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Move Fast and Break Wallets
When serving the unbanked and underbanked, high-octane digital financial services threaten to do more harm than good.
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Around the globe, digital financial services (fintechs) that claim to serve the underrepresented (unbaked or underbanked) are causing widespread hardships. While ostensibly “democratizing” and speeding access to financial services, time and time again, fintechs are taking advantage of regulatory gray areas and exploiting users, who tend to be vulnerable.
For example, in India and Kenya, thousands of instant loan apps drive people deeper into debt and expose them to shoddy collection practices. There are more than 4,000 instant loan apps on the Google Play Store in India alone, with little distinction on which ones are legal. When one gets shut down, ten others pop up.
In North America, Robinhood, the stock investment app, encourages its young and inexperienced user-base to trade at very high frequencies (by some estimates, 40 to 88 times higher than average retail investors). These trades have been turbocharged by easily accessible options trading, margin accounts, and “herding events” (e.g. Hertz, Tesla, GameStop). There are stories of staggering losses, at least one loss-induced suicide, and expectations of widespread wipeouts. There have also been several regulatory complaints filed against Robinhood.
There are more examples. A category of “democratizing” fintech is “buy now, pay later” (BNPL). BNPLs are on a mission to help customers “say yes” to buy more of what they want but cannot necessarily afford, using installment loans. BNPL customers tend to be low-income and with tapped out credit. Affirm, PayPal, and Klarna lead the pack, with plenty of clones popping up everywhere.
The Flywheel Moral Hazard
Exploitative finance is age-old and predates tech. But the story arc is more or less the same:
New financial services thrive in regulatory gray zones or take advantage of loopholes.
Mass growth (sometimes manic and hysteric) is achieved, and profits are made.
Negative consequences and hardships spread, and/or systemic risks emerge, leading to public outcries.
Regulatory intervention and/or reactive response from the financial services provider and/or no action.
However, today, there is a unique danger: regulatory intervention may never be able to catch up to technology's pace. Exploitative fintechs are ingeniously following Silicon Valley growth playbooks. A “Flywheel” in Silicon Valley parlance is a business model where each transaction begets new customers and even more transactions; growth is exponential. A simplified example of a flywheel: the more users post and share on Facebook, the more their friends would join the site, engage, and keep visiting. Facebook’s entire suite of apps is geared towards new user acquisition and increasing engagement.
This flywheel business model is highly coveted. Fintechs, in their tens of thousands, are competing to build better flywheel mousetraps. And the VC community enthusiastically funds startups that demonstrate the flywheel effect.
According to the famed VC Andreessen Horowitz, distribution insights are critical to building successful fintech flywheels: cost-effective ways to acquire and engage large numbers of users. Typically, two metrics govern distribution insights: the cost of customer acquisition (CAC) and the customer's lifetime value (LTV). The former should be minimized, and the latter maximized.
For example, Robinhood baked into its app viral referral programs (“Open Account, Get Free Stock”) and gamified engagement. And Affirm, the “buy now, pay later” (BNPL) platform, embeds itself as a payment option on e-commerce checkout pages to seamlessly acquire customers then cycles them through its properties for further purchases. Both of these companies have low CACs. To maximize LTVs, they deploy various methods that encourage repeat usage, often pushing emotional buttons like FOMO, herding/“get rich quick,” consumerism, and despair.
Furthermore, Andreessen Horowitz anticipates that the next evolution of fintechs will be social+: products will be built on unique social networks to leverage the power of community and peer-to-peer engagement. The flywheels will be even more optimized to reduce CAC further and increase LTV: deploying product-level growth loops, increasing the scope of user engagement, maximizing retention, and therefore achieving defensibility (and sky-high valuations along the way).
The VC firm (and it’s by no means alone) calls for a hyper-optimization of access to financial services and repetitive use. This is, per se, not a bad thing. But when it comes to serving the “underrepresented,” it invites many negative consequences.
In her award-winning book, No Filter: The Inside Story of Instagram, Sarah Frier chronicles social media’s powers over our society:
Social media isn’t just a reflection of human nature. It’s a force that defines human nature, through incentives baked into the way products are designed.
Shamelessly egging on and funding social+ fintechs to target the needy, inexperienced, or financially illiterate while running far ahead of regulators will reproduce Social Media’s negative consequences in new ways. This is the definition of moral hazard.
Chamath Palihapitiya, another famous VC, recently tweeted about Robinhood, deriding them for not “optimizing for integrity”:
“Optimizing for integrity” is a fantastic guiding principle. The financial well-being of users and their best interests should be the top metric for fintechs. This could mean that products are built-in with behavioural nudges to discourage self-harming activities, cool down periods when users are too active, financial assessments when signing up, and financial knowledge delivery.
But, “optimizing for integrity” increases friction. CACs and LTVs may not look so attractive anymore, and the flywheel might lose momentum. Maybe venture-backed fintechs shouldn’t be serving the underrepresented?
In the past, I built utility-scale solar power plants. As a financing condition, we had to subject our projects to environmental and social impact analyses (ESIA). The ESIA assessed the impact of the projects on: the local economy, flora and fauna, air quality, noise levels, water resources, archeological sites, and much more. The goal was to identify risks and develop mitigation plans. The investors would then expect bi-annual reports to track those risks and address issues. Wouldn’t it be cool if fintech pitch decks had a slide or two on how their products and strategies might negatively impact their users? Even better, VCs should demand such analyses and reporting as a condition of doling out their money. Impact insights should go hand in hand with distribution insights. Can there be a Silicon Valley VC mea culpa?
Who am I kidding!?
There will be Many More Wake up Calls
Exploitative fintech will be around for a long time; it’s just too lucrative. The unbanked and underbanked markets are big and alternative finance innovations are plentiful (crypto, digital currencies, social+, super apps). Moreover, the regulatory landscape is fragmented with too many vulnerabilities.
Without coordinated regulatory and industry (VC and fintech) action globally, the hardships will keep on coming.
Notes & Sources:
Robinhood Has Lured Young Traders, Sometimes With Devastating Results, the New York Times.
Affirm: The Morality of Money, The Generalist.
Time to tighten rules on ‘buy now pay later’ operators, Financial Times.
The Big Ideas Fintech Will Tackle in 2021, Andreessen Horowitz.
Community Takes All: The Power of Social+, Andreessen Horowitz.