The Next Wave Of Fintech Will Be A Tsunami vs The First Fintech Wave
(Editorial Note: This is a high-level, big picture post that might not be suitable for hardened financial technology geeks. Don’t worry, we’ll have more for you in subsequent posts.)
It used to be that financial services intermediaries were to a large extent immune to outside innovation. While entire industries have been obliterated or reimaged over the last 30 years by waves of technological innovation (think retail, entertainment, or travel), financial services has remained relatively unscathed. Yes, electronic exchanges have replaced physical trading pits, online brokers and ETFs have replaced stock brokers, and cards have largely replaced paper checks. But even today, despite the hype around fintech, the core systems, operations, and players (outside of payments) remain fundamentally the same. We do not believe this will be the case a decade from today.
The financial services sector’s charmed existence in an analog world is not sustainable. Technology is poised to overcome regulatory and capital constraints as a force for fundamental change. The transition to front-to-back digitization will completely transform the sector — its primary actors, products, services, pricing, regulation — the very foundations of business models. The breadth, depth, and intensity of the changes over the next decade will be drastically different from the past with profound implications for the future. What’s next will be big, really big.
Digitization is at a tipping point where increased penetration will quicken the pace of adoption and enable waves of innovation at unprecedented scale and velocity, creating new businesses and a host of products and services around those businesses. Much as liquidity begets more liquidity in formerly illiquid capital markets, digitization will beget more digitization by expanding access, lowering costs, and reducing friction. Innovation will rewire the middle and back-offices, enabling technology and service breakthroughs within institutions and across platforms. And, in turn, simplified workflows will open up competition from new entrants. This will profoundly reshape how financial institutions interact with each other and their customers.
Industries in transition are devastating to (most) incumbents but enriching to creative entrepreneurs. Our new fund we aim to invest in the best early stage startups in Europe and North America that are rearchitecting financial services over the next decade and beyond.
Massive Market Opportunity
The global financial services industry accounts for anywhere between 11% and 19% of total GDP, which would put it well over $15 trillion in 2019 (see here). Ponder that for a moment, the second largest economic sector in the world is just beginning its digital transformation. The sector already invests huge amounts — some $500 billion annually (see here) — mostly on maintaining legacy tech stacks. As the core technology backbone transitions, technology add-ons will become cheaper and easier, paving the way for accelerated innovation. The current technological spending firehose will then turn to new digital, techfin (technology-first) platforms, or deeptech (pioneering or cutting-edge technology) solutions. The result will seed significant winners across multiple verticals and financial adjacencies. There will also be massive losers (80% of incumbents will be extinct in 12 years according to Gartner Group).
Simply put, it’s a good time to be an entrepreneur (as well as a venture investor looking to back the best teams with the best ideas).
This is a fundamental change from the past (including the last several years). Financial services incumbents have been successful enough in steering their ships through technological change during our lifetime (e.g., personal computer, internet) without too much damage. This began to change with mobile/cloud computing, as innovation quickened and customer preferences accelerated the adoption of new technologies by new entrants. But even today, these changes have not fundamentally altered the critical middle and back-office operations of incumbents. APIs (open banking), AI/machine learning, advanced data analytics, IoT, and blockchain/distributed ledger are core enabling technologies that optimize the use of data and will create unprecedented disruption and opportunity.
To this we should add the avalanche of data created by the information economy. Gone are the days where simple data sets could be mastered relatively easily by financial intermediaries. The increase in noise (quantity of data) requires tools (systems, processes) that can ingest data in real time and provide actionable signals with increased accuracy. This too will have a profound impact on an industry which has made a living off of knowledge asymmetries and a tight control over data.
Product Innovation Has Largely Supported the Status Quo
This promises a revolutionary shift in the financial services sector, a departure from incremental, evolutionary product development that has largely defined the sector up until now. We teach a graduate school course on financial innovation, the history of which begins with a module on the creation of money and banking. Despite endless innovations over centuries, the vast majority of financial innovation has been in products, not services or business models (although payments — with Square and PayPal as two prominent examples — is a notable exception). Thus, innovation has largely been incremental, rather than transformational. Stocks, bonds, derivatives, commodities, mortgages, credit cards, debit cards, prepaid cards, securitizations, mutual funds, ETFs…we could list a page on product innovation.
The result, in the analog financial services world, are businesses and processes that rely on people, paper, and place — infused with a heavy dose of capital and overseen by strict regulatory regimes. Incumbents have become siloed fortresses that print profits within a walled garden of safety and regulation.
Thus, there should be little mystery why financial services has not historically been an attractive neighborhood for venture capital. The traditional industry is antithetical to the very idea of “fail fast” or “run fast and break shit”. The capital intensity and maze of regulatory requirements, enough to crush the dreams of any sane VC (or LP), are not easily overcome with a Seed Extension or Series A funding round.
New products via internal incumbent innovation, rather than new entrants, drove competition.
Service/Business Model Innovation Will Power a Revolution
This is about to change in a big way. Service and business model innovation, enabled by full-stack digital tools, will far surpass product innovation over the next decade as the fundamental driver of change. We have begun to see early, incremental signs of innovation on this front:
Lending (p2p, marketplaces, credit scoring, alternative lenders)
Capital Markets (electronic trading, automated trading, high frequency trading)
Payments (electronic payments, remittances)
Asset Management (quant/data strategies, robo advice)
Insurance (p2p, shopping bots, recommendation engines)
These (and other) examples illustrate how technology helps reduce friction to deliver the twin (and reinforcing) benefits of broader access and lower costs (both capital and operating costs).
However, despite these early successes, with notable VC-backed startups hitting escape velocity — Stripe, Robinhood, Coinbase, Revolut, TransferWise, Affirm, to identify but a few — the power and impact of the transition from analog to digital has not yet registered in a fundamental way. People, paper, and places continue to dominate the business processes of incumbents. Branches, face-to-face KYC, wet signatures, complex clearing/settlement processes, compliance workflows…the industry is still very much a creature of the analog world.
Moving Beyond The Front-End
In an admittedly dumbed down example for illustrative purposes, consider the entertainment sector as a comparison. Decades ago, movie theaters and Blockbuster Video dominated retail distribution. Redbox and Netflix entered the market with different tools (remote location access or online ordering for snail mail delivery). Once customers saw the power of a digital front-end (ordering), the demand for fully digital entertainment became inevitable. Netflix perfected the model for fully digital streaming with the emergence of key technologies (cloud computing, Ai/ML, high speed internet, smart phones, online payments). The result: Blockbuster is bankrupt and movie theaters are verging on zombie land.
This has critical relevance to financial services for three reasons:
What began as a simple, innocuous online catalog was really the first foray of digitization.
The front-end was attacked initially, before the middle and back-end.
A full stack digital and seamless service (including a new business model) obliterated the analog world.
We have already seen meaningful front-end innovation in the financial world (e.g., adding the catalog to a webpage in the Netflix example). The low hanging fruit was consumer facing, either through new business models (e.g., p2p lending) or a better customer interface for the mobile era (e.g., neo banks and now chatbots).
The middle and back-end layers have only just begun to innovate. For example, startups like Revolut, N26, and Monzo are innovating past the front-end (Monzo has actually written its own narrow core banking software). These digital offerings are targeting digital natives and give us a glimpse into a fully digital future. With big data analytics, ML, and various types of AI in their middle and back-end layers, these firms are pioneering a frictionless and joyous customer experience unburdened by legacy analog systems.
Upheaval Brings Risk & Opportunity
In the next decade, all actors will have to harness financial technology, which is to say, they will have to develop, sell, or implement technology that has been customized for the industry, or in so doing develop new products, services, or business models that were up until now difficult or impossible.
This is easier said than done, and the stakes could not be higher. Massive companies will be created, while many current providers will be greatly diminished, or worse. Nimble and forward thinking incumbents may make the transition to a fully-digital enterprise but they will need the tools to do so.
Given this challenge, we continue to be surprised that the potential disruption to the financial incumbent establishment is generally not front-and-center in the boardroom and fundamental to strategic discussions. There is not the hair-on-fire urgency that we have seen (often too late) in other sectors. There has not been a Ford Motor event, where a leading CEO is pushed out for not moving quickly enough to confront technological challenges (electric cars in the case of the 2017 ouster of Ford’s then-CEO). It certainly isn’t because most incumbents have crafted the perfect strategy to navigate this technological upheaval. In our countless dealings with incumbents, we have rarely found a firm fully dedicated to a complete digital transformation. It is not too late for some, but winter is coming.
Our Investment Compass
With this context as a backdrop, let us now put some definition around how we view the investment opportunity over the next decade. We are in the twin business of helping founding teams realize their dreams and investing capital for our limited partners on an appropriate risk return basis.
To be clear, the financial services opportunity is not monolithic. We map financial services into its five core sectors:
- Payments
- Lending
- Capital Markets
- Asset Management
- Insurance
While there are certain commonalities across these sectors, the business and service opportunities are differentiated, and in some cases, overlapping. From this perspective, we do not limit ourselves to fintech as a banking phenomenon, or to insurtech, regtech or defi (decentralized finance) as existing outside of fintech. Fintech is the meta universe for many existing narratives and where many new ones will find a home. There are even concepts and investment themes which, while not purely “financial services” centric are crucial to the industry and included in our remit. Proptech, or property/real estate technology is one example. Digital identities also come to mind. The fundamental cost/time/risk challenges associated with client on-boarding, AML/KYC, fraud/compliance, and cybersecurity are inherently part of our remit within each of the five sectors. Finally, how data is managed, edited, shared, analyzed, stored, and monetized — and above all complied with — although at first glance not a fintech theme per se, is an area of focus for us.
As mentioned above, the first fintech wave was mostly centered around direct to consumer business models, which did not exactly live up to the early hype. A better mouse trap does not necessarily overcome significant customer acquisition costs (particularly true in the financial services space). Even as the playing field for new direct to consumer strategies may become more welcoming in the next decade, our predilection is to focus on b2b or b2b2c business models as we believe that “pick & shovel” strategies will have a marginally higher rate of success.
For example, we are not interested in cryptocurrencies or spending a lot of time on the first wave of consumer uses in DLT (bitcoin, tokens, wallets, unregulated exchanges, etc.). However, at the bottom of bear markets, when the hype bubble has burst, real innovation happens. Right now, the infrastructure of a new financial architecture is being built through decentralized finance, where very large future companies are being built today, far from public view. Additionally, it is clear to us that many of the issues relating to how data and identities are handled may well be solved, partially or wholly with a sprinkling of cryptography, a sliver of smart contracts, and a dosage of blockchain technology, when appropriate. Indeed these technologies will help the industry with evolving new business models and offer dynamic approaches to governance. These are core investments targets for MGV.
A Shared Financial Ecosystem for Coordination & Orchestration
Yesterday’s secret to success for a given corporation was to own an entire value chain AND excel at cooperation with other corporations that in turn owned their entire value chain. Today’s digital economy is focused on building value chains that can be shared among a plurality of participants WHILE orchestrating and coordinating. Orchestration and coordination require drastically different skills than cooperation. Data insights need to be more granular and exact to better facilitate analysis and value creation. New actors must be less opaque and more translucid. Technology tools need to allow for the transfer of value, and interoperability between different stacks.
With this in mind, we are most attracted to startups and teams that are working towards facilitating or unlocking coordination, be it via AI, advanced data analytics, cryptography/blockchain technology, APIs, or cloud computing. We also believe financial services firms will need to master data and customer engagement better than big tech corporations have to date. By “better” we mean with enough trust across corporates or between firms and consumers that minimum friction and costs are inserted in any given workflow. Any startup that facilitates this is onto something special, hence multi-party computation will become a buzz word shortly.
Investment Themes
Taken together, this worldview naturally helps inform our core investment themes:
- Starting Over: As emphasized above, the transition from the analog financial services world requires digital tools. There is a massive digital replacement cycle of core systems that is just beginning (be it in banking with core banking systems, or in payments with new rails, or insurance with policy management systems). Crypto infrastructure is an example, taking advantage of a fully digital environment from birth.
- Embryonic Asset Classes: New technology waves are unlocking new capabilities (data), and, in certain instances, new areas of exploration (cryptoland). Any model that fosters higher degrees of trust — think identities, verification of data, sharing of data/analytical output — are essential for this new landscape. Technology that re-architects value and exchange — think cryptocurrencies, decentralized exchanges (within reason), decentralized workflows and processes including new issuance mechanisms (within reason) — will participate in the future of the industry
- Innovating Oversight: Try as we might, we will never be able to get rid of oversight in financial services. It is neither desirable nor prudent. What is necessary is for this oversight to refine and upgrade itself for this new era. Digitizing regulatory oversight, whether in a heavy or light regulatory regime, will unfold at pace and create net positives for regulators and the regulated (and the innovators behind the new tools). RegTech and Digital Identities reside here as core themes.
- Platforms (Instead of Silos): As noted, many business models will avail themselves of the tools that will allow for orchestrating and coordinating value, both internally and externally. Digitization will make this inherently more seamless, leading to more open, transparent, and interoperable ways to conduct financial services business, particularly as successful incumbents look to source and integrate a broad array of outside innovations. Bank as a Service, Bank as a Platform, and API banking are current examples.
- Better is Best: One of the perennial criticisms of the industry is its lack of customer centricity. New data and technological tools to analyze that data will drive new customer models that can deliver financial services at much lower price points. There are many positive outcomes to be derived from customer centricity (financial inclusion, financial wellness, literacy, optimization of risk management, etc.). This category will expand greatly as the value proposition for given customer segments and the availability of choice help drive a more inclusive financial ecosystem.
MiddleGame’s Role
In summary, we believe that financial services is at the beginning of a massive disruptive cycle that will create incredible investment opportunities across multiple vectors (sub-sectors and technologies). At MGV, we are excited to be one of the few VCs focused solely on this sector. Given the many financial and technological cross-currents and significant regulatory constraints, we think specialization is paramount as is experience working with entrepreneurs, incumbent financial institutions, and regulators. We think we have the platform, and are excited to put this to work on behalf of the next wave of innovators and our investors.
We will be back frequently on this page and others (e.g., Pascal’s finiculture blog) with updates and deeper think pieces on many of the themes addressed in this initial blog. Stay tuned. Something big is happening, something really big.
