Fluent Essays

Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China Technology is the DNA of Dianrong. — Soul Htite, Founder & CEO of Dianrong Soul Htite, Founder and CEO of Dianrong, one of the largest online peer-to-peer (P2P) lending platforms in China, completed his speech with a smile on his face. He was one of the key speakers at RISE in Hong Kong, a preeminent technology conference in Asia, and talked about Dianrong’s recent fintech initiatives, which aimed to create better financial service offerings using technology. Considerable progress had been made at the company, but Htite’s mind remained fixated on the recent issues that the company had been confronting. On July 12, 2017, Dianrong announced the acquisition of the asset-origination operations of Shanghai-based Quark Finance, augmenting Dianrong’s asset management capabilities across China.1 Quark Finance operated 71 borrower service centers in 47 Chinese cities, providing comprehensive loan underwriting data collection and servicing. The acquisition also included Credit Studio, a platform providing data analysis through automated and human interactions to achieve mass-production credit evaluations and processing. In March 2017, Dianrong had also announced the development of blockchain technology a for supply chain finance.2 Blockchain, a frontier technology that had generated a lot of hype around the world, especially in the fintech space with US$ 1.53 billion of investments from banks, business and governmental organizations from 2013 to 2017,3 was rapidly gaining prominence. Dianrong aimed to create the first blockchain platform for supply chain finance in China. The goal was to provide capital to smaller suppliers in the supply chain, and provide enhanced visibility and transparency of supply chains for large multinational manufacturers. a Blockchain was a self-sustaining, peer-to-peer ledger technology with an integrated set of computer codes for managing and recording transactions without the involvement of any central authority. (See the “Blockchain Note” of Harvard Business School by Prof. David Yoffie for more details.) Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China The company had made several recent forays into other related sectors, with their creation of “DR Group” as an umbrella corporate structure that included all wholly-owned businesses, joint ventures, and partnerships. This rebranded group structure encompassed the various aspects of “The New Finance,” leveraging fintech innovation to deliver value for borrowers, lenders, and investors. The DR Group included the flagship Dianrong operations in China, as well as other regional and global business activities. (See Exhibit 1 for more details.) However, whether the company should pursue diversification aggressively at this stage in order to capitalize on the current market opportunities was far from certain. Recent advances at the company, while promising, were complicated by the uncertainties in the political and regulatory landscape. The Chinese government had recently announced sweeping reforms for the P2P lending market. While Dianrong had robust compliance systems in place, the general perception and market sentiment towards the sector were not favorable, as the domestic Chinese market had recently witnessed a wave of fraudulent cases in the P2P sector, including Ponzi schemes and investment scams that took advantage of investors. Dianrong found itself at a crossroads. How should the company leverage its advantage in technology and position itself in the market? Which sectors within its larger umbrella structure were the most promising avenues to focus on? Was Dianrong tackling too many sectors and problems at once? Htite’s view was that in order to truly succeed in China a technology company had to “create” much of the ecosystem and infrastructure oneself, as opposed to in the US where companies could simply “provide add-ons” to existing firms and capabilities. But the reality of trying to excel in so many different areas was daunting. Taking a seat at the front row at the RISE conference, Htite took a sip from his coffee cup, and started to prepare for his upcoming investor meetings. Industry Overview The Traditional Banking Industry in China Based on statistics from a Bank of China research report, assets and liabilities of China’s commercial banks posted double-digit growth rates of 15.6\% and 15.3\% from RMB 155.8 trillion (US$ 22.6 trillion) and RMB 144.3 trillion (US$ 20.9 trillion) respectively as of the end of 2015, 4 while the economy continued to grow at a stable yet slower pace of 6.7\% in the third quarter of 2016.5 The banking system handled savings deposits of RMB 49 trillion (US$ 7 trillion),6 and the assets of the five major Chinese banks b accounted for 55\% of total bank assets. 7 However, the outlook of the traditional banking industry was drawing concerns, as the majority of China’s banks were state-owned, and capital naturally flowed directly to large state-owned enterprises, which crowded out the funding for small and medium enterprises (SMEs) that were increasingly starved of credit to grow. According to the 2016 Blue Book of Internet Finance, China’s slowing economic growth did not bode well for SMEs, and had potentially contributed to an “increase in the risk of loan defaults.”8 Not only was the application process for a bank loan tedious, complex and time-consuming,9 traditional banking services relied heavily on the build-out of physical branches with highly-trained professionals and financial advisors servicing clients. The banks tend to focus on working with SOEs or real- estate companies on large deals so their underwriting and operational costs can be diluted over a larger loan amount, and SMEs and individuals were often underserved. Problems in the Chinese financial sector were further compounded by the lack of an appropriate system-wide credit-profiling mechanism. China’s Credit Reference Center was currently in charge of the nation’s credit-profiling system.10 While profiles of over 800 million individuals had been collected, b The five major banks were the Industrial and Commercial Bank of China (ICBC), Bank of China (BoC), China Construction Bank (CCB), Agricultural Bank of China (ABC) and China Industrial Bank (CIB). 2 Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China many such profiles contained only basic information such as names and identification numbers. In fact, merely 350 million (less than a third of the total number of Chinese adults) had credit records, with the rest rendered “credit invisible.”11 In contrast, only about 14\% of the U.S. population lacked a credit score.12 The Rise of Peer-to-peer Lending With the emergence of the Internet, the financial sector was one of the most digitized industries globally.13 Referring to the application of new technology and innovation in the financial sector, the term “fintech” was coined in the 1980s.14 While the U.S. had witnessed waves of startups in the sector, the development of China’s fintech space had lagged that of its Western counterparts, as the Chinese financial services sector gradually modernized along with the liberalization of the economy. (See Exhibit 2 for more details.) The number of P2P lenders and total transaction volume in China was much larger than those of the United States and Europe combined. Along with nine other regulatory agencies, the People’s Bank of China (PBOC) released a set of guidelines in July 2015 implicitly acknowledging the issues of accessibility presented by traditional financial institutions, and the promising potential of fintech in addressing them.15 The macroeconomic environment was also conducive to the emergence of fintech, especially P2P lending, in China. Rapidly growing domestic spending patterns, coupled with relatively limited financing options, had created opportunities for P2P platforms connecting borrowers and investors.16 P2P lending became popularized in 2011 as the Chinese leadership encouraged the application of fintech to broaden the reach of financial services to small businesses and individuals. In 2016, the transaction volume of P2P lending in China surpassed RMB 2.8 trillion (US$ 406 billion), representing an increase of 138\% from 2015. But the sector’s growth had slowed down to slightly more than half of that in 2014 and 2015, according to a report by Shenzhen-based financial portal P2P001.17 China’s P2P lending space had experienced explosive growth as it was “too easy to attract investments,” according to Michael Zhang, Chairman of the Beijing-based Puhui Finance (a P2P lender). 18 Since 2007, the number of P2P platforms had ballooned nationwide, as P2P offered an alternative fundraising channel for SMEs in dire need of capital, while lenders were enticed by higher returns offered by P2P lenders.19 Abner An, Founder of Daokoudai, another Beijing-based P2P platform, added that “there was no entry barrier to start a P2P business [at the beginning],” and anyone could “spend RMB 40 (US$ 5.8) to buy some [P2P] software from Taobao… c to start an online lending business without any regulator’s scrutiny.”20 Since 2014, the entire Chinese peer-to-peer (P2P) industry had descended into a period of turmoil, where hyper-growth became the norm, quality of industry professionals declined rapidly, and questionable transactions emerged.21 Escalating market competition pressured firms to take on risky projects, which eventually led to a downward spiral in the P2P space (i.e. “a race to the bottom”). The absence of a comprehensive regulatory framework resulted in a series of scandals, including deceptive practices, fraudulent claims, and business collapses. Retail investors in China lost billions of dollars in 2016 when certain P2P platform operators disappeared with investors’ cash. In January 2016, police detained more than 20 people associated with a Ponzi scheme after the founder of Ezubao (a P2P platform) allegedly scammed over 900,000 investors of RMB 50 billion (US$ 7.2 billion)d across the country.22 c Taobao was a Chinese online shopping website similar to eBay and Amazon that was operated by Alibaba Group. d Based on an exchange rate of 6.9 Chinese Yuan (RMB) per United States Dollar (US$), according to foreign exchange quotes from OANDA Corporation. 3 Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China A Vital P2P Regulatory Framework To better regulate the sector, the Chinese government stepped in and intervened in August 2016 with the “Interim Measures for Administration of Peer-to-Peer Lending Information Intermediaries,” published jointly by the China Banking Regulatory Commission (CBRC), Ministry of Public Security, Cyberspace Administration of China, and the Ministry of Industry and Information Technology.23 (See Exhibit 3 for more details.) With P2P platforms defined as “information intermediaries” rather than “financial institutions,” the official document detailed a negative list of P2P business activities.24 P2P platforms were barred from taking public deposits, creating asset pools, and providing any forms of guarantee for lenders. The new rules explicitly prohibited online lenders from guaranteeing principal or interest on loans they facilitate, nor were they allowed to market wealth management products or issue asset-backed securities.25 The instigated measures also required P2P lenders to appoint banks as their custodians to safeguard investors’ money, with full disclosure of how their clients’ funds were used.26 All this was easier said than done, however, with only 183 platforms establishing custodian accounts at commercial banks,27 while another 122 were in the process of signing a custodial agreement by the end of 2016.28 Battered by the turmoil and chaos in the P2P space, banks had shown lukewarm response to the custodian business.29 Also, as P2P platforms were now considered online information intermediaries, they had to secure the Internet Content Provider (ICP) license to continue operations in China, but so far fewer than 50 P2P operators met this requirement.30 The policy measure also spelled out the loan size limits for P2P lending, with RMB 200,000 (US$ 29,000) from one lending platform and RMB 1 million (US$ 145,000) across platforms in total for the amount an individual could borrow. For an institution, the limits were RMB 1 million (US$ 145,000) and RMB 5 million (US$ 725,000) respectively.31 With the new rules, “regulators were trying to turn P2P into a supplement of the banking industry [to minimize risks]”, explained Xianyong Wu, Chief Executive at Shenzhen-based Touna Financial Services.32 Jianpeng Deng, Vice President of the Internet Financial Innovation Research Institute, stated that “the current regulations increased the operating costs of P2P lending platforms” and that the majority of P2P lending firms “would likely vanish in the next two or three years.”33 A report co- published by Beijing Bureau of Financial Work and Nanhu Internet Finance Institute detailed how the explosive growth of P2P in recent years “exposed a multitude of problems,” and “P2P operators and regulators would face stern challenges to ensure a healthy growth of the P2P sector.”34 The Dawn of a New Era While it was expected that the number of active users of P2P would surpass nine million in 2016,35 the industry continued to be clouded by uncertainties. The Chinese government initiated a review of P2P lenders in late 2016 with spot checks by provincial-level financial service offices, assessing risk management, operational scale, IT infrastructure, investment sources and shareholders’ credibility before giving P2P lenders the green light to continue operations. 36 While the deadline for implementation of the new PBOC P2P rules was extended for a year, many platforms were expected to close down in March 2017 when Chinese authorities completed the review of the credentials of 3,000 P2P lending operators, which might trigger a run on deposits.37 Industry insiders estimated that merely 200 P2P companies would survive Beijing’s investigations.38 The impact of the P2P debacle was bleeding to other industries. A case-in-point was P2P’s contagion effect on China’s real estate sector. During the height of the P2P boom, P2P firms occupied a lot of China’s prime real estate. This was no longer the case, however, with P2P lenders vacating office buildings since the nationwide crackdown on fraud in the sector.39 For instance, “vacancy rates in Grade A office buildings in the Futian and Luohu districts in Shenzhen went up in the first quarter, as a rising number of P2P companies closed up or surrendered their tenancy,” as detailed in a Cushman 4 Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China & Wakefield report.40 “Some high-end office buildings did not welcome P2P companies now. They worried that potential fraud from this sector would hurt the image of the building,” explained Qiang Hu, a property agent based in Shenzhen.41 Local authorities in Shenzhen, Shanghai and Beijing had also ceased the registration of new firms with names containing words such as “finance”, “P2P,” and “online lending,” while promotional activities (e.g. celebrity endorsements and media advertisements) of P2P lending were prohibited.42 According to Yin Zhentao, Secretary General of the Research Center for Financial Law and Regulation under the Chinese Academy of Social Sciences, proper fintech policies and regulations would help guide the sector to “standard-compliant growth.” 43 At the same time, “capricious policymaking could be dangerous,” said Yan Yipan, Chief Executive of the law firm Zhejiang Panyuan, and added that “the government needed to have a better understanding of what P2P was. Heavy- handed regulation might undermine the long-term growth of the fintech sector.” 44 Establishing a regulatory framework for the fintech sector was one of the top priorities of the Chinese Government,45 which sought to strike a balance between technological innovation and societal stability. The Beginning of Dianrong Headquartered in Shanghai, China, Dianrong had branches in more than 30 cities across the country. Dianrong originated more than $500 million in monthly assets for 4 million retail lenders. With loans totaling RMB 29 billion (US$ 4.3 billion), and a non-performing loan rate of 2.3\%, the platform was ranked third in the country, and first in terms of compliance, transparency and technology, according to the P2P statistics website Wangdaizhijia. The company had a comprehensive system and infrastructure in place with more than 5,000 employees at the end of 2Q17, which included more than 600 fintech engineers and hundreds of risk-management professionals. Founded in 2012 by Soul Htite and Kevin Guo, Dianrong combined strengths in both engineering and legal, similar to the Lending Clube in the United States. Htite had solid technical expertise and contributed international management and consumer finance experience to the duo, while Guo’s legal knowledge guided the company to focus on legal and compliance as top priorities from day one. Dianrong announced its series A financing in early 2014, with Northern Light Venture Capital leading the round. Tiger Global Management, which also invested in Yahoo, JD.comf and other prominent Internet companies spearheaded the subsequent B round of investment in early 2015. The company raised US$ 207 million in its recent series C-round of funding (an industry record in terms of funds raised for such a round) led by Standard Chartered Bank, along with other investors including China Fintech Fund, Bohai Leasing (now Bohai Financial Investment Holding), and Max Giant Capital. The company was named in 2016 to the executive directorship of the National Internet Finance Association of China led by the Peoples Bank of China. Dianrong’s series D-round materialized in 2017, led by GIC, the Singaporean sovereign fund, along with CMIG Leasing Holdings Limited and Simone Investment Managers. Technology remained a core strength of the company, with senior management directing a lot of attention towards blockchain, artificial intelligence, and data analytics, utilizing latest technologies to augment its product and service offerings. (See Exhibit 4 for the background of the senior management e A peer-to-peer lending company headquartered in San Francisco, Lending Club was the first an online lending platform to register its offerings as securities with the Securities and Exchange Commission (SEC), and to offer loan trading on a secondary market. f JD.com, also known as Jingdong and formerly called 360buy, was a Chinese e-commerce company headquartered in Beijing. It started as an online magneto-optical store, but later diversified into electronics, mobile phones, and computers. 5 Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China team at Dianrong.) The company offered a broad array of products, with loans as small as RMB 10,000 (US$ 1,500) and as large as RMB 1 million (US$ 150,000), targeting entrepreneurs, small businesses, as well as suppliers. The company enjoyed a competitive advantage in terms of its technology with notable developments such as automated credit assessment, facial recognition capabilities, as well as algorithm-driven asset syndication and capital allocation technologies. The Technology Edge Dianrong’s technology traced its roots to Lending Club, a peer-to-peer lending company headquartered in San Francisco. As the former CTO of Lending Club, Htite applied his expertise to further develop Dianrong’s technology, and localized it for the Chinese market. The company now had technological capabilities that were “beyond” that of Lending Club. When Dianrong first started in China, it noticed that the domestic market lacked the adequate infrastructure for online lending. In the United States, credit bureausg held the credit history for 95\% of the population. In China, however, such a system was almost non-existent. To effectively serve investors and borrowers across various devices (e.g. computer terminals and mobile phones) with varying payment amounts, Dianrong had to coordinate among disparate payment channels and put in place a settlement process in the back end. Dianrong found itself having to create the infrastructure required for such an integrated system from scratch in China. Since its founding four years ago, Dianrong had a comprehensive system and infrastructure in place with over 600 technicians to support its operations in credit analysis. · Payment: Teaming up with a host of third-party payment solution providers, Dianrong allowed borrowers to make repayments automatically. Borrowers could repay smaller amounts with their mobile phones, and larger sums with their computer, providing a seamless customer experience across various channels. The integrated approach to payment was optimized in terms of transaction costs and rate of payment success, resulting in transparent and traceable cash flows in the payment process. · Account management: Dianrong had a robust user account (i.e. “wallet”) management system. Each account showed the history of recharge and top-ups, relevant investments, debt transfers, case withdrawals, and perks received from promotional activities. The process of matching investors and borrowers could be challenging, as it often involved highly-fragmented technologies that may not be compatible with one another. Each loan on Dianrong’s platform might have tens of thousands (or hundreds of thousands) of investors, meaning that every transaction entailed extensive record management, with records that had to be updated in every user’s account simultaneously. · Credit profiling: Dianrong utilized data from domestic third-party information providers to improve its risk management capabilities, with data sources including the Internet, publicly- available data, third-party partners’ user and transaction data, and third-party credit institution’s data. The company’s data partners included Zhima Credit, h Experian, Wind g In the United States, the big three credit bureaus were Equifax, Experian, and TransUnion. h Zhima Credit, also known as “Sesame Credit,” was a social credit-scoring system developed by Ant Financial Services Group, an affiliate of the Chinese Alibaba Group. 6 Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China Information i and other industry-leading credit institutions. Armed with data from various sources and platforms, along with its own insights, Dianrong was looking to form its own credit-rating system in the long term. · Customer information collection: Unlike traditional banking firms that mostly still relied on paper for documentation purposes, Dianrong leveraged the Internet and technology to gather information on its customers. Through the company’s app, users could complete the entire identity verification process online. Customers first submitted a photo of their ID, the authenticity of which a third party would help to verify. Users would then be asked to submit selfies via the app, after which the system would use facial recognition algorithms to confirm their identity. Moreover, the system also asked users for their mobile phone call logs, which were used to provide additional security by comparing frequent contacts with the emergency contacts provided by the customers. Other information, such as social security details and provident fund account information was collected from government websites. In addition, with users’ consent, the system would utilize GPS tracking capabilities to gather information on the geographic activity of users. Dianrong’s offline customer service team also utilized the company’s app to gain insights into customers with information such as credit-application approval status, loan application records and repayment history. (See Exhibit 5 for details.) Aside from managing the team’s commission, the app for the customer service team came with a pre-configured “black list” that would issue warnings about potential issues. · Automatic credit assessment: Dianrong had developed an automated credit-scoring system to facilitate the transactions on its platform. The process of vetting loan applications entailed numerous steps, including automated ones (e.g. system verification), and manual ones that were segmented into modules. Each module was assigned randomly to a loan officer, with the system yielding credit ratings, loan prices, and other statistics at the end. · Debt collection management: The company also had a robust debt-collection management system, with loan records and system updates connected to third-party debt collectors. The regular debt collection analysis and reports generated also aided in the assessment of debt collection officers, which also determined their reward. · Customer acquisition: Technology also helped further Dianrong’s customer acquisition efforts. Unlike traditional financial institutions which mainly relied on offline channels to engage customers, Dianrong had devised an Internet-advertisement tracking system, which logged advertisement exposure, users’ clicks, as well as each step of the entire platform registration process. Armed with this technology, “every step was clear and traceable,” said Jing Pan, Chief Marketing Officer of Dianrong. “By tracking the churn rate of every step in the process all the way to the point of actual purchase, the company could determine the effectiveness of its marketing efforts in terms of product, channels, and creativity.” Dianrong also leveraged technology to make its offline branches more productive and cost-efficient. · Customer service: Dianrong had established its own call center management system tailored for the Internet era. On the one hand, the system offered functions including IP phone, tracking, calling and account access. On the other hand, online services provided by the company’s app were also consolidated within WeChat, the popular social media platform in China. Should issues arise from either investors or borrowers, the company’s app provided a wealth of i Often known as the “Bloomberg of China,” Wind Information was the market leader in the provision of real-time fundamental data, exchange data, earnings estimate data, market data in China. 7 Dianrong: Marketplace Lending, Blockchain, and “The New Finance” in China information for potential questions, and could direct specific questions to dedicated customer service representatives. Products & Services Dianrong’s platform was created in a modularized fashion which was common in the modern Internet era. Each module was relatively independent, with components that could be re-assembled, re-configured, and re-arranged. All this offered a customizable, scalable, flexible solution that could quickly adapt the technology to and industry’s and customers’ changing needs and preferences. The company differentiated itself from the competition with a comprehensive product line. The company was reportedly the only one in the industry with products spanning a wide spectrum, ranging from RMB 10,000 (US$ 1,500) to RMB 1 million (US$ 150,000), including: · Online loans: Dianrong’s platform offered loans averaging RMB 10,000 (US$ 1,500) online. Borrowers could submit loan applications, along with the relevant personal information, via Dianrong’s mobile app. Subsequently, both the application vetting and loan distribution processes were completed online. · Consumer loans: Consumer loans were another product on Dianrong’s platform, with an average loan size of RMB 75,000 (US$ 11,000). An offline servicing team helped to collect information, vet online applications, and distribute the loans. The company offered these consumer loans primarily to high-quality (i.e. near primej) customers at a low interest rate. · Cash advance loans: Dianrong also provided cash advance loans with an average size of RMB 350,000 (US$ 51,500), focusing on the retail, and food and beverage industries with steady cash flow. The vetting process was conducted by connecting to the merchants’ POS machines, WeChat Pay and Tencent Pay accounts, and additional data provided by third-party payment companies. Backed by an automatic daily repayment mechanism, these cash advance loans had a low interest rate as well as a low bad-debt rate. · SME loans: The company also offered small and medium-sized enterprise (SME) loans with an average loan size of RMB 350,000 (US$ 51,500), with an offline service team collecting credit- related information and going on site visits for data verification purposes. · Supply chain finance products: Supply chain finance …