumer rejection of brand loyalty to big banks. Even if Big Banks jump back in if they don’t fear regulation so much, there is a whole generation of consumers who have never had a close relationship with a bank and if they think of them at all they have a negative brand connotation.

The P2P disrupter

In May 2000, a venture called CircleLending was founded and went through the normal VC rounds, but failed as a business after briefly being branded Virgin Money. It was a classic “idea ahead of its time”. The idea was simply to service loans between friends and family. This is fundamentally different from loans between strangers, because a relationship of trust exists. I financed my first property this way and it was a good result for me and for my sister as the investor. It is a fundamentally disruptive idea, because no external lender is involved. The intermediary only handles the back office part. The idea was reborn in 2010, when a former Virgin Money US employee launched a new venture, National Family Mortgage. The average interest rate is 2.96% as I write and they take zero points. The numbers loaned to date are a drop in the proverbial bucket, but this has the potential to scale fast.

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If you want to comment, please go to this thread on Fintech Genome.