“We spent more than $9.5 billion in technology firmwide, of which approximately $3 billion is dedicated toward new initiatives. Of that amount, approximately $600 million is spent on emerging fintech solutions—which include building and improving digital and mobile services and partnering with fintech companies.”
– Jamie Dimon (CEO of JP Morgan), 2016 Letter to Shareholders
The financial services industry is increasingly acquiring the “tech” suffix as Silicon Valley takes aim at one of the world’s most profitable and highly regulated sectors. This change not only brings with it new technology, but a need to attract and develop talent that have the skillset needed to operate in this changing environment. Organizations are also grappling with how to simultaneously foster innovation and entrepreneurial risk-taking while also ensuring stability and financial prudence.
What Is Fintech?
How should we define “fintech” and what can be considered actual versus forecast? Fintech is the popular label for an emerging market sector that uses technology to make financial systems more efficient. It is a similar phenomenon to disruptions in industries like media, communications, and retail, where the application of technology has created a unique set of companies and services that are taking a share from legacy players. It is also ushering in a new set of capabilities from large data analytics to trading algorithm development that is reshaping the talent market.
However, as the chart below indicates, the evolution of this change in financial services is still at an early stage, even in the United States, one of the world’s most advanced digital economies. Globally, fintech represents less than 1% of the global financial services industry, versus ~10% for eCommerce and ~40% for digital media.
Investment in fintech is growing, with VC investment in the sector reaching $13.6 billion in 2016 though still a very small amount given the $11 trillion global financial service industry. To put this into context, Facebook alone raised $16 billion in its 2016 IPO to compete in the $2 trillion global media industry. While early signs are promising, we are still early in the lifecycle of the fintech industry.
There are five traditional areas of financial services that are seeing a lot of innovation:
- Payments and money transfer: Verifying identity and creating accounts in which to store money (e.g., bank accounts), tools for depositing and withdrawing money (e.g., checks and debit cards) and systems for securely exchanging money between different parties (e.g., ACH).
- Borrowing and lending: The consumer institutions that collect money from savers and then provide credit to borrowers (e.g., credit cards, mortgages, or car loans)
- Wealth management: Advisers, brokers, and investment managers who provide advice on and execute transactions related to financial investments (e.g., investing in the stock market) and retirement and estate planning (e.g., pensions and annuities).
- Insurance: Both property and casualty insurance (e.g., car insurance, homeowner insurance, or health insurance) as well as life insurance policies.
- Currency: Nation-state-backed stores of value, unit of account and medium of exchange (e.g. US dollar, Sterling, Euro)
Traditionally, these services have been offered as a bundle by large financial institutions. But fintech startups are leading the “unbundling” charge, selectively targeting and specializing in services in order to achieve differentiation and scale quickly.
Winds of Change — Fintech Is Coming
Fintech bulls believe this sector is facing a unique confluence of technological and behavioral change.
On the technology front, we are seeing the digitization of money as financial transactions are increasingly happening over the internet. This in turn giving rise to vast amounts of data along with the tools necessary to mine it for valuable heuristics and algorithms. The proliferation of mobile is deepening and broadening access to consumers in a way that is unprecedented. A digitally interconnected user base is allowing innovations like the blockchain to fundamentally challenge the architecture of trust and verification systems.
Consumer behavior is also evolving, driven by the growing millennial workforce and the recent financial crisis. Traditional financial brands are losing trust and struggling to meet the needs of consumers for authenticity and meaning in the brands they use. Consumers are also taking greater responsibility for their financial decisions, willing to do their own research and go directly to online services instead of relying on “trusted advisers.” Finally, consumers’ financial needs are changing, as the desire for asset ownership (e.g., cars and vacation homes) is being replaced by a desire for unique experiences and instant access (e.g., AirBnB or Uber).
“I think what we came to the realization of is that the war is really against cash and against waste”
– Dan Schulman, CEO of PayPal
This is where we have seen some of the earliest and largest success stories in fintech with competitors like PayPal, Stripe, Square, Hyperwallet and TransferWise. They have built superior user interfaces on desktop and mobile to acquire customers and quickly build large peer-to-peer payment platforms. Their cloud-based and digitally-delivered services gives them what McKinsey estimates is “a 400 bps cost advantage over banks, because they have no physical distribution costs.”
As they collect increasing amounts of purchase and payment information, they will also be well positioned to develop consumer behavior analytics teams to predict purchase needs and pre-emptively meet them. One of the main challenges they face is that of security and fraud prevention, and they will have to invest in capabilities to stay ahead of digital bank robbers targeting them from basements (and government facilities) around the world.
Much of the initial success here was in peer-to-peer lending where players like Funding Circle, Lending Club, and SoFi would use an online platform to directly connect retail borrowers with lenders, providing better rates to both parties by cutting out the bank middlemen. Some also claim to use unique data (e.g., social network information) to develop superior credit scoring algorithms and, while this may become a unique competitive advantage in the future, the predictive power of current datasets is still unclear.
Recently, institutional investors have begun piling into these platforms and buying up whole loans (see image below) and the concern is that they are cherry picking the best loans. In addition to being left to invest in the riskier loans, retail investors do not have the traditional government protection (e.g., FDIC insurance) since P2P loans are considered securities. As concerns grow about loan delinquency rates, these companies will have to develop strong credit assessment and monitoring capabilities to maintain the trust of their retail lender base and not become simple loan origination and servicing portals for traditional loan underwriters.
3. Wealth Management
This is the area that sits most squarely at the intersection of the two trends I described above. Millennials are now over a third of the workforce but, faced with decreasing job security and economic uncertainty, are looking for smart solutions for generating passive future income. At the same time, they are losing trust in traditional investment advisers whose track records have been less than impressive over the past decade.
Companies like Learnvest are approaching this from the financial education angle, looking to build trust with customers through more transparent engagement and educational resources. Robinhood and AngelList are examples of services providing greater access to investments and reducing the transaction costs of making them. Finally we have robo-advisors such as Wealthfront and Betterment who use algorithms to automatically manage customer portfolios at a fraction of the cost of traditional portfolio management services. Success of these offering has forced traditional players like Charles Schwab, Fidelity, and TD Ameritrade to follow suit.
Going forward, financial literacy and algorithmic investing represent significant opportunities where technology and talent with an understanding of online education and machine learning are proving they can play a big role. Concerns will be around how “fake advice” is regulated and the dangers of flash crashes caused by systematic errors in the algorithms.
Here we see parallels to what has played out in the lending industry: A number of players like Zenefits, Lemonade, and Oscar have acquired large customer bases (including new insurance buyers) by building superior online user experiences and customer acquisition tactics. This has helped them effectively carve off the origination and servicing part of the value chain.
While some are underwriting their own policies, the majority of the risk is still being offloaded to traditional reinsurers. However, as datasets increase especially to cover the lifetime of a policy, we could see startups with big data and AI talent making inroads into the underwriting business. Companies like Zhong An (valued at $8 billion) are already collaborating with players like Alibaba to tackle new digital economy insurance needs (e.g., phone/drone insurance), while at the bleeding edge, Synerscope is looking at how IoT data on cars and other devices can be incorporated by insurers.
Incumbents are also seeing the opportunity as signalled by the recent partnership between IBM and Swiss Re to develop “underwriting solutions that rely on the cognitive computing technologies of IBM’s Watson.” The main risks (especially in the US) will be around regulatory change and how that will impact initial beachheads that have been established.
5. Digital Currencies
In 1976 Friedrich Hayek (Nobel Prize winning economist) published the Denationalization of Money, in which he advocated the establishment of competitively issued private moneys. With the advent of cryptocurrencies like Bitcoin and the underlying blockchain technology, there is again a push to make Hayek’s vision a reality. This area has the largest and most uncertain potential for change as it challenges the traditional monopoly of governments and the ecosystems that have grown around those monopolies.
We are seeing these alternatives gain attention, with Japan recently allowing Bitcoin as a legal method of payment and new regulations being developed by Europol, Interpol and the Basel Institute to protect Bitcoin exchanges and users. Here is where talent with experience working with multiple stakeholders from governments and regulators to consumer groups are proving valuable in helping to shape the rules of the game. Given the potential for the privatization of the currency industry, it’s also not surprising to see strategic corporate investors eager to ensure an early seat at the table:
You may think this is already a whirlwind of innovation—and, dare I say it, disruption—but there are a few more changes wafting over the horizon:
Nation-states Are Looking to Make the Jump to Cashless
The Indian government has stated that one of the main goals of its flagship Digital India program is “promoting cashless transactions and converting India into [a] less-cash society.” Many other emerging and developed markets are also actively steering their societies to using digital payments. In emerging markets, the benefits are clear, as it allows governments to promote financial inclusion without having to make heavy investments in physical banking infrastructure (e.g., branches). It also allows governments to crack down more easily on tax evasion and fraud while reducing administration costs. Even in advanced economies like the UK, one of the implications of Brexit has been a greater focus on the opportunities fintech provides for London.
“Fintech will transform the way we live and do business. Whether it is cashless transactions between friends sending remittances to family in other countries or apps that automatically invest savings at the best rates fintech provides consumers with better services, more choice, and lower costs.”
– Philip Hammond, UK Chancellor of the Exchequer
The recent advances made in behavioral finance are already being applied in the fintech space where the ability to quickly conduct A/B testing and precisely control user experience make it an excellent testing ground. Startups like Payoff look to understand your financial personality as a way to provide you with the tools needed to curb any non financially prudent traits. Qapital gamifies spending with users setting themselves “fines” for any guilty pleasure spending. While still in the experimentation phase, the psychologist’s mindset may have a large role to play in shaping better systems and products for consumers.
Incumbents Putting More Than Their Toes In
Goldman Sachs, the poster child for elite financial services, is developing internal fintech startup capabilities, recently launching an online lending platform called Marcus (named after its 19th century founder Marcus Goldman). Others, like MasterCard, are developing partnerships with players like Coin to expand payments into the realm of wearables. Large retail banks like CitiGroup and Spanish bank BBVA are setting up completely separate groups that are looking to reinvent these banks “from the outside.”
The challenge will be building the consensus to allow cannibalization of proven, stable legacy services, systems, and skillsets with smaller and more uncertain new innovations that have greater momentum. Torres Villa, the CEO of BBVA, articulates the challenge as “the inertia around how you’ve always done it, including the money associated with it. If things are going well, why change? Why do it in a different way if we’re making money?”
“Every act of creation is first an act of destruction.”
– Pablo Picasso
The fintech future is certainly exciting and looking increasingly inevitable. How it plays out will depend on harnessing the talent who balance the cognitive dissonance of simultaneously having an intimate appreciation for the legacy system while being able to see new possibilities with untainted eyes.