The Fintech Boom
The boom in consumer facing fintech startups is a global phenomenon. From Silicon Valley and New York, to London and across Asia and Australia's financial hubs of Singapore, Hong Kong and Sydney, startups offering tech-enabled payments, currency exchange, crowd funding, online lending and wealth management services are sprouting and competing with traditional retail banking and financial services firms. The number of fintech startups is difficult to pinpoint, but data sources and industry watchers estimate that Asia has approximately 2,500 fintech startups while the U.K. and the U.S. have a combined total of 4,000. Even these estimates are best guesses and underestimate the true count, since fintech startups that haven’t received funding are likely not to be documented in any database.
The investment in these startups has been growing as well. According to CB Insights, since the beginning of 2010, more than $24 billion has been invested in fintech startups worldwide. More than $11 billion of that amount was invested in the first three quarters of 2015. The data provider cites that the fintech sector has averaged 50 exits per quarter, giving investors a long list of success stories.
What explains the boom? The credit crisis of 2008 and the heavy level of financial services regulation that followed created a perfect vacuum of innovation in banks. Following the credit crisis, banks have been slapped with several new regulations and dealt heavy fines and penalties for non-compliance. Regulators have forced banks to contain their risk taking by imposing new compensation rules and requiring more liquid assets and Tier 1 capital. This has forced banks to pay more attention to their back offices and spend more on compliance and risk management programs than ever before. Meanwhile, front-office, client focused talent pools, once happily employed and generously paid by banks are moving into the technology and startup arena. Fintech startups have been able to create business models which avoid the structural formalities of being a bank, while providing a more efficient means of serving customer needs. For example, marketplace lending, with players such as Lending Club and Prosper in the U.S., represent a fintech category where the lack of capital stringent capital requirements on newer players has provided far better returns for these new upstarts compared to traditional banks. This brain drain, lack of innovation by banks and low cost of technology platform development has resulted in the fintech startup boom that is much talked about today.
The Uniqueness of Fintech
Several other startup sectors have also experienced a boom over the last five years. Data analytics, on-demand services, SaaS and others have seen innovation, investment and a flurry of new startups being formed. But fintech seems to have some unique characteristics. "Fintech is different from many other startup sectors because the financial world is heavily regulated and mostly consists of a relatively few number of large, well-established firms.” says Houman Shadab, a law professor at New York Law School, who also chairs the annual fintech conference which has been held by the school for the past two years. The professor’s point is an important one which explains the esoteric nature of fintech. The relatively high level of regulation surrounding financial services is the same worldwide and for good reason. Financial services, after all, handle people’s assets, retirement savings and hard-earned salaries. Regulation protects the retail banking customer and average investor while also keeping the entire system in check. Because of this, fintech founders tend to be, on average, a decade more experienced than their counterparts in other startup sectors. Fintech founders are often people who have worked in banks and bring strong domain knowledge and a deep understanding of the processes and problems which need to be fixed. The opportunity for them to implement their ideas and create solutions, without the heavy baggage of legacy systems, makes the fintech entrepreneurship startup route all the more appealing.
The Challenges Facing Fintech Startups
But not everything is coming up roses for fintech founders. Small fintech startups face many hurdles before they can achieve their mission. Regulation is a barrier for many fintech startups that need to establish themselves globally. For example, money transfer and mobile payment platforms startups eventually need to expand beyond their home country to facilitate international payments and gain scale. Regulation just to establish in one’s home country can be daunting and expensive. Legal fees to file and apply for licenses can be a burden on an early stage startup. The U.S. alone has ten regulating bodies which oversee different parts of the financial sector and additionally each state has its own rules and regulators. Relatively speaking, the UK and Singapore have friendlier rules for fintech startups that are setting up. Gerben Visser who runs the Singapore Fintech Consortium explains, “It might not be immediately apparent, but there are more than 100 fintech startups based in Singapore. The heavy involvement of the Monetary Authority of Singapore (MAS) in fintech activities is a positive development for Singapore which will attract founders. The MAS has affirmed its strong commitment to fintech by committing $225 million to the Financial Sector Technology & Innovation scheme.”
Expansion and scaling is a hurdle for startups in any sector, but for fintech startups it can be a monumental challenge. The varying and complex nature of regulation in each country means that cross-border expansion becomes an expensive legal and compliance undertaking for fintech startups. Justin Hall of Golden Gate Ventures, which has invested in eight fintech startups, notes that “Not only are startups required to learn local laws and regulations, but their networks are usually not as robust, so it's much more difficult and time-consuming for them to work their way up to the relevant decision-makers. Many times, they're unable to do so, handicapping their ability to expand into other jurisdictions.” Startups that have already established a strong brand in their home country and proven their value may have an easier time gaining traction and acceptance in other markets. Preparing for cross-border expansion requires a strong commitment to marketing and pitching in all the regions where the startup eventually wants to do business. When the market regulators and consumers can see the value of a new fintech service, the founders are likely to have more success in their expansion efforts. Janos Barberis, who runs Fintech HK advises, “Start-ups need to articulate to regulators the value-add they provide to the financial markets as a whole. Pitching your idea to the regulators should take the same level of care as to an investor. In the same way that you need funding to scale, regulation can either allow you to grow or not.”
Finally, there is the issue of cyber security and the risk of a cyber attack on fintech startups. Startups at a seed or early stage growth may not have the funding to establish the same level of protections that large banks might have in place, but it is a very real risk that grows as more customers join and use a fintech platform. The ideal scenario would be to have a full-time Chief Information Security Officer, but it’s not a realistic proposition. Few early stage startups can afford a dedicated function and staff. There haven’t been any large scale cyber attacks or data breaches in the fintech startup world just yet and so founders may not think of this as an urgent point to address. But they should heed the warning given by FBI Director, Robert Mueller at RSA’s Cyber Security Conference in 2012, “I am convinced that there are only two types of companies: those that have been hacked and those that will be.” Consulting experts in the cyber security area recommend that startups have data protection protocols and recovery procedures which can react quickly to a cyber attack or threat and isolate an issue. Others have advised startups to store as little sensitive and personal data as possible. The choice is either to create the right level of protections and defenses or to devalue the type of data held by the company in the first place.
Bank Innovation Programs
The boom and the challenges of fintech beg the question of how banks are responding to the fintech revolution. Today there are sixteen bank-backed corporate accelerators around the world which are investing in fintech startups. The banking sector is one of the leaders in adopting open innovation and setting up accelerator programs. These programs are setup with the strong notion that banks must quickly address the threat of disruption and engage with startups. In reality, while fintech startups have certainly innovated new platforms and gained traction among retail banking customers, the scale of their achievement, whether measured by lending or investments is still a small sliver of the retail banking market in developed nations.
Banks that are based in developed markets should approach their innovation programs with a well-thought out strategy. The current open innovation trend, while admirable and a good step in the right direction, lacks aim. Too many banks are entertaining a wide variety of fintech startups ranging from mobile payment apps and data analytics platforms to trade finance and crypto currencies. It is difficult to pinpoint whether banks are intentionally exploring every category of fintech startups or whether innovation haste has led to a wide net being cast to “catch as catch can.”
Open innovation teams should be adopting a more structured approach which is rooted in strategy. Bank leadership teams need to clearly articulate where they want to focus their innovation efforts by taking a long term view of what they want their bank to look like in the future. Open innovation programs should focus on a few fintech categories which are strategically important to the bank and then focus their activity engaging with selected startups on prototyping, scaling and marketing those solutions and services which drive strategic growth.
On the flipside, fintech startups should choose their bank partners carefully. Entrepreneurs shouldn’t carelessly join an accelerator just because of a bank’s brand or the prestige factor. But at the same time, forming a strategic relationship or accepting minority investment from a global bank might prove to be a smart growth strategy which can mitigate some of the challenges of regulation and expansion and eventually lead to a strategic exit through acquisition. The key is to identify a complementary fit between the startup’s growth plan and the bank’s strategic needs.
The reality is that banks won’t be disappearing anytime soon. As much as they stand to be disrupted by fintech startups, they can also be strategic collaboration partners which enable fintech startup success.
This article is part two of a two part series. Part one covered the evolution of fintech and the role of banks in the context of fintech startups.
