Financial innovation goes to rehab
The UK economy is reaping the benefits from a new wave of innovators.
The crisis and innovation
Financial innovation became very much a dirty term in the wake of the crisis of 2008 and the ensuing dip into recession. It became synonymous with complex investment products where debt was packaged and repackaged until investors had little true knowledge of the quality of the underlying assets they were investing in. Nor were regulators able to keep track of which institutions were exposed to which asset classes and to what extent. While many of the innovations that led up to the financial crisis were well intentioned, their design and execution led to a complex and opaque system and ultimately did more harm than good.
Curing the complexity addiction
However one positive that has come out of the crisis is a new wave of financial innovation that seeks to do almost exactly the opposite. Firstly, they are in the most part operating independently of the large institutions were at the root the crisis. Secondly, and more importantly, whereas innovations of the noughties like Collateralised Debt Obligations or Credit Default Swaps meant investors had little real knowledge of where their money was actually going, new models like crowdfunding and peer-to-peer lending are remarkable for their transparency and simplicity. This new ‘alternative finance’ movement is making use of technology to bring those with money to invest closer to those who need it, allowing investors to create diversified portfolios, avail of tax incentives, back growing businesses and all without the need of large traditional institutions.
The road to recovery
To get a better idea of what impact these new innovations are having and how quickly they are growing, we recently produced research with Cambridge University and UC Berkeley to examine the market. We found that in over the last 3 years alternative finance intermediaries facilitated almost half a billion pounds of business funding, through crowdfunding, peer-to-peer lending and invoice financing. But how does this compare to the overall size of the SME finance market?
Small...but maybe not for long
· In 2013 peer-to-peer lenders lent around £200million to SMEs. This is still less than 1% of the SME lending market but at their current rate it will be over 1% next year.
· On the equity front, crowdfunders raised around £28m this year. The BVCA reports around £220m inverted annually in seed and early stage deals while best estimates of the difficult to measure business angel market put it somewhere north of £300m per annum. All of this would give equity crowdfunders around 2% of the seed and early stage equity investment market already. Again, going on current form this is on course to more than double in 2014.
While they’re currently taking relatively small pieces of the pie, their current growth rate suggests it’s not long before they become quite important players in the market. The 5,000 businesses that were funded by alternative finance providers in the last 3 years, will certainly agree that financial innovation, in its rehabilitated form, is starting to deliver real value to the UK economy.
 Total SME lending figure taken from Bank of England’s Trends in Lending report.