5 The Digital Disruption of Banking and Payment Services: David Arnold and Paul Jeffery

5 The digital disruption of banking and
payment services
David Arnold and Paul Jeffery*
INTRODUCTION
The prospect of digital disruption in financial services is being taken

increasingly seriously by some of the most credible voices in the industry.
Andy Haldane, Chief Economist and Executive Director of the Bank of
England, the UK’s central bank, has suggested that ‘Banking may be on
the cusp of an industrial revolution. This is being propelled by technol-
ogy on the supply side and the financial crisis on the demand side. The
upshot could be the most radical reconfiguration of banking in centuries’
(Haldane, 2013). The Federal Reserve in the USA echoes this view,
finding that ‘The ubiquity of mobile phones is changing the way consum-
ers access financial services’ (Federal Reserve, 2015). The consulting firm
McKinsey forecasts that by 2025 approximately US$200–600 billion (or
20–60 percent) of global banking profits associated with five major retail
banking businesses are at risk of either being lost to new digitally attuned
industry entrants, and/or being weakened by the margin- compressing
effects of heightened competition (McKinsey, 2015).
However, the same McKinsey report also notes that the loss suffered
by banks to date, in terms of market share and profits in various lines of
business, ‘has been little more than a rounding error’. Academic research
reflects the uncertainty in the industry: Kroszner notes that since the
financial crisis of 2008 commercial banks have shown ‘resiliency’ in terms
of deposits and loans as a share of GDP, to varying extents in differ-
ent regions, but also notes that ‘We are, perhaps, at a defining moment’
because of factors including ‘business-model innovations . . . that seem to
have the potential to dismember and disintermediate banks’ (Kroszner,
2015). Beyond banks, certain sectors of the industry have seen market
leadership fall into the hands of disruptive innovators: M-Pesa, ultimately
owned by mobile telecommunications firm Vodafone, is the market leader
for mobile payments in much of Africa, having expanded from its origins
in Kenya; its success is mirrored in the online payments sector by PayPal,
a California-based firm that launched its payment service in 1999; price
comparison websites known as ‘aggregators’ have disrupted sectors such
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104 Research handbook on digital transformations
as auto insurance in many northern European markets; and peer-to-peer

lending platforms such as the US sector leader Lending Club are growing
rapidly and attracting significant investment to continue their incursion
into the loans market.
It is in emerging markets that disruption has progressed furthest in
financial services; disruptors such as M-Pesa in Kenya, Smart in the
Philippines, bKash in Bangladesh and M- Paisa in Afghanistan have
achieved over 50 per cent market share in multiple sectors of the industry
(Runde, 2015). In such markets, as is explained in the following section of
this chapter, the necessary conditions for disruption are met, given the less
developed state of the financial services industry and the consequent large
proportion of national populations that are unserved or underserved by
banks and their peers. In a study of disruption in Asian financial markets,
Chung et al. (2015) identify bank account penetration as a key indicator of
the state of market development, categorizing as ‘early-stage’ markets ripe
for disruption those with 60 percent or more of the population unbanked.
Low-cost financial services can have a life-changing effect in such circum-
stances, lifting customers out of poverty, improving market efficiency and
stimulating economic growth (Kendall and Voorhies, 2014).
In more advanced economies, by contrast, while thousands of entre-
preneurial ‘fin tech’ players are targeting the financial services industry,
some with considerable success, the major players are yet to be disrupted.
It remains possible that certain characteristics of the industry, notably the
high level of regulation, which is increasing since the 2008 financial crisis,
will stifle entrepreneurial activity. Research in both the professional and
academic communities highlights the potential for disruption, but has
yet to establish empirical patterns of irreversible disruption. This chapter
examines this potential from theoretical starting points, examines how
this theory applies in the context of financial services, and looks at some
specific examples of disruption in action in the sector.
THEORY OF DIGITAL DISRUPTION
Disruption is a theory of industrial change flowing from Clayton

Christensen’s research into evolutionary patterns in the disk-drive indus-
try, in which market leadership repeatedly changed hands with advances
in the dominant technology (Christensen, 1997). Contrary to earlier theo-
ries that characterize industry evolution as a Schumpeterian race between
competing technologies (for a summary, see Grant, 2012, Chapters 8 and
9), disruption postulates that the ‘value networks’ of incumbent firms
sometimes prevent them from exploiting opportunities even when they


105
The digital disruption of banking and payment services
have the capabilities and resources required to adopt them, thus providing
an opening for a new product or competitor, a ‘disruptor’. These value
networks may include both internal and external assets that act as inhibi-
tors of innovation (Stabell and Fjeldstad, 1998): because of the firm’s
cost structure, for example, it may judge the opportunity to be too small
to meet its investment hurdle rates; the firm’s close relationship with its
major customers may inhibit change, in the event that those customers are
committed to current product technologies and unwilling to write off sunk
costs; or the firm may judge the new technology to be inferior to current
alternatives and so unlikely to cannibalize its existing business (Gilbert
and Bower, 2002). Firms that realize that an initially inferior technology
could eventually cannibalize their business may take preemptive action
to protect themselves against disruption, but in many cases incumbents
continue refining existing technologies or business models well beyond the
point at which they no longer create superior value for the mainstream
market.
The net effect of this narrow focus on existing technologies and exist-
ing customers is a drift away from market-driving value innovation. The
disruptor is the player who takes the opportunity to introduce a product/
service customer value proposition that, in the language of strategic mar-
keting, has the effect of creating a new value line in the industry (Jeffery
and Arnold, 2014). This new value line offers products/services that are
more relevant to mainstream customer needs, frequently at a lower stand-
ard price. Typically the creators and providers of these new value lines
are legacy-free newcomers who bring both radically innovative products
and lower cost structures to an industry. Christensen’s initial research
highlighted that in certain industries, such as steel, the shifting of the value
line in the industry resulted in a major redistribution of both the revenues
and profits between competitors, resulting in more of a breaking up rather
than a leveling of the competitive playing field of an industry. As a con-
sequence, disruption in an industry can be viewed as a development that
carries within it the seeds for not just incumbent marginalization but also
extinction.
The necessary conditions for disruption are therefore: (1) an under-
served segment of a market; (2) an innovation with the potential to offer
an improved value proposition to that segment; (3) incumbent firms with
value networks that inhibit them from adopting the innovation; (4) the
capability of the disruptor to move beyond their entry segment into the
mainstream market while maintaining a value advantage that cannibalizes
incumbents. A major contribution of disruption theory is the insight that
a product innovation regarded by incumbent firms as an inferior technol-
ogy may be regarded by underserved segments of the market as superior


value. The customer value proposition is thus a key driver; critically,

even an ‘inferior’ product technology may represent superior value if the
customer costs are reduced more than the customer benefits. An industry
is therefore vulnerable to disruption when it carries cost drivers that no
longer deliver the proportionate level of benefits to customers. A perfect
example is the retail branch network of major banks in developed markets;
this legacy channel remains largely in place while a large proportion of the
market has switched to online banking and rarely uses the retail branch. A
2013 study by consulting firm McKinsey estimated that traditional banks
faced a cost disadvantage of 425 basis points (4.25 percent) when com-
pared with peer-to-peer platforms such as Lending Club, mostly because
of this channel cost (McKinsey, 2013).
DRIVERS OF DIGITAL DISRUPTION IN FINANCIAL

SERVICES
A number of contextual factors, particular to the financial services indus-

try, are relevant in judging the likelihood of extensive and irreversible
disruption. While some of them highlight the vulnerability of the industry
to disruption, others provide potential explanations for the slow onset of
disruption in this sector, and may continue to limit changes in the industry.
The first factor, regulation, illustrates this ambiguity. While financial
services have always been heavily regulated, the burden has increased
significantly since the financial crisis of 2008. The Basel III accords,
introduced in 2011 with the objective of avoiding a repeat crisis, have
increased the capital adequacy and liquidity requirements of banks, to an
extent that banks may have to alter their business model. The financial
consequences of this regulation constitute an inhibiting factor in the value
networks of commercial banks, and a competitive disadvantage relative to
non-bank disruptors such as peer-to-peer (P2P) lending platforms (Allen
et al., 2011). While this facilitates disruption, it should be noted that the
currently favorable regulatory environment enjoyed by P2P players is
under regular review, and a variety of new regulatory schemes are under
consideration or being piloted (Macchiavello, 2015). The vulnerability of
heavily regulated incumbents to lightly regulated challengers is therefore
uncertain.
Second, the Internet threatens incumbent financial services firms with
disintermediation. Distribution channel theory identifies a number of
functions via which an intermediary creates value for buyers and sellers,
including the establishment of a network hub or marketplace that mini-
mizes search and transaction costs for parties on both sides of the platform


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(Coughlan and Anderson, 2015). Much of the financial services sector is

intermediation rather than production, bringing together investors and
borrowers, and acting as a nexus for information flows and contracts. It
should be noted that disintermediation in financial services predates digi-
tization, with public and private sector organizations increasingly selling
debt directly to investors on capital markets for several decades.
However, the relatively new field of platform economics has established
that digitization can fundamentally alter the reach and efficiency of such
intermediary marketplaces or platforms (Evans et al., 2011). Specifically,
digitization has dramatically increased the extent and accessibility of
information, and enabled the establishment of new multi-sided businesses
or platforms, defined as ‘an organization that creates value primarily
by enabling direct interactions between two (or more) distinct types of
affiliated customers’ (Hagiu, 2009). Multi-sided digital platforms are able
to threaten disruption because they are asset-light, flexible and scalable
(Olleros, 2008). Two classes of platforms of prominence in the financial
services sector are exchanges, which facilitate contact between lenders and
borrowers in a peer-to-peer marketplace, and transaction systems, such
as mobile payment systems (Evans and Schmalensee, 2008). At present,
disintermediation in financial services is a threat rather than a reality; the
persistence of incumbent firms has previously been noted.
Importantly, it should be noted that from the perspective of market
structure the emergence of digital platforms represents reintermediation,
since they still act as a nexus for information flows, thus performing a
mediating role between parties on either side of the market. At the market
level, what occurs is a shift from heavy to lean intermediation, rather than
disintermediation. From the perspective of incumbent banks, however,
the threat is certainly one of disintermediation, because at the margin (that
is, the individual transaction) customers can often choose a marketplace
that offers not only lower costs but a fundamentally different business
model, with direct contact between borrower and lender, and the lender
rather than the intermediary bearing the credit risk.
Third, the information intensity of financial services makes digitization
particularly relevant to the development of new customer value proposi-
tions. It has long been recognized that services are more easily copied than
physical products, because their intangibility lowers the barriers to entry
compared to the high up-front investments in fixed costs typically required
in product manufacture (Berry and Parasuraman, 1991). Also, markets
with products that can be easily digitized are more likely to switch to
Internet-based competition (Lal and Sarvary, 1999). The financial services
industry is inherently data-centric, being in essence a market for informa-
tion (Haldane, 2013), and digitization of the core product of financial


services, which is essentially a contract, creates an opportunity for new

business models. The industry was an early adopter of computer technol-
ogy, with ATMs and electronic transfer of funds being introduced in the
1960s, but until the financial crisis of 2008, the digitization of finance
did not alter the structure of the industry, with change driven more by
competitive consolidation and the effects of episodic tumult in the global
financial economy, than by new digitally savvy entrants into the market.
The disruptive potential of digitization is in the ability for ‘datafication’,
the processing of isolated pieces of information into a rich database that
has not only descriptive but also predictive capabilities, known popularly
as ‘data mining’. A traditional role of banks and other financial interme-
diaries was to reduce the asymmetry of information present in financing
markets, with lenders often lacking sufficient information to judge the
credit worthiness of potential borrowers. Information on an applicant’s
financial history, such as income level and stability or repayment of
previous debts, was the traditional source of such assessment, and such
information was of course in the possession of the financial intermediary.
It is now some decades since such assessment processes were digitized,
either by the financial intermediaries or by specialist credit rating third
parties, and this in itself caused no disruption. Since the 2008 finan-
cial crisis, one major cause of which was the inaccuracy of many credit
ratings, there has been added impetus behind the development of better
credit assessment models. One particular way in which the digitization of
society has facilitated this is the expansion of information available due
to increased online activity (Pasquale, 2015). The incorporation of social
media data offers two opportunities for disruption: first, such information
is available outside the databases of incumbent financial intermediaries,
thus eliminating a barrier to competition (Lohr, 2015); second, such data
supplements financial history to provide a richer pool of data as the basis
for assessment. Wei et al. (2015) conclude that the use of social media
and social network data can be expected to improve the quality of credit
assessment.
Fourth, the financial services market has started to be the target of
competition from firms for which financial services is not a core business.
As described later in this chapter, the development of payment systems
by Internet giants such as Apple and Google can be assumed to be moti-
vated by a search for economies of scope in the development of an ever
wider relationship with their customers, and the establishment of what
Apple describes as the ‘ecosystem’ it wishes to build through a portfolio
of complementary products and services. Payment systems not only offer
an additional convenient service that can enhance the value to users of
their mobile operating system; a user’s financial transaction history is a


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rich dataset that can be ‘mined’ with learning algorithms and then sold
to advertisers and sellers. The user’s financial history is therefore of value
as a gateway to future consumption, rather than as a consumption item
in itself, and the strategic stakes for Internet technology companies in
entering the payment systems market are therefore different from players
offering money transmission as a core service. At one level, this is an
example of hypercompetition, defined as dynamic competition in which
forces such as globalization and disruption undermine the sustainability
of competitive advantages (D’Aveni, 2010), and the broader trend in
marketing for ‘relationship-based marketing’, in which individual product
profitability may be subordinated to the search for economies of scope at
the account level. More specifically, multisided platform theory identifies
cross-product or cross-platform subsidies as a central and optimal element
in digital platform business models (Evans, 2012).
Theory makes it clear that financial services incumbents are certainly
vulnerable to disruption, given their costly, rigid and highly centralized
value networks, the inflexibility of which is exacerbated by increasing
regulation. These asset configurations are inhibiting the ability of these
players to respond to digital innovations such as peer-to-peer platforms,
and richer data and learning algorithms. However, it is possible that some
of the advantages enjoyed by disruptors may be temporary.
AREAS OF POTENTIAL DISRUPTION IN

FINANCIAL SERVICES
At its core, the financial services industry, or at least the banking i ndustry,
which accounts for the lion’s share of financial service industry activities,
has focused on providing two main services: financing and payments.
In both of these service areas banks now face a broad range of non-
traditional competitors. Underlying the specific areas of vulnerability
highlighted in the previous section, it should be noted that, in common
with many other industries, banking faces new competitors with signifi-
cantly lower-cost operating models; not only is capital and the recording
of its movements now digital, but wider developments in information
technology, and particularly the emergence of cloud computing (Newman,
Chapter 18 in this volume), have dramatically lowered the cost of produc-
tion, market making and information processing, thus reducing barriers
to entry. The core value proposition of many of the following disrup-
tive competitors is improved value through lower pricing. Research has
proved inconclusive on whether scale economies exist in traditional
banking (Kroszner, 2015). For firms not classified as banks and therefore


outside the regulatory regime, the lower marginal costs of software-driven

applications, and the ability to access data from other technological plat-
forms such as mobile telephone usage, offer opportunities to enter sectors
of financial services such as payments with a cost advantage relative to
incumbent operators.
Financing
Banks’ financing activities, both with retail and corporate customers, are
dominated by lending. After the global financial crisis of 2008, digitally
enabled, non-bank lenders have entered a broad cross-section of lending
markets as banks, encumbered by financial regulators with greater capital,
liquidity and customer reporting obligations, have shrunk their activities
(Fitch Ratings, 2013). The most notable of the new non-bank lenders have
been the so-called peer-to-peer (P2P) or marketplace lenders which, over
the last three years, have experienced exponential growth in the value and
volume of the loans they have originated (Moldow, 2014).
Peer-
to-
peer lenders represent a radical departure from traditional
financing business models in several ways that reflect disruption theory.
First, they have no branch network, with the customer experience being
executed entirely online: as has been noted, this dramatically lowers the
cost base in a way that incumbent lenders, with their legacy assets, will find
difficult to match in the short to medium term. To the extent that they pass
on these savings to customers, they have a significant price advantage.
Second, they are archetypal platform business models, facilitating
the provision of loans via the creation of an online market place ena-
bling direct connection between customers on either side of the plat-
form. As the phrase ‘peer-to-peer’ indicates, the customer is promised a
leaner intermediation, with the P2P platform’s reintermediary role being
restricted to introductions, and excluding risk- taking and/or advice;
this is, in effect, a self-service option. This is a radical departure from
traditional banking models in which borrowers and lenders are invisible
to each other. Vitally, P2P platforms do not take deposits, nor do they
employ their own balance sheet in the origination of loans. As a result,
they execute a platform-based pricing model that is fee-centric rather
than spread-centric (spread defined as the net interest margin made on the
rates they pay on deposits versus the rates they charge for loans). Lending
that takes place in online P2P marketplaces is a dollar for dollar arrange-
ment and thus, unlike the fractional lending model of a bank, involves no
financial leverage.
Third, P2P platforms employ learning algorithms on rich and diversi-
fied data sets (‘big data’) to allocate borrowers into risk categories. Being


111
non-bank and therefore lacking any government deposit guarantees, it is

vital for P2P platforms to reassure lenders of their risk assessment capabil-
ities, and the data support their common claim to outperform traditional
banks in this regard: Zopa, a major player, reports a default rate of 0.25
percent, compared with the 2–3 percent typical of most major UK banks
(Jeffery and Arnold, 2014). This is of course partly a function of a more
conservative acceptance rate of 10 percent of applicants for loans. While
credit assessment processes remain confidential, industry commentators
regard as plausible the claim by P2P lenders to be best-in-class in this field
(The Economist, 2015).
Clearly, P2P lenders meet multiple conditions of disruption theory. The
improved customer value proposition to borrowers is that they are offered
access to a stable supply of capital that is considerably better priced for
both borrowers and lenders, easily accessible online and offered with
transparent fees and a direct connection to the counterparty. This business
model has the potential to create a new segment of the financial services
market, because P2P loans are a new financial asset class in the same way
that non-investment-grade or ‘junk’ bonds became a new asset class from
the 1970s; this new P2P asset class, largely comprised of consumer and
SME loans, was not hitherto accessible to the general investing public
and was the preserve of banks. Significantly, this new asset class offers
attractive returns while having a low correlation with other asset classes
(Evans, 2015), suggesting the potential to create a sustainable new option
for investors.
Lending Club, the world’s largest P2P lender, was listed on the New
York Stock Exchange and attained a listing valuation of US$6.5 billion.
Lending Club offers individual borrowers fixed rate, monthly amortizing
loans on three or five-year terms. The borrower can repay the loan at any
time within term for no additional charge. Loans are applied for online via
an application process commonly taking less than 30 minutes to complete,
and using algorithm-based credit assessment, loan (dis)approval decisions
are completed within minutes. A successful borrower’s loan application is
then given a credit grade, ranging from A to G, to which is added a recom-
mended annual rate of interest to be charged. The loan is then advertised
/ offered to lenders via Lending Club’s online marketplace. The company
claims that the average borrower to date has been able to achieve a 32
percent reduction in their annual borrowing costs by replacing existing
debt with a Lending Club loan (Lending Club, 2015), implying an average
500–700 basis point (5–7 percent) reduction in the annual cost of debt the
borrower is carrying.
The potential for this to disrupt the payments sector is considerable. As
of 2014, 46.7 percent of US households had a credit card balance, with


the average balance of an indebted household being US$15 706 (Federal

Reserve, 2014), amounting to an aggregate revolving balance of credit
card debt in the US of over US$890 billion. The typical charge on credit
card balances in the US is 21 percent (CompareCards, 2015), and so a
price improvement of 5–7 percentage points represents a compelling value
improvement.
Lending Club might be the largest US P2P lender and arguably the most
well-known online marketplace lender in the world, but it has plenty of
company, particularly in the US, UK and China. Lending Club’s largest
domestic P2P competitor is Prosper. Prosper has originated over US$5
billion in prime and above credit scored unsecured consumer loans. In
2Q 2015 Prosper had a quarterly loan origination run rate of greater
than US$1 billion. SOFI, founded in 2011 and focused on disrupting the
US market for student loans, has originated more than US$4 billion in
loans and is now branching out from student loans to mortgages. Avant
Credit, a sub-prime unsecured consumer lender founded in late 2012,
has originated more than US$1.5 billion in loans and in 2014 expanded
its geographic footprint beyond the US to include the UK. In the UK,
meanwhile, Zopa, Funding Circle, RateSetter and LendInvest, the four
leading P2P platforms, have collectively originated loans with a value
of over US$5 billion. In China, a country where the State-owned bank
dominated banking sector has often been viewed as having starved pri-
vately owned companies and individuals of credit (World Bank, 2015),
P2P loan volumes have accumulated even more quickly than in the US
and the UK. According to a report on Internet finance in China issued by
Credit Suisse, the stock of outstanding P2P loans in China stood at over
US$16 billion as of the end of 2014 (Wei, 2014). China has been reported
by the Wall Street Journal as having over 2000 P2P lenders (McMahon,
2015). Many of China’s P2P lenders are sub-scale, poorly managed and
will probably commercially perish in time. The larger players, however,
like Lufax, CreditEase, Renrendai and Dianrong (interestingly founded
by Soul Htite, one of the founders of Lending Club), look well placed,
regulation permitting, to grow into very large companies, helping to finan-
cially power China’s switch from being an export-driven to a domestic
consumption-driven economy.
Stepping back and once again turning to the potential for the financial
service industry to experience a major digital-based disruption by new
market entrants such as P2P lenders, it is worth noting that all of the P2P
lenders mentioned in the previous paragraph were growing their loan
origination volumes at year-on-year rates of in excess of 75 percent as of
30 June 2015.


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Payments
The global financial payments system is a highly complex ecosystem.

Banks have a commanding position in this ecosystem, which includes
technology providers and payment networks such as those of Visa and
MasterCard. According to the Boston Consulting Group, globally banks
are involved in US$400 trillion of payment-related transfers every year
from which they extract US$1 trillion of fees (The Economist, 2015). Banks
are the largest issuers of credit cards, and beyond getting a commission on
purchases, the so-called interchange fees charged to merchants by credit
card providers, banks make money from payments by charging high rates
of interest on the debt that is often incurred by consumers to make those
purchases that generate the payment.
Founded in 1998, the ‘grandfather’ of would-be disruptors of the pay-
ments industry is PayPal. Today, PayPal’s online payment service is avail-
able in 203 countries and processes over US$200 billion in payments a
year (PayPal, 2015). PayPal’s value to its customers is based on its ability
to make e-commerce payments simple, convenient and secure. Having set
up an online account with PayPal, which involves a consumer uploading
their bank account and credit card details, PayPal’s consumer customers
never have to re-enter their credit card and/or bank account details again
when making an online purchase or funds transfer to a PayPal enabled
merchant or another PayPal account holder. Payments or funds trans-
fers can be made simply either via an email address and a password or a
mobile number and PIN. These payments can be made by desktop, tablet
or mobile phone. As of the end of September 2015, PayPal had 169 million
individual consumer accounts.
PayPal’s merchant customers, once they have installed PayPal function-
ality on their website, normally in the form of a ‘payment button’, receive
payment-related monies within minutes of a PayPal payment having been
made. Merchants also benefit from PayPal assuming all fraud-related
risks on the payment. The simplicity and convenience of PayPal’s online
payment process typically has the added benefit to merchants of improv-
ing the conversion rate they experience on consumer traffic to their web-
sites. PayPal claims a typical boost to a merchant’s sales of 7.4 percent
after that merchant has adopted PayPal as a payment option for its
customers (PayPal, 2015). As of the end of September 2015, PayPal had 2
million business customers.
Having gained a payments beachhead with its customers, PayPal, in
recent years, has evolved into being a lender to those customers. In 2009
the company launched PayPal Credit, a loan service offered to PayPal’s
consumer customers. In 2013 the company launched a service in the US


called PayPal Working Capital, which, as the name implies, offers working
capital loans to PayPal merchants. The loans range from US$1500 to
US$85 000 in size and are payable monthly from incoming receipts to the
merchant’s PayPal account until such time as the balance is paid. Since
launch of the working capital service, PayPal has lent more than US$500
million in the US to small businesses. After a successful launch of PayPal
Working Capital in the US the service was launched in the UK in late
2014. What these developments demonstrate is that a customer relation-
ship that a new financial services industry entrant develops originally in
payments can over time be successfully projected into other service areas
like financing.
Affirm, a company founded in 2013 by Max Levchin, one of the co-
founders of PayPal, provides unsecured loans to consumers and seeks to
compete with PayPal and credit card companies by focusing on transpar-
ency and fairness, with no late fees and interest that does not compound.
Affirm, through utilizing big data, advanced data analytics, machine learn-
ing and algorithm-driven credit assessment, is making both the decision
to loan and the provision of a loan instantaneously possible at the point
of purchase. Consumers can apply online via their mobile phone for an
Affirm loan to purchase goods from Affirm-registered merchants. The
process for doing so is fast and easy, simply requiring the consumer to input
their email address, date of birth and mobile phone number into the Affirm
mobile app. Affirm is then able to instantly access and analyze up to 70 000
points of data on the applicant – only some of these data points relate
to what would traditionally be thought of as strict credit data (Haycock,
2015). With this data in hand, Affirm then makes a near instant decision
about whether to offer a loan, the maximum size of the loan and the rate
to be charged on the loan. The prospective borrower is then informed of
the loan terms and offered a range of 3, 6 or 12-month repayment options.
Affirm says it is ‘using modern technology to re-imagine and rebuild core
components of the financial architecture from the ground-up’ (Affirm,
2015). Central to this approach is the use of technology to harness data sets
in new, quicker and more effective ways. It is no coincidence that one of
Max Levchin’s co-founders of Affirm is Nathan Gettings, the former chief
technology officer of Palantir. Palantir, a non-publicly listed company
founded in 2004, has a current valuation in excess of US$20 billion and is
one of the world’s leading data analytics companies (Perez, 2015). Affirm’s
specialization in harnessing data to deliver a lending proposition to con-
sumers that is more convenient and less expensive than that of credit-card
issuers suggests the company has a disruptive future in consumer lending,
particularly given that ‘banks are currently realizing only 10–20% of the
potential of their data’ (McKinsey, 2015).


115
Stripe, founded in 2011 and already commanding a private market valu-

ation of more than US$5 billion, is a payment service provider seeking to
add value in payments via apps (Russell, 2015). Specifically, via its Relay
service, Stripe allows merchants to upload details of their products directly
to Stripe and then publish a link to buy the product in question across a
range of social media. In effect, Stripe’s Relay service puts a buy button
simultaneously in multiple apps for a merchant’s product via a single inte-
gration. Thereafter, Stripe administers the payments generated by those
buy buttons. Stripe’s social media customers include Apple, Facebook,
Twitter and Alibaba. It is hard to imagine any of the established banking-
related incumbents would have come up with a service as innovative and
as relevant to millennial customers as Stripe’s. The plain fact is that to date
they have not. Further, it does not take much of an imaginative leap to
think that, like PayPal before it, Stripe might move to become a financier
to its customers as well as a payments service provider.
For every Stripe, Affirm and PayPal there are literally hundreds, if
not thousands, of new, non-banking entrants coming into the market for
financial payments. So much so that payments services can currently be
seen as being in something akin to a Cambrian age where new commercial
life forms, radically different from those that have preceded them, are
emerging. If the scale of the latent disruptive effect a Cambrian moment
in finance suggests were not enough, financial incumbents, and the incum-
bents of the financial payments system in particular, arguably face an even
larger disruptive threat looming over the horizon. That threat is posed by
the established giants of the technology industry intent on entering the
financial-services space.
The most heralded of the technology giants to have entered the market
for financial payments is Apple. In October 2014, Apple launched a
mobile payments and digital wallet service called Apple Pay. The payment
service is available as a mobile app and from 2015 has been preloaded on
all Apple iPhones, iPads and Apple Watches. Apple Pay stores customers’
credit and debit card details but does not pass those details on to mer-
chants when making payments, thus enhancing security and also keeping
proprietary control of customer data and metadata. Apple Pay enables
contactless in-store payments via the use of near-field-communications
technology. Twelve months after its US launch, Apple Pay was usable
in over 1.5 million stores and enjoyed the backing of the top 10 leading
banks in both the US and the UK. Apple for now is not trying to bypass
the traditional back-end rails of the payment system, dominated by Visa
and MasterCard, but it is potentially compressing the profits that incum-
bents make from those rails by taking a cut of 0.15 percent of all pay-
ments made through Apple Pay. There is also a clear danger that Apple


might eventually choose to raise its cut and/or provide credit directly to
borrowers itself.
In September 2015, Google launched Android Pay in the US to
compete with Apple Pay. Android Pay launched with a fleet of major
banks, such as Wells Fargo, Bank of America and Capital One, as well
as leading retailers like Toys R Us and McDonald’s. The big prospective
danger posed by Google to banks’ payments businesses is not the danger
that it takes some of their margin but rather that it entirely removes
the margin in the business by pursuing a different business model.
Android Pay is tied to Google’s electronic wallet through which payments
can be made at the point of sale via phone (just like Apple Pay). Unlike
Apple, Google, because of its search business, may be willing to give mer-
chants a much discounted interchange rate because they are able to link
a purchase of a specific product to a previous search that a customer had
carried out. If they can do this, it would turn their cost-per-click search
revenue model into a much more value added, and thus bigger margined,
cost-per-acquisition model (Haycock, 2015). To get this valuable infor-
mation and outcome, Google may well ultimately treat payments as a
loss-leader business that is cross-subsidized by the high-return search
business.
Facebook has applied for an e-money license in the US, is reported to be
developing a P2P payment product within Facebook Messenger and has
hired a former president of PayPal to run Facebook Messenger (Heath et
al., 2015). Facebook have also tied up with Venmo, a hyper social, free,
mobile accessible digital wallet that allows users to make and share pay-
ments between friends. Amazon is continually bolstering the quality of
its payments service Amazon Payments. Samsung has launched a mobile
payments service, Samsung Pay. In China, Internet giants Alibaba and
Tencent have very popular payments services, which between them
accounted for more than 70 percent of all online payments made in China
in 2014.
Whether they are fin-tech start-ups or the giants of the technology
industry, new players are challenging incumbent banks for the right to
provide payment services to consumers and merchants. At the very least,
this is weakening the relationship banks have with their customers and
suggests the distribution of profits associated with making financial pay-
ments is likely to be very different in the near future from how it was in
the past. The extent of that redistribution is likely to ultimately be deter-
mined by four elements. First, the degree to which customers will come
to eschew debit and credit cards all together. There is some evidence that
millennial customers are already starting to do that (Haycock, 2015).
Second, whether new entrants into financial services have the ambition


117
and the ability to move beyond the provision of payments and broaden
the range of their activities into other areas of financial services such as
financing, wealth management and perhaps even deposit-taking. Third,
ongoing technological breakthroughs, like the blockchain technology that
has made crypto-currencies like Bitcoin possible, resulting in new and as
yet uncertain financial services provision models (Pilkington, Chapter 11
in this volume). Fourth, regulation: changes in financial sector regula-
tions and requirements can occur at any time and have the effect of either
making it materially harder or easier for non-incumbents to disrupt the
financial service sector. Since the global financial crisis of 2008, which so
discredited many financial incumbents in the eyes of a large number of
regulators around the world, the trend of financial regulation has been to
widen the access to, and promote greater competition in, financial services
(HM Treasury, 2015).
CONCLUSION
The financial services industry is certainly in the throes of a digital revo-

lution. In the areas of payments, credit-risk assessment, market making,
and even investment advice, digitization is transforming the way in which
both retail and corporate customers transact business. The industry is also
attracting both large numbers of entrepreneurial start-up ventures seeking
to exploit these digital innovations more rapidly than the incumbents, and
technology giants such as Apple and Google who see financial services as
a keystone of the ecosystem they seek to establish for their users.
While usage patterns have already been widely disrupted, the industry
has not yet been disrupted to the extent suggested by disruption theory;
large incumbent firms still enjoy market leadership in all sectors of the
industry. Some of the conditions facilitating the current period of extended
experimentation are arguably temporary, such as the widespread distrust
of large financial institutions after the 2008 financial crisis and several
exposures of malpractice. Some, such as the shift to mobile payments and
the development of learning algorithms to assess credit risk, are likely
to be irreversible. The status of financial services as a quasi-utility, with
the consequent high level of regulation, may inhibit the growth of new
entrants to the point at which they displace incumbents, as may c oncerns
over data confidentiality.
It seems unlikely that many of the new, most technology-enabled and
adept entrants to the financial services industry will take the ultimate step
and become a bank themselves by turning into deposit-taking institutions.
However, there appears to be a good fit between the characteristics of the


financial services industry and the conditions identified by research as

necessary for disruptive innovation. In particular, digital technologies are
in the process of transforming the economics of the industry, both through
the digitization of the product and associated assessment and advice, and
through the establishment of more efficient marketplaces and associated
mechanisms. The efficiency of the industry is being drastically improved,
and the value networks of the established, asset-intense organizations are
likely to struggle to adapt with the necessary speed.
NOTE
* The authors gratefully acknowledge the research contribution of Kirsten Zverina,

London Business School Sloan Fellow 2015 and Director of Analytics, Hedgehog Logic
Limited.
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5 The Digital Disruption of Banking and Payment Services: David Arnold and Paul Jeffery

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5 The digital disruption of banking and

The prospect of digital disruption in financial services is being taken

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 103 24/08/2016 15:20

as auto insurance in many northern European markets; and peer-­to-­peer

THEORY OF DIGITAL DISRUPTION

Disruption is a theory of industrial change flowing from Clayton

David Arnold and Paul Jeffery - 9781784717766

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David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 105 24/08/2016 15:20

value. The customer value proposition is thus a key driver; critically,

DRIVERS OF DIGITAL DISRUPTION IN FINANCIAL

A number of contextual factors, particular to the financial services indus-

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 106 24/08/2016 15:20

(Coughlan and Anderson, 2015). Much of the financial services sector is

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services, which is essentially a contract, creates an opportunity for new

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 108 24/08/2016 15:20

AREAS OF POTENTIAL DISRUPTION IN

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 109 24/08/2016 15:20

outside the ­regulatory regime, the lower marginal costs of software-­driven

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 110 24/08/2016 15:20

non-­bank and therefore lacking any government deposit guarantees, it is

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 111 24/08/2016 15:20

the average balance of an indebted household being US$15 706 (Federal

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 112 24/08/2016 15:20

The global financial payments system is a highly complex ecosystem.

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 113 24/08/2016 15:20

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 114 24/08/2016 15:20

Stripe, founded in 2011 and already commanding a private market valu-

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 115 24/08/2016 15:20

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 116 24/08/2016 15:20

The financial services industry is certainly in the throes of a digital revo-

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 117 24/08/2016 15:20

financial services industry and the conditions identified by research as

* The authors gratefully acknowledge the research contribution of Kirsten Zverina,

Affirm (2015). Our mission is simple. Accessed at www.affirm.com/company.

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 118 24/08/2016 15:20

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 119 24/08/2016 15:20

David Arnold and Paul Jeffery - 9781784717766

M4036 - OLLEROS PRINT.indd 120 24/08/2016 15:20

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5 The digital disruption of banking and

as auto insurance in many northern European markets; and peer-to-peer

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