# Fintech Overview

NOT for quotation

Date February 26, 2016 Louis J. FORSTER (General Partner, Green Visor Capital) / Sam WEN (Venture Partner, Green Visor Capital) MATSUDA Naoko (Fellow, RIETI / Assistant Professor, Policy Alternatives Research Institute, the University of Tokyo) 12:15-13:30 (Registration desk and seminar room open at 12:00)

## Summary

### Introduction

Louis J. FORSTER

Fintech has recently become a buzzword and is attracting quite a lot of media attention. The reality is somewhat different, though, and not as exciting as one might think. About 15 years ago, I gave a speech to the senior members of one of the Japanese ministries. After the speech, the feedback I received from the organizer was that it might not have went over so well. I had been talking at the time about the problem of bad debt in Japanese banks, and the organizer did not have a positive opinion about my talk because I did not reveal any secret solutions. I answered that there are no secrets. The same is true of fintech. There is only hard work to do. There are no secrets!

It would be useful to define fintech. Fintech is simply the disintermediation of existing business platforms in the area of financial services. Venture capital attempts to disrupt business models. For example, Uber Technologies, Inc. disrupted the taxi business. Fintech seeks to disrupt financial services. There is nothing particularly unusual or difficult to understand about fintech; there are no secrets. It is true that sometimes the underlying technology can be difficult to understand, but the problems and solutions are generally simple.

Sam WEN

Green Visor is a fintech-only venture capital firm headquartered in Silicon Valley. We only invest in early-stage companies involved in fintech-related work. We have five themes for our activities at Green Visor. The first is next-generation banking and insurance: what does a bank do and how can it be done less expensively? The next is payments: Bitcoin has received a lot of news, but there are many other potential ways to disrupt the existing payment systems. The prize for this is huge. The cost of payment systems in modern society is high. The third is asset management: the way financial assets are held and organized tends to be expensive and difficult (broker statements, financial advisors, multiple accounts, etc.). The fourth is information services: all of fintech is a subset of information technology (IT), but in this case, what is specifically being pointed out relates to how information is distributed in the financial services world. Bloomberg L.P., for example, has 375,000 terminals on desks around the world. The cost is $25,000 per terminal, and it does not give discounts, earning them 900 billion yen in revenue. Everything available on the Bloomberg terminal is available somewhere else for free. You are buying the convenience of information aggregation and brand value. How much of that is brand value and how much is aggregation/convenience? Many startups are challenging that model by providing some or all of that information at very low cost or even for free. The fifth and final theme is other financial software: much of this is software designed to help a bank, insurance company or investment bank conduct its business activities; the heating, ventilation, and air conditioning (HVAC), so to speak, middle and back office operations. How can companies reduce their dependence on legacy systems, which are extremely expensive to maintain, and perhaps gravitate toward something cloud-based and hence cheaper? Here is a good example of an emerging software solution: since the financial crisis and the increase in global terrorism, every financial institution is facing tougher regulatory constraints in terms of customer identification and prevention of money laundering. A bank might enter a name into a Google search, determine whether the person is clean, and then file the determination away with no dynamic updating. However, improvements in data science allow for software that enables continuous, dynamically updated customer identification and money laundering prevention. When something happens, the bank is alerted that there is a problem. This is a situation in which regulators are more advanced than banks. The regulators know about this particular software solution and, in the United States at least, are pushing the financial institutions to adopt. ### Current technological trends Some of the following technological trends underlie the specific definition of fintech. The mobile phone is the first. The smartphone becomes the bank branch in the way that people buy and sell stock or look at their brokerage accounts or check on any kind of financial information. There has been a rather rapid conversion to mobile platforms. The second big trend is the migration of functions to the cloud. The entire back end of the bank or insurance company migrates eventually to the cloud. The third is what we call automation of the analyst. Analysts do research, but that can be done now using software with artificial intelligence and machine learning. The emerging technologies read millions of documents in a very short time, assemble and compile it into reports, and eliminate the early stages of a research project. More sophisticated analysts can focus on a much better defined product. Fintech is reducing the role of the broker. An easy example is initial public offerings (IPOs). In the past, investment banks were able to charge 6% or more of the proceeds sold to the public. Now, by crowdfunding or distributing equity privately, a company can reduce distribution costs and grow with no IPO. There are great pressures on brokers now. Real estate commissions are coming down because buyers and sellers can meet on the internet. Finally, big data has been very influential. An institution knows its customers are being revolutionized by the prevalence of data and the institutions' ability to analyze it. Research tools are used to understand customers and poach them from competitors. ### Reasons for fintech boom We think there are several reasons for the boom in fintech. One is the smartphone and the power of it. One smartphone has 25,000 times more memory and speed than the best technology from 60 years ago. There has been a several-million fold reduction in cost in terms of money per MHz. It has penetrated through society so today everyone can have their bank branch on a mobile device. Foot traffic to Japanese bank branches has been declining month-on-month for 10 years in a row. Another reason for robust activity in fintech is the regulatory problems for existing financial institutions since the financial crisis. U.S. and European banks especially were hammered by the regulators. Fintech startups that can do something that a bank does without falling under the same regulatory regimes have a big cost advantage. Banks, insurance companies, and financial institutions are also suffering from IT spending. They have to maintain their legacy systems. Worldwide, the largest financial institutions are making outlays of$300 billion-$350 billion per year for IT spending. Unfortunately, most of that is not for new technology but to maintain legacy systems. The financial crisis itself damaged consumer sentiment regarding banks. They are scared of banks and continue to look for alternatives. Regulators and consumers are forcing financial institutions to disaggregate. Also, young people do not like banks and do not think about them in the same way as their parents do. Millennials also do not use credit cards in the same manner as their parents. Another reason is that it is huge. The top 100 financial services companies in the world comprise eight trillion yen in market capitalization. The financial services sector is 20% of the Standard & Poors (S&P) 500 index in the United States. The Goldman Sachs Group, Inc. estimates that$500 billion in annual profit is at risk from new players in financial services. That's a very large market for these fintech startups to focus on.

One example is remittances. Small-balance remittance, meaning transfers between countries of $1,000 or less, totals about$1 trillion per year. The current cost of such transfer, e.g., the revenue earned by Western Union, etc., is between $50 billion and$75 billion, or 5%-7%. That makes no sense. That is just one sector within fintech where advantage can be had. To use an analogy, imagine that someone here wants to sell his or her condominium. The broker must go and see the place, spend time, show it to the buyer, the buyer says no, they show it again, it takes time, and the cost is 5%. You go to Western Union and transfer money, and it presses a button and receives 5%. That very large distribution cost in combination with rapid increases in technology will get a lot of attention.

We are just at the beginning. We think the transition will take 10-20 years. The earliest successes will be in something like the plumbing in the bank, where the bank knows it has a problem with a legacy system, and it is easy to demonstrate the benefits of a new alternative, etc., but changing consumer sentiment will take more time.

### Fintech success stories

I would like to mention some actual companies achieving some success in fintech that have potential applications in the Japanese market. The first is Kash, a closed-loop payment system. It does not involve credit card companies. The total cost of paying with this method is effectively zero. Suica is roughly 3%. With Kash, you download the application to your smartphone. You buy a coffee for 250 yen, go to the Kash application, and it gives you a QR code on one tap. Show that to the merchant, he captures it, and the transaction is done. The exact route in the United States would probably not work in Japan, but the main point is that mobile devices can eliminate point of sales (POS) equipment and credit cards, creating a closed loop with almost nonexistent settlement costs. For a café owner who might be paying as much as 5% to credit card companies and for POS equipment, this would be a huge change.

Another company is FiscalNote. Compliance is a huge problem for financial institutions all over the world. It's an even bigger problem in the United States, which has both federal and state laws and regulations. FiscalNote automates the process. Every national law and regulation and those of all states and even municipalities are online and automated. If you enter a keyword pertaining to a specific compliance issue, you get a list of all the laws and regulations in every jurisdiction, changes to them currently being proposed and the probability that those changes will pass. Toyota Motor Corporation is one adopter.

Cloud Lending migrates lending to the cloud. The customer has a user interface, enters his or her data, and it goes immediately to a loan administration system in the cloud.

### Q&A

Q1. I would like to ask about ways of demolishing legacy systems. Do we need an additional negative impact—some other important factor—to replace them? How can we do this?

Louis J. FORSTER
It is very hard. We think banks will find specific business units or functions, and, piece-by-piece, portions of the general ledger will go to the cloud. But it is very hard to simply replace the legacy systems. The banks will be under enormous pressure to do it. Non-bank and non-financial institutions do not have the regulatory or legacy cost problems, and they are becoming very important in the provision of financial services. Alibaba Group Holdings Limited is doing a money market fund like a deposit account. It doesn't have deposit insurance, but it only buys government bonds, so does it need deposit insurance? In a very short period of time, it attracted the equivalent of \$100 billion.

Q2. Fintech is a huge element, that is, disruptive innovation. Do you think it can lead to breakthroughs in the reduction of cybercrime, money laundering, etc.?

Louis J. FORSTER
I'm somewhat pessimistic. It's like the germ theory of disease. We have known for hundreds of years what makes us sick, but we still get sick. Cybercrime is very similar. I don't think we can hope for an end to data breaches. But let's talk to a security expert.

Sam WEN
I agree with Louis Forster's sentiments. Knowing what I know about computer security, we are never going to be able to end it. The general notion is to reduce the amount of surface area exposed to attack. That is one method, from a technical perspective. The [Sony] PlayStation 4 was hacked to play pirated software. It was a very sophisticated attack. Knowing that these types of attacks are out there, there will be no end to the need for security measures and highly-trained security staff. New technologies will help prevent attacks from succeeding, though.

Louis J. FORSTER
Another analogy would be any kind of munitions-based warfare, which results in mutual escalation in the types of weapons employed by both sides.

Q3. Fintech is most related to open rather than closed networks (such as ATMs). Open networks by their nature are more exposed to attacks, which makes financial authorities cautious about introducing fintech. What can be done?

Louis J. FORSTER
The U.S. authorities are very concerned about it, but they look at the rise of e-commerce despite huge data breaches. Regulators are focused on it, but its prevalence does not seem to be impeding the growth of e-commerce or e-banking. It seems that the amount of actual theft from people is going down as we develop as a civilization. I wonder whether that is true. I think it must be.

Sam WEN
Security is also an interesting discussion because it is usually a response to something. People don't want to walk to a bank branch; they want to do it on their phone, which is why we have the functionality we have today. That must also be taken into consideration.

Q4. You mentioned that young people don't like to go to the bank. Why? Where do they save their money? What would your advice be for people working at banks or law firms whose jobs could be eliminated by fintech?

Louis J. FORSTER
Young people don't have a lot of money so they don't need a bank account in the same way that an older person would. They can keep money in an electronic wallet or with a large vendor. They transfer money to their friends using Venmo or other electronic means. Lawyers should not have problems. Bankers are a very difficult social problem, very acute in Japan, where every region has a regional bank and hundreds of branches, and the branch manager of each makes a nice living. They are a strong element in that community. That's a very big social problem. I don't have an answer for what should be done about it, except that we have to face the problem. There are going to be a lot fewer branches in the future.

Q5. What are the characteristics of fintech innovators? Are they mostly financial-related persons?

Louis J. FORSTER
To paraphrase Sir Isaac Newton, no one invents anything without standing on the shoulders of many other people. The man responsible for building Kash didn't do it all by himself. He is actually a lawyer who worked at a law firm specializing in payment systems. Who is attracted to fintech? Of course, engineers, who build the technological stack that makes these companies possible; former regulators, who have thought about these problems and join someone with technological skill; lawyers; bankers, people from all fields. What unites the enterprise is the engineering talent.

Q6. I am interested in where fintech innovation is occurring. Everyone talks about Silicon Valley, San Francisco, and Singapore, but no one is talking about Tokyo. What do you think about the differences between these cities?

Louis J. FORSTER
The big centers are Silicon Valley; you could say San Francisco, Singapore, and London. Not much is coming out of Tokyo. I don't know why. There is very good engineering talent in Tokyo. Tokyo has excelled in materials and pharmaceuticals. We visit Japan eight to 10 times a year. People are investing and interested, but there is not a lot of investment opportunity here.

Sam WEN
One point I read which might be inaccurate is that Japan is not a prime location because of cultural restrictions on startups in general.

If there are no more questions, I would like to talk quickly about Bitcoin and the blockchain. I didn't get any questions about Bitcoin, which is rare. Bitcoin is important because it is a very interesting software solution to a money problem. Currency is a piece of paper which can be lost and destroyed. It is possible but very hard to lose Bitcoins. Underlying it is the blockchain. Everyone is talking about it; NASDAQ wants to make a blockchain, but not many people understand what it is. It's a distributed ledger. There is no central authority. Imagine that you are a mayor of a small village. Instead of the books being kept by you, anyone in the town can put an entry into the ledger, but at least half of the town has to agree that the ledger is correct. That's inefficient. The authors knew that, but they wanted it because the tradeoff was trust: they never wanted a central authority to have control of the ledger. When we hear about a company wanting to adopt a blockchain, it doesn't make sense. If the central authority is working, distributing the ledger to the participants is messy and inefficient. Bitcoin itself is inefficient. Bitcoin is not a good medium of exchange because the distributed ledger slows everything down. We do not see it as very interesting in terms of a fintech investment until it can be made to be faster and more efficient.

*This summary was compiled by RIETI Editorial staff.