Financial technology is proving less of a battleground than feared

IN JUNE 2007 a banker, or anyone else with $499 to spare, could try a novel distraction from work: Apple’s first iPhone had just gone on sale. In October 2008, after Lehman’s fall, another technological innovation was more quietly unveiled. A paper published online under the name of Satoshi Nakamoto described and advocated a form of electronic cash which people could send to one another without going through discredited banks. It was called bitcoin.

As banks have adapted to the crisis and its aftermath with varying degrees of success, the rest of the world has not stood still. Smartphones and, less visibly, cloud computing have transformed people’s daily lives—and hence their use of money. Consumers expect to be able to use the powerful computers in their palms to pay for goods or move cash around as easily as they can tweet, stream videos or share photos with friends. Corporate customers are equally demanding. Yet banks’ information-technology systems are a curious mixture of the old and rickety and the sleek and modern. Malevolent hackers continually probe for weaknesses as banks are striving to stay ahead.

And if they don’t? Bitcoin embodied an anti-establishment, libertarian threat to banks: that upstart technologists might disrupt them as Amazon has disrupted bricks-and-mortar retailers and Uber cabbies. So far that has not happened, to the chagrin of ambitious financial-technology (fintech) startups and the relief of many bankers. New competitors have made some inroads, but—in Western countries, at least—they are finding that collaboration is a likelier path to success than a full-on fight. Moreover, far from being usurped by bitcoin, banks are eager to turn blockchain, the technology on which it is based, to their own ends. Again, co-operation with technology companies, and sometimes with other banks, is the order of the day.

To be sure, a gang of newcomers have muscled their way into their domains. Peer-to-peer or marketplace lenders, such as Lending Club and SoFi in America, or Funding Circle and RateSetter in Britain, connect people and companies that want to borrow with those that have money to lend, promising both sides keener rates. Britain’s MarketInvoice allows small companies to borrow against receivables immediately, rather than turn to a bank or wait for bills to be paid. Digital banks such as N26 in Germany, Tinkoff Bank in Russia and an array of British hopefuls are challenging incumbents.

But banks are not easily displaced. Peer-to-peer lending, for instance, has grown rapidly, but still amounted to just $19bn on America’s biggest platforms and £3.8bn in Britain last year, according to AltFi Data, an analytics company. And some marketplaces now involve banks. Lex Sokolin, director of fintech strategy at Autonomous, a research firm, argues that music—one of the first industries to be attacked by digital revolutionaries—was fairly easily disrupted. Retailing was a little harder, but customers got used to not handling books, cameras and clothes before buying. Finance and health care, he says, are much more difficult. People are rarely inspired by financial products, says Mr Sokolin, which makes it costly to build a brand. It is easier to team up with those who already have the customers.

Banks command resources that small startups can only dream of: last year JPMorgan Chase spent over $9.5bn on technology, including $3bn on new initiatives. As well as economies of scale, they enjoy the advantage of incumbency in a heavily regulated industry. Entrants have to apply for banking licences, hire compliance staff and so forth, the costs of which weigh more heavily on smaller firms. Even tech giants, which are moving into finance and may enjoy more trust from younger customers than banks do, could be deterred. Apple, Google and Samsung all have apps allowing people to pay shopkeepers from smartphones, and Amazon offers loans to businesses selling on its platform, but may not want to be supervised as closely as banks are now.

In the West, regulation is opening up more of the field to fintechs, both large and small. A revised European Union directive on payment services, known as PSD2, allows third parties to offer more convenient ways of paying online or to consolidate information from different accounts (with the holder’s permission) so that people can keep track of their finances. America has no equivalent, but the Office of the Comptroller of the Currency, which oversees national banks, has proposed giving special licences to fintechs.

How China does it

China’s digital behemoths worry less about such things. Companies like Ant Financial, the financial arm of Alibaba, an e-commerce giant, and JD.com, another online marketplace, have masses of data about those who buy and sell on their platforms. They know their spending habits and how much cash they can spare, so an easy next step is to offer them small loans. Big Chinese banks in any case neglect consumers and small businesses, so customers feel no loyalty towards incumbent lenders. Regulators have also been willing to let online companies shift into finance. No wonder that Asia accounts for the bulk of investment in fintech (see chart).

Wherever they are, even small fintechs have at least two advantages over bigger rivals. First, they are nimble, writing and rewriting code, testing and retesting products, discarding what doesn’t work and improving what does. Better, an online mortgage-broker in New York, updates its products “20 or 30 times a day”, says Erik Bernhardsson, the company’s chief technology officer. Banks might do so “every six months”. Second, fintechs attract bright, mainly young people whom banks might have hoped to get to work for them (see article). Plenty of them used to. Joseph Lubin, the founder of ConsenSys, a blockchain company in Brooklyn, came from Goldman Sachs; Andrew Keys, the head of business development, was previously an analyst at UBS; and other colleagues used to work at Bank of America, Deutsche Bank and HSBC.

A profitable symbiosis

All this fosters co-operation between banks and fintech companies. Fintechs gain access to banks’ scale and customers. Banks can exploit fintechs’ expertise in programming and in analysing mountains of data. Co-operation may also lessen (but not eliminate) the danger that banks are reduced to dumb utilities, maintaining basic systems on which others make money from fancy new products. Application programming interfaces, or APIs—routines that connect two lots of software—are taking symbiosis a stage further. Small businesses, say, might use accounting software, created by a fintech, through a bank’s online platform.

Banks (and central banks) have invited startups to develop products in controlled environments such as in-house labs and accelerator programmes. That can lead to more formal arrangements. Bipin Sahni, head of research and development in Wells Fargo’s innovation group, says 11 young firms have gone through his bank’s six-month programme since 2014. Being based in San Francisco, Mr Sahni adds, “we see more interesting companies than a bank sitting in other parts of the United States.”

For fintechs, symbiosis need not mean minnowhood. Stripe, a San Francisco firm, processes mobile and online payments on companies’ behalf, linking them to card networks (and through them, banks) in much the same way as bricks-and-mortar retailers and offering them additional software tools. It was valued at $9.2bn in November, when it last raised money. Patrick Collison, who founded Stripe with his brother John in 2010, explains that from the beginning the plan had been to work with credit- and debit-card networks. “It was always clear there was no viable independent strategy,” he says.

Some fintechs allow lenders to reach customers they might otherwise miss—for instance, by improving underwriting. Better funds mortgage applicants with capital from more than 20 investors, including Fannie Mae and most of America’s big banks, letting its software decide which of the investors’ underwriting criteria suit the borrower best.

Chinese internet giants, too, are using smaller fintechs. Douglas Merrill of ZestFinance in Los Angeles says that Baidu, a search-engine titan that has a stake in his firm, increased approval rates for its small-loans programme by 150% without a rise in losses; ZestFinance’s software crunches reams of messy data, allowing less obviously creditworthy people to borrow. A big American credit-card issuer, Mr Merrill adds, has cut annual losses by “a nine-figure number”; a carmaker has reduced credit losses by more than 20%.

Adam Ludwin of Chain, another blockchain company, calls examples like these, in which new and better products are connected to banks’ own infrastructure, “top-down fintech”. “They do what financial institutions should have done, but do it more quickly.” Blockchain, by contrast, he calls “bottom-up”: new infrastructure, either within banks or shared among them.

Blockchain enthusiasts stress that its potential stretches far beyond finance. In essence, a blockchain is an immutable shared record known as a distributed ledger. It might list transactions, payments or simply owners of money, land, shares or other assets. All parties have their own copies, which are updated instantly once changes are agreed on. That makes it lightning-fast by comparison with traditional transactions. Transfers between American banks, for example, can take three days. International transfers, which may involve several banks, can take even longer, and senders do not always know how much recipients will get after banks have taken their cut. Settlement of securities trades can be held up because one bank’s record of who sold what to whom, when and for how much may differ from another’s. A blockchain permits just one version of the truth, holding out the promise of huge savings in back offices. “Blockchain reduces the cost of trust,” says Mr Lubin of ConsenSys.

Chain reaction

Banks, central banks, regulators, exchanges and technology companies both large and small are working on a host of projects using blockchain. Collaborative efforts abound, including Hyperledger, run by the Linux Foundation, a non-profit group that promotes open-source software, and backed by IBM; R3, a consortium involving several banks; and the Enterprise Ethereum Alliance (EEA), the newest such group, which includes Microsoft and ConsenSys, as well as an array of banks. Among Chain’s projects is a payment-settlement system for VISA, a credit-card network, which is due to go live this year. Another hopeful, Ripple, has payments partnerships with several banks, including Santander. Digital Asset is developing a clearing-and-settlement system for the Australian stock exchange.

This mix reflects different ideas about which version of blockchain will work best. The EEA is building private, secure blockchains with technology repurposed from an open, public network, based on ethereum, another blockchain platform, which its creators believe will be the next generation of the internet. Others think blockchains will be more specialised. Ryan Zagone, Ripple’s head of regulatory relations, likens bitcoin to the Model T Ford: since that first appeared, carmakers have produced vehicles in many shapes and sizes for specific uses. Blockchain, he thinks, will follow the same pattern.

This technology is still in its infancy, but with plenty of applications in the pipeline, banks should soon start to learn whether, and in what form, it lives up to its promise. Until then they have little choice but to pursue it. They are under pressure from supervisors and shareholders to reduce costs, and from clients to work better and faster. The eventual gains will probably flow to customers rather than producers, because that is usually the way with leaps in technology. But the banks know that it is better to be first than to bring up the rear.