Wall Street vs. Main Street: Amateur Investors Buy Into IPOs

This first appeared in the monthly CFI fintech newsletter. Subscribe to stay on top of the latest fintech news. 

SoFi, Robinhood give mainstream investors early access to IPOs

Seema Amble

A few weeks ago, SoFi and Robinhood both announced they would start allowing their customers to buy shares of companies going public, before they hit the market in an IPO. This type of access was previously only available to institutional investors and high-net-worth clients through investment banks. With SoFi and Robinhood’s new offerings, now mainstream investors will have access to IPOs – and the potential “pop” in share price.

While this idea is not new (online brokerage firms like Schwab, Fidelity, and E*Trade already offer it for select IPOs), such access has traditionally been reserved for the wealthy. Fidelity, for example, requires at least $100,000 or $500,000 in non-401(k) assets (depending on the IPO type), then chooses qualifying customers based on their assets and revenue. That’s far more than SoFi’s offering, which only requires $3,000 across a customer’s SoFi investment accounts.

But while brokerage firms have secured access, they often do not get an allocation to the most highly sought-after IPOs. Ultimately, if Robinhood or SoFi want access, the company issuing the IPO stock needs to make room for these platforms to get an allocation. Investment bank underwriters are likely to push back, since they want to reserve allocation for their clients. They are typically willing to make room for someone like Fidelity because of its mutual fund business, which is made up of the same institutional investors that might traditionally buy into IPOs. But given the rising importance of retail investors – as we’ve seen with GameStop – issuers might be more incentivized to offer some allocation.

One potential approach might be to manage directed share programs (DSPs), which are targeted IPO share purchase options set aside for employees, customers, or other “friends and family” of the company. Consumer companies often want their customers to be shareholders because it can help generate goodwill and loyalty. Uber, Lyft, and Airbnb have offered shares to their drivers and hosts through DSPs. Even this idea is not new – back in 1995, the Boston Beer Company sold customers discounted shares by attaching coupons to six packs of beer – but it seems to be making a comeback.

SoFi plans to become an underwriter, meaning that it will buy the securities from the issuer then sell them back, as opposed to strictly acting as the broker. This makes sense, given CEO Anthony Noto’s background as a Goldman Sachs investment banker. However, it is unlikely that SoFi, as a newcomer, will be chosen as the lead underwriter with pricing and allocation power. The process of going public is one of a company’s most high-stakes decisions; historically, they have been hesitant to take a risk on a new allocation strategy or to counter their investment bank’s advice, especially if it’s unclear how retail investors will react. This is also part of the reason why SoFi has a longer “flipping” period, the wait in which the stock cannot be sold: 30 days, versus 15 days for Fidelity. Companies prefer investors to hold their stock long term, which is part of the reason they typically favor institutional investors. By imposing a longer flipping period, SoFi wants to ensure that its clients hold on to the IPO shares they purchase, making them more appealing buyers for the issuing companies.

The takeaway: while more companies may be tempted to follow in SoFi and Robinhood’s footsteps and offer mainstream customers access to IPOs, their challenge will be in securing allocation. We’ll see what creative ways new fintech companies will offer to get this access.

— Seema Amble, CFI fintech deal partner

Fintech’s role in the “Social Security for kids” stimulus payment

Rex Salisbury

Past stimulus measures have provided direct cash transfers as one-off checks. Now, for the first time, the most recent stimulus bill proposes a recurring monthly payment for parents – something akin to Social Security for children, but administered by the IRS instead of the SSA. If fintechs can establish themselves as the cheapest, fastest, and most convenient way for people to receive government cash, neobanks stand to benefit.

In prior stimulus efforts, fintechs have done just that. Over the past 12 months, fintech companies have facilitated the rapid transmission of government cash into the hands of its intended recipients. Cross River Bank, for example, distributed $6.5 billion in PPP loans to more than 198,000 businesses. That puts it behind only Bank of America and JPMorgan Chase in distributing such loans, despite being less than one-100th their size in assets. Last month, while the customers of large banks were still waiting for funds to clear, Chime had already distributed $3.5 billion in stimulus checks to over a million customers.

The federal government plans to begin mailing parents stimulus payments of $250 to $300 per child in July. It stands to reason that many consumers will turn to fintechs to access these monthly cash transfers. Unlike past parental support policies like the Child Tax Credit and the Earned Income Tax Credit, this program is also available to parents who are not working. That means for some parents these benefits will be their biggest source of income; they’ll want a service that is fast, convenient, and inexpensive.

Of course, this is where fintechs excel. Earnin and Chime pioneered early access to wages. Propel makes managing a SNAP balance (colloquially known as food stamps) far easier than the default government interface. The importance of speed and convenience in enacting these new measures should not be underestimated.

At a societal level, this program promises to reduce child poverty from nearly 14 percent to 7.5 percent, with a particularly large impact on Black, Hispanic, and Native American families. In this context, the follow-on effect of boosting fintech adoption is important, but secondary. If fintech can make these benefits more readily available on the margin, society will be better for it.

— Rex Salisbury, CFI fintech deal partner

Latin America’s fintech boom

Angela Strange, Matthieu Hafemeister

The Brazilian fintech company Nubank is now the largest neobank in the world, with 33 million customers and a $25 billion valuation. That valuation is already half that of Itau’s market cap, the largest bank in Brazil, which has been around for more than 75 years. Even among fintech enthusiasts, Nubank’s rapid rise seemed to come out of nowhere – from slightly more than 1 million applications in 2016 to more than 30 million in a few short years. Nubank has become one of fintech’s most impressive companies in teerms of scale, growth, and velocity. One key advantage? Nubank figured out early on what has since become obvious to the rest of the world: there is an enormous amount of untapped opportunity in Latin America for financial services of all types.

Latin America is currently experiencing an explosion of fintech activity. There are many historical and structural reasons for the latent demand for fintech, which we explore in detail here. But a combination of factors indicate that this is finally fintech’s tipping point in the region:

• New consumer expectations and methods of distribution: In Mexico, 43 percent of the population is under the age of 25. This large, youthful consumer base expects their banking service to more closely mirror the apps they use on a regular basis. Additionally, smartphone usage is becoming the norm, rather than the exception; WhatsApp is commonly used throughout Latin America to text, shop, and pay.
• Fintech-friendly regulation: Mexico’s fintech law, “Ley Fintech,” is set to take effect this year. The law creates a framework for fintech companies to offer new products and operate legally under the same regulatory and supervisory requirements as traditional financial institutions (more on that below). In addition, the first phase of Brazil’s Open Banking project went live earlier this year. Other countries, Peru, Chile, and Argentina among them, are expected to follow suit by passing open fintech regulation within the next few years.
• The COVID effect: Though cash is still the predominant method of payment in Latin America, business shutdowns over the past year prompted the increased acceptance of digital and online payments. Ecommerce has seen double-digit growth over the last few months.
• The existence of real-time payment infrastructure: In contrast to the U.S., real-time payments have existed for over a decade in Mexico. Brazil is in the process of rolling out its own version of real-time payments, called PIX. New fintechs are poised to take advantage of these efficient rails.

As a result, we see four core areas of opportunity for new fintech players in Latin America.

Read the full post »

— Angela Strange, CFI fintech general partner, and Matthieu Hafemeister, CFI fintech analyst

Mexico takes an alternative approach to spur fintech innovation

Matthieu Hafemeister, Alex Rampell

Venture capital invested more than $42 billion into approximately 2,000 fintech startups in 2020, according to CB Insights. That figure stands in stark contrast to the number of new financial institutions approved by the FDIC in recent years. From 2011 to 2020, only 38 banks were approved. (In 2012, 2014, and 2016, zero new banks were approved.) This shift is partly due to more stringent government regulation since 2008. But it also reflects the emergence of new paths for fintechs to operate without becoming a bank. In the U.S., fintechs have few options:

1. Obtaining a Money Transmitter License (ex: PayPal / Wise): This application and regulatory process is complex and expensive. MTLs may not lend against their own balance sheets.
2. Becoming a bank (ex: Square / Varo): Acquiring a bank license is an even more expensive and lengthy process. It can take years to get approved – Varo, for instance, took more than three – and can cost tens of millions of dollars, in addition to ongoing maintenance costs.
3. Using a bank sponsor (ex: Chime / Current): This is the most common choice among fintechs, considering it takes a fraction of the time and cost of the options above. The sponsor bank holds the funds and takes care of all KYC, AML, and ongoing maintenance costs. These agreements are often structured as revenue share agreements.

In comparison, Mexico has taken a different approach, as we note above. Mexico’s fintech law allows crowdfunding platforms to take capital from retail investors (Instituciones de Financiamiento Colectivo, or “IFC”) and provides a new form of depository institution for neobanks (Instituciones de Fondos de Pago Electrónico, or “IFPE”). More than 93 fintechs in Mexico have applied for regulatory approval.

The Mexican fintech startup Cuenca recently received an approval letter from the National Commission of Banking and Securities (CNBV) to become a licensed fintech (though there are still conditions to be met before it publicly becomes a licensed financial services entity). It has obtained its own Bank Identification Number (BIN) to become a direct card issuer. This marks a significant milestone in neobanking regulation: now Mexican neobanks can obtain a single license as an IFPE and be regulated directly, without needing to rely on a bank partner.

The Mexican fintech law raises two interesting points. First, this is a classic case of an emerging country leapfrogging the U.S. in regulations. It’s not the first time! Mexico has already surpassed the U.S. in financial infrastructure. Since the 2004 introduction of SPEI, Banco de México’s electronic funds transfer system, real-time payments have become the de-facto payment method in Mexico. Meanwhile, in the U.S. ACH transfers still take up to three business days to process. (This, of course, has given rise to Venmo, Zelle, and Cash App.)

Second, regulation can be used in a positive way to encourage financial innovation and inclusion. As the Mexican government continues to approve fintech companies, the outdated technology and predatory practices of legacy Mexican banks will hopefully become a thing of the past. Though the partner bank model has helped many smaller banks modernize in the U.S., Mexico’s pro-fintech mandate demonstrates that it’s not the only way – or necessarily the best way – to spur further fintech innovation.

— Matthieu Hafemeister, CFI fintech analyst, and Alex Rampell, CFI fintech general partner

The resurgence of active trading

Anish Acharya, Matthieu Hafemeister

Conventional wisdom holds that passive trading is the rational investing strategy. Active traders are often portrayed as gambling rubes or lucky opportunists who will (eventually) be handily beaten by index funds. But the steady growth of platforms like eToro and Robinhood, coupled with the acceleration of investing communities like WallStreetBets, has tipped the power from institutions back to individuals and created a renewed interest in active trading.

The internet has always aggregated fringe behaviors; now it enables individuals to coordinate trading strategies in a way that was previously only possible through institutions. That technological shift, coupled with cultural upheaval – thanks to a combination of loose monetary policy and an uncertain economy, younger Americans’ path to financial progress is steep – has catalyzed a lean-in mindset around investing, particularly among Gen Z. The reasons behind this shift are part psychological, part structural, which we delve into deeper here.

As a result, we’re seeing of four types of active investing emerge, supported by a growing set of dedicated tools:

• Distributed hedge funds: In the old world, the best investors worked on Wall Street, executing their strategies behind the balance sheets and research departments of hedge funds and banks. Now individual retail investors can share and coordinate their own research, trading strategies, and collective balance sheets. Through communities like WallStreetBets and execution layers like Numerai, that coordination is becoming more distributed.
• Individuals as institutional scale asset managers: Wall Street has always had star stock pickers. The internet version of this phenomenon is the unbundling of indexes – enabled by platforms like Apex and startups like Doji – and the ability for anyone to follow in the footsteps of Cathie Wood and create new ones. In the future, retail traders will follow individual investors that align with their investing style and return profile.
• Low-code trading IDEs: Just as GitHub and Figma provide collaborative environments for programmers and designers, there are now a number of emerging collaborative development environments for hobbyist and prosumer quants. With a “GitHub for investors,” the best managers in the world could build a public record of successes and participate in the economics of fellow investors that leverage their primitives.
• Bottoms-up communities: Through Stocktwits, WallStreetBets, Commonstock, and more, investing communities are becoming increasingly centralized. The infrastructure exists to open up trading data and put it at the forefront of new social platforms.

Read the full post »

— Anish Acharya, CFI fintech general partner, and Matthieu Hafemeister, CFI fintech analyst

More fintech news

Most Big Debt Collectors Backed Off During the Pandemic. One Pressed Ahead. (WSJ)
Sherman Financial Group has bucked industry trends during COVID-19, filing more lawsuits to collect cash from people behind on their credit-card bills than it did pre-pandemic.

Auto Loans Get Their SoFi Moment (Bloomberg)
The online lender Social Finance Inc., best known for reworking student debt, is partnering with MotoRefi to refinance auto loans.

All the Fintech Companies in Y Combinator’s Winter 2021 Batch (Fintech Brain Food / Substack)
A round-up of all 43 fintech startups.

Walgreens to Launch Bank-Account Offering Through Partnerships (MarketWatch)
The bank-account product will be linked to a Mastercard debit card issued by MetaBank.

Bank of America Acquires Healthcare Tech Startup Axia (American Banker)
It’s the latest move in the bank’s efforts to build out payments offerings in healthcare, an area that still relies heavily on paper bills and checks.

Ensemble, an App to Help Divorced Parents Avoid Arguing About Money (TechCrunch)
The expense tracking app aimed at reducing tension among co-parents is coming out of stealth.

Instacart and DoorDash Plan to Launch Their Own Credit Cards (WSJ)
The delivery companies hope the cards will reinforce customer loyalty; the banks aim to diversify beyond travel rewards cards.