Financial disintermediation theory

Financial intermediation theory explains the existence of financial intermediaries as the result of information asymmetry. Intermediaries reduce information and transaction costs to efficiently channel funds between lenders and borrowers.

This helps us understand why these intermediaries are being disintermediated by efficient agents who can further reduce costs. I employ a conceptual framework grounded in financial intermediation theory called the “Financial Disintermediation Framework” (FDF). (Don’t judge the name :)

It is important to break down how intermediaries in the credit market decrease information and transaction costs. There are four main components that inform the FDF:

1. Provision of liquidity, allowing lenders to exit investments at any time, reducing transaction costs

2. Transformation of risk characteristics of assets through specialisation in analysing data, reducing information costs

3. Diversification of investment, leading to reduced risk of default and monitoring costs

4. Level of agency, affecting transaction costs arising from principal-agent problems (conflict between interests of client and intermediary)

The FDF is used to analyse the effects that digital platforms had on the credit industry. P2P lenders are analysed and compared to banks in four aspects to show whether and by how much these new agents reduce information and transaction costs, leading to disintermediation of current players.

Provision of liquidity

One of the key sources of transaction cost reduction in credit markets is the increase in liquidity provided by intermediaries.

Because markets are unstable and most lenders are bad at predicting when they will need capital back, the ability to liquidate an investment makes them more likely to invest and increases the efficiency of fund transfers.

Banks are huge hierarchal institutions that provide savings accounts to customers who are looking to earn fixed interest on their deposits and leverage those deposits to extend credit. Given their scale and reserves, banks can provide depositors with the ability to withdraw funds at any time without having to collect funds from debtors.

Marketplace lenders also pay fixed interest on “deposits”, but offer a different product than savings accounts. Most platforms have a ‘secondary market’ feature that enables lenders to exit investments at their discretion before the maturity date. Exits, however, do not usually happen instantly, but after the buyer for that loan has been found that lenders can withdraw funds. This delay varies across platforms from a few days on smaller ones to almost instantly on the ones with larger volumes.

It is quite clear that lending platforms are inferior to banks in this regard. However, invoice finance platforms have quite a liquid product due to the nature of the underlaying asset (most invoices are payed back in 40–60days). Also, we can expect the platforms to catch up with banks as the sector grows and volumes ramp up.

Transformation of risk

The ability to understand and transforms risk in the underlying asset into a price impacts the capacity of financial intermediaries to effectively allocate funds.

Financial institutions can better understand underlying levels of risk in assets like loans or investment projects than individual lenders. Banks have departments dedicated to risk management and an army of risk analysts. They primarily rely on information from credit bureaus and use outdated models like FICO developed back in 1956. Most of the processes are manually performed with ‘unscalable gatekeepers’ and a very limited level of automation. Further, the risk is not translated to lenders because investment strategy is completely at the discretion of banks.

Conversely, marketplace lending platforms specialise in using novel technologies. Their risk models employing ‘big data’ sources and machine learning based algorithms. The processes are more automated and the model improves as the business grows and gathers more data.

Further, this knowledge is passed on to lenders in the form of risk classes shown on the platforms that are used to communicate underlying levels of risk. This empowers investors to make their own informed decisions on the investments they would like to get exposure to.

Although information asymmetry still exists, it is clear that P2P lenders decrease such market inefficiency, contributing to a reduction in information costs.

Diversification of investment

Since the time of Fisher (1975), investors and financial institutions have known that diversification is crucial to hedging the risk and limiting the effect of an unsuccessful investment on the portfolio.

In credit markets, intermediaries like banks can diversify across a range of loans by utilising their scale. They also increase their specialisation in debt monitoring to reduce transaction costs in the market by enabling lenders to avoid such activities. However, this diversification occurs on the level of bank’s balance sheet, so individual lenders do not know how diversified their funds are and they could lose all of their investments if the bank goes under.

Marketplace lending platforms integrate the concept of diversification into their product offerings by splitting the money of individual lenders across a range of loans/ invoices to ensure that lenders only lose a portion of their portfolios when borrowers default. They focus on building risk capabilities, while the collection process is usually outsourced to specialised collection agencies.

Therefore, from the institutional perspective, banks can be seen as more diversified than P2P platforms, but from the individual perspective, platforms offer better diversification of individual portfolios. They also communicate this information to investors, greatly reducing transaction and information costs.

Level of agency

Financial markets face principal-agent problems, where intermediaries act in their own interest rather than that of their depositors, creating transaction costs.

The level of agency that banks exercise is high because lenders have almost no control over or knowledge of where their capital goes. They fully rely on banks to receive their returns.

Digital P2P platforms create a digital environment and tools for lenders to create individualised investment strategies or follow platform suggestions. This gives investors an increased level of control and transparency, decreasing agency problems. However, it can be argued that because P2P lenders do not lend their own funds, they are more likely to take risky credit.

The business of the lenders is dependent on trust in the platform, which is driven by low default rates. So, the risk assessment and the ability to pay back interest to lenders is at least of the same importance to them as to balance sheet lenders. Therefore, it becomes evident that the overall level of agency executed by P2P lenders is quite low, leading to a reduction in transaction costs in the market.

Conclusion

We can see that platforms outplay incumbent players in three out of four categories mentioned above. They better transform risk for clients with machine learning risk models and usages of extended data sources available on the web. They further diversify individual investor portfolios through algorithm driven automatic allocation across a wide spectrum of assets and fractional ownership of such. Being a technological platform, rather than a fund manager, allows them to mitigate principal-agent problems by giving investors a very well guided way of choosing their own investment strategies.

The only dimension in which they do not contribute to more efficient financial markets is provision of liquidity, with siloed individual secondary markets that are not particularly efficient due to size. Yet, this can be solved through tokenisation on the blockchain. By putting assets on the blockchain platforms will be able to easily sell /exchange them for other tokens on public exchanges (similarly how stocks are traded now) gaining access to incomparably larger levels of liquidity.

So what’s next?

The future is more decentralised and less dominated by monopolistic players. Every industry will see this phenomenon occurring, but the Financial Sector, in particular, will have to go through a radical change.

Centralised authorities like banks are not positioned to transition smoothly into the new world. At least not in the form they currently are. As we’ve seen above new digital players facilitate a more efficient movement of capital, unlocking liquidity and reducing transaction costs. So, what we will see is a cooperation of FinTechs each focusing on a particular service like payments, current accounts, loans, invoice finance, wealth management, etc. stacking together in a bundle to offer consumers a full range of financial services of a better quality and at a lower cost than banks.

Finance is the blood of the society and we are at a stage when we are ready to collectively take control of it.

We now possess technologies and tools that allow the masses to interact with capital efficiently themselves. Data analytics allows people to draw insights from their spending habits to better adjust them, wealth management and alternative investment platforms provide an opportunity to access new asset classes and make informed investment decisions. Invoice and Trade Finance startups provide growth capital by unlocking liquidity tied in the trade. Cryptocurrencies allow direct P2P transactions increasing the speed of capital movement at lower transaction costs. Finally, blockchain gives us a trustless, transparent and automated system of digital asset exchange.

Fintechs are now building systems that will give each individual and humanity as a collective an opportunity to be in control of their capital.

The vision of Finverity is to create a world where capital is allocated efficiently and is accessible by everyone.

We want to create a system that allocates resources in an automated way according to the needs of each individual or a group. While in some parts of the world resources are sitting idle losing value, in other places there is a desperate need for such value as it can facilitate local growth immensely.

You can call it a global sharing economy on steroids.

Once the lower levels of Maslow’s pyramid are met and people are not driven by the fear of being broke, everyone can do what they love and search for a deeper meaning in life. Humans can focus on exploring our gifts.

This transition is already happening.

Of course, this is the long-term plan and we will start by building a cross-border invoice trading platform. However, there is a clear picture of where we aim to arrive and that is what helps me wake up in the morning and get to the office with a smile on my face.