If someday you find yourself at a tony cocktail party with tech investors and you’re having trouble engaging, here’s the plan: Just start talking about how your nerdy friends from college quit their jobs to do a fintech startup. Throw in a little blockchain, mention encryption and maybe real-time loans, and boom! You’re the life of the party. But be careful, if your story is too good, those investors won’t leave you alone.
They can’t help it. It’s Pavlovian, and money is pouring into fintech like water over Niagara Falls. Both 2018 and 2019 saw about $140 billion (that includes VC, PE and M&A activity) invested in the space. For understandable reasons, that was down to $25.6B worldwide for the first half of 2020, which put the year on pace with 2017. To put that in perspective, worldwide fintech investment is about equal to all venture investing in the U.S. over the same period. About a third of investments came from VCs and two-thirds from private equity investors in 2018 and 2019. This year, about 85% is coming from VCs since for them, the nonexistent revenue common among early-stage companies isn’t a problem like it is for later-stage investors. Those investments are being spread over thousands of companies with the hope of finding the next PayPal (present market cap: $225B) or Square ($76B).
So what constitutes fintech, and why is it so hot with early-stage investors?
Fintech is a loosely-defined term that describes technology that brings payments, credit, insurance and most anything else that has to do with banking and finance into the online world or otherwise takes old, slow, cumbersome finance processes and speeds them up with technology.
As for why it’s so hot, let’s start with the saga of PayPal. Founded 1998, the company's original goal was to support online payments and transfers that would otherwise be done with paper checks or services like Western Union. The World Wide Web was less than a decade old then, and was mostly the domain of research and high tech — so who was doing online transactions in those early years? eBay, for one. The company, founded in 1995, needed a way to simplify the exchange of payments between buyer and seller. Combining PayPal payments with the Web as a platform led eBay’s IPO in 1998 to a first-day market cap of nearly $1.9B.
PayPal had its IPO in 2002, and later that year, eBay bought it for $1.5B. At the time, PayPal handled 70% of eBay’s transactions. In 2014, bull-in-a-china-shop investor Carl Icahn stuck his nose into eBay’s business and demanded that PayPal be spun out. When he got his way, PayPal began trading with a $47B market cap, while eBay shrunk to $34B.
Turns out Icahn was on to something, in a broader sense. Venmo (owned by PayPal), Zelle, Apple Pay, Google Pay and a raft of others have since cropped up to either augment or replace the way consumers pay for goods and pay each other.
Since then, PayPal has seen steady growth, topping out in February at about $143B and heading down to $100B in this past spring’s market slide. As of early October, it’s climbed to $225B. The quick snapback happened as retailers moved online through the spring and summer, and often chose PayPal as a way to take payment — either via PayPal’s own method, or as a secure credit card processor.
Then there’s Square. The company was founded in 2009, offering technology that let smartphones read credit cards, making it one of the first mobile device payment options for retailers. Square’s first device let small businesses use standard mobile phones and tablets for card transactions as well as other functions like order taking. Since then, the company has added services and devices that serve the needs of small business, from payroll handling to financial services. The company IPO’d in 2014 with a $6B valuation and is now worth $76B. From mid-2018 until early this year, its stock traded in a narrow range with its valuation centering around $30B. The pandemic and the push for contactless payments has been good to Square, as it’s more than doubled in value since the virus hit.
The chart below shows how Venmo (PayPal) and Cash App (Square) have surged compared to traditional bank payments since 2016.
There are many more examples of fintech companies whose valuations have skyrocketed as they’ve demonstrated their ability to reduce the time and cost associated with financial transactions during the pandemic. Stripe is a Square and PayPal alternative that’s making a splash with larger companies looking to highly integrate payments into their web presence. Robinhood is a brokerage alternative that operates exclusively through crypto trading. Its IPO is highly anticipated. Outside of the U.S., Ant Group is an affiliate of China’s huge Alibaba (China’s version of Amazon) in the financial services space that’s looking to a high-value IPO (likely highest ever). Nubank is rocking the boat in Brazil — where the banking system badly needed a good rock. The phrase du jour is “removing the friction,” and early investors see these technologies as highly transformative to the finance industry, and particularly so now as business increasingly happens online.
The fintech fascination isn’t exactly new. JPMorgan Chase CEO Jamie Dimon warned in 2015 that Silicon Valley was coming, and he didn’t mean it in a friendly way, like, “Hi, we’re from the government and we’re here to help.” It’s more like, “Hi, we see your grossly inefficient and ineffective processes, and we’re here to put you out of business.” Dimon said those words upon seeing non-banking firms using big data to speed up and loosen up business lending. It truly is all about removing friction, and business lending has been slow and ugly since the Great Recession.
The Consumer Finance Protection Board finds that about half as many loans were written in 2017 as in 2004. That’s the sort of stat that makes the market seem ripe for disruption, because let’s face it, there’s no way demand hasn’t grown past 2004 levels. In part, the slowness is due to the Fed policy of paying interest on excess reserves (money banks hold in reserve beyond what regulations require). Those funds have nearly doubled to $3.4T since the COVID-19 outbreak, and that Fed interest is essentially paying banks not to lend. The rate is currently at 0.1%, down from a pre-COVID rate of 0.5%. That’s low, but it’s risk free earnings for banks in very risky times. There are other factors at work, but however it’s happened, there’s a vacuum in business lending, and unregulated tech companies would like to fill it. The thing is, once you start working as a lending bank, you’re subject to banking regulations.
Both financial services firms and tech firms used to think like Dimon did five years back. But since 2017, the approach has become more nuanced. Tech firms have had great luck with payment processing, but have had a harder time penetrating lending and insurance because the market incumbents have the assets, trust and client base, and they’re adept at managing through all the regulations that come with those businesses. Meanwhile, virtually all of the large banks and investment houses have declared themselves to be technology companies. A contributing factor to the fintech startup space running so hot is that technology companies and financial services companies are both vying for the technology startups are creating. And it’s a global phenomena, not just a Silicon Valley one.
PWC conducted an excellent survey that compared how tech companies view the fintech opportunity compared to their financial services counterparts. The survey shows some differences in approach as well as what each believes will be winning features.
In terms of the technologies that will drive fintech, IoT tops PWC’s list for tech companies, while AI is seen as most important by financial services companies. To a certain degree, it’s fair to apply the adage, “If your best tool is a hammer, then you’re likely to see the opportunity to use lots of nails.”
Tech companies are strong in IoT and see it as a way to revolutionize many sectors of finance. In auto insurance for instance, tech companies want to use IoT to offer “pay as you drive” insurance. If your car is sitting in the garage most of the time, you’d appreciate a significantly lower insurance bill versus someone who’s driving their car as part of their job.
Insurance companies have a toe in the IoT pool already, but in a much less ambitious way. Some will offer drivers a device that connects to the standardized data port on their car used for repair diagnostics. The device monitors how you drive — including overly fast starts and stops. Good drivers can get a discount; aggressive drivers just get shamed. The swing in your insurance payment is typically less than 15%, whereas usage-based insurance could more substantially lower your bill.
Meanwhile, financial services companies are more interested in AI as a way to speed underwriting of insurance and loans while improving risk management, which is both their strength as well as their greatest challenge. Since the Great Recession, underwriting loans has become more arduous, and certainly the attention to risk has gone up considerably. Replacing actuaries and underwriters with AI and data scientists is appealing as a way to improve speed while reducing costs and risk.
PWC’s data here is interesting, but in virtually all instances it’s combining these technologies that really makes a difference. For instance, AI without big data is like buying yourself a Corvette but not filling up the gas tank. More pervasive IoT will depend on 5G connectivity, and virtually all fintech services will involve process automation and some level of AI/machine learning. Both tech and financial services companies want to build platforms that will allow for the combinations of technologies to offer better versions of existing services as well as new services that aren’t feasible today.
The goals for fintech seem to be somewhat broader for tech companies than financial services companies. To be sure, technology companies want to improve other disciplines of financial services the way they’ve improved payments, and financial services companies want that too. But the tech companies are more likely to hold a more radical vision of what an improved service might look like. Take for example “pay as you drive” auto insurance (the tech company solution) versus simply gathering a bit more data on how you drive (insurance companies’ common approach).
The thinking tends to get broader and in some ways more mature as you move outside of the United States. Asia in particular looks to be further along in the fintech revolution, likely due to its accelerated tech adoption and shorter history with mature and extensive regulatory environments. Developing countries too are taking a keener interest, as there’s a greater need to serve unbanked consumers and growing companies not well served by physical banks. As a result, fintech companies, both mature and startups, are spread around the world.
So what are the characteristics of financial services that fintech looks to improve? Again, PWC’s research does an excellent job of breaking down the difference between tech and financial services companies.
Here again, the list probably says more about the history and challenges for financial services and tech rather than what consumers necessarily want. Take ease of use: As anyone who’s worked with a bank for a personal loan, business loan or line of credit can attest, ease of use was not a design criteria for the process. Insurance is better (sometimes right up until you make a claim), but you’ll still detect the inverse relationship between the involvement of lawyers and ease of use in those dealings. The tech giants have a good handle on ease of use, but in many cases, they’ve had a harder time with personalization. That puts them ahead of the game, as ease of use is a step along the way to personalization.
Financial services companies have a leg up in the area of trust, which involves both their long established relationship with customers and their ability and tolerance for staying on the right side of regulators.
So each camp has its own high ground, but there are distinct battlegrounds. Speed, cost and trust are the common battlegrounds, or more likely the places for cooperative improvement. The three are highly related, but trust is the biggest obstacle to overcome.
For low dollar transactions, automated clearing houses can do the work of assuring that payments get from payer to payee. The clearing house is responsible for setting up trusted transactions between payers and payees, creating a hub-and-spoke relationship between merchants and their banks, and customers and their banks. Consumers give authorization and information on their account to a merchant in real time, and the merchant sends that information to the clearing house. Clearing houses and banks exchange settlement information a few times a day, which means transactions don’t immediately settle.
The alternative is going through a card processor like Visa/Mastercard. Here too, transactions don’t settle immediately, and processing fees are a reality of dealing with bank cards through the VisaNet (or Mastercard’s) network.
Both systems are somewhat fast and somewhat inexpensive, and their primary value is in their existing relationships with consumers, businesses and banks. Trust is not set up on the fly for these sorts of transactions; it’s established well before transactions begin.
One goal of some fintech companies is to disintermediate ACH and card processors while still providing a trusted way to exchange funds for goods. For example, a company might want to create a marketplace for a certain commodity and let sellers and buyers form relationships through a non-traditional trust mechanism (i.e., no middleman). That’s a good use for blockchain and cryptocurrencies.
In this system, if you’re a consumer, you can deposit some amount of fiat currency with the marketplace, which then issues you cryptocurrency that you can use to bid on commodity lots. If you’re unsure about dealing with a new supplier, you may find that an insurer operating within the same marketplace will offer insurance on your commodity lot. You can then buy from a variety of suppliers in the marketplace. This gets commodity consumers the supply chain diversity they need along with price efficiency.
This isn’t supply chain Nirvana, but for commodities, it’s a good way to get access to a broader set of sellers and visibility into the efficiency of the marketplace. And of course, there’s no reason that such marketplaces must be limited to commodities or use auction mechanisms. The marketplace could exist based on some business rules that form the basis for establishing interest between buyer and seller. Once there’s interest, the two use the mechanism of the marketplace to form a contract, and boom — commerce.
In last fall’s Brainyard survey, we saw little interest in blockchain among business leaders, and that’s as it should be. As a business consumer, worrying about whether a company is using blockchain as the basis for its service is like our Corvette buyer worrying if Chevy uses an aluminum or cast iron engine block in the car’s motor. Who cares? It’s Corvette; get in and drive. If fintech companies are marketing themselves based on their use of blockchain, they’re missing the point. Cryptography and multiple distributed ledgers are really important, but what consumers really want to know is that their transactions are secure and non-reputable. They want to know that their contract is binding and fixed and that money has changed hands as they expect it.
That’s the goal of blockchain, and because it works without a central authority like VisaNet or an automated clearing house, it can be cheaper, faster and more flexible. The distributed public ledgers are important because they hold encrypted versions of the contract you create. Encryption makes them immutable, and the public storage of multiple versions means that if a discrepancy should arise, there are many copies of the contract, so it’ll be easy to spot the corrupt one. Finally, you hold the encryption key, so while the ledger entry is public, no one can decipher the contents unless you say they may. These are the functions provided by systems like VisaNet (or title companies when it comes to real estate). And just as you don’t really care how Visa’s five secure data centers work, you really don’t care about a blockchain public ledger system. Just as long as it works. Regulators, however, will care.
If you think of blockchain, big data, AI/machine learning, wired and wireless high speed connectivity and the pervasiveness of the web as the building blocks for fintech, you can see that combining them in different ways can lead to lots of cloud-based services that help improve finance. Here are a few other examples of areas in which these technologies combine to make new and useful services.
Talk about a gift that keeps giving. Any company that can build a service that delivers regulatory compliance from the cloud will find a receptive audience. In cloud models like infrastructure as a service, the goal is providing access to virtually unlimited computing resources to use as you please. Regtech isn’t quite that way. What these startups offer is consumable expertise on the regulation you’ll encounter by undertaking certain business opportunities. Want to start selling in Europe or Asia? These companies can help you understand the risks and regulations that you’ll encounter. The regulations and how they’re applied is the big data. How companies like yours will fare against them is the AI-based risk assessment.
So Warren Buffett’s advice to keep your money in index funds isn’t good enough for you? Then perhaps an army of researching bots is more your style. Robo-retirement to micro investments coupled with big data and AI should combine to do better than Buffett’s S&P 500 index fund, right? There’s now trillions of dollars backing that bet. Most of the 1% are likely to still want a human component to their wealth management, but more and more those humans are backed up by big data and AI — or at least that is the plan. Just remember, when Warren goes, he’ll leave his wife assets in index funds — so you know how to compare Wealthtech returns.
The unbanked and underbanked need ways to buy too. Smartphones and 5G will be the way to deliver banking around the world, and not just to individuals. Business will benefit from digital banking delivered on mobile technology.
A lot of the work of startups in the fintech space isn’t to create a finished product that delivers banking or payments or other such services. Many are working on technologies that let banks and tech companies more easily use encryption services, authenticate users or otherwise provide the plumbing for digital services. Cryptosecurity is one area that gets a lot of attention, but there are other enabling technologies that fill niches.
The analysts are following thousands of fintech related startups in a market that likely needs dozens. Fintech is hot right now and will remain hot for the foreseeable future, but just like cloud computing, which has been on a 20-year evolution, banking will change slowly and will involve a lot of consolidation. The process started in the ‘90s with online payment processing and has taken over 20 years to get to its current state. Enabling technologies like public key encryption have been around a while, but it’s taken the combination of ubiquitous networking, powerful endpoint devices and very cheap computing, along with evolving use cases, to fuel fintech’s maturing.
COVID-19 has been like tossing some gasoline on the fire as it’s created more need and more obvious benefits. One major hurdle anticipated by both tech companies and financial services companies is that many fintech innovations will put the innovators at odd with regulation.
It’s not that regulators don’t see this coming. They do, but they’re bound by the laws that created the regulations in the first place. And it’s not just banking laws that will get in the way. Big data and data privacy laws are typically at odds.
The EU’s GDPR had a big year in 2019, handing out over 440 million euros in fines. Banks, insurance companies and big tech are among those fined: Consider Sweden’s 7 million euro fine of Google this spring and a 20 million euro fine by Croatia of an unnamed bank.
Last year, Marriott U.K. and British Airways rang the bell for biggest fines: Over 200 million euros for BA, and 123 million for Marriott. Both were hacked. BA execs, when they saw the fine, wondered whether a decimal had been displaced. It hadn’t. There’s good reasons for the interest in cryptosecurity.
Google’s fines to date might be more concerning, as they’re often centered around using data for personalization in ways that users didn’t agree to. That’ll be the sort of issue that’s tough to sort out as personalized service becomes a key fintech differentiator.
In short, fintech is largely enabled by access to copious amounts of data, and rules like GDPR and emerging laws in the U.S. and elsewhere are making it harder to get and use data as fintech companies want. It’s just one example of how regulations can get in the way of well meaning fintech.