Technology and Risk in Finance
Technology and the commercialization of the internet have greatly affected our lives and the way we communicate. From the way we shop and hail cabs to how we order food, technology has disrupted the traditional formats of many industries. More recently, it has started to change the way we think about financial services.
FinTech has become a universal buzzword to describe the new ideas and startups that intend to shake up the “business as usual” approach of the finance industry. These ideas have disrupted existing processes, unbundling the big bank infrastructure to provide superior products that are cheaper, faster, and more user-friendly.
For example, Venmo is a mobile payment service that allows users to transfer money without the need for the recipient to have an account with the same financial institution. In 2016, Venmo processed $17.6 billion in payments according to its quarterly press releases. The services saves consumers time and effort over going to ATMs, writing checks, and paying fees.
This is a simple illustration, but startups like Venmo have taken business away from well-established players in all corners of financial services, from the mortgage market in retail banking to advisory services in the investment space.
While technology innovation within financial services is a little late to the game compared to other industries, the growth of investment dollars and opportunities has spiked in recent years. As seen below, venture capital investment has been on an upward trajectory, finishing 2016 with $13.6 billion in newly invested capital.
The Challenges of Valuation
Because of the nascent technology and limited history of these startups, valuation is often a difficult practice. What would Google’s seed round have looked like if investors back then knew what we know today? Conversely, what would the seed rounds of the failed tech bubble companies have looked like?
In speaking with a few angel investors and venture capital professionals recently, I’ve realized that the VC method that is learned in the CFA Program and in business schools across the country is a good starting point, but the terms of the arrangement as well as the valuation are mostly up for negotiation. Sometimes the desire to have “skin in the game” exceeds prudent practices.
Per the graph above, the dollar values per deal have been increasing, particularly over the last three years, indicating the desire and demand from VC funds to position themselves early in these startups. The competition for good opportunities is heating up!
Despite the rise of financial startups and their focus on using technology to disrupt current practices, these firms face their own technological roadblocks. FinTech startups need funding to capitalize on first-mover advantages, and economies of scale limit an entrepreneur’s ability to focus on operational and cybersecurity risks. Given the lack of available capital compared to the likes of Fortune 500 companies, the need to build a viable product that serves a market need, and the limited number of employees, these companies are much more vulnerable than established financial institutions.
Trust and ethical practices are the foundation for building a strong, long-lasting customer base. Losing trust in a financial system, as many did during the Great Recession, puts the structure at risk. In fact, one could argue that the reason FinTech firms gained traction around 2008–2010 was exactly because of the Great Recession: lack of trust in the system led consumers to try something new that was less tainted in their minds.
Concerns about Security
Technology and internet connectivity have paved the way for innovators to create better and faster ways of doing things and connecting people. The magnitude of positive and negative events are far greater than any other time in our history.
As we have seen from the Bangladesh Bank heist and the WannaCry ransomware attack, nefarious actors exist and will take advantage of inexperienced people and cracks in software for personal gain. Gaining critical mass is important for achieving financial returns, but from a hacker’s perspective, as startups gain in popularity, they become a prime target, often unprepared for security risks.
Financial startups have gained a significant amount of attention in recent years. Firms dedicated to payments, lending, investment platforms, insurance, and real estate have challenged preconceived notions of what banking entails and how we utilize these services. Venture capital firms have poured money into the space and I believe that the big industry players will continue to see challenges from small startups.
Whether these firms take away market share or get acquired by the traditional banks remains to be seen. Significant critical mass still needs to be established. Startups have a tremendous opportunity here, but in order to be truly successful, entrepreneurs must also recognize, value, and solve for operational and security risks. For many firms, this will be a tall order, but those that are successful will reap great rewards.
About the Author
Andrew Gallagher is a product manager for Citi’s Agency & Trust business, which manages $5 trillion in trust assets globally. He works with corporations and financial institutions to address their fiduciary, fiscal, and agency needs for debt issuances and money market programs. Prior to this role, he worked in various positions including financial planning and analysis, business management, and market strategy. Andrew is currently an MBA candidate at NYU’s Stern School of Business. He is a CFA Charterholder and a graduate of Columbia University, where he received a B.A. in Economics.