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FinTech in the Face of Rising Rates and a Possible Recession

December 2022

Analyzing the Impact on Business Drivers and Revenue for Six FinTech Sectors

Low-interest rates and an ebullient economy greatly benefitted the FinTech sector over the past decade. But the dramatic turnaround in Fed policy, driving up interest rates by almost 400 basis points in just 5 months, with another 75-100 basis points expected over the next two quarters, will significantly affect the FinTech market. But not all sectors and business models within those sectors will be affected equally or in the same way. This Viewpoint describes the impact of higher rates and a slowing economy on major business models in each FinTech subsector and provides examples to shed light on what’s happening. This Viewpoint has two goals: 1) to give you a framework to think about how rising rates and a slowing economy will impact the FinTech sector, so you can do your own analysis and brainstorm about the effects on your own business or your portfolio holdings, and 2) to share our thinking of how we expect rates to hurt or benefit individual business lines across different FinTech sectors. In each FinTech subsector, there are specific factors that rates will impact: in Digital Lending it is Net Interest Margins, in Payments it is Transaction Volumes, and in Capital Markets, rates impact volatility which drives securities trading volumes. To deeply understand the impact of rates on each FinTech subsector, it is essential to dig deep into how each business makes money, what its revenue equation is, and how that equation is impacted by rising rates, directly or indirectly.

In each FinTech sector, there are business models that are not directy impacted by rising rates, and we don’t cover those in this Viewpoint. There are also firms that provide picks and shovels to customer-facing providers in each FinTech sector, and they will experience a second-order affect of rates via an impact on their clients. We don’t discuss those service providers in this Viewpoint either.

Broad Observations and Implications of Rising Rates on FinTech

·        Rising rates and a weaker economy will expose stark differences across sectors and between firms within a sector. Low rates and unbridled investor enthusiasm in the last few years meant that the rising tide lifted all FinTech boats and marginal players also got funded. But the new economic environment will separate winners from losers. Differences in business models (balance-sheet or capital intensive, transaction or volume-based, SaaS-driven, Spread or commission-based), pricing power, operating leverage, and even the quality of management teams will emerge

·        Rising rates impact the business and financial performance of FinTechs with a lag. The effect was not fully evident in Q2/Q3 2022 financial results for the 54 public FinTechs that we track. Analyzing the Q2/Q3 financial results of public FinTechs reveals that they are still performing well, growing revenue and driving key performance metrics for the most part. Exceptions are firms like Coinbase or Robinhood who are highly exposed to the Crypto market so their revenues have contracted severely. The full effect of higher rates will become evident in the financial results of FinTechs over Q4 2022 and Q1/Q2 2023, so investors should brace themselves for additional impact as the financial condition of some public FinTechs worsens going into 2023

·        Incumbents may regain their advantage over FinTechs in newly emerging market conditions. Private FinTechs benefitted from abundant, low-cost equity capital in the last few years which fuelled rapid customer acquisition, product development, and overall growth. In every FinTech subsector, it gave upstarts valuable time and resources to grow and compete with incumbents. But as rising rates and a slowing economy make private capital more expensive and less available to FinTechs, it could improve the competitive position of incumbents and traditional financial institutions. As higher rates squeeze the spigot of private capital, FinTechs will need to refocus on unit economics, profitability, and organic growth to drive customer acquisition

·       Higher rates drive-up the cost of funds for all financial companies but there are differences - across sectors, and between firms within the same sector. Sectors like consumer banking are more directly sensitive to rates (than Payments or InsurTechs) as it drives their cost of funding for lending operations. The second dimension is that even within a sector, two firms could be impacted differently depending on their particular sources of funding. A large incumbent consumer bank like JPMorganChase has better access to capital than a consumer FinTech like Chime, so a rise in rates may affect JPM less than Chime

·        Great uncertainty lies ahead. How FinTech sectors actually perform in 2023/2024 will greatly depend on the pace and extent of the Fed raising rates, and how the economy responds. A soft landing versus a hard bump in economic growth could have widely different implications.

Let’s analyze the impact of higher rates and a slowing economy on six major FinTech subsectors.

Challenger Banks

Challenger Banks are a bundled set of offerings with different business and revenue models under a single firm. Mature Challenger Banks like Chime, Revolut, NuBank, and others like MoneyLion, have several revenue lines across banking, payments, lending, investing and insurance, which will each get impacted differently by rising rates. We will cover the impact of higher rates on these revenue lines within the respective sections below.

Challenger banks that have large transaction-driven business models (payments, remittances, rewards, etc.), shouldn’t be impacted directly by rising rates. Their drivers are payment volumes and the average interchange fee which remains largely unaffected by rising rates. But their business model will come under pressure if the economy weakens meaningfully in 2023 or hits a recession making customers curtail non-essential purchases.

Challenger Banks that have a bank charter will do better in a period of rising rates and a slowing economy than non-banks. Most Challenger Banks have not secured bank charters and are dependent on third-party bank partnerships (Cross River, Silvergate, Sutton, Thread Bank) for services they offer. Such firms may not be able to respond nimbly to changing market conditions compared to firms that have their own charter.

Firms with special products like Early Wage Access (pioneered by Chime) should fare well as consumers use them to bridge cash flow needs in a tough economy. The drivers for these are the number of customer accounts and the services they subscribe to, and the monthly fees per account. There are also firms (e.g. Digit, N26), that charge monthly subscription fees for premium services that they offer. An economic slowdown may hurt such revenues as customers cut back subscriptions to these premium services.

Digital Lending

The basic revenue equation in Lending is: the volume and dollar value of loans originated (credit cards, lines of credit, BNPL, mortgages) times the Net Interest Margin (NIM), minus Charge-offs that lenders need to deal with as rates rise and the economy slows. Unlike Challenger Banks which has many different bundled offerings so teasing out the impact of rates is tougher, the Lending sector is more straightforward and Net Interest Margins are the single biggest driver of revenue for this sector. Rising rates are good for most types of lenders but could have a mixed impact on others.

The big story in lending is that Secured vs. Unsecured Products have different exposures to rising rates. Higher rates push down volumes for secured products like mortgages and auto loans while volumes should not only hold up but grow for unsecured products (personal loans and credit cards) as consumer “balance sheets” become weaker and people try to bridge their short-term income and expense gap.

Higher rates generally help lending businesses as their NIMs rise, but a lender’s funding source matters greatly. Lenders that rely on high-cost funding sources like private investor capital in exchange for equity may not be in as good a position as traditional lenders like Citi or Bank of America (or Challenger Banks with a bank charter) that have customer deposits that can be loaned out.

If the economy weakens from higher rates as expected, delinquencies across both secured and unsecured products will rise, although ultimate credit losses will depend upon metrics like employment, income, and personal savings of consumer households. How the value of collateral for secured loans holds up (home and car values) will play a big role in determining ultimate losses as well.

Tightening underwriting standards may reduce the availability of credit — especially for those who need it most. Lenders with a largely prime customer base will benefit from increased NIMs, while those with subprime customers will likely pull back lending volume — or face the risk of increasing delinquencies. Subprime lenders may benefit from an inflow of near-prime customers who get bumped-off prime lending platforms that deem them to be too high a risk in a rising rate environment. This inflow could soften the impact on sub-prime lenders (which a lot of FinTechs are) from potentially higher defaults and delinquencies.  

One sector within lending that has been very popular in prior years – BNPL, is experiencing a tremendous reversal of fortune due to increased cost of capital, a shift in consumer spending from discretionary to essential spending, and tighter credit spreads. We can expect further pressure on these models in 2023, which is already evident in the public stock price of firms like Affirm and in the lower valuations of privates like Klarna.

The biggest impact of rising rates on the lending sector that is already evident is in Housing. There are three issues here: a drop in refinancing volumes, the high proportion of adjustable rate mortgages (ARMs), and a slowdown in new home loans. US home refinancing volumes have plummeted in Q3, and Q4 numbers may come in even lower than that. A lot of lenders make money off refinancing so revenue for these firms will suffer greatly. Second, the growing percentage of adjustable rate mortgages (ARMs) could be a significant issue as rates rise. ARMs now constitute 10% of all mortgages, up from 4.5% in 2020. When rates are low, ARMs pose no problem. But when rates rise suddenly, ARMs become an issue as homeowners struggle to make monthly mortgage payments that suddenly shoot up. Consider the $93Bill of 5/1 ARM mortgages taken out in 2017 at an average rate of 3% that will reset this year at 7%. This is bound to drive-up defaults and delinquencies. The third issue is new mortgage origination for new homes sold. With 30-year fixed mortgages for confirming loans climbing to 7% from 3.5% just 12 months ago, home prices are declining, and new mortgage originations have hit their lowest mark since 2019. This is bad news for all the RealEstateTech firms out there, and we are already seeing the stocks of public firms in this sector like Rocket and Open Door hit hard as the housing market takes rising rates on the chin.

Payments

Payments is a sector relatively unaffected by rising rates and a slowing economy and performs much better than other sectors in tough economic times. This sector has historically continued to deliver growth through both rising and falling rate cycles and also during recessions, making it the most resilient of all FinTech subsectors. Neither volumes nor pricing have been meaningfully impacted during business/economic cycles in the past. We analyzed a 15-year period during 2003-2018 when the Fed funds rate rose significantly during 2004-2007, then declined precipitously during GFC over 2008-2009, and then started rising again in 2016-2018. As the chart below illustrates, debit and credit transaction volumes have grown over that entire period of time, despite the ups and downs in the Fed funds rate. Processing volumes for the big card networks (Mastercard and Visa) during the global financial crisis didn’t show a demonstrable decline over the long term. Their YoY growth rate may have slowed but overall volume didn’t decline.

This demonstrates the resiliency of the Payments value chain even during periods of rising and falling interest rates. If history is precedent, we can expect the same to happen in this period of rising rates.

There are two deeper insights about transaction volumes. There is a slightly different dynamic between credit and debit card transaction volumes. The former are pressured more by higher rates and economic activity while the latter are more resilient to higher rates. The second insight is that transaction volumes for discretionary items (new cars, restaurants, luxury goods) usually take a hit while essentials like education/healthcare are not impacted as much.

The revenue equation for this sector is straightforward: Payment transaction dollars multiplied by Network Usage fees. Both factors remain relatively unaffected by rising rates, at least initially. But if rising rates remain high for a sustained period of time and begin pushing the economy into slower growth and a recession, then Payment transaction volumes can eventually decline, pulling down revenue for these firms.

Capital Markets

Capital Markets tends to be a feast or famine business, with prospects for this sector greatly determined by the economic and market cycle. But firms in this sector perform differently at various stages of the market cycle. While interest rates don’t impact trading businesses directly, they have a secondary impact via two other drivers – transaction volumes and bid/ask spreads. The core revenue equation for capital markets companies is Trading Volumes times the Spread. The fate of a lot of firms in this sector is eventually driven by this simple equation. Both trading volumes and Spreads tend to rise with rising rates, although the impact of rising rates on the former is not always a straight 1:1 correlation.

A rise in rates, especially when it happens at the rapid pace like this time, is accompanied by higher market volatility, albeit delayed by a few quarters. We analyzed a 30-year relationship between the fed funds rate and the VIX and noticed that the VIX lags movement in the Fed Funds rate as the full impact of rate increases takes several quarters (to a year) to show-up in volatility. Sometimes higher rates cause an immediate response in higher volatility while other times, it takes a quarter to several quarters to impact volatility.

Higher market volatility generally results in widening spreads and usually drives up trading volumes, significantly boosting profitability for firms in this sector. This year, the VIX has averaged 24 (touching as high as 36) after hovering in the teens for much of 2021. High volatility drives trading volumes with the correlation between average daily volumes (ADV) and VIX ranging between 0.6 and 0.9. During periods of market stress and upheaval (like those driven by quick and big interest rate changes), this correlation rises quickly and drives towards 0.9, as happened several times this year. A deeper insight is that volumes correlate with volatility up to a certain point, beyond which institutional participation declines as investors get into a “wait-and-see” approach. We have not seen this happen as yet but it could materialize in 2023 if the economy enters into a tailspin. Since high VIX levels drive-up average trading volumes, they especially benefit market makers like Virtu, Two Sigma, and Citadel Securities.

We must mention that the Capital Markets sector includes businesses besides Sales and Trading (which we have discussed above), including Investment Banking, M&A advisory, etc which have their own sensitivity to rates. For e.g., higher rates make it more expensive for Private Equity firms to pay for acquisitions which could drive changes in M&A deal volume, and the type of funding that such acquirers utilize in funding deals. Lastly, rate-sensitive products like margin accounts and securities lending benefit from rising rates although their volumes may decline in a falling market.

Wealth/Asset Management

There are multiple revenue models in wealth management, with the same firm possessing multiple offerings across these models. The bulk of assets managed in this sector is based on Advisory fees, which includes traditional asset managers like Blackrock and Fidelity Investments as well as robo advisors like Wealthfront and Betterment. As mentioned above, the revenue equation here is AUM times the Management Fee.

Then there are Commission-based models adopted by Financial Advisors like LPL and Raymond James. The revenue model here is simply trading volumes times the commission rate. Commission rates don’t tend to be impacted by rising rates or the economic cycle. The third, less popular model is subscription-based financial and budgeting apps like Acorns and Stash. Their revenue equation is the number of customers times the average monthly fee.

Higher rates impact Wealth Management adversely for several reasons but the biggest factor is that rapidly rising rates often result in market declines and lower equity values which directly impact the level of Assets Under Management (AUM) – a direct driver of fee revenue.

Consider the change in AUM for two large asset managers over the last year: Blackrock and Invesco. Their AUMs declined 21% and 18% between Q1-Q3 2022, almost in line with a 25% decline in the S&P over this period. What’s the connection with rising interest rates? As rising rates push down market valuations across the board and pressure the stock market, it leads to lower AUM and consequently lower investment management fees for asset managers like Blackrock and Invesco. Investment management fees for these two firms declined commensurately (16-17%) to AUMs and the overall S&P500 over this same period.

Besides market activity, the other key variable affecting total AUM is the Net Flow of Assets. Analyzing Blackrock’s change in AUM between Q1-Q3 2022 reveals that of the 21% decline in its AUM, the majority is due to market activity, and only 5% is driven by Net ouflows or redemptions. So the bottom line is: AUM levels at Asset managers are largely driven by Market Gains/Losses which is greatly correlated to the pace and extent of interest rates.

But not all investment managers and advisors are impacted equally. Smaller, specialized investment managers like ARK Invest that are exposed to high-beta stocks, could be impacted very differently than larger money managers. ARK Invest’s AUM between Jan 2021-Jan 2022 declined 60%, significantly more than the S&P500 or the AUM level of larger money managers.

Robo advisors have also surprisingly bucked the downward market trend this year by registering portfolio inflows, some at a 20-40% growth, even amidst a very challenging market environment. This is somewhat perplexing but may be driven by retail investors looking for an inexpensive avenue to manage investments after being burnt from the onset of this year’s bear market.

One final point is that a rising rate environment drives investors to reallocate portfolios tofixed-income to capture higher yields, at the cost of rotating out of higher-margin equity investments. This has implications for the revenue of investment management and wealth firms, by benefittingfixed-income advisors at the expense of equity managers.

InsurTech

There are two revenue equations for InsurTechs that are relevant to rising rates and a slowing economy. Underwriters are driven by the number of policies written, the average premium per policy, and event-related payout rates. So basically its the number of policies X premiums minus any Claims paid. Rising rates generally do not have a big effect on the number of policies, premiums, and payout rates, although a softer economy could dampen new policy origination. Economically-sensitive products such as Mortgages may perform adversely during a recession as the value of the collateral may sometime dip below the loan value, which may increase the risk for mortgage insurers, but the majority of insurance products are not necessarily interest-rate sensitive.

The second revenue equation is invested assets X the return on these assets. While the underwriting side of InsurTech’s business is not rate-sensitive, the investment side of the business is rate sensitive, which are of course premiums that are invested. Rising rates help insurers earn higher yields from their fixed-income portfolios of longer-dated securities, which constitute a majority of their portfolios. We can see this in the net interest income (NII) of public InsurTechs like Lemonade and Oscar which has risen nearly two-fold from a year ago. Lemonade’s NII in Q3 2022 is up 333% YoY while Oscar’s NII is up 676% during this period. Across all Insurers, 45-65% of assets are allocated tofixed-income securities: Life and Annuity firms allocate 45% while Property and Casualty carriers allocate about 65%. So the investment income for P&C carriers will be even higher than for L&A during rising rates as they allocate a greater proportion of invested premiums tofixed-income assets.

Conclusion

Rising interest rates can be the kryptonite for financial assets. No other single metric affects the prospects of financial companies and FinTechs than rates with both primary and second-order impacts.

This Viewpoint began with a bird’s eye view of how rising rates will impact the FinTech sector overall and then delved into the specific impact on six different FinTech subsectors. In each sector, higher rates impact different revenue and business drivers and the sensitivity of each sector varies to rising rates and a slowing economy. For example, higher rates will lift-up the net interest margins (NIMs) for Digital Lenders driving up their Net Interest Income (NII). Similarly, higher rates drive changes in asset allocation by investors as they increase exposure tofixed-income securities which raises the investment income for InsurTechs who maintain higher allocations to Bonds. That’s a big change from prior years when theirfixed-income portfolios earned very low yields due to record-low interest rates.

It is too early to see the full affect of rising rates and a slowing economy on the FinTech business right now. It will become evident in the business and operating performance and the financial results of private and public FinTechs, over Q4 2022 and Q1/Q2 2023. The FinTech index of 54 publicly held firms is down 70% YTD as of December 8, 2022 but more pain could be ahead for firms exposed to the negative affects of rising rates and a slowing economy.

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