Silicon Valley has the banking industry in its crosshairs. Hardly a day, hardly even a nanosecond, goes by without a VC, entrepreneur, or tech media pundit claiming that some Internet-something-or-other is going to take out the stodgy financial services industry.
It’s even gone mainstream: Lesley Stahl’s breathless "60 Minutes" interview with the 20-something Stripe founders ends with the anchor exclaiming, “Oh! You want to buy them out,” referring to the banks.
Unfortunately, "60 Minutes," famous for investigative journalism, missed the really big story in FinTech. A few days later, one of the founding fathers of FinTech, Renaud Laplanche, was forced out of Lending Club, the peer-to-peer lender he founded in 2006, following scandals over loan disclosures and conflicts of interest. The U.S. Department of Justice has launched a criminal investigation.
The really interesting, though less juicy, story is what got Lending Club into trouble.
Peer-to-peer lenders “match borrowers and lenders directly the way Uber connects passengers and drivers,” as Stripe’s Patrick Collison put it to Stahl as he recited the ways FinTech is disrupting banking.
The problem is that while peer-to-peer worked great for Uber, it hasn’t work so nicely for Lending Club. Regular people, quite sensibly, are much happier driving strangers around than they are lending them money. Lending Club found that it couldn’t get enough people to finance loans and had to turn to institutional investors.
Persuading these investors to take on the debts was apparently the source of the shenanigans that resulted in Laplanche and several of his deputies getting thrown out. For all the talk of the miracle of peer-to-peer, Lending Club found that it’s been difficult. It has lost more than 80 percent of its market cap since its late December 2014 IPO. Most others have struggled, too. Just before the Lending Club scandal broke, Prosper laid off more than a quarter of its workforce.
What’s most remarkable, though, is that Lending Club and other peer-to-peer lenders relied heavily on snail mail to fish for borrowers. According to The Wall Street Journal last October, “thanks in large part to online lenders, the average monthly volume of personal-loan offers sent through the mail has more than doubled in two years to 156 million in the year through July from 73 million in the same period in 2013.” Lending Club alone sent an astounding 33.9 million personal-loan solicitations in July 2015.
Peer-to-peer lending looks like the latest “Internet of Finance” evolution that wasn’t – it looked like any other consumer finance organization, just based in Silicon Valley.
A few years ago Silicon Valley visionaries were sure that bitcoin was going to transform financial services. On January 21, 2014 Marc Andreessen explained, “why bitcoin has so many Silicon Valley programmers and entrepreneurs lathered up” and compared it to the “Internet in 1993.” VC money flowed into bitcoin startups that were going to revolutionize just about all aspects of payments and make it virtually costless, and the tech media were flooded with breathless stories about mainstream merchants taking bitcoin.
Again, it hasn’t worked out. Bitcoin grew explosively after its 2009 introduction by becoming the currency of choice for criminal commerce, including hiring hitmen, giving the term “killer app” new meaning. Now it powers "ransomware," one of the hottest new trends in hacking – businesses now even budget for it. Key bitcoin players are behind bars or under criminal investigation. That’s a pretty shaky foundation for the Internet of Finance. As we show in "Matchmakers," successful platforms have to work hard at eliminating bad behavior in their communities; bitcoin seemed to revel in it.
Beyond criminal activity, bitcoin startups have struggled to find a problem for which bitcoin could provide a solution that would live up to the hype. This is a classic “technology-in-search-a problem” failure. It turns out that some of the leading bitcoin startups were increasing friction in transactions, not decreasing them, without saving any money. Overstock.com got a lot of hype when it announced it was working with Coinbase, a bitcoin wallet provider, to accept bitcoin payments. For customers who didn’t already have a stockpile of bitcoins, here’s how it worked. An American customer had to buy bitcoins from Coinbase using dollars. The customer then “paid” Overstock in bitcoins – and paid a fee to buy those bitcoins. But Overstock didn’t really want bitcoins because of the exchange risk. So Coinbase then resold the bitcoins almost instantaneously and gave Overstock dollars – of course, Overstock paid a fee on that conversion as well. So much for the “free” bitcoin internet of money theory.
The FinTech pundits now tell us, well forget about bitcoin, what really matters is the blockchain technology that powers bitcoin, and that’s what’s going to power the revolution. There’s even a new book, the Blockchain — you guessed it — Revolution with the subtitle “How the Technology Behind Bitcoin Is Changing Money, Business and the World.” There is some chance that it might. You proclaim a revolution often enough, and you’ll hit the jackpot at some point.
Blockchain technology is quite innovative. The problem, though, is that while bitcoin had a governance problem after securing critical mass, blockchain startups will struggle to get critical mass. The big idea behind the blockchain is having a distributed ledger in which entities all around the world compete to validate transactions and collectively host the entire ledger. Then people and businesses can engage in all sorts of transactions over that processing system — not just making payments, but buying and selling securities and other financial instruments. It’s all transparent and secure.
To get critical mass, though, blockchain startups have to get enough entities to validate transactions, enough entities willing to use their solution to make transactions, and enough entities willing to accept those transactions. And an infrastructure capable of moving trillions of transactions in nanoseconds – which it does not today and won't for a very, very long time. Getting critical mass is a tough problem, as any number of failed, and extraordinarily well funded, payment startups, like Softcard, can testify.
Bitcoin attracted processing capacity in part because speculation drove up the price of bitcoins, and the entities that operated the ledger got generous rewards. It attracted senders and receivers who wanted to engage in speculative trades and to hide criminal activity. If bitcoin cleaned up its act and installed a good governance system, the blockchain startups could leverage the existing bitcoin network. Without that, though, these startups have a tough road ahead.
So far, only one “Internet of Finance” company has become a blockbuster outside of China. That’s PayPal, which was started almost 20 years ago, has a market cap of close to $50 billion, and operates a global payments business with hundreds of millions of users. It solved a really significant friction well. Lots of other FinTech companies have made great contributions, on a smaller scale and without the hype, like Braintree which is now part of PayPal. Today, many FinTech startups are tackling significant frictions in financial services, using modern internet and software-powered platforms. Some of the most important FinTech innovations, like mobile banking and check capture, aren’t replacing banking, but making it better. And all of those innovators are innovating on top of compliant and functioning systems that deliver the safety and soundness that is key to our financial services systems.
Financial services, for sure, is ripe for innovation, as is known by anyone who has gotten into the trenches with bankers and seen just how antiquated some of their computer systems are. That doesn’t mean, though, that entrepreneurs and investors should be flooding into this industry now, thinking that it’s easy pickings. As the economics and history of matchmaker businesses show, starting, igniting, and scaling a pioneering platform is tremendously difficult. It’s especially so in financial services. Many of the frictions in the existing system result from annoying, but arguably necessary, regulations aimed at safety and soundness and at preventing money laundering.
Most importantly, FinTech entrepreneurs and investors should beware of the hype. To be successful they must find the sweet spot where there’s a significant friction in financial services that can be solved with modern technology and where it is feasible to develop a sound business model that can secure critical mass and sustain profitable growth.
David S. Evans is an economist, business adviser, and entrepreneur. He has done pioneering research into the new economics of multisided platforms. He is the co-author of Matchmakers: The New Economics of Multisided Platforms.
Richard Schmalensee is the Howard W. Johnson Professor of Management and Economics, Emeritus, at the Massachusetts Institute of Technology. He served as the dean of the MIT Sloan School of Management for nine years and as a Member of the President’s Council of Economic Advisers. He is the co-author of Matchmakers: The New Economics of Multisided Platforms.