Data Flows and Money Flows Will Drive the Future of Fintech
Despite the rapid pace of fintech innovation we witnessed over the last decade, we believe fintech is entering a new, exciting phase of innovation: The Era of Contextual Financial Services. It is analogous to contextual commerce, where retailers integrate purchasing opportunities into everyday activities and natural environments (think Pinterest or Facebook ‘Buy’ Buttons). In the era of Contextual Financial Services, trusted brands can offer financial services products that are both timely and relevant to their customers. Thanks to a wave of “open banking” APIs, brands can seamlessly offer these financial solutions to their customers within their own platforms. In this new and evolving fintech paradigm, companies that are well-positioned within their customers’ data flows and money flows will be long-term winners.
2020 was a big test for fintech and the ecosystem rose to the challenge. Throughout the back half of the year, we saw an acceleration in fintech adoption across the board, as both businesses and consumers adapted to the COVID-19 health and economic shock. According to a September 2020 Survey conducted by Plaid, nearly 60% of Americans confirmed they were using more fintech apps to manage their money and over 70% were convinced that digital money is part of the “new normal” (see Figure 1).
Figure 1. Fintech is the New Normal
Fintech companies — particularly in high-income economies — have addressed some of the biggest obstacles to financial services innovation — including a fragmented, legacy infrastructure, data connectivity challenges, and regulatory compliance issues. These investments paid off for customers, the ecosystem, and its leading innovators. Paypal and Square had banner years in the public markets; theirs shares soared by 100% and 200%, respectively. Visa announced plans to acquire Plaid for $5.3 billion and Stripe’s valuation is approaching $70bn.
And yet, we believe we are just starting to see how impactful this new wave of fintech innovation will be to the financial lives of consumers and businesses. We expect to see a surge of new fintech applications thanks to a wide range of open-banking APIs. Many of these applications won’t necessarily come from traditional “financial services companies”. Indeed, just about any company can consider launching financial services to become increasingly relevant to their customer’s financial lives, enhance their near-term profitability, and gain a long-term competitive advantage.
The clear winners from the coming wave of fintech applications are the individuals and businesses that consume them. But how can investors make sense of a world where every company is potentially a fintech company? How can up-and-coming fintech startups think about their long-term positioning in such a rapidly evolving landscape?
We believe that data flows and money flows will drive the future fintech winners. In other words, companies will need to think through two key factors in order to form a long-term competitive advantage in the new fintech landscape. First, companies will need access to relevant proprietary data — either directly or indirectly. Second, companies will need to position themselves in their customers’ flow of funds in order to act on that data.
Companies that achieve this will have the ability to offer customized, targeted financial solutions that are relevant to their customer’s current context. By doing so, these companies will remain important to their customer’s ever changing financial needs. Data flows and money flows are at the heart of the new paradigm in fintech innovation: Contextual Financial Services.
(1) Follow the Data Flows
Needless to say, data plays a critical role in financial services. Financial institutions have long leveraged data to underwrite credit, authenticate customers, and flag potential fraudulent transactions. The nature of that data — where it comes from, how it is generated and who provides it — has evolved rapidly, however. Data from web apps, mobile devices, and even social networking platforms are now leveraged in financial services. As a result, most of the recent fintech innovators have leveraged these alternative data sets to launch better credit, insurance, payments, and other financial services to customers.
The accessibility to this data has greatly improved in recent years thanks to API driven solutions from Plaid, Yodlee, and others. These solutions enable companies to directly connect to their customer’s financial accounts, enabling a seamless consumer experience. Similarly, companies such as Marqeta, Galileo and others enable fintech companies to seamlessly issue payment credentials to their customers. These open banking solutions have facilitated the launch of several innovative financial services applications.
(2) Follow the Money Flows
Similarly, we have witnessed how companies can leverage their positioning within the flow of customer funds to gain a long-term competitive edge. This positioning enables companies to greatly enhance the overall consumer experience by offering differentiated, often customized solutions. One example of this is the merchant working capital product. For years, payment processors, point-of-sale vendors and banks with merchant processing arms have successfully deployed working capital solutions for their merchants.
But perhaps none are as differentiated as PayPal and Square. As payment processors, both of these companies leverage historical sales data from their merchants. This enables them to model out the consistency and seasonality of those sales. As a result, these companies can detect when retailers are likely to have relatively weaker sales (i.e. a seasonal pattern) and proactively offer working capital loans that can cover those tougher months.
Access to data is only half the story, however. It is the positioning within their customers’ money flow that enables Paypal and Square to offer a credit product that is superior to many alternatives. Merchants opt to pay a fixed percentage of each sale towards the loan. This percentage is automatically deducted from the sales until the loan is paid off. The percentage approach helps merchants smooth out their cash flow, paying more towards the loan in strong months, and paying less towards the loan in slower months. The entire loan product and — more importantly — the loan repayment schedule is designed to adjust based on the strength of their customers’ sales. That is contextual.
(3) Investing in Contextual Financial Services
Merchant working capital is just one example of how companies can combine access to relevant data and direct positioning within their customers’ flow of funds to offer contextual financial services. On the consumer side, for example, companies like Affirm and Klarna offer customers ‘buy now, pay later’ options within their shopping experience.
We note that some companies might lack the capabilities to leverage data efficiently. Other companies might have access to data but lack a direct positioning within their customers’ flow of funds. What makes the contextual financial services paradigm so unique, however, is that companies can largely solve these gaps by integrating relevant open banking APIs.
There are a number of ways to invest in this secular trend. As a fintech VC, we are primarily focused on two categories. The first category of investment opportunities is what we refer to as “network platforms”. These companies are equipped to offer contextual financial services directly to their customers. In other words, they have access to the data flows and the money flows. The second category is what we refer to as “contextual fintech enablers”. These API driven platforms provide financial services, software vendors, marketplaces, and other brands with the tools to offer white-label financial services through their platform.
Category 1: Network Platforms
B2B Payment Platforms. As we previously noted, we believe that B2B Payments Automation is finally having its moment. Over the last two decades, much of the enterprise from CRM to ERP to People Ops has moved into the cloud. B2B payments, however, have remained stuck in the pre-digital age. The secular trend away from manual, paper based processes accelerated in 2020. We expect the growth in digital B2B payments to remain elevated, as the ecosystem plays catch up to B2C and C2C payments.
In addition to digitizing accounts receivables and accounts payables, we see B2B payment platforms as well-positioned in the era of contextual financial services. B2B payment platforms have an opportunity to help enterprises manage the full customer sales cycle from the contract to the order/invoice to the actual payment. In addition, by offering customers corporate-based expense cards, these B2B payment processors can track expense patterns over a larger set of transactions.
B2B payment processors will leverage this payment data to offer competitive products to their business customers. These products include accounts receivables financing, corporate credit cards, FX conversion and other commercial banking solutions. We point to similar strategies in the B2C (merchant working capital) and C2C verticals (see Venmo’s debit and credit card offerings).
These contextual financial services could profoundly improve the financial reality for businesses, particularly in emerging markets. As we previously noted, in regions such as Latin America, cash remains dominant and businesses are very early in the process of automating their workflows. As a result, only a small fraction of businesses have access to formal credit products.
Our investments in this category include Paystand (US) and Yaydoo (Latin America).
Payroll Processing Platforms. Payroll processing platforms can emerge as leaders in the age of contextual financial services given their access to unique payroll data and an advantageous position in the flow of funds from employer to employees. In the US, a large percentage of the population cannot cover $400 in unexpected expenses and the Federal Reserve found that 60% of the population do not have liquid assets to cover 3 months of expenses. It is clear that US employees need access to a lifeline when unexpected short-term shocks occur. In other words, US workers need the ability to smooth out their cash flow as their context changes. This would be equivalent to “the merchant working capital case study” we mentioned above.
We believe payroll companies are best equipped to fill this void. Payroll processors can enable employees to access their unearned wages earlier in the payroll cycle or even take out short-term emergency loans. The loan amount can then be deducted from the employee’s future paychecks.In the US, this could serve as an attractive alternative to the predatory practices of payday lending. In emerging markets, where large percentages of the population are unbanked, we believe payroll processors could play a pivotal role in financial inclusion (see our take on how these companies can help tackle financial inclusion in Mexico).
And this is just the beginning. Payroll/HR platforms can see when an employee recently married, had a new child, received an end-of-year bonus, earned a promotion, and more. As a result, we fully expect payroll companies to push into banking/payment products to offer employees contextual financial services.
Our investments in this category include Gusto (US) and Worky (Latin America).
Category 2: Contextual Fintech Enablers
Payment Processing APIs. Large marketplaces, including Amazon, Airbnb, Pinterest and Uber have invested millions in bringing their payment processing needs in-house. The near-term economic rationale for these large platforms is clear. At a certain scale, the cost of outsourcing payment processing to a third-party does not make sense even after tacking on the ongoing maintenance and regulatory compliance cost. But this move also provides powerful data streams that these platforms will leverage to offer their marketplace participants a suite of financial products. A notable example is the Uber wallet, which is offered to uber drivers in order to receive, transfer and spend their earnings.
That said, taking payments processing in-house is not economically or operationally feasible for the majority of small/mid-size companies. In order to compete with their larger peers, these companies need to either outsource their payment processing or integrate a white-label payment infrastructure.
We predict the second option will look increasingly attractive to companies that want to (1) turn payment processing into a revenue generator and (2) offer contextual financial services within their platform. For example, software vendors can add payment processing to the suite of products they offer their customers, potentially enhancing their customers’ LTV. In addition, providers of smart point-of-sale devices can process transactions on behalf of their merchants, paving the way for other solutions, such as the merchant working capital noted above. Moreover, online lenders can offer their businesses payment processing services to enhance revenue and offer a combined loan/payment product. (see Kabbage Payments as an example).
Our investment in this category includes Finix Payments (US).
Insurtech Based APIs. Digital insurance companies will increasingly embed their APIs in third party platforms to scale efficiently, while greatly improving the insurance shopping experience. There are numerous applications where this makes sense. For example, digital auto marketplaces should integrate insurtech APIs to offer their customers the ability to tack on auto insurance at the point of purchasing a car and without having to leave their platform. Online real estate marketplaces (which we speak about more below) can integrate home insurance offerings within their platform as well.
Neobanks, moreover, will look for incremental sources of revenue to increase their LTV. Insurance products should be at the top of their list. While some of the largest neo-banks may opt to build out their own insurance brokerage infrastructure, we believe most will opt to integrate third-party APIs. These insurance integrations are particularly critical for underbanked consumers and for emerging markets where insurance remains largely untapped (read our take on Mexico’s auto insurance opportunity).
Our investments in this category include Guros (Latin America) and Listo Financial (US).
Proptech Based APIs. Prior to COVID-19, residential real estate lagged nearly every major industry in online commerce penetration. According to Properties Online, nearly 100% of customers start their search online, but only 1 in 5 consumers actually transacted or even contacted an agent online. We believe 2020 was an inflection point for online real estate transactions, as COVID-19 forced buyers and sellers to adopt digital tools. The public markets are seemingly pricing this in as well, as illustrated by the 200%+ surge in Redfin and Zillow shares and the recent Opendoor Technologies IPO.
We expect to see a flurry of innovation in the proptech industry. New proptech innovations will facilitate how consumers execute transactions online and, equally importantly, how they finance those transactions. These solutions are necessary in order to narrow the homeownership gap for the most financially vulnerable populations — namely minorities, women, and young individuals.
We see ample space for creative real estate financing solutions — including how consumers purchase a new home, refinance their property, and tap into their equity to smooth out their cash flow. These proptech platforms companies can package their solutions and offer it to real estate marketplaces or neobanks through APIs.
As a result, neobanks that want to “grow” with their customers can offer them innovative, affordable alternatives to traditional mortgages instead of losing them to competitors. These same neobanks, robo-advisors, and budgeting platforms can help customers save for a down payment, before offering them a mortgage-like product. Moreover, payroll processors can offer these innovative mortgage solutions to employees who just got married or recently had a child. The opportunities for contextual financial services in proptech are plentiful.
Our investments in this category include Haus.
Neobank APIs. Scaling a neobank is difficult and costly, which will cause neobanks to rethink their distribution strategy. As a result we expect neobanks to increasingly bundle and integrate their solutions into third-party platforms. By doing so, neobanks can enable marketplaces, and software vendors to embed banking products into their suite of offerings. Taking it a step further, neobank APIs can enable payroll companies — or employers themselves — to offer white-label banking solutions directly to employees.
Indeed, neobank APIs could help transform banking into a central component of an employee’s financial wellness. This has the potential to strengthen the relationship between employers and employees, while providing employees with the tools to better manage their cash flows. Over the long-term, neobank APIs could have a transformative impact on financial inclusion. This is the case even in the US, where 25% of the population was underbanked prior to the COVID-19 shock (read our take on how fintech can help bend the curve for the underbanked.).
Our investments in this category include Rev Worldwide and Challenger (Disclaimer: while Challenger is not a LEAP portfolio company, one of our Partners is an angel investor in the company).
The Future of Fintech is Contextual
The combination of open banking APIs and embedded financial services has ushered in a new, exciting era of contextual financial services. In this era, trusted brands will offer timely, relevant and often customized financial services directly to their customers. These solutions could adapt to the customer’s changing financial reality and these trusted brands need not be traditional financial services companies. Consequently, there are undoubtedly several game-changing fintech applications that we have not even considered yet.
The era of contextual financial services is just getting started. It might get increasingly difficult to gauge the “winners” as the ecosystem evolves. But as a starting point, we recommend you follow the data flows and follow the money flows.
