Change is in the air.
Banks and financial services institutions, which ran amok with risk during the recent financial crisis, have competition. Bitcoin, a form of digital currency, has emerged as the most prominent symbol of disruption of the financial services industry. But a new breed of finance tech startups have also staked claim to that title by becoming alternate lending platforms. According to a recent Goldman Sachs report, they are poised to take away as much as $11 billion in profits from the traditional financial services industry.
In their simplest form, finance tech startups connect borrowers with lenders using a technology platform. In fact, one could argue that sites such as Kickstarter, a crowdfunding platform, are the new faces of finance because they enable artists to seek funding for their pet projects. But unlike normal investments, project backers on such sites are not rewarded with returns.
The new bunch of startups are not pure crowdfunding vehicles. Instead, they have taken a page out of the financial services playbook to create innovative securities. They facilitate lending by using Notes that are registered with the SEC. Similar to other financial instruments, investors can choose from a variety of options and investment horizons. The startups also enable investments in cash, something that only money market funds could do earlier.
Not surprisingly, the sites became popular during the recession and have benefited from the Fed’s low interest rate policies, which has reduced the number of investment options available in traditional avenues.
It will be some time before the tech startups transform the finance industry, due to a number of reasons.
The loan amounts serviced by these startups are also small, or amounts that traditional lenders are unable or unwilling to service. And, their default rates spiked during the recession, when the economy tanked. In recent times, those rates have improved.
Still, they have succeeded in making a dent in the financial services sector. Here are three startups that have forged a new path in the financial services industry.
1. Peer-to-peer lending startups
As the name denotes, peer-to-peer lending startups are online platforms that connect individual borrowers with lenders. The platform vets borrowers on a number of criteria and assigns specific interest rates based on an assortment of criteria, such as credit scores and availability of revolving credit. Loans made to individuals are subsequently repackaged and sold to banks.
The two largest lenders in this space — Lending Club and Prosper — work with Utah-based WebBank to disburse loans. The startups issue short-term SEC-registered convertible notes that can be reimbursed upon maturity of loans.
There are a couple of ways in which peer-to-peer lending startups differ from banks or other loan disbursement agencies, such as credit card agencies.
First, they use crowdfunding to fulfill loan requests. Thus, a single loan on a P2P lending platform may be financed by multiple lenders. Each lender collects an amount based on interest rates calculated by the site. It is difficult to imagine multiple banks servicing the same loan, as they prefer to lock in customers.
Second, these sites enable average Americans to participate in the lending process and earn interest on their savings. SEC guidelines stipulate that only accredited investors (investors who earn $200,000 or more or $1 million annually) are allowed to participate in funding startups. But peer-to-peer lending startups make fewer demands on their investors. For example, Lending Club, the largest peer-to-peer lender in the space, only requires social security number verification for an investor to get started. The site’s income requirements are also comparatively relaxed, since investors only need a minimum annual income of $70,000.
Prosper was the first peer-to-peer lending startup in the United States. It started operations in 2006. It had high default rates and things quickly went south after the financial crisis. However, Prosper (and Lending Club) have stabilized operations in recent times. Lending Club even went public last year.
2. Real estate funding startups
Although it is generally considered a safe investment, real estate can be expensive. There are also other problems with investing in the real estate industry.
For example, the large amounts of financing involved for real estate deals make it impossible for lay investors to garner action in the sector. Real Estate Investment Trusts, or REITs, offer a way for investors to tap into the real estate boom. But the exposure is indirect and they are dominated by institutional investors, such as mutual funds. The real estate industry is also a relatively insular industry. As such, it is difficult for individual investors to participate in deal flow within the industry.
However, a new wave of real estate funding startups is offering a slice of the real estate pie to lay investors. Investors from these startups can put in as little as $100 to get started with their deals. They work in a similar fashion to the peer-to-peer lending space by using crowdfunding as a tool to raise large amounts of cash. Similarly, the startups offer a relatively short time horizon for investment (approximately 3-5 years) and vet real estate deals in advance. Investors are given a share of rental income from commercial properties, and also a portion of profits from its sale upon maturity.
The startups in this space all have prior history of working within the industry, which gives them access to lucrative real estate in prime markets, such as New York. For example, Fundrise, a startup in the industry, is backed by Silverstein Partners (the real estate firm involved in developing the World Trade Center) and holds Class I bonds in WTC 3. The startup claims to have completed 30 transactions in 10 markets, including eight in New York City.
According to Daniel Miller, chief executive officer at the startup, crowdfunding improves a real estate deal’s outcome. Investors are more likely to patronize the restaurants they help to fund and buy the condos of the developments they back, Miller explained. While Fundrise is focused on long-term commercial property deals, others such as Realtyshares, enable investment in a wide variety of properties, including single-family homes and apartment complexes.
But real estate crowdfunding startups have the same drawbacks as other crowdfunded investments, in that they account for a relatively small slice of the large real estate pie. For example, Fundrise’s largest transaction to date is a $10.5 million deal in New York City, which will close later this year. Considering the prime market and resurgence in real estate prices, that amount is not much.
One could also argue that a $100 investment in a real estate deal hardly has the potential to revolutionize financing in the industry. Still, as the number of users for such sites increase, they might end up becoming profit centers in the larger real estate ecosystem.
3. Student Loan Startups
The burgeoning student loan market is expected to be the next default crisis. Student loan debt has already surpassed nearly a trillion dollars, an amount that trumps figures for credit card and auto loan debt. A number of factors have coalesced to make student loans an unsustainable debt proposition. These include wage stagnation, rising tuition fees, and unemployment among millennials.
Student loan startups are taking advantage of loopholes in federal loan statutes to create a new market for their services. For example, federal student loans are statutory rather than risk-based. This means factors important in evaluating these loans, such as credit worthiness and graduating institutions, do not play an important role.
Student loan startups have taken advantage of this discrepancy to stake out a new market. They target students who have graduated from top-tier universities and reprice their federal loans at low interest rates. Subsequently, they repackage these loans into securities and resell them to investors. Some startups, such as San Francisco-based Social Finance, have also begun using the services of existing banks to craft bonds from their student loan pool.
The startups use innovative tactics to build out their business. A number of startups in this space use the network effects of community building and alumni relations to spread the word. Common Bond, an NYC-based student loan startup, designed its first fund for 40 MBA students and graduates at the Wharton School at the University of Pennsylvania.