Is Fintech - Finally - Gaining Ground?

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By Knowledge@Wharton

Technology is changing the global financial system so rapidly, the World Economic Forum recently noted, that there is an "urgent need" to set standards and develop regulations. While the "use of technology in finance is not new, nor are many of the products and services that are offered by new entrants to the sector," the group pointed out, "it is the novel application of technology and its speed of evolution that make the current wave of innovation unlike any we have seen before in financial services."

The report, developed with input from leaders of the world's biggest banks, grew out of discussions at the group's annual gathering in Davos, Switzerland, in January, where the focus on financial technology, or fintech, was so intense that Bloomberg News ran a story headlined, "Biggest Global Banks at Davos: We're All Fintech Innovators Now."

At its simplest, financial technology - or fintech - applies technological innovations to financial processes, products and services. The attention to fintech has accelerated quickly. In 2014, big banks began shifting focus in earnest toward fintech and away from the regulatory compliance issues and cost-cutting fallout from the economic crisis. That year, global investment in fintech ventures tripled, to $12 billion - mostly in the U.S. - from $4 billion in 2013. In 2015, investment in private fintech companies rose nearly 60% more, to $19 billion, according to Citigroup and consulting firm CB Insights.

And investing in startups is only the beginning.

Bank of America spends $3 billion a year on what it called "technology initiatives" in its annual report. Likewise, JPMorgan Chase (NYSE:JPM) chairman and CEO Jaime Dimon wrote in his annual letter to shareholders the bank spent about $3 billion on new investments in technology last year.

Dimon said that the bank has built its own "extraordinary in-house big data capabilities - we think as good as any in Silicon Valley - populated with more than 200 analysts and data scientists." The data those techies are crunching is being used to court new customers in commercial banking, to improve underwriting and marketing, to make the bank's operations more efficient, and, of course, to optimize trading, Dimon said.

The interest in fintech from major banks reflects the fact that the digital market is barely tapped. Citi estimates only about 1% of North American consumer banking revenue has shifted to new digital business models so far. It forecast that figure will rise to 10% by 2020 and 17% by 2023. And it points out that the shift is already well underway in China, where top fintech companies like Alipay and Tencent (OTCPK:TCEHY) have as many or more clients than the biggest banks. Greg Baxter, Citi's global head of digital strategy, notes that 96% of all online sales in China are conducted without a bank.

Fintech is no longer a niche.
- Matthew Carey

The potential for losing market share to startups is just one of the reasons big banks are pouring money into their own technology, as well as startup ventures.

"Digital disruption has the potential to shrink the role and relevance of today's banks, and simultaneously help them create better, faster, cheaper services that make them an even more essential part of everyday life for institutions and individuals," wrote Julian Skan, managing director in financial services at Accenture, in a 2015 report. "To make the impact positive, banks are acknowledging that they need to shake themselves out of institutional complacency and recognize that merely navigating waves of regulation and waiting for interest rates to rise won't protect them from obsolescence."

Fintech - No Longer a Niche

With major financial institutions moving into the fintech space at a rapid clip, where does that leave the startups? To some, it means fintech is no longer pigeonholed.

"Fintech is no longer a niche," writes Wharton alumnus Matthew Carey, the co-founder of Abaris, an annuity comparison site that has raised $720,000 in two rounds of funding according to CrunchBase, in a post on the school's Entrepreneurship Blog. "Where once venture capital firms scoffed at the burdens of launching a startup in financial services, there are now few sectors generating more attention."

Carey points to a comment last summer from Goldman Sachs CEO Lloyd Blankfein that the venerable investment bank is now first and foremost "a technology company" as proof that fintech has entered the mainstream.

But while money and attention is flowing in from banks and venture capital, so far fintech is getting less attention on a wider scale.

Saikat Chaudhuri, director of Wharton's Mack Institute for Innovation Management, says the lack of visibility is due in part to fintech being such a broad term, with some portions that seem immediately viable, some that are more difficult to envision and some that are aimed at markets outside the U.S.

"If you think about fintech in terms of Paypal (NASDAQ:PYPL) and Apple Pay (NASDAQ:AAPL) and Google pay (NASDAQ:GOOG) and everything else 'pay' - as an alternative to, say, credit card payments or direct deposits - that's already in action," he says. "That's happening in a world of innovative devices."

The next major step for payment services is likely growth in less developed countries that can use mobile devices for payments, "not so much a substitute, but an enhancement," Chaudhuri says. In emerging markets where banks have far less reach, for example, new platforms can be exploited to serve the unbanked market.

MasterCard (NYSE:MA) President and CEO Ajay Banga, for one, has for years beat the drum about the inefficiencies of cash and the potential for digital payments in countries where residents who have no access to banks already carry mobile phones.

"It's not just an alternate payment channel, it's that we're allowing other entities in the system to act as banks." -Saikat Chaudhuri

"That addresses a whole new market and it really addresses the unbanked market," Chaudhuri says, noting that the technology could also serve U.S. consumers who don't use banks. By some estimates, up to 50 million Americans don't use banks or use them minimally, and mainly rely on alternative financial providers like check cashers, a potentially huge new market for fintech companies.

Citi data shows that 73% of the investment in fintech last year was dedicated to personal and small business banking, including 23% into payments and 3% into money transfer.

Another area with enormous potential that has been a bit slow out of the starting gate is peer-to-peer lending, especially those platforms that are integrated into social media.

Online platforms that match borrowers and lenders have been around for a decade, but account for less than 1% of total retail loans outstanding in the U.S., and, according to Citi data, at current growth rates would just crack about 3% by the end of 2018.

Chaudhuri says regulations are still a challenge for this portion of fintech, especially those with a social media component. That may contribute to slower growth despite the vast potential, but it also depends on what lending arenas are targeted, especially after the housing market crash.

"It's not just an alternate payment channel, it's that we're allowing other entities in the system to act as banks," he explains. "The way that it would have to proceed, is that some of these big online properties and social media would really need to almost apply for a banking license. I'm not sure the regulators, after what happened in the financial crisis, would allow for that."

Investors are piling into lending, however, with 46% of the capital deployed in private fintech companies going to that arena, according to Citi.

Virtual Currencies in Murky Territory

Also in murky regulatory territory is digital currencies. Bitcoin and its cousins are already in use, of course, but many see alternative currencies as mainly a way to facilitate underground transactions. The technology behind them however - officially called "distributed ledger technology" but more typically referred to as the "blockchain"- is of great interest to large financial institutions.

What Wall Street is most interested in is the underlying technology of the crypto-currencies.
- Ron Quaranta

"What Wall Street is most interested in is the underlying technology of the crypto-currencies," says Ron Quaranta, chairman of the Wall Street Blockchain Alliance, a trade association.

True believers claim blockchain technology can transform international financial transactions in much the way the Internet transformed communications. But with players from startups to Goldman Sachs (NYSE:GS), Citi (NYSE:C) and BofA (NYSE:BAC) developing their own versions of the blockchain, how they might work together is still up in the air.

"We're very early into understanding how firms interact with each other in a blockchain world," Quarant says. Nevertheless, he expects the technology could some day extend "up and down the chain of financial services and capital markets."

In fact, he envisions that the blockchain, which incorporates the ability to trace individual transactions, will someday extend to other industries as well. The entertainment industry, for example, could use distributed ledger technology to ensure that every time original content is copied, royalties are paid to the creator, thus limiting the revenue-draining problem of intellectual piracy.

Digital currencies received about 3% of the capital spending by private fintech companies last year, Citi data showed.

Overall, the pattern in any technology sector is well established, Chaudhuri says, and he doesn't expect fintech to be very different. Startups disrupt the landscape, then larger actors step in and "carefully cannibalize" the technology, either through M&A or developing their own versions. "In turn, that's what legitimizes the technology," he says.

Still A Young Cycle

The fintech cycle is young, and there are still a lot of players and designs at all levels. A shakeout of both the technologies and the companies behind them looks to be inevitable at some point.

"We haven't seen that yet, which is why you are seeing this amount of money being spent," Chaudhuri adds. "We're in the middle of it right now. Some things will work out and others won't." He notes that fintech applications are for the most part new approaches to doing business that's already done. "These are just alternative technologies. I don't think it's a sector in itself."

That's not to say fintech applications don't have powerful potential, though it may take many years, even decades, for them to fully emerge. "In terms of the number of the number of people who can participate in the financial system and in transactions, I think it's revolutionary," Chaudhuri said. "The traditional system kept so many people out of the system, I think this is going to fundamentally change that."

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Republished with permission from Knowledge, the online research and business analysis journal of the Wharton School of the University of Pennsylvania.

Disclosure: None