Traditionally, asset managers and banks need to deploy large investment to achieve return at scale. The universe of investments has thousands of large investment opportunities and millions of small investment opportunities. Thus we can describe the distribution of investments to be a “Long tail distribution” similar to retail. Traditionally, asset managers have focused on the head of the tail such as corporate credit and sovereign bonds for various reasons including scarcity of time.
In the 1970s, bankers saw an opportunity to bring these many small investments to large institutional players by packaging mortgages into collateralized mortgage obligations. As a result, the asset manager gained access to high yielding financial instruments with high diversification effects. The bankers who packaged the pool of mortgages made a lot of money. The local mortgage dealer was able to lend more and maintain their labor intensive, non-scale-able relationships. All parts of the lending supply chain benefited.
Today, there are still many niche asset classes where technology could provide opportunity for asset managers to gain access to many small high yielding investments with one big investment. These specialized markets can employ SaaS to establish new industry networks, resulting in network effects. The SaaS provider’s competitive advantage will be high switching costs.
One example of employing software in the long tail of finance is connecting community banks and credit unions with larger institutions including regional banks, asset managers and big banks. The community bank market is highly fragmented with over 5000 banks. Traditionally, the community banks lend in their local community and carry the loans on the banks’ balance sheet. Sometimes the community banks buy and sell loans through brokers for portfolio management. Because of informational asymmetry and a fragmented network, buying and selling loans is expensive. Currently the process to sell loans begins with the bank or a bank’s agent calling other branches about the opportunity. Next the banks send out spreadsheets with loan metrics and collect bids from their brokers; a labor intensive process for all parties. Thus community banks can have highly concentrated local economy portfolios and are not optimizing fee generation. If these community banks were efficiently connected in a network with other community banks, regional banks and large asset managers, then a new lending-supply-chain could form, lowering transaction barriers. In turn, community banks could optimize their balance sheet and generate more fees. An electronic market place could augment the banks’ operations, maintaining and enhancing the banks’ local relationships.
Another benefit of an electronic marketplace for community banks is reduced frictions in disposing legacy assets from acquisitions. After 2008, many community banks closed. Additionally, the community bank industry has been consolidating for over a decade. After merging banks, the consolidated bank’s balance sheet can breach regulatory standards or management’s appetite for a particular risk such as geographic or sector risk. By accessing a SaaS platform, these banks can achieve their risk management goals with less time and lower cost and create capacity to generate further revenue. An asset manager could participate in the process by trading in the secondary market for small loans or by syndicating loans with the lead community bank.
Supply chain finance is another long tail financial market in which SaaS could be employed. Supply chain finance starts with a transaction between a corporate buyer and a corporate supplier. Typically, the buyer is larger and has a better credit rating than the supplier. The buyer and the supplier agree to credit terms such as 60 days, creating an accounts receivable balance on the supplier’s balance sheet. Then a trade finance division from a bank will offer an opportunity to the supplier to receive the account receivable cash at a discount after invoice. If the supplier accepts, then the bank is now owed money by the buyer and, sometimes, can extend the time for the invoice to be paid to the bank.
Because the bank is effectively lending money to the buyer, the bank could sell this credit investment to an asset manager at yield equal to buyer’s senior unsecured bonds and earn an arbitrage between the supplier’s discount rate and the buyer’s discount rate. This market exists for corporate buyers with high quality credit scores and for suppliers with invoices over a certain dollar amount for the bank to care. But low credit quality companies and/or low dollar invoices participating in the business to business marketplace may not have access to the supply chain finance market. Thus there exists an opportunity.
From the examples above, we can conclude that by deploying SaaS to enhance current entrenched institutions and remove expensive, labor intensive frictions. Inaddition to the revenue generation and investment opportunities, SaaS can be used to aggregate data for long tail market investors. While the extent of the power of the data is still being uncovered, data could enhance financial liquidity, provide better decision making and in turn strong capital allocation. Furthermore, the market participants could pool risk in a scale-able, streamlined process benefiting local economies across the United States and the aggregate economy.