Finance is fundamentally an exercise in pricing risk, and pricing risk is in large part a function of the cost of information.
Given this reality, it is somewhat surprising that in the last few decades the internet has not more fundamentally revolutionized how individuals and businesses broadly access capital.
To be sure, the internet has unleashed all sorts of interesting, specific evolutions of finance. Things from high-frequency trading to at-scale, algorithm-driven home flipping to on-the-fly credit at checkout are all financial children of the internet. There is a strong argument that the robust late-stage private capital market we have today is as well.
What I question, however, is why, with the dramatic increase in access to information, consumers are largely stuck with millennia-old forms of debt financing rather than having access to more modern forms of equity finance for their personal growth and needs?
I further question why the average investor is so limited in the investment products he or she can access. There are fewer public companies today than there were in 1980, while the markets for buying securitized slices of art, media rights, real estate and collectibles have yet to truly come to be, even though the internet should in theory support them.
Some attempts have been made to introduce new forms of financing. For instance, alternative forms of financing student education through equity-like Income Sharing Agreements (ISAs) have been experimented with for 20 years. In the last few years, Lambda School and others have formalized the idea of students paying for coding bootcamps with loans that they pay back over time, with the amount based on their income after graduation.
Simultaneously, the securitization narrative on alternative assets is also picking up steam. Companies like Rally Road are using the JOBS act to make a serious go of securitizing and selling slices of collectible rare cars. Many in the crypto world are convinced that open marketplaces for digital and physical assets will be a major vector to propel the ecosystem world forward.
The question is whether we are seeing the beginning of sea change, where finance is fundamentally overhauled, or if these experiments will be nothing more than flashes in the pan with limited long-term impact.
How the Internet Theoretically Should Fundamentally Impact Finance
In theory, the internet dramatically increases the availability of information, and lowers its cost. All else being equal, this should reduce the cost of capital and it should expand the equity markets.
The internet’s impact on the cost of capital
To understand the link between the internet and the cost of capital, consider, by way of illustration, some of the least expensive loans in the world. If a large company wants to finance accounts receivable, or a very wealthy individual wants to borrow cash on margin against the value of a liquid stock portfolio, the cost of those loans approaches zero.
There are a few reasons that loans like those are so cheap.
First, and most importantly, it is because there is effectively zero likelihood that the borrowers will default on the loans. Second, there is an extremely low information cost for the financier in checking that so the likelihood of default is negligible. The financier can see the assets or purchase orders in a trusted and easy to process format. Third, because it is easy for the borrowers to share the information with the lender that proves the reality of their collateral, it is easy for the borrower to share the same information with anyone else, which means the lending market is competitive. And finally, because the information about the loan is easy to package and re-transmit to others, it means that the lenders can themselves easily borrow against the near certainty of repayment on the loan to others, meaning that their cost of capital upstream is low.
If that is what the picture looks like when information makes capital very cheap, consider investing in brand new startups at the other end of the spectrum. All of the facts illustrated above are inverted.
Capital is expensive for the startup first because the company is likely to fail. The “Vegas” odds are dramatically against them. Second, a financier has to undertake time-consuming esoteric work to evaluate and price the risk of investing in the startup.
Because the risk is high and pricing the risk is non-standard and time-consuming, there isn’t a very deep market force driving competition among financiers. It is hard for the financiers to prove they made a good bet (or not) for years to their investors. These factors mean that each investment has to be weighed as an opportunity cost against other investments for whomever ultimately decides to invest.
The point is simple. The more information that is available, the more people and businesses get very inexpensive capital. So, the internet should—all else being equal—make access to capital less expensive.
The Actual Impact of the Internet: Scale Over Innovation
If that is the abstract picture of how finance should change with more access to information, then how do we explain the relative lack of change to date?
I think that the biggest answer is that most of the financial companies have used the internet to increase the scale of what they were already doing, and become more profitable—rather than innovating new products.
This pattern, toward scale and profitability, has been true even in companies that have innovated in finance—like peer-to-peer lending platforms. They started out with reasonably innovative models, but as they grew it became far more profitable and sensible for them to plug into the large traditional financial institutions as a capital source rather than trying to scale both lenders and borrowers. The platforms ended up looking like any other traditional digital lender.
This same “scale over innovation” theme helps explain why there are so few public companies today. The biggest and most successful firms have used the internet to get even bigger, crowding out most of what would otherwise be the public mid-market (think Amazon versus dozens of smaller vertical or regional companies).
I don’t want to overstate this point. There are pockets where the internet has clearly had the anticipated impact, and the cost of capital and especially the cost of equity financing has declined a lot. There is no question that Silicon Valley and New York startups, with tons more funds and foreign money pouring in to the market, benefit from these effects.
But, when you scope out and think about how most of the country and most of the world experience finance before and after the internet, scale has dominated innovation.
There aren’t a whole range of new financial options for people and ventures, but big banks and big private equity firms are operating at more scale more profitably.
The Specific Case of Financing Education and ISAs
The question, then, is what financial innovations from the internet could be coming soon?
Perhaps the most intriguing innovation on the near horizon is the idea of moving educational financing away from traditional debt and toward new innovative models like Income Sharing Agreements (ISAs).
Rather than having students borrow money to pay upfront for their education, instead they would pay a certain percentage of their income for a certain number of years after they graduate. If they do very well, the amount they pay will be higher, but if they struggle or don’t make much money, then they don’t have to worry about the debt and pay less overall.
ISA ideas have been around for more than 20 years. The first company I tried to start was attempting to do “venture style” equity financing for individuals in 2000. Even at that time I was not alone. Others were experimenting with variations of the idea back then.
Recently, however, there has been an explosion of ISA ideas and companies specifically targeted at coding bootcamps.
The Specific Case for Coding Bootcamps
It makes sense that ISAs are taking root in coding bootcamps for several reasons. Firstly, the anti-debt narrative particularly appeals to the millennials attending these coding bootcamps, who are notoriously wary of debt as a generation.
Secondly, since the entire promise of many bootcamps is that the skills they teach will help you get a good high-paying job, it makes marketing sense for them to align their incentives with that of their students. In a sense, income-sharing agreements to pay for coding bootcamps is almost a “money-back guarantee” to their students.
Third, when you apply the financial information lens we have been using, ISAs make good sense for these coding bootcamps because they are vertically integrated or tightly coupled finance + service organizations. The coding bootcamps themselves control the application process, as well as the education they are providing. This removes much of the cost associated with vetting students or education institutions that other external financiers would need to bear. As service businesses, these bootcamps are already paying all the information costs associated with their student bodies, so the cost of the information needed to finance the students is effectively zero.
A related point: Very few people would attend a coding bootcamp and then not want to get a high-paying job afterwards. I am sure there are some people who want to go into nonprofit work or take time off after. But for the most part these boot camps are grueling enough that few people do them for fun. Most people want to get paid well on the back end.
Finally, there is the question of how the coding bootcamps can themselves finance the ISAs. They do need working capital after all. This again is the information problem. These coding bootcamps can do enough volume over time that they’ll have data on which students to accept and lend to. That should drive down their cost of borrowing money to run these ISA programs.
The only real challenge to the coding bootcamp ISA model might be competition from other ISA offerings from third parties with slightly different models.
If, hypothetically, a given coding bootcamp offered an ISA or non-ISA option, then there would be an adverse selection problem. The people who thought that the ISA was a good deal would probably—slightly—on average be worse off than those who don’t. If you as a student had access to many different ISA formats with different periods of payback and percentage sharing on income, then the pool of students could be divided up in ways that wouldn’t be good for lenders. People who don’t intend to make money will opt for an ISA while others take traditional, cheaper debt.
The solution could be for certain institutions to only allow ISAs, or their own home-grown ISA (as Lambda does), as a way to pay. But obviously that will not scale to the broader world. I can’t imagine a world where traditional debt is banned.
The Broader Case for ISAs
If this is a seemingly viable direction for the small slice of coding bootcamps in the world, the important social question is whether or not this model works as an option for personal finance in a broader sense.
There are several good arguments for why ISAs are good, and we will finally see equity-like options for personal finance.
You can argue that ISAs are the right intellectual type of product for the uncertain and “spiky” future of human work. We all know that the days of people having steady employment through their entire careers are gone. At a minimum, most people will now have several different jobs at several different institutions over their lives. At a maximum, most of us will go through periods of unemployment or underemployment. This spikiness of employment doesn’t match well with consistent and standardized payments.
You can also argue that ISAs and broader equity financing options for people should become less expensive for people just as debt is becoming more expensive.
The opportunity cost of having debt is that you need to make decisions that help you pay that debt consistently. Just like being stuck in a mortgage, does being stuck in debt force you to make suboptimal decisions for your long-term career—like not starting a company—because you can’t afford the short-term expense and risk?
The hard cost of debt is also on the rise. It isn’t just that the cost of education is high. Low inflation rates of recent years hurt students: the cost of their loans doesn’t inflate away. And, at least in the case of private student loans, the uncertainty of the macro future and the declining default equity value in being an American worker force up prices.
Also, the reality is that if income is becoming more and more unequal, pooling risk in the form of ISAs, where the people who earn the most can carry some of the cost for everyone else in the pool, makes sense for everyone. Under this model, 2% of the earnings of a future billionaire covers the “cost” of education for thousands of people who don’t end up earning money. The ISA pooling model means that the most successful end up underwriting everyone else.
On the flip side, there are many strong arguments against ISAs.
Some are structural and regulatory. We need legislation to govern how to treat ISAs and equity for individuals, and how taxes work for both financiers and for people “borrowing” on this model. These could be worked out, but it will be a long road.
Second, there is the Jeff Bezos problem, and how that affects the cost of money that comes from an ISA. To conceptualize the extreme case, imagine that Jeff Bezos had financed his early years by selling 1% of his future earnings rather than borrowing money for school. If that ISA had been a short-term proposition, then the financier wouldn’t have captured much of the upside. A two-year ISA agreement wouldn’t really capture much upside in almost any entrepreneur.
But even if that ISA had been long-term, covering the decades from when Jeff Bezos borrowed to the present day, it would have captured very little of the $100 billion fortune that he has amassed. That’s because the richest people borrow money to finance their lives and don’t sell their equity value. Bezos doesn’t take a salary from Amazon: his wealth is in his stock, so there is nothing for the ISA to share in, until he liquidates his stock. The way we calculate income allows superstars to easily avoid their contribution.
This might sound fine to some. Few people shed a tear for a financier missing out on a big gain. But what you should realize is that the details on how the “upside” is captured very much affect the rate at which money can be efficiently “lent” in forms like this. If there isn’t enough upside on an investment when there is a win situation, then the cost of the capital as a percentage of income ends up being very high.
The government, of course, already has an income-sharing agreement with its citizens in the form of income taxes. If an ISA layered on top of taxes took someone’s complete tax rate from 55% to 56% because the ISA was long enough term and complete enough to have a low 1% rate, that might make sense and be manageable. But at the other extreme, if an ISA meant that you were paying another 20% on top of taxes, that would be hard for most people to afford.
Finally, of course, there is the broader market problem of adverse selection. If people can choose between debt and equity investment, then the financier doing ISAs / investing in equity is left managing the fact that those who think they will earn the least are most likely to choose the ISA structure over traditional debt.
This is only a small survey of part of the ISA discussion. But it should give you a sense of the possibilities that the internet, bringing with it far better access to information, should offer for financial innovation.
The upshot is that ISAs are likely a good niche fit in the coding bootcamp world. But I am holding my breath about whether or not they will run the gauntlet and provide an example of how the internet can fundamentally alter rather than just enable the financial world.
The Road Forward
The invention of the joint stock company and modern equity was a major propellant for the modern world. Opening up access to capital beyond the landed gentry who had hard assets to borrow against made the world more open and fair, and helped begin move the world out of the poverty of the Middle Ages. All of that innovation took a lot of legal and policy work, but it was fundamentally built on top of literacy, the printing press—and then accelerated by the telegram and telegraph.
We are in the middle of the biggest information revolution possibly in human history, but we are waiting for the next evolution of finance. So far, all we have gotten is more scale and more efficiency around our old financial products.
I believe there is a strong case that opening up access to equity financing could and should be a major part of the story, and is a strong candidate for relieving the debt pressure whose structure no longer fits our more nimble and less certain society.
In my mind, we all are cross-invested directly in each other’s success as a society writ large, as Americans. It only makes sense for us to formally invest in each other as well.
In a sense, we already do this style of cross investment with taxes. It is easy to think about your income tax bill as an income-sharing arrangement with the rest of the citizens of the country. Does it not make sense to open up that idea for other forms of cross-investment if the power of the internet makes it feasible?
This is just one of many ideas that I hope will be debated and tried not just as a niche point solution for a specific small industry, but with a mind toward how we can use new tools to deeply change how finance—the fundamental exercise of pricing risk based on information—evolves in the near future. It is clear we need some innovation.