We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run — Roy Charles Amara
Change, like growth, is rarely linear. While technology has continued to eat the world, financial technologies are yet to mature and scale up. As Robinhoods’ foray into deposit products in 2018 revealed, it is not easy to enter regulated markets. Understandably, regulations are designed to protect the common man. In December 2018, Robinhood communicated the roll out of a high yield deposit product (3%) which wasn’t insured by the Federal Deposit Insurance Corporation (FDIC) as is the case with deposit products offered by most banks. In its communication, Robinhood stated that the SIPC (Securities Investors Protection Corporation) insures its deposit products up to $250,000. SIPC responded by saying Robinhood did not contact it prior to roll out and that it insures deposits only if they are placed with a broker for the ‘explicit’ purpose of investing in securities.
As Financial Technology companies mature, they have entered into partnerships with incumbent financial services providers to learn to scale and deal with complex regulations. One thing is missing though — experiencing a complete business cycle from boom to bust and back. The incumbents, on the other hand, are shying away from out rightly buying FinTech startups.
This article looks at the state of FinTech today and their uneasy partnership with incumbents as both parties try to take away each other’s marginal advantage. It ends with a simple and profound challenge that both FinTech and incumbents alike need to tackle to gain the ultimate advantage.
“We’ll eat your lunch!”, said many a FinTech CEO to their counterpart within the banking and financial services industry. That proclamation has yet to come true as the incumbents deliver strong growth and continue to partner with FinTech companies to bring their technologies into their fold. On the other hand, FinTech companies need to scale, learn to deal with complex regulations and regulators. Finally, they need to stress test their business model through many economic cycles. In a nutshell, this is the state of an uneasy collaboration that exists between the challengers and the challenged. It is a complex relationship that is both co-opetition and fierce competition.
Challenges Facing FinTech Today
As per CBinsights, 2018 was a record year for FinTech with 1,700 deals worth $40 billion. The top 3 core markets were the USA, UK and China. The US remained the top market with 659 investments amounting to $11.89 billion. There continues to be significant momentum from Silicon Valley and Private Equity (P/E) firms as well as existing financial services companies which continue to pour millions of dollars into financial technology. A lot of that investment is intended to overhaul archaic plumbing and to deliver great user experience while driving down costs within the financial services sector.
1/ Historically, a typical FinTech company used sophisticated algorithms to identify under served clients. These clients were excluded from traditional banking either because they did not have an adequate credit history or a credit score that most banks catered to. Also, in the aftermath of the 2008 financial crisis, most banks significantly tightened their lending standards thereby excluding most people except the ones that had stellar credit. The pendulum swung the other way — from lax lending standards to very strict ones. This gave FinTech players a niche market. On the other hand, many of these startups were funded by capital provided by Venture Capital and Private Equity which typically look for a high return on their investment. Thus, if FinTech players cannot scale and deliver consistent growth and profitability, they cannot meet the hurdle rate of . The classic case in point is what happened to peer to peer lending marketplace OnDeck. One of the biggest problems with targeting under served clients is that some of them were under served for a reason- they were not good bets to lend money to. If adverse selection leads to too many of such bad loans on the balance sheet, it cripples the ability of a FinTech to survive.
2/The next challenge with FinTech players today is to hire great talent that not only understands regulations but can be the face of the company to the regulators. Regulators are not robots. They are humans just like you and I. It takes a significant amount of consistent performance and history to develop trust and comfort. Understandably, FinTech players are now on the lookout for talent that can make sense of regulations as they enter the mainstream. For instance, as Robinhood expands into the UK market, it is on the lookout for top talent to deal with regulations. One of the other ways of tackling regulation is to create a common shared services consortium/entity that is a centralized resource for all things regulation for FinTech companies.
3/ Economic cycles can be a brutal reminder of the vagaries of nature. Many financial institutions have been around for decades and some have been around for centuries. What this means is that they have been around enough booms and busts to experience first hand what happens to their business during these cycles. Typically, the GDP of a country is a rough proxy for the growth of most businesses. If the economy is growing at 2–3%, business revenue typically follows that trend. A company may use disruptive technologies to grow faster but it hits a ceiling eventually. FinTech players will gradually go mainstream and will have greater diversity in their client portfolio. The next challenge will be to test those client portfolios through extreme downturns. FinTechs are yet to be stress tested by regulators because they are not big enough yet.
The World Of The Incumbents
Recently, the SWIFT (the Society for Worldwide Interbank Financial Telecommunications) recently announced a proof of concept (PoC) to connect its members to multiple trading platforms including ones based on the Blockchain such as R3’s Blockchain platform Corda. This is a good example of the mainstream opening up to smaller platforms to try out their technologies.
While financial services companies have invested in and brought a lot of FinTech technologies inside, they have shied away from M&A activity. The reasons are understandable. Firstly, many technologies such as the Blockchain, Crypto currencies and payments technologies are yet to mature and prove their worth at scale. Secondly, technologies have a very short shelf life. New technologies are eating the old ones and making the old technologies obsolete quicker. Most importantly, customer response to new and emerging technologies is not always positive. For financial services, the competition is no longer just FinTech rather it is any technology company including Apple and Amazon today. For all these reasons, the incumbents have a variety of responses instead of just a single one.
1/ Let’s begin at the top. Very few directors in the Board are techies. A dated but relevant piece of research by Accenture revealed that Only 6% of board directors and 3% of CEOs of leading banks have professional technology experience. This statistic may have shifted significantly since publication. Nevertheless, there is still a large room for top talent to create a technology first company. This is even more important as overseas competition mainly in form of Chinese giants Baidu, Alibaba and TenCent set their eyes on global expansion. The most important thing to remember is that these companies are ‘social media and technology first with financial services baked in’ companies which is very different from financial services first and technology second companies.
2/ Traditional business models dictate the flow of capital to the most profitable enterprise which makes it hard to invest in long term technologies especially when you have quarterly results to deal with. This requires quick bursts of innovation with a longer term plan which is easier said than done. Let me give you an example- if a company decides to go full force on marketing on Facebook, it might realize people have moved to YouTube, Snapchat or the next platform. Just when they think YouTube is the way to go, Vimeo becomes a consideration. Technology cycles have become dramatically shorter than incumbents can handle.
3/ It is one thing to keep pace quite another to outpace. Clients will increasingly conduct their banking using voice based digital assistants — Alexa, Siri, Google home and the like. However, Augmented Reality and Virtual Reality are already entering the mainstream. Thus, financial services companies will have to figure out how to design an extremely delightful client experience that even their clients haven’t thought about — an experience that is more spiritual and less physical. Steve Jobs was a good example of designing experiences that outpaced client expectations.Right now, companies such as Amazon, Apple and Google are radically re-defining client experiences. The challenge for the incumbents is how to we outpace these pioneers.
Ending On A Philosophical Note
All of us need a helping hand. For people who are left behind in world where globalization is slowing down, nationalism is on the rise and technology is poised to transform and eliminate jobs, financial security is paramount to avoiding social unrest and anarchy.
Most people think ‘financial inclusion’ is an egalitarian, socialist goal. In the world of technology where a platform and it’s network effects rule the roost, I would re-frame financial inclusion as the battle for every single client on planet earth. In that sense, both FinTech players and incumbents have a common goal and battleground.
The ultimate purpose of any business today is to serve the society at large. It makes a profit only when members of the society see value in its products and services. Financial Technology companies have long touted ‘financial inclusion’ as their goal. They used technology to drive down marginal costs and include more people at the middle and at the bottom of the wealth pyramid. There is no denying the fact that technology will continue to drive down costs. In many cases, services like broking, cross border foreign currency transfers and most of the financial services can be delivered at zero or near zero cost to clients either on or off the Blockchain. For free broking accounts, the classic case in point is Robinhood whereas for free foreign currency ATM transactions, newer FinTech players such as N26 is a good example of things to come. FinTech companies such as Ripple have higher ambitions of controlling a significant share of the Internet of Value.
Continuously declining marginal costs is not just a FinTech phenomenon. Goldman Sachs, for example, has a pure play digital offering where clients can simply open a high-yielding savings account or a Certificate of Deposit (CD) in minutes. On the other hand, the adoption of Blockchain, Robotic Process Automation (RPA), cloud based AI and chatbots are all significant drivers of lower marginal costs.
The net result, ironically, is good for clients. If everything can be done digitally even in the remotest corners of this planet, everyone can be part of a financial revolution. Today, the competition is building up to that very likely endgame. Ultimately, there will be an inflection point where one of the players has a marginal advantage. This scenario, in no way, means the demise of the other player. It just means a re-framing of the rules of the game skewed towards the victor.
When all else is done, the financial services industry will have to become the Archimedian lever that pulls the poor and destitute out of poverty and into the mainstream. Financial inclusion becomes a human right. The battle between FinTech and the incumbents will create the biggest social experiment in applied humanity the world has ever seen. Some stories do have a happy ending. At least, that is my hope.