The prospect of founding, joining, or investing in a financial services company in Silicon Valley can be very seductive. What’s not to like – there’s a huge TAM and and the belief that the incumbents are lazy, dumb, and rich. It also has an implicit draw where companies seem to grow revenue fast….very vast. But the dirty secret is that while there is infinite cheap revenue in financial services…in reality there is no free money.
Financial products are very close to a commodity, the only way to make real high-margin money is by building some novel technical product or going up the risk curve. Building a novel offering in one of the most advanced and largest markets is devilishly hard…and even harder to tell if you’ve found PMF. What more often than not happens is 90% of financial services/fintech companies wander up the risk curve (maybe even accidentally) while masquerading as innovative technology companies -- usually fooling themselves as well.
The tricky party about financial services is that numbers can go up even when things are going catastrophically wrong. Deposits skyrocket, TPV moons, everyone slides into confirmation bias. It’s understandable. Most founders, employees, and investors have only seen software companies where “users and revenue go up” means things are going very well! Yet in financial services when numbers go up… things are often going terribly wrong.
Let’s break this down into two general patterns to be wary of.
The deposit trap
Every few years a founder (sometimes very well intentioned) realizes that there are potential users (businesses and consumers) in a complex geographic market or industry that seems underserved and wants access to the US financial system -- somehow they’ve been accidentally overlooked! These users seem down to trust your new product and don’t really need interest on their deposits. Huge. Founder discovers a magic market! Well, no. What the founder discovered is that the US financial system has strong global product-market fit, and that there are hundreds of billions of illicit, fraudulent, and noncompliant dollars that want very badly to be inside its perimeter. If you’ve spent more than a few years abroad you know that this is an evolutionary outcome rather than a bug. These companies advertise ballooning TPV and fat deposit numbers…until the risk catches up, years or even a decade later.
There are tells that can help save you from funding or joining a deposit trap:
The company says that the big banks are too stupid or lazy to bank these markets. Or, the founder claims that US banks will only open accounts for US citizens but the founder had a brilliant idea to open US accounts for international customers.
- No. The big banks are not dumb. Every bank can open US accounts for international customers. The big banks have just been around long enough to have a better sense of long-term cost of risk – that these deposits aren’t what they seem and won’t be free for long. Citi owns a very successful bank in the Democratic Republic of Congo; JPM set up a bank in Iraq in 2003 while bullets were still flying! The big guys know what they’re doing and aren’t afraid of risk. If they aren’t willing to bank certain markets, founders should think really really hard about why they can.
The company uses “technology” to do compliance in a way that nobody else can
- No. KYC is a commodity, not a risk tool. “Proprietary KYC technology” is usually just a rubber stamp that lets an executive feel good when everyone else is digging deeper.
The company has government connections that nobody else does, so they can do things no other bank can
- No. Regulators are obsessed with a level playing field. I’ve found this true across admins. Also: half the Treasury Secretaries came from a big bank/wall street. And there’s a tradition of TFI and sanction leads coming from Citi and the other large international banks. Political connections are rarely as special as people make them out to be. And tends to be a core warning side, more on that later.
The company hired people from FinCEN/Treasury/OFAC, so they can do things that no other bank can
- No. Ex-regulators tend to be terrible risk underwriters because they’ve rarely been practitioners. And again, every large bank is a revolving door for financial regulators, so there is nothing unique here. Having them in an organization lends false credibility to outsiders, but doesn’t allow you to play any different game.
But anyways, you don’t have to take it from me, just read a bit of financial services history before you go down this road.
Two banks I’ve studied in detail that more people should know about:
BCCI touted itself through the 80s as one of the world’s fastest growing banks. They got to $20b in deposits faster than any other bank in history. They were specifically built to collect deposits from the developing world and high risk jurisdictions. They were extremely politically connected around the world and invested heavily in the US, even hiring the legendary DC power broker Clark Clifford as Chairman to bolster their air of invincibility. BCCI’s political connections carried the bank for a couple years, but compliance risk caught up with them and they collapsed in spectacular fashion, wiping out $10b of investor money. Political connections are not a silver bullet. As I like to say, the statute of limitations is much longer than term limits. Lots of books in the 90s were written about them, I’d read if you want to build, invest or work in the space.
Riggs Bank (ironically now a great hotel in DC, killer breakfast), same thing. Went around the world in high risk jurisdictions collecting deposits from places that other banks wouldn’t touch. It touted its political connections as its core safety net. It billed itself as “the most important bank in the most important city in the world”. It sat across from the Treasury building, and was a revolving door for political hires; it even hired its own OCC examiner as an executive. Riggs also collapsed in spectacular fashion when compliance risk caught up to them in 2005.
I could go on. This story repeats itself every decade: collect deposits from the markets no one else will touch, ramp up a lot of TPV and deposits, tout deposit and TPV growth over ROE, make the company look politically invincible, and post big numbers. But risk always. catches. up. The music stops. The music always stops no matter the network, investors, or story.
The underwriting trap
If I’ve learned one lesson from the history of financial services it’s that if somebody tells you they have “unique underwriting”, run for the hills. Silicon Valley is plagued with well-meaning technologists (plus fraudsters) who think that underwriting is a fundamental technology problem that will generate infinite free money once solved. Not so.
Almost every year I hear some variation of:
We discovered, invented, or hired our way into a novel way of underwriting....
- Revenue financing
- Asset banked financing
- Consumer unsecured
I hate to be the bearer of bad news. They have not. Ten times out of ten it’s just taking excessive risk that other people don’t want or a failure to price in the risk properly. Founders can argue that they have a bigger risk appetite than the banks and private lenders, but need to be honest with themselves, investors, and employees, about that fact -- that they’re building a risk company and not a technology company. Their differentiation is risk tolerance. But no one is ever honest because no one wants the valuation multiple of a risk company; they want that sweet sweet technology revenue multiple.
Once again, let’s look to history for examples:
A fintech called Greensill Capital invented a new supply chain finance product. Suppliers got immediate payment on invoices; large corporate buyers got extended repayment terms; Greensill clipped a fee in the middle. However, they soon realized that supply chain finance is a competitive space and they can’t get tech returns with their NIM in a properly-risk-managed lending. So instead they claimed to have invented a new underwriting model by hiring specialized people who knew the secrets to financing future (undelivered) receivables with high predictability through proprietary algorithms. The business grew explosively (there’s infinite money to lend to bad borrowers!) and raised $1.5b+ on exploding TPV. Greensill stacked their advisors and hires with the politically connected (even ex-PM David Cameron). In reality, all they were doing was going up the risk curve and pretending to be differentiated. Credit eventually turned bad, Credit Suisse froze $10b in associated funds overnight, and Greensill filed for insolvency. Investors got wiped out.
Silicon Valley has always struggled to underwrite financial services. VCs aren’t trained to be risk managers, they’re trained to be optimistic technology investors -- and given the complexity and nuances of financial services, it’s easy for a risk company to masquerade as a technology company. Hot take, most Silicon Valley scandals are actually caused by risk companies masquerading as technology companies…. FTX, Wirecard, Synapse, BlockFi (and those are just the ones that come to mind in 20 seconds). They all have the same story: excessive risk masquerading “unique technology” with the promise of deep political cover.
Why write this? Why sound like the harbinger of doom? Doesn’t this go totally against my financial interests? I started two companies, Plaid and Column, both of which depend on other founders building companies in complex financial services markets. I make my living on the beautiful gift that is the entrepreneurial spirit of Silicon Valley: the endless and optimistic creation of new companies set against the reality that most will fail…
However, I’m also an ardent student of history and recognize that for a country to have a vibrant, innovative, financial services sector, we need stability and consistency. And to have stability and consistency we can’t be perpetual yes men. If you’re a reader of Howard Marks, you may know that he writes on the illusions of cycle highs, warning that the euphoria of a boom blinds people to the math of the inevitable correction:
Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which leads to a cessation of lending, which dampens prosperity. The thrill of the upside causes people to forget that down cycles always extract a far higher price than the up cycles paid out in pleasure.
I want financial services to boom in Silicon Valley for many more decades. That’s good for me, good for the market, and good for the country. But to protect the industry, we need to call out the grift, bullshit, and naivete permeating the space – before another blow up with a massive blast radius – and especially as we enter euphoric highs.
So be careful, fellow travelers. This market is full of monsters with friendly faces.