ULTIMATE ALTERNATIVE FINANCE FINANCE GUIDE

Chapter 1: Understanding Alternative Finance

ULTIMATE ALTERNATIVE FINANCE FINANCE GUIDE

Chapter 1: Understanding Alternative Finance

Introduction

What is alternative finance?

Alternative finance refers to forms of finance that are outside the institutional finance system of banks and capital markets. ‘Fintech’ is the ecosystem within alternative finance made up of companies, technology, and processes that aim to improve traditional methods of finance in categories such as:

  1. Payments and invoicing
  2. Consumer lending and credit
  3. Small business lending and credit
  4. International money transfers
  5. Equity financing and crowdfunding
  6. Insurance
  7. Consumer banking
  8. Wealth management
  9. Savings and investments
  10. Capital markets
  11. Risk management
  12. Regulation management
  13. Cryptocurrency and blockchain

Alternative Finance Basics

What does fintech stand for?

Fintech stands for financial technology. Originally, the term referred to the back-end technology that was used in the traditional financial sector, but since the start of the 21st century, the term has expanded to include new technological innovations in the financial sector, such as cryptocurrencies and online lending platforms.

Simply put, fintech applies technology in order to improve financial activities.

Who are fintech companies?

Fintech companies are often startups or more established financial and technology companies that are trying to improve upon traditional forms of finance. North America has the greatest density of fintech companies in the world, closely followed by Asia (Investopedia).

What do fintech firms do?

Fintech companies are the providers of financial technology that enables transactions for consumers and businesses, or helps other companies manage the financial aspects of their operations. Fintech firms offer a wide array of products and solutions such as:

  • Crowdfunding platforms, to help raise funding for start-ups
  • Cryptocurrency and digital cash to facilitate online transactions
  • Blockchain technology, a digital ledger in which transactions using cryptocurrency are recorded
  • Smart contracts, to automatically execute contracts between buyers and sellers
  • Open banking, which provides third-parties with access to bank data to build applications, such as budgeting and money management tools
  • Insurtech, which uses technology to streamline the insurance industry
  • Invoice factoring, to cover cash flow gaps for small businesses
  • Peer-to-peer lending, to facilitate lending outside of the bank
  • Regtech, which helps financial service firms meet industry regulatory and compliance rules
  • Robo-advisors, which automate investment advice at an affordable price for consumers
  • Cybersecurity, to protect against unauthorized use of electronic data

When did fintech start?

Fintech is often thought of as a recent phenomenon, which brings to mind technological innovations such as Bitcoin or mobile wallets. However, technology has played a key role in the financial sector for a long time.

Fintech technically dates as far back as the 1950s, when credit cards were introduced to ease the burden of carrying cash. It has been evolving ever since, with the introduction of ATMs, an electronic stock exchange, mainframe computers at banks, and the rise of the Internet, allowing for e-commerce and financial services across multiple devices. Have you ever taken a photograph of a paper check to deposit it into your account? That’s a recent fintech innovation too!

How does fintech work?

A fintech company is a financial company using technology to innovate upon existing institutional financial products. Generally, fintech innovations work to improve upon specific areas of a financial product, up to and including the speed of transactions, security, accessibility, cost, and the overall user experience. These companies typically consist of two core teams, with the engineers on one side and the financial analysts on the other side.

How does fintech make money?

There are multiple business models that fintech companies use to earn revenue. The most common ones are listed below.

Brokerage Fees

Similar to a traditional broker, fintech companies receive a fee or commission for facilitating a transaction. Here are some examples:

  • Payment providers charge a 2-3% fee for each payment.
  • Money transfer platforms charge a fee for each currency conversion
  • Online stock brokers charge a fee for each trade
  • Online lenders receive a percentage of the transaction for connecting a borrower and lender

 

Service Fees

These are different from brokerage fees because they are not dependent upon transactions to generate revenue. For example:

  • Robo-advisors charge a management fee on assets that are actively being invested
  • Online lenders receive interest payments or fees from their borrowers 

 

Lead Generation

Some insurance and lending marketplaces receive a commission for sending customers to partner businesses. The fee can be paid out based on traffic, leads, or conversion.

  • Lending aggregators earn a commission by sending would-be borrowers to the right lending solution
  • Affiliates earn an affiliate fee by driving traffic to partners through content and search results

Who uses fintech?

There are four main categories of users: 1) consumers; 2) business-to-consumer applications 3) business-to-business applications; and 4) the clients of financial services companies.

  • Consumers use fintech products to improve accessibility (making it easier to complete a transaction) and to find an optimized user experience. Some fintech products are positioned to be more affordable than other traditional products.
  • B2C fintech users are making use of products that enable faster or better quality customer service; including machine learning algorithms, credit underwriting automation, and onboarding services. Often these products simplify the back-office functions or improve their customers’ experiences.
  • B2B fintech applications let businesses transact more efficiently and affordably. Invoicing, payments, accounts receivable, and accounts payable functions (among many others) all have opportunities to improve through automation and efficiency efforts.
  • Finally, some new fintech innovations are often not the direct choice of the end user; some organizations adopt a new financial platform and obligate their users to create a profile and engage with the business on this new interface. Some payment platforms and security platforms require users to conduct business with their client through these products instead of through traditional means (over the counter, email, postage mail, etc.)

 

Fintech solutions also provide opportunities for groups that were previously underserved – these are consumers who have limited or no access to traditional banks and financial services.

Why is fintech popular?

Fintech is popular, both in headline news and also as measured by growth in the sector, because of two core shifts in the market. The “sudden” emergence of fintech (growth compared to other areas of startup innovation) can be attributed to developments in technology and a shift in user adoption of digital financial products.

Fintech is growing in popularity because access to technology has evolved to a place where smaller companies are able to offer competitive products. Financial products are no longer exclusively offered by traditional financial institutions. Consumers using mobile apps or the web now have instant access to their finances and don’t have to visit bank branches or wait on hold on the phone. Fintech has offered consumers and businesses the option to take charge of their own personal financial decisions at any time they choose.

Why is fintech important?

Fintech innovation matters because it is providing financial access to underserved markets that went unaddressed in the traditional financial ecosystem. For example, fintech has made access to capital easier in developing countries and creates new opportunities for “under-banked” consumers and businesses who previously had few options to access credit.

For small businesses, fintech has not only made access to capital faster, but possible. Historically, 69% of small businesses have fallen into the “under-banked” category of borrowers, meaning they did not receive the full amount of credit they needed to grow (SBCS).

For everyday consumers, fintech has made it easier to manage finances and have access to financial products and services at a much lower cost and with greater convenience.

Are fintech companies regulated?

While there are concerns that the fintech landscape is less regulated than the traditional financial services industry, fintech companies are still bound by many of the same obligations as their institutional counterparts.

For example, many fintech companies and federally-regulated financial institutions have partnered up to improve back-office functions, such as settlement, clearing, and loan approvals. There are also fintech companies that exist outside this regulatory framework, but they still have to comply with certain federal and provincial/state regulations that apply to the entire financial services sector.

As with any new industry, regulation in fintech will continue to evolve over the next few years in order to optimize user experience.

Who regulates fintech?

In Canada, the regulation of financial services as a whole falls under the shared jurisdiction of the federal and provincial governments. Regulators oversee aspects of financial services such as investor protection and securities law, consumer protection, anti-money laundering, privacy and data security, and payment processing.

In the U.S., the federal government oversees the financial services industry, with occasional involvement from state and local officials to help regulate markets and certain companies.

What is fintech ranking?

The International Data Corporation (IDC) releases an annual ranking of all fintech companies based on calendar year revenues.

The categories are divided into ‘FinTech Rankings: Top 100’ for vendors that derive more than one-third of their revenue from financial institutions, and ‘FinTech Rankings: Enterprise 25’ for companies that derive less than one-third of their revenues from financial institutions, and serve multiple industries.

What is fintech 100?

The Fintech 100 is a showcase of the world’s leading 50 ‘Established’ fintech companies, and 50 ‘Emerging Stars’ that is released by KPMG and H2 Ventures on an annual basis.  

Can fintech fix financial services?

Fintech was pioneered by people from the banking industry who were tired of the old way of doing things and business owners themselves, who are committed to providing a better, more transparent experience for users.

This is already having a ripple effect within traditional financial services. Many fintech companies and banks have started to form partnerships to help improve upon the current business model. As long as these partnerships continue to put customers’ needs first, the outlook is promising.

What is alternative funding?

Alternative funding refers to all the non-bank options that are available for small businesses, such as non-bank lending (including online lending), crowdfunding, grants, angel investors, venture capitalists, and factoring or invoice advances.

What are non-bank financial institutions?

A non-bank financial institution (NBFI) is not considered a full-scale bank because it doesn’t engage in both lending and accepting deposits – they do either one or the other. For example, a retail store offering a credit card is a non-bank institution since it does not accept deposits.

Who are non-bank lenders?

Non-bank lenders provide alternative loans. Some traditional forms of non-bank lending for small businesses include merchant cash advances, accounts receivable financing, and invoice factoring – these provide funding based on accounting data such as future sales and pending invoices.

Some traditional forms of non-bank lending for personal loans are retail credit cards and payday loans.

What is fintech lending?

Fintech lending, or online lending, refers to newer forms of non-bank lending that are made possible due to technological innovation. In particular, online lending has become a popular financing option for small businesses, as opposed to obtaining a loan from a bank.  

This is because banks require a strong credit history, something that a small business with little to no historical records is unable to provide. Due to this and an increasingly conservative financial climate, banks have scaled back on the number of loans that are offered to small businesses, which has led to a sizeable credit gap.

Approximately 60% of small businesses require loans that are under $100,000, which is exactly the market gap that online lenders seek to fill (Forbes).

What do lending companies do?

Put simply, lending companies provide loans to individuals or businesses. A lending company will provide a quick and simple way to access cash, often to help small businesses sustain their daily operations.

Lending companies typically have arrangements with investors to provide the ‘loaning money’ to their customers.

How does online lending work?

Similar to a loan at the bank, you need to apply for a loan with an online lender.

Unlike banks, which put a heavy emphasis on personal and business credit, online lenders have the ability to take other factors into consideration, such as cash flow, sales history, online reviews, and even social media interactions.

Why online lending?

The biggest benefit of online lending is that the entire process is much easier than with a traditional bank. Below are some of the biggest benefits:

  • Quicker approval: a traditional application form for a bank loan takes a long time to review, and you may need to visit the branch in-person. With online lending, you can instantly find out whether or not you’re approved, the amount you can borrow, and what your payment plan will look like.
  • Easier approval: in order to approve a loan, banks require a high credit score and multiple years of credit history. This makes it difficult for most startups or small businesses who do not have years of credit history. In contrast, online lenders offer much more flexibility and will turn to other methods to evaluate your trustworthiness, such as utility payments.
  • Lower fees: since online lenders don’t have the same overhead costs as a physical location, they are able to charge smaller service fees and at times, better interest rates.
  • No collateral required: in addition to credit history, banks typically require the loan to be secured against your assets. Fortunately, most online loans are unsecured, meaning that if you fail to repay the loan, your assets won’t get possessed, but your credit score does have the potential to drop.
  • Specialization: traditional banks offer multiple services and financial products, whereas online lenders typically offer just one service – lending. Specialization enables a better customer experience, ranging from more customized solutions to greater employee knowledge and expertise.

What is fintech banking?

The European Central Bank defines a fintech bank to be one which has “a business model in which the production and delivery of banking products and services are based on technology-enabled innovation”.

In layman’s terms, the central role of technology is what separates a fintech bank from a traditional one.

How will fintech affect banks?

Although fintech companies are putting pressure on traditional financial institutions, the reality is that fintech won’t kill banks. Fintech companies are growing fast, however they are still tiny in comparison to the banking industry. For example, the biggest fintech lender till date has arranged loans of up to $9 billion, however credit card debt in America alone is at $885 billion. Fintech companies are dealing in billions, whereas banks are dealing in trillions.

Plus, banks have some ingrained advantages such as access to customer chequing accounts, being able to create credit at a whim, and having nearly every household as their existing customer. While fintech companies won’t kill banks, they may reduce their profitability and force them to change to make their services more competitive.

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