Financial innovation is actually happening

Patrick McKenzie (patio11)

If you say the words “financial innovation” many people incorrectly believe it is largely negative (or at least risk-taking) or not happening. This is incorrect. The world is actually getting better, within our own lifetimes. Much of the improvement has been to under-the-hood infrastructure not paid much attention to by the general public, but since the financial system touches almost every part of our lives, it is worth knowing what has happened and on which axes we can expect further improvement.

Free-as-in-beer banking

Advocates for the un- and underbanked have long had one request of the financial system: can you just get us a free basic checking account, please. This was the white whale for decades. It was technically possible but would have been extremely burdensome for community banks, because it is (fundamentally) a call to subsidize some depositors at the expense of others. That subsidy would have been bearable for the largest, most broadly distributed financial institutions in the world, but would have covered almost the entire deposit base of many community institutions. The tough part about subsidies is that someone has to pay for them. As we discussed previously, community banks exercise quite a bit of influence in the U.S., and so proposals for "free banking" got quietly killed.

So it would probably surprise advocates, burned from this discussion in the 1970s, 1980s, 1990s, and 2000s, that in 2021 the U.S. has nationally distributed free banking offerings that users love, that are profitable for the industry, and that do not stem from a regulatory mandate.

The key driver of the change has been competition for the deposit business of regular households. It's a fascinating story.

Perhaps some readers may not remember this, but prior to the mid-1990s checking accounts had price tags. In the 1990s, “free checking” became a marketing phenomenon, partly aimed at growing the number of banked households but mainly a pricing war between a consolidating industry hunting for share in local markets.

Free checking wasn’t free. Instead of most depositors paying a predictable (and relatively small) fee for their checking account, a tiny portion of the depositor base was assessed many, many $25-$35 fees stochastically based on how frequently their incomings and outgoings were temporarily mismatched. This resulted in a perverse tax-the-poorest-harder situation, where more than $10 billion annually was collected, with the large majority of it coming from less than 10% of banked households [PDF]. Overdraft fees made the math for free checking work for most of the country, at ruinous cost for a portion of it.

But. Things. Are. Getting. Better.

Online and, especially, mobile banking have given consumers more up-to-date visibility into their funds flows and allowed them more control over fees. That alone wouldn’t have helped (and didn’t help) folks whose primary problem was that they didn’t have enough money for obligations at least some of the time.

What has helped there is competition by apps, which a) knew that users who experienced them virtually universally hated overdraft fees and b) successfully decreased servicing costs for marginal users to the point where they could be profitable on tiny amounts of per-account contribution margin.

This combination let them ostentatiously kill overdrafts and use that for marketing. Chime’s recently highlighted “Fee-free overdraft up to $200.” Cash App similarly leaned into this for years.

The financial industry thought, for many years, that the customers added or retained by these improvements would be disproportionately expensive to service and low-revenue. Cash App has experimentally disproven that. Their cohort graph is a thing of beauty (see page 9 here [PDF]); enterprise SaaS level net expansion revenue on cohorts of consumers recruited at a $5 cost of acquisition.

This did not go unnoticed in the financial industry, particularly in 2020 when “widely distributed branch network” became a tougher thing to sell on. Online-focused banks are aggressively competing on this axis. Ally Bank dropped overdraft fees entirely. Some in the industry expect at least one top-10 bank to shortly experiment with it for marketing purposes, which (given competitive dynamics, particularly vis regulators) will likely cause a lot of following.

We’re not done with improvements here, given approximately $10 billion in overdraft fees assessed a year, but it was considered impossible for decades to do the thing you can now get from multiple competing providers available on every smartphone.

Sidenote: Smartphones themselves are a beautiful example of technical and financial innovation making new capabilities almost universally available. When the iPhone debuted it was high-end consumer hardware. These days entry-level Androids are given away to attract mobile service contracts.

Fast transfers

If you’re an internationally-minded American in the financial industry, you get ribbed about two things constantly: checks (“what do you mean the country that invented high-frequency trading mails around pieces of paper to move money and that those pieces of paper have account security tokens literally printed on them in block letters to make them easier to read”) and transfer times.

“Moving money between bank accounts takes 3-5 business days” has been the rule in the United States for most of my life. This quietly changed and many people have not really noticed. It happened via a combination of sustaining innovation, greenfield transfer networks, and heuristic credit decisions made at superhuman rates by computers.

The Automated Clearing House (ACH) moves about $60 trillion (!) a year. It was started as a backoffice improvement to solve the problem that banks processing checks would have to mail or courier checks between each other, and gradually expanded into electronic payments over time.

ACH payments historically operated on a daily or twice daily batch processing, and they’re (importantly) “negative confirmed.” This means that you do not get immediate reliable feedback that an ACH transfer or withdrawal has succeeded. The association’s rules require financial institutions to report errors (via even more batch processing) within 5 business days, and given that errors are expected in the ordinary course (most commonly, insufficient funds, since funds availability is not and cannot be guaranteed at transaction time), businesses and banks have to make decisions on what degree of risk they’re willing to tolerate.

ACH moved to same-day settlement (rather than next-day settlement) in 2018 for most transactions. This has accelerated funds availability, but it did not achieve real-time or near-real-time guarantee about funds sufficiency, so giving the user money before the 5 day window expires still runs some credit risks.

Banks have gotten much better at evaluating this credit risk and accelerating payments for low-risk transactions, such as federal government transfers, established direct deposit relationships, and others. The “others” is the most interesting category, because it’s a problem which would have been intractable prior to computers but is now fairly pedestrian data science, and using it is uniformly pro-consumer (giving people access to their own money faster).

Depending on the institution, some of the factors that go into heuristic acceleration might include age of account (more established accounts experience less errors, of virtually all types, than newer accounts), frequency of the transferer/transferee relationship, experience across accounts regarding the transferer (“Shouldn’t we treat Google transfers as money-good? They literally never bounce.”), desirability of the customer relationship (“Shouldn’t we be willing to take a tiiiiny bit of credit risk to keep e.g. a dentist’s custom? They’re very lucrative.”), etc.

In a pattern we often see in finance, this innovation has occurred in parallel with new user behavior and new networks, most obviously the Zelle consortium in the U.S. and app-driven closed payment networks like Venmo and Cash App.

Zelle was, in large degree, a response by banks to avoid being disintermediated by the payment apps, and now processes more than $300 billion of transactions annually. These are both free to consumers (banks subsidize them to keep their depositors from going elsewhere) and almost instant, including outside of banking hours. Venmo and Cash App both have transaction run rates around $250 billion per year.

Perhaps counterintuitively after quoting twelve digit sums, the impact on consumers of these innovations is larger than it looks. Single-day or single-weekend liquidity mismatches are responsible for large financial and social consequences, particularly for less well-off users, ranging from multiple $35 overdraft fees to getting one’s power or water service turned off. Being able to tap friends and family for funds instantly, or move money between one’s own accounts instantly, helps to avoid this.

We see this in B2B services, too. Many small businesses operate very close to the margin essentially all of the time, and the number one request from businesses of almost all sizes at Stripe is accelerating payout timing. It turns out there are many ways to do this at an acceptable cost for acceptable levels of marginal risk if one is creative, and we continue to be very, very creative. That helps to turn Stripe into an overlay network on the global financial system. We can do internal settlement at Internet speed even between businesses that have a very complicated least-cost route between them through existing financial institutions.

Remittance costs are cratering

A phrase that no one has ever said: “I really enjoy making international wires.”

Nonetheless, this has gotten better over the last few years, especially over heavily-used corridors. (In remittances, “corridor” is a term of art meaning an origination location, a destination location, and a currency or currency pair. For example, “US to Mexico while converting dollars to pesos” is one of the busiest remittance corridors in the world; the opposite direction is a different ballgame for structural and demand/supply reasons. As a result, professionals think of it differently.)

Anecdotally, as someone who has for almost 20 years had to move money between the U.S. and Japan, all-in costs have declined by 90% for small transfers and double digit percent for large ones. Japan to the U.S. is a relatively high-cost corridor (mostly due to user willingness to pay), but Wise (nee Transferwise) has gotten the pricing on a $1,000 transfer down to about $10. The best provider in the market used to charge $40 plus a (conveniently underdisclosed) ~2% spread on the currency conversion.

Interestingly, there are now multiple Japanese banks that actively court foreign depositors (which was almost unthinkable 20 years ago), and they finally do for retail users what sophisticated counterparties have long had available: constantly publish reliably available prices for currencies with tight spreads. One of these banks currently quotes a spread of .3 JPY per dollar, which works out to about 0.25%.

More active corridors like the aforementioned U.S. to Mexico have similarly benefitted from vibrant competition by the financial and non-financial sectors. Walmart is a major player here (through partnerships, a frequent feature of non-financial firms offering financial services), and has fairly competitive pricing, at about 3% at the typical remittance (about $300).

One of the major themes in driving remittance pricing down has been focusing on operational costs, which for remittances are dominated by retail presences at both endpoints of the transaction. Transitioning remittance senders to apps (and encouraging them to do their cash management in either the traditional banking sector or in adjacent ecosystems like pre-paid cards) reduces the labor and retail footprint required on one leg of the transaction. In cases where both legs use apps (or websites, or phone centers), the transaction can asymptotically approach free.

Since remittances are a high-salience user need for some user groups, financial institutions (and other businesses) on both sides of the border can choose to sacrifice revenue on remittances to win more business from those customers. We see this pattern again and again: because financial transactions are high-salience and often high-frequency, non-financial firms would prefer to commoditize their complement and drive the cost of transacting to nearly zero. This was historically difficult for a host of reasons, but technological and business innovations are making it so achievable that many don’t realize how quickly it is happening.

Common themes

Innovation in finances often starts at the “edges” of the traditional financial ecosystem but moves in, sometimes gradually and sometimes rapidly. It is not the sole province of either tech startups or banking incumbents; partnerships between the two are responsible for most interesting product development in the space. The competitive interplay between startups (with attractive new user experiences) and incumbents (with operational scale and distribution advantages) is a core driver of improvements becoming ubiquitous. Another is regulatory or quasi-regulatory action; finance is networks at every scale, and sometimes fiating the existence of a new equilibrium is more efficient than hoping that everyone simultaneously decides to move there together.

Stripe believes that financial services for businesses are also getting better, through measured and responsible innovation happening at financial institutions, software companies, and elsewhere. We partner with leading financial institutions to make capabilities that either didn’t exist or were limited to only the most sophisticated businesses more widely available. This helps put startups on a level playing field with incumbents, increase the pace of innovation for all industries, and improve the lives of everyone who transacts on the Internet.

That's why I work there. If building better financial infrastructure for the Internet to enable the next few decades of financial innovation sounds like an interesting challenge, we're hiring aggressively.

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