FinTech Trends
The Tipping Point? — July 2017
Executive Summary
It is an exciting time for FinTech entrepreneurs, investors, consumers and other stakeholders. The sector has gone through an unprecedented period of innovation and disruption over the last few years. While industries such as media, travel and ecommerce experienced some of the earliest technological transformations, financial services, one of the economy’s largest sectors, has been one of the laggards.
FinTech has come a long way since PayPal’s launch almost 20 years ago, considered to be one of the first FinTech companies. We are now living in an era of unprecedented disruption of the financial services sector. While the end of the 20th century saw some advances through the introduction of ATMs in the 60’s, debit cards in the 70’s, and online banking in the late 90’s, the financial services industry has until recently remained mostly offline, plagued with unsatisfactory customer experiences reflected by subpar Net Promoter Scores and a lack of new product/service innovation.
The recent recession contributed significantly to the emergence of the FinTech sector and its wider acceptance in the developed world. New capital constraints and ever increasing legal and compliance demands burden established banks with higher costs, leading to reductions in technology investment budgets that stifle internal innovation. The high number of redundancies created a large talent pool many of whom migrated to FinTech startups. Finally, consumers’ trust in traditional institutions has eroded according to a number of polls, making them more willing to try alternatives.
Mobile banking, peer to peer (P2P) loans, crowdfunding, free share brokerages and FX, and automated wealth management services are some of the areas forcing the financial industry to undergo a radical transformation, pushing incumbents to rethink their core business models and embrace digital innovation. These are largely driven by advances in mobile technology, big data, machine learning and blockchain technology.
Herein we discuss some of the key themes and trends in FinTech which have also been raised and discussed at length during Lepe’s FinTech dinners. These dinners brought together thought leaders from the industry including investors, entrepreneurs, executives, regulators and government officials to give their perspective on the industry.
Overview of Financial Technology
The major themes we see running through the various sub-sectors are as follows:
- Improved Customer Experience
- Democratization of Financial Services
- Partnerships between FinTechs and Financial Institutions
Goldman Sachs estimates that $4.7tn in revenue for financial services firms is at risk of being displaced by new tech-enabled or FinTech entrants, creating a wide array of opportunities to challenge incumbents. There is a very real possibility of banks becoming disintermediated and facing their “Kodak moment” if they do not keep pace with FinTech developments.
Estimated FinTech Impact by 2025
Venture Capital investment has been attracted by the large markets, high customer life time values and slow innovation from incumbents. 2016 saw FinTech companies globally raise $12.7bn across 836 deals.
FinTech companies offer consumers efficiency, lower costs, and greater speed. This could not come at a more welcome time for the technologically adept millennials who are experiencing low wages and high debts, and have helped to drive a large part of the adoption.
While the 2017 World FinTech Report (CapGemini) found that 50.2% of respondents use at least one FinTech service, surprisingly, the sector only represents less than 10% of the £200bn financial services market in the UK. Rising consumer adoption driven by increased trust and awareness in FinTech firms (and their brands) is expected to accelerate growth in the coming years.
Over the last 10 years FinTech has seen a rapid acceleration in the pace of innovation. The advent of smartphones and a more flexible regulatory environment with respect to technology and innovation in financial services have facilitated much of the progress and innovation that has occurred to date.
London has taken advantage of its unique global position as a political, technological and financial centre, establishing itself as a leading FinTech centre. While no one can ignore the uncertainty generated by Brexit for the UK’s position as one of the leading global financial hubs, London still retains the key criteria that position it as the ideal place for a FinTech business, including the required tech talent.
Lepe Capital’s FinTech Investment Thesis
First movers with frictionless and reliable customer experience that can gain consumers’ trust while saving people money. The winners we are after have low customer acquisition costs through improved offerings. They use modern infrastructure to drastically reduce their cost base as well as data to obtain relevant insights and offer segment specific propositions.
- Challenger Banks: “One challenger bank to rule them all”; We expect to see a consolidation in products and services within the highly fragmented FinTech space via partnerships, greenfield product development and M&A. Certain challenger banks that manage to put together a complete offering of financial services and products are primed to become the critical FinTech platforms.
- Blockchain: We believe the next wave of innovation is already being driven by blockchain technology. Having said that, Venture Capital is still figuring out how to invest in blockchain. In the early days, VCs invested in the equity of blockchain companies, while some are now pioneering investing through tokens, which provide liquidity to venture as an asset class.
- AI & ML in FinTech: The application of machine learning algorithms to the data aggregated by FinTechs allows them to carry out risk assessments with improved accuracy and to customise individual product offerings. Applications include capital markets, fraud, cybersecurity, financial advice, credit scoring and insurance.
- Alternative Finance: We believe the market opportunity in Europe for marketplace lending and equity crowdfunding to go mainstream is still present. While some companies have established a leadership position, the race for market share is still on. Platforms that manage to lower customer acquisition costs and run an efficient marketplace will succeed in establishing themselves as true leaders.
- London as the Global FinTech Innovation Hub: While the effects of Brexit are hard to accurately predict, London remains a leading digital, financial and political centre with a supportive regulatory environment (FCA Sandbox & Innovation Centre). London also has 320k tech employees (1.5m in the UK) and more early stage venture capital than any other global tech hubs other than Silicon Valley and China.
Regulation
Although regulation may have created an initial hurdle for innovation, the regulatory body in the UK has been highly supportive of the FinTech sector with initiatives such as the FCA Sandbox.
The Payment Services Directive 2 (PSD2), proposed by the European Commission in 2013 and to be implemented in 2018, is set to increase, improve and integrate payment efficiency across the EU, while offering better consumer protection. PSD2 will create an open banking landscape by requiring banks to open their infrastructure and data to third parties via open APIs. These changes will allow FinTechs to aggregate account data from multiple institutions into a single view by becoming Account Information Service Providers (AISP) as well as authorize payments directly from their account, simplifying the flow of transactions and payments by acting as Payment Initiation Service Providers (PISP).
The founder of TrueLayer, a company that has built a developer platform to make it easy for FinTech companies to access bank APIs, believes that “PSD2 will be a once in a lifetime opportunity for startups to displace incumbent banks and financial service providers”.
Account Information Service Providers & Payment Initiation Service Providers
PSD2 will not only have direct implications in the FinTech sector but will also provide opportunities in an adjacent sector, Regulation Technology (RegTech), a growing market benefitting from larger available data sets. Companies such as Onfido and Jumio are using AI and biometrics to help banks and companies from the sharing economy comply with a changing regulatory environment, and manage the customer on boarding processes including KYC and AML requirements.
Payments and FX
While almost two thirds of the dollar value of transactions are already digital, c. 80% of global transaction volume is still cash-based. The inefficiencies of using cash in today’s economy are many, from the loss of tax revenues from the underground economy to the cost of logistics and transportation.
The early winners in the space relied on fees that increased with the total dollar volume of payments processed. While companies such as PayPal and more recently Stripe have capitalised on rising eCommerce volumes, the next generation of disruptors are focusing on obtaining value per individual transaction, driven by the aggregation of transaction data, which is estimated to be a $125bn opportunity. Mobile POS companies such as Square and iZettle are also helping to support digital payments by providing a convenient and cost-efficient technology for all retailers to accept card payments.
It is becoming increasingly obvious that “the future of payments is mobile” (Dan Schulman, PayPal CEO). Smartphone penetration is set to reach 75% by 2020 supporting the growth of mobile payments by 15x from $1.1tn in 2015 to $15tn by 2020. New technologies like NFC (contactless) and security features like Biometric scans will only help to increase adoption of mobile wallets and P2P payments.
In China, Ant Financial (which runs Alibaba’s payment affiliate, Alipay) has capitalised on the 600m under-banked smartphone users. The company is the leader in a widely used mobile payment market ($235bn market size) of which it has captured 68%, allowing it to become the largest FinTech “unicorn” at a valuation of c. $60bn.
The other innovation in payments has been driven by companies such as Transferwise, CurrencyFair and Revolut, disrupting the retail foreign exchange market by reducing fees and offering a more seamless user experience. Major retail banks are expected to lose up to 10% of their profits when international transfer repricing takes place as consumer demands and behaviours adapt to the new status quo.
In a similar way, the likes of WorldRemit and Azimo have capitalised on the innovation in the $600bn remittances market, capturing migrant labour money flows, taking away market share from incumbents like Western Union and Moneygram.
Challenger Banks
Mobile banking is increasingly becoming the most important channel as desktop usage drops and banks close down branches. The drive to mobile banking is being led by younger consumers, who demand a different experience. According to consultancy firm CACI, mobile logins now account for over twice the number of branch visits and this is only expected to increase.
Some of the leaders in the race to create a new challenger bank include Revolut (>600k users), Monzo (>200k users), Pockit (>100k users) and Atom Bank in the UK, N26 (>300k users) in Germany, and Simple in the US. The opportunity for business banking is equally large where newcomers including Tide (UK) and Qonto (France) are trying to establish themselves.
The main USPs of challenger banks has been product innovation, leading to an improved customer experience, and lower costs. Initially starting with a simple pre-paid MasterCard debit card, some have obtained banking licenses and now offer full bank accounts in addition to lending, investing and other financial products.
These challengers have mostly adopted a freemium model where they impose “reasonable” limits to their free services and provide a premium monthly subscription entitling users to unlimited access to all services. Partnerships with other FinTechs give challenger banks provide the opportunity to offer a wider variety of financial services and unlock additional monetisation channels. Examples include N26’s partnerships with Transferwise, InsurTech platform Clark, savings account aggregator Raisin and robo-advisor Vaamo. In the UK, Revolut partnered with robo-advisor Moneyfarm, pension provider PensionBee, and P2P lender Lending Works.
Robo-Advisors
Robo-advisors are in the process of transforming the wealth management industry by offering full-service, technology-enabled and low-cost investment solutions.
Robo-advisors, such as Nutmeg, Moneyfarm and Scalable Capital in Europe and Betterment and Wealthfront in the US, are addressing the mass-affluent market previously underserved by incumbent wealth managers. The current record low interest rate environment has provided an additional impetus for investors to shift savings from banks to fund investments. The low fee and transparent investing proposition from robo-advisors has helped to attract new customers to the industry. These trends are expected to contribute to the tripling of global robo AUM in 2017 from $0.2tn to $0.6tn, reaching $8.1tn by 2020.
Robo-advisors have benefitted from the shift from active to passive investment strategies as most active investors continue to underperform the market. Furthermore, the incumbent players are suffering from industry-wide cost pressures, driving revenues and margins down as investors withdraw substantial amounts ($326bn in 2016) from active investment managers.
2016 AUM Distribution and Outlook. Fee Change and Net Flows by Product.
Alternative Finance
Following the Great Recession, small businesses were faced with a shortage of bank financing options, in part due to the stricter regulatory requirements under Basel II. The gap is now being filled with the creation of a number of “alternative” financing methods provided by individuals and institutional investors. These include debt-based crowdfunding (a.k.a. P2P or marketplace lending) for both businesses (e.g. Funding Circle) and consumers (e.g. Zopa and LendInvest), and invoice factoring (e.g. MarketInvoice). Equity crowdfunding platforms have also gained substantial traction (e.g. Crowdcube and Seedrs), with other models including rewards-based (e.g. Kickstarter and IndieGogo) and donation crowdfunding (e.g. JustGiving and GoFundMe).
The sector has been experiencing one of the fastest growth rates in the financial services industry over the last 10 years, reaching $145bn in 2015. Alternative finance is benefitting the economy through a more efficient capital allocation model with fewer intermediaries, creating an unprecedented opportunity to finance more businesses, projects and philanthropic causes than ever before.
Blockchain & Cryptocurrencies
Blockchain technology has made a lot of noise recently, and with good reason. Cryptocurrencies and tokens built on blockchains have seen a spectacular rise in 2017 creating shockwaves throughout the worlds of finance and technology. The price of 1 Ether (the 2nd largest cryptocurrency by market cap after Bitcoin) increased almost 50x from $8 in January reaching an all-time high of c. $390 in Jun-17. Other currencies including Ripple, Litecoin and ZCash and tokens such as IOTA, Iconomi and Augur have followed suit.
Such dramatic volatility is being driven by speculators trying to ‘make a quick buck’ as well as investors who believe blockchain technology will completely transform how organisations in almost every industry will be structured and managed in the future. Beyond simple digital currencies, blockchain’s distributed ledgers, cryptography and smart contracts allow for decentralised organisations that foster trust between parties that have never met each other, without the need for a central counterparty, making many of the existing ‘middle men’ in today’s economy redundant.
Initial Coin Offerings (ICOs), a way to crowdfund the release of a new cryptocurrency (or token) are taking off as new financing model with blockchain startups raising large rounds[1] in extremely short timeframes, potentially disrupting the current VC model. Sceptics argue this is another bubble, but many see blockchain as the next Internet, “Web 3.0”.
Albert Wenger from Union Square Ventures argues that we are already in a crypto currency bubble while explaining that “a bubble isn’t in and of itself a bad thing. In fact, almost every wave of technology has brought with it a financial bubble phase. During this phase, a lot of financial capital flows into a sector which finances real innovation and accelerates the build-out of physical infrastructure”.
In addition to the more obvious applications in the financial services industry such as improved clearing & settlement processes for capital markets, trade finance and payments, most agree that blockchain has the potential to disrupt a wide number of sectors including: cyber-security, IoT, music, gaming, transportation, energy, real estate, insurance, healthcare, cloud and retail.
FinTech in Emerging Markets
The boom in Chinese FinTech over the past five years established China as the world’s largest FinTech market by number of users (c. 500m) and market size ($1.8tn). Developments across multiple hubs, such as Shanghai, Hangzhou, Beijing, and Shenzhen have allowed China to exceed, by far, levels seen in the US and Europe.
Key drivers behind this growth include a highly-developed eCommerce sector, thanks to industry champions like Alibaba and JD.com, an open and supportive regulatory environment and finally the large unmet demand for finance from what used to be a largely unbanked population.
As China’s FinTech ecosystem matures, the opportunity shifts to other large emerging and frontier markets such as South East Asia, India and Africa. India seems to be in a similar position to where China was a few years ago with a large and growing eCommerce market (with players such as Flipkart competing strongly against Amazon) and a latent demand for financial services.
In Africa, where as much as 80% of the continent is unbanked and up to 90% of retail transactions are made using cash, FinTech is likely to have a big impact, particularly in South Africa, Nigeria, and Egypt, which account for about half of the continent’s economy. However, in its own way, Africa experienced a FinTech wave prior to the rest of the world. Launched by Vodafone’s Safaricom mobile operator in Kenya in 2007, MPesa provides mobile phone-based money transfer, financing and microfinancing services. The system is now used by 30m people in over 10 countries. Another emerging player to watch in this space is Jumo, a mobile financial services marketplace which uses behavioural data from mobile usage to profile Micro-SMEs and consumers not economically reached by banking networks.
Consolidation: Partnerships vs. M&A
Banks are increasingly relying on partnerships with FinTechs in their pursuit of digital expertise. FinTechs on the other hand are benefitting from the large existing customer base of traditional financial institutions and their established brands and customer relationships to deploy their solutions to a wider audience. Examples include JP Morgan’s partnerships with Digital Asset Holdings for a trial blockchain initiative to make the trading process more efficient and cost effective, BBVA’s deal with FutureAdvisor a leading US Robo-advisor and HSBC’s partnership with Tradeshift which enables companies to manage their global supply chains and working capital requirements.
PWC research shows that 47% of UK financial services firms intend to acquire FinTech companies in next 3–5 years. Considering the billions of dollars spent on technology development every year by big banks, a consolidation based on acquisitions may appear to be a very obvious scenario, however the question is whether banks manage to acquire startups without meddling with their culture, traction and growth? Banks such as BBVA have proven successful at such acquisitions, acquiring challenger banks Simple and Holvi without integrating them into their business. Full integrations have proven more complex and destructive to value in the past, making banks generally cautious and more inclined to let acquired companies operate as separate business units.
Sources: ARKInvest Research, Caci Consultancy, Cambridge Centre for Alternative Finance, CapGemini, CB Insights, Cryptoinsider, Deloitte, EY, Forbes, Goldman Sachs, Harvard Business Review, House of Commons: Business, Innovation and Skills Committee, McKinsey, Morgan Stanley, Oliver Wyman.
[1] Mozilla co-founder Brendan Eich’s new Basic Attention Token (BAT) raised $35m in 30 seconds. BAT is the token of a new blockchain-based advertising platform built on top of the company’s Brave browser. Another example is the Bancor token project which raised $150m in under 3 hours. Bancor is a protocol that enables built-in price discovery and a liquidity mechanism for tokens on smart contract blockchain.
Thanks to the team at Lepe as well as to Carlo Biggio at Anthemis Group for your patience and help in drafting this piece.
Feel free to comment below or to email me at felipe@lepepartners.com, I would be very happy to chat or share notes.
