The pending advent of blockchain in FinTech

Blockchain technology has been hogging the hype cycle for a few years now, but despite a great deal of optimism and investment, deployed applications outside of Bitcoin have been rather scarce. Bitcoin might itself continue to exist only on sufferance from the Chinese government, being that its primary use has been to provide one of that country's main stores of excess funds. Bitcoin and other cryptocurrencies have another fundamental problem, but more about that below.

In order for this technology to transition from promising to widely deployed one or more "killer apps" will be required which are capable of obsoleting current practices - always assuming that blockchain reconciliation latency issues will have been resolved in the relatively near future. As I see it, today such applications are primarily in the areas of FinTech and GovTech. As such, the killer app trifecta for blockchain would consist of payments, settlements, and identity verification. Let's discuss each application in its turn.

Payments

Whether or not Bitcoin and other cryptocurrencies ever become established as mainstream payment methods, which in my view is fairly unlikely, it does not mean that blockchain-based payment solutions are dubious undertakings. To the contrary, I firmly believe that reliable, secure payment is a major killer application for this technology.

The main reason I believe that cryptocurrencies are unlikely to gain widespread traction as a medium of exchange has to do with the complex relationship between money and government. Money, as Econ 101 teaches us, has three functions: as a medium of exchange, as a store of value, and as a unit of account. Not so very long ago, all three of these functions were efficiently fulfilled by gold, and to a lesser degree by silver. Metal currency had the advantages of universal adoption, stable exchange rate and low propensity to be subject to monetary shocks. Even when paper money was first adopted as a medium of exchange after the mid-1700s (at least in Europe), it was backed by gold - that is until the crisis that was the Great Depression. Without going into a book-length disquisition on the history of abandoning the gold standard, I can safely say that the key reason was the need of governments to gain control over their collapsing post-war monetary systems. This control is not something that today's governments are likely to be prepared to relinquish, partly for fear that the monetary conditions that birthed the Great Depression might return. Partly also, those governments who now enjoy or seek to establish reserve status for their currencies would be loath to give up the benefits that accrue from it: benefits such as low cost of borrowing and control over quantity of money. Governments of many developing net exporter nations, such as China's, also seek to control cross-border money flows in order to limit capital flight, providing even more incentives for them to keep tight control of their monetary policies. Not least important, governments who lose control over their currencies also lose control of their monetary policies, and with it their economies - as the South European Eurozone members have found out to their ongoing horror.

Today, payment systems tend to be either proprietary walled gardens operated by the likes of Visa and the larger commercial banks, or else low-penetration interoperable solutions advocated by mostly struggling startups. Blockchain technology, being based on an open standard, is capable of bridging such broadly adopted solutions without forcing users to rely on yet-unproven companies as clearinghouses. Furthermore, because blockchain takes the clearinghouse function out of any single vendor's hands, it lowers the costs of linking proprietary payment systems together vs. using available commercial solutions for banks and money managers. Costs can conceivably come down enough to enable the use of blockchain-based payments for even very small transactions. Of course in order for this application to gain acceptance, blockchain performance will have to be improved to the point where billions of transactions can be handled in near-real time.

Settlements

Transaction settlement is another area where blockchain can have a significant impact on the way we do business. Today, transaction settlement friction ranges from having to take e-commerce product delivery on trust after payment has long been processed to complex and pricey escrow services for real property transactions.

Once blockchain technology is developed to the point that offline events can be easily incorporated into the chains, I can see escrow services becoming functionally obsolete, especially if they are coupled with blockchain-based title insurance products, as I will discuss below. 

I can also envision blockchain securities settlements, enabling efficient bond markets that do not rely on primary dealers, market makers or inventories, which could revolutionize the enormous global bond market and cause some large players to lose significant revenue streams.

The key to development of this application is the ability for blockchain to extend beyond pure-paper transactions such as securities trades by incorporating transparent tools for attaching and extracting hashes for offline events. Ironically, the larger transactions that today require sophisticated escrow and interbank settlement services would likely be easier to implement than a humble delivery verification for goods ordered online by virtue of them being fewer in number and harder to misplace.

Identity

The area where FinTech and GovTech can both benefit from adopting blockchain is in establishing positive identity of persons and capital goods alike. In theory, positive identification can be useful for even small items, down to the size of a container or a package, if performance for verification can ever be made sufficient to handle such large numbers of simultaneous transactions. However, even for such items as cars and real property the benefits can be enormous. The promise is so great that it has even become an election talking point.

Fundamentally, today our tools for establishing positive identity and ownership chains are, to say the least, quite poor. Government IDs such as passports, social security cards and driver's licenses are often enough forged, necessitating secondary ID checks like finger-printing that are costly, time-consuming and intrusive. Car theft has been on the decline in recent years, but should it mount a return, police ability to identify parts from broken-up cars would be as limited as it had been in the pre-LoJack dark ages. For real estate especially, each transaction requires title search and insurance services that add a significant percentage to transaction costs and often take weeks to finish.

Blockchain holds the promise of providing positive ID and ownership-chain tracing with much lower intrusiveness and at a very low cost and changing a good part of the familiar business landscape in the process. Such businesses as CarFax and whole industries like title insurance and customs/freight tracking would become threatened with existential crises, while our beloved trips through passport control and to the DMV might never be the same again. In order for this nirvana to become manifest, standards would have to be adopted for transparent, easy to use tools for indelibly attaching hashes to real-world objects.

Bottom line

It can be difficult to become used to so much disruption of so many industries in such a short time. It also can be easy to be over-optimistic about the better-hyped technologies that might never see wide adoption. No technology can hope to win in the long run absent a killer app that renders its use worth the new-tech risk because it lowers costs, improves ease of use, or even creates an entirely new use category. Blockchain is now at that precipice: ready to enter prime time, provided that it develops the extensions and standards permitting its killer apps to begin emerging. I will be waiting.

Cross-posted to LinkedIn

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Your chart for navigating the coming FinTech meltdown, Part II

In the last post of this miniseries, I explored the reasons why this is the right time to prepare for the coming shakeout in FinTech. I also set out the first 5 of the 10 principles for consideration in planning the downturn strategy for your portfolio. Since I had posted Part I, the drumbeat has continued for FinTech as a disruptive force which threatens all financial service industries, again highlighting this topic's relevance. In Part II of this article, I explore the rest of the ten principles and their implications for portfolios.

6. Think base hits instead of swinging for the fences

It has been standard practice of many venture capitalists to encourage their charges to aim for the largest win, nevermind the risks inherent in maximizing growth. When the market is expanding - and both entrances and exits are abundant - it may well pay off for the investor to spread his bets among as many long shots as he can fund with a view to some big exits. Yet when the market does revert to doldrums these high-risk ventures are often the first ones to falter, mostly because their investment in fast expansion cannot be easily re-leveraged for mere survival. They tend to blow through their cash reserves before they figure out just how to address cost management, and once they do start cutting back they often lose their luster, and with it their key staffers. The trade press as a result will often turn against them, their customers become turned off, and before you know it they are has-beens and even laughingstocks. Sometimes there is a way back to the top, but not very often.

In this pre-downturn period, you, as the investor, may consider scaling back your company's ambitions from growth at all costs to a more sustainable position. You might have the company prepare a downside strategic plan with reduced growth targets, lower headcount, less marketing investment, scaled-back R&D spend, and less-ambitious strategic targets for the next few years. The company may lose some of its old sex appeal, but it is more likely to be around for when the market stages a return. One example of tactically scaling back might be to seek to deliver simpler products with more basic functionality to a smaller universe of customers. A company-in-being with product on the market will always be better placed during the resurgence than a startup-in-potential, and well positioned to leverage expansionary-phase growth in demand.

7. Outlast the competition - cash is going to be king

The biggest key to weathering the coming downturn will be your company's ability to not run out of money before the headwinds turn. You would be wise to reduce cash burn to a trickle and, better yet, target profitability before maximizing scale, anathema as it might be in better times.

As the enterprise's management team is working on its downside plan, you might want to direct it to assume that no new funding will be forthcoming until growth has been reestablished. Costs not directly tied to creating revenue would be eliminated. Overhead would be reduced to bare minimums - support headcount may be cut, expansion real estate put on the market, smaller and less-expensive quarters investigated. On the R&D end, platform and backend work would be deferred and feature sets pared back. HR investments and internal travel would be minimized. Marketing would be redirected to less-expensive channels, while sales T&E would be slimmed down despite the howls from the salesforce. The channel strategy may require a new rethink, even if it might lead to reduced sales over the short term.  In short, cost savings would become the mantra, rather than expansion.

Moving to cost reduction as a new regime, especially for formerly high-flying startups, could be a wrenching dislocation that well result in lowered morale and possibly some personnel departures, but it is far better to absorb this pain while the company still has a strong footing than having to crash- tack when nearly upon the rocks. Your management would have to first persuade itself that the shift is truly necessary, and then to sell the new reality to the employees. It will not be not the easiest or most pleasant of assignments but far better for the company, not to mention to you as the investor, than laying off hundreds and shutting down shop when there is no money left.

8. Use M&A for defense until the shakeout burns itself out

Some of that cash that you had your company place in reserve might well be put to a good use in winnowing down the competitive landscape, even as the storms rage all around. It might even be worth a bit more of your fund's dry powder to finance some bolt-on acquisitions, while they are cheap, to bolster your company's longer-term competitive position.

Consider: does your company have the full set of functionality that its customers require? Do other players offer complementary products? If so, then a shakeout environment makes it a great deal cheaper and far faster to acquire than it would be to build. Do some of your company competitors control some market segments where your company has had a hard time establishing? Buying customers and markets at a discount may be an excellent use of the reserve funds. You might consider expanding overseas through acquisition - a foreign market may offer welcome diversification in the event domestic one is slow to recover. If you do your M&A right during the downturn, your company will emerge the stronger on the far end of the down cycle.

There are some tricky aspects, however, to adding those bolt-ons that you will have to keep in mind in order to make sure that your M&A investment is well placed. Managements may suffer from the not-invented-here syndrome - pervasive as it is in the tech world - making you expend hard efforts to surmount. Entrenched managements might well require a good shakeup before they tumble to the proper mindset about buying before building. Moreover, acquisition integration is another aspect that might vacuum up a great deal of your attention. Teams who had not run extensive M&A beforehand can hardly be expected to know how to manage through the process to successful resolutions, and so you would be well advised to make quite sure that they are backfilled with just the right set of expertise. It would be prudent to place the new talent at the C level, in order to empower the new executives with the authority to make all necessary changes that will make for smoother and far more effective integration.

9. Stick to your knitting

Managements often wish to grow product lines in all directions with they believe to be adjacent to core products - new segments, new modules and entirely new product lines. It is laudable of course for them to be ambitious during the good times, but a looming downturn might not be the best time to think expansively. Particularly, it may well be prudent to avoid diversification for its own sake. Rather, it would pay better to concentrate on the most proven segments and on those products that have market traction. 

R&D plans especially might be confined to incremental changes before new products or new functionalities receive any funding. New products would require not only speculatively invested engineering funds, but also scarce marketing resources that may well be better spent in downturns on remaining solvent.

10. Shut up and execute

Fundamentally, the core principle of successful navigation of a shakeout is management's ability to keep focus on immediate priorities at hand: conserving cash, defending markets, judiciously investing in R&D to consolidate positions, and, most importantly, avoiding all distractions from shiny objects that might be just there out of reach. Not every growth-oriented top executive, and especially not each entrepreneur, has the right mindset to put cost management above growth, scale back ambitions or to reduce staffing. The right time to evaluate team composition is well before the excrement approaches the fan - rather it is now, while you still enjoy the luxury of time. Good management alone can get the a vulnerable enterprise through the forthcoming hard times.

You, as the investor, would be well-advised to ask the question whether your CEO is the right person for the new conditions, and if he isn't then could he be brought round? Whether he is or might not be, you would be well-served to have a strong backup option. If you have any doubts in your CEOs capacity to manage downscaling, you might consider inserting a trusted resource into the company as an executive chair, to guide your management toward the right direction and to be prepared to step in as CEO should it prove necessary, armed as he will be with all the context for the smoothest possible transition. This resource could alternatively be placed as COO, if naming an exec chair proves infeasible. 

They key, regardless of the title, will be for the executive whom you select to be responsible to you as the investor before satisfying the old CEO. The role will assuredly be a difficult one for your person to play well. It will require a great deal of gray-hair maturity, political sensitivity and plain finesse to manage to a happy resolution. The alternative to adding your own person to the management may well be to manage all the blocking and the tackling on your own, tying you up among minutia just as the buyer's market really gets going.

To bring it home

Despite what our short memories might tell us good times do not last forever, and the shrewd investor uses what is left of boom times to prepare for the inevitable downturn. No matter how cherished our ideology might be about disruption, or scale, or plain tech magic might be, eternal laws of business do not change - even if they are sometimes suspended. Old-lime competitors still have many teeth left, and investors cannot afford to show endless patience while their companies are burning through their cash hoards. This is a good time to wake up to the need to bring back good management and discipline to FinTech, while there is still time.

Implications for VCs

Many of the principles I outline here challenge cherished tech orthodoxies by injecting doses of reality of business outside the gold-rush boom times. The past few years have been extraordinarily good to the VC community: many established industries have seen strong tech-enabled challengers, valuations have soared to unprecedented levels, consumers and B2B purchasers alike have shown a great willingness to adopt technology and new business models. Conversely, though, there has been a glaring dearth of IPOs, and of the few companies that did go public many have become since tarnished. Despite unicorn-level valuations, big exits have been quite rare. A few of the tech giants have been feeding the exit mill through their acquisition programs, but beneficiaries have been relatively few, and the big buyers' appetite to keep acquiring could well wilt a bit when their own businesses begin flagging. Profits, tellingly, have been elusive for many erstwhile startups, public and private both, and willingness of markets to support their valuations without bottom-line results remains still to be seen.

On the plus side, there is some real value in many of the FinTech companies, most particularly ones with demonstrated market penetration and revenue traction. They key to strategizing FinTech portfolios would be to triage investment into buckets by profitability: cash-positive today, on the cusp of break-even, and the remainder. Companies far from break-even might best be disposed of now or else eased into shutting down, and, most importantly, they should be granted no further funding. The other two categories should be stress-tested for downside conditions. If they have the fiscal resources and market traction to survive, then their managements would be augmented with the right skill sets for navigating the rough waters and some funds might be set aside to sustain them through the worst and for perhaps bolt-on acquisitions. If they lack depth, however, then you ought to be prepared to replace their C-suites altogether, if you do not put them up for sale at once.

Implications for buyout shops

As a buyout firm partner, you are quite well-versed in the dark arts of risk management, and you do not need to be reminded to reduce exposure. Your portfolio is most likely profitable, efficient and led by a mature team. Your challenge for the downturn would be less to de-risk than to ensure that your company can function on reduced cashflow and to take advantage of a target-rich buyer's market for bolt-ons, which you should be able to acquire at a good discount. 

A stress test for reduced profitability and stalled-out growth will be a most useful exercise for your management teams, as it will be for your analysts. You likely will be looking at how well the company can continue its debt service at present leverage and without cutting cost structures through the muscle, right into the bone. The temptation to cut back expenditures before reducing debt loads will always be there, but no matter how accommodative today's debt markets might be, there is a level of reduction that can kill the patient rather than reduce his waistline. It may well be worth your while to invite in some expertise for an outside opinion about which reductions are available and which might be life-threatening. Judicious leverage reduction now might well make the difference between a solid exit down the line and a BK.

Implications for incumbents and strategic M&A

For incumbents in the industry the coming downturn will be an unrivaled opportunity to shore up defenses by acquiring those vendors who extend your offerings and market reach. You will be able to pick up all the sex appeal enjoyed by tech-enabled startups, attraction which they worked so diligently to build, at a fraction of the cost and without jeopardizing your well-established culture.

For the well-funded FinTech market players, it will be the best time to round out offerings, broaden markets, reduce the field of competition and, generally, simply outlast competitors. You will be able to go on a fantastic shopping spree to pick up functionalities and markets, and to squeeze out your less well-funded competition.

I expect to explore these topics in greater detail in the coming weeks, and meanwhile I look forward to your comments.

Update: Financial Times appears to agree.

Cross-posted to LinkedIn Pulse

Your chart for navigating the coming FinTech meltdown, Part I

An old story tells us that the seven fat cows tend to be followed by that many lean ones, and so it seems that it would be wise for those of with funds at stake in FinTech to heed this sage advice.

The early madness that surrounded FinTech valuations has of late begun to grow a bit threadbare, with former high fliers such as Lending Club finding themselves in trouble, and the entire robo-advisor segment coming under question because of its inability to defend its space against incumbents. Even the better-managed early stars, such as SoFi, reportedly find themselves hard-pressed to unload their paper and are forced to resort to setting up captive hedge funds to take it off their hands. The payment space is vastly overcrowded, with profits for many of the more recent entrants being as scarce as unicorns once were. Because many of the players are still sitting on large cash hoards, the shakeout - that otherwise would by now have manifested - has instead become a slow-motion defenestration, but a defenestration no less real for its glacial velocity. In the valley of no profits, these cash hoards can postpone the inevitable for those players who have bad business models, and they may well disappear all the more quickly as these companies succumb to the twin temptations of buying market share and their equally ill-starred competitors. This state of affairs is enough to give sleepless nights to investors holding the once so exciting FinTech portfolios.

I am advancing the following 10 principles to help you strategize your way through the coming mini-Armageddon. In this post I will explore the first five. Part 2 will discuss the balance and the implications for planning your portfolio.