FINTECH Attackers: Six Markers of Success
Predictions are dangerous, especially about the future. – Yogi Berra
While the current situation differs from the dot-com boom, the failure rate for FINTECH businesses is still likely to be high. However, in a minority of cases, FINTECH focused on the retail market, will break through and build sustainable businesses, and they are likely to profoundly reshape certain areas of financial services – ultimately becoming far more successful than the scattered and largely sub-scale FINTECH winners of the dotcom boom. Absent any mitigating actions by banks, in five major retail banking businesses - consumer finance, mortgages, lending to small and mediumsized enterprises, retail payments and wealth management - from 10% to 40% of bank revenues (depending on the business) could be at risk by 2025. Attackers are likely to force prices lower and cause margin compression.
We believe the attackers best positioned to create this kind of impact will be distinguished by the following six markers:
1) Advantaged modes of customer acquisition. FINTECH start-ups must still build the most important asset of any business from scratch: customers. Banks already have them, and attackers will find it difficult to acquire them cost-effectively in most cases. FINTECH attackers are subject to the same rules that apply to any e-commerce businesses. Over time, a key test of scalability is that gross margins increase while customer acquisition costs decrease. During the dot-com boom, eBay, a commerce ecosystem with plenty of customers, was able to reduce PayPal’s cost of customer acquisition by more than 80%. FINTECH attackers this time around will need to find ways to attract customers cost-effectively. In the payments point-of-sale (POS) space, several FINTECH attackers, such as Revel and Poynt, are seeking to capitalize on an industry disruption – the rollout of EMV (Europay, MasterCard and Visa – the global standard for chip-based debit and credit card transactions) in the U.S. and the resulting acceleration of POS replacement cycles. They are attempting to leverage distribution from merchant processors and others with existing merchant relationships to acquire merchants as customers more quickly and less expensively than would otherwise be possible.
2) Step-function reduction in the cost to serve. The erosion of the advantages of physical distribution make this a distinctive marker for the most disruptive FINTECH attackers. For example, many FINTECH lenders have up to a 400 bps cost advantage over banks, because they have no physical distribution costs. While this puts a premium on the importance of the first marker, it also enables FINTECH businesses to pass on significant benefits to customers with regard to cost and time to process loan applications.
3) Innovative uses of data. Perhaps the most exciting area of FINTECH innovation is the use of data. For example, several players are experimenting with new credit scoring approaches – ranging from looking at college attended and majors for international students with thin or no credit files to trust scores based on social network data. Many of these experiments will fail, stress-tested by credit and economic cycles (it is not hard to lend based on different underwriting criteria when times are good; the hard part is getting the money back when times are tough). But big data and advanced analytics offer transformative potential to predict “next best actions,” understand customer needs, and deliver financial services via new mechanisms ranging from mobile phones to wearables. Credit underwriting in banks often operates with a case law mindset and relies heavily on precedent. In a world where more than 90% of data has been created in the last two years, FINTECH data experiments hold promise for new products and services, delivered in new ways.
4) Segment-specific propositions. The most successful FINTECH attackers will not begin by revolutionizing all of banking or credit. They will cherry pick, with discipline and focus, those customer segments most likely to be receptive to what they offer. For example, Wealthfront targets fee-averse Millennials who favor automated software over human advisors. Lending Home targets motivated investment property buyers looking for cost-effective mortgages with an accelerated cycle time. Across FINTECH, three segments – Millennials, small businesses and the underbanked – are particularly susceptible to this kind of cherry picking. These segments, with their sensitivity to cost, openness to remote delivery and distribution, and large size, offer a major opportunity for FINTECH attackers to build and scale sustainable businesses that create value. Within these segments, many customers are open to innovative, remote FINTECH approaches not offered by traditional banks.
5) Leveraging existing infrastructure. Successful FINTECH attackers will embrace “co-opetition” and find ways to engage with the existing ecosystem of banks. Lending Club’s credit supplier is Web Bank, and PayPal’s merchant acquirer is Wells Fargo. In the same way that Apple did not seek to rebuild telco infrastructure from scratch but intelligently leveraged what already existed, successful FINTECH attackers will find ways to partner with banks, e.g., acquire underbanked customers that banks cannot serve or acquire small business customers with a SaaS offering to run the business overall while a bank partner supplies the credit. Apple Pay offers a template for this: with tokenization capabilities supplied by the payment networks, it seeks to provide an enhanced digital wallet customer experience in partnership with banks.
6) Managing risk and regulatory stakeholders. FINTECH attackers are flying largely under the regulatory radar today, but they will attract attention as soon as they begin to attain meaningful scale. Those that ignore this dimension of building a successful business do so at their own peril. Regulatory tolerance for lapses on issues such as KYC, AML, compliance, and credit-related disparate impact will be low. Those FINTECH players that build these capabilities will be much better positioned to succeed than those that do not. More broadly, regulation is a key swing factor in how FINTECH disruption could play out. Although unlikely to change the general direction, regulation could affect the speed and extent of disruption, if there were material shocks that warranted stronger regulatory involvement cyber-security issues with leading FINTECH. The impact could also vary significantly by country, given different regulatory stances, e.g., Anglo-Saxon regulation on data usage versus other EU countries; payments system directives in Europe that cause banks to open up their Application Programming Interfaces (APIs) to nonbanks; Brazil’s regulatory stance on P2P lending; or stricter regulation in some Asian markets.
As with disruptors in any market, the ultimate test of whether a FINTECH player succeeds or fails is whether these six markers combine to create a sustainable new business model. Consider what inventory means for Netflix, or storefronts are for Amazon. A successful business model would change the basis of competition and drive revenues differently, e.g., data advantages may be more important than distribution, and revenues may not rely on traditional banking spread and fee economics. Despite what is likely to be a large failure rate among FINTECH, the small number of winners will have a business model edge that sustains them through economic and credit cycles and helps them build enduring brands.