The Rising Buzz About Fintech
17 Mar 2020The financial technology sector is gradually resembling the golden age of social media in the 2010s. The social media revolution constituted a continuous wave of hyper-growth startups, now household names including Facebook, LinkedIn, and Twitter. They raised mega financial rounds and exited in temporal proximity. Looking back, these media products entirely changed the perception of digital technology for individuals and businesses. Similar phenomena can now be observed in fintech and will only become more visible as more major liquidity events hit news headlines.
Not only are newcomers introducing new ways for consumers to interact with financial services via technology, incumbents are also investing heavily into utilizing in-house built and third-party software products to win the growing customer expectations. End-users could expect actions from all players in the market: startups are introducing new channels for millennials to manage investments and acquire loans, banks are partnering with software companies to offer a modern digital experience, and even non-financial institutions are launching financial products to control customers’ spending habits. Angela Strange of a16z made a bold prediction stating “nearly every company will drive a significant portion of its revenue from financial services”, which in fact could become a reality given how emergent fintech services are simplifying the steps to create new revenue streams. Payment processing, credit card issuing, white-label compliant software services, one-tap transactions - innovative methods are constantly being reimagined and all that a company has to do is to integrate for pilot. Rising cohorts of fintech unicorns and a seemingly endless stream of private capital to back various initiatives mark the thrilling zeitgeist of this industry.
The Driving Forces of Financial Innovation
In the lending space, there are three key forces pushing for modernized loan processing, states Tim Mayopolous of Blend (also my current affiliation). Consumers, investors, and new market entrants are defining a new set of digital standards in a traditionally paper-driven industry. The kind of frictionless and personalized user experiences that consumers enjoy on Netflix and Amazon would eventually become the ubiquitous expectation in financial services, forcing all players in the lending market to rethink how to incorporate digital solutions.
In fact, zooming out from lending and refocusing on fintech holistically, the same paradigm shift is happening across payment, banking, personal finance, and insurance. Plugging the three key forces into most fintech equations, we see that 1) consumers demand seamless and accessible financial transactions with a few taps on their phones, 2) investors rely on modern data analytics tooling to extract quality insights for decision making, and 3) new market entrants build on top of a maturing fintech infrastructure to reach wider distribution. A whole new generation of financial products were unlocked by smart phones and cloud infrastructure. And the trend shows more aspects of the financial market will be digitalized despite regulatory challenges.
The driving forces of innovation are even provoking the biggest financial institutions to adopt forward-thinking initiatives motivated by the risk of losing market share. Now that fintech startups are challenging incumbents with direct-to-consumer products, incumbents are incentivized to collaborate with fintechs to launch better digital offerings in a shorter amount of time, forcing other legacy players to adapt or to become irrelevant. For instance, an increasing number of banks are partnering with fintechs to provide digital banking solutions to traditional retail customers, all while reducing in-house IT spending. A win-win situation could be achieved when banks leverage efficient digital products to drive additional revenue and fintechs indirectly acquire banks’ customer networks to reach tremendous scale. Whether a fintech is partnering with or challenging incumbents, consumers are the ultimate winner with more innovative, secure, yet simple financial products to pick from.
Innovative Startups in Financial Services
When you fuel an industry with abundant cash and applicable technologies, many valuable companies will be created. This explains why regulatory complexity does not hinder the financial services sector from being dynamically adaptive and ever-changing. So far there are dozens of fintechs reaching unicorn status across the globe. Although most valuations are still speculative, the surge of innovative ideas merging software and financial services is unparalleled. But what innovations are making the giant leaps in financial services? The current landscape of high-growth fintech startups indicates most innovative ideas are manifested in the following ways.
- New Business Model: Fintechs are introducing new consumer interactions and lowering the barrier of entry by leveraging mobile, data, and cloud infrastructure. A few tweaks in business models, such as zero trading fees and fractional homeownership, could move the needle based on the premise of universal internet access and software automation.
- Improved Efficiency and Automation: Value creation is straightforward when productivity increases and cost decreases. By harnessing the power of software to automate manual processes, fintechs are putting wealth management on autopilot, reducing time to acquire loans, and simplifying payroll management. Or to say - let software do the work.
- Emergent Software Infrastructure: Assume the total addressable market of fintechs keeps on growing in the following years, then one of the safest bets an investor could make is perhaps to put money in software building blocks that any other fintechs would need. Whether it is tooling to integrate with banks or become banks, more innovative products will emerge and they are fascinating to learn about.
Among the topics on the next fintech trend, there is a common thread about new startups being built in banking-as-a-service, fintech infrastructure, full-suite fintech apps, and new B2C/B2B marketplaces. A quick Google search will find you numerous predictions about the future of fintech by industry leaders. There are also heated debates about the use of artificial intelligence and blockchains in fintech. No doubts, these emerging technologies have a great potential of disruption and democratizing them is the million dollar question. Ideas like crypto lending platforms are one of a kind in the financial services space, but it could still take years for these emerging applications to become mainstream. However, as it seems there is still plenty of room for disruptive innovations.
The Tech Challenges
Despite being in a drastically different industry, fintechs share a fair amount of technical challenges as software startups in other industries. Great software engineers from Facebook who work on media related problems should have no problems ramping up at Coinbase, a fintech company building a crypto trading platform, and vice versa. This is because the fundamentals of building a large-scale software system are universal. Just to name a few: authentication/authorization, system monitoring, databases management, and network security are challenges found in most software systems designed to scale. Fintech startups are expected to invest significantly into their technical infrastructure to meet the business demands, and it is difficult to cleanly offload development work because of the evolving nature of an application.
If we rule out the fundamental technical issues, there are also many challenges unique to a fintech company. A difficult hurdle to start and scale up a fintech business is the regulation requirements inherent to the financial services industry. If the product fails to comply with the regulation of your concern, the cost could be hard to recover (whether it is financial penalty and prison time). The tricky problem is exactly how to make sure the software complies with the laws 100% of the time. For example, under the TILA-RESPA Integrated Disclosure (TRID) rule, a mortgage lender is required to provide the borrower a form detailing loan fees and limiting fee changes within three days after starting a mortgage application. Any violations could result in fines ranging from $5,000 to $100,000 per day until the issues are mitigated. To satisfy the demand of the legal system, the business would need deliberate software automation combined with manual scrutiny to ensure the product is error-free. The technical complexity naturally grows when the system is expected to be fully compliant under various regulations.
The Uncertainty Ahead
What goes up must come down, especially in speculative valuations. A growing number of growth-stage venture capitalists believe that a retrenchment in the broader private market is looming. Besides the impacts from the macro market, there are also questions around the appropriate valuation methods (ie. using SaaS multiples or book value multiples) for correctly evaluating a late-stage fintech. The general wariness could lead to fewer risk-taking projects for innovation and shrinking market value for fintechs.
Nevertheless, it is an exciting time for the financial services industry. Thousands of startups and banks are launching new initiatives to make the previously cumbersome financial process more transparent and simple. As we move onward in the decade of the 2020s, it wouldn’t be surprising to see more fintechs become household names and bring on game-changing solutions. This technological shift in the financial services sector could and should make people’s financial lives better overall.
Thanks to Mark Goldberg, Rinko Shen, and Rohan Varma for feedback.