Why FinTech Failed
Explaining the Reasons Technology Hasn't Competed Away Financial Rents
In case you’ve been living under a rock, one of the biggest trends in Finance the last decade has been FinTech — the application of new technology to financial services. As one of my colleagues Thomas Philippon has argued, the rise of new entrants and technological innovation holds the promise to expand financial inclusion, improve financial stability, and lower the high profits and rents characterizing the financial industry.
My argument is this has basically been a failure so far for a variety of fundamental reasons, and is unlikely to improve anytime soon.
What Does FinTech Failure Mean?
First, let’s do a quick gut check on one of the largest and most important consumer credit markets: residential mortgages. This is an industry that, over the time span from 1997-2023 shown below, has seen enormous technological changes. You saw computers being substituted for underwriting decisions (as Fannie and Freddie rolled out desktop software); credit scores used for underwriting decisions (this is a classic example of FinTech in the sense that we start to use algorithmic tools to collapse a variety of consumer credit attributes into a number for loan underwriting decisions); the rise of private label securitization and then FinTech mortgage companies; the availability of the internet and cost comparisons online; so on and so forth. This follows also the mass adoption of Option Adjusted Spread techniques in the 80s to quantify prepayment risk.
Suffice to say it’s a large, sophisticated marketplace with a high degree of competition at multiple levels. But what does that ultimately mean for consumers? We can look at the total price of intermediation: the mortgage rate that consumers pay above a risk-free benchmark, like the 10-year Treasury. This rate is actually high these days — close to 300 basis points — and you can see this is close to historic highs.
Now, you might say that’s a product of an unusually inverted yield curve, and implied prepayment risk in the future as future mortgage rates fall (that shows up as the green bar for prepayment risk). But you can also see the primary-secondary spread there: that’s basically the fees charged by mortgage originators, and you can see that’s also pretty high by historic standards. So despite the growth in FinTech mortgage lending; the cutthroat competition across the expansion of technology in the sector — the cost of mortgage origination has basically never been higher. So why are things getting more expensive even as technology gets better and better?
Steelmanning the Case for FinTech
So here, it’s probably helpful to define FinTech a bit more and think about why technological innovation is plausibly a disruptive force we should expect to have a bigger deal. As one friend wrote to me when I ran a poll to establish people are interested in FinTech as a topic on this substack: “I'm a longtime fintech skeptic; if you write about that, would love to see a non-ZIRP, non-crank explanation for why anyone thought it would succeed.”
I think the basic argument is that technology has pretty strongly disrupted many industries its entered — particularly industries that are focused on information, for which advances in processing are plausibly important. There are a few key domains in which you imagine this is important:
Loan Origination: Consumer credit is all about establishing risk to make an underwriting decisions, and there are basically two things you can do. Either you can require collateral (giving you an asset to repossess in the event of default), or you use soft information. Historically, this entailed sort of looking over the person as they walked in your bank to see if they were sort of the chap who would pay you back — basically a social reputation thing, and you can imagine all the pitfalls associated with that.
Instead FinTech offers you the potential to use all sorts of “hard” information — ie numerical touch points predicting borrower risk — to replicate the “soft” information you previously arrived at through human judgement. The end product is being able to use a much broader range of information to accurately predict default risk, and so make more lending decisions. A pretty tangible way this matters is through something like consumer credit scores or corporate bond ratings — innovations in information which generate concrete measures of performance, thereby enabling more lending to creditworthy firms or consumers (who otherwise would have been pooled in risk with riskier borrowers).Financial Valuation: You’d expect that improvements in data acquisition, data processing, and so forth would improve our ability to value and price financial assets, and indeed there is some evidence that financial markets have grown more informative (in the sense that current market prices better predict future cash flows).
Financial Competition: Think about banks in the 1970s. Banks were strongly regulated in their ability to open branches; and so you were stuck banking at your local community organization. Compare that today, where you can move funds across financial institutions with a click of the mouse. Surely, that amount of competition should erode away rents associated with financial accounts; just as ending geographical rents has resulted in arbitrage of other goods? Surely the cost of borrowing would fall as firms have access to a much broader range of intermediaries, and can more credibly demonstrate their creditworthiness through new data and analytics? And free entry should erode away rents that do wind up?
Technological Innovation: To further support all of this, you would expect to see new technologies and new services pop up, especially by new firms, in order to cater to customer needs and demands — as indeed you do see across all sorts of sectors. Some of this might wind up being technological disruption, in the Clay Christensen sense of new low-frill options to capture ignore markets, and ultimately wind up lowering costs.
And some of these positive innovations have indeed happened. If you’re accessing your bank services through a phone app, investing with a roboadvisor, borrowing through a DeFi platform on crypto, or using a nonbank company for your mortgage or student loan — you’re benefitting from FinTech.
But none of this is the main story. The main story is that the provision of financial hasn’t really changed that much, especially the cost of providing those services. So now let’s turn to the various reasons for that.
Asymmetric Information
The first problem is information asymmetries, and a great example here is iBuyers — companies like Zillow or Opendoor making house sellers take it-or leave it offers by leveraging their detailed housing information to make accurate valuation offers. It makes a lot of sense, and has the potential to disrupt the realtor network: why should agents continue to make 5-6% for every housing transaction in a world in which websites can list housing attributes, and algorithms can accurately assess housing values?
Greg Buchak, Gregor Matvos, Tomasz Piskorski & Amit Seru have a great paper which describes the key problem: home owners have a lot of detailed private information about their house value, and only sell to iBuyers when it turns out the algorithms have overvalued the property. So even when the algorithms are doing a pretty good job of assessing house values in isolation, they play a role in a complicated game featuring strategic interaction and adverse selection, and in the end the machines lose out.
Platform Economies
One of the key innovations technology has opened up in the last few decades is the notion of platforms — information aggregation devices which collect and integrate information and market interactions, thereby opening up a lot of economic value but also providing a centralization location for value capture.
One platform example, brought up with realtors, is the MLS platform: where realtors list properties for sale. It’s commonly thought that realtors sustain their 5-6% fee structure through their control over the MLS platform
Or take another specific example: interchange fees, and Visa specifically. The Acquired podcast has a great episode on them here and describes the fee structure for credit card processing:
Visa, let's round it to 0.2%, gets 20¢ of that $100 shoe sale. But the cool thing about their 20¢ is there are basically no variable costs. It's not dealing with fraud. It's not moving heavy data around. Merchants are allowed to have a 20-character name in Visa's network. This is tiny amounts of data. Stack as much metadata as you want on top of that, we are not shipping around huge payloads here…
The most shocking thing about the business is they have 50% net income margins. Of the $30-ish billion that they made in revenue, their net income was $15 billion.
David: This is absurd. All the picture we painted in the whole story, it was all building toward that climax of they have created something with essentially zero marginal costs in, perhaps, the largest market out there, certainly one of them is global commerce—both e- and non-ecommerce.
Ben: As Visa would argue, both consumer but also B2B commerce.
David: Fifty percent net income margins on $30 billion in revenue. There it is.
Ben: You might say, wait, if they have 50% net income margins, what is their gross margin? Because is it SaaS level good at 75%–85%? Their gross margins are 98%. There are no variable costs in this business. There are no cost of goods sold. It's crazy.
As their episode goes into in detail: setting up the whole credit card interchange system to create an interlocking set of interests did entail a lot of technological and business innovation. But now that it’s here: it’s basically pure profit in the form of $550b market cap for Visa, $413b for MasterCard, and $146b for American Express. So that’s basically a trillion dollars in the market value of pure rents extracted by the credit card companies for the cost of processing payments: a durable monopoly because it sits on the commanding heights of a payments platform that it’s in everybody’s interests to sustain with huge network effects — the Chase Sapphire-Americans who benefit from rewards points, issuing banks who benefit from customers — at the cost of retailers who pay a substantial tax to keep the whole thing going, ultimately passed on to consumers.
There is a better solution here, but it requires substantial government investment. Pix in Brazil, UPI in India, Faster Payments in the UK are all state intermediated payment processing technologies which create platforms for payment processing at close to zero costs, thereby removing the 2% tax on the whole economy extracted by the credit card companies. For India in particular, the payments layer serves as the base for whole additional layers (the “India Stack”) of financial technologies providers. Imagine, for instance, businesses and consumers who can credibly commit to loan repayment based on verifiable histories of sales volumes as recorded on payment transactions.
So what’s the takeaway here? I think the lesson, as Sergey Sarkisyan suggests, is that technology adopted by first movers, applied in financial contexts, can easily exclude rivals and grow monopolistic. To avoid that, you really need open protocols which ensure democratized information access.
Regulatory Burdens
Returning back to loan origination — I think a key driver here of those rising loan origination expenses have been genuine increases in paperwork and regulation. Now these may be good regulations which address the fraud which was common before the GFC. But it has steadily added to the cost and expenses inherent in loan origination, as lenders now undergo extensive income verification, and indeed many lenders have simply pulled back from the space entirely especially out of threat of lawsuits.
This is a tricky issue, because some degree of prudential regulation seems warranted (remember the point above; there is asymmetric information in this space) but it all reflects a bit of an informational arms race. People can use IT and technology to do more fraud, which requires more resources to clamp down, which triggers more regulation, which increases compliance costs and expenses. A related regulatory problem is systemic risk: regulators (naturally) want to avoid fragility concerns, and to an extent that’s mitigated by cozy insiders who sit on rents.
Arms Race Losses
Also in the category of arms races is the general zero-sum nature of a lot of financial activity, which generally results in a lot of sort of wasted effort to front-run others profits. This is of course most evident in high-frequency trading, which is highly competitive and features huge investments, but is basically entirely socially wasteful in shifting around some fixed set of profits among a small set of high-frequency firms (with dubious, at best, benefits on liquidity overall).
But you see similar trends across the FinTech space — here are a few firms (Affirm, soFi, Worldline, PayPal).
For companies like SoFi or other mortgage FinTech firms — the arms race that I have in mind is just cream-skimming good quality customers and offering them lower interest rates as rates continued to go down. That’s a zero-sum game, and in particular is only value as rates kept falling. And so that’s in part why I think you’ve seen the stock prices of many of these companies start to fall once we hit that rising rate cycle. It turns out there just wasn’t as much fundamental business innovation; so much as these more zero-sum arms race components.
Behavioral Biases
Let’s come back to banks. As Itamar Drechsler, Alexi Savov, Philipp Schnabl have emphasized, banks pay consumer interest rates on deposits far lower than true market rates. And the resulting bank betas — how sensitive consumers are to moving deposits with different interest rates — are if anything even lower these days than historical norms. The upshot is that consumers basically lose enormously on money sitting in bank deposits, the entry of other institutions hasn’t done anything to help, and this all winds up as bank profits (one caveat here is banks wind up spending a large chunk of the resulting profits on paying for bank branches and customer acquisition costs more broadly to get these people in the door).
It’s all fairly surprising given the ease of price comparisons and money transfers, especially given the internet, and broadly I think it’s hard to think what’s going on here aside from consumer inattention.
Especially in the wake of the zero lower bound period: the whole issue of deposit rates just really weren’t salient to consumers, and so people focused instead on other characteristics and features of banks to decide on, and so depositors were pretty “sleepy.” Similarly, people are “woodheads” or inattentive in their refinancing decisions; they pay outrageous fees for consumer credit cards; high rates for actively managed investment products; and creating low fee products just doesn’t move consumers the same way that it does in other product categories.
Why all this is happening is maybe a bit puzzling at some deep level; but for our purposes we can chalk this all up to the idea that consumers basically don’t seem to spend that much time or energy thinking about financial issues, get pretty strongly bamboozled by financial institutions as a result, and there’s probably not that much that technology is going to do about it.
One thing we could potentially do here is make it easier to handle payments through non-checking systems — ie, imagine you could pay rent by writing a check from a money market mutual fund invested in a high rate of interest. But that’s banned by regulators — those funds can’t access the ACH system of payment processing — in part (back to an earlier point) because regulators don’t want the systemic risks that might happen from those deposits fleeing the system for mutual funds.
How to Make Better FinTech
How to fix this whole situation — and help FinTech realize its initial promise — turns out to be a pretty tricky process. There’s probably room for some regulation to address prices which are not salient to consumers, which wind up driving up fees and expenses, but you have to be careful to avoid overregulation in ways that drive up costs. It seems helpful to have some public utilities control the commanding heights of certain digital platforms to enable information sharing rather than value capture, but you also want to ensure adequate incentives for private actors to build some necessary infrastructure themselves. You could imagine creating more public goods here — maybe Central Bank Digital Currencies which directly pay out a fair rate of interest, cutting out bank deposits entirely for the purpose of liquid transactions — but that would have pretty disruptive impacts on existing markets and raises all sorts of privacy issues. You could try to break up existing private exclusive platforms (like interchange or the MLS platform), but the incumbents would probably fight those pretty strongly.
So there are no magic bullets here, and so my basic expectation is the fundamental challenges in this space are so strong that FinTech will steadily move along without drastic or revolutionary benefits for consumers, and hence will broadly be a failure from the perspective of the lofty claims and hype made on its behalf. But at least it will mint a few billionaires along the way. And I could be wrong! I had greater hopes for innovation in this space, and it’s possible they’ll get realized eventually.