A fintech investor’s view of the industry in 2020 and beyond
“What does fintech and the wider financial services sector look like in a post-Covid-19 environment?” No one can yet answer this with any certainty, but little happens in the European fintech space that does not cross our radar screen and we believe there are some notable trends that can help to better understand some of the possible outcomes. It is those factors that we elaborate on below, through exploring the banking, lending, brokerage and infrastructure sub-sectors.
- Fintech challengers are far better-suited than incumbents to respond to the structural opportunities that will emerge from Covid-19, due to their inherent agility, culture of innovation and use of the latest technologies and data. The opportunity for fintech remains greater than ever.
- Incumbents pursuing gradual progression to digital offerings will need to accelerate transition: existing partnership and acquisition trends will continue with increasing vigour.
- The UK government’s commitment to fintech and supporting a world-class digital economy will be challenged by the institutional response to the crisis. The outcomes of well-intentioned government initiatives such as BBLS and CBILS would be dramatically improved with wider inclusion of fintechs, such as alternative lenders.
- The funding environment will weaken in the short term with a greater focus on positive unit economics and stronger balance sheets. Consolidation and opportunistic acquisitions will become a feature of the coming 12 months. Valuations will be impacted but will likely recover in the second half of 2021.
- The trend of technology companies staying private for longer (due to availability of capital and attractive M&A opportunities amongst other reasons) will be strengthened in light of public market volatility.
Since lockdown, many in the investment community have asked us how fintech might fare in a post Covid-19 environment. It is still too early for the data to provide definitive answers but the Bank of England’s prediction that 2021 will see a 15% bounceback from the GDP loss of 14% in 2020 is a reasonable working assumption. What we do know is that the crisis will create scope for accelerated innovation and change. While the majority of businesses will face challenges there will also be significant opportunities for those capable of meeting customer requirements in a changed and significantly more digital world. As is the case for many sectors across our economy, fintech faces a test of resilience in the months ahead.
Today, the label of ‘fintech’ applies to companies innovating across the full depth and breadth of the financial services sector, bringing a huge amount of diversity under its umbrella. The scale of the opportunity across banking services, wealth management, insurance and infrastructure is unparalleled and we will continue to engage and ultimately invest in outstanding companies that will enhance our fintech portfolio.
The fundamental attributes of successful fintech companies: world class technology, data driven processes, operational efficiency and customer-centricity, along with levels of responsiveness and agility unachievable in traditional institutions are advantageous under Covid-19-related economic uncertainty. Structural changes in our economy driven both by long-term trends and reactions to lockdown measures are also of benefit to the fintech sector.
In this note we share our initial views on the positioning and possible outlook of fintechs and traditional institutions operating within four key areas of financial services; banking, lending, brokerage and infrastructure. In each case we consider how the economic environment and structural behaviour changes are likely to impact companies within each space.
Fig 1: Macro outlook for fintech sub-verticals during the Covid-19 pandemic and recovery
Under the conditions of lockdown, digital channels have been essential to the continued delivery of key services, including banking. Challenger banking platforms such as Monese and Tide, designed to serve customers on a fully digital basis, have found their value proposition and branch-free operating models to be advantageous in meeting customer needs, compared to traditional banks.
Growth and revenue performance metrics across both traditional and challenger banks will reflect the negative economic impact of the Covid-19 pandemic. However, the step change in the uptake of digital services will favour challenger banks as they are better positioned to deliver a digital experience that aligns with modern expectations. Key elements to meeting these expectations include simple onboarding, low cost and personalised features.
As digital banking has grown in popularity, more traditional banking interactions have fallen away, and behavioural shifts have accelerated with the Covid-19 pandemic. Bank branch networks were already in decline pre-Covid-19; 34% of the UK’s bank branch network closed in the years 2015–19¹ and many of those remaining operate with reduced opening hours. Under lockdown, branch visits are highly restricted, inadvertently pushing customers who might previously have relied on branches towards the convenience of digital channels. This boost to remote access banking in the immediate term is likely to have a lasting impact on branch footfall, leading to an accelerated rate of branch closure, as operating costs become untenable for traditional banks.
Fig 2: Branch and ATM networks are a significant overhead for traditional banks
The general decline in cash usage, in large part due to the widespread acceptance of convenient alternative payment methods such as contactless, has also been accelerated by the Covid-19 pandemic. While a relatively uniform reduction in ATM transaction volume was seen across 2017–19, data for 2020 shows a sharp decline². Several dynamics are in play here, including lower overall spending, a reduction in in-person transactions (with a share of spend reallocated to ecommerce) and fears around virus transmission from cash. In response to virus transmission fears the British Retail Consortium accelerated the decision to raise the contactless limit to from £30 to £45. In the month since, c.43% of card transactions within the £30-£45 range were conducted with contactless³. As with bank branches, the immediate term impact of lockdown measures is likely to have a lasting impact on cash usage in society by entrenching behavioural patterns across demographics.
Fig 3: Weekly UK ATM transactions have fallen sharply under the Covid-19 lockdown
Banking goliaths, despite retaining dominant market share, have sought to emulate the success of challengers with their own digital bank propositions, with little success to date. RBS recently announced the closure of their challenger bank Bo, rumoured to have had a budget of £100m, after only five months of operation following disappointing traction. JP Morgan shut down their millennial focused mobile bank ‘Finn’ after one year of operation in the US, after failing to gain momentum with their target audience (JPM continues to operate an alternative digital offering under the ‘Chase’ brand). The Goldman Sachs digital banking brand ‘Marcus’ has had more success acquiring customers in the US, although three year costs stood at $1.3bn⁴.
The mixed fortunes of incumbent entries to this space speak to the challenges of launching a successful digital bank, which evidently requires more than a trendy brand and significant capital. Creating the requisite energy, culture, talent and technology should not be underestimated in difficulty. Some say that fintechs can build more in a month with 100 people and £1m than a traditional bank could build with 1,000 people and £100m in three years⁵.
While challenger banks are suited “operationally” to the current situation, revenue streams in the immediate term will be more exposed to a Covid-19-related downturn. In particular, transaction interchange and foreign exchange revenue streams will contract in line with reduced transaction value and volume at home and abroad. In a low interest environment liquidity transformation activities will also be challenged. Challengers who have achieved some level of diversification across revenue streams — e.g. through account subscription fees, commission generated through marketplace offerings, or credit provisioning via a market place — will have a greater level of insulation. Adoption as a ‘primary account’ amongst users with multiple banking relationships continues to be a key focus for challengers. Perhaps lockdown related reliance on technology to conduct critical path interactions remotely will have positive implications for consumer confidence in technology companies across sectors.
Somewhat ironically, one of the criticisms of challenger banks has been the pace at which they have launched (or plan to launch) credit offerings to their customers. In light of Covid-19 a low level, or complete absence, of balance sheet risk will shield these companies from the painful defaults which many banks are preparing to face.
Many challenger banks are operating without a full banking licence, although the acquisition of one remains a high priority for some. We expect banking licence applications made in the future will take more time and be more stringent as regulators refocus their energies on the many challenges that the existing banking industry is facing. There are likely to be attractive M&A opportunities for well funded challengers in the aftermath of the pandemic, in particular opportunities to acquire digital lending players hard hit by the pandemic. We believe the days of neobanks being bombarded with capital at sky-high valuations will now be consigned to the history books, with renewed focus on improving unit economics and paths to profitability as challengers adapt to a less favourable cyclical environment.
In the long term the ability to respond swiftly to structural changes, differentiation of product, technology and scale will win the day along with an all important robust and deep balance sheet. In terms of capitalising on structural trends, challengers find themselves advantaged over traditional institutions but only those that get to scale or become truly differentiated will survive.
Fig 4: Macro outlook for traditional and challenger banks during the Covid-19 pandemic and recovery
Lending is likely to be the fintech sub-sector to experience the greatest short-term impact of Covid-19. Many existing loan books are exposed to significantly higher-than-expected default risk and new business volumes will be restricted by tighter lending criteria. For businesses within the lending space, the duration of the lockdown, corresponding level of contraction in the economy and the scope of government support packages will be particularly significant.
Both traditional balance sheet lenders and fintechs operating with a marketplace model will feel the impact of an economic slowdown; however, the models require different responses and, as the economy recovers, will be able to capitalise on the structural changes brought about by the Covid-19 pandemic in different ways.
Balance sheet lenders have increased loan loss provisions in anticipation of higher defaults. In the US loan loss charges across 6 major banks saw a 350% quarterly increase to $25bn in Q1. Defaults will be painful for the banks to endure from a profit perspective but they find themselves with far stronger balance sheets than in comparison to 2008 due to tighter lending practices and regulation in the preceding years.
Fig 5: Banks have lower lending risk exposure relative to 2008
Marketplace lenders also operate reserve funds but have less ability to bolster reserves during a time of crisis. Defaults in excess of loss provisions will negatively impact investor returns. Augmentum Fintech portfolio company Zopa demonstrated during the 2008 financial crisis that the marketplace model is capable of sustaining positive annualised returns during the crisis. As was the case in 2008, cash preservation alone in the current environment would equate to a strong return relative to public market returns, down 20% since the start of 2020⁶.
Fig 6: Zopa maintained positive annualised returns through the 2008 crisis
Zopa, in the final phase of launching a bank, will likely be a beneficiary of the timing of the pandemic. Zopa will begin lending as a bank in the coming months and with 15 years of lending expertise and over £5bn leant to date, it does so with a clean balance sheet.
Beyond limiting impact on investor returns, marketplace lenders will also have to adapt to a restricted supply of funding as investor risk appetite reduces. Players who have established a diversified lender base across retail and institutions will be more resilient. Capital inflows are likely to slow from both investor groups, and most significantly from retail. Although this will reduce loan volume capacity from the supply side, stricter underwriting criteria will also limit approvals on the demand side; estimates suggest new loan volume could fall by up to 80% in April compared to January. Lower availability of capital therefore aligns with a reduced pool of approved loan applicants maintaining platform liquidity through a downturn. It would be hard to envisage a scenario where we don’t see a number of lenders (both balance sheet and marketplace), beset by a weak balance sheet and limited scale, fall by the wayside.
The expectations around digital services delivery discussed in our banking section, also extend to lending. Loan applications will start to recover in the coming months from individuals and businesses alike, while margins for lenders will improve. Fintech lender processes offer a superior end-to-end customer experience which will provide structural advantage during the recovery period. For example, while a McKinsey survey of global banks found average ‘time to decision’ for SME lending was three to five weeks and ‘time to cash’ was three months in traditional banks, digital lending technologies enable fintechs to reduce both periods to measures of minutes and days⁷.
A key unknown data point at this time is the impact that furloughing, the Bounce Back and CBILS schemes will have on loan performance and loan demand for pre-Covid-19 SME lending products. CBILS has had a disappointing start, partly due to the inability of the accredited banks to process the sheer volume of loan requests as well as a lack of alternative bank lenders being approved. Although The British Business Bank has since accredited a handful of fintechs, OakNorth and Funding Circle included, with others (including iwoca and Tide) expected to be approved albeit later than hoped. It remains to be seen whether the approval of more non-bank fintech lenders will catalyse a much needed acceleration of approvals for SMEs. So far this substantial stimulus package feels like a missed opportunity for the fintech sector, who could have proven their ability to work at pace leveraging the technology and analytical advantages they have built in recent years. The crisis presents new opportunities for collaboration, both between fintechs, traditional banks and the government, although disappointingly we are seeing some established banks using their early accreditation as a way of pressuring SMEs to switch their current accounts across in order to benefit from these stimulus packages. We also anticipate that the £500m Future Fund (50% of which will be funded by British Business Bank) will deliver a timely capital boost for those tech companies that have been caught out by the crisis.
Fig 7: Macro outlook for balance sheet and marketplace lenders during the Covid-19 pandemic and recovery
The emergence and growth of commission-free trading platforms in the years preceding the Covid-19 pandemic proved to be a disruptive force in the brokerage market and prompted established digital platforms to respond by reducing trading commission fees. Now, the combination of heightened market volatility and low cost market access has led to a significant uptick in retail investment activity.
Fig 8: Digital brokerage platforms have seen increased activity levels in Q1
Although revenue from commission fees will be lower across the sector relative to market activity in previous periods, increased trading activity is broadly beneficial to all platforms in the space. Beyond commission fees, brokers have access to a number of other revenue streams including platform membership fees, charges for advanced trade types, FX fees on foreign trades and treasury earnings on margin loans and uninvested deposits. Payment for order flow, a practice banned under the ‘best execution’ article of European MiFiD II Regulation but legal in other jurisdictions including the US, is also utilised by some brokers. As part of the response to Covid-19, central banks have reduced interest rates to record lows which will have an impact on treasury income streams across the brokerage space. Operating profitably with these alternative revenue streams requires significant scale, a function of both users and assets under administration, which current market conditions appear to foster.
Neo-broker platforms are playing a role in engaging a new cohort of investors, particularly in Europe where, for structural and historic reasons, engagement with public markets is lower than in the US. In addition to low costs, onboarding is simple; utilising the likes of Onfido for digital identity verification where some traditional brokers still require physical witness documentation. Neo-brokers have a comparatively reduced offering in ‘on-platform’ portfolio monitoring, data and educational resources, into which more established platforms such as interactive investor have invested significant resources.
This speaks to a divergence in investor types and their respective broker selection criteria along a spectrum running from first-time investors, who typically have a lower value portfolio and a less developed investment strategy at one end to more experienced investors managing high value portfolios with data driven strategies at the other. Robinhood has added 3m brokerage accounts this year alone, although half of these are first-time investors. Higher value, and often older customers have proven to be more stubborn switchers, and remain stickier to digitally weaker platforms that often charge a premium for an average service. Whether the portfolios managed through neo-broker platforms will mature and grow over time, and whether this growth will remain on a neo-brokerage platform rather than moving to a more established broker remains to be seen. However the stickiness of investment platforms is such that if you can develop the product as your customer evolves, then retention should remain high. Nevertheless, for the majority of active investors, service uptime, trust and quality of execution are fundamental drivers of brokerage selection above price. Neo-brokers must ensure they have built a world class technology and product platform as trust takes time to build. Without it their proposition will struggle to get to true scale.
The impact of fintech innovation in brokerage, as is the case for all areas where fintechs are challenging incumbents, ultimately benefits customers by delivering greater value. Over time, we expect convergence within the space, with established platforms adapting their user experience to appeal to first-time investors and neo-brokers increasingly expanding their platform offerings to appeal to more experienced investors. There are already examples of acquisitive behaviour in the market and this we expect to continue:
- Consolidation from established platforms: Charles Schwab acquired TD Ameritrade for $26bn, Morgan Stanley acquired E-Trade for $13bn
- Continued fundraising for neo-brokers in April 2020: Robinhood raised $280m additional private capital at an $8.3bn valuation, Trade Republic closed a $67m Series B funding round
- Fintech platforms expanding into brokerage: US lender SoFi acquired Hong Kong neo-broker 8 Securities, Revolut introduced commission-free stock trading as an account feature in 2019
This plays into a wider trend of technology companies staying private for longer (due to availability of capital and attractive M&A opportunities, amongst other reasons), and this will only be strengthened with volatile public markets.
Fig 9: Macro outlook for digital brokerage platforms during the Covid-19 pandemic and recovery
The Covid-19 pandemic and response has placed many areas of financial services infrastructure under extraordinary strain. Across the sector there are examples of legacy technologies failing to keep pace with the current situation and leaving customers unsatisfied. Anecdotal instances of this, such as delays to the processing of CBILS applications, speak to a much greater challenge facing incumbent institutions across financial services; that of modernising legacy technology infrastructure to keep pace with changing customer expectations and increased competition from fintechs.
This challenge represents a significant opportunity for B2B fintechs; where once core systems were only developed in-house, fintech innovation has seen an unbundling of financial services capabilities and underlying infrastructure.
Fintechs are capturing an increasing share of financial services tech spend as institutions recognise collaboration as an effective means of innovation, with many fintechs engaged in multi-year projects to migrate core legacy systems to cloud native technologies. Fintechs such as Onfido deliver products which bring the latest technology and data techniques to critical path processes and ‘Banking as a Service’ is an emerging space offering financial service infrastructure on an outsourced basis.
Maintaining legacy systems and attempting to innovate on top of them is a constant, and expensive, challenge for financial institutions. As seen in Figure 10, the sum of venture capital deployed across European Fintech in 2019 ($8.5bn) in total was less than the individual annual technology spend at several major banks and was dwarfed by the estimated $500bn that global banks collectively spend on technology each year⁸.
Fig 10: Annual tech spend by individual banks matches VC investment in European Fintech
On average, 70% of total bank tech spend is diverted to system maintenance and only 30% supports new innovation⁹. Conversely fintechs, operating on modern tech stacks, divert development budgets almost entirely towards new innovation.
In addition to maintenance, the unyielding nature of legacy systems also results in additional unforeseen costs. In 2016, despite seven years of effort and £1.5bn of spend, RBS failed to spin out their SME banking unit Williams & Glyn, due to an inability to safely carve out the core technology. This failing resulted in the restructuring of government support terms and the creation of the £775m Alternative Remedies Package which mandates RBS to promote competition in UK SME retail banking¹⁰. Over 60% of the remedies funding has been directed towards fintechs in the SME space, including digital bank Tide and marketplace lender iwoca, facilitating much needed innovation and providing government-led endorsement of fintech’s central role in developing the financial services sector.
As organisations across the financial services sector turn their attention to cost reduction and efficiency in the coming months, B2B fintech will benefit as an anti-cyclical segment. Through both partnerships and acquisition, fintech infrastructure players will receive greater access to the significant resources of global financial institutions with huge, positive implications for the growth of the sector.
Fig 11: Macro outlook for legacy and fintech infrastructure during the Covid-19 pandemic and recovery
Across the four areas we have discussed, both fintechs and incumbent organisations will be tested by the Covid-19 pandemic, but cyclical and structural changes to the global economy will bring about opportunities for companies able to adapt. Accelerated digitisation is an overarching theme across financial services and, as a digital-first industry, fintech is clearly well-positioned. So too are fintechs advantaged by their ability to quickly adapt in order to capitalise on the current situation. Agile operating models, cultures of innovation and incorporation of the latest technologies and data will all prove to be competitive strengths in the coming years.
Financial institutions who were pursuing gradual technological transitions prior to the Covid-19 outbreak will have received a wake-up call in recent months and are likely to be finding systems and services under acute strain during this period. For organisations in this position, working with fintechs through partnership or acquisition likely represents the optimal way to ‘keep pace’ with industry developments in a post-Covid world. This has exciting implications for the growth of our sector.
As is the case through all business cycles, we will see multiple winners and losers from the crisis and there are likely cases where this process will either be accelerated or diverted from one trajectory to another as a result of the timing and unique circumstances. It remains to be seen whether the initiatives spearheaded by the UK government will deliver the required impact for tech companies caught out by the crisis. It’s clear that outcomes would be dramatically improved with wider inclusion of fintechs who already solve such challenges, e.g. alternative lenders. Where value has been created and timing is on side, companies will either flourish on their own or become attractive acquisition targets for well-capitalised fintechs or incumbents with strong balance sheets. It is still too early to see this trend play out in any substantive manner, but we expect to see this dynamic develop over the coming 12 months and beyond.
As the UK’s only publicly listed investment company focusing on the fintech sector in the UK and wider Europe, and one of the only fintech-focused venture funds globally, Augmentum Fintech is uniquely positioned to capitalise on current and future opportunities. With private companies staying private for longer, a trend likely to be reinforced by public market volatility, Augmentum Fintech provides investors with rare and high quality access to some of the very best fintech opportunities in Europe that we hope will deliver compelling venture returns over time.
Learn more about investing in fintech with Augmentum Fintech at www.augmentum.vc/investors
Read “Staying Private: The dynamics of public vs private capital in a changing world”, written by Augmentum Fintech Partner Martyn Holman here.
² LINK ATM Data
⁴ Wall Street Journal
⁵ The Finanser
⁶ Financial Times
⁷ McKinsey — ‘The lending revolution: How digital credit is changing banks from the inside’
⁸ Atomico — The state of European Tech 2019, Innovate Finance
⁹ Celent Insights — ‘Global Tech Spending’
This financial promotion is issued by Augmentum Fintech Management Limited which is authorised and regulated by the Financial Conduct Authority under Firm Reference Number: 811734. Augmentum Fintech Management Limited is appointed as manager to Augmentum Fintech plc. This financial promotion is for information purposes only and nothing contained in this financial promotion constitutes investment advice. This financial promotion is intended for professional investors and for retail investors who have sufficient knowledge and experience of UK listed investment trust companies. If you as a retail investor are uncertain whether an investment is suitable for you, you should seek advice from a regulated financial adviser. The value of investments, and any income from them, can fall as well as rise and you may not get back the amount invested. Reference to “Augmentum” or “Augmentum Fintech” refers to “Augmentum Fintech Management Limited” unless otherwise stated. Reference to the “Company” refers to Augmentum Fintech plc. Reference to “we”, “our” and “The Augmentum Team” refers to employees, consultants or advisors of/to “Augmentum Fintech Management Limited”.