This first appeared in the monthly a16z fintech newsletter. Subscribe to stay on top of the latest fintech news.
Last month, the FinCEN files were leaked to BuzzFeed, which then shared them with a global consortium of investigative journalists. FinCEN, aka the Financial Crimes Enforcement Network, is the part of the U.S. Treasury responsible for combating financial crime, including money laundering and terrorist financing. The FinCEN files contain more than 2,000 Suspicious Activity Reports (SARs) covering over $2 trillion worth of transactions. The serious allegations revealed within the files have been examined in detail. It is perhaps more important to ask why, despite the billions of dollars spent by banks and other institutions on anti-money laundering, our systems remain so ineffective. The UN estimates that up to $2 trillion is laundered each year — 2 to 5 percent of global GDP.
Here’s how the system in the U.S. works today: At a high level, banks are responsible for monitoring both who makes transactions (i.e., don’t bank anyone on a terrorist watch list) as well as what the money is used for or where it comes from (i.e., don’t finance terrorist operations or, deposit large sums from the drug trade). If banks suspect wrongdoing, they should file a Suspicious Activity Report to FinCEN, which will often pass the information on to local authorities.
The challenges — and hence, the inadequacy — of the system are complex. Banks are incented to file SARs (or risk large fines), but it is unclear how often they actually stop doing business with clients suspected of suspicious transactions. It can be a resource constraint — compliance is often isolated and does not have the tools to fully investigate claims. But there are also misaligned incentives: stopping business could mean giving up lots of fees from lucrative clients.
From the regulatory point of view, FinCEN was flooded with more than 2 million SARs last year. The organization does not have the staff to effectively analyze that volume of data. The average FinCEN employee has 4,000 SARs to investigate per year! It is also extremely difficult for regulators to prosecute the executives of banks involved in ongoing laundering operations.
What can be done? To start, companies often use a complex network of shell companies to hide their ultimate owners. There is currently a bill in Congress that, in part, would require companies to disclose their owners to FinCEN.
This is an area where technology could have a powerful influence. For instance, a transaction monitoring system with better connectivity and visibility into the full customer profile and transaction history could auto-populate SARs, drastically reduce the compliance workload, and provide FinCEN with better data. Even more powerfully, a software company with multiple bank customers could leverage cross-bank data anonymously to better train its models, potentially reducing false positives and freeing up compliance officers to focus on high priority cases.
As the expression goes, follow the money. It’s easy to run into roadblocks in that pursuit when pertinent information is siloed within institutions. This is a highly nuanced topic with many regulatory complexities and privacy concerns. But the future of effective money laundering controls may require the creation of powerful centralized networks. Similar to lenders’ ability to ping the credit bureaus before extending credit, imagine equivalent institutions for financial crime, beyond the sanctions lists that exist today. The best way to stop crime is to cut off the money supply.
Payroll provider Gusto recently launched Gusto Wallet, a suite of financial wellness products for its SMB customers to offer their employees. The new offering includes an interest-bearing account, a Gusto debit card, and Cashout, the company’s early wage access product. Moreover, Gusto is offering all these products to its customers for free. So, why would a payroll provider get into what looks like a neobank offering?
Payroll providers like Gusto have a great vantage point for offering financial products. Because they see a consumer’s income stream, they have real-time data on that employee’s ability to repay loans, which enables them to offer products like daily pay, wage advances, and other lending products. Through the Wallet, Gusto already has the direct deposit relationship with customers that is coveted by most consumer fintech companies, since it typically becomes the primary transaction hub for employees. Additionally, in launching a B2B2C product, Gusto doesn’t have to pay the steep customer acquisition costs that consumer neobanks often do.
The product also drives stickiness with its SMB customers. SMBs often don’t have access to or can’t afford the same benefits platforms that larger companies provide, including 401(K) plans and insurance products. Being able to offer such employee benefits could help small businesses retain employees, particularly during COVID-19. This is part of a broader trend in which financial wellness and planning products are being turned into an employee benefit, with the help of companies like Brightside and Origin. For Gusto, the addition of this wallet product makes its core payroll product more attractive to potential SMB customers. Similarly, Gusto offers basic HR tools for free, which many small businesses typically didn’t have access to.
Finally, Gusto’s wallet is a lifetime account — the employee retains the account even if they part ways with their current employer. For Gusto, this can be a customer acquisition mechanism: when the employee moves to another job, ideally they can evangelize Gusto to the new employer.
While payroll has traditionally been viewed as a B2B product rather than a consumer-facing product, today more employers are recognizing the value in offering financial benefits to their workers. The payroll provider can be a great place to start.
LendingClub, founded in 2006 as a peer-to-peer (P2P) platform, is now shutting down peer-to-peer lending entirely. Why? First, the P2P component has become much less important over time; it’s easier to raise $100 million from Wall Street than to raise money from tens of thousands of retail investors. Second, with the acquisition of Radius Bank earlier this year, LendingClub now has access to deposits — a far cheaper source of capital.
The story of LendingClub is a microcosm of broader developments within fintech. Fintech has moved from the fringe into the mainstream, reimagining financial services in the process. Fintech companies went from doing deals with big banks to becoming the banks outright.
When LendingClub was founded in 2006, it had a few problems with going to Wall Street for capital. In the beginning, LendingClub’s approach was a non-starter: it was new, unproven, and its loans consisted of very low dollar amounts. By comparison, P2P lending was a great way to jumpstart the marketplace; lots of other lending companies followed suit.
By the mid 2010s, LendingClub and others had proven that loans originated by fintech companies was a new asset class worth paying attention to. Wall Street had more appetite to help package and sell these loans. And even if Wall Street wouldn’t work directly with a new fintech from day one, specialty credit funds (whether individuals or hedge funds) were willing to help bridge the gap by providing the initial capital to fund loans. Lending-oriented fintechs were able to start lending without building a P2P apparatus.
P2P operations were largely a vestigial organ. Now LendingClub has chosen to excise P2P lending entirely, which brings us to the next chapter. Today, fintechs are increasingly choosing to own the deposit relationship, whether or not they are chartered. This affords the lowest cost of capital, a deeper relationship with the customer, and a more reliable means to cross-sell. The explosion of neobanks is a testament to the market’s belief that there are potentially lucrative approaches worth pursuing.
In a sense, deposit funding is essentially another form of P2P lending, since one customer’s deposits become another customer’s loans. Of course, FDIC insurance insulates the depositor from the need to concern themselves with the actual risk associated in lending. P2P is dead, long live P2P!
As businesses recover from the coronavirus fallout, one key question is financing: In the absence of ongoing stimulus measures, where will businesses get the capital they need to reestablish themselves?
Historically, the capital markets have been woefully inadequate when it comes to underwriting small businesses, particularly those that are nascent or newly formed. By offering merchant cash advances, startups like Kabbage and Square have been able to fill the gaps in short-term financing needs for existing businesses; unfortunately, there are far fewer options for those companies seeking longer-term loans in order to launch or expand. And though the Small Business Administration guarantees conforming small business loans made by banks, the onerous process and reams of paperwork required to receive them means that such loans are rare.
In the face of these challenges, some startups are taking a novel approach. SMBx and Mainvest enable small businesses to issue bonds, which can then be purchased by customers and repaid as a cash coupon or (eventually) redeemable products and services from the business. For example, a neighborhood brewery might issue bonds to customers and other investors to finance expanding into a brewpub.
Such bonds pose a promising alternative for both the customer and the business. Traditionally, customers who wanted to support local businesses were faced with two options: an equity investment (where it’s often difficult to get liquidity) and crowdfunding (effectively charity). The bond approach may provide a better choice. These investors may even have an edge on traditional capital markets — their local knowledge may make them better informed to underwrite such opportunities. Meanwhile, the bond model also allows small businesses to attract incremental demand. You could imagine the aforementioned brewery hosting a special night for investors or allowing customers to take their coupon payment in the form of a discounted bar tab.
Despite the uphill recovery before us, new technologies, new avenues of funding, and new models of customer engagement are emerging to help bolster and rebuild small businesses in COVID-19’s wake.
One of the most important catalysts for the recent growth in financial services has been fintech enablers and infrastructure. Companies like Plaid wrap otherwise byanztine legacy infrastructure in modern APIs, allowing every developer to easily integrate financial products with software products, often to the great benefit of consumers. The importance of Plaid and the API market more broadly cannot be overstated — an entire generation of neobanks, lenders, and financial management tools has been made possible through programmatic access to bank transaction data.
A new set of platform players are emerging that follow a similar pattern. Much as Plaid allowed consumers to make their bank transaction data available to fintechs, these new platforms are giving fintechs access to payroll, insurance, credit, and ERP data. We took a deep dive into the particular potential for payroll-connected APIs, including the best model for market entry and the long term outlook for these companies at scale.
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