Financing

Daniel Kim
Motivation
• Last week, Paul described p2p lending business as problematic.

• He might be right.

• In fact, FinTech financing is not as successful as FinTech

payment.
• FinTech financing includes p2p lending
• Fintech financing is smaller in market cap than fintech payment
Why?
• Non-fintech financing solution tries to address inherent challenges in
financing.

• Fintech financing tried to address the same challenges

• However, it seems that fintech solution is not as good non-fintech financing
solution
• The severity of this problem is the largest in p2p lending
Overview: Non-fintech vs. Fintech
Non-fintech financing Fintech financing
Personal financing P2P: Personal, business
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding
Challenges in Financing
Financial Market
• Ideal world!
• Savers know everything that borrowers know
• Borrows know everything that savers know

Borrowers
Savers (a.k.a.
(a.k.a.
investors)
entrepreneurs)
Financial Market
• Ideal world!
• Efficient allocation of funds

Good borrowers 5% interest

Savers

Bad borrowers 15% interest

Potential Problems
• But the world is not ideal….

• Information asymmetry
• As emphasized by Anders last week!
• borrowers know more about the business than lenders

• Lenders have to figure out who is bad and who is good

• In mose cases, lenders do not have resources
• This has serious consequences: adverse selection
Financial Market
• Adverse selection
• If savers cannot distinguish between good and bad borrowers, savers will
assume that everyone is bad
• Thus savers charge high rate for both good and bad

Good borrowers 15% interest

Savers

Bad borrowers 15% interest

Financial Market
• Adverse selection
• Good borrowers will not stay in the market. Only bad ones will stay
• Inefficient outcome!

Savers

Bad borrowers 15% interest

A potential solution

• Financial intermediaries to the rescue!

• Financial intermediaries supposedly decrease such an inefficiency
 A potential solution
• Supposedly reduces information asymmetry by helping
lenders to distinguish good from bad
Good borrowers 5% interest

Savers Financial
Intermediaries

Bad borrowers 15% interest

A potential solution
• Financial intermediaries are acting on behalf of savers

• Thus, financial intermediaires are helpful only if

Assumption 1: Financial intermediaries are skillful AND
Assumption 2: Financial intermediaries are honest
• For this class, let us assume that Assumption 1 holds and focus on
Assumption 2
A potential solution
• Financial intermediaries provide service for FEE
• and this fee is often their main income source

• Given that financial intermediaries are private companies, it is

reasonable to think that they will act in a way to maximize the fee
A potential solution
• Thus, this new solution would work only if the fee is structured in
a way to incentivise financial intermediaires to be honest

• Due to many reasons (including the lack of regulation), the fee is

not structured in such a way

• Moreover, sometimes, the consequences of being dishonest is

not severe enough!
Moral hazard
• In summary, their fee structure does not incentivise financial
intermediaires to be honest

• Thus, create a problem….

• The problem is called moral hazard

Moral hazard
• Suppose that financial intermediaires exactly know who are good
and who are bad (Assumption 1)

• Borrowers, who are classified as good, pay lower interest than

borrowers, who are classified as bad.

• Thus, bad borrowers will do anything, including paying higher

fees, to be classified as good
Moral hazard
• Being dishonest earns financial intermediares higher fees than
otherwise

• Thus, financial intemediaires will be dishonest and claim that bad

borrowers are good
 Moral hazard

Good borrowers 5% interest

Savers Financial
Intermediaries

"Good" borrowers 5% interest

Moral hazard
• Problem?

• Savers are not properly compensated for the risk!

Moral hazard
• In order to mitigate moral hazard problem, it is important to
specify severe consequences for being dishonest

• And thus requires proper regulation!

Moral hazard
• This was one main reason behind the 2007-2008 financial crisis
in the U.S.
• Bad borrowers were not able to borrow before
• But due to moral hazard problem, bad borrowers were able to borrow
• And those bad loans had negative ripple effects on the entire economy!
Non-fintech Financing
Corporate Financing
• Firms borrow…
• By issuing bond
• By taking out loan

• Firms sell a part of their owership…

• By issuing equity
Financial Intermediaries
• Depository institutions
• Commerical banks
• One stop shop for many financial services
• E.g. Bank of America, JPMorgan Chase, etc
• Credit unions
• Smaller in scale, serves particular affiliation
• E.g. Educational Employees Credit Union
• Savings and loan associations
• Specializes in accepting savings and making loans
Financial Intermediaries
• Nondepository financial institutions
• Institutional investors
• E.g. pension, insurance companies
• Securities brokers/dealers
• Buys and sells securities on behalf of its customers
• Investment banks
• e.g. IPOs
 Investment Bank Revenue Breakdown

Top 10 Fee M&A Equities Bonds Loans

Banks
Total 89.0B USD 31% 18% 30% 21%

Investment Bank Revenue, 2016, Thompson Reuters data

Source: John Hill, Fintech and the Remaking of Finacial Institutions: pp76-77
Non-fintech vs. Fintech

Non-fintech financing Fintech financing

Personal financing P2P
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding
Non-fintech financing Fintech financing
Personal financing P2P
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding

Non-fintech: Bond Financing

Bonds
• Contractual promise to pay back

• Characteristics
• Maturity date: the date the bond comes due
• Current yield: interest payment as percentage of current market price

• In order to issue bonds, firms typically need to be assigned

credit rating
Credit Rating
• Determines the likelihood that the borrower will be able and
willing to pay back
• A high credit rating indicates a high possibility of paying back the loan
without any issues
• Significantly determines bond’s characteristics, notably maturity date and
current yield
Credit Rating
• Who assigns them?
• Standard & Poor’s, Moody’s, and
Fitch
• These rating agencies are paid
by the entity that is seeking a
credit rating
Credit Rating
• Potential problem
• There are three credit rating agencies
• Thus, corporations can shop around for favorable credit rating
• Example: If Standard & Poor’s does not give a favorable one,
they will just go to Moody’s

• Why is that a problem?

• In order to attract more customers, credit rating agencies are
incentivised to issue good ratings
• This decreases quality of credit rating!
Credit Rating
• “The skewed assessments, in turn, helped the financial
system take on far more risk than it could safely handle.” Paul
Krugman, The New York Times columnist

• Ratings agencies “were key enablers of the financial

meltdown,” the Financial Crisis Inquiry Commission (2011)
Credit Rating
Credit Rating
• This problem is not limited to the US

• Eurozone Debt Crisis

• the inaccurate sovereign ratings by the credit ratings agencies led to the
worsening of the eurozone debt crisis (European Central Bank (ECB))
Credit Rating
• Series of lawsuits

• " The credit ratings agencies continue to pose a threat to the

existing financial system. "
• Security and Exchange Commission (28.12.2015)

• Big Three continue to control 95% of the credit ratings market

Credit Rating
• This is at the heart of Reason 1 (no skill) and moral hazard
problem
• Credit rating agencies are supposed to provide skill that others lack
• Yet, this creates moral hazard problem!
Credit Rating
• Thus, it is important to see how fintech addresses this problem

• Does fintech outsource this like nonfintech companies do and suffer from
moral hazard problem?
• Or
• Does fintech address this in-house and avoid moral hazard problem?
• Is in-house solution scalable and trustworthy?
Non-fintech financing Fintech financing
Personal financing P2P
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding

Non-fintech: Personal
Financing
Personal Credit Rating
Non-fintech financing Fintech financing
Personal financing P2P
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding

Non-fintech: IPO
Initial Pubilc Offering
• Prior to IPO,
• a company is considered private
• Investment from founders, family, friends, VC, and angel investors

• IPO
• Investment from the public with help from underwriters at a fee
Initial Pubilc Offering
• IPO: steps
1. Company signals interest to underwriters
2. Underwriters present a proposal
• offering price, amount of shares and estimated time frame
3. Compay chooses underwriters
4. Underwriters, laywers, accountants, and SEC experts form a team
5. Prepare IPO documentation
6. Create marketing materials for new stock issuance
7. Do other prep works to turn private company public
8. Issue shares on IPO date
Initial Pubilc Offering
• However, IPO is costly!
• Explicit cost:
• 4-7% of gross proceeds plus fixed cost
Initial Pubilc Offering
• However, IPO is costly!
• Implicit cost (IPO underpricing)
• The first-day closing price is often higher than the IPO price
• Represents the wealth transfer from entrepreneurs to new
shareholders
• Google IPO (August 19, 2004)
• IPO price was 85 USD whereas the first day closing price was
100.34USD
• 300.7M USD loss!
Non-fintech financing Fintech financing
Personal financing P2P
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding

Fintech Financing
Important Question

• How does fintech address the aforementioned problems?

• Does being transparent address this problem?

• Information asymmetry implies adverse selection

• Thus, we need some solutions to address information

asymmetry
• Why did information asymmetry arise?

Reason 1: no skill
• No skill to distinguish between good and bad borrowers

Reason 2: hiding (untionally or intentionally)

• Not being transparent about the process
• Solution 1: pre-fintech system
• Commercial banks, investment banks, credit rating agencies, etc

• Data suggest that the system has somewhat mitigated adverse selection
problem!
• Good borrowers are in the market, searching for funds!
• Solution 1: pre-fintech system
• This implies that
• Pre-fintech system addressed both Reason 1 and Reason 2
• Or
• Pre-fintech system addressed only Reason 1 and Reason 2 was not
important
• Or
• Pre-fintech system addressed only Reason 2 and Reason 1 was not
important
• Solution 1: pre-fintech system
• Caveat
• Moral hazard
• High fees
• Solution 2: fintech
• The system is lightly and transparently intermediated
• Smaller moral hazard problem
• Low fees
• Transparency: solves Reason 2
• But does not address Reason 1
• because having more information does not mean anything unless
you know what to do with it
• è Key issue
• Solution 2: fintech
• Data imply that fintech financing suffers from adverse selection problem!
• Only bad borrowers borrow from fintech companies

• This implies that

• We are still in transition stage (i.e. we have not reached an equilibrium
stage yet)
• And time will tell!
• Or
• Reason 1 was a real problem, Reason 2 was not a problem
• Thus, addressing Reason 2 will not mitigage adverse selection
problem!
• Bottom line:
• Being transparent is not necessarily good especially if it comes at the
expense of higher adverse selection problem!

Pre-Fintech Fintech
Adverse selection Low High
Fee High Low
Moral hazard High Low
Transparency Low High
Non-fintech financing Fintech financing
Personal financing P2P
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding

Fintech: P2P Lending

 P2p lending

• Different terminologies between me and Geir

Crowdfunding
What is it?
• Lending money to individuals or businesses through a platform
service that matches lenders with borrowers.

• Their main revenue source is fee to lenders or borrowers

Benefits
• Lower cost, i.e. lenders earn higher returns while borrowers can
borrow money at a lower interest rate.

• Generally operate online and have lower overhead costs, and can therefore
provide cheaper lending than traditional financial institutions.
• Overhad cost is lower because they supposedly do not face unnecessary
hurdles or do not do unnecessary tasks
• Caveats
• Are those tasks truly unnecessary?
• Will this hold even after new regulations are imposed?
How does it work?
• Most P2P loans are
unsecured
personal loans
• Thus, similar to
personal
financing

.
link
Price
• The interest rates can be set by
• Borrowers compete for the lowest rate or

• Intermediary company fixes it based on of the borrower's grade

Assigning Grade
• P2P firms assign grade to each project
• Similar to credit rating system
• Uses its own information to assess the creditworthiness of new companies
• Sometimes based on the money a start-up raises and the cash it
spends
• Amazon lends to vendors using its own data.
• Kabbage, which provides loans to eBay sellers, says that it uses “real-
time” business performance data instead of credit scores.
Assigning Grade
• Lending club
• Uses a combination
of a proprietary
scoring model, FICO
score, and other
credit features of the
applicant.
Assigning Grade
• Prosper
• Uses a combination of a proprietary scoring model (Prosper Score),
credit reporting agency score, debt-to-income ratio and other “soft
checks” conducted by credit bureaus.
Assigning Grade
• Upstart
Pros and Cons
• Pros: bank run is not possible
• When a lender offers money on the platform, their funds are matched
directly with specific borrowers
• Should be encouraged by regulators!
Pros and Cons
• Cons
• Liquidity issue
• Fund cannot be withdrawn immediately unless they found another
lender

• The lender's investment in the loan is not normally protected by

any government guarantee, which normal saving banks are

• Bankruptcy of p2p company that facilitated the loan may also put the
lender's investment at risk
• as happened in 2015 in the case of TrustBuddy.
How would it look in the future?
• Challenges
• P2P’s small fee maybe due to its lack of due dilligence

• P2P’s low interest rate for borrrowers

• This could be very sensitive to business cycle

• Moral hazard problem

• P2P typically does not have skin in the game
• Nearly all of its revenue comes from origination fees on loans made
through its platform.
• No incentive for P2P to perform good credit analysis
China’s P2P Lending Market
• Lufax
• Second largest online lender
• Backed by the rock-solid balance sheet of China’s largest insurer
• 20% market share
• In 2018, new users increased by 20% and loans grew by 33%
• There is little loyalty to any single platform

• Announces that it will shrink its p2p business

• Lufax hedged its expsoure to P2P lending by adopting the business model
that it was set up to challenge
• Build up a wealth management business and consumer lending license
 P2P Lending
Bond Personal Loan P2P Lending
Financing

Adverse selection Low Med High

Fee High Med Low

Moral hazard High Low Low
Transparency Med Low High
Non-fintech financing Fintech financing
Personal financing P2P
Bond financing Grade assignment
Credit rating
Initial public offering crowdfunding

Fintech: Crowdfunding
Why crowdfunding?
• Traditional way (IPO) was inefficient
• Definition of efficiency: finance the most promising business
• Was complicated and needed lots of luck!
• Need to shop your idea around to a limited pool or wealthy individuals
or institutions (banks, angel investors, and venture capital firms)
• Entrepreneurs spend months sifting through personal network, vetting
potential investors, and spending time and money to get in front of
them.
• Failure to find the right investor or firm at the right time results in waste
of your effort, time and money
• Crowdfunding to the rescue!
Crowdfunding
• A single platform to build, showcase and share your pitch
resources to the public!
• this approach dramatically streamlines the traditional model.
• Much easier for you to get your opportunity in front of more interested
parties and give them more ways to help grow your business

• Raising capital through the collective effort of friends, family,

customers, and individual investors
It is not new
• The book was crowdfuneded
• French philosopher Auguste Comte (1798-1857)'s scheme to issue notes
for the public support to his further work as a philosopher.
• The book will be written and published if enough subscribers signal their
interest to buy the book once it was out.

• Base for Statue of Liberty (U.S.A.)

• A newspaper-led campaign attracted small donations from 160,000 donors
in the 1830's.
• Gained popularity and mainstream use in the arts and music
communities
• The first noteworthy instance of online crowdfunding in the music industry
was in 1997. The fans underwrote an entire USA tour for the British rock
band Marillion, raising US$60,000 in donation by the means of fans-based
Internet campaign.
Crowdfunding
• Three types

• Rewards-based crowdfunding

• Donation-based crowdfunding

• Equity-based crowdfunding
Rewards-based crowdfunding
• Contribution in return for the product or service (e.g. Kickstarter,
Indiegogo)

• Investors?
• Do not seek financial gain

• So, perhaps better called sponsors, donors or patrons?

link
Donation-based crowdfunding
• Contribution in return for no financial gain (e.g. GoFundMe)
link
Equity-based crowdfunding
• Contribution in return for becoming part-owners, who ultimately
receive dividend

• If the business goes bankrupt, you might lose your money

• Similar to other types of investment
Equity-based crowdfunding

• Illiquid and volatile

• Early-stage companies are more illiquid and more volatile compared to more
established firms (e.g. Apple)

• Investors might find it difficult to access their money after it has been
invested
link
Comparisons
P2P lending vs. Crowdfunding
• They both raise financing online from a number of people
• p2p lending is sometimes called debt crowdfunding or crowdlending
P2P lending vs. Equity-based
crowdfunding
• p2p lending is less risky than equity-based crowdfunding

• Equity-based crowdfunding is more for sophisticated investors

than p2p lending
P2P fundrasing
• Different from P2P lending

• Crowdfunding on steroids
• Crowdfunding: collecting many smaller donations from multiple donors
• P2P fundraising
• Each participant has their own crowdfunding-style page
Fun Fact: Size of the Market
• Nordic countries just jumped on the bandwagon (p2p lending,
crowdfunding)!

• Online alternative finance total volume (2015)

1. Finland 142M euro
2. Denmark 88M euro
3. Sweden 86.5M euro
4. Norway 4.9M euro
• Source: the Cambridge Center for alternative finance
Situation in Norway
• Norway has one of the strictest rules on crowdfunding in the
EU
• In Norway, there are currently 16 crowdfunding platforms and most of them
work in P2P lending (a.k.a crowdlending area), while only two companies
offer crowdfunding
• A license to handle equity is necessary to operate in crowdfunding.

• Source: Fintech beat 2019, thefactory.no

• This is why Norwegian Crowdfunding Association started

• Geir Atle Bore at Funding Partner will talk about this!
Direct Public Offering
Initial Pubilc Offering

• IPO might not be necessary for firms that

• are well recognized
• do not need large financing

• For such firms, alternative ways such as direct pubilc offering

(DPO) might be cost-efficient way to raise capital
Direct Public Offering (DPO)
• Raises small amount of money independently without the
restrictions associated with SEC (security exchange
commission), bank and venture capital financing

• Typically works for companies which are already well recognized

and well capitalized
2018

2019

1984
1. Ben Cohen and Jerry Greenfield needed funds for their ice cream business.
2. They advertised their ownership stakes through local newspapers for
$10.50 per share with a minimum number of 12 shares per investor.
3. Their loyal fan base in Vermont took advantage of the offer and the
company,
4. Ben & Jerry’s Ice Cream, raised $750,000 within the year.
Direct Public Offering (DPO)
• This suffers less from adverse selection problem!
• Only market-proven players can do direct public offering
Direct Public Offering (DPO)
• Not for everyone!
• DPO cannot raise large amount of money
• DPO requires filers to be well recognized

• Thus, IPO is here to stay

• Despite its hefty fee
 IPO vs. DPO

IPO DPO
Adverse selection High Low
Fee High Low
Moral hazard High Low
Transparency High, due to Low
regulation
 Lesson Learned
IPO DPO Pre-Fintech Fintech
Adverse High Low Low High
selection
Fee High Low High Low
Moral hazard High Low High Low
Transparency High Low High Low

• Perhaps, Fintech can learn from DPO!

Regulation
Regulation
• Savers and borrowers need trust in financial institutions

• And regulation helps to boost financial institutions

• And….. Hint hint!
• regulation also helps to instill trust in Fintech industry
• Note: It is sometimes tempting to think of regulation as strangling
innovation. But some regulation is necessary to ensure systemic
stability and can sometimes increase the industry (read John Hill’s
chapter 15)
Fintech Regulation
• Given its short history, the regulatory system for such
relationships is still developing.

• UK
• USA
• Australia, Canada
Fintech Regulation: UK
• Authority: Financial Conduct Authority (FCA)
• Suggests to make changes to prevent investors from taking
risks
• Strenghtening requirements for borrowers
• Improvement in risk training and management
• Limitations for particular types of investors
• Full disclosure or the role of a platform
Fintech Regulation: USA
• Authority: Securities and Exchange Commission
• A compulsory platform registration in the SEC and FINRA
• The maximum amount of securities issused within a crowdfunding campaign
• Limitations of investment amoutns and securities sale
Fintech Regulation: Others
• Australia
• Australian Securities & Investments Commission ASIC
• the registration process, risk and conflicts of interest management, resource
requirements, and disclosures.

• Canada
• The National Crowdfunding Association of Canada (NCFA Canada)
• specifies offering limits, types of securities, issuer and investor limitations,
software requirements, etc.
References
• FinTech and the Remaking of Financial Institutions by John Hill
• College Grads Sell Stakes in Themselves to Wall Street
• https://www.bloomberg.com/news/articles/2019-04-09/college-grads-sell-stakes-in-themselves-to-wall-street
• Credit Rating
• https://www.investopedia.com/terms/c/creditrating.asp
• The Indisputable Role of Credit Ratings Agencies in the 2008 Collapse, and Why Nothing Has Changed
• https://truthout.org/articles/the-indisputable-role-of-credit-ratings-agencies-in-the-2008-collapse-and-why-nothing-has-changed/
• Initial Public Offering
• https://www.investopedia.com/terms/i/ipo.asp
• Direct Public Offering
• https://www.investopedia.com/terms/d/directpublicoffering.asp
• How Spotify’s direct listing is different from an IPO
• https://www.cnbc.com/2018/04/03/how-does-spotify-direct-listing-work.html
• The 4 Best P2P Lending Platforms For Investors in 2017
• https://www.forbes.com/sites/oliviergarret/2017/01/29/the-4-best-p2p-lending-platforms-for-investors-in-2017-detailed-analysis/#c6468952abbc
• Can there ever be a run on a P2P platform?
• https://www.lendingworks.co.uk/BLOG/PEER-TO-PEER/CAN-THERE-EVER-BE-RUN-P2P-PLATFORM
• What will P2P lending look like 5 years from now?
• https://ftalphaville.ft.com/2015/02/19/2119569/what-will-p2p-lending-look-like-5-years-from-now/
• What is Crowdfunding? Clear, Simple Answer Here.
• https://www.fundable.com/learn/resources/guides/crowdfunding/what-is-crowdfunding
• Comparing The Top Online Fundrasing and Crowdfunding Platforms
• https://www.crowdfunding.com/
• 5 of the Best Crowdfunding Sites for Charitable Giving
• https://www.thebalancesmb.com/giving-to-charity-online-2501931
• Here is why Fantex, the athlete stock exchange, is working
• https://fortune.com/2015/03/31/athlete-stock-exchange-fantex/
• The difference between P2P Lending and crowdfunding
• https://justcoded.com/blog/the-difference-between-p2p-lending-and-crowdfunding/
• Leader of China’s 9 billion Ezubao online scam gets life
• https://www.reuters.com/article/us-china-fraud/leader-of-chinas-9-billion-ezubao-online-scam-gets-life-26-jailed-idUSKCN1BN0J6
• Chian P2P/Ping An: end of peer show
• https://www-ft-com.ezproxy.library.bi.no/content/7a28aaa0-a9dc-11e9-984c-fac8325aaa04?segmentId=8f356614-1478-b0ad-bacd-bbdf90d4bfb6