FinTech is in a boom. The number of successful FinTech companies has surged due to investor interest and consumer appetite. 2018 was a big year for FinTech with over 1,700 deals worth nearly $40B. And the trend is not showing any signs of slowing down. Nor should it — FinTechs are filling a need that traditional financial services have ignored for decades, namely making easier and cheaper to access to financial services.
This post explores 5 FinTech trends enabling access to financial services, their potential second-order negative effects, and how to prevent them.
Focusing on growth may distract FinTechs from the right impact metrics.
Positive selection may lead to exclusively servicing wealthy consumers which can increase inequality.
Leveraging alternative data may push users to share more data and reducing privacy.
Moving fast may lead to FinTechs underestimating the importance of regulation.
Improving user experience may make it too easy for consumers to take risky actions.
FinTech companies like to say they’re democratizing finance, helping the average consumer escape the high fees and predatory practices of the big banks or shadow banking. While this is true for many and the intent of most, the reality isn’t so black and white. Certain FinTech business models have negative second-order effects on society, further increasing the entrenched inequalities in the country.
We’ve seen this in other tech-enabled industries that were focused on providing consumer value. Platforms such as Facebook that intended to bring us closer together actually make us more angry and isolated. The intent of founders did not meet the reality of their product’s impact— mainly due to the complexity of human nature and misaligned incentives embedded in their business models. If revenue relies on engagement at all costs, for example, the product will likely drive consumers to feel extreme emotions and dependence.
Finance and Technology are two powerful forces that, when combined, can have a strong influence on society. With great power comes great responsibility. This post highlights 5 alarming trends in FinTech and what companies should do to avoid them.
1. Focusing on the wrong impact metric
Trend: Focusing on growth
Many investors and founders subscribe to the ideology that growth is a proxy to the value a company provides to consumers: “if consumers line up to use my product, I must be adding value”. At a high level, consumer demand is an acceptable proxy for consumer need. FinTechs have been able to gain the trust of consumers that are reluctant towards financial services by building strong brands and marketing networks. This, in turn, has helped many get awareness and access to necessary products.
Danger: By assuming growth means consumer need, FinTech leaders and investors may not be investing enough on measuring their impact on society.
Unfortunately, in FinTech it’s not that simple. Just because a company experiences a high conversion / low cost of acquisition (CAC) does not mean that consumers are better off. It simply means consumers think they need the product based on your marketing.
Take lending for example — many credit restricted individuals would line up to take out a loan, but that does not mean they should. Under this metric, one could argue that the predatory practices of the payday lending industry are good for consumers, given roughly 2.5 million American households use payday loans (hint: they are not).
Focusing purely on growth is especially dangerous when your business model may be orthogonal to consumer financial health. Companies like Credit Karma, while providing important advice, ratings, and transparency, are also incentivized to keep pushing you to take out more debt (given that is how they make money), which could be harmful to your financial health.
Measuring impact is not easy, which is why many FinTech companies fail at doing so. Thankfully, there are many options to explore:
Leverage expert 3rd party institutions to measure your impact objectively. FinTechs don’t have to go about measuring impact alone. CFSI, for example, has built a methodology for measuring financial health which can be leveraged to measure the trend of your consumers versus an equivalent control group.
Align your business models with financial health. The more business models are aligned with the impact on consumer financial health, the better. Earning, for example, relies on a tip based revenue model which ensures that if the consumer sees value from the product, the company is compensated.
Clearly define and track impact metrics at the board level. Not having clear impact metrics and boundaries embedded in business decisions can lead to negative consumer impact even when all the financials point up and to the right. Founders should clearly lay out how they intend to measure their impact on society. This should be visible to all employees, investors and even consumers to ensure accountability and alignment towards a common goal.
Define boundaries to stand behind as you build product features and scale. This will be especially important when the going gets tough and investors put pressure to reach a certain return on investment.
I am not arguing that every FinTech company should measure their impact — it is fine in our society to have a legal for-profit business that does not leave the world in a better place. But the ones touting being “socially minded” better step up their game.
2. Focusing exclusively on wealthier consumers
Trend: Positive selection
One of the key competitive advantages of FinTechs is their ability to build a brand around a target segment and aggressively market to them. By doing so, they steal the best consumers from incumbents who are stuck with their existing brand and limited retention strategies. In lending, for example, positive selection is key since it greatly reduces the aggregated risk of a given pool. As such, FinTechs are able to charge lower fees and interest for the same product and compete against the incumbents.
Sofi for example focused on the “HENRY” customer segment (“High Earners, Not Rich Yet”). They realized that everyone pays the same for student loans, but how much someone makes after graduation could make them eligible for a lower rate. Sofi built a multi-billion dollar business on this arbitrage opportunity.
Danger: By often going after wealthier segments, FinTech companies may be furthering the income gap instead of reducing it.
If FinTech continuously builds products for wealthier segments, wealthier segments will become… wealthier. In SoFi’s example, one of the second order effects here is that the students who did not take high-income positions after college will likely see borrowing costs rise. Reason being, if the less risky borrowers leave, the average risk of the pool will increase, and the bank will need to increase rates to compensate for higher losses. This might make college even less accessible for some.
FinTechs are right to focus on acquiring the right consumers as it is the first piece of the puzzle. But FinTechs need to more than this:
Invest as much time trying to change consumer behavior (nurture) as you do marketing to the right consumer (nature). By doing so, FinTechs can give opportunities for consumers that otherwise seem to not have potential. While this is significantly harder, it is infinitely more valuable for consumers.
Focus on neglected consumer segments — by understanding and fostering trust with a specific neglected consumer segment, FinTechs can build massive businesses. Chime is a great example of a company following this ideology by focusing on providing free checking accounts to subprime consumers that have been dinged by overdraft and service fees for too long.
We cannot stop the trend of companies using data to price consumers more accurately given their risks. But we can focus FinTech on those who are more disadvantaged to make sure they have the opportunity to also reap the rewards, even if the challenge is less obvious, easy, and potentially lucrative. With 56% of Americans face some kind of medical financial hardship, the opportunity is massive.
3. Requiring users to opt into sharing more data
Trend: leveraging alternative data
When it comes to lending, more data is always better. In the past, data was limited to two main sources: information from your application, and information from the Credit Bureaus (e.g. your credit score). Thankfully, lending is governed under FCRA law which forces the lender to provide adequate reason for a decline to the user, including what source of data was used so that the user can verify the accuracy and completeness of that data.
That said, FinTechs have found ways to use alternative data to increase the accuracy of their underwriting in several ways. One such way is to allow the user to opt into sharing more information. Petal card, for example, uses cash flow underwriting to make decisions, leveraging your bank account transactions that consumers provide by logging into their bank on Petal’s site. Earning requires you to opt into sharing your location so you can prove that you go to work which is a good risk indicator. This helps provide a lower price product for those that want to opt into sharing this information.
Danger: By having users opt to share more data in order to get better products, FinTechs are pushing us down a path where consumer information is no longer private.
More data may not be better for consumers long term. By incentivizing consumers to share more data for access to a certain product, FinTechs are resetting norms around what information remains private. Today, you cannot get a loan if you don’t consent to have banks look up your credit score. Tomorrow, you might not be able to get a loan if you don’t consent to have banks look through the depth of your cellphone — a strategy being used by Branch outside of the US.
This is a step towards a big brother model where institutions know everything about consumers. In China, for example, the social credit score model is used in lending and covers not only whether you have paid your loans on time, but whether you had a speeding ticket or gave to charity. In such a world, mistakes are not tolerated. Today, Credit Bureaus have policies when it comes to how long they keep information on your record, which helps give consumers another chance down the road. But tomorrow, jaywalking may prevent you from getting access to basic financial services.
To prevent this, FinTechs need to think hard about why they are asking for or using alternative data sources and the potential repercussions of this data being used now and down the road.
Have clear policies to justify the use, quality assurance, and retention of this data before doing the analysis is necessary.Ensure that the use of data does not have disparate impacts on specific consumer segments.Only use data if it is critical to providing more affordable options to a wider customer segment should it be even considered.
4. Underestimating the importance of regulation
Trend: Moving fast
One of the key advantages of FinTechs is its ability to take bold moves that disrupt financial conventions and lead to innovation. Technology startups have a strong culture to move quickly, test, and learn (Lean Methodology). They leverage their small size to be more risk seeking, and often fly under the regulatory radar until they reach a certain scale.
Danger: By trying to move too quickly and not investing enough in legal and compliance teams, some FinTech companies may be doing more harm than good.
The reality is that financial services are a highly regulated market with many laws aiming to protect borrowers written by several governing agencies such as the CFPB, FDIC, OCC, FED, CFTC, FINRA, SEC, state regulators, etc. Could these laws be simplified? Sure. Are they important? Absolutely.
The regulatory risk might be obvious, but surprisingly many FinTechs still break the law. Sofi was fined by the FTC for inflating the average amounts borrowers would save by refinancing. Robinhood had to temporarily stop the launch of their cash management account after misleading consumers to think it was a checking account. Many FinTechs founders underestimate the complexity of laws and forget to build a culture of compliance supported by strong rules and teams.
Which makes you wonder: how many scandals have not been identified? The Trump administration has largely dismantled the CFPB by stripping it of its enforcement power. The regulatory scrutiny of FinTech companies is at its lowest ever. To make matters potentially worse, non-financial services companies are jumping into FinTech — Uber, Airbnb, Amazon, Google, Facebook are all investing in building out their own FinTech ecosystems. These companies may bring a culture of “breaking things” to a sector where doing so has a significant impact on consumers.
To avoid these mistakes, significant investment needs to be made to ensure compliance is part of the culture, not as a necessary evil, but a necessary good
Ensure every individual in the company should understand regulations and their purpose in protecting consumers, especially the product and engineering teams building products.
Compliance training should not be a box to check but part of formal development and performance reviews.
Leadership should invest in processes to oversee risks without impacting velocity by embedding compliance members into individual teams and aligning incentives.
5. Making it too easy for consumers
Trend: Optimizing user experience
One of the biggest advantages of FinTech companies is to rebuild product experiences that make it as easy as possible for consumers to perform complex actions which would otherwise take hours if not weeks to complete. One of the most extreme examples of this is DoNotPay that allows users to sue anyone with one click.
Simplifying processes makes it easier for all segments to be able to complete them. Back in the day, consumers had to walk into a bank branch, talk to potentially biased agents, and fill out complex forms. These barriers to financial services are now substantially reduced by FinTech. Consumers can now open bank accounts, investment accounts, insurance from their mobile phones. FinTechs are investing heavily in making experiences as easy as possible to maximize conversion and therefore decrease the cost to acquire consumers.
Danger: By focusing on conversion, FinTech companies are reducing necessary consumer friction and awareness which may lead to more harm than good
Should everything be as easy as a click of a button? Take point-of-sale (POS) lending for example. Companies like Affirm make it easy for consumers to take out a loan when they make large purchases while they are paying. Loan pricing is clear and fixed, unlike a credit card on which balances can roll over indefinitely. However, adding this as a checkout option can entice many to purchase beyond their means and not think critically about the implications of taking out a loan.
Another example is Robinhood that has enabled anyone to invest in the public market for free. Before Robinhood, buying or selling a stock cost a fee — now anyone can buy public stocks and even cryptocurrency with a single swipe. This sounds great when the market returned on average 22% in 2018 (S&P500), but can lead to financial harm when asset classes drop significantly like Bitcoin dropping more than 80% in under 6 months. Not everyone should be day trading using their entire savings—diversification has proven to be a more successful long term investment strategy and requires significant knowledge of investment strategies to accomplish.
Financial services are a great tool to build wealth but also to destroy it. It is critical to make sure consumers understand the implications of their choices.
Integrate well-placed friction points in workflows to ensure that consumers take a moment to review the implications of terms and pricing.Ensure transparency by boiling down the implication of decisions in dollar terms and providing clear pricing of alternatives in the market.Focus on educating users throughout the journey is as critical as making that journey accessible.
I am an optimist that transparency and competition, fueled by technology, will revolutionize access to financial services for the better. Yet we must all do the needful to ensure that we are leaving the FinTech ecosystem better than we found it. Here are 3 forces that could help ensure this in the FinTech ecosystem:
Fostering social impact investing — the more we have investors who care as much about impact as returns, the more businesses will learn to balance these two forces.
Supporting regulation — we must continue to support regulators and ensure they deeply understand consumer needs and market risks in order to craft sound regulation.
Leveraging third-party rating agencies — we must build standards as to how to measure, track and report impact to financial health from different financial products.
Here’s to building fairer and more inclusive financial services.
Are you working in the financial health space? Reach out!
Shoutout to Kristen from Catch for the inspiration from her talk at Cambrian Ventures in May 2019.