Fintech 🧠 Food - 20th Nov 2022

Hey everyone 👋, thanks for coming back to Brainfood, where I take the week's biggest events and try to get under the skin of what's happening in Fintech. If you're reading this and haven't signed up, join the 24,198 others by clicking below, and to the regular readers, thank you. 🙏

Subscribe now

Weekly Rant 📣

The Future of Trust when everything seems broken.

Trust is a word that gets thrown around, but it seems like the world lacks it. From commerce, politics, journalism, and technology.

What is trust, and where did it go?

Trust is a hard thing to define.

The human brain applies trust to things it recognizes. As this article describes:

Trust is a complex neural process that binds diverse representations into a semantic pointer that includes emotions.

The neurons in your brain point at something and give it meaning and emotion.

Psychologists have wrestled with definitions which I've taken the liberty to condense down to three main factors.

Trust is the human brain believing that x activity is worth doing because:

1. It will work
2. It will behave consistently
3. It is dependable and will fix things that go wrong

Trust is a promise. 

That manifests in financial services as follows:

• For deposits, trust promises that if you deposit your money with an entity, it will still be there when you want it back. It works; it's consistent and dependable.
• For payments, trust promises if you send money to x - x will faithfully receive that money. More importantly, if something goes wrong (like you bought something that was never delivered), you will get your money back or be made whole.
• For lending, trust promises that if you repay faithfully, all debt will be cleared. Good lenders promise that if you fall on hard times, the consequences will not be severe, and you'll be given time and chances to get back on the right track. 

The way trust works with brands.

When you see this logo, what does it say to you?

To me, it says,

"When you see this logo, the payment you're trying to make will work, and if something goes wrong, it will get fixed." 

(Sorry, Mastercard and AMEX folks, your logos say the same thing, but you have to hand it to Visa on the brand front).

When you see this logo, what plays in your head?

The promise made is:

This will taste the same as you expect, no matter when you are in the world. It's consistent and dependable. 

It's those themes. It will work; it's consistent and dependable. The trust that users give the brand is earned over many repetitions. The more reps a user has with a brand, the more trust grows and, over time develop, a personality in the human mind.

The human brain interprets a brand logo with the same process used to give semantic meaning to a face.

How centralized brands grow trust.

Trust is a steady, compounding process that builds through consistency. But consistency is hard if what you do is as full of edge cases, possible fraud, and risks as payments or banking.

Take one of my favorite one-liners, "Payments are easy; edge cases are hard. "You begin to appreciate the incredible job the payments schemes do (not just cards, all of them). 

If you buy a widget from the other side of the world, and that widget never got delivered, there's a process for getting your money back called a "chargeback." This process is created and managed by the card scheme and must be followed by anyone who wants to make or accept payments with that card logo. 

Like all things in finance, the simple explanation hides the complexity. For example, imagine you issue a chargeback, but the goods arrived, and you just wanted a refund? This friendly fraud is the scourage of any merchant or Fintech wallet. Now we need a dispute process, where the merchant, their bank, and the issuing bank try to figure out what went wrong to fix it. 

All of this process gets expensive.

And that's why card rails have interchange. To pay for all of this "what happens if something goes wrong" stuff.

Visa doesn't move money banks do. Visa provides the rules and processes allowing all banks to agree on what should happen and settle.

That creates consistency.

And consistency creates trust.

The story of Visa is a great one to study. The founder Dee Hock had to get competing banks together and agree to a set of rules that benefitted the common good. In retrospect, it is herculean that schemes connect thousands of banks, millions of merchants, and billions of consumers to the same set of rules. All so that when you pay, it works consistently.

Contrast that with a push payment type like local rails (e.g., ACH, Faster Payments, etc.) These services send messages to instruct a bank to move money. The bank moves the money when a customer sends a message to pay the XYZ account. No ifs, no buts, no coconuts.

Push payments work consistently.

But you might not be made whole if something goes wrong.

They lack an element of trust. And you can see that now in the headlines about "Zelle scams" or Authorized Push Payment Fraud. It is no surprise that regulators and banks are now trying to figure out how to fix that bug.

You can go across the entire banking value chain and see similar patterns.

The bank brands that have lasted the test of time lend successfully, regardless of market conditions. They become viewed as "safe" for deposits because government schemes back those deposits. 

And historically, banks won consumer trust.

Something interesting happened to trust since the Financial Crisis.

The global financial crisis rocked the trust the world's largest banks took for granted. The past two decades have seen a general downward trend in consumer trust in almost any traditional, large institution, especially governments. 

Edelman's 2022 trust barometer survey found that nearly 1 in 2 people globally view government and mainstream media as divisive forces for society.

And in the wake of the "social media" and fake news concerns, trust is at all-time lows.

Banking hasn't recovered since the financial crisis. It is the second least trusted industry sector.

We have a crisis of trust in institutions. 

But trust is the fabric of commerce.

We need it for things to work, don't we?

The emergence of trustless.

The centralized actors are seen as failing for many reasons. Social media has too much censorship or too little, depending on your political persuasion. Governments are doing too little to prevent climate change, or the government is too big and should get out of the way.

It doesn't matter which side you fall on.

Chances are you fall on one of those sides and view something as broken and untrustworthy.

And in financial services, large financial institutions picked up a lot of bad habits that break trust.

Hidden fees, automatic call center robots, and a perceived focus on corporate profits over consumer health. Not helped by scandals and headlines like LIBOR (in the FX markets), mortgage miss-selling, etc.

Bitcoin has entered the chat.

A reaction to centralized institutions losing trust is the swing to decentralization. 

The Bitcoin genesis block published in 2009 contains the famous quote, "The Times 03/Jan/2009 Chancellor on the brink of second bailout for banks." In 2022, we now have decentralized technology and increasing pushes for open-source scientific research and nutrition, and Baljais is creating a decentralized state.

The promise of decentralized technologies and models is a reaction to the issues with centralization. Where the institutions are seen as opaque, unfair to the little guy, and purely for profit, decentralization promises:

• Transparency by design
• No intermediary taking a cut
• Trust code, not humans

DeFi needs to do a better job of building trust.

Most consumers lost money on Crypto between 2015 and 2022.

1/ The BIS has published a study on retail crypto trading (2015-22) incl. some remarkable charts. TL/DR: When the price of #Bitcoin rises, more people download & actively use crypto exchange apps. 73-81% of retail investors have likely lost money on their initial investment. 👇

Over the past year, scams, hacks, fraud, and wash trading have been rampant in the entire Crypto industry.

This isn't the fairer, more affordable financial services future we saw in pitch decks.

It's unfettered capitalism where the little guy loses.

And you could argue that the collapse of Alameda/FTX is a Lehman/Enron moment for Crypto.

While true decentralization advocates would point out that if you manage your own Crypto, you will have no exposure when a centralized intermediary like FTX, Voyager, or Mt Gox collapses. 

And they're right.

Anyone who held their own Crypto in a self-custody wallet did not lose out. But in return, users have to manage their own Crypto. The digital equivalent of stashing your net worth under the mattress (and sometimes fortifying the room with excellent operational security AKA op-sec).

Self-custody has a UX problem. This is solvable and likely will be solved in time.

But the hacks, scams, and fraud, who makes users whole when something goes wrong?

The good centralized intermediaries will attempt to help where they can, but

• If a user sends Crypto to a scammer, that is gone. 
• If a state can hack a wallet (like North Korea is alleged to with the Ronin wallet) and wash those proceeds through a decentralized mixer like Tornado Cash. That cash is gone, and a pariah state got away with it.

An extreme techno-libertarian view says those hacks are valid because the bugs were there for anyone to exploit.

But holy shit, if institutions have a trust problem, does decentralization have a trust problem brewing (and I get it, a centralized exchange failing is not DeFi, DeFi is working, absolutely fine). 

But for this technology to live up to its promise and become widely adopted, it must create trust.

Is regulation the answer?

I have seen arguments that say regulation hasn't prevented blow-ups in Crypto because we lack regulatory clarity.

The argument goes that if legislators had provided that clarity, the US industry would play a larger role in Crypto markets and, instead, are forced offshore to take advantage of innovation.

Hogwash.

Regulatory clarity would have helped, but it won't have prevented offshore development. 

Crypto is the default global financial services infrastructure that operates 24/7.

Programmable, permissionless, and composable.

It is available everywhere an internet connection exists. It is a petri-dish for financial innovation that doesn't fit neatly in any jurisdiction or regulatory perimeter. 

More legislation and regulation are inevitable, and it should start with some sensible things (for example, MiCA in Europe requires disclosures and reserve requirements.

But regulation in one jurisdiction will not build trust in this new infrastructure.

Is transparency the answer?

It will be a huge part of the answer if we use it properly.

The technology is default transparent, but intermediaries are not. 

The intermediaries can use transparency, though.

For example, Kraken is a centralized exchange that publishes its proof of reserves on-chain.

This is a transparent disclosure of holdings and solvency visible to anyone. 

Transparency of assets is good, but that wouldn't have prevented what happened with FTX. If an organization can borrow from someone else, off-chain, OTC, that is a paper agreement. That paper agreement has nothing to do with the on-chain facts.

We need transparency on liabilities, which is much more challenging to achieve.

But this thread gives a possible solution. 👇

Suppose creditors refused to fund any institution that did not provide proof of liabilities on-chain. In that case, we'd build a feedback loop of lower credit risk in the market (also, imagine proof of liabilities in the TradFi world!)

Proof of Reserves is a good start, but it needs to be coupled with Proof of Liabilities in order to be useful.

What's super powerful about this approach is unlike regulatory reporting, it doesn't rely on the intermediary to "report" to the regulator or some centralized entity what their liquidity is (or isn't). 

Technology does that. 

Share the wallet address, and anyone can look it up.

Transparency on disclosures, market activity, and solvency are great ways to build trust. Even as we exist in a default global, 24/7 market, we could quickly bifurcate "has proof of reserves" from "does not have proof of reserves." 

But that wouldn't solve many other trust issues with either centralization or decentralization. The scams, hacks, and fraud are still a wild west, and the global nature doesn't help.

Gaps the Crypto world needs to address to improve trust.

Trust really gets earned when you're there for people in bad times. 

DeFi came through for people who are sophisticated enough to be their own bank, but what about everyone else? 

What happens when something goes wrong?

How do we get a more consistent and dependable experience to unleash the power of DeFi?

The heavy lift Visa did at inception was creating a shared set of standards that were widely adopted. We need the same for DeFi, Crypto, and, frankly, the future of financial services.

We could do the same. 

There is an interesting precedent for global standards in financial services; the Global FX Code. 

FX had a reputation issue following the LIBOR rigging scandal. In response, the Bank of International Settlements (the central bank's central bank), major central banks, and the largest financial institutions created a code of conduct. 

FX has similar challenges to Crypto. It is default global and doesn't fit in any jurisdiction or regulatory perimeter. While there are many local laws and regulations, they're inconsistent, and gaps will always exist. 

By ensuring the market follows this code, the industry has shown improvement, and it acts as a high watermark for behavior.

If Crypto had a code, it could:

• Address proof of solvency with on-chain transparency for both assets and liabilities
• Have a standard for on-chain disclosures of any other material holdings or risks
• A single way to ensure a smart contract has been audited and a standard for showing this in a self-hosted
• Have centralized entities (CASPs) collaborate on fraud, scam, and hack prevention and reporting with Traditional Finance

Standards are hard, but they helped build the internet and the financial services we have today. Standards are harder when they're global. But standards create consistency and help us determine what happens when something goes wrong. 

Stablecoin payments are a type of programmable push payment. How do we program in the "what happens if something goes wrong" standard?

Self-hosted wallets are the browser for the new era of finance. How do we program in the certificate authority style "this smart contract has been audited" standard and make that meaningful to users? Could wallets have an easy mode and an expert mode? Is that best practice?

I don't have the answers.

But imagine if the best solutions could be tested transparently, with the entire global regulatory community watching.

Why wouldn't we do that if we have nothing to hide and value transparency? (In fact, that's what this paper from *GDF proposed)

Rebuilding trust.

It has been a horrible week for trust. Heck, a horrible couple of decades. But new technology with good old-fashioned risk management could help us build the answer.

Banks aren’t off the hook because Crypto had a big market failure.

The fundamental macro challenge of trust is one we all face.

The Crypto industry needs to think less nationally and become the default global.

Banks and FIs should think about demonstrating they are trustworthy through transparency.

The show, don’t tell.

Let’s build more trust.

The world needs it.

ST.

4 Fintech Companies 💸

1. ModernFi - Deposit marketplace for banks

• ModernFi helps connect banks with "excess deposits" to banks that require funding to drive more lending (and therefore revenue). It is a modern, technology-driven interbank market. ModernFi is taking what was an operational back office function and attempting to make it much more efficient with technology.
• 🤔 ModernFi is leaning into a few trends emerging for 2023. Fintech infrastructure for banks and financial institutions, and going deeper into the back office infrastructure side of finance. ModernFi is a bit like Stonecastle, which has been around for ~10 years, and is heavily used by regional banks. Especially valuable for partner banks who may not want to break their Durbin cap but have massive Fintech clients with millions of customers and $xxbn in deposits.

2. Nickel - Vertical SaaS & Payments for Materials Suppliers

• Nickel helps companies that sell materials (e.g., construction, home, and industrial) to big box stores (e.g., Home Depot) manage billing, payments, collections, and accounting. Nickel also allows the material supplier to provide customers with a dashboard and instant checkout.
• 🤔 Materials buying is often complex, and a quote can involve much back and forth. Often this happens via emails and with a poor paper trail. Automating that and providing workflows over the top is neat.

3. Virgil - Making property ownership more normal in France

• Nickel helps consumers in France become property owners for the first time by co-investing in a property. In France, a consumer must take 100% property ownership and secure a line of credit. The concept of home equity is less helpful to homeowners. Virgin co-invests up to 100k and takes up to 30% equity in the property for 10 years to help ease this burden.
• 🤔 Will this raise prices or leave Virgil with lots of equity worth less than they bought it for? It could do either. The consumer need is real as in Europe renting is common and home ownership is much rarer. But investing in property doesn't feel like a venture business to me. Property returns are gradual and measured in percentages, not multiples. 

4. Monite - Embedded invoicing, and AP Automation 

• Monite lets B2B Neobanks and SaaS platforms embed accounts payable and invoicing functionality via an API. Instead of a mid-size business using Bill.com to manage their invoicing and accounts payable, increasingly, they look for that from the core marketplace or Neobank they use. 
• 🤔 While many of the largest players in B2B Neobanks and marketplaces have added this functionality, there are a lot of vertical SaaS businesses in that ~sub $100m ARR range looking to grow revenue. Like all embedded finance, it drives more engagement with the platform too. Everything is embedded.

Things to know 👀

1. Genesis halts withdrawals and lending activity.

The lending arm of global Crypto trading firm Genesis has "temporarily" halted customer lending and withdrawals in the wake of the FTX collapse. According to its website, the lending unit at $2.8bn loans outstanding in Q3 of 2022. The CEO noted that the custody and trading unit are independently capitalized and would not be impacted by the lending business's liquidity challenge. Genesis had an estimated $175m locked in FTX, and its parent DCG infused $140m to help it with liquidity. 

• 🤔 Genesis lending failing will impact "earn" and DeFi yield products. For example, Gemini (also with a G) and many other wallets allow consumers to earn yield by "locking" their Crypto and passing that to Genesis, who lends that Crypto to funds. If that falls apart, it's unclear what happens to consumer funds.
• 🤔 It's not a sure thing that Genesis group is impacted. The CEO says they have separate funding for custody and brokerages; for now, we have to take him at his word for that. If it's true, that's the first sign of sensible risk management being effective in this capitulation. 
• 🤔 Gemini will impact family offices and "whale" traders. Instead of working via a consumer-facing wallet, larger traders would park their Crypto with Gemini directly for higher yield. How many of these might be impacted if the lending business goes insolvent is unknown. 
• 🤔 This is the worst market to try to raise money in. The best way to fix insolvency is to raise capital, but the valuation that Gemini could achieve when the fear of Crypto is at an all-time high might be much lower than their last round.
• 🤔 Who's not exposed? It's unclear how many projects are secretly dead because they had funds locked up in FTX or had borrowed from Genesis. This may continue to unravel. But the less affected companies are being public about that (e.g., Anchorage)
• 🤔 What about Tether? Tether has publicly stated they have no exposure to FTX or Genesis, but there's still an open question about their solvency. Because of the role it plays underpinning much of the DeFi and Crypto ecosystem, that would be massive. While Tether claims to be backed 1:1 with USD equivalents, it's unclear how liquid they are. 
• 🤔 I'm still long-term bullish on the survivors of winter. Crypto needed this reckoning. Failures teach lessons faster than success. But I believe in the tech to create a much more efficient, fair, and transparent finance infrastructure. The folks that survive this are super well-placed to capture that value.

2. Unit launches Charge Cards

BaaS provider Unit will add charge cards to its existing offerings (debit cards, credit card, and revolving loans) to target more embedded finance plays (e.g., a construction company that adds lending). The "swipe fees" on credit and charge cards are at least 0.5% higher than those from debit cards. CEO Itai sees embedded finance or "vertical finance" as more blue ocean than red ocean. New opportunities to lend and provide financial products that are underserved.

• 🤔 Everything BaaS is going B2B2X. Embedded finance is arguably *the* topic in Fintech as a new way to distribute financial services to companies who would traditionally not have considered offering finance. Shopify is the canonical example of a company that makes ~50% of its revenue from financial services, but that's mostly on payments. Payments have been the Fintech story, but that is changing.
• 🤔 Everything BaaS is going credit. Most BaaS providers offer (or will soon offer) credit cards, revolving loans, BNPL, and more. That's not surprising as it comes with more revenue (especially in a higher interest rate environment), but it also comes with much more hidden complexity.
• 🤔 Lending is easy; getting paid back is hard. Lending decisions are often made at the front of the process (the KYC and the underwriting often all happen at once). Brands that get into lending will need to consider what happens to their brand image with customers with defaults, complaints, or errors?
• 🤔 Balance sheet power still matters. The big banks haven't entered the fray publicly for embedded finance via BaaS platforms, but that's a matter of time. If they did, their lower cost of capital would make them highly competitive. But these things always come to risk appetite. Who's the end customer, and will they pay me back?
• 🤔 Regulatory headwinds create a longer window of opportunity for smaller partner banks. Regulators are already questioning how banks ensure the Fintech companies they partner with perform marketing or managing customer complaints complies with the regulation. Now imagine what that looks like for fair lending? Collections? Bias in lending? 

Good Reads 📚

1. The Death of the DeFi mullet?

Consumer Fintech is in a hard place, as it gets harder to drive more revenue incrementally with fewer advertising dollars to spend. But Liam says we need to reframe moving from TradFi to DeFi as a trendy speculative product but as critical financial infrastructure.

Liam calls for Fintech companies that want to benefit from a global, 24/7 financial market structure to check their incentives. Is it making a quick dollar, growing engagement, and making investors happy? Or is it about using a technology that delivers fairer, more transparent, and more efficient services to users?

🤔 No. We need the DeFi mullet more than ever. The sheer scale of things that can go wrong will need willing and engaged participants to help consumers use DeFi. If we don't do that, DeFi will remain a fringe infrastructure for experts and nerds but always a pariah. 

🤔 Two things will happen at once. 1) Self-hosted wallets will up their game on fraud and scam prevention by giving users simpler tools to manage risk. 2) Exchanges and Fintech companies operating in DeFi will use DeFi as an infrastructure for finance instead of another financial product on the shelf.

🤔 No surprise; I heartily agree with Liam on this one. The Fintech company is the "face" of DeFi to many users. That face may hide a lot of complexity under the hood, but it also obfuscates responsibility. We need to invert that model.

🤓 Extra credit: Mario assesses his, our, and FTX's failings in this incredible piece.

🤓 Extra credit: Matt Levine wonders if Binance is proposing a central bank for Crypto

That's all, folks. 👋

Remember, if you're enjoying this content, please do tell all your fintech friends to check it out and hit the subscribe button :)

--

Disclosures: (1) All content and views expressed here are the authors' personal opinions and do not reflect the views of any of their employers or employees. (2) All companies or assets mentioned by the author in which the author has a personal and/or financial interest are denoted with a *