Introduction

Financial innovation is the act of creating new financial instruments as well as

new financial technologies, institutions, and markets. Recent financial innovations
include hedge funds, private equity, weather derivatives, retail-structured
products, exchange-traded funds, multi-family offices, and Islamic bonds (Sukuk).
The shadow banking system has spawned an array of financial innovations
including mortgage-backed securities products and collateralized debt
obligations (CDOs).
There are 3 categories of innovation: institutional, product, and process. Institutional
innovations relate to the creation of new types of financial firms such as specialist
credit card firms like Capital One, electronic trading platforms such as Charles
Schwab Corporation, and direct banks. Product innovation relates to new products
such as derivatives, securitization, and foreign currency mortgages. Process
innovations relate to new ways of doing financial business, including online
banking and telephone banking.
Financial innovation is the process of creating new financial products, services, or
processes. Financial innovation has come via advances in financial instruments,
technology, and payment systems. Digital technology has helped to transform the
financial services industry, changing how we save, borrow, invest, and pay for
goods.

While large banks continue to invest in mobile banking, FinTech companies,

like Stripe, help small businesses conduct online payments, and investment
broker Robinhood seeks to democratize investing and finance. These innovations
have increased the number of financial providers available to consumers, borrowers,
and businesses.

Background
Economic theory has much to say about what types of securities should exist, and
why some may not exist (why some markets should be "incomplete") but little to say
about why new types of securities should come into existence.
One interpretation of the Modigliani-Miller theorem is that taxes and regulation are
the only reasons for investors to care what kinds of securities firms issue, whether
debt, equity, or something else. The theorem states that the structure of a firm's
liabilities should have no bearing on its net worth (absent taxes). The securities may
trade at different prices depending on their composition,and they must ultimately add
up to the same value.
Furthermore, there should be little demand for specific types of securities. The capital
asset pricing model, first developed by Jack L. Treynor and William F. Sharpe,
suggests that investors should fully diversify and their portfolios should be a mixture
of the "market" and a risk-free investment. Investors with different risk/return goals
can use leverage to increase the ratio of the market return to the risk-free return in
their portfolios. However, Richard Roll argued that this model was incorrect,
because investors cannot invest in the entire market. This implies there should be
demand for instruments that open up new types of investment opportunities (since this
gets investors closer to being able to buy the entire market), but not for instruments
that merely repackage existing risks (since investors already have as much exposure
to those risks in their portfolio).
If the world existed as the Arrow-Debreu model posits, then there would be no need
for financial innovation. The model assumes that investors are able to purchase
securities that pay off if and only if a certain state of the world occurs. Investors can
then combine these securities to create portfolios that have whatever payoff they
desire. The fundamental theorem of finance states that the price of assembling such a
portfolio will be equal to its expected value under the appropriate risk-neutral
measure.
The acceleration of the process of liberalization and globalization in the financial
sector which began in the United States in the 1970s, initiated and spurred on by
changes in information technologies, has not been accompanied by a parallel
development of the system’s regulatory framework, whose instability has steadily
increased. Financial innovation in derivatives and securitization, fuelled by a lax
monetary policy, created a bubble in the housing and credit-supply markets which
burst when the subprime mortgage crisis hit in 2007. In the past, major technological
changes such as the railway, the automobile or the internet have been accompanied by
speculative bubbles in a context of asymmetric information and biased predictions,
and the effects of financial innovation on derivatives and securitization are no
exception to this historical trend.

Understanding Financial Innovation

Financial innovation is a general term and can be broken down into specific
categories based on updates to various spheres of the financial system. While the
following is not an exhaustive list, major financial innovations have come in the
raising of equity capital, remittances, and mobile banking.Investment crowdfunding
began making the process of raising equity capital more democratic. It has eradicated
the belief that only privileged few can invest in early and growth-stage companies.
Now, individual retail investors can invest in projects according to their interest. Such
individual investors receive shares of the company they have invested in.

1. Investment Crowdfunding

Investment crowdfunding has begun to open up and make the process of raising

equity capital more democratic. While investing in early and growth-stage companies
used to be reserved for a privileged few (generally institutional investors), new
infrastructure and regulations have allowed individual retail investors to invest in
projects they are passionate about and/or have other connections to for a small sum.
Individuals receive shares of the new company commensurate with the amount they
have invested.Two popular platforms for equity crowdfunding are SeedInvest and
FundersClub. In addition, micro-lending platforms such as LendingClub and Prosper
allow for debt financing similar to crowdfunding. In this asset class, instead of
owning part of the company, individuals become creditors and receive regular
interest payments until the loan is eventually paid back in full. Also, P2P lending
marketplaces enable both people and companies to buy whole or fractional loans.

2. Remittances
Remittances are another area that financial innovation is transforming. Remittances
are funds that expatriates send back to their country of origin via wire, mail, or online
transfer. Given the volume of these transfers worldwide, remittances are
economically significant for many countries that receive them.In the early 2000s, the
World Bank established a database where people could compare the prices of
different transfer services. The Gates Foundation subsequently began tracking
remittances in 2011. Western Union and Moneygram once monopolized remittances;
however, in recent years, startups such as Transferwise and Wave have competed
with their lower-cost apps. Given the onset of Bitcoin, Ethereum, Stablecoins, and
Blockchain technology, remittances are becoming more affordable. The lower costs
are in line with the Sustainable Development Goals (SDG) of the World Bank to
reduce the cost of remittances from 7% to 3% by 2030.1

3. Mobile Banking

Finally, mobile banking has made major innovations for retail customers. Today,
many banks like T.D. Bank offer comprehensive apps with options to deposit checks,
pay for merchandise, transfer money to a friend, or find an ATM instantly. It is still
important for customers to establish a secure connection before logging into a mobile
banking app in order to avoid their personal information being compromised.

4 Examples of Financial Innovations

When discussing the future of financial technology (fintech), the conversation has
moved over the years from EFT to PayPal, and most recently, to Bitcoin. Many
financial innovations have transformed our lives, and some have failed drastically.
There are lessons to be learned from both.

1) PayPal

PayPal is one of the world’s biggest financial innovation examples, with 361 million
active users currently.1 In 1998, PayPal, known as Cofinity Inc. at the time, was
founded by Ken Howery, Luke Nosek, Max Levchin, Peter Thiel, and Elon Musk.
Almost immediately, the company saw great success, growing at approximately 10%
every day. By mid-year of 2000, the organization hit five million users, and just two
years later, PayPal was acquired by eBay for $1.5 billion.2 PayPal eventually split
from eBay in 2014 – a move most were expecting since investors had been urging
them for quite some time.

Today, the organization has a market cap of $112.50 billion (March 2022)3 and is still
growing. It’s acquired companies such as Braintree, Venmo, VeriSign, iZettle, Honey
Science Corp., Xoom Corp., and Hyperwallet Systems Inc.4

Success or failure?

The success behind PayPal becoming the biggest online payment processor has a lot
to do with its founders meeting a gap in the market. This was especially evident
during the COVID-19 pandemic.5 
 In 2021, statistics showed that consumers were 54% more comfortable
making cross-country purchases if PayPal was an accepted payment
method of the merchant. 6

PayPal went through six iterations before becoming the online payment giant it is
known as today. Max Levchin describes how they had to regularly pivot in a matter of
days, and be agile enough to take the next step towards success: “But between the
founding and the actual PayPal, it was just this tug-of-war where it was like, ‘We’re
trying this, this week.’ 

Every week you go to investors and say, ‘We’re doing this, exactly this.
We’re really focused. We’re going to be huge.’ The next week you’re
like, ‘That was a lie.’”7

PayPal offers dedicated customers special discounts at selected retailers and has a
reputation of being exceptionally safe, ensuring all information is
encrypted.8 According to Dean Turner, PayPal’s previous Director of Security
Intelligence, “If you care about the product [and] you care about your customers, you
care about your customers’ security – this is what you have to do.”9 This level of
excellent customer service puts this financial innovation in high demand.

2) Funding Circle

Funding Circle is a platform connecting organizations that have available money to

lend with creditworthy businesses seeking finance. Its founders, Alex Tonelli and
Sam Hodges, started the platform after experiencing how difficult it was to gain
funding for their small business. After opening a number of fitness centers together,
the two failed to grow the business any further because they couldn’t get a loan.10 This
experience sparked the idea to create Funding Circle.

Based on peer-to-peer lending, also known as social lending, Funding Circle is now
one of many lending platforms offering this service. However, it found great success
by being the first of its kind. Following two years of cost contraction, the company
reported an $83 million profit for 2021.11

Success or failure?

With banks becoming increasingly regulated and start-up capital becoming difficult to
secure, peer-to-peer lending has stepped in to meet the demand of new lenders and
borrowers. In an environment where there is easy money, however, rapid credit
source expansion will often lead to financial disasters like the 2006 mortgage
bubble.12 This is because individual lenders don’t necessarily have the know-how
when assessing credit risk. Peer-to-peer lending might have its faults, but as a
business, Funding Circle is now on its way to becoming London’s biggest fintech
IPO, with net assets valued at $331.1 million.13

One of the major reasons behind its success is that value is created
through a return on investment, which Funding Circle is able to
typically offer at a higher rate than traditional financial products.
Those who choose to invest in Funding Circle gain value through its credit scoring.
This speaks to the credit integrity of its potential borrowers, mitigating the risk to
lenders.14

3) M-Pesa

Starting out as a convenient way to send money back home, M-Pesa has since become
the largest payments platform in Africa. Today, this platform allows many unbanked
Kenyans, who mostly live in rural areas, to deposit, transfer, and withdraw money and
pay for items using their mobile phone. M-Pesa is one of the examples of how
financial innovation has led to financial inclusion by creating a service geared towards
the unbanked and underbanked.16 This branchless banking service works by allowing
users to store money in an account accessed via their mobile phone using PIN-secured
text messages.

Success or failure?

M-Pesa was acquired by Safaricom in 2007.

Brian Wamatu, who heads up the product development, said, “We

stumbled upon M-Pesa 10 years ago, for people working elsewhere in
Kenya that could [now] send money to their families. We were looking
for a platform that enabled payments and that was sustainable.” 18

It was reported that in 2022, more than half of Kenya’s entire GDP is transacted on
M-Pesa.19 And in terms of revenue, M-Pesa’s transactional value grew by over 50
percent year on year, resulting in a total revenue of 146.4 billion shillings in 2021.20

However, while many acknowledge M-Pesa is a huge success in Kenya, there are
contradictory opinions regarding the success of M-Pesa everywhere else, particularly
in South Africa. M-Pesa was brought to South Africa in 2010; six years later, the
platform only had 76,000 active users, leading to its closure the same year. A large
contributor to this failure was South Africa’s excessive regulation when it came
to mobile money.

4) WeChat

WeChat has become one of the world’s most popular, independent mobile apps
through monthly active users. It has over one billion active users, making it one of
just five apps in the world that have surpassed that user milestone.22 First launched by
Tencent in 2011, WeChat was just a simple messaging app that eventually evolved to
become an ecosystem of its own.23

Today, users can access a multitude of functions on the app including:

 Banking
 Travel
 Booking a doctor
 Networking
 Filing for divorce
  Job searches
 Making reservations
 Online shopping
 Entertainment
 Applying for a visa
 Research

With the introduction of WeChat Pay, the company officially entered the fintech
realm, which allows users to access multiple payment methods, settlement across
major foreign currencies, and in-app purchases on their shopping page.25 Tencent’s
financial innovation has led to a number of industry awards, with them recently
receiving the Singapore Business Review’s Technology Excellence Awards 2021 for
the cloud services category.26

Success or failure?

WeChat has been a major success. However, some speculate as to whether WeChat’s
success – specifically in China – is largely due to the popular messaging application,
WhatsApp, being banned in the country. WeChat has been accused of sharing
personal user’s data with authorities in China, while WhatsApp offers end-to-end
encryption. Yet, WeChat continues to offer many more features compared to
WhatsApp and is said to have been ahead of the curve even before WhatsApp was
banned. Already in 2013, WeChat users could send monetary gifts, pay bills, and
transfer money.

As of January 2022, daily active users on WeChat sub-applications reached 450

million, with the number of active mini-programs growing by 41% year-on-year, and
the average daily use times increasing by 32% year-on-year.30

A large reason behind the company’s success was capitalizing on the

opportunity to add new major functions, transforming the app from
merely being one focused on messaging.

Ultimately, the success behind financial innovation is based on meeting the needs of
people through the disruption of the status quo. In the words of PayPal’s Max
Levchin, “You can’t get married to any one particular plan.” This means accepting
that you need to adapt as your customers’ needs evolve. Often, the end product bears
little resemblance to your original idea – with good reason.

HOW TECHNOLOGY IS TRANSFORMING THE FINANCIAL INDUSTRY

There are many ways technology is transforming the finance world, from automating
long tasks, to a whole new monetary world called cryptocurrencies. In this article, we
breakdown these changes into three main categories. Within each category, we
explain the impact technology is having on the finance industry and how tech is
shaping its future.
• Technology creates a new level of visibility and improves capabilities by providing
better and more accurate financial insight and analytics

• Technology enables automation which saves costs and drive efficiencies to allow
teams to focus on other key priorities

• Technology adds stronger, more secure foundations of financial transactions

Technology opens a new world of opportunity for companies, cutting out unnecessary
costs and enabling an ease of processes. A great example of this is mobile banking
apps, enabling customers to view their financial data on the go, removing the need for
visiting a physical visiting a store and freeing up staff to focus on other customer
needs and priorities.

Technologies such as AI and predictive intelligence, help users and finance experts
create better educated decisions on cash flow and forecasting. Technology brings with
itself a variety of data sets that would not have otherwise been available if it wasn’t
for digital systems. These systems and algorithms bring a neutral, unbiased prediction
based on the facts when it comes to data-backed prediction decisions.

In recent times, the term for financial technology is now widely known as FinTech.
When a finance company introduces technology into its organisation, such as
computer programmes and other technology used to support or enable banking and
financial services, it’s known as FinTech. Blockchain technology and ATM machines
are also included in this.

There are eight FinTech categories, with some FinTech companies spanning into
more than one category:

1. Banking – Core products include personal current accounts, savings, and

mortgages.

2. RegTech – Focuses on companies with technology and activities focusing on

reimaging and streamlining risk, credit scoring and compliance.
3. InsurTech – Includes companies selling insurance digitally or introducing new
digital business models or reinsurance software.

4. Lending – Companies focusing on innovating credit, including commercial to

alternative and specialist lenders and platforms that facilitate P2P.

5. Business Banking – Primarily focused on supporting SME businesses with services

such as accounting, payroll, invoices and expense management.

6. Payments – Businesses that provide money transfer, remittance and foreign

exchange services.

7. Quote Aggregators – Provide online comparison systems for consumer quotes such
as insurance and mortgages.

8. WealthTech – The largest category, focuses on investment and management

platforms, sales and trading analysis tools, personal finance management and crypto
exchanges.

FinTech’s crucial aspect is the price; customers and financial firms can save money
on the transaction costs. The main advantages of this technology are the speed,
security and accessibility it brings. Being able to prevent financial software from
being attacked is crucial for all companies.

With the nature of the pandemic, the shift to remote working has required the need for
Cloud technology more than ever before. Cloud adoption has been key to permissive
home working and while this can bring many security and resilience perks, numerous
of them rely on organisations constructing cloud environments accurately with
security-built in.

If you’ve used social media recently, you’ll have probably heard of the term, Bitcoin.
Bitcoin is a virtual currency, each Bitcoin is a computer file which is stored in a
“digital wallet” app on a smartphone or computer. Bitcoin and many other
cryptocurrencies have become popular in recent times and this type of technology is
called Blockchain.

Blockchain is a distributed digital ledger that stores data of any kind. A blockchain
records important financial data such as cryptocurrency transactions. To break it down
for you, the digital ledger is defined as a “chain” which is made up of singular
“blocks” of data.

When new data is systematically added to the network, a new “block” is established
and connected to the “chain”. The key to why blockchain is considered so
exceptionally secure is how these new blocks are created. New data must be verified
and have the legitimacy confirmed before a new block can be added to the ledger.

Blockchain is a much cost effective way of carrying out transactions. Blockchain is a

sophisticated technology that dramatically decreases the chance of human error which
makes it one of the safest and most secure financial transaction mechanisms currently
available.

Another big change has been allowing customers to be at the forefront of ease and
accessibility. As time goes on, customers are leading a more digital lifestyle that
provides them with more options. And this is no exception for banking. Digital
banking software creates a more unique and personalised digital experience for their
customers.

When a customer opens an account with the bank, they are offered a free mobile app
that allows them to manage their finances online at their fingertips. Mobility, instant
service and reliability are the big advantages of digital banking services. Banks who
are slow to adopt these innovative technologies will fall behind against their
competitors if they don’t offer these now expected, modern services.

Finance firms are aiming to increase their growth and innovation by investing in
digital solutions. The customer centric focus and speedy services are attracting new
customers and in return, increasing the profitability of the finance sectors. It’s
important for the finance industry to keep up with the digital world, but it can become
an issue when technology is on a low budget.

As technology advances, the amount of customer data gathered continues to increase.

From banks making lending decisions based on a user’s credit score to insurance
companies reviewing your driver and health records before offering a policy; as
people and technology devices become more unified, new streams of real-time data
are apparent, and with them, innovators use that data to back their financial decisions.

A US health insurer company, Oscar, offers its policyholders a free wearable fitness
tracker, and in return, encourages their customers to be more active. As these analytic
models and wearable devices advance, we will likely see more and more financial
companies working to encourage their customers to improve their lifestyle and
behaviours in return for monetary incentives.

The core way tech has transformed the financial industry, is through automation by
simplifying the tedious tasks which provides a raft of benefits from cost and time
saving which enables staff to focus on other key priorities and in turn provide a better
service for their customers.

A brilliant example of this, is that people can now simply track and categorise
expenses at the click of a button rather than manually entering and categorising
expenses line by line. Another great example of this is computer systems and tools
which enables users to instantly download and scan documents and receipts quickly
and efficiently. which then improves machine learning meaning our devices are
continuously learning and improving.

Machine learning is a powerful tool in our modern day, it‘s algorithms use statistics to
find patterns in a mass amount of data, which embodies a number of things such as –
words, numbers, clicks or images. If it can be stored digitally, it can be passed into a
machine-learning algorithm.
All in all, technology is transforming the way the finance industry functions and
operates for the better. Technology is constantly evolving and improving, which saves
people the number one valuable thing in life, time. If companies don’t keep up with
modern digital solutions, they’re likely to get left behind as more and more firms are
leading with the customer experience and ease as their priority.

If your company needs advice or assistance in digitising your finance solutions our
expert team can help. From custom software, mobile apps or customer portals, we
specialise in helping organisations understand and leverage the power of digital and
technology to improve efficiencies, engagement, and drive true transformation with
tangible results.

Function of Financial Innovations

Financial institutions, instruments, and markets tend to perform a plethora of

functions. You can say innovations are only useful if they improve the way these
functions are. At times, parts may seem to be working out, but they are only
temporary. All they do is leave some socially pernicious collateral effects.Here are
some of the major Functions of Financial Innovations –

Payments

One of the most critical fucntion of finance is to offer a means of payment and to
store wealth.As humans, we know money as coins, livestock, and food grains, but
now money has a different meaning, which is in the paper. Thanks to stunning
technological developments, money is mainly transferred electronically that is
through automated clearing houses. 

Savings & Earnings

Secondly, the finance function also includes generating money for earning interest
and dividends on the investment. The basic plan of financial institutions is to promote
saving. Saving is socially essential because it funds capital investments to generate
more income in the future. Another economic function is to channel savings to assets
that are productive. 
Allocate Risks

Another function of finance is to allocate risks to those who don’t want to take risks.
Sometimes, people confuse this with finance reduces overall risk. You must know that
the main agenda of financial innovation is to hedge against risks.In simple terms, you
can say economic design is an act of creating some new instruments and then
popularizing the same. Besides financial devices and payment systems, we can see
financial innovation in payment mechanisms in the economy. 

Creating Financial Services

Some of the essential services that economic systems offer are evaluating, screen,
allocating, monitoring, and facilitating transactions. With the help of these services,
the capital flows to the place of utmost need. It then promotes sustainable growth and
development. Financial innovation also includes the creation of new securities,
markets, and institutions that help in improving the financial services sector.

Accelerating Growth of Financial Industry

Above all, the main aim is to accelerate the growth of the financial industry. Some of
the advances in financial innovation include innovations in technology, credit and
equity generation, and risk transfer. Over time, a plethora of designs is in rolling, like
the ATMS, mutual funds, debit cards, venture capital funds, etc.