Financial Services Unbundling, Revisited
A lot has been written recently about the potential for startups in the financial services sector, from Marc Andreessen’s “we can reinvent the entire thing” rallying cry to some great blog posts about the future landscape of unbundled FinTech. This excitement (and the concurrent 3x increase in FinTech funding) makes sense — as these authors note, now is definitely a transformative time for the industry.
However, despite the great successes in FinTech in the past year or so, we still haven’t seen the emergence of a full stack financial services startup. Almost every high-profile new company has an old-guard financial institution behind it, not to mention the longstanding financial infrastructure that underlies almost every global transaction. Lending Club and Simple rely on banks, for instance, while Wealthfront, FutureAdvisor and others use fully-disclosed clearing firms to run their respective businesses.
This post attempts to show how FinTech startups are evolving at different layers of the stack by by looking at the financial services value chain. The majority of innovation to date has happened in the front office, but we’re eager to see more and more new startups filling in layers further down the stack in the future.
One quick note—I realize this is a simplified way to look at a really complex ecosystem, and is not intended to be a comprehensive market map (there are already plenty of good ones out there). In particular, I’m excluding payments, insurance, and standalone applications (e.g., risk management or data analytics systems). While also seeing exciting innovations, these are worth addressing separately.
The framework follows the principle of why financial institutions exist in the first place — the intermediation between capital needs (e.g., debt and equity financing) and capital sources (e.g., savings and investments). Both sides of the cycle can be laid out on the same value chain:
Distribution / Front Office: The owner of the customer relationship, either through an individual adviser or banker, a physical branch location, or more recently, a captive, online front-end.
Manufacturing / Back Office: The product creator (e.g., asset manager or underwriter) as well as back office activities like trade execution and loan servicing.
Market Infrastructure: The “guts” that intermediate asset transfer, including exchanges, market makers, central clearing houses, and settlement providers.
In the age of the financial services supermarket, the “distribution” and “manufacturing” stages were tightly coupled. Investors would buy a Vanguard mutual fund through a Vanguard brokerage account, savers would open an account with Citi, borrowers would get a mortgage from Wells Fargo, and corporates would contract with Goldman to raise financing from investors:
There have been many examples of new players assuming some of the supermarket’s roles in the past (think securitization and other buy side “shadow banking” activities). As startups increasingly focus on financial services, they will fill in layers of the stack as well, starting with the front office but moving back over time:
Some trends we’re seeing in each piece of the value chain:
1. Independent, digital front ends. A number of companies have achieved quick traction through replacing the human, face-to-face interaction with a beautiful online user experience for basic product selection (e.g., Wealthfront for managed accounts or Simple or Moven for personal banking). Traditional firms that have built their own front ends have been slower to innovate in UX / UI, driving the adoption of independent budgeting tools like Level and trading tools like ChartIQ and eSignal.
2. API driven middle / back office. As discussed, most of the new applications have been built on legacy infrastructure (and although marketplace lenders have dipped further into the traditional bank’s territory with underwriting and loan origination, they still often use banks for regulatory reasons or to raise capital). However, in order to enable the next generation of front office, developers need open, well-documented APIs, which many old-world firms either poorly support or don’t offer at all. To solve this problem, a few new startups have gone to market with an API-driven offering — for instance, Standard Treasury in banking or Tradier in online brokerage.
3. The electronification of market structure. This is an old story for many financial markets, with the complete transformation of equity and FX market structure over the past 20 years due to electronic trading (and several new venues that would be seen as “unicorns” today). Regardless, many capital markets are still intermediated by bilateral, voice-driven trading methods, and central clearing firms like the ACH, DTCC, CME and others haven’t changed workflows for many years. Partially driven by regulation, other asset classes liked treasuries, corporates and OTC derivatives are undergoing their own revolutions. Even further on the horizon, the use of blockchain technology for smart asset transfer could replace these intermediaries entirely.
Across these themes, we’re most excited about the latter two; though there are still a lot of great problems to solve on the front end, they are not the high hanging fruit in the industry. However, with anything in financial services, regulations and market conditions will dictate how — and how quickly — these trends play out. Onerous regulation isn't going anywhere, and the scale advantages large incumbents have in dealing with them aren't either. Further, what one day looks like innovation can quickly become evil “shadow banking” or “predatory HFT” in the eyes of the regulators and the public, especially during periods of intense volatility.
The hope is that the new players can overcome this challenge by remaking the culture of the industry, layer by layer. By starting with transparency, integrity, and a maniacal focus on delighting the end user, current and future FinTech startups can make financial services better for every consumer in the long run.
