We’ve heard all the buzz phrases, ranging from ‘peer-to-peer lending’ to ‘cryptocurrencies’. But behind the hype, what exactly is alternative finance, and what are the benefits and risk?
In this episode, joining podcast series host Michael Kitson, University Senior Lecturer in International Macroeconomics at Cambridge Judge Business School, are Robert Wardrop, co-founder of the Cambridge Centre for Alternative Finance; Stelios Kavadias, Margaret Thatcher Professor of Enterprise Studies in Innovation and Growth at Cambridge Judge, and Bart Lambrecht, Professor of Finance at Cambridge Judge.
This is the seventh in a series of “Cambridge Judge Business Debate” podcasts featuring faculty and others associated with Cambridge Judge Business School and the broader Cambridge community.
This latest podcast focuses on the topic of alternative finance, which includes cryptocurrencies such as bitcoin and also new routes for lending and borrowing that originate outside the traditional banking system.
What is alternative finance?
Michael Kitson: “Finance is the main lubricator of modern finance, but the financial sector itself is going through a period of rapid change – awash with a confusing range of new products and technologies such as cryptocurrencies, crowdfunding and peer-to-peer lending. So just what is ‘alternative finance’”?
Robert Wardrop: “What it isn’t is private equity or alternative investments. In fact, many alternative investments are part of the incumbent system with well-established rules. We’re interested in alternative channels and instruments that emerge from outside the incumbent system. That incumbent system has to deal with this disruption: how does it absorb it, what does it do with it, does it kill it?”
Stelios Kavadias: “That key word channels is a good definition, and what becomes very critical is the absorption component. It seems that the incumbents have been worried for some time now, but in the past couple of years they seem less worried because they are finding ways of dealing with alternative finance. There will be new tech channels offering some new services, but the big banks will have some say.”
Bart Lambrecht: “One important element is that of tech-enabled intermediation, such as peer-to-peer lending. In the traditional banking model, savers put in deposits and banks make money from the difference between the lending and borrowing rate, while with the peer-to-peer lending model you have a platform that immediately matches borrowers and lenders. The platform here acts as a middleman who charges fees.”
Banking? Peer-to-peer platforms are becoming “robo advisers”
Robert Wardrop: “The peer-to-peer lending model is essentially an asset manager-like model: it’s become sophisticated to the point where they are investing heavily in technology and algorithms on credit scoring to be able to construct portfolios of my loans for me like any asset manager does when you sign up: ‘Here is your expected rate of return for the risk you can tolerate’ – and they basically fill up your portfolio. Is that really banking? Really that platform is becoming a robo adviser in a self-originated domain of investment products. It happens to be peer-to-peer loans to either consumers or businesses.”
Regulators are playing catch up
Robert Wardrop: “Regulators frankly are catching up. No one is regulated today like really being an asset manager, even though effectively they’re acting in that manner.”
Stelios Kavadias: “The fact that regulators are catching up implies a somewhat typical situation in many innovation cycles, where there is this new way of doing things and we don’t quite understand how that will affect every single constituent in the ecosystem. That creates value initially, but as we learn more we understand the risks that may be happening. Eventually those risks will call for the bigger boys or the regulators to step back in and create a new equilibrium.”
Bart Lambrecht: “Regulation will be important, because this alternative finance sector is still relatively unregulated, and as always it only takes a few bad apples to undermine the confidence of consumers and investors. This whole tech-based infrastructure, while potentially very efficient and very smart, can also reduce transparency and increase the scope for fraud and even cyber risk.”
Beware the long bottom tail
Robert Wardrop: “The problem is not the mean performance, which is arguably at least as good as banks; the problem is the distribution around the mean. The bottom end of the bucket is pretty bad, I suspect, in terms of operational performance. It’s like investing in venture capital: all the returns are in the top quartile but it doesn’t mean the venture capital industry doesn’t have value in the economy.”
Michael Kitson: “But it’s the bottom tail that can cause systemic risk.”
Robert Wardrop: “Correct, it’s the bottom tail and and it’s a long tail. There are low barriers to entry to get into the market, and people at the top quartile are increasingly worried about risks they can’t control in that bottom tail.”
Predicting the long-term impact of alternative finance
Michael Kitson: “Here’s the big issue question: will the overall impact of alternative finance to the wider society be to make markets more efficient and create more competition, or will there be potential harmful effects such as widening inequality or different access to these products, or could it even lead to the next financial crisis?”
Bart Lambrecht: “These new forms of alternative finance will undoubtedly create competition, and that’s usually a good thing, and it may increase efficiency and speed. So I think on the whole it is a good thing and will benefit consumers, but every coin has two sides and there are potential risks like fraud and we don’t know how it’s going to affect market volatility.”
Stelios Kavadias: “If we start with the idea that this is the outcome of innovation, which is usually associated with bettering things, we always end up with a new equilibrium which is better than what we began with. Should we envision there will be some risks in between – absolutely.”