The growth of fintech is having a profound impact across financial services with digital transformation set to accelerate the division between winners and losers. However, the discussion on the outlook for the sector is often framed as the rise of fintech and the demise of the incumbents. While complacent companies are certainly at risk of disruption, a zero-sum outlook assumes all incumbents are standing still, ignores regional variations and the recent experience where fintech ambitions are increasingly focused on collaboration.
Given the hype associated with often nascent technology, we feel it is important to have a more nuanced view and to distinguish between the different types of fintech as each segment is operating at a different stage of development, customer adoption and regulatory framework.
We outline below some of the key fintech themes, investment opportunities and challenges for the incumbents.
Payments
The payment space includes some of the most successful fintech companies and are a core part of the team’s fintech investments (PayPal, Mastercard, Visa, Adyen). With cash remaining the dominant form of global transactions (c80-85%) and only 8-10% of all electronic transactions being fully digitized, there is a long path of structural growth ahead. There are some uncertainties related to regulation (PSD2), competition from QR-based payments in emerging markets as well as the future role of blockchain and distributed ledger technology (DLT – discussed below). However, the long-term drivers for digital payment growth remain powerful (rise of e-commerce, contactless payments, smartphone/wearables penetration) and, unlike many other fintech segments, payment companies are highly profitable, have low capital intensity and offer strong visibility on earnings growth.
P2P
In the aftermath of the financial crisis, peer-to-peer (P2P) lenders benefited from the withdrawal of credit by traditional lenders, offered attractive rates by leveraging online efficiencies and focused on disrupting the incumbents. The enthusiasm for P2P as a disruptive force has waned – with listed P2P stock prices well below their pricing at IPO – following mixed performances by the leading players with asset quality issues impacting both On Deck and LendingClub, and slower growth following tighter regulation (China). The business models at Zopa (banking licence granted in 2018) and Funding Circle (increasingly reliant on institutional funding) have evolved at the same time as traditional UK lenders have reacted to improve their online SME offering (NatWest’s Esme loans; Santander’s partnership with Kabbage). Consequently, the distinction between P2P disruptors and traditional lenders has blurred, collaboration has increased (Funding Circle’s partnership with Santander and RBS; 60% of LendingClub’s originations are funded by banks and other institutional investors) while Zopa’s moves to gain a banking licence highlights the funding cost advantage that comes with government-backed deposits. We expect P2P models to continue to evolve as they look to gain scale and would need to see more evidence of asset quality performance through a cycle (and the potential impact on their funding) before turning more positive on the investment opportunities within this segment.
Blockchain and DLT
One area of fintech that has the potential to be truly disruptive – and has attracted significant attention – is blockchain and DLT. However, it remains in its early stages of development and direct investment opportunities are limited. Given inefficiencies in transaction banking and particularly the SWIFT correspondent banking model, fintech and banks are exploring the potential to use DLT for remittances, cross-border B2B payments and interbank settlements. Banks are at the forefront of this investment,
spending c$1.7bn pa, with the industry moving past the proof-of-concept phase with >75% of projects expected to be live within two years. Consequently, while certain bank fees are at risk from fintech innovation (TransferWise’s cost of remittance transaction is 10% of a bank’s cost), banks are investing heavily in the next generation of the financial system’s rails [platforms/networks to move money from payer to payee]. This can be seen in SWIFT’s partnership with R3’s Corda (an open-source DLT consortium)
which is trialling linking SWIFT GPI’s member banks with DLT-enabled trade. The key point is that the incumbents including banks and payment companies (Mastercard has 80 patents on blockchain) are positioning themselves for the next generation of payment rails which offer a more secure, faster service and have the potential to materially reduce costs. Control of the back end of the financial system’s architecture, that requires a co-ordinated and ubiquitous solution that has regulatory approval, suggests
that fintech models are more likely to remain focused on front-end innovation (TransferWise is built on top of traditional payments rails).
Banks
The banking landscape has changed materially in the past few years with the emergence of digital neo-banks (Monzo, N26, Moven) while recent regulatory changes are likely to accelerate a transition under way in the sector. Open Banking (UK) and PSD2 (Europe) require the sharing of bank-held customer data, with customer approval, to third parties through APIs (application programming interfaces). Open Banking remains in its nascent stage and customer adoption has been slow but the shift to an open ecosystem is likely to heavily influence the future shape of the industry.
However, the claim that banking is facing its ‘Kodak moment’ ignores the response by the incumbents and the considerable advantages that come from cheaper funding, large customer bases, high regulatory barriers to entry and control of the back end of finance. Customer acquisition costs in retail banking are relatively high (£200-£500 per customer for robo-advisers) leading to an increased focus on partnerships with banks for fintech firms looking to achieve scale. As noted with DLT, banks are also
outspending technology companies in terms of fintech R&D (c$3bn per annum by JP Morgan and Bank of America) while fintech companies are increasingly opting to collaborate with banks as a distributer (OnDeck and JP Morgan), technology supplier (Bud and First Direct) or as a result of M&A (Simple Bank and BBVA). Banks are also responding with their own digital offerings with Goldman Sach’s consumer-lending franchise – Marcus – quickly gaining scale (over $3bn in US consumer loans issued since
2016).
The emphasis on collaboration rather than competition does not mean banks can afford to be complacent and the winners in an open banking world will be those that can leverage an efficient cost structure to offer competitively priced products and emb race a digital strategy (DBS Bank noted online clients were 42% more profitable than their ‘traditional’ clients). Nordic banks are at the forefront of mobile banking adoption and have improved efficiency by dramatically reducing their branch network (Swedbank and
DnB have cut branches by 60% and 80% respectively since 2008). Innovation in account aggregation (ING’s Yolt app) and flexibility in structure will also be important factors as the sector evolves – BBVA chose not to integrate Simple Bank after its acquisition in 2014 in order to retain its distinct approach and customer base.
As investors, we are excited about the evolution of the sector. Innovation in payments, lending and savings will continue to broaden our investable universe with fintech becoming an increasing proportion of the funds. The rapid development in the sector prompted by technological and regulatory changes inevitably carries risks to incumbents who do not adapt. However, there is a lsosignificant opportunity for those traditional banks that embrace digital transformation and leverage the advantages associated with
a cheap funding base, high regulatory barriers, large data sets and customer trust in handling savings. Given the high valuations often attached to fintech (Monzo and Revolut are at ‘unicorn’ status despite uncertainty on how they will grow profitably), investors should not overlook opportunities with traditional players who are well positioned for the future while the losses suffered by investors in P2P IPOs highlights the requirement for a selective approach to fintech investment.
Written by George Barrow of Polar Capital
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