Peering into the Crystal Ball
The FinTech movement kicked into high gear in 2020 driven by the COVID shutdown giving a boost to all digital finance models. Thirteen FinTechs went public in 2020, there was a massive step-up in the valuations of FinTech Unicorns led by Robinhood, Coinbase, Stripe, Oscar and Chime, and M&A recovered nicely by the end of the year. Our FinTech Banking group hosted a webinar in December 2020 and wrote a Viewpoint recapping key FinTech trends in 2020 that are available here.
In 2021, we expect the FinTech movement to continue and even accelerate in certain areas as firms evolve and mature into their next phase of growth to FinTech 2.0 and 3.0 in some sectors.
There are four over-arching themes in financial services that will define the state of evolution in 2021, two pertaining to enterprise-facing B2B businesses, and the other two being consumer-facing:
1. In the Enterprise-facing space:
• New markets are being created, as new assets get digitized and tokenized
• Across financial services, new infrastructure is being built, which will be the rails on which modern finance will run in the future.
2. On the consumer-facing side:
• FinTechs are becoming full-service entities, applying for banking licenses and getting regulated, bringing them directly in competition with traditional financial institutions. But many of these firms are smartly laying off risk on the back-end, making them very popular among investors.
• Brand and loyalty in finance is being redefined by modern FinTechs like Square and Stripe.
Let’s analyze these trends by looking at brief examples that illustrate each issue. For each trend, let’s see what is happening, why it is important, and what are examples of FinTechs that are enabling it.
TRENDS IN ENTERPRISE FACING BUSINESSES
Creating new markets in illiquid financial and non-financial assets
When we think of the concept of a market, an exchange where securities are traded comes to mind. But elementary Economics defines the fundamental concept of a market as a system where buyers and sellers meet equally and transparently, creating a price discovery mechanism that leads to an agreement to exchange goods for money or barter one thing for another.
A fundamental pre-requisite of a well-functioning market is a tradeable asset, and financial securities have historically been the easiest to trade. But the future involves converting non-traditional assets (both material and intangible assets that may not even exist yet) to some form of digitized security, and then enabling such assets to be traded on platforms. There is a growing list of new assets that can be traded including art, music, real estate, as well as personal consumer data, and intellectual property rights. Over time, a new class of investable and tradeable assets could emerge beyond financial securities forming the basis of next-generation wealth management, driven by digital assets.
But well-functioning markets like securities exchanges require a set of players and participants, and a market infrastructure, that allows buyers and sellers to conveniently and cost-effectively exchange securities. An example of an asset where a market infrastructure is rapidly being built to trade such an asset is the secondary trading of private securities. Until recently, trading private securities has been manual, expensive, opaque, with a great asymmetry of information that caused wide spreads. But smart FinTechs are building out infrastructure for the private market to drive greater transparency, liquidity, and trust into this space. The idea is to extend the price discovery process that we take for granted in the public equity market, and extend that to private securities.
Carta is a great case study of a firm building out infrastructure for the private market. Starting as a cap-table-management company, it has assembled one of the largest databases of private companies, who the shareholders are, what funding rounds they have had, the types of securities they have issued, corporate governance rights, etc. With the launch of CartaX, a platform to trade private shares, the firm is well positioned to grow even further. With growth in the Private Market expected to grow handsomely for many years, there are major investment opportunities to fund players like Carta that provide fundraising, trading, and fund administration services for private securities.
Another example of a firm involved in developing and fostering new marketplaces of tomorrow is Figure. It has helped 20,000 homeowners unlock $1.1Billion of home equity by digitizing it, so it can be traded on the firm’s blockchain-based marketplace called Provenance. There are three benefits of this: 1) it creates secondary market liquidity, 2) allows real-time bilateral settlement, and 3) significantly reduces custody and servicing expenses, a huge issue in homeownership. The firm has delivered an average of 120 basis points in savings to homeowners representing $5-6 billion in overall savings.
The long-term promise of digitizing assets and making them tradeable will eventually herald a new era in wealth management, widely expanding the universe of investable assets. Think about digitizing new assets like art, music, and even intangible assets like personal consumer data, and making it available in fractional shares, or via tokenization to retail and institutional investors. Examples are StockX and FanDuel that are digitizing things like personal consumer goods or fantasy sports, allowing them to be traded by investors. ErisX is a digital currency exchange and clearinghouse that has applied to the CFTC for approval to trade futures contracts for NFL games. Bakkt allows consumers to unlock the value of digital assets, including cryptocurrency, loyalty points, in-game assets, and gift cards, while giving merchants and loyalty program sponsors greater customer engagement and cost savings.
Infrastructure for the crypto market is rapidly building up
For many years, Crypto enthusiasts had been waiting for greater institutional adoption to take place, as that would provide greater legitimacy and pave the wave for further growth of this business. In 2020, greater institutional adoption finally began to happen, and the momentum will continue in 2021 and beyond. With greater institutional interest, a range of FinTechs, service providers, and traditional financial institutions like Fidelity Investments has begun to roll-out pieces of a full infrastructure stack required to support crypto, replicating the pre-trade, trade, and post-trade services that exist in securities trading.
This is causing a landgrab among big crypto players who have begun acquiring key assets to build out their platforms and service offering. Coindesk is expanding beyond its media platform and bought TradeBlock to give it analytics and trading tools needed by crypto investors. Coinbase – one of the biggest success stories in the crypto market and expected to go public in Q1 2021, bought Tagomi last year as the foundation for its institutional trading business and recently acquired the trade execution platform Routefire.
One example of building out crypto infrastructure is the rise of securities-style prime brokers. A few, including Genesis Trading and BlockFi, are early entrants and building formidable businesses. BlockFi provides a critical piece of crypto market infrastructure that is required to attract and support institutional interest in this asset class. It offers critical borrowing/lending facilities for crypto that traders, investment funds, market makers, and other crypto-related businesses like crypto ATMs, require to serve customers. Arbitrageurs often need to borrow crypto in order to take advantage of mispricing between exchanges or dispersed markets. Similarly, margin traders need to borrow to execute trading strategies. Just like OTC desks need to keep inventory on-hand to meet client demand, there is a growing demand for crypto lending services.
2021 will see rapid growth in the development of infrastructure in the crypto market creating lucrative investment opportunities for investors. A good example of infrastructure being built in the crypto market is Stablecoins, which we discuss next.
Stablecoins slowly emerge as part of settlement infrastructure
The current interbank settlement market infrastructure (Fedwire and CHIPS in the US, CHAPS in the UK, CNAPS in China, net settlement systems like BACS) has been used for global interbank payments for almost 30 years now with little change. While this infrastructure works quite efficiently, it involves many intermediaries, taking many days for international payments to process, and with multiple points of potential failure. This creates systemic risk and additional costs. One of the biggest costs is the liquidity buffer that the top 30 banks have to maintain to manage this risk. Oliver Wyman estimates that the top 30 banks reserve $250 billion in such capital buffers, with almost a quarter of it to meet intraday needs.
Some of these issues can be potentially addressed by crypto infrastructure running on blockchain like Stablecoins. The OCC’s announcement in early January allowing US banks to use public blockchains and dollar Stablecoins as settlement infrastructure in the US financial system is a big boost to innovation in money settlement and a perfect example of a trend described above: new infrastructure being built for modern finance to operate on, which could support the next generation of financial products like digital assets. The OCC’s approval allows banks to treat public blockchains as infrastructure similar to SWIFT, ACH, and Fedwire, and use Stablecoins (like US Digital currency) as electronic stored value. Other countries (ECB, the Chinese Central Bank) are also moving ahead to legitimize the use of Stablecoins as settlement infrastructure.
There are three crucial implications of the growth of Stablecoins: 1) Being more stable than cryptocurrencies, they hold greater promise to replace fiat currency, 2) it allows the blockchain to serve as alternative rails to current payment infrastructures like ACH, FedWire or SWIFT, and 3) it gives BigTechs the ability to enter Payments and better compete with incumbent financial institutions.
Circle’s CEO Jeremy Allaire says that the growth of Stable coins and their greater legitimacy is proof that decentralized, permissionless, internet-mediated software could one day very soon become the foundation for modern finance.
Financial products are being embedded into non-financial activities and services
The next example of modern infrastructure being built for financial services is Embedded Finance (EF). The Rosenblatt banking group has deep knowledge of this space and has covered it extensively at our FinTech Summit in 2020, and in several Viewpoints we have written on the topic.
The broad concept of EF is now well understood by most market participants. Financial services are increasingly being ‘embedded’ or deeply integrated into the fabric of a customer’s life. Furthermore, these services are being increasingly distributed by non-financial companies, both BigTechs like Amazon, Apple, and Google, or by thousands of vertical software companies. The most advanced use case for this is in Payments, with the best example being embedded Payments in ride-sharing. So why are ride-sharing companies like Uber and Lyft, ecommerce companies like Shopify, and all types of vertical software providers incorporating Payments into their service offerings? For two major reasons:
· It allows them to offer customers a seamless UI/UX that greatly improves customer satisfaction, increase loyalty, and reduces switching
· It expands the total addressable market (TAM) for these firms by giving them an opportunity to earn a profit on the Payments they enable.
While the embedding of financial services into non-financial services may have started in Payments, it is rapidly happening in Lending, Insurance, and even in the embedding of crypto trading into other services. In the Brokerage industry, Drivewealth is a leader that helps FinTechs and other firms in spinning out new trading services within their platforms.
Two powerful examples of the power of embedded finance are Stripe and SoFi. In December 2020, Stripe rolled out a product called Stripe Treasury, an API that embeds financial products (FDIC-insured savings accounts, debit cards) directly into Shopify’s platform, offering over a million merchants ‘out-of-the-box’ financial services. An important element of this arrangement is that Stripe doesn’t take balance sheet risk and doesn’t have to be regulated as a bank, as it has partnered with Barclays, Citi, Evolve, and Goldman Sachs at the back-end.
SoFi acquired Galileo in 2020, which gave it access to millions of customers through Galileo’s APIs, supposedly used by over 90% of modern FinTechs. Galileo powers Robinhood, the money transfer company TransferWise, the Challenger Bank Chime, and thousands of other companies. Galileo is a perfect example of a growing set of firms rapidly building out infrastructure for companies to embed financial services into their service offerings. With this acquisition, SoFi is able to partner and serve-up services to financial, technology, and ecommerce businesses much more easily than it could have done alone.
TRENDS IN CONSUMER FACING BUSINESSES
FinTechs mature and evolve from 1.0 to 2.0
2021 will further demonstrate how FinTechs are maturing and evolving from 1.0 to 2.0 as they move from customer acquisition to greater customer monetization, using sharper tools like customer segmentation to deliver a higher value proposition. Examples of FinTechs evolving to a 2.0 model are: Challenger Banks like Chime getting more sophisticated by offering services like early-wage access, or HM Bradley offering interest-rate tiering checking and savings accounts that pay a certain interest rate proportionate to the account holder’s savings rate. These are great examples of Challenger Banks thinking creatively how to serve customers in alignment with their needs, compared to traditional banks that often charge fees that seem excessive like $35Bill in overdraft fees in 2020.
Another example of the evolution of FinTech is next-generation Buy Now Pay Later (BNPL) companies that offer POS lending solutions that are deeply integrated into a merchant’s offering, giving customers a much better ‘buy and borrow’ experience. Firms like Affirm and Klarna have done exceedingly well recently, with the blockbuster IPO of Affirm earlier this month. The economics of this new crop of BNPL players is especially compelling compared to traditional lenders, as they don’t depend on lending fees and spreads, but get paid a commission for ‘converting’ leads into sales for online platforms like Shopify. Both Affirm and Klarna earn almost 45% of total revenue from such commissions rather than generating straight lending spreads like traditional lenders.
In 2021, we expect to see more examples of FinTechs in every sector evolve their business models and service offerings, become more sophisticated, and encroach onto the turf of incumbent financial institutions.
FinTechs are becoming regulated entities and competing headlong with incumbents
FinTechs and InsurTechs are evolving from low-risk models like distributors, aggregators, and online marketplaces to risk-bearing models where they leverage their balance sheets, take risk in a principal capacity, and become full-stack service providers.
The growing list of FinTechs in consumer banking that has applied and received banking licenses include prominent Challenger Banks Chime, Revolut, Varo, and digital lenders like Lending Club. This phenomenon is not limited to banks, with InsurTechs like Lemonade and Hippo being great examples of firms transforming consumer experience of the insurance lifecycle in home insurance and home warranty insurance, across policy issuance to claims payments. While Lemonade launched as an insurer, Hippo started as an MGA but acquired Spinnaker, a nationally P&C insurer, with licenses to operate in all 50 states. Hippo Insurance’s acquisition of Spinnaker gives it access to A-rated paper while giving Spinnaker access to capital to grow its third-party programs business.
What’s driving this trend? FinTechs are moving beyond distribution and up the value chain for three reasons: 1) to control the front-to-back consumer experience, from client acquisition to service and delivery. E.g., in insurance, generating leads, quoting, binding and issuing the policy, and also settling claims, 2) to have the flexibility to offer new products and pivot into new services, rather than being dependent on their financial services partner, 3) it gives them greater legitimacy and engenders trust now they are regulated, and 4) because product distribution has become very competitive while principal, risk-bearing activities have higher barriers to entry.
‘Brand and loyalty’ are being redefined by modern FinTechs
Brand has always been extremely important in financial services and has been a driving factor for customer acquisition, retention, and growth. A new class of FinTechs (e.g., Stripe, Square) are redefining the concept of the ‘financial brand’. Rather than the traditional concept of the financial brand pushed by large banks which highlighted trust, size, and scale as important elements of a financial brand, the new concept of a financial brand being pushed by modern-day FinTechs is a firm that is innovative, approachable, cool, in-touch with customers, and ingrained in their lifestyle.
Square Cash app is a good example of how new financial brands are going to look like in the future. It has high engagement and loyalty especially among millennials and younger people, being much better integrated into their everyday lives. It brings financial activities like Payments into the core lives of consumers instead of finance being a standalone activity, distinctly separate from a customer’s life which has been the case until now with traditional Payments. If you visit the Square Cash website cash.app, you would be struck by the modern, tech-like feel of the brand, instead of the typical branding of traditional banks that often showed big pillars of a building as a symbol of trust and confidence. FinTechs like Square, Stripe and many others want their brand to come across as modern, approachable, and relatable for customers. Square has even created a Cash App “Culture”, a concept that is not traditionally associated with a financial brand.
A strong brand is crucially important for FinTechs (like Challenger Banks) that have spent millions of dollars in acquiring customers in the last few years, and are under pressure to monetize this investment (i.e., drive up their LTV/CAC ratios). With low switching costs for most digital financial services, FinTechs have to depend on a strong brand that resonates with customers and is integrated into their lives, something that stands out, and can help them acquire and retain customers.
Social finance and multiplayer finance models become popular
Historically, most financial services have been offered to customers as a pure, standalone transaction. You made a payment, got a loan, made an investment, or insured something. It was purely a transaction, with no interactive element or emotional aspect to it. But a major change is now taking place called Social Finance. Modern FinTechs and non-financial services companies are appealing to people’s emotions and tapping into their collective feelings about the financial decisions they make. By evoking people’s emotions about money and finance, companies can more easily acquire customers, retain, and drive them to transact. The magic of Social Finance happens when firms combine the interactive or social element with the transactional element, which creates a powerful flywheel affect that drives more transactions and improves customer retention.
FinTechs like eToro are bringing together communities of people who interact with each other and use the combined power of their knowledge, experience, and judgment to make trading decisions. Its Social Trading is a very effective example of Social Finance in action. People openly discuss trading strategies, sharing about their wins and horror stories, all of which evokes emotion and drives activity on the platform. It also creates brand loyalty and increases stickiness, quite different from a customer’s experience with a traditional brokerage firm like Schwab or E*Trade. eToro goes one step further by tracking the popularity of traders on its platform and giving top traders called “popular Investors” a monetary reward if they earn a certain threshold of followers. The firm is also employing Social Finance principles in crypto trading, with the deep understanding that for a lot of people, crypto evokes emotions about a democratic, libertarian attitude to life, which further ties them to eToro’s platform and drives greater transactions.
Other examples of Social Finance are firms like Early Bird, which is an app that lets families and friends gift investments to their children. Finally, Social Finance is also increasingly about non-financial companies (BigTechs like Facebook) using money and finance as a way to attract people, getting them to communicate openly about emotional issues tied to money, and then monetize their attention by selling them other services. In 2021, even more non-financial companies will recognize this powerful trend and push into Social Finance.
BigTechs are offering financial services as loss leaders for other services
With non-financial companies being able to offer financial services more easily than ever due to digital innovation and the ability to easily ‘embed’ financial technology, BigTechs and other non-financial companies are offering financial services as loss leaders to sell other services. A good example is Amazon Prime offering 5% cash-back on purchases. Or Uber offering cheap/free financial services to its drivers. This a critical issue to watch in 2021 and beyond, as it could signify how the financial industry is changing with non-financial companies offering a suite of payments, lending, insurance, or brokerage services, to simply acquire customers while actually making money selling other services. This could prove to be a competitive disadvantage for financial companies who have a less diversified revenue stream compared to these non-financial companies and may struggle to match the discounted pricing for financial services offered by BigTechs. E.g., it could be tough for consumer banks like BofA or Citi to offer 5% cashback on purchases, to match what Amazon and Apple are able to offer on financial purchases on their platforms.
Non-financial companies are also better equipped to offer cheaper, more convenient, and more effective solutions than traditional financial providers as they have better access to data. For example, Peloton is better positioned to offer health insurance than traditional carriers as it has a real-time window into the health and fitness of an individual using its equipment. Similarly, Apple can offer better health insurance with its ability to monitor a person’s lifestyle and real-time health situation using the Apple Watch or the iPhone. Tesla is offering insurance to customers and has a much better ability to price its policies with access to engineering and real-time car performance data. Contrast that to a traditional insurance carrier that prices policies based on a driver’s DMV record, which is a backward-looking and delayed metric.
Cyber security and risk threats are growing, impacting the economics of FinTechs
2020 highlighted the critical importance of cybersecurity, identity management, and privacy with the COVID shutdown and digital threats rapidly growing. These areas will continue to be hot in 2021.
An important aspect of this issue is that modern-day FinTechs carry much higher risk and cost of ensuring cybersecurity and identity management (AML/KYC), and the combined cost of these issues is beginning to drag down the economics of their business. This issue came into sharp focus during COVID, with lifestyles changing dramatically, resulting in an explosion of cybersecurity and identity failures. Some firms responded by employing the most conservative approach and denying a payment transaction at the slightest risk, called “False Positives” in statistics and probability. This meant a lost sale or greater friction in transactions that deteriorated customer experience. Deep Labs, an innovative cyber security and identity management company tackles the problem of False Positives using their “persona”-based technology that triangulates a variety of data points to validate a customer’s identity. Another good example of a company that offers a new standard for KYC is Europe-based Onfido, which provides fraud detection for modern FinTechs.
2021 will continue to drive tremendous interest in cybersecurity issues providing a big tailwind for firms that offer solutions that address fraud, AML/KYC, and privacy issues for FinTechs , financial institutions, and the many non-financial companies beginning to provide financial services.