How ‘Financial Engineering’ Is Being Surpassed by a New Watershed in ‘Financial Innovation’
first published in The Street | Aug 30, 2016

When I first went into finance more than 20 years ago, financial innovation could effectively be summarized as the clever manipulation of “right” over assets. Different types of bonds were being developed — for example, high yield bonds. Rights to assets in the future were emerging everywhere, including hedges (derivatives). Instruments were being structured to avoid tax costs, bonds were being funded only by asset pools, including asset backed debt, CDOs, and credit risk was being parceled out via credit default swaps.

Back then, financial innovation was all about “financial engineering” or “structured finance.”

This was the crux of the financial revolution of the 1980s, 1990s and early 2000s. Some of it continues: the recent emergence say of contingent capital bonds (which convert to equity when a given bank hits certain distress levels), or some of the more creative forms of more mid-market debt funding in the non-depositary shadow lending/specialty finance space.

Still, the above type of innovation is now small fry compared to something else that has emerged as a huge financial juggernaut: financial technology innovation. Of course, the old type of innovation always had its limits. It was fundamentally “epicycles-on-epicycles” of some of the world’s oldest financial instruments, namely debt and equity. But the fin tech revolution, and the extent to which it has reached today, is now of a huge magnitude.

Technology may have periodically brought diseconomies to our banking system (whether it is via misinformation from the Internet, or abuses from high speed trading, or endless replication of sometimes unoriginal and wasteful social media start-ups). However, that aside, former Federal Reserve Chairman Paul Volcker’s famous statement that “The only thing useful that banks have created in the last 20 years is the ATM,” was probably correct.

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The application of technology to finance is now so ubiquitous, with so many possibilities, that nothing short of a new financial innovation revolution is going on due to fin tech. Many of these stocks (if listed) are well worth watching and studying. It just takes in so many forms:

  • On-line lenders – OnDeck, Funding Circle, Upstart, Kabbage, Lending Club, Better Finance
  • Payment systems – WorldPay, Square, PayPal, FUNDtech, Vantiv
  • Trading systems – Tradeweb, markit, E-Trade, Ice, fxcm
  • Financial research – Stocktagon, Bloomberg, SNL, Seeking Alpha
  • Personal finance – Credit Karma, smartasset, OnTrees, mint
  • Retail investing – motif, FutureAdvisor, StockR
  • Insurance – Ebix. Guidewire
  • Back-off systems – fiserv, Sage, FIS, Paychex
  • Consumer credit – Cardlike, Simple
  • Equity finance – angel.me, CicleUp, TAIL
  • Real estate/mortgages – move, Ellie Mae
  • Institutional finance – Addepar, Quovo, StockTwits, estimize
  • Mobile banking – iDa Mobile, Apply PayTo some extent, this financial revolution was a natural product of the broader tech revolution. But it was also accelerated since the credit crisis. It was catalyzed in this way because the depositaries were simply so constrained post the credit crisis, that they were not meeting the credit/finance demands of the U.S. So the shadow banking or specialty finance market (that is, non-depositary funded finance companies) has re-grown significantly since the crisis to fill that gap. But this phenomena collided with the tech revolution, meaning many of these new specialty finance companies are not just old-style lenders.

To be sure, some specialty finance companies are conventional, providing say traditional leases over a given asset, but the dynamic innovation in specialty finance has been from those players who themselves also became fin tech companies. They incorporated fin tech integrally into their business — in their selling methods (selling product online), in their underwriting systems (using AI algorithms to analyze cohorts of borrowers), using fin tech to accelerate the back-office and transaction processing. So the heavy-handed regulation of the depositaries per Dodd Frank itself assisted in this fin tech break-out.

That said, the larger banks are now rapidly catching-up, incorporating these new financial innovations into their old legacy systems, buying the innovative (once start-up) players, and slowly learning to innovate fin tech themselves (perhaps?). It is critical for the banks to do so and in time we are likely to see more of said innovation from the banks themselves.

These changes have socio-economic consequences also. The idea of the “wealthy” 1% of the financial revolution itself is becoming obsolete. That’s because just as technology took away many jobs in industry, it is today taking away many jobs that were once the lucrative jobs of the 1990s finance business (stock broking or commodity trading). Increasingly, cash equities trading, commodity trading, futures trading can be done and serviced electronically. The margins in these businesses have thinned, and these trading functions simply do not need the volumes of people they used to.

It does however perhaps leave a 0.1% – that is the very few who own unique technologies or IP or patents that are making a difference. That small group is able still to make dramatically outsized income and capital gains relative to the rest of the population. And this is not some socialistic observation; rather, it is just the nature of advanced technological capitalism.

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Of course, the counter argument to the above is that the tech revolution itself has created many new jobs. All those who must service the systems in the banks (about 10% of all big bank staff are now IT technicians), all those who must write the programming code and so on. Still, the concern is also creeping in that even these jobs can largely be done by AI machines sooner or later (if not already). For example, the coding itself can already be written just by other computing systems, etc.

Keynes talked of the nirvana where all our work would be done by clever machines, and the central problem of economics (finite resources) would be solved — all men could live at leisure. He was on to something, but it is clearly not panning out how he envisaged. Nor do I believe old-style socialism or heavy-handed tax-based, wealth re-distribution is the answer (ideas that were themselves largely just the product of the industrial, not technological, revolution). Redistribution on a massive scale tends always to damage growth and innovation.
Perhaps at some point (and perhaps it is happening already), all the technology ownership rights, or the IP, as it matures, needs to be released into a type of ‘blogosphere’ where it becomes a common good, like the air — free for all to access. How that might work is difficult to know, and it has the smell of utopianism.

Still, it is clear that the fin tech revolution has changed the face of banking innovation, the tech revolution is changing the face of our economies, and we must find new forms of political economics that make this new world work for at least the large bulk of the population.