Despite a global pandemic, fintech is in the middle of a renaissance. New fintech products are still launching, “fin-fluencers” are tweeting, Clubhouse rooms are opening up, and our parents are calling to tell us that there’s a new company called “Techfin” to try out (this really happened). The point is, anyone who has a bank account will tell you that fintech is the new big thing. Except, of course, that it’s not new at all.
So why all the buzz about fintech right now? Ironically, the reason for the fintech renaissance isn’t because fintech is new — it’s because it’s so old. The card networks and core processors that were so innovative a few decades ago have become antiquated, due to risk aversion, and good old fashioned inertia. These early fintech innovators have become behemoths, flush with cash, but too encumbered by massive operations and legacy infrastructure to be nimble.
Starting in the 1950s, innovations in financial services have made our transactions more convenient and less burdensome, with everything from credit cards to ATMs to online trading, and e-commerce. And in the process of changing the nature of our transactions, fintech has also reshaped the very architecture of the financial world. Even if you are still writing checks and walking your deposits over to the teller window, core fintech is still powering your transaction — your teller is using fintech on the other side of the window.
That combination of cash and opportunity is an entrepreneur’s dream, and it’s created a fintech gold rush. In Q3 2020, dollars invested into fintech startups increased to $10.631 billion, the second-best single-quarter tally since mid-2018. Even in the global pandemic, entrepreneurs are starting new fintech companies, card networks are acquiring and investing, and core processors have discussed further consolidation. But buyer beware: not all fintechs are created equal. If you want to get in on the new fintech gold rush, you first need to understand the three distinct business models that exist in the landscape.
(Major h/t to Aaron Frank for breaking this down in his super articulate twitter thread).
Fintech Model #1: “We’re a fintech because we’re building a tech enabled financial institution”
Fintechs in this category are making structural changes to the ways that financial products are engineered. They’re in the business of creating new versions of existing financial products — and if their financial engineering is right, they can potentially replace existing financial institutions. Whether it’s taking in deposits, providing loans, issuing cards, or buying/selling securities, they are actually touching the money, and their technological innovations center around how that money is exchanged. These companies make money on transactions, whether it’s interchange fees, interest on deposits/loans, or, for something like Robinhood, routing your stock purchase orders to different market makers as a broker/dealer. They are playing to change the game — like going from a typewriter to a PC. The tradeoff, of course, is just how much they need to get right to make this work, because there are stringent regulations and serious penalties for getting it wrong and finance is highly capital intensive.
These fintechs tend to be laser focused on the financial innovation objective that they are trying to accomplish, often sacrificing other revenue streams in the process. This is understandable; if the goal is to replace an antiquated financial system or process, laser focus on getting it right seems like the way to go. But it can also be problematic, business-wise: the market may not be ready for the specific financial innovation, startup costs are high, and the margins can be low. Moreover, there’s not a lot of room for error or iteration. Either your solution works — you conduct your core transaction better and it isn’t illegal — or customers will keep doing things the old way.
Fintech Model #2: “We’re a fintech because we’re building software to improve the user experience of financial products”
If the first model is all about financial engineering, the second is all about how financial interactions feel to the user. How things feel to the user is a big deal, especially in finance — between the cumbersome processes (ie. deposit slips, loan applications, long customer service hold times, inflexible business hours) and the general anxiety people feel about money, dealing with a legacy financial services company usually ranks somewhere between the DMV and the dentist. Fintechs in the second category are out to fix that, by changing the way that users interact with their finances. They are behind the wave of consumer fintech apps with friendly names and helpful taglines: Dave, Credit Karma, etc. Unlike model #1, they aren’t changing the way that transactions are financially engineered; rather, they are in the business of making financial services feel simple, accessible, inclusive, and tailored to your needs. They are also in the business of collecting your data and potentially upselling you other financial services. In keeping with the feel-good-about-your-finances strategy, these products are free or low cost to the end user. They basically function like any other consumer app, and they make money in similar ways. In addition to these consumer apps, there are also B2B fintechs that have a similar structure and revenue model to any other SaaS company.
There are some terrific upsides to this model. For one thing, there is a seemingly endless list of things that feel cumbersome and annoying when it comes to dealing with finance, which means that there are also endless ways to make people feel better about them or make them more functional for the end user. There is so much space for iteration when it comes to making annoying things less annoying, and these kinds of user experience improvements can really mean the difference between whether someone can access or even wants to use a financial product or not. Plus, the low startup cost of this model can yield high margins. The downside of this model, of course, is that the fintech must be able to create its market as opposed to selling into existing demand. They will face high customer acquisition costs (B2B fintechs will face long sales cycles), finding product-market fit can take a lot of time, and lifetime value of the customer may not justify the cost of customer acquisition.
There’s also an underlying issue that a lot of financial products need more than a face-lift. Take credit, for example: even if you build a terrific mobile app that demystifies my credit score, the credit system in this country will still be exclusive. Unless your app has a time machine in it that allows me to start building my credit back when I was in the womb, you probably can’t help me. That’s a problem that requires some of the financial engineering from model #1.
Fintech Model #3: “We’re a fintech that defies the narrow system of categorization” (aka a hybrid of models #1 and #2)
Most of the modern fintechs out there fit into the framework described by models #1 and #2. But there’s nothing about the models described above that makes them mutually exclusive — a great company can find its way to being both. Robinhood has done it — they found a new way to be a broker/dealer, and they built a fabulous UX that makes people feel like stock trading is for them — not just Wall Street traders. Stripe has done it — they’ve reimagined how payments are processed and built an API for developers to seamlessly integrate payments into tech stacks and business models. Companies like these that combine the “moat” of model #1 (financial engineering) with the growth and margins of model #2 enjoy out-sized valuations. An example of this valuation premium in the public markets is Shopify. Although a software company, it earns nearly 60% of its revenue by processing payments (powered by Stripe Connect) and has a trailing-twelve-months Price-to-Earnings ratio of 420.59x compared to the rest of the software industry’s Price-to-Earnings ratio of 31.15x.
It’s not easy to create a company that combines models #1 and #2, because it requires a dual focus, deep knowledge of the inner workings of the financial system, and the ability to not let one of these considerations overtake the other. That’s one of the advantages of what we are working on at Clowte: it rebuilds the system for furnishing credit data, in a way that makes the credit accessible to more people. Clowte leverages this unique data and doesn’t try to sidestep the mainstream credit system; instead, Clowte’s API infrastructure turns everyday transactions into debt free credit events that allow businesses to impact their customers’ credit history. People will feel better about their credit, because their credit is actually getting better.
If you’re a business interested in learning how we can work with you to help customers impact their credit history please email us at email@example.com!
Huge thanks to Christa Williams-Collett for your ongoing support and for reviewing this blog post.