Fintech 101: Change is Coming
Unicorns and Decacorns are changing financial services in a way like no other
A lot has happened since the last article for Margin Squeeze was released. COVID is still a thing (albeit several different variants), the wealth gap continues to grow, Bitcoin is back, and everyone loves talking about this thing called the Metaverse (for future discussion).
There is a lot to write about, but as a fintech & banking veteran, it’s only right to kick off the first article of 2022 with a discussion on fintech — a sector that raised over $132 billion in venture capital money in 2021 alone (equivalent to the GDP of all of Hungary).
But at the same time, fintechs lost about $50 billion in value while going public to retail investors through the various IPOs and SPACs of 2021. So what’s really going on?
In today’s edition of Margin Squeeze, I will be walking you through what fintech is, how I classify the different segments within, value propositions presented, if fintech is hype or reality, my learnings in the space, and the real winners.
So what is fintech? It is financial technology!
Generally speaking, if you are using technology in some sort of manner to make financial services easier, you meet the definition of fintech. The definition of fintech is broad, and this results in a wide spectrum of value generation.
The different types of fintech
Searching “fintech segments” on Google will yield a variety of results, but generally speaking, most will say there are 6–7 key business segments in fintech including payments, insuretech, regtech, wealthtech, cybersecurity, and crypto.
But what if your wealthtech offers crypto services? Your neobank with its proprietary payment rails? How do you define a company like Paypal? Things can get very confusing very fast and conversations can quickly fill up with a lot of buzzwords that lack substance.
Based on my experience in the space, I think there are really 4 key types of fintechs based on characteristics; infrastructure builders, connectors, value-adders, and goliaths.
Infrastructure builders
Infrastructure builders are the coolest and the greatest value generators in fintech (in my opinion). They build the foundations of technology to create value-generating and/or customer interactions in finance. Great infrastructure builders in fintech include the likes of Stripe, Marqueta, Plaid, Lithic, Paypal, Moonpay, and Flinks.
Of course, goes to say Mastercard & Visa are also infrastructure builders along with the Fed with regards to ACH transfers — but I believe they cannot truly meet the fintech requirement of “to improve and automate the delivery and use of financial services”… they just own their rails.
Key characteristics of infrastructure builders are that:
- Each of these players owns and manages their tech stack (each of these organizations has a lot of really talented engineers)
- Upstream dependencies that can be feasibly used as a blocker for growth are minimal (eg. Plaid would need all major banks to push back against usage to affect the product they sell, which hurts banks as well)
- The product is majority B2B and used by other fintechs as a license to operate
- The unit economics of the value proposition usually make a lot of sense
We can dive deeper using Stripe as an example to understand infrastructure builders better.
Stripe is used by Medium (the business) and by myself (the consumer) that writes on Medium to monetize my content. Stripe is a payments platform, has its tech stack managed by lots of engineers, doesn’t have too many incumbent competitors that can end the business overnight, is a platform, and from an economics perspective is something very scalable (everyone in digital payments needs to use them).
Now of course it can be questioned that Stripe is built off the existing banking infrastructure of today as a “layer” and is not truly an infrastructure builder — but my counterpoint would be that digital payments would not exist regardless of which app you use without Stripe and it’s competitors.
Connectors
I view connectors as intermediary layers of infrastructure that generally have a niche focus to start with. Connectors start with a nuanced business problem and will often eventually face the crossroads of expanding their product offering and turning into an infrastructure builder or continuing their niche focus. Connectors are often earlier stage infrastructure or just focused on newer problems that are not as mature. I also find them very exciting.
Key characteristics of connectors are that:
- Like infrastructure builders, each of these players owns and manages their tech stack (lots of really talented engineers)
- There is typically a single focus and the offering is usually a single or few APIs vs. an overall platform
- The product is majority B2B and used by other fintechs to offer a specific service, but the economics are driven by B2C interactions (conversions)
- The unit economics of the value proposition usually make a lot of sense but tech costs have likely not yet fully scaled on a unit basis (and may also never do so)
- Upstream dependencies that can feasibly block growth are minimal but are possible given lack of scale(eg. A large fintech player could purchase the infrastructure a connector depends on to force a change in business model)
Examples of fintechs that fit this criterion include Pinwheel & Atomic. both offer Payroll API connectivity layers, and both (likely) are working on increasing the variety of offerings available. While fintechs such as neobanks (value-adders) can in theory work without their products — they need them to differentiate. Another great example is ZeroHash, a fintech that offers crypto as a service to other fintechs such as neobanks.
Value-adders
Value-adders provide the interface to customers built on the foundations set by infrastructure builders and connectors. They solve real problems for customers but rely on other fintechs to package up and offer core services.
Value-adders have a generally lower barrier to entry (look at how many neobanks exist offering the same services using the same providers) in an often saturated market — but are likely the hardest to execute successfully on as a result.
Value-adders can be neobanks, wealth management tools, budgeting software, or any product that uses infrastructure builders and/or connectors to interface and solve customer problems. Examples include neobanks such as Chime and Revolut, apps such as Robinhood, Truebill, and Remitly to name a few.
Key characteristics of value-adders are:
- Unlike infrastructure builders and/or connectors, most of these players still own and manage a tech stack (still lots of really talented engineers) but the purpose is to gather data from other Fintechs
- They are typically aggregators of data that connect to a variety of different Fintechs
- The product is majority B2C where UX/UI differentiate to solve common customer problems. Churn is a real concern
- The unit economics are murkier given saturation in the space (look at how many neobank & budgeting apps advertise to you online) resulting in high CACs on a low margin product
- The value proposition to investors is growth in customers and the promise to eventually monetize better by cross-selling without seeing churn (isn’t that just a regular bank?)
- Upstream dependencies aren’t a big issue as providers can always be switched
Truebill is a great example of a value-adder. Truebill is a service that aims to help you save money on your monthly bills. In return, the company gets a cut of the money it finds to put back in your pocket. Competitors include Co-pilot Money, Mint, etc. Truebill is B2C, focuses on customers, in the end, is solving problems around budgeting (which isn't an earth-shattering problem) but does so in a really amazing and intuitive way made possible because of the APIs offered by Plaid.
Goliaths
Goliaths are large fintechs that compete with incumbents (banks, etc). They are a combination of infrastructure builders and value-adders and offer scale. They have B2B offerings, B2C offerings, offer vertically integrated embedded solutions, and have hit a point of critical mass where the value proposition is on solving problems at scale versus niche. Examples include Square/Block, and Paypal. Goliaths are the Amazon of fintech.
Key characteristics of goliaths are:
- They own and manage a tech stack that offers a mix of integrations and connectivity
- Similar to Amazon, may offer a B2B offering (ex. AWS) and use that same infrastructure to offer a great B2C experience (ex. Amazon.com). A great example in fintech is Square POS and Block.
- CAC is low given brand awareness and scale and unit economics as a result make sense.
- The value proposition to investors is growth in customers and operating efficiencies
- Regulation is the biggest headwind.
Paypal is a great example of a goliath. They own and operate platforms for merchant payments and worldwide remittance while also integrating with other fintechs to offer banking-like services through the Paypal and Venmo Apps. The business makes money and the newer tech stack gives it the ability to solve problems at scale. I believe that Paypal has the potential to crush the entire neobanking landscape by offering the same offerings as competitors if the growth/monetization balance along with the information architecture of the app can be iterated to offer an easy and effective customer experience.
Is it Hype or Is it Reality?
I fundamentally believe that infrastructure builders and connectors along with goliaths are not hype and are indeed reality.
Customer demand for fintechs grew at a record pace as evidenced by hundreds of millions of downloads in 2021 — and that's because these products are solving real problems that all of us face.
Let’s be real, access to financial services is needlessly complicated.
There will always be a demand from customers for easier, seamless, and better financial experiences and as a result, there will always be a demand for Infrastructure Builders and Connectors to power them.
While it may not seem like it today, Capital One was originally a fintech when it was first conceived to increase access to consumer credit through the adaption of risk-based decision approaches that leveraged technology.
The technology for risk-based decisions did not fully exist, and this consumer demand built a market where infrastructure was built to support these needs and allow Capital One to increase access to credit. Capital One’s investments in infrastructure that they built, integrated with, and bought are examples of why there will always be a need for infrastructure builders and connectors.
Likewise, goliaths such as Paypal and Square/Block solve so many customer problems, are so seamless, and have such scale that they can deliver solutions to customer financial problems in an extremely sustainable manner. Customer acquisition costs are low (since the brand is so well known) which open up all kind of product opportunities that would not be sustainable elsewhere.
For example, take Paypal’s consumer banking product. Everyone knows the Paypal brand, there are over 350 million users, and the overall business generated over $20 billion in 2020 revenue. That’s a brand awareness other fintechs spend hundreds of dollars per customer to acquire — money that Paypal does not need to spend on acquisition but can spend on building better products that solve consumer banking problems to create a flywheel effect of customer acquisition.
However, I believe that there is some hype when it comes to value-adders and this belief is shared by the markets (as evidenced by IPO performance).
Worrying trends of what I call WeWork metrics (Adam Neumann era) such as EBITDAM by Aspiration and similar valuation methods by other value-adder fintechs raise alarm bells in my head on financial sustainability given extremely high CACs on relatively low margin products.
Revolut’s current valuation of over $2000 per user where the average deposit volume is only $250 annually is a clear case of questioning financial sustainability. Doing some quick math using some assumptions from my own experience:
- CAC: $100 -$150
- Spend Based Contribution Margin: 0.25%-0.5% per dollar spend after basic costs such as fraud, operating expenses, API costs and assuming $10,000 in annual spend
- Other revenues: 5% of deposits in banking fees per year (avg deposit ~$250)
- $150 = [(250 x 3%) x Y] + [(0.25% x $10,000) x Y]
- Y= 4 years
Breakeven is at least 2–4 years away assuming zero churn, and the $2000 value per customer is only possible if future products such as credit or high-fee offerings in trading & crypto are offered or billions in AUM are loaded into Revolut accounts.
These product moves are all extremely difficult to deliver on in a very saturated market while also going against the current value proposition that makes products like Revolut amazing for consumers.
For example, a credit product earning Revolut a 20% return (typical credit card interest rates) on the average $250 deposit would still take over 10 years to generate $2000 in value for Revolut still assuming zero churn and not differentiated to consumers relative to other existing credit products out there.
Outside of product-market fit and a compelling value proposition, low churn rates are not realistic given how saturated the space is. For example green neo banking fintechs, Aspiration, and Ando.
Both offer green banking, both offer a similar user experience, both have similar product offerings through the same infrastructure providers, and both target the same customers. As a customer, is there a specific reason why you would choose one over the other outside of signup incentives?
While for early-stage VCs invested in Revolut and other quickly growing fintechs, this $2000 per customer valuation is an amazing return on investment — would you as a retail investor buy this promise at IPO when VCs will be selling their stock (assuming it happens)? After all, buying stock is essentially buying a stream of future cash flows at an appropriate representative price. rephrased, doesn’t the end goal for Revolut seems to be mainly a bank, so should you be investing in it like you would with a bank?
Needless to say, I still love Revolut as a consumer because the product is great, extremely easy to use, and makes my life easier — preferences change over time as does the overall market, so it’s still quite possible that financial sustainability will develop over time.
Fintech is an extremely exciting space and I highly recommend that anyone working in financial services get exposure as it’s truly customer-focused and full of innovative solutions to disrupt an industry that has long forgotten the customer.
Infrastructure builders and connectors are changing the way we interact with financial services and value-adders are opening up access to those that would typically be missed by traditional players in the field.
Specific to Value-adders that work in B2C, barriers to entry are low and as a result, there is a lot of fierce competition, and just because a fintech has raised incredible amounts of Venture Capital money does not translate into success in the public markets where the focus isn’t on raising money but on building a sustainable business with realistic future cashflows. As I write this article, Acorns canceled their public raise via SPAC with the decision to raise more money from Venture Capital and Private Equity.
When looking at fintech, it’s extremely important to think of the following:
- Products are not differentiated on features (because everyone can offer the same features) but on the user experience associated since every value-adder has the same access to technology
- Fintechs are new and are very susceptible to churn — so it’s really important to compare CAC vs. the margins of the product being sold. LTV is extremely sensitive and not many of these products have been in the market enough for a clear read
- Consolidation will likely occur through takeovers and mergers; and also just money running out. Monzo is a great example, but also a more realistic valuation
- Incumbents, such as banks, are starting to understand why consumers love fintech and are starting to respond
- Question the value proposition of a feature. For example, 2-day early payroll is a common feature in fintech that is positioned as helping avoid late fees, etc. But are features like this helping the root problem of liquidity? Or just shifting the payment cycle to turn a Friday problem into a Wednesday one?
- Innovation changes with time. A company that starts out as an innovative fintech can mature into something more traditional like a bank as assets under management increase. Capital One is a great example of this (going AWS doesn’t make a fintech, but it does result in cost efficiencies).
- Building the best tech stack leads to great customer experience — but fintechs don't control the complete tech stack. Partner banks are banks that a fintech may work with to deliver their services. Sure a fintech may use APIs to offer cost-efficient solutions that make low-margin businesses scalable, but partner banks that give fintechs a license to operate charge fees, unit costs, and most importantly — run on legacy software that the fintech needs to adapt to. Is this really an edge?
The Real Winners
The business models of all these types of fintechs may or may not be successful but in the end, two major winners come out on top.
- Consumers; for the first time in a long time, consumer needs are front and center in building products and experiences that are helpful. Financial services have needed an overhaul since inception and fintech has helped with a wide range of experiences ranging from ease of access, education, to plain and simple functionality. Seeing banks start to remove Overdraft and NSF fees is just a start to how the entire ecosystem is changing for the better for consumers.
- Infrastructure Builders & Connectors; Consumer demand drives the creation of Value-adders which further increase demand for fintechs that build foundational technology. Demand is increasing as evidenced by hundreds of millions of downloads globally, and that number will continue to grow as exposure to fintechs increases. Goliaths and similar companies in/outside of financial services are also looking to vertically integrate financial services as part of their offerings — and this will drive further demand for these foundational fintechs.
