Making Use of Systems Thinking for Financial Technology Capital Management

In the opening of her book Thinking in Systems, the late Donella Meadows states: "We tend to focus on isolated objects and events, but the world is actually a web of relationships, and each detail is connected to all the others." The quote and the book give a comprehensive overview of systems thinking. Despite its success in many fields, systems thinking has only had limited impact in the nascent area of fintech capital management. An article published on this topic is as follows: I am an employee of Stripe, however, the opinions expressed here are solely my own. Meadows defines a system as an interrelated collection of components that work together to produce a result. Having an understanding of the systems around us and their common properties may be beneficial. The typical difficulties encountered within systems, including the hindrances created by policies, the 'tragedy of the commons', the positive feedback cycles that lead to a 'success to those who are successful' outcome and the strategies that can be used to counteract them. Exploring the various intervention points within a system to produce change and the effectiveness of those interventions: Leverage points are arranged in a sequence of growing effectiveness. For example, starting with the modification of numbers or parameters (e.g. adjusting tax rates to reduce the national deficit) is usually much less influential than the most potent one, the capacity to surpass paradigms. A fintech is located at the intersection of technology/software companies and financial services firms. It is composed of interrelated components which are used to fulfil its purpose. In a similar way to many businesses or organisations, fintechs are likely to have a principal mission, or purpose. To illustrate, Stripe's mission is to 'boost the GDP of the internet.' A mission is akin to a north star, serving to guide the trajectory of a voyage over the course of an extended period. It specifies the 'what' but not necessarily the 'how': how can Stripe increase the Gross Domestic Product (GDP) of the internet? An essential part of fintech is capital management. To effectively fulfil its purpose, it is important for a fintech to:¹ Yes, a fintech must have products with features that please users. Nonetheless, unless customers are paying enough to cover its costs and offer an adequate ROI to its investors, it is not creating value and will ultimately cease to exist. If it ceases to exist, it cannot reach its goals. A Wall Street Journal study projects that the rate of unsuccessful ventures which were backed by VCs is quite large, estimated to be as high as 75 percent.² Case studies showing how systems thinking concepts can be used in fintechs involve topics such as foreign exchange, interest income, collateral calls and losses. Considering that these aspects are not generally associated with achieving success within a traditional tech setting, people may not understand how they can impact a fintech’s objectives. Wise (formerly known as Transferwise) has accumulated a sizeable and expanding customer base and a profitable business owing to their initial provision of low-cost FX. Their FX rates (~8–10x cheaper than traditional FX) and almost instantaneous money transfer are enabled, in part, by 'internalizing' the corresponding needs of their users. The diagram below demonstrates how internalization might function: FX internalization can cut external variable hedging costs which can then have an impact on user pricing. Additionally, with internalized flows being mainly book-entry, transaction times are decreased. What this means is that less money is required to stay in transit at any given time among the user, fintech, and FX hedging counterparties, thereby freeing up capital that can be more productively used elsewhere. In the end, internalizing operations decreases the chance of suffering losses due to movements in FX rates and settlement of FX obligations (which is commonly called Herstatt risk). Thus, the capital required to safeguard against such risks (stability) is diminished. Through a systems thinking lens, Wise's FX product capitalizes on the advantages of balancing outflows to decrease external variable costs, money that is moving, as well as the associated risks and capital. Due to this, Wise is able to give these savings to their customers, ultimately leading to higher customer satisfaction and a rise in the number of users. It is expected that this would trigger a positive feedback circle, with the progressively growing user numbers creating even greater returns, as well as resulting in greater investments being made into the product over time. In November 2023, AirBnB revealed net interest at nearly $500 million for the first nine months of the year, with almost $200 million being generated in the third quarter. Marcel van Oost noted that this was mainly because they had invested customer prepayments and security deposits in short-term investments or accounts that earned interest. In our current landscape, when it is foreseeable that all enterprises will be taking on fintech characteristics, recognizing substantial gains or losses from interest can disclose formidable prospects in addition to considerable difficulties. With AirBnB's net interest revenue amounting to $500 million, this is equivalent to: From a systems thinking perspective, $500m of interest income could result in cash inflows which could be reinvested in AirBnB’s business, like creating extra products or features. If this cyclically repeats, it sets up a beneficial feedback system. Compared to a debt or equity capital raise, this cash flow does not include any continuing interest expense or the dilution of current shareholders (causing capital expenses). At the peak of the meme stock craze in early 2021, the number of Robinhood stock traders surged dramatically. Consequently, DTCC, America's leading clearing counterparty for stock trading, determined that it should acquire more collateral from participants to curb the possibility of a breakdown in trading and settlement. Robinhood’s risk assessment had anticipated that the need for collateral would at most double from existing levels. Nonetheless, they had to deal with a 10-fold increase in the amount of collateral they were expected to provide. Looking at the problem through a systems-thinking lens, Robinhood had to take action in order to balance the system due to insufficient buffering capacity (cash) to address the sudden increase in cash outflows that accompanied the rising trading volume. To do this, it had to: In November 2021, Zillow declared its departure from the iBuying business, which sought to create a bridge between buyers and sellers of homes using their "Zestimate" of the property's value as a benchmark for fair prices. With the closure of this service, Zillow had to let go of 25% of their staff, leading to a $400 million loss for the quarter and a subsequent 25 to 30% plunge in their stock price following the announcement. Zillow created iBuying with the goal of becoming a market maker, connecting home buyers and sellers and collecting a commission for their services. This type of business works best when there is a high number of transactions, high liquidity, good information on pricing, and minimal costs. Through iBuying, Zillow temporarily puts out cash (when buying homes) which is then offset by a cash return when they sell. The stock of houses and the amount of cash remains in balance. Due to various causes, the iBuying segment of Zillow developed into a “reserve” business, whose profits depended on whether it earned or lost money on the housing it owned. In Q2 2021, its pricing system had produced almost 600 basis points of margin (difference between the amount it used to buy and the sum it gained when selling the same home), which surpassed its desired margin. In 3Q2021, Zillow attempted to counteract this by altering its model. Unfortunately, this took place concurrently with an economic slowdown and declining house prices, resulting in a stockpile of unsellable homes for the amount paid by Zillow, thus reducing their cash reserves. This caused the iBuying system to veer away from its balance. A systems thinking approach can lead to the discovery of delayed feedback loops and the complexities of forecasting asset values in a dynamic setting, especially during macroeconomic turning points, causing ‘oscillations’ in revenues, cash flow and money reserves in trading enterprises. Grasping the effect of delayed feedback loops is essential considering how promptly external and internal variables can morph and the amount of capital that can be in danger. In hindsight, Zillow might have stayed away from certain losses by not adjusting its pricing plan in the third quarter 2021, diminishing the eventual fluctuations. Furthermore, although capital (or, backup funds) can offer a time buffer, this should be taken into account when creating a business policy and goals. Ultimately, Zillow decided that the money made from iBuying was not worth the cost of the capital. In its 10-Q for the third quarter of 2023, PayPal revealed two noteworthy credit losses: one stemming from transaction losses from its main payment processing operation, and the other from the Merchant Credit Portfolio (which presents working capital solutions such as PayPal Business Loans to traders). PayPal saw a decrease in payment processing-related transaction losses concurrent with a rise in volumes. The $114 million loss in 2022 from one merchant was responsible for the drop in transaction losses, but no similar occurrence occurred in 2023. Following this incident, PayPal put new protective measures into effect, most likely leading to the further decrease of losses. Second, charge-offs associated with PayPal's Merchant Credit Portfolio experienced a ~5.5-fold rise from 3.6% to 20.4%, despite outstanding balances being reduced by roughly ~30%, from $2 billion to $1.4 billion, due to the acceptance of riskier loan parameters in 2022 which caused a decrease in the credit quality of loans related to the PPBL product. The amount of credit losses depends on revenue and the amount of the exposure type, such as payments processing or loans. They can be delayed, and they have to do with the creditworthiness of the merchant, establishing the significance of underwriting. A Systems Thinking approach can help to counteract the lack of prompt feedback from credit losses by considering the revenue and risk together. Fintech capital management tools and strategies address several of the key points spotlighted by Meadows to create beneficial modifications in a system. Starting from here is natural. An important goal in fintech capital management involves targeting the liquidity and equity reserves to match any potential stress scenarios and outflows. Generating sufficient buffering capacity is essential in ensuring the system is durable. However, according to Meadows, this is a minor factor in the overall scheme of things. It is costly to maintain a buffer and if the costs are not apportioned to the products and services requiring it, it could result in a form of communal disaster. Fintech boards and management teams that assess users, businesses, projects and initiatives with metrics taking into consideration capital, risk, and regulatory requirements, in a risk-adjusted manner, will boost system thinking. This kind of system thinking guarantees that fintechs will create value, or are on a course of producing value, instead of just transferring wealth or inadequately pricing risk. Breaking down the performance of users, user segments, products, and regions over time and relative to budget and capital investment offers a greater understanding of both issues and opportunities. An essential component of success is not merely possessing capital plans and good metrics, but utilizing them to encourage the desirable conduct and limit the undesirable conduct. Rewrite: Incentives and restrictions are capable of magnifying the effect of any action taken, and can bring different factions into agreement on the advancement of the system (the company and its environment). Distributing risk and capital expenses and assessing products, customers and companies on risk-adjusted measurements helps to safeguard and enhance a fintech's limited capital assets. Establishing objectives that recognize the fintech's existing status and motivate further progression foster responsibility and an attitude of stewardship. Having a set risk appetite and tracking limits, key risk indicators (KRIs) ensures that any threshold transgressions evoke meaningful discussion related to possible risk exposures. If multiple limits are exceeded at once, it could be a sign that the organization could be more predisposed to sudden events. Cutting back on the amount of time taken for data to reach the required parts of the fintech can downsize its OODA cycle, leading to greater stability in unpredictable situations. Frequently, the speed of reaction hinges on the speed of data transmission throughout the organization. Data that is internally generated is often scattered, necessitating careful filtering by researchers and examination and dialogue by administrators in order to agree upon a plan of action concerning altering the course of action. Numerous entities become aware of the requirement for quick financial availability and danger data just when faced with a crisis, by which stage it is often too late. Capital planning, risk management, and stress testing are able to uncover essential metrics that demand both accuracy and rapidness to be able to cope with economic declines and disturbances. To finish, planning for potential difficulties and conducting simulations (e.g., partner disruptions or emergency financial events like collateral) can be used to recognize significant participants and activities essential during an actual event that can expedite the process of reaching equilibrium. It is worth spending time analyzing the wins and losses of other companies. Can we gain insight that is pertinent to our own operations? Are systems and strategies in place to help emulate the successes and reduce the chances of failure? Many financial services firms have experienced failures and setbacks in the past, such as Goldman Sachs narrowly avoiding bankruptcy when a client for which it had sold commercial paper - Penn Central - declared bankruptcy. However, Goldman Sachs ultimately emerged from this trial stronger than before, having developed a well-known central risk system and fostering a 'partnership' culture that emphasizes cautious hazard taking.⁶ Fintechs often reflect the vision, background, and experience of the founding team and other key players, typically from large tech companies or other tech startups. Despite this, there is a substantial untapped market for firms who accurately comprehend the melding of ‘fin’ and ‘tech’ principles and can view the entire fintech system with an encompassing perspective. Visa's path to success was driven largely by Dee Hock's ambition and foresight to form a leading business in the electronic exchange of currency. Further, the utilization of data and systems was paramount to ensuring quick verifications, limiting fraud, and quickly reconciling and deducing expenses, ultimately reducing risk along with the expenditure. It may be tempting to view the current American card market ruled by Visa and Mastercard as inhibiting the ability to alter the current state or envision a different future. Nevertheless, such an outlook would be short-sighted. Numerous new technologies and advancements are developing and reaching maturity, such as real-time payments, distributed ledgers, tokenized deposits, stablecoins, central bank digital currencies, artificial intelligence, and quantum computing. Fintechs with a clear vision, a comprehensive understanding of both financial and technological fields, the capability to act quickly, and a holistic approach to problem-solving will be capable of revamping financial services to better serve future generations' needs. This summary takes into account both Throughput Accounting (systems thinking applied) and Economic Value Added (EVA). Subsequent accounts declare that three-quarters of financial technology companies that have been financed by venture capital sources have been unsuccessful; however, they appear to be referencing a more general WSJ piece from 2012. I have reached these conclusions based on publicly available information; however, there may be additional factors that could have led to different outcomes. The circumstances here are a bit unclear and complicated; it is conceivable that DTCC's margin system was not capturing the shifting trends once new buy orders were limited and the stock dipped and that the waiver more accurately indicated the risk reduction. The substantial drop in balances could have been a major factor fueling the growth of net charge-offs in proportion. Goldman has been accused of prioritizing its own needs over those of its clients: some lessons can become too deeply ingrained.

Source: https://medium.com/@mason.a.reeves/applying-systems-thinking-to-fintech-capital-management-6b14c8cce136?source=rss------fintech-5