How FinTech Disruptors Are Rewriting The Rules

Silicon Forest Provides Fertile Ground For Startups

A report on the global financial-services sector last spring by PricewaterhouseCoopers should come free with every Ferragamo tie purchased by an industry executive.

Of the seven key messages in the March 2016 report, six address how new and evolving internet finance technologies pose an existential threat to the natural order of things in the financial services world.

For added drama, the seventh point -- that financial service firms are surrounded by hundreds of small, but efficient and hungry, financial technology startups -- is illustrated with a graphic resembling cancer cells attacking an internal organ.

[Want more on fintech trends? Download the Tech Digest Top IT Trends to Watch in Financial Services.]

Indeed, new business models based on distributed networks are being rapidly built by fintech startups around blockchain technology, smart contracts, big data, and data analytics. The products come integrated with new levels of cyber-security and analytics capable of producing profiles of individual customers.

PwC's report suggests there already are 700 fintechs reconfiguring products and services that once were the sole domain of the old guard.

Of course, established financial services companies are not headed for chemo. Many large and small players in the sector are investing in internet finance technology, at least for proofs of concept.

"Many areas of financial services are very rich," said Vivian Zhang, founder and CTO of the NYC Data Science Academy boot camp, in an interview with InformationWeek. "They can invest where they want, and this is one area they want" to invest in.

Zhang, also an adjunct professor at Stony Brook University, said having terabytes of data, and the ability to analyze that data, is a relatively new experience for many financial services firms.

"The bottleneck was capacity," she said, and that is gone. So armed, many executives are taking internet finance technology seriously.

At the same time, "Fewer people are using related SAS and Microsoft products," she said. Open-source software alternatives are making innovations rapid, multiple, and less expensive to come by.

In the unlikely case that incumbents were to ignore this trend en masse, they have the deep regulatory and political experience, cast-in-concrete infrastructure, and business connections required to dominate the sector for long decades to come.

Indeed, Mark Beeston, founder of London-based venture firm Illuminate Financial Management, is skeptical of those hectoring established financial services firms into quickly adopting internet finance technology.

"By and large, this is a solution searching for a problem," Beeston said in an interview with InformationWeek. "It's exciting and has the potential to have an impact, but there is so much other lower-hanging fruit for the capital markets to address -- such as regulation." Illuminate has positions in four startups that are all aimed at creating efficiencies in the existing financial services technology environment.

He might be reading the industry mood better than technology proponents.

PwC surveyed 544 C-level financial services executives in 46 countries for its report. More than eight out of ten respondents said they were only "moderately familiar" with blockchain technology. Virtually none of them said they felt "extremely familiar" with it.

At least one notable internet financial software maker is taking nothing for granted.

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Startup Digital Asset Holdings cautions on its website: "Assets are not currently issued solely into these distributed networks, and may never be." The company, led by CEO Blythe Masters, who is a 27-year veteran of J.P. Morgan, pitches its software as a way of keeping conventional processes -- which depend on intermediaries -- and distributed networks synched.

None of this back and forth surprises Don Talton, senior manager of platform operations and engineering for credit score service pioneer Fair Isaac Corp (FICO). The organization helps companies spot good and bad credit risks, and sells predictive-analytics services to businesses trying to anticipate consumer trends.

"Financial services is a visually modern industry, but it's still very conservative [operationally]," Talton said in an interview with InformationWeek. Yet his company, best known for its FICO scores, is moving into new markets with deeper data analytics and looking at expanded sets of credit criteria.

Although Talton might be loath to say so, FICO's expansion into internet financial technology could be influenced by the noise of those 700 rapacious startups. Among the better known disruptors facing down the established players are:

While it's worth paying close attention to the startups -- which are backed by respectable, if not spectacular, levels of venture capital and guidance -- usurpers and incumbents will likely coexist, said J. Dax Hansen in an interview with InformationWeek. Hansen is chair of the electronic financial services and blockchain and digital-currency practice groups at law firm Perkins Coie.

"They can't live without each other," said Hansen. Fintech disruptors lack the history and experience of their forebears, but are infinitely more flexible and welcoming of risk. And, to date, they are far less regulated.

"I am employed because of all the regulations," Hansen half-joked. The fintechs can push this technology forward faster. Their end, presumably, would come in buyouts by financial services firms, if not initial public offerings.

Pressure Points

Beyond figuring out how to stay ahead of newcomers, the big players have two imperative technology-related pressure points.

First, executives are very concerned about competitors experimenting with internet finance offerings in hopes of wringing efficiencies out of their operations. For some segments of financial services (such as insurance), cutting operating costs is an executive's best bet for boosting the bottom line.

Second, the financial services industry needs to move away from a model that holds the hands of its richest clients with kid gloves while giving everyone else a dated brochure. The wealthiest command a customer-centric relationship, while everyone else gets a product-centric experience.

Johan Joseph, principal in global accounting firm Grant Thornton, said in an interview with InformationWeek that product-centric approaches made sense during the industrial revolution, when "everything was about big, big, big volumes."

Executives today have to provide -- at a profit -- an experience that feels more universally customer-centric. That kind of approach for lower-income clients starts

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with an assessment of an individual client's needs, and results in customized, integrated products and ongoing service designed to address these needs.

Squaring that circle may prove impossible, but internet financial technology might at least come close to achieving "the economics of specificity," Joseph said.

Blockchain: A Rising Star

Blockchain technology has been rapidly upgraded from an oddball idea in the financial services industry to one that's in vogue.

Digital shared ledgers already exist on financial networks, but as a rule, the networks are centralized, with topologies making it easier to scam or otherwise disrupt the networks because there is one potential point of failure. The central computer verifies all transactions on the other nodes. Among banks, central clearinghouses are the central nodes.

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The blockchain was conceived as a nearly real-time, secure infrastructure for transactions in the cryptocurrency bitcoin.

Blockchain setups are decentralized and often geographically distributed (the bitcoin network is both). Crucially, all blockchain nodes on a network run identical consensus algorithms, which are used to verify shared data independently.

It generally works like this: Each network node continuously records transactions in tamperproof data blocks. Average block sizes fluctuate, but they have been reaching just shy of one megabyte, according to software vendor Blockchain Ltd.

Periodically, a block is shared among all of the nodes. Running consensus algorithms, each node judges each transaction of a block. A basic function is making sure a customer has not tried to complete multiple transactions with the same money.

If a majority of the nodes' consensus algorithms validate all of a block's transactions, all nodes accept the block, adding it to their ever lengthening chronological chains. Rejected or duplicate transactions are discarded.

Updates can happen in milliseconds.

[Even the best intentions can go horribly wrong. Read 10 Ways to Doom Your Next Mobile App.]

A person with nefarious intent cannot use a single node to change the rules governing the blockchain because the rest of the nodes would invalidate the move.

Swiss banking monolith UBS, part of a 40-bank blockchain consortium experimenting with the technology, signed a contract in June with Andreessen Horowitz-funded services startup Ripple Labs to adopt the new technology for cross-border settlement of payments. UBS also presented a whitepaper at this year's World Economic Summit in Davos, Switzerland, that points repeatedly to perceived blockchain opportunities.

The potential uses for blockchain technology sprawl beyond banking.

In a 2015 report, Goldman Sachs Group said blockchain technology's inherent security, speed, and disintermediation capabilities will have far wider implications. According to the report:

From banking and payments to notaries to voting systems to vehicle registrations to wire fees to gun checks to academic records to trade settlement to cataloguing ownership of works of art, a [blockchain] has the potential to make interactions quicker, less expensive and safer.

Voting -- one of the examples cited in the Goldman Sachs report -- may sound unlikely, but it is apparently being considered by Moscow government officials. They reportedly are looking into blockchain-supported voting as a way to eliminate ballot fraud.

Equity trading is a more obvious blockchain use, and it's being investigated by financial services companies. Using blockchain, multiple parameters can be automatically monitored and, when the agreed-upon condition arrives, the trade is made and payment flows, all automatically.

J.P. Morgan Chase in February partnered with Digital Asset to investigate how blockchain technology could make settling securities and fund transfers less expensive and complicated. Investors in Digital Assets include J.P. Morgan, Citibank, Accenture, IBM, and Goldman Sachs.

In May, The Wall Street Journal reported that the Nasdaq stock exchange had begun experimenting with a blockchain infrastructure for trading shares in private companies. The Journal has also chronicled blockchain investments made by the New York Stock Exchange, influential trading-services firm DRW Holdings, and Goldman Sachs.

Enabling Smart Contracts

Even the typically staid insurance industry is giving blockchain a look.

Allianz SE, a German financial-services firm specializing in insurance, succeeded in its first blockchain experiment, which was conducted in June, said Richard Boyd, chief underwriting officer of the company's risk-transfer unit, in an interview with InformationWeek.

Working with investment-management company Nephila Capital, Allianz created a smart contract -- a blockchain contract app that executes itself without human intervention -- for a simulated insurance transaction. Allianz said in a prepared statement the test "significantly" simplified and accelerated the process compared to manual, paper-based transactions.

The simulation involved an esoteric but comparatively simple transaction called a catastrophe swap, or cat swap, in which the insurance risk of a catastrophic weather event was sold to a third party. A smart contract with standard stipulations and coverage triggers was created, and the claim was settled autonomously after a (thankfully) fictional hurricane hit Florida.

"Our aspirations for whether it would be a success were fairly low," said Boyd. Any conventional policy has multiple levels of intermediation, and in this scenario all of them were eliminated.

"We in the industry are in a bit of an arms race," he said. "The pricing of [policy] contracts across insurance has been stripped back to minimal margins." Cutting costs through greater efficiency is standard operating procedure today, according to Boyd.

"We'd like to try it again," he said about smart contracts. Boyd is considering perhaps experimenting with life insurance policies, which are generally simple, objective contracts. There is little room for interpretation about when to pay on a life-insurance policy.

From there, it gets more complex very quickly when scenarios such as auto insurance claims are considered.

"A lot more thinking needs to be done," Boyd said, before smart contracts can be successfully deployed for auto liability. "Auto has whole levels of claims actions" with copious opportunities for subjectivity, he said.

Predictive Analytics: Room for Growth

Putting a focus on analytics in a discussion about new technology might be a head-scratcher for a lot of people. Businesses have been combing through ever-larger data stores since the internet boom. Yet swaths of the financial services sector have only recently tried to pull deep insights out of big data.

Executives are looking for more and more kinds of data in order to judge a potential client's upward financial mobility, because they need more customers. FICO's load-bearing product, the FICO score, judges an applicant's creditworthiness based on his or her borrowing history, but even that company has begun looking into more specific data, said Talton.

FICO has been working on a service that digs through databases for information that could help a retailer, for example, decide on

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issuing a credit card to someone with no credit record. Without a credit history, a consumer has no FICO rating.

The new service gathers a consumer's history of paying utility and phone bills, along with how often they change addresses, in order to produce what it feels is a reliable credit picture.

That is far from the most exotic of "alternative" credit metrics that companies -- particularly fintech startups -- are pulling from big-data stores.

SharedLending, founded in 2013, asks credit applicants 37 questions, including how many steps they take daily. Other internet lenders are plumbing applicants' social media presence and their use of punctuation. One yearling, Cignifi, records how much time someone uses their mobile phone.

Not all financial services are deploying such innovative (and, to be candid, kind of creepy) Internet finance technology.

David Gumpert-Hersh, vice president of business analytics at $4 billion Wescom Credit Union in Anaheim, Calif., oversees data-analytics programs that find insights in the information customers ordinarily provide a financial-services company, combined with their account history.

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"Wescom built an analytical platform," Gumpert-Hersh said in an interview with InformationWeek, "that probably should be used by everybody in the firm to collaborate on the end goal: advancing our members' financial well-being." Although he did not say as much, the platform would also likely be used to improve its balance sheets.

"Do you know how you get preapprovals for loans in the mail?" he asked. "They're not really preapprovals." They are enticements to apply for a loan, for which a consumer may not be approved after filling out the forms.

"We send out actual preapprovals" based on insights gathered by Wescom's homegrown analytics application from its non-cloud big data stores, said Gumpert-Hersh. The marketing program began in 2011, about three months after the economy had bottomed out, which would demonstrate a high degree of confidence in the technology.

Gumpert-Hersh declined to give specifics about available data points collected to judge his members' creditworthiness, though he did say the credit union's average losses have declined compared with what it was experiencing in 2008.

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For example, he said, 60% to 70% of the firm's consumer car-loan business comes from preapprovals, a figure he said compares well across his industry.

"What is starting to emerge is a notion of being able to match assets and liabilities of a household on an ongoing basis," said Joseph, from accounting firm Grant Thornton. "In the past, that would have been onerous and challenging." An understatement to be sure.

Joseph said robo-advising, in which bots interact with clients to find the optimum products for them and the vendor, "is one piece of the puzzle." The goal is to have continuing conversations involving automation or person-to-person interaction supported by automation.

Joseph is optimistic about the near-term spread of internet finance technology.

"What's the issue at hand?" he asked. "We see Baby Boomers entering the retirement and savings space." They and much of the rest of the population have low savings rates.

"Financial-services firms as a whole have a lot of products that can help people save. The challenge is people are overwhelmed by the choices and decisions they have to make, and there's a general distrust of large financial institutions," Joseph said.

Internet finance technology can better deal with the millions of impacted people, and vendors are increasingly interested in selling from a customer-centric stance, with rafts of related products that address the needs of every individual.