Where is My Cash Box?

Financial technology, popularly called as ‘Fintech’ refers to providing technology enabled financial solutions. This is a marriage between finance and information technology. Interlinkages of finance with technology is not a new phenomenon. Application of information technology on delivering financial solutions has more than hundred years’ history. We can classify them as Fintech 1.0 (1866-1987); Fintech 2.0 (1987-2008) and Fintech 3.0 (2008- toll date).

Fintech 1.0 refers to the first period of financial globalization supported by technological infrastructure like transatlantic transmission lines. Fintech 2.0 refers to financial services firms increased digitization of processes and since 2008, Fintech has become globally pervasive with its impact on financial services in both developing and developed world. The current generation of Fintech revolution has given birth to new generation companies challenging the large players, market regulators and policy makers. These companies try to balance between potential benefits of innovation with possible risk of new service models. We will discuss different era of Fintech in the following paragraphs.

Fintech 1.0 (1866-1987) 

Finance and technology are interlinked with each other from earlier stages of development of financial services industry. The earliest recording of financial transactions dates back to Mesopotamia civilization. The development of money as an intermediary for transaction in financial services has a long history in every civilization. One can see evidence of use of technology for financial calculations such as the abacus, numbers and mathematics. This evolutionary development is seen in the context of trade with finance emerging from an early stage to support trade (financing and insuring ships and infrastructure like bridges, rail, roads and canals) as well as supporting the production process of goods for the trade. Double entry book keeping emerged from the intertwined evolution of finance and trade in the late middle age and renaissance. Financial revolution in Europe in late 1600 involving joint stock companies, insurance and banking played a crucial role in industrial revolution (1.0). Finance supported the development of technologies that helped the industrial development across the world.

Finance and technology were combined in late 19^th century to develop what is popularly known as financial globalization. The same continued till first world war. Technologies like telegraph, railroads, canals and steamships and steam engines helped in financial interlinkages across nations. This led to rapid transmission of financial information, transactions and payments across the globe. The financial sector simultaneously provided necessary resources to develop these technologies.

John Maynard Keynes in his essay The Economic Consequences of the Peace (1920) writes “The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his door-step; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble”.

Matthew Spoke in his article How Blockchain Tech Will Change Auditing for Good wrote “Paper is a technology that stores values. A same size bank note can store INR 10 as well as INR 50 as long as there is a state or central bank guaranteeing the bearer of the note to be paid. Thus the amount printed on the note has theoretically no limit. Indonesian rupiah is dubious for its million domination notes. Block chain technology is like double entry book keeping system as any transaction processed via the blockchain is registered and sent to the whole network which can be re-accessed for subsequent auditing process. Block chain accounting is a decentralized process whereby scope for fake transactions are minimized as somebody has to erase the whole blockchain network thus removing the scope for financial frauds (Coin Desk, available at http://www.coindesk.com/blockchains-and-the-future-of-audit/)

Financial globalization was constrained for decades due to the world war and on the other side there were rapid change in technology particularly in the field of information and communication technology. IBM (International Business Machines) developed code breaking tools for commercial application by creating early stage computing devices. Texas Instrument developed hand held calculators in 1967. Americans were introduced to credit cards like Diners Club Card, Bank of America and American Express cards in 1958. This movement was supported by creation of Interbank Card Association (now called MasterCard) in 1966.  By the same period the world experienced a global telex network providing basic communications for developing next stage of Fintech revolution. The commercial version of telex called Fax machines were introduced by Xerox in 1964 under the name Long Distance Xerography (LDX). Barclays bank in UK introduced first ATM machine in 1967.

Launch of calculators and ATMs in 1967 is referred to as the modern period of Fintech (1967-1987) as that was the time when financial services moved from analog to digital.  The Inter Computer Bureau was established in UK in 1968 forming the basis of today’s Bankers Automated Clearing Services (BACS). US Clearing House Interbank Payments System (CHIPS) was established in 1970. Fedwire, originally established in 1918, became an electronic instead of telegraphic system in the early 1970s.  SWIFT (Society for Worldwide Interbank Financial telecommunications was established in 1973 to interconnect domestic payment systems across borders. The failure of Herstatt Bank in 1974 highlighted the risk of increasing international financial linkages through payment system technology. So a combination of finance, technology and regulation constitutes todays USD 5.4 trillion global foreign exchange market which is the most digitized component of the global economy.

Establishment of NASDAQ in 1971 and with end of fixed securities commission and eventual development of National Market System marked the transition from physical trading of securities dating back to 1600 AD to today’s full electronic securities trading. Online banking was introduced first in the US in 1980 and in UK in 1983 by the Nottingham Building Society. Financial institutions increased their IT usage during this period for internal operations, replacing most forms of paper based mechanism. They also started using computerized systems to map and manage risk. Michael Bloomberg started Innovation Market Solutions (IMS) in 1981 whereby use of Bloomberg terminals by financial institutions increased rapidly across US and Europe.  Yang Kaisheng, CEO of world’s largest bank in terms of market share and asset size writes, “There is a perception that when banks develop internet technology, it is not regarded as Fintech. Some people say this is a new idea, a new ideology that will get rid of agents and intermediaries and that banks can’t adapt (ICBC Chairman welcomes Fintech Reg, Finance Asia, available at http://www.financeasia.com/News/400732,icbc-chairman-welcomes-Fintech-regs.aspx). As an example approximately 33000 staff working in Goldman Sachs are engineers which is more than LinkedIn, Twitter or Facebook.

Fintech 2.0 (1987-2008)

Fintech 2.0 is credited for developing traditional digital financial services. Regulatory attention was on a rise due to increased risk of cross border financial transactions and their interconnectedness with information technology.  In the movie Wall street (1987) the investment banker was seen flouting a mobile phone for transactions. This year also marked the black Monday stock market crash whose effect on market across the world clearly reflected the interconnectedness of different national markets through technology.

Though the reasons of the crash are not yet known but most of the people accused the computerized trading system used by financial institutions which bought and sold stocks automatically based on pre-set programmed price levels. Such a crash led to use of various mechanisms to control the stopped of price changes (called circuit breakers). This crisis along with the 1982 crisis in developing nations brought in regulators across nations to cooperate on cross border transaction issues. The Single European Act (1986) came into effect leading to establishment of a single financial market across European Union (1992). The high profile financial liberalization process in the UK in 1986, combined with the 1992 Maastricht Treaty and an ever increasing number of financial services Directives and Regulations from the late 1980s, set the baseline for the full interconnection of European Union financial markets by the early 21st century.

By the late 1980s, financial service industry turned to be more of a digital industry based on electronic transactions between financial institutions, financial market participants and customers across the world under the vigil of regulators. By 1998, financial services industry had become a complete digital industry. This also gave birth to computerized risk management systems replacing the Long term Capital Management (LTCM) in the wake of Asian financial crisis of 1997-1998.

Wells Fargo provided online account checking services in 1995 which lead to emergence of the Internet for the next level of technology development. Eight banks across in USA were providing online checking facilities to one million customers in US by 2001. By 2005, first direct banks without physical branches emerged e.g. ING Direct, HSBC Direct. Bank’s internal processes, interactions with outsiders and customers had become completely digitized by the beginning of 21^st century. The regulators were using more of technology for security exchanges to collect information regarding market manipulations. E-banking during this period was simply treated as another channel to serve customers along with branch banking. There emerged new risk as customers had unlimited access to their accounts without physically being present in the branch for withdrawals. This increased the scope of liquidity crisis as banks couldn’t forecast necessary cash reserve during transaction periods.

Rapid adoption of online banking increased the probability of credit risk. It was expected that competition would increase due to removal of physical link between consumer and a branch as borrower would have access to greater list of lenders across geographies. This sounds good from marketing point of view but was a challenge in bringing financial stability. The structured data collected from various sources were more helpful in understanding creditors profile than a physical acquaintance of branch manager with the customer. Banks could customize offerings to match the risk profile of customers. Markets in a sense could be micro-segmented. Use of big data analytics helped in more granular analysis of consumers profiles and creating more diverse market segments. It was expected during Fintech 2.0 that the e-banking will be done only by licensed financial institutions and banks. The Fintech 3.0 shows that e-banking is no more confined to regulated and licensed entities only. Provision of financial services by non-banking institutions led to the fact that the regulators have a limited or no role to play in safeguarding interest of consumers.

In a survey in USA in 2015, it is found that the level of trust Americans have in CitiBank is 37%, whilst trust on Amazon and Google are at 71% and 64%. Amazon and Google are massive, well-established and well known organizations. But the reality is that in emerging markets like China and India, there is an increasing number of non-listed companies and young start-ups that are handling customers’ money and financial data. China alone has 20000 P2P lending platforms outside the regulations. For billions of people who are unbanked, the bank name doesn’t make a difference as long as they get the services. They hardly bother about money flowing from or into regulated or unregulated bankers.

Fintech 3.0 (2008- till date)

The period from 2009 is for Fintech 3.0 known as period of democratization of digital financial services. Customer trust on large, regulated financial institutions started dwindling post 2008 global financial crisis leading to the growth of Fintech 3.0. The realignment of market forces supported the emergence of innovative and technology led financial service providers. The factors that contributed this change include public perception, regulatory scrutiny, political demand and emerging economic conditions.

Financial crisis of 2008 had two major impacts in terms of public perception and human capital. The public perception of banks went down drastically as their dependence on ‘behavioral legacies’ (how the customer has behaved in the past) was found to be erroneous. The IT legacy systems were not equipped enough to capture the deviations and to analyze the emerging trends on demand for financial services. The financial crisis was so large that it became an economic crisis as 8.7 million people in US lost their jobs. The general public developed distrust on traditional banking systems and many financial professionals lost their jobs or settled down with lesser emoluments. This second set of people found a new industry in Fintech 3.0 where they applied their skill, knowledge and experience leading to emergence of new startups in financial services sector.

Increased regulation in the post financial crisis period led to stricter compliance norms for banks; rejig of commercial incentives and business models. Misuse of financial innovations like collateralized debt obligations was regarded as a contributor to the financial crisis as it detached credit risk of the underlying loan from the loan originator. Post financial crisis situation has led to rise of new technological players limiting the capacity of traditional banks to compete in the marketplace.

The post crisis regulations gave birth to new technology players as startups emerged in providing better services to customers. Basel 3 norm expects banks to have increased capital requirements. This norm helped in market stability and greater risk absorbing capacity leading diversion of funds from private individuals and small and medium enterprises. So these two set of lenders now have to depend on P2P lending platforms for their credit requirements. Increased unemployment and reduced availability of credit has made government to start new initiatives like Start Up India, Digital India, Mudra Bank etc. in India. These are alterative ways to fund businesses through various government led initiatives.

Fintech industry has experienced phenomenal growth in last one decade. Global investments in this sector has tripled from 930 million USD in 2008 to 3 billion USD in a decade. The US Fintech industry received 83% of this investment leading to development of technology for augmenting financial services transactions. The Fintech industry ecosystem can be divided into four verticals (1) digital and electronics currency (2) digital payment systems (3) online finances and investment platforms and (4) big data analytics. Each of these verticals have experienced significant growth in the past decade due to advances in technology, rapid consumer adoption, changing investor and consumer preferences and a shift in regulatory landscape and renewed efforts via mobile banking.

Electronic currencies are bringing greater financial inclusion. The most popular one in Africa is M-Pesa a mobile account system launched in 2007 in Kenya. Venmo in US processed 468 million USD in peer to peer payments. PayTM in with its digital currency wallet is a successful story in India. Similar to the virtual currency, the use of electronic currency is converging into next Fintech vertical- digital payments- by enabling transactions that fall outside the traditional payment system.

Digital payment systems continue to evolve and transform the way consumers transact with business. The Rupay, Phonepay are examples of digital payment systems in India. Both Apple and Google have also launched their Apply pay and Google pay systems which are additional mobile payment service provider disrupting the payment marketplace. Companies like Square, PayPal are experiencing large growth on their business where PayPal transacts around USD 7000 in payments every second. These two companies, backed by data analytics are entering into small business lending markets by providing customized loans. Innovations in communicating payment, ensuring security in transactions are changing digital payment landscape. Use of smart chip payment technologies used by EMV (Europay, Mastercard and Visa) are driving the old POS (point of sale terminals). NFC (near field communication) technologies are allowing mobile devices to communicate payments by placing devices within close proximity of each other.

As more and more transactions take place on digital platforms, there will be a huge amount of data available for credit risk analysis and predicting demands. Massive data aggregation and use of analytical tools are helping financial services platforms and service providers to offer low cost, innovative products and services. Companies are developing credit risk models with multi attribute dash boards to ascertain the credit risk; to develop real time innovative products and services and service customers without much delay. Algorithm based trading practices rely on complex aggregation and analytics. The rising role of data is building a challenge including issues related to cybersecurity, personal privacy and data theft and insider trading.

Source: KPMG Fintech Report 2018-23

(From Authors Upcoming Book – Who Stole My Money)

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