The financial services industry has proved remarkably resilient to change. Major innovations, including the introduction of credit cards, ATMs, online banking, hedging, new financial markets and so on have been adopted by the larger and older institutions with few problems. New entrants such as Paypal and Egg have been accommodated. The finance industry has been protected because the capabilities that are the bedrock of the industry - trust, economic knowledge, capital management, risk management, capital distribution etc. - have until now been better incarnated in large, integrated organisations like banks. However, this could be about to change as IT technologies become good enough to allow some of these capabilities to be disconnected and redistributed in ways that the industry could find it very difficult to defend against. To understand where vulnerabilities might exist it is necessary to look at where the financial service delivers value, its cost structures and its value system. New business models and new technologies that could form the basis of new business models must be evaluated to see if they can meet the criteria for disruption. For managers in technology and business units, this is a key issue.
The rest of this article is rightly focused on best practice and methodology for the deployment of technology. This article serves as a warning shot across the bows that insufficient attention and lateral thinking about new innovations could lead to disaster whereas historically such innovations have led only to minor annoyance. The underlying value proposition for the financial services industry is to manage, distribute and lend assets and to redistribute risk. Banks create wealth through capital lending to consumers and wealth-creators. Other financial companies act as intermediaries in what is often a zero-sum game. Some clues to where technology-based disruption may come from are given by Betfair, which has provided a platform where, for a small fee, gamblers may bet against each other and the odds are set by matching of bets. In traditional gaming the gamblers bet against the bookmaker and the bookmaker carries the risk of losing heavily in some events. The bookmakers set odds that allow them, on average, to make sufficient money to carry on the complex operation of betting. Betfair, on the other hand, does not get involved in the risks of gaming and makes a very good living from merely providing the platform. This means that more attractive odds can be found on Betfair, and the platform is causing considerable disruption to the traditional bookmakers' livelihood. Betfair and others are now moving into the spread-betting part of the financial market where they may cause a similar disruption. Zecco.com is an online financial portal and community where investors trade stocks for free.
Zecco has attracted executives from Brown and Co. and E-Trade with its zero-cost concept. Zecco is a lot more than a trading platform, it is a community for the exchange of ideas and information about shares between the shareholders. Zecco makes its money from interest on margin balances, the interest on deposits placed by traders (a minimum balance of $2500 is required to get free trading) and from commissions on premium brokerage products like options trading. Like a lot of disruptive startups Zecco does little marketing, preferring word-of-mouth to acquire new customers. This is using the power of networks to create its market, and provides something of a natural limit on competitors because word-of-mouth marketing favours the largest. Low-end unsecured lending will also be a target for entrepreneurs. Person to person lending is a new development in lending that takes investments from individuals of any size and provides small unsecured loans. In one example, Zopa the business model is a marketplace with Zopa taking a fixed fee for arranging a loan. It takes deposits from lenders, with interest rates being set by the lenders and with no level of return being guaranteed. Borrowers are credit checked. The service distributes the risk of each loan across many lenders and pays interest to the lenders based on the overall income. Defaulters are chased by a collections agency whose cost is borne by Zopa. Lenders' money, when not lent, is retained in an escrow account. As these systems are markets, not banks, this is a potentially disruptive model. The reasons are by cutting out the middleman the system promises lower interest rates to borrowers and higher returns to lenders if they actively manage their lending.
Zopa is a product that redistributes risk. Entirely in line with the rest of the financial system, the lender accepts a higher risk in return for higher returns. A Zopa lender runs the risk of individual defaults, even if these are low, and is also exposed to systemic risks which could, in the worst case, see the loss of their entire stake. A bank depositor is only exposed to systemic risks affecting the rate of return on their deposit, with the deposit itself largely protected by the banking systems. Zopa itself assumes no risks except the cost of chasing defaulters, whereas the financial system owns the entire risk of its loans. It remains to be seen whether Zopa and its peers are able to step up towards collateral-backed or mortgage lending. There are no technical obstacles to Zopa offering an increasingly sophisticated range of lending products using the same mechanism, offering a wide range of different lending opportunities to those looking for higher returns. Betfair, Zecco and Zopa and their peers are all disintermediators. They replace a financial intermediary with an automated matching system and are happy to accept much lower fees in exchange for higher volumes and, most importantly, no share of the risk. As the rewards are volume-dependent, as these businesses scale well and as the platforms are essentially interchangeable these new players are likely to consolidate quickly with the most successful operator buying other successful operators and the weakest failing.
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Note: This article was sent to us by: Mike G. at 01182010
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