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Three and a half years ago I was sitting in the Rose Garden at the White House as President Obama signed the JOBS Act into law. He called the work we did on modernizing the securities laws (which we thought would go into effect that year based on Congress’ 270-day mandate) “game changing.” For the first time in 80 years, startups and small business were supposed to be allowed to raise debt or equity capital from their friends, families, and communities (regardless of their net worth) online through the use of Securities and Exchange Commission registered platforms.
Little did we know the world would take the framework we developed and leapfrog the U.S. while politics in Washington stalled the opportunity at home. This finally seems to be on the cusp of changing. Last week, FINRA released its rules on how crowdfunding platforms will have to comply with registration and compliance when securities-based crowdfunding goes into effect. If these rules are the precursor for crowdfunding portals to start transacting business, and if we can take at face value SEC chair Mary Jo White’s earlier comments that the final rules for Title III will be completed before the end of the year, then the United States might finally be joining the rest of the world in the age of modern finance.
But will we be able to catch up?
Since 2012, the four types of crowdfunding — donation, rewards, debt (peer-to-peer and peer-to-business), and equity — have been reclassified as Alternative Finance. The United Kingdom led the way by crafting policy that was data intensive and prescriptively light. Rather than regulating the industry out of business due to fear, the U.K.’s Financial Services Authority (FSA) decided to understand how these online platforms are digitally storing data on companies that never existed in the private capital markets before, providing transparency and immediate access to company data, performance, and disclosures so investors can make informed decisions, and efficiently facilitating the flow of capital at very cost-effective rates. In response, both the debt and equity markets for crowdfunding skyrocketed, companies and individuals that didn’t qualify for traditional bank financing were receiving access to capital, fraud turned out to be nonexistent, and default rates are averaging lower than those experienced by banks. To substantiate this, an Alternative Finance Market report by the University of Cambridge and Ernst & Young found that in 2014 €2.34 billion ($ 3.61 billion) worth in crowdfunding was transacted in the U.K., making up nearly 75 percent of the total value of the online alternative finance market in Europe.
At the same time, Asia saw the explosion of peer-to-peer lending in China, with one platform originating over $16 billion in loans last month alone! And now Latin America is seeing the rapid adoption of fintech companies leveraging state-of-the-art technologies that are algorithm based and customer friendly to help make credit decisions where credit scores didn’t exist before. These fintech companies are driven by artificial intelligence that moves identity away from things that we know, like payment history and personal identification numbers, to things that we have, like a social network, face, voice, and fingerprints. They use algorithms based on psychometrics, mobile usage, geolocation, and social networks to create feeds of millions of collective inputs that are analyzed and generate scores that are much better at assessing credit risk than a human could ever be. Based on the billions of dollars flowing at low default rates, it is easy to see how the digital recording of billions of data points can create better credit risk profiles than we have today and can better determine who should get funded and with how much.
In China, one of the P2P lenders raised $93 billion in deposits in less than a year. All banks globally didn’t accomplish that last year. And the default risk of P2P lenders is half that of banks. P2P lending platform Zopa, for example, has a default rate of .005 percent. Why? Because it has better data.
The most innovative banks are now figuring out where they can partner with these fintech companies based on how they have been successful at unbundling services, filling a void, and meeting demand. Traditional banks provide a wide range of services, from lending to cash management to payroll and merchant services. These technology players don’t aim to take on all those services, just fill the voids that have been created.
When the Securities and Exchange Commission finally decides to stop playing politics and start helping small businesses by okaying securities-based crowdfunding, this is what the U.S. can expect:
- Transparency: Companies that tend to be successfully funded have spent a significant amount of time prepping for the raise, preparing their financials for review, and creating necessary disclosures for investors to vet.
- Access to capital: Companies have access to short-term financing that the banks have been unwilling or unable to finance.
- Sophistication: Companies tend to follow a path of management discipline, internal governance, and external communication.
- Deal flow: Companies that are transparent, leverage this capital smartly, and execute on their plans are seen as quality deal flow for follow-on investments, VCs, and even traditional banks.
- Diversification: Investors have access to a broader and more diverse set of investment opportunities within a regulated and transparent environment at attractive yields.
By 2025, it is estimated that $2 billion will come into the banking system on smartphones. The total unmet demand for credit by all formal and informal small and mid-sized companies is estimated to be $3.5 trillion. The International Finance Corporation estimated the formal SME gap to be $1.5 trillion globally. Even Goldman Sachs has jumped into the space, stating, “We see over $4.7 trillion of revenue at the traditional financial services companies at risk for disruption by the new, technology-enabled, entrants. Assuming a 10 percent profit margin implies a $470 billion total profit pool at risk.”
The money, opportunity, and technology are there. The question remains, will the SEC regulate the opportunity to death, or will it foster the development of this ecosystem and position the United States as the leader that will live up to President Obama’s statement that this is “game changing”?
Sherwood Neiss is a partner at Crowdfund Capital Advisors. Neiss helped lead the U.S. fight to legalize debt and equity based crowdfunding, coauthored Crowdfund Investing for Dummies, and cofounded Crowdfund Capital Advisors, where he provides strategy and technology services to those seeking to benefit from crowdfund investing. Neiss and Jason Best are credited as the fathers of Title III of the JOBS Act. After attending the bill-signing ceremony at the White House, they formed Crowdfund Capital Advisors to study what is happening in crowdfunding, analyze results, report trends, and follow opportunities. They are active investors in the crowd finance space.
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