Financial Innovation vs FinTech
So much has been said about FinTech that leads me to believe there is a commonly misunderstood concept: that FinTech is synonymous with Financial Innovation. It isn’t quite the same and here I will briefly touch upon the following topics:
- What are the differences between financial innovation and FinTech
- Why these differences matter
- The right toolbox
As pointed out by Frame and White (“Empirical Studies of Financial Innovation: Lots of Talk, Little Action?”, Scott Frame & Lawrence White, American Economic Association, USA, March 2004) financial innovation is “… something new that reduces costs, reduces risks or provides an improved product/service/instrument that better satisfies participants’ demands…” driven by new technology, new regulations and/or changes in society’s economic development. Financial Innovations examples range from automated teller machines to interest rate swaps. The impetus behind financial innovation is driven by the maximisation of profits within a regulated and free market (“Some Causes and Consequences of Financial Innovation”, Preston Martin, https://fraser.stlouisfed.org/files/docs/historical/federal%20reserve%20history/bog_members_statements/martinp_19821007.pdf, Washington DC, October 1982).
On the other hand, Financial Technology is a form of financial innovation driven by the application of new technology to the world of finance. In PWC’s report (“Top financial services issues of 2017”, PWC, December 2016, https://www.pwc.com/us/en/financial-services/research-institute/assets/pwc-top-financial-services-issues-2017.pdf) they rightly state that “.. the rise of financial technology … is changing the way people and companies save, pay, borrow, and invest”. Examples of FinTech are distributed ledger technology such as blockchain, and crowdfunding.
Financial Innovation is therefore a wide definition of change in the finance industry, while FinTech is a form of financial innovation focused on technology, with the potential to disrupt the existing financial framework.
Why do these differences matter? They matter because the forces behind financial innovation and developments in FinTech are different and have different aims. Innovation for the sake of it is often a narcissistic exercise that leads to nowhere. Furthermore, Financial innovation has traditionally been pursued from within the financial community and has sometimes led to unfortunate consequences, as regulators have struggled to catch up with the development in financial products, see the recent subprime crisis and Lehman Shock for example. On the other hand, the emergence of FinTech has been mostly a by-product of new entrants: technology companies and specialists moving into the financial sector. Hence, all the headlines you’ve probably read about FinTech disrupting the financial landscape.
Finance companies will not stop to innovate nor will they dedicate all their resources to developing FinTech solutions to their businesses but will form an integral part of the Schumpeterian process of creative destruction that we’ve grown accustomed to in modern society: some will succeed in taking advantage of the changing landscape of the financial market, some won’t. However, most of the technology companies exploring FinTech solutions are looking to find incremental solutions to inefficiencies and shortcomings in the financial space, and consequently adopting a very similar business model to that of the companies they purportedly aim to disrupt. True game changers are few and far between. So, the type and depth of financial innovation that FinTech companies aim to achieve is what defines their potential impact in the market.
What is the right toolbox to evaluate truly disruptive FinTech developments in the financial industry? Traditional fundamental analysis is somewhat challenging and other metrics based on the number of users or downloads or clicks are, in my opinion, ephemeral and temporary. Some of the disruptive changes which have taken place in other industries, such as advertising and retail do however provide a possible guidance to evaluate disruptive FinTech companies. Google and Facebook have not wiped out ad agencies but they have become dominant players in the mass advertising industry and more importantly, they have allowed a greater degree of inclusion, taking down costs and difficulty for individuals and small companies willing to advertise their services and products. The same has happened in the retail space with Amazon and Alibaba helping a plethora of companies and entrepreneurs to reach clients worldwide.
However, for years Google and Amazon were seen as cash burning businesses with no real business case. These examples show us a possible path for disrupting FinTech companies and markers to be on the lookout for: a focus on inclusion and wide participation, a technology that truly delivers cost reduction, and overall simplicity of use. And let us not forget that despite living in an age of celebrities (from chefs to movie stars to entrepreneurs), it still pays handsomely to invest in the right people and teams.
To conclude, I recommend any investor and potential investor in the FinTech space to avoid the hype and look at the possible drivers of value in each of the companies you invest in, to find some of the traits highlighted: potential for wide inclusion, cost reduction and simplicity.
