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Fintech: Disruptive Technology Or A Flash In Pan

|Includes: AXP, BABA, DFS, LendingClub Corporation (LC), MA, MGI, SCHW, SQ, TCEHY, V, WU

The past six months have seen significant developments in the fintech space across the world. In a speech in November 2015, Antony Jenkins, the ex-boss of Barclays said that banks will experience a painful "Uber" moment where big banks will face up to 50% reduction in headcounts and 60% reduction in profits in certain areas due to disruptive fintech. He named startups like Lending Club (NYSE:LC), Funding Circle, Square (NYSE:SQ), Nutmeg and TransferWise as potential disruptor.

In February 2016, Chinese P2P lending company eZubao, which attracted $7.6 billion from over 900,000 investors, was revealed to be a Ponzi scheme. The company was shut down and 21 individuals were arrested. The collapse of eZubao sent shock waves through the then largest P2P lending market in the world, as the authorities started to crack down on P2P lending. Following the announcement of tougher regulations for P2P lenders by the CBRC in December 2015, the PBOC announced in March 2016 that P2P lenders can no longer lend money for property downpayments. The impact of the crackdown can be felt as P2P lenders vacate their porsche office locations.

Across the Pacific, the founding CEO of US P2P lender Lending Club, Renaud Laplanche, resigned in May 2016 amid scandals over loan alternations, falsification of documents when selling loans to investors, and the non disclosure of a stake that Laplanche held in an investment fund that the Lending Club was considering to purchase. As the time of this writing, the Lending Club appears to struggle to sell loans to investors, as a number of institutional buyers halted loan purchase from the company. With 20/20 hindsight, Antony Jenkins probably spoke too soon.

We do not believe that all fintech companies are created equal and we broadly classify fintech companies into two camps - transaction-oriented companies that do not make capital allocation decisions on behalf of their customers, and capital allocators that do.

The first camp of fintech companies, the transaction-oriented ones, acts as a platform to enable transactions between parties and have no discretion over the allocation of capital. In the traditional world, these would be credit card processors and stock brokers. In the fintech world, examples of transaction oriented companies include Square, TransferWise, WeChat Pay (SEHK:700), AliPay (NYSE:BABA). So far, transaction oriented fintech companies have achieve considerable success in terms of business volume. For example, Square achieved $35.6 billion in gross payment volume in 2015, representing a 50% y-on-y growth.

We do not believe that all FinTech companies are built equal, and we broadly categorize FinTech companies into two camps - transaction-focused and capital-focused. In China, mobile payments reached US$2.8 trillion in Q3 2015, with Ant/Alipay and WeChat accounting for a combined 89% of the market. What is interesting to note is that in the same quarter, banks saw US$86 trillion of e-payments transactions, which means banks are also beneficiaries of online payments. Who do these disruptor impact then? We believe they impact credit card companies like Visa (NYSE:V), MasterCard (NYSE:MC), Discover (NYSE:DFS) and AmEx (NYSE:AXP). Companies like TransferWise might also give the likes of Western Union (NYSE:WU) and MoneyGram (NYSE:MGI) a run for their money. But to cause banks to cut 50% headcounts and lose 60% profit? Probably not.

The second camp of fintech companies are the capital allocators that seek to replace discretionary capital flows. These camp of fintech companies have potential to disrupt traditional financial services companies like banks, asset management firms and even alternative investment firms like hedge funds, private equity funds and venture capital funds. As we have seen, without proper regulations and controls, capital allocators are susceptible to abuse and fraud, as in the case of P2P lending in China. Let's assume for a moment that there is sufficient control and integrity in the system and look at the business models. Prior to the scandal, the Lending Club has performed reasonably well for its lenders, primarily because of the availability of individual credit scores, i.e., FICO (NYSE:FICO) Scores. This means that the work of evaluating a credit worthiness of an individual is essentially done for you. Then there's Funding Circle, which takes the idea a little further: consumer-to-business lending, and uses an Experian check for the borrower. This is where we think it breaks down. When banks lend money to corporations, it is often quite a rigorous process, which includes leveraging banking networks to check on the reputation of a company, management interviews, site visits and other due diligence exercises. This part of the equation is more art than science and requires significant experience for a proper gauge. Leaving consumers to judge the credit quality of a corporate is a risky proposition.

Another class of capital allocators that have surfaced in the industry today are robo-advisors - computers that make portfolio investment decisions on behalf of the individual. Wealthfront and Betterment are the two leaders in this space, with Schwab's Intelligent Portfolio (NYSE:SCHW) and Vangard's Personal Advisor Services quickly catching up. The proposition is elegant - computers algorithms which are 100% objective and not subject to human emotions such as greed and fear, will make the best investment decision in the long-run. Robo advisors also have the advantage of being much lower cost than financial advisors. Many, if not most, robo advisors are based on the modern portfolio theory (MPT), expanding the theory to include multiple asset classes - which is made possible by the emergence of low-cost ETFs such as GLD and SLV. Theoretically, you can take the concept further by leveraging ETFs for different stock market indices such as Hang Seng Index (SEHK:2833), Nikkei 225 (TYO:1329), and FTSE Europe (NYSEARCA:VGK). The Black-Litterman model is often utilized in robo advisor implementations. In essence, robo advisors are a fund flow of well-balanced ETFs. Not a very risky proposition, but not a very creative one either.

In summary, we have not seen any "Ubers" in the capital allocators camp. In the next article, we will look at fintech in the alternative investments, and we will examine whether fintech can be a disruptive force in the lubricative 2/20 (2% management fee and 20% performance fee - a norm in private equity and hedge funds) industry.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.