The changing world - digital upstarts are going deeper
It’s been a well-documented phenomenon that legacy players in financial services have been losing ground to some digital upstarts. The likes of Square, Stripe, Lending Club, and others have been making great strides in moving from being primarily UX-focused startups to offering some exciting infrastructure.
The world of finance has been turned on its head thanks to the digital revolution brought about by FinTech companies. While incumbent banks were busy investing billions on new home-grown technologies and platforms to deliver improved services, tech startups raised cash from VCs and built cheaper alternatives. The next stage in this race begins now as an industry. FinTech is moving downstream into deeper areas of financial services such as lending, cash management, and capital markets that were once the big banks’ preserve.
FinTechs earned their place by putting the customer first and placing their experience at the center
At the start of the FinTech revolution, the best way for startups to steal market share from incumbent financial institutions was to offer a better user experience on problems related to information retrieval and key transactions.
Like the rest of their digital upstart brethren, FinTechs obsessed over the customer experience. They achieved notoriety by designing user-friendly interfaces that reimagined the way customers conducted the most mundane financial tasks, delighting customers and earning fans in the process. Nimble teams allowed rapid testing and feature iteration cycles. Infused with a design thinking culture, this created a flywheel of innovation in these growing companies.
Excellent customer experiences has resulted in skyrocketing adoption rates of these products.
Innovation in the financial space thus far has been driven mainly on the front-end within these specialized offerings, by improving customer-facing facets of financial services.
Here is a side by side comparison design agency, UXDA, conducted of the banking UX of a large bank vs. its digital-first competitor:
HSBC Bank
Chime
App Store Rating: 1.9 stars
App Store Rating: 4.7 stars
Behind the curtain
The back-end of finance consists of the established infrastructure that banks use. These "rails" allow them to distribute and service customer transactions, process and settle payments, finance new loans, provide financing, hedge risks, monitor the credit portfolio of borrowers, secure settlements and cash transfers across jurisdictions, and more.
Behind the intuitive customer experience and beautiful interface, a fintech startup’s back-end largely follows the same processes as incumbent institutions. Some examples:
When a user makes a payment through Venmo, gets a loan through SoFi, or invests in Betterment, the user is not using an entirely new financial system. These firms utilize the same legacy infrastructure that banks use.
Users who delight in the intuitive savings ideas and seamless cash transfer of products like CashApp, Chime, Acorns - don’t see the behind the scenes cobbling together of different banks, compliance, custody and other vendors.
A customer who likens doing a peer-to-peer foreign exchange on Transferwise to a breath of fresh air cannot appreciate the almost impossible feat achieved - considering the inherent complexity of cross-border payments
Every single fintech innovator needs a set of financial services to build their businesses. The collection of services needed is shared across all markets. Some of these services include payment processing, compliance, custody of alternative and traditional assets, accounts for individuals, businesses and retirement programs, trusted transaction settlement, reporting, escrow, debit cards, and (especially in crypto) fiat on/offramps and liquidity.
The traditional bank core systems – FIS, Fiserv and traditional trust company core systems, SunGard, Innovest and others – are expensive, slow and cobbled together with decades of processes and regulatory changes. Their ability to change and to handle non-traditional business models isn't in line with the pace at which digital upstarts want to move. This is a significant roadblock to fintech innovation.
Continuing to rent these underlying platforms and relying on a purely front-end driven business mode won’t sustain in the long term. Profitability will always be under pressure as the costs to use the rails will always be higher than the incumbents since they are renting them. As middlemen, they are at the incumbents’ mercy, which presents a survivability risk - incumbent institutions can turn the lights off at a whim.
Historically, there have been obstacles to smaller firms building their own rails
Infrastructure companies are complex. It takes a significant amount of time to get off the ground, particularly if you’re in a regulated industry. Several key factors have resulted in the concentration of core capabilities amongst a few large financial institutions who have the scale and budgets to support the required on going upkeep of these platforms.
Some of these inhibitors include:
Technology budgets: Reliability and stability are a significant factor for core infrastructure. Investing in the engineering required to meet regulator mandated resiliency requirements is an expensive endeavor. Smaller, regional banks cannot easily match larger banks’ level of technology investment in digital capabilities and channels.
Regulatory upkeep: Mckinsey’s research shows that “investment in strategic and business-enabling programs is further constrained by the “change the bank” spending these firms must direct to essential maintenance and regulatory initiatives such as the Fundamental Review of the Trading Book (FRTB) and trade surveillance.”
Large banks like Citigroup alone employ over 30,000 team members to keep up with growing regulatory scrutiny within their compliance divisions.
Product expertise: In certain niche products, regional and national banks may lack sufficient expertise and market presence to price competitively. As a result, their investments in transactional flow products often suffer from lower profitability relative to larger banks. And yet, to remain competitive, they feel compelled to retain these offerings.
User Volume: To make the costs work, FinTechs have needed user volume to justify the investment to build out the infrastructure. The rails are only as good as the number of people transacting on them. No one has historically been able to compete on those levels.
As more customers flock to FinTech experiences, increasing funding has followed, unlocking opportunities that were previously cost prohibitive
Over the past decade, driven by a surge in customer growth, investments have ballooned from $2 billion in 2010 to over $50 billion in venture capital in 2018 and on-pace for $30 billion+ this year).
The combination of a large user base and skyrocketing funding is allowing these Fintechs to now focus on the underlying plumbing and infrastructure of finance
According to research by Saison Capital, disruption in the back end (rails) is happening across three major categories:
Aggregation
Commercial Optimization
Technical Optimization
Aggregation
The main value proposition of aggregators is the seamless gathering of processes and data. This aggregation mainly occurs because multiple industry players are required to build parallel one-to-many networks. In turn, they are combining many existing flows into one flow.
The arbitrage lies in the inability of banks to serve the needs of the few. New rails merely enable basic ‘UI arbitrage.’
For example, Plaid acts as an intermediary between apps (like Venmo) and your bank so that you can log in and share data securely. As simple as it may seem creating these connections is difficult because of the varying specifications of APIs, legacy technology, and inconsistent user experience across all the financial institutions a new FinTech would have to connect to. By taking on this challenge centrally, Plaid makes it easy for developers to offer this capability without the upfront development cost and the long-term maintenance burden.
The same principle applies to credit reports, payments (Stripe), and card issuances (Marqueta).
Commercial Optimization
Strategy in a commercial optimization business model is about recognizing the new paths created by technological or other changes and figuring out how to explore them. It's about identifying new market spaces that will emerge and figuring out the issues, constraints, and opportunities that these spaces contain.
Root insurance is a great example of a FinTech leveraging data and technology to change the underlying commercial model of a business. Traditional insurers use static data like a user’s DMV record, age, and credit score to determine premiums. By leveraging technology Root is able to determine premiums using live driving data as the most determinant factor (in addition to the more traditional factors). This allows Root to offer up to 50% lower pricing on insurance.
Technical Optimization
The technical optimization business is one where the primary value proposition is on providing a better technical approach to do something. Such an improvement can be better efficiency, higher accuracy, or greater convenience. The critical point is that the product itself delivers some improvement over current alternatives.
Robinhood made waves when it announced that it would self clear its trades. Clearing is the trusted transfer of securities and funds between the buyer and seller, an essential function on Wall Street. A small number of online brokers are self-clearing, while most rely on a third party like Apex Clearing to clear the transactions.
At the time - this was a momentous undertaking as clearing systems have been around since the 1960s. In two years, a team of 70 engineers, designed and built a clearing platform from scratch using modern technology. The achievement unlocks an end-to-end view of their customer’s transactions for Robinhood. And more importantly, allows Robinhood to innovate and scale more nimbly relative to peers who still rely on legacy clearing solutions.
Other examples of newer fintechs going in deeper: Dapi.co, PIX UPI, Rtgs.global, Whatif.io, Moov, Bill.com, BronID AML/CTF Toolkit, Icomplyis, Eco.com, Deserve cards, Square / cash app, Ripple, Bankshift, Tink, Rapyd, Pasar Polis, Bond Technology, Cover Genius, Oy!, Setu, and Treasury Prime.
What does the future hold?
There is no doubt that fintech has shaken up the world. Several innovations have been created, many of which will impact and transform the future of personal finances as we know it. Fintech will continue to disrupt financial services in staggering ways over the next decade.
There is no apparent limit as to how big fintech can be or how radically it can reshape our society for the better. It’s true, we are only just beginning to understand the potential of fintech and how it will permeate into every aspect of our lives.
However, in ten years, banking and wealth management for Millennials might look like Amazon does now.
Sources
“How ‘Trading as a Service’ Unlocks Opportunities for Banks.” McKinsey & Company, 22 Mar. 2021, www.mckinsey.com/industries/financial-services/our-insights/how-trading-as-a-service-unlocks-opportunities-for-banks?cid=other-eml-alt-mip-mck&hdpid=2dd341a9-ee7a-4c53-90fa-9bfe6572a98b&hctky=11560250&hlkid=2e02913354064a89a5f968a602b14685.
Penn, D. (2020, December 22). Building Better: A Look at Fintech’s Infrastructure Revolution. Retrieved from https://finovate.com/building-better-a-look-at-fintechs-infrastructure-revolution/
Kennedy, S., O’Brien, M., Ross, M., Speakers, M., Barbetta, B., Nishiyama, A., … Dunne, D. (2020). Upgrading fintech infrastructure: Don’t forget the incumbents. Retrieved from https://www.wellington.com/en/insights/fintech-infrastructure-incumbents-us/
A. (2020, October 15). Fintech Infrastructure: Classifying and framing investment decisions. Retrieved from https://saisoncapital.com/fintech-infrastructure-classifying-and-framing-investment-decisions/
PWC Fintech Global Report. (2016). Retrieved from https://www.pwc.com/il/en/home/assets/pwc_fintech_global_report.pdf
Fintech and Banks: Four Ways Banks Can Respond Better | Toptal. https://www.toptal.com/finance/investment-banking-freelancer/fintech-and-banks