Fintech 🧠 Food - July 24th 2022 - Incentives in Finance, Coinbase Insolvent? Ramp ramps up revenue and why Pix in Brazil matters

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Hey Fintech Nerds 👋

How's Inflationmageddon treating you? 

Fresh from last week's birthday celebrations, I'm back and thinking more about incentives than ever. Can we get incentives right in finance, and if we do, do we end up with a better economy and world?

We could really use that. People are struggling. We need you builders. Do your thing.

Fintech isn't dead. As ramp doubled it's revenue there are still massive growth stories out there and reasons to be optimistic.

I also wanted to go deeper into the rumors about Coinbase being insolvent. The contrast in those two stories feels like this moment in time and felt worth analyzing.

Lastly, this week's Good Read looks at the pragmatic payment system Pix in Brazil. 

Until next time :)

Weekly Rant 📣

Incentive alignment in finance.

Finance is a minefield of bad incentives and bad outcomes. Often the most profitable activity is the most socially destructive. Sub-prime lending with high fees, financing commodities like oil, and taking the other side of a trade where institutions win and consumers lose.

But sub-prime consumers are a higher loan default risk than higher earners, the economy still needs oil to function, and without a counterparty to trade with, we wouldn't have an economy. 

Without banks, we get no schools, healthcare, charity, and no AirPods. 

So is that it? 

We just accept that if we want to offer an opportunity to people on lower incomes, we must give them a higher mountain to climb? We assume that the world needs oil if we want AirPods, and the consumer always loses in markets? 

I think both things are true

1. Finance obeys universal laws we can't ignore

2. But we can do better if we understand the incentive structure

Therefore the trick will be to better align outcomes between the buyer of financial services and the seller. 

On some level, they are aligned.

Providing financial services over the long term requires sensible risk management (i.e., Not lending to people who can't afford to repay). Sensible risk management means an organization gets to stick around and get bigger. Organizations that stick around and get bigger build an ephemeral quality called "trust." 

And this "trust" is what bankers talk about as their USP.

They're regulated, they're big, and in theory, they're sturdy. 

But trust can't just mean being a rational lender and pricing for the financial cycle if we want to do better.

We have to get on our customer's side and actually help them.

To me, that's why we're all here.

So take a walk with me as we explore

• Existing pricing and fee structure dynamics

• The rise of hidden fees and predatory lending

• The measures create the incentives

• The rise of Fintech companies

• An argument for why finance will always revert to the mean

• And what incentive game dynamics we can play with

Banking and finance pricing dynamics.

We can unpick the incentives if we understand the dynamics from first principles. 

If we take the three core functions of finance (store value, move value, lend value), each has its own pricing dynamic but is also linked.

To store an asset for a customer means you have to protect that asset; this could be as simple as a vault for jewelry or as complicated as providing accounts for multiple currencies and asset classes. The risk is that an attacker might steal that asset, and you'd have to potentially make that customer whole. 

Yet typically, most organizations will pay (in the form of interest) for the privilege of storing a customer's asset. Because when you deposit your cash at a bank, you're really lending to them. And they can use your money to fund other activities (like lending, payments, and more).

Banks have an incentive to attract as many deposits as possible. It fuels their growth. 

Moving an asset also carries a cost. Moving cash requires physical security to move that cash without being stolen, and digital payment infrastructure requires integration with countless payment types. Many things can go wrong with payments, like a sender not having sufficient funds.

Most payment types have an associated fee (whether you, the consumer, pay that or not is another matter). Card payments are paid for by merchants, while international payments are paid by whomever the sender is. These fees pay for the cost of running the infrastructure and managing the complexities when something goes wrong. 

Banks have an incentive to manage as many payments as possible as a source of revenue and growth.

To lend to a customer, you have to price the risk of that lending. Advancing cash to a consumer or business is a minefield of things that could go wrong. Is the lending going to the right person? Can this person or company afford the lending? And crucially, are they likely to pay back the loan? With every loan a lender makes, they will win some and lose some, but the rate they charge for lending should be enough to cover any losses, the cost of running their business, and still make a profit.

Loans are usually priced as a % of the principal in APR or APY. e.g., If you borrow $1,000 at a $10 APY over 1 year, your repayment should be $1,100. Loans can be secured (with collateral like a house) or unsecured, and they can be over a fixed term (e.g., 1 year) or revolving (like a credit card that re-sets monthly).

Lenders have an incentive to lend at a high APY but must find a balance between who can afford to pay and the competitors who could undercut them on prices.

These three incentives combine into a flywheel.

Store more deposits, move more money (and collect that fee), and be allowed to lend more. Over time, learn what is good credit and bad credit, and grow trust.

The business model has a rational and historically socially useful set of incentives.

So why all the fees?

The risk of hidden fees and predatory lending.

If finance were that simple, we'd have no predatory lending or hidden fees. But we do, so how come they get to exist?

• Fees as a way to drive revenue: Over the past two decades, the core business of banking has become less profitable as the costs of being regulated and running technology infrastructure have increased. FI's have tried to recoup some of this by introducing fees for things like unarranged overdraft usage. The rational argument is if a customer is creating more risk or cost, they should pay for that. 

• Predatory lending: Consumers in the most financial difficulty will always have a high demand for lending. Lending can be a lifeline for a consumer just trying to make rent, but revolving debt like credit cards can also be a trap and a vicious cycle that worsens problem debt. The rational argument is that the risk is priced in, and those who pay back can use these products effectively.

Over the short term, these rational decisions make sense, but over the long term, they damage the trust and brand an institution has with its customers.

Payday lenders and loan sharks come and go and are often weeded out by regulation, public opinion, or both. This is why often large banks don’t do predatory lending (if anything, they’re more likely to shy away from low-income consumers), but they often have plenty of hidden fees. Their business model benefits from customers in problem debt.

But if we go back to the core USP: Banks and large institutions have sticky relationships with their customers because they have trust. That trust is eroded by a business model that benefits from catching customers out.

Customers are now willing to adopt Fintech apps and services because that trust has eroded. And it eroded from decision making by spreadsheet.

What works on the spreadsheet doesn't always work with humans.

The measures create incentives.

Goodhart’s law states

There are perhaps no organizations more obsessed with spreadsheets than large financial services companies. In many cases, this is a very good thing. We want detail-oriented organizations to make rational decisions.

But I think we’ve swung too far the other way, especially after the Financial Crisis; large banks became obsessed with one metric (as did analysts and shareholders).

ROTE. 

Return on Tangible Equity describes the return generated by money shareholders invested in the company. It becomes a rule of thumb measure of how well a lender or bank manages its costs, balance sheet, and lending activity compared to its peers, and you'll often see it cited in reports. 

Large banks will generate a "ROTE" anywhere between 10% and 15%, while some niche banks can deliver 20 to 25% but with much lower overall revenue. 

Fees are a great way to drive up ROTE.

And drive away customer trust.

The rise of Fintech lenders

The first wave of Fintech lenders from ~2010 (SoFi, Prosper, LendingClub) initially targeted market gaps left by banks, who had exited unprofitable consumer lending segments after the financial crisis. 

Banks exiting left small businesses and consumers demanding lending but with little supply. And so, initially, these lenders found they could drive revenue by selling lending to an underserved segment.

Through the next decade, these lenders struggled to scale and build a balance sheet because they didn't have the cheap funding source the banks did (deposits), and customers' ability to repay changed over time (credit risk is related to the economic cycle). 

Many of those organizations are now banks themselves. 

The next generation of Fintech companies is now experimenting with their lending. We credit builder cards built on open banking data, cash advances paid for with “tips,” and even “Gen Z focussed credit cards.”

It’s not obvious these products will fare any better than their predecessors.

Although I am hopeful that we can use more data about a customer, we can better understand their risk.

Must finance always revert to the mean?

Finance feels mean.

The rich get richer, and the poor have the highest borrowing rates. It feels unfair, even if it's rational.

The lenders with the largest data set and most deposits get to be the most profitable over the long run, and often that's the big banks. They're like a gradual snowball, getting slightly larger in the short term but compounding in scale over the long term.

That's the way it has worked for centuries.

Because the regulator can fine you, but the shareholders can fire you.

Apps that just deliver customer value risk delivering no revenue to shareholders.

Businesses that deliver revenue risk delivering ever less value to customers over time.

But could we do more with incentives?

The physics of finance are hard to mess with. Those with the biggest balance sheet will continue to exist. But they also bear the biggest responsibility and opportunity to impact consumer and social outcomes.

The big lenders are best placed to make a meaningful difference to society. But often lack the focus and skill to align the business model to customer outcomes.

Fintech companies are masters of building products to solve customer problems. Perhaps they can play with aligning incentives and use that to grow like fungus in a petri-dish. Alex Johnson gives some really good examples of business models that are driving revenue and customer value in his latest piece here.

Customer outcomes are easy to measure.

The reality is that improving consumer outcomes is not a giant mystery. Good finance advice is generally well known (in the Financial Health Score and countless SubReddits). Compounding, rainy day fund, building resilience, building credit scores. The metrics are there.

So what if there was a prize feedback loop for building products that improved customer outcomes?

Why can't we reward the positive and link that to revenue?

My inspiration here is how ESG ratings work (yes, I know they're gamed, but I'd argue they're a net positive). Stocks that pollute, mistreat employees, or produce adverse outcomes for society typically get a worse "rating" from rating agencies. 

Like diversity on boards, I'm 100% certain we'd see that companies with better customer outcomes also had better financial outcomes.

With lending, if we build someone’s credit score, they might one day take out a mortgage and be super loyal too. They might just be willing to pay a subscription for how much their life is improving.

Can we build the metrics for that that don’t fall prey to Goodharts law?

A credit score shouldn’t be a life sentence.

It should be a lifeline.

And our goal should be to build that.

Let's make finance better.

Let's experiment.

Let's do this.

ST.

4 Fintech Companies 💸

1. Marketwolf - The anti-Robinhood for India 

• Marketwolf offers stock trading and is a direct member of the National Indian stock exchange. Marketwolf does not charge brokerage fees unless user trades end in profit, and every trade set on Marketwolf must have an exit strategy. Marketwolf also offers novice users a practice mode and has seen 2 out of 3 trades make a profit (out of its last 1m trades).

• 🤔 I've been waiting for Fintech companies to align their product incentives with users as clearly as this. Marketwolf only gets paid if its users end in profit, imagine if banks only charged interest or fees if their customers had good outcomes? This is how it's done, people. I really hope we see more of this incentive alignment. Incentives matter. 

2. Fletch - Embedded Insurance API

• Fletch enables digital businesses to create embedded insurance solutions with its API and widget. Fletch providers reporting and behavior data and manage the integration with insurers. Fletch has a wedge with specialist digital pet insurance providers like prudent pet and pets best. 

• 🤔 Embedded insurance hasn't caught fire in the way debit cards and credit cards by non-banks and Fintech companies have. I wonder if that's timing, market maturity, or just not having found that perfect wedge and growth client. Perhaps the best buyer is a Fintech company who needs to drive new revenue from its large user base?

3. Plannery - Debt consolidation for Healthcare professionals

• Plannery auto deducts payments with payroll enabling them to offer lower rates than many debt consolidation providers. Users sign up, add their payroll provider and pay a single fee for credit card debt monthly. 

• 🤔 The payroll APIs are quietly powering a financial inclusion revolution. Debt consolidation always made sense; paying a single interest rate to one provider is better than multiple revolving credit cards at a higher rate. But traditional credit models have limits, and more data often = better outcomes when scoring is involved. PS. Love the tagline, "looking after the financial health of those who look after your health."

4. Cryptio - Enterprise-grade accounting for Crypto

• Cryptio enables organizations to track all of their transactions across DeFi protocols and Crypto exchanges to build a complete picture of digital asset activity. Transactions are imported to GAAP and IFRS grade ledgers, and reporting is then integrated into tools like Xero or Netsuite. 

• 🤔 Crypto accounting is fragmented, varies by jurisdiction, and is just hard. As large institutions, Fintech companies, and even non-banks have gained exposure to Crypto; this accounting problem impacts more than just the industry. Also, if "Digital assets" become how we model all assets in the future, we'll need tools like Cryptio to be backwardly compatible with real-world tax jurisdictions. PS. Cryptio is larger than many of the companies I cover on Brainfood, but it was new to me, so 🤷‍♂️. 

Things to know 👀

1. Fintech isn't dead as Ramp doubles revenue.

• Ramp the expenses card and spend management platform reported doubling its revenue run rate since the start of the year. Ramp also said it's seeing most of this growth come from the enterprise segment (300%), mid-market (55%), and SMBs (22%) growth. Ramp is increasingly aiming to differentiate by automatically helping customers save costs, a boon in an environment with less easy funding available. 

• 🤔 Fintech is still a revenue and growth monster. The mood music around Fintech has been very negative, and public stocks have taken a beating, but how many incumbents would kill for a 2x revenue growth year? Yes, incumbents are profitable, but shouldn't growth companies, you know, grow. 👀. Growth has temporarily lost its attractiveness in public markets. But I'd rather younger companies grow and prove they can hit profitability, but only when growth starts to slow. Wouldn't you?

• 🤔 Profitability still matters, and I wonder if Interchange alone can be a revenue source that gets there? Ramp is putting a lot of work into saving customers money and burning R&D dollars. My gut says they're going to charge for this someday. But also, enterprise tends to spend pretty big, and 2% interchange revenue on larger spend pools is very different from 1% on consumer debit monthly spend. A consumer spending $500 per month vs. a business spending $200,000 a month has an entirely different LTV. 

• 🤔 300% up in enterprise is good but likely from a low base. If they had one enterprise customer, a 3x increase isn't that impressive. But, interestingly, both they and Brex are intentionally shifting up the market. The last 10 years have produced an explosion of VC-backed growth companies, and how many of these would choose a traditional provider over a more modern one? 

• 🤔 I wonder how much switching there is between the major expense cards, or is this all net new business? Are these enterprise and mid-market companies coming from Brex or not having a provider? This is a super competitive environment, but are these companies essentially becoming the everyday operating platform for their clients while most of the venture capital funding sits at an incumbent? My sense is yes. But the battleground is also the R&D speed and ability to save customers money.

• 🤔 The cost story is compelling; spend management in start-ups is free for all. If you have 100-person staff and 2-person finance teams, they're likely just trying to keep up with the last funding round and payroll. This pushes a ton of autonomy to the employee, which is fantastic for trust and letting them get on with the job. But it produces obvious inefficiencies in pricing and economies of scale. The pain is real; pour one out for your head of finance 🍸

2.  Is Coinbase insolvent?

• Coinbase has announced its affiliate program's "temporary closure" and is also closing its professional trading platform Coinbase Pro. This follows Coinbase stock falling 83% from its high of $355 in June 2021. Coinbase laid off 18% of its workforce in June, and its NFT marketplace launch has failed to gain meaningful traction.

• 🤔 Some big competitors like BlockFi and Celcius have experienced bailouts and bankruptcy, so no doubt Coinbase isn't immune to market conditions. Coinbase is still the default regulated on-ramp into Crypto for most consumers. The problem is that no consumers are on-ramping as their disposable income is swallowed by inflation. Coinbase lives or dies by speculation, and that's a massive risk to their business.

• 🤔 Maybe the SEC letter was a blessing in disguise? You may remember Coinbase CEO Brain Armstrong going public about his frustrations with the SEC for threatening Coinbase if they launched a DeFi yield product. Coinbase being a public company, put them clearly in the SEC sights. Coinbase felt it was unfair that competitors like BlockFi and Celcius could launch these products. But BlockFi had to settle with the SEC and suffered dramatically in the market fall. If Coinbase is struggling now, imagine if they also had gone full Degen with their lending? 

• 🤔 Coinbase is effectively ceding the professional trader audience to FTX. Professional traders are in the market whether the price is up or down, which is a market FTX has comfortably. It makes sense for Coinbase to cut off the bits of the business that aren't driving meaningful profit and value, but it's also preventing them from diversifying. And they need to diversify from speculation as a feature. Catch 22. 

• 🤔 Coinbase still has the best UX in the business for consumers, massive brand equity, and has become a gold standard in being a well-run, regulated Crypto exchange. I sense they will be fine, but they can't be all things to all people. This market downturn will force focus, which is not bad. 

• 🤔 Meanwhile, actual DeFi protocols are fine. The Crypto folks keep yelling at people to look at DeFi protocol volumes, and they have a point. People confuse Celcius with "DeFi," and they couldn't be more different. Protocols like MakerDao, Uniwap, AAVE, and compound are working and still being used. In fact, the DeFi protocols are at the top of the preference stack in liquidations. Noodle on that (yes, over-collateralization is a big reason, but that's a rant for another day).

Good Reads 📚

1. Exploring Pix - The Real-Time Payments Infra in Brazil

• Within a year of launch, more than 70% of consumers in Brazil have made a Pix payment. Pix is used for Person-to-Person and consumer merchant payments and features no fees for consumers and small businesses. 

• 🤔 Given the speed of adoption, this is arguably any country's most successful real-time payment launch. No doubt accelerated by the timing during the pandemic, but even if you strip that out, it's incredible. Payment behavior change usually takes longer. 

• 🤔 Pix got a few things right. Pix is a tax-free transaction (no sales tax), which means the grey economy can adopt the payment method. It has zero fees, it's mobile-first, and enrollment is slick. It's one thing to want to launch real-time payments; it's another to execute exceptionally and accept the reality of the grey economy. 

• 🤔 The Scandinavian payment methods often get overlooked, but there are significant lessons for anyone building payments. Swish was launched in 2012 by the 6 largest banks in Sweden; it requires a national ID and has nearly 100% adoption by the adult population. Both Pix and Swish understood their country's reality; with Swish, they had a national ID system and high bank usage penetration, giving them instant national coverage. 

• 🤔 This contrasts with central banks talking about retail CBDCs (I'm looking at you, ECB). The value proposition can't be "people will use this digital asset because it's official." The service has to solve a problem for the market, represent real value to the user, and be incredibly simple to use. My sense is that it's more likely to come from the private sector in the US and pan-European context.  

• 🤔 The Europe-wide payment system "SEPA" achieved 824bn Euro ($827bn) in payment value last year. That sounds like a lot, but just one of the UK payment systems (Faster Payments) managed £2.6 trillion ($3trn). Europe tends to do slow bureaucratic rollouts of infrastructure that gain limited adoption compared to national systems. A European CBDC wouldn't be successful just because the ECB built it. 

Other great reads

1. The Crypto banking system - This is an incredible overview of what a Crypto-based banking system would look like. I need to re-read it a few more times to fully digest. Incredible work 👏

2. Should Robinhood and BlockFi sell to FTX - Lex breaks down the commercial logic for FTX potentially buying BlockFi or FTX

Tweets of the week 🕊

That's all, folks. 👋

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