I recently had the pleasure of listening to a panel sponsored by Wharton Fintech discussing investments in the fintech sector. Also, a friend asked me recently about what companies in the fintech sector I thought were particularly interesting. It seems apposite, therefore, to set out some of my thoughts in a more structured and public form.

The term fintech is somewhat ambiguous. It is a portmanteau of “finance” and “technology”. There are multiple definitions and one can legitimately disagree on what should be considered as a fintech startup. I prefer to define fintech as the application of technology towards improving access to and the experience of using financial services. One may argue that this is a vague definition. It is, and deliberately so.

The roots of the fintech industry lay in developing technological solutions to problems faced by financial institutions. These technological solutions included data processing, data management and storage, risk management, customer relationship management, and payment processing. The clients of these early fintech companies were financial institutions such as commercial banks, investment banks, insurance companies, and payment platforms. The majority of these solutions were incremental improvements to existing processes at traditional financial institutions.

Fintech has changed since those early days. The current fintech industry encompasses:

  • Lending: The traditional model of lending involves financial intermediaries that match borrowers with savers. Fintech startups in the United States and elsewhere are employing online marketplaces and algorithms to match borrowers and lenders directly. These include Lending Club1, SoFi, and OnDeck.2
  • Capital markets: Startups in the capital market space are extremely diverse. They encompass trading systems, portfolio management tools, risk management tools, digital exchanges, derivatives analytics and modeling tools, and consumer-facing brokerages. Some of these companies have become well established already, and most are not household names given that their primary customers are financial institutions. The most recent recognizable—and substantially hyped—startup in this space has been the zero-fee brokerage Robinhood, which has received venture capital financing from no less than Google Ventures and a16z.
  • Wealth management: The wealth management space has seen a significant number of startups marketing portfolio management services directly to consumers, notably in the form of “robo-advisers” such as Wealthfront, Betterment, WiseBanyan. These robo-advisers use algorithms to automate portfolio selection to suit their customers needs and risk appetite, and typically charge very low fees3 compared to the fees charged by traditional wealth management firms. Another interesting angle taken by some startups in the wealth management space has been to identify inefficiencies or information asymmetries and develop marketplaces or automated advisers to alleviate these inefficiencies or information asymmetries. An example of a startup pursuing this strategy is Abaris, a platform for comparing and purchasing annuities.4
  • Online banking: Some new banks, recognizing that one of the most significant costs of operating a bank is the network of physical branches, have gone online only, taking advantage of smartphones and mobile connectivity to get rid of the physical branches. These include Atom Bank in the United Kingdom and GoBank in the United States.
  • Payments: The idea behind many of the payments startups is that the existing payment systems—Western Union, wire transfers via SWIFT, and credit cards—are outdated and/or expensive. We can say that PayPal was the first really successful payments fintech company. Subsequently, companies like Venmo, Stripe, Square have reduced the friction of making payments. We have also seen the rise of integrated payment systems in messaging software such as WeChat payments, which dominates mobile payments in China. (It will be interesting to see if integrated payment systems will gain a similar level of traction in the United States and Western Europe.)
  • Bitcoin and blockchain distributed ledgers: The bitcoin and blockchain space is interesting. I have already expressed my views on this part of the fintech industry, and those views have not yet changed significantly.

Looking at this diversity within the current fintech industry, I am minded of the diversity of life that existed during the Cambrian Period some 542 million years ago, when most major animal phyla developed. The fintech industry appears to be in a similar phase. It will undoubtedly result in a fair number of failed startups. The few that survive will be those that have found their unique monopoly and used it to earn economic profits.

Which startups will be among the successful? That is beyond the scope of this blog post. I do have a few observations with respect to factors that might be important when considering which fintech startups are likely to be interesting.

Size Does Matter

The simple fact is that any startup that intends to succeed must scale quickly.5 This is particularly the case for startups in the fintech industry given that many of their incumbent competitors—banks, insurance companies, asset management companies—are huge and well-resourced. In most cases, assuming that the incumbents are not stupid, the startup may come up with a better solution and still be crushed, simply because the incumbents can bring more resources to bear on retaining customers, developing in-house versions of what the startup is doing, or even acquiring the startup—or another competitor with a similar product—outright.

Some fintech startups may choose to target a niche market—often one that incumbents are not interested in targeting—with the hope of dominating that market quickly and using that as a base for expansion into adjacent markets. This may work for certain industries, but not for others, and especially not if you are taking aim at a core market for an incumbent, for example robo-advisers and traditional asset management firms, or P2P lending startups and banks.

I would be cautious about the ability of a fintech startup to successfully compete with an incumbent—even an incumbent hated by most of its users—in its core market unless the startup has a solution that has a lower cost structure.6 This is one of the key elements in my analysis of any potential investment, whether in fintech or other industries: Is it possible for the startup to deliver the same or a better solution at a lower cost than the incumbent? If the answer is “yes”, then the startup has a chance and I would consider delving deeper into the startup.

Geography Matters

Sometimes, geography can make a big difference in the life of a startup. I speak of the potential, in emerging markets, to leapfrog incumbents by taking advantage of the lack of investment—by customers—in the traditional solutions. If the incumbents have limited market penetration, there is an opening for a truly disruptive solution to grow to scale before the incumbent can develop a coherent strategy to fight back. The most cited example, at least in business school, is without a doubt the m-pesa mobile payment platform in Kenya.

Similarly, one can look at the existence of substantial numbers of under-banked or un-banked people in many emerging markets—Indonesia and the Philippines come to mind given my background—that could be targeted by startups riding on smartphone adoption.

Winter Regulation is Coming

Leaders at fintech startups should be constantly aware of the likelihood of regulation from financial regulators and financial industry associations and should keep abreast of regulatory developments that could impact their business. This is the bare minimum. Skillful fintech leaders should not be waiting for regulations. They should be shaping the agenda by thinking about the types of regulations that would be either beneficial to their business or would have the least negative impact on their business, and actively advocating for their point of view.

The Problem with Robo-advisers

Robo-advisers are a popular example of how “software is eating the world”, even in traditional fields like wealth management. They have secured financing from some of venture capital’s luminaries, including Sequoia Capital, Bessemer Venture Partners, Venrock, a16z, and Greylock Partners. Their proponents claim that they will disrupt the existing wealth management industry. Their detractors claim that they offer little that is truly disruptive and are burdened with a flawed pricing structure.

I am skeptical of the robo-advisers. We can look at it as, firstly, a simple question of scale. Assuming that a typical robo-adviser charges 0.25% as an annual fee, what would its revenue be under various AUM assumptions?

These numbers are telling. On a $1 billion in AUM, a robo-adviser earns only $2.5 million from its annual fees. Even assuming a very lean cost structure, this revenue stream on its own will not keep the lights on or pay the rent. A robo-adviser would have to seek alternative revenue streams, for example by up-selling addition services, to create a sustainable long term business.

Moreover, the services offered by robo-advisers are not the kind of services that lend themselves to the creation of durable competitive advantages. By its very nature, the technology is replicable. The mathematical models behind the robo-adviser algorithms are derived from well known asset allocation models such as MPT, and while each robo-adviser may claim to have added its own “secret sauce” to the mix, it is by no means clear that most of their customers know enough to be able to judge which “secret sauce” is better. We can already see that incumbent asset managers such as Charles Schwab and Vanguard have launched their own competing products, often with lower fees than the startup robo-advisers, and with the brand recognition, established customer base, and customer acquisition machinery that the robo-advisers lack. To me, wealth management through robo-advisers has the feeling of a market with many perfectly adequate substitutes, i.e. one where it is difficult to avoid competing primarily on price. While some measure of customer “stickiness” will undoubtedly keep customers from casually switching to another robo-adviser, if the price differential is sufficient to overcome the switching costs, I cannot see any rational reason why one would choose to stay with one’s existing robo-adviser.

The customer acquisition costs for robo-advisers is high and likely to rise. Given that they are targeting primarily millenials with relatively small accounts, the robo-advisers will likely have to spend an increasing fraction of their already small revenue base on customer acquisition. Now, one can argue that the current customers of many robo-advisers are young, and will eventually grow to have larger accounts. It may well be that customer acquisition costs may go down over time. I’m certainly willing to concede that point. I question whether these costs will go down quickly enough to keep the robo-advisers from burning through their venture capital funding and failing for lack of follow-on financing.

For now, many of the robo-advisers are burning through cash from their venture capital funding and are likely not profitable. It remains to be seen whether they will ever be profitable enough to generate the kind of returns that venture capital expects.

Of course, you might point out that the fact that a large number of very intelligent investors have chosen to invest in this field could mean that I am missing something in my analysis. That is undoubtedly correct. Still, the numbers I have seen on the revenues, the assets under management, and the potential customer acquisition cost for most robo-advisers do not inspire me with much confidence.

Robo-advisers 2.0

It may also be that as time goes on, a “last mover” may enter the market with an improved business model and pricing structure, as well as a unique value proposition that is not easily replicable. I remain cautiously optimistic about this possibility and would keep observing the space for further developments.

Conclusion

Is investing in fintech a good choice for an angel investor or venture capitalist?

The answer is, “It depends.”

I think there are entire sectors within fintech that are over-hyped. I am skeptical of robo-advisers for the reasons I have mentioned above. I am also skeptical of zero-fee online brokerages like Robinhood because they, too, lack a clear pathway to profitability, especially with their primary revenues being from interest on customer balances and some margin lending fees.

I am interested in blockchain related startups. I worry, though, that too many of these startups rely upon excitement about the technology and not necessarily upon a real problem that is better solved by blockchain and/or Bitcoin.

I am bullish on fintech—particularly in payments (especially remittances) and online banking—in emerging markets because I feel that the threat of incumbents is lower in these markets and the long-term upside from claiming a dominant position is greater. There are also opportunities to use data analytics coupled with P2P lending to facilitate micro-loans in emerging markets where credit scoring systems are less developed and access to credit is constrained.