Archives For Financial Services

Race to the Bottom

Matt Harris —  May 5, 2014 — 1 Comment
I don't always invest in commodity products, but when I do, I prefer not to lose all my money.

I’d like to think that the vast majority of the investments we make are in companies whose products and services are not commodities, and not subject to the brutal forces of commoditization.

In those cases, we are looking at markets where companies can win based on product differentiation, or where what they are doing is very hard and/or protected by intellectual property.  That said, the broadest definition of what we as venture capital investors do is invest in disruption, and certainly one of the vectors of disruption is through commoditization.  So while backing a company about to be commoditized is, well, stupid … backing a company that is doing the disruptive commoditizing can be exciting (despite some recent commentary to the contrary.)

Exciting, and terrifying.

Particularly terrifying if you don’t have a gameplan; without one, you may succeed at chowdering an industry’s margin structure without creating any value.  Through trial and error in this field of endeavor, I have found four general models that can work.

1. Be the lowest cost provider

One of the sneaky elements of our investment in Simple (fka BankSimple) was that, while the common perception was of a company leveraging awesome mobile-first design and zero fees to acquire and delight customers, the actual key was the ability to serve customers far more cheaply and hence more profitably than banks.  The customer acquisition stuff worked also, which was nice, but in fact the way to make money in the DDA segment (a commodity) is through disruptively low costs.

Another segment purportedly running this playbook is the “peer to peer” lending community (Merely writing that phrase makes me want to tear my hair out.  While it’s kind of delightful to imagine a multi-billion dollar hedge fund and a near-prime borrower as “peers”, it’s not exactly accurate.) I’ve seen a ton of charts detailing the “cost to serve” advantages of these companies.  My issue with this analysis is that, of the meaningful elements of the cost bar of a lending  business, at least three (cost to acquire, cost of credit losses and cost of capital) far outweigh cost to serve.

The one thing we know conclusively is that these lenders have a stratospherically higher cost of capital than their bank competitors, who leverage their nearly free deposits for liquidity.  Alternative lenders who can create durable advantages in customer acquisition and/or underwriting will create value; merely being low cost in terms of operations will not be sufficient.

2. Lock up differentiated distribution

In the relatively near future, most retail investors will have their money managed using algorithms that solve for market returns, properly allocated across asset classes, rebalanced tax efficiently and optimized for minimal fees.  This will be hideously disruptive for stockbrokers and other corrupt money managers, but will it create value for the disrupters?

There are a whole crop of new companies who are steadily building Assets Under Management using this new model.  The challenge is that the classic “cost to acquire vs. lifetime value” math is almost always upside down when you are providing a service that is, by definition, undifferentiated and focused on lower costs.  The winner(s) here will be those companies who get introduced to their customers for free, either through harnessing viral growth (has not yet happened in this category, though Robin Hood is showing signs) or figuring out a high volume channel.

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

Square has had a tough time in the press recently.  They have gone from a $10B IPO candidate to a lost cause/acqui-hire in a 3-4 months, on no news.  This says more about the state of financial punditry than it does about Square.

PayPal figured out something fundamental 15 years ago, which is that while most underwriting models start by saying “no”, it’s smarter to say “yes” to nearly everyone and then throttle usage on the backend.  In this way, you enable faster growth and accumulate the necessary “bads” to train your models, all the while managing losses through tightly gated credit limits.  High delinquencies, but low severity.  Square adapted this methodology to merchant underwriting, and in doing so enabled millions of merchants previously shut out of electronic payments to get in the game.  At various times in their lifecycle, they have been over-valued, but those who now dismiss them do so at their own peril.  Their recent moves, to tack back from their experiments with Starbucks and p2p remittance towards a more robust value proposition for small merchants, represent a doubling down on what made them special to begin with.

Merchant payments has never been a particularly interesting business.  Retailers fundamentally don’t care who provides their payments, and will ultimately largely view it as an embedded feature of a commerce system.  But Square’s landgrab in a previously unserved segment may provide them with sufficient escape velocity to make their optimistic investors look smart, particularly when combined with a legendary founder and a world class team.  And I’m enough of a contrarian to have their back now that the world has turned against them.

4. Change the game

This is the one in a million shot, and ultimately why most of us do what we do. Once in a career, maybe, you get a chance to back a team that is turning a commodity business into one that creates huge value for customers and for the company.

Merchant payments is a commodity?

 Well, what if you also have the cardholder information, and can disintermediate the visa/mastercard model by creating an “on us” transaction.

Remittances are a commodity?

How about turning cross-border cash transfers into cross-border commerce, and enabling immigrants to pay bills, top up mobile phones and create gift cards for free, instead of getting gouged on fees.

Factoring is a commodity that can’t scale?

What if you had comprehensive information on when the buyers would pay their bills, and could turn a risky transaction into a riskless transaction.

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

Redefining FinTech

Matt Harris —  December 17, 2013 — 10 Comments

I’ve spent the better part of my career investing in technology companies involved in financial services.  Given that, it’s a bit surprising how much I hate the term FinTech.

Historically, FinTech has defined the technology vendor community selling into banks and broker/dealers.  Until 2008, this was a reasonably good business.  Since then, there has been increasing consolidation, both on the financial institution side and on the vendor side.  As a result, while ostensibly there are still thousands of banks in the US, the vast majority of the budget is tied up by 20 FIs, and the vast majority of the revenue goes to the large, incumbent vendors.  It is a classic logjam, and woe betide any small firm looking to selling into that mess.

The much more interesting opportunity in financial services isn’t selling to financial institutions, it is competing with them.  As I have written elsewhere, banks in general are retreating from customer-facing activities, not vigorously defending their turf.  This happened in merchant payments, for example, even in advance of the financial crisis.  In 1988, banks had 62% market share in the acquiring industry; now they have 38% and shrinking.  Currently, banks are losing share in the DDA market, the lending market and the personal finance market, among others.  I anticipate that the corporate treasury services market will be next, hence my current obsession with b2b payments.

As you might expect, entrepreneurs figured out this new reality far more rapidly than venture capitalists.  One example from my experience is OnDeck, a small business lending company, and a ridiculously fun and exciting company to be involved with.  I invested in their first round of capital and have been on the board since 2006.  From the time of that initial investment until I finally came to my senses, I was one of several investor directors urging the company to offer their underwriting and processing platform to banks as a vendor, in addition to (or instead of) being a direct lender to small businesses.  Thankfully, the entrepreneur (Mitch Jacobs) and the CEO (Noah Breslow) kept their eyes on the prize, and while the company has several very productive referral relationships with financial institutions, OnDeck has continued to originate loans directly.  As a result, it has grown like topsy and will soon pass the $1B mark in terms of capital lent to small businesses.

To paraphrase the pushback of the management team, their basic argument went like this, “Do we really want to put our destiny in the hands of bankers?”  That argument, in brief, explains why every time someone asks me if I invest in “FinTech companies”, I respond that actually I invest in financial services companies.  Given that this distinction, while meaningful to me, is always met with blank stares, I’ve now tried to put some analysis around it, which you can see here:

Market Cap - Bank vs non bank analysis vjb5(2)

My colleagues and I (thanks to Jordan Bettman and Matt Brennan for their help with this) defined three universes of companies:  Banks, Bank Vendors and (for lack of a better term) Finsurgents, ie, companies providing functionality that had historically been the province of banks.  The results are clear.  The bank vendors’ market capitalization relative to banks’ market cap remains relative constant, with a slight premium reflecting the fact that technology spending at banks is growing faster than bank revenue.  But the Finsurgents’ market cap relative to banks grows at twice the rate, which is quite logical in that these players are taking an increasing share of profit pools that would otherwise belong to banks, not depending on banks for their revenue.

In defining these groups, we had the requirement that the companies be public for the whole period 2003-2013.  As such, while the bank and bank vendor universes contain all the logical players (vendors include Fiserv, Deluxe, D+H, TSYS, Diebold, ACI, etc), the Finsurgent group misses key players who have either gone public post 2003 (Visa, Mastercard, Fleetcor, Wright Express, Cardtronics, Vantiv, Higher One, Greendot, Netspend), plus companies who are still private or are subsidiaries (Square, Paypal/Braintree, Stripe, Lending Club, OnDeck), not to mention the entire Bitcoin universe, etc.  In 10 years, I suspect that these lines will have entirely diverged, as the banks become relatively stable financial utilities, their vendors settle into a symbiotic but unexciting and slow upgrade and refresh cycle and the Finsurgents complete their takeover of customer facing applications and innovation in the sector.

 

Submerging Payments

Matt Harris —  December 5, 2013 — Leave a comment

The mimagesost important development in merchant payments right now isn’t happening in Silicon Valley (though I do think PayPal is only a few chess moves away from becoming the fifth network.)  It isn’t happening in New York City (though I’m increasingly convinced that NYC can be the center of the alternative lending universe.)  It isn’t happening in Atlanta (though I do like the mojo Frank Bisignano has brought back to First Data.)  And it isn’t in cyberspace (though surely math-based currencies will have their day.)

It’s in Durango, Colorado.  And it will likely destroy much more value than it creates.

The trend I’m referring to is commonly referred to as integrated payments, or embedded payments, but I think of it as submerged payments.  The leading (and, indeed, defining) company in the space is Mercury Payments, in remote Durango.  Before Mercury, the traditional retail payments industry practice was for merchants to make two decisions regarding their point of sale (POS); first, they pick a software provider, and then separately, a payments provider.  Sometimes these two were loosely coupled through various integrations, but rarely were they tightly linked (basically never for small and medium sized merchants) and almost never sold together.  In the world of on premise software, it was difficult to merge a necessarily dynamic platform like a payment processing system, which changes frequently due to association rules, with a static POS system that could only be upgraded through CDs sent in the mail.

What Mercury realized was that the increasing adoption of SaaS-based solutions at retail meant that payments could be far more easily (and far more tightly) integrated into POS software.  They began a landgrab in the retail software developer community, offering payments wholesale to these developers, who could then offer attractive rates to their customers on an embedded basis.  Better yet, they could use the payment card data (with sensitive details tokenized) as the basis for a CRM system, so that in essence the payments platform became the identity utility for the software system.  Good luck to the ISO salesperson who walks into a salon looking to sell payments at a 5 basis point discount, when for the merchant a decision to change payment processing providers means switching software vendors, or at least losing access to your customers’ tokenized card numbers.

Merchant acquirers currently differentiate primarily on distribution (generally feet on the street), and only at the margin on technology, approval rates, customer service and uptime.  In a submerged payments world, that is entirely flipped around.  Distribution changes from sales to business development, and payment companies will be pitching POS developers on their technological sophistication, advanced features and nimbleness.  Those are not adjectives commonly thrown around about the incumbent merchant acquirers today.

This trend is not entirely lost on the industry.  Both Vantiv and Global Payments have made acquisitions in the space (see here and here), and everyone else has at least added the word “integrated” somewhere on their website.  But they are also doing some of the wrong things, in particular acquiring or investing in POS software companies themselves.  If I’m a developer, am I going to choose an embedded payments partner who has a software package in the market competing with me?

Ultimately, regardless of what they do, this is a bad trend for the sector.  Payments are becoming dial tone … expected to be there, always on but never acknowledged, and certainly not worthy of a premium price.  At its IPO, Mercury will likely be worth $2-3B, representing approximately 5% of the enterprise value of the merchant acquiring segment, by my estimates.  In five years, they will likely be worth $5B, given the likely share gains they will see as SaaS POS systems crowd out on premise software.  Sadly, by that point, I expect they will be fully 20% of the segment’s market value, as price erosion and market share losses degrade the margin structures of their over-levered, largely fixed cost competitors.

It turns out that no one wants to buy payments, they just want commerce.

What’s The Big Idea?

Matt Harris —  October 4, 2013 — 4 Comments

Perhaps I’m just simpleminded, but one of the most important things I look for in a company is the ability to summarize the problem they are solving in one sentence.  Often, at the outset, I’m less interested in solutions than problems; I want to be asked a question that stops me in my tracks.  At the heart of most transformative companies is a simple question, and once you’ve heard that question you are instantly convinced that there has to be a better way.

Starting with a question, rather than with a solution, gives you a telling diagnostic for the magnitude of the problem.  Way too many companies start with a solution and go looking for a problem, and as a result end up without anyone who really needs what they are selling.  Perhaps the most acute example of this in financial services is the current obsession with mobile wallets at point of sale.  “Why can’t I pay for something with my cell phone?” is about as much of a burning question as “Why can’t my dog speak French?”; both things would be cool but aren’t exactly mission critical.

Here are some examples from the industries I follow:

  • Square/Braintree/Stripe:  Why can’t most merchants take credit and debit cards?
  • Xoom/iSend:  Why are international remittance fees 10% of the value being transferred?
  • Taulia/Tradeshift/Billtrust:  Why are most business to business payments made by paper check?
  • Wealthfront/SigFig:  How can the asset management industry extract so much value while significantly underperforming index funds?
  • CAN/Kabbage/OnDeck:  Why do banks underwrite small business loans using the business owner’s credit score?
  • The Climate Corporation:  Why can’t we predict the weather?
  • Bluebird/Moven/Simple:  Is it necessary for banks to charge fees?
  • Paypal/Dwolla:  Why is it so hard to move money around?
  • SoFi/Common Bond:  Why do all student loans have the same interest rate?
  • ZipCar/RentTheRunway:  Why do we have to own expensive goods that we use infrequently?
  • Yapstone/Plastiq/Zipmark:  Why do I still pay my rent with a paper check?
  • DriveFactor/CellControl:  Why do good drivers subsidize bad drivers?

Once you have your question, then you can do the required research to find out the answer.  Sometimes the answer is a brick wall, but other times the answer points towards a solution.  Frequently, as you can see from my answers below, there have been legitimate blockers to a solution historically, but advances in technology newly allow hard problems to be solved.  When you find a circumstance like this, a painfully acute problem that was historically intractable, but due to new innovations is now solvable, please email me.

My Answers:

  • Payments acceptance:  Primitive and stodgy underwriting needlessly excludes many low risk merchants; legacy hardware creates a prohibitive fixed cost for low volume merchants.
  • Remittance expense:  Cash handling, both on the send and receive side, is wildly expensive.
  • Paper in B2B payments:  There is tremendous inertia, driven by workflow on both the AP and AR side.  [This will not be solved quickly]
  • Value destruction in asset management:  In the absence of clear data, investing choices have been driven by brand preference vs. rational analysis.
  • FICO scores in small business lending:  Historically it has been the only scalable and low cost way to underwrite a sub-$100,000 loan.
  • Weather prediction:  The data capture and analysis problem has been too large and expensive to solve.
  • Banking fees:  Banks have to support a very expensive branch infrastructure, as branch location has historically been the primary decision factor for consumers in selecting a bank.
  • Money movement:  The four party payment model and the resulting interchange economics were built to compensate issuers for credit transactions and have been inappropriately applied to other types of money movement.
  • Student lending:  Government driven programs are slow to change, and as a society we have issues with financial discrimination relative to education (and health care.)  [This may still end up being a problem]
  • Sharing economy:  The transaction costs in rental models have outweighed the benefits in the absence of inexpensive real time communication networks and scale infrastructure investments.
  • Checks in rent payment:  Landlords have mini-monopolies once renters move in, and therefore lack motivation to sacrifice any economics to make payments easier.
  • Auto insurance:  Collecting information on safe vs. risky driving has historically been impossible.
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[This post originally appeared on forbes.com here:  http://www.forbes.com/sites/bruceupbin/2013/02/15/tokenization-and-the-collapse-of-the-credit-card-payment-model/]

It’s been a fascinating couple of weeks in the token world.  We have Monopoly’s decision to replace the iron with a cat, based on a poll launched on their Facebook page.  Feels like selection bias to me; is anyone surprised that the population of people who are fans of board games on Facebook also like cats?

More germane to my obsession with payments was the announcement that Braintree re-launched Venmo as a cardholder side multi-merchant tokenization system.  I realize that’s a mouthful, but here’s what it means:

  • Braintree provides payment acceptance to many (most?) of the most popular online and mobile merchants, like Uber, Fab, HotelTonight, LevelUp, etc.
  • Because all of these merchants have huge mobile traffic, they encourage users to “vault” (ie, store) their credit card information with them, so when they return they can check out with one click (or in the case of Uber, no clicks.)  In actuality, all of these payment card details are vaulted at Braintree.
  • Braintree has convinced at least some of these merchants to contribute their users, on an opt-in basis, to a consortium, such that if I am an Uber customer, and I show up to HotelTonight for the first time, Braintree recognizes me and asks me if I want to use the credentials I’ve already stored with Uber to check out with HotelTonight.
  • Braintree has 35MM credit cards vaulted … maybe 20% of the adult US population, and probably 100% of the early and mid adopters in this country.
  • The reason this works, from a security perspective, is the data on the device you are using.  Because they fingerprint your phone (or PC), and require a password, they have the classic “something you have” and “something you know” security formulation nailed.  In the mobile use case, they also have fraud sensitive data like location; if anything I think this will be a more secure transaction than a typical e-commerce situation (more on that later.)

In the real world, the concept of a token generally refers to the act of substituting something simple and convenient for something more cumbersome or complicated.  Think of the utility of a subway token in preference to cash, or (as in Monopoly), how much easier it is to move a game piece around a board than your physical self.  In the payments world, tokens have traditionally been used to enhance information security.  Tokenization* is a system where you substitute a proxy set of identifying information for the real payment card data, so that merchants don’t have to handle this sensitive and regulated data and it isn’t exposed more than necessary.  This original logic for tokenization (keeping merchants free from hosting payments data) has been taken to the next level by Braintree … the same idea is now being used to make the payment experience quicker and easier, through their consortium model (“if you’ve paid anywhere else, you can pay here, too.)

The important irony here, which is also true of Square’s tokenization strategy (Square Wallet, where you the Wallet serves as a “token” to mask the underlying payment card credentials), is that the tokens being used are actually more authentic than the underlying “real” identity.  Historically and generally, tokens are nonsense strings of characters, designed to abstract away from and hide the true goodies, your credit card number.  But consider the token that Braintree is using:  the fingerprint of your device plus your location plus a password.  And Square?  They use a picture of your face.  What’s more real, a 16 digit number or a picture of your face?  Remember, the purpose of the payments query that a merchant initiates when you try to pay for something, whether on-line or in-store, is authentication, ie, are you actually you?  This gets done through the inherently flawed mechanism of merely checking that the card that has been presented (or typed in) is actually valid.  What Braintree and Square have done is create self-authenticating tokens in a natively multi-merchant construct, and that is a frigging big deal.

The current retail payments industry rests on what is called the four party payment model.  The four parties in question are:  1)cardholder, 2)cardholder’s bank, 3)merchant and 4)merchant’s processor/bank (known as the merchant acquirer).  When the cardholder swipes their card at a merchant, the card and transaction data flow through the merchant acquirer to the cardholder’s bank, which confirms that the cardholder is authorized to make the transaction.  This structure was invented and is perpetuated by Visa and Mastercard, who serve as the information switches between the four parties.

They’ve never been linked, that I’ve read, but I think it’s more than a coincidence that Visa was founded shortly after the interstate highway system.  Before Visa, non-cash transactions were done using store credit … because most merchants knew most of their customers before the 1950s, you didn’t need elaborate authentication schemes.  After the 1950s, Americans grew far more mobile, and store credit became less practical; hence Visa and Mastercard emerged, to enable transactions between strangers.  If you’ve ever used Square Wallet, you’ll know what I’m talking about here:  it feels like the 1940s.  When your face pops up on the retailer’s point of sales system, and the clerk calls you by name, you are no longer a stranger.  I’ve yet to have the pleasure, but I’m certain that when I show up on OpenTable and am greeted by name and asked if I want to check out with my Uber credentials, I will also feel warmly recognized.

This is horribly threatening for all of the incumbent players in the four party model:  traditional acquirers, issuer and the networks.  Plain vanilla merchant acquirers will struggle to compete with Braintree online and Square offline as their tokenized user bases grow (NB:  Square is actually well behind Braintree on this front and we’ll see how they do; IRL is harder than online.)  The issuers lose their ability to differentiate.  Once tokenized and hidden, any given card product is far more vulnerable to being displaced, as the issuers have already learned from PayPal.  How do you stay “top of wallet” when there is no real wallet?  As for the networks, their demise is harder to articulate.  Visa and Mastercard are fortresses, growing 20% per year like clockwork, despite the law of large numbers.  I will leave it at this:  in a world where everyone is known, there is no need for an omniscient middleman.  That feels like a scary fact for the networks.

*Per usual in these blog posts, I’m sure there is a specific definition of tokenization that I’m getting wrong.

Square Puck

Matt Harris —  November 24, 2012 — 21 Comments

Replica of first hockey puck ever used (it actually was square-ish)

Square Puck:  sounds dangerous, right?  I think it is.

There’s a famous/trite expression, commonly cited in the venture business, about how you want to skate to where the puck is going, not to where it is right now.  As I watch the payments industry grapple to deal with the phenomenon of Square’s micro-merchant processing business, I’m reminded of this truism, and increasingly convinced that all the incumbents are skating in the wrong direction.  This doesn’t mean that Square will achieve the kind of world domination that their valuation implies, but it does mean that lots of other folks are wasting vast resources and time pursuing the wrong goals.

In just the last week, Bank of America announced a micro-merchant offering, and TSYS bought ProPay, a vertically focused Square clone.  In the past year, we’ve seen a steady drumbeat of product announcements from Verifone, Intuit, PayPal, NCR, WorldPay* and PayAnywhere*, all directly focused on competing with Square’s dongle-based merchant payments service.  Meanwhile, in the investment community, there is a lot of self-satisfied sniggering about Square’s business model, in which it is assumed that given pricing and risk, Square loses money on every swipe.  Their recent move to undercut Starbuck’s already razor thin processing costs, even though they aren’t the low cost provider, reinforces this view … there’s no way that is profitable business for Square.  If Square is entirely dependent on merchant processing revenues, they are not only overvalued, they are in fact worthless … that business will never produce meaningful cash or be strategic to anyone.

But that’s irrelevant, as it is increasingly obvious that the merchant side of Square’s business is somewhere they had to start, but nowhere near where they plan to land.  At the end of the day, Square is a consumer-facing company; that is their DNA, their culture and their IP.  The entire merchant processing effort is a loss leader, a necessary evil on the way to building up sufficient retail coverage to make their mobile app useful to consumers.  It’s not too different from what LevelUp is doing, but Square’s approach, both in terms of pricing and design, is far more elegant and nuanced, probably because they control their own payments infrastructure and LevelUp outsources to Braintree.   All of the incumbent merchant processing and terminal infrastructure players who are freaking out about this and building direct rivals are totally missing the point, and are lunging to compete in a segment that will ultimately have a negative profit pool.

Typically in this blog, and more generally in life, I avoid making explicit recommendations and predictions.  I’ve just been humbled too many times by the world’s unpredictability.  But I’m going to make an exception in this case.

The recommendation is that Verifone should swallow their pride and do a comprehensive business development deal with Square, where they enable their entire existing merchant base to accept Pay With Square in exchange for essentially taking over Square’s merchant processing hardware business.  Given Verifone’s bluster and defensiveness regarding Square, I think this is unlikely, but it would be a master stroke.  Square doesn’t think hardware is strategic and is increasingly just trying to build their merchant base (see:  Starbucks deal) and they are only messing with Verifone as an accidental byproduct of their initial go to market strategy.  Square would do this deal if Verifone could convince them that they would take good care of their customers.

The prediction is that in six to twelve months, the conventional wisdom on Square will have changed to reflect the growing reality that Square isn’t primarily a merchant acquirer, but instead a mobile wallet provider.  Pay With Square, just like Google Wallet, PayPal and the other wallet providers, creates a unified merchant-facing cardholder application, which aggregates the user’s existing payment accounts behind the scenes, and layers on offers and enhanced information.

At that point, someone (probably not Verifone, unfortunately for them; my bet is Heartland or Global Payments, with Chase Paymentech as a long shot) will do the business development deal I describe above and PayPal, Verifone, BAMS,TSYS et al will be left holding their dongles.  The whole merchant processing community will then lurch toward some kind of cardholder side functionality, directly or through partnerships, and an unbelievable amount of time will be wasted essentially recreating the current Visa/MC merchant-issuer network in a Balkanized and therefore useless way.  Discover will get bought by Google for $35B and Amex stock will go up 30%.

Unfortunately, by that point, the puck will have moved again, and Square will have abandoned the mobile wallet play in favor of their actual ultimate goal, which is to become a new tender type, disintermediating payment cards altogether.  He shoots…he scores!

*For the record, I think WorldPay and PayAnywhere, with their focus on the SMB segment vs. the true micro-merchant segment, have it right.  NB:  my firm is an investor in WorldPay.

Jamie Dimon

JP Morgan

 

 

 

 

 

 

 

It’s a hard time to be a banker.

I’ve had this post in my draft folder for a long time, held back from finishing and posting it by the concern that, at least until now, it didn’t seem all that hard to be Jamie Dimon (America’s Banker ™), and he certainly didn’t seem to need a defense.  Alas, no longer.  The final bastion of respectability and prescience in the banking industry has been resoundingly toppled, and we can now look upon the rout in retrospect and try to glean some lessons.

My conclusion is that the dystopian epic that is the story of late 20th century/early 21st century banking is, at heart, about a group of people asked to do the impossible.  For reasons I will articulate below, a catalog of constraints and ill winds conspired to create an unbridgeable gulf between what was asked of them and what they could conceivably achieve with the resources available.  Of course, the story is also filled with knaves and opportunists, and probably everyone involved made more money than was reasonable, but in my experience most of the actors were principled, working hard and trying to do the right thing.  Jamie Dimon serves us well as an example here.  His cardinal sin was not about risk-taking, greed or arrogance, it was his (basically virtuous) ambition to make JP Morgan an important, innovative and growthful company.  I believe strongly that those adjectives are not what should be sought by the CEO of a modern bank, and men like Dimon should find other lines of work.  All of the industry analysts exhorting our current banking leaders to “Do Better” should be change their tune to simply “Do Less.”

About 10 years ago, I decided to focus my investing career on financial services companies.  At the time, this was a bizarre choice for an early stage venture capitalist; I don’t think anyone else in the industry was similarly exclusively focused, and only around 2% of the VC dollars went into the sector.  I had a number of reasons for the choice, which I won’t go into in detail, but one of the most significant was my view that the increasingly radical levels of bank consolidation left the industry vulnerable to entrepreneurial competition.  As I thought about the industry, there were three key segments:  payments, lending and capital markets.  In each, the banks had one or several exposed flanks.  I wasn’t smart enough to predict the financial crisis, but frankly should have been.  It was evident from what I was seeing that the cracks in the dam would turn into deep fissures, in each one of those segments.

It may seem comical to those outside financial services, but there is in fact a robust industry that has grown up around the idea of banking innovation.  You could attend a conference every week of the year on the topic, and fill your non-conference hours reading newsletters and blog posts about it.  Most of what the pundits think the banks should be innovating around is payments, which is basically the act of moving money from point A to point B.  The problem with this idea is that a payment mechanism consists of two things:  a technology architecture and a set of rules.  The technology part is probably obvious, but the rules part is important and distinctive.  Payments is an eco-system business, and the rules define the roles played by all the coordinated but independent parties.  By definition, an innovative payment mechanism, one which represents an advance from what exists, involves an exotic and novel technology or a new set of rules — or both.  For a variety of reasons, most notably the fact that their systems are a patchwork quilt of archaic, mainframe based architectures cobbled together from the dozens of acquisitions behind each of our large banks, banks are not good at technology innovation [one caveat here:  some banks are very good at trading technology, more on that later.]  They have to spend nearly all of their time, energy and resources on vital functions like uptime and security, and that leaves very little for the kind of playful tinkering that underlies most breakthroughs.

Banks are even worse at evolving new rules.  There are three ways to make new rules, two of which don’t work.  The first is to get all parties to agree:  FAIL.  The second is for a small but powerful cohort to band together and try to exert their will on the others:  also FAIL, at least in banking, where despite the consolidation there are still over 8,000 banks in the country, and as many credit unions.  The third way is for a renegade establishment to break the existing rules and keep moving fast enough that they get to critical mass before the rule enforcers notice and can do anything about it.  Banks are not good at breaking rules, and are really not good at moving fast and avoiding regulators.  This is why payment innovation happens by companies like PayPal, Venmo, Dwolla, Zipmark, Simple and Stripe.  Is everything they are doing strictly by the book?  Not even close.  Will some of them achieve escape velocity before they get shut down?  Yes.  [Am I engaging in the pernicious blogger habit of asking and answering questions?  Yes I am.  Will I do it again later in this piece?  Yes, indeed, I will.]

So in the payments world, banks face critical shortcomings as it relates to innovating.  You would think that would be less true when it comes to lending.  After all, that is what banks were set up to do in the first place:  take in deposits from savers, and turn them into loans for borrowers, making money on the spread in between.  To a certain extent, this is still their core mission and they do it well.  There are four key dimensions of competition in lending:  cost of capital, credit losses, cost of customer acquisition and operating expenses.  For a plain vanilla consumer loan, say a mortgage, it’s very hard to beat banks.  They pay depositors roughly nothing (very low cost of capital); in ordinary course the FICO or consumer credit score is highly predictive (controlled credit losses); they benefit from large branch networks and high brand recognition (lowering customer acquisition, though online lead gen models have reduced their advantage here); and they run large, systematized factories for processing these loans (low operating costs).  But the dirty secret is that there isn’t a lot of money to be made in these commoditized categories, and every once in a while there is a crisis and you lose your shirt.  Banks need higher yielding assets, which come in the form of higher interest consumer loans, or business loans of all types.

Not coincidentally, if you canvas the fast growing world of alternative credit now, you will find largely two types of new entrants:  high rate consumer lenders (Wonga, Zestcash, Think Finance, Global Analytics, etc) and business lenders (Kabbage, The Receivables Exchange, Capital Access Network, On Deck Capital, etc.)  The entrepreneurs are, logically, going where the yield is, and where the banks aren’t (there’s a Jesse James joke to be made there somewhere, but I can’t quite sort it out.)  Banks are structurally disadvantaged from entering new areas of lending because the regulators force them to take capital charges against loan types that aren’t tried and true.  This negates their cost of capital advantage.  By definition, these loan types have short histories in terms of credit performance, and are only vaguely related to existing underwriting strategies, which takes away their credit loss advantage.  They probably still have a customer acquisition advantage, but their brands work against them in the consumer categories as they are incredibly skittish about being involved with anything high rate.  Finally, while they can be low cost where they have massive scale, at low levels of scale they are horrifically high cost, given average wages and the tendency of highly regulated entities to constantly invent new “i”s to dot and “t”s to cross.

Given the structural disadvantages that face banks when they attempt to innovate in payments and lending, two areas that should be their bread and butter, is it so surprising that they pushed hard to end Glass Steagall and double down on their capital markets businesses?  I have this image of a bunch of men in grey (possibly brown) suits, sitting around a board meeting in the mid 1990s, post that credit crisis.  One of them stands up in the front of the room and says, “Right, then.  We’re facing stiff competition in all of our high margin payments business and we don’t know how to compete.  We just got our hats handed to us in mortgage, and all we can do on the lending side is pile the consumer card debt higher and deeper; we’ll do that, but it’ll only go so far.  We pushed hard into international, but lost our shirts in Latin America.  The way I see it, we can either admit defeat and become the financial equivalents of public utilities, or we can try to be like Goldman Sachs.  What’s it going to be boys?  ConEd, or the Concorde?”  In my mind, the motion to hire the lobbyists was passed unanimously and drinks were served before 5pm.

But there I go, demonizing bankers, which I promised not to do.  In fact, my image is flawed.  The meetings that caused the problems weren’t backroom meetings like that, they were shareholder meetings, way out in the open.  Bank CEOs were being pressured to grow earnings at 10%+/year, when in fact they should be expected to grow as a function of inflation and population.  Under that pressure, they behaved like human beings, which is to say they looked for ways to do the impossible.  The impossible, as it relates to the third core business of banks, is to prudently grow earnings quickly in a capital markets business.

Let’s look at this most recent JPM debacle as an example of the vise these guys are in.  First, you have to realize that these losses ($2-6B, depending on who you ask [my bet would be on or under the low end]) aren’t from one of their trading desks, which are either oriented towards taking positions to make money on them, or taking positions to facilitate a trade for a client.  The losses took place in a hedging operation, set up to manage and mitigate risk originating from other parts of the business.  There are those who claim that through mission creep, this group ended up making speculative bets way beyond their original brief.  I would submit it’s hard to know that one way or another, and that’s just the beginning of the list of things we don’t know.  We don’t know what the 1, 3 and 5 year P&L of this group looks like.  We don’t know how much profit was generated from the activities that these trades were meant to hedge against.  We still don’t know the ultimate disposition of these trades, much less what that would have looked like if JPM hadn’t been forced by the regulators to go public with their positions and forcibly unwind them.

The answers to all of these could be such that reasonable people would look upon these positions, in the context of the track record of the group and the broader business objectives, and say this was bad execution at worst, and a missed putt at the end of a great round at best.  What we do know is that even at the high end of the contemplated range, it represents less than a 5% hit to equity, and less than 30% of JPM’s annual profits in any of the last 3 years.  Bad news?  Surely.  Punishable by firing squad?  Not in my book.  But here’s the best part:  Predictable?  100%.  What is clear, beyond a shadow of a doubt, is that in capital markets (eerily like in payments or lending), the party that is less regulated is the party who will win.  The story of this bad JPM trade is one of the unregulated hedge fund wolves stalking and slaughtering a sheep wearing an electric fence shock collar.  Not a fair fight, and expecting that JPM will be a winner in similar fights in the future is laughable.

The good news, for bankers, is that there is a way forward.  There is a role, or a set of roles, for banks in all of these business that may not be exciting, high growth or particularly sexy, but can be high margin and massively defensible.  Banks should a)manage regulation and compliance; b)manage security/fraud/identity and c)steward depositor capital into risk managed pools.  Each of these roles demands a separate blog post, but suffice it to say that each is a critical infrastructure layer across the core segments of banking, and banks are uniquely situated, in terms of current regulation, technology assets, brand identity and culture, to own each layer.  By focusing on these roles and not trying to compete with nimbler foes, banks could massively reduce overhead, value at risk and operational complexity.  The banks themselves, and the bankers who work there, would go back to being perceived as pillars of the community, literally supporting the entire ecosystem of commerce.  Not entirely incidentally (at least not for me), a thousand or more entrepreneurial flowers would bloom, as businesses sprung up around the banks, fulfilling the customer facing and innovation functions that so desperately need to be filled.  I predict that companies like American Express (great at payments & brand), Capital One (great at marketing & credit risk) and Goldman Sachs (great at trading technology) would “de-bank”, and choose to partner with Citi, BofA, JPM and others, who would shed many non-core businesses.  This restructuring of the financial sector would put the US back on the path to being the global leader in this area, as well as de-risking the global economy.

And as for Jamie Dimon?  He should call me.  We can do something exciting together.  Definitely not a bank.

When I was an undergrad, in the early 1990s, I spent a little time trying to figure out how to invest what meager savings I had (generated by my lucrative summer pizza delivery gig). My first efforts were directed at figuring out what public equities I might invest in. [Sidenote: Ultimately I ended up putting all of my savings in my roommate's start-up, which I do not recommend but which did end up allowing me to buy a house five years later.] I ordered a bunch of annual reports from the investor relations departments of companies I was interested in, got a pencil and some graph paper, and did some rudimentary calculations, like: how fast are these companies growing? what are their PEs? Obviously this seems ridiculous to those weaned on Yahoo Finance, but trust me, much of what I was doing those days would seem ridiculous to most sensible people.

My point is this: even as a 19 year old liberal arts trained neophyte, my first instinct upon deciding to invest in stock was to do some math. So when I read all of these people attacking “quant traders”, I have to wonder: as opposed to what? Instinctive traders? Psychic traders? Insider traders? As someone who now spends his time figuring out how to invest in financial services start-ups, understanding the actual contours of this new phenomena is important to me, so I’ve done some thinking about it. I will leave the question of who to demonize up to you, but I will do my best to lay out some frameworks that hopefully introduce some nuance into the debate.

In actual fact, most of what people are complaining about when they decry quant trading is actually a sub-set of quantitative trading (admittedly the largest part) called high frequency trading or, somewhat interchangeably, low latency trading. In fact, these are two different techniques often used in combination: High frequency = lots of trades/second, Low latency = getting the trades into the marketplaces very quickly. High frequency/low latency trading marries two skill sets: a)an analytical pursuit of transient pricing anomalies and b)a hardware/software/communications configuration designed to get trades into the various markets more quickly than the next guy. Part (b) is important because of the key word “transient” in part (a). This kind of quantitative trading has been around for decades, since the advent of computers essentially. Firms of this type input massive amounts of market data, across all types of securities and geographies, and then look for correlations, eg, if the price of this commodity future goes up 5%, the stock price of this Indian company should trade down 2%. [note: this example is obviously over-simplified to the point of parody, as will be other examples, so please check your condescending vitriol at the door, if you can.] They carefully back-test these observations to determine their validity and robustness over time, then build trading strategies built around looking for events in the future that mirror these historical correlations.

The problem with this type of quant trading is that, over time, with everyone working on the same data set, everyone makes these same observations. So then the question becomes who can trade on the data first. Hence the massive investment in infrastructure to turn these quantitatively-derived investment ideas into low latency trades. What is important about that is one quickly realizes that in order to minimize cycle time, you need to cut the slowest link in the chain out first: the human brain. As a result, we now have computers trading directly with other computers, and this has created many of the market structure issues we are dealing with now, such as “flash crashes” and high levels of volatility. In addition, even if you get there first, the profits available in a given trade are often tiny. Hence the other customary component of this trading style, the high frequency part: if you’re making a penny per trade, you’ve got to do a lot of trading.

But let’s back up a second. The reason that this branch of quantitative trading led to high frequency trading is that, in a sense, the observations are “obvious” (at least if you have $100MM worth of computing power and all of the market data in the world.) As such, making the observations is a commodity, albeit an expensive one; it is trading first on them that is the money-maker. But what about types of quant trading that are predicated on making investment decisions that are non-obvious? Specifically, investment decisions based on information that is coming from outside of the markets, versus strictly from inside the markets, ie, prices.

Quite clearly, that is what most great equity investors do. They get to know a company well, analytically and otherwise, make a prognostication about the future of the company and then buy or sell the stock when the rest of the world disagrees with their prognostication. The frequency of their trades can be high or low, depending on how quickly it takes for the rest of the world (ie, the markets) to figure out that they were correct. Another simplistic example: I think Coke is worth $70, and it’s trading at $67. I buy at $67 with a plan to sell at $70, regardless of whether it hits $70 in 10 minutes or 6 months. If i’m truly disciplined about that, this could be a high frequency trade indeed, if the market comes to agree with me quickly.

Our view is that the next great revolution will be applying the information technology techniques of high frequency trading to this kind of non-obvious investing, which relies on the intake and synthesis of exogenous data (from outside the markets) to make pricing observations. In that these kinds of observations will have a kind of duration durability far in excess of endogenous observations (based on readily available market data), they will generally be far less dependent on speed, and as a result not destabilizing. These new types of firms will use computers to enable and validate human investing intuition, rather than using computers to try to be first past the post in a race to the bottom. Two of the emerging winners in this space include Two Sigma and Kinetic Trading. I would humbly submit that these new firms should be called quantitative investors, rather than quantitative traders, and I look forward to backing some of the best of these players.