Fintech post-COVID 19: Spelling the end for mediocre startups

Fintech is the future and a global recession will drive an impetus for change but not all startups have what it takes to survive the occasional turmoil that tends to be inherent to the financial industry.

While traditional financial institutions are used to disruptions, the COVID-19 pandemic poses an unprecedented challenge to these institutions. Their nightmare of digital finance becoming prevalent is now a reality and it came without much warning. Lockdowns and social distancing requirements mean that few customers, if any, can be served in a physical branch, putting additional strain on other channels at a time when record numbers of people are panicked as their finances have been impacted due to fallout of this pandemic. Businesses, too, are seeking additional help due to a dramatic drop in revenues.

Fintech companies, on the other hand, are well-placed to deal with increased digital demand and remote working conditions. The potential of digital financial services in providing secure, low-cost, and contactless financial tools to a widespread customer base has become even more apparent during the crisis.

2020 was already portrayed as the defining year for the fintech industry as markets were maturing and well-known investors were throwing their weight behind it. The COVID-19 pandemic could have further accelerated the process as customers are forced to rely on the convenience of fintech.

But there’s a catch, the reliance is on the ‘convenience’ that digital finance provides and not necessarily on the unicorn startups that have driven the rise of fintech. The industry has essentially boomed only after the 2008 financial crisis and the resources of even the biggest startups are not comparable to traditional institutions. Moreover, many of the startups leverage their “tech” tag and aren’t subjected to traditional regulations that are meant to ensure the stability of financial institutions during an economic contraction, which is almost certain at this point.

The industry, which claims to disrupt finance, has only witnessed the economic expansion and most companies are only 6-10 years old. A global recession could inflate the problems of fintech companies as they face funding uncertainty in a volatile period. This would be at a time of increased pressure of fulfilling their promises to address the problems with traditional banking and bringing it at par with expectations of the 21^st century.

Underlying problems

• Regulations

While these companies combine finance and technology to come up with game-changing innovations, they are still financial institutions, and virtualizing financial risk by putting it in fintech companies doesn’t change the fundamental nature of actual risk.

Digital technologies are reducing the barriers to providing financial services and making it possible to bring these services to people who lack access. But a 'bubble burst' in the sector could cause several economies to cripple, especially the low-income countries which are well-positioned to gain late-mover advantage and utilize digital technologies to connect its underbanked population.

Many countries are waking up to the possibility of a crash and strengthening regulations for fintech companies. Regulatory compliance is a factor inherent to the financial industry, but the increasing pressure is felt particularly keenly by fintech companies, raising questions on the viability of many startups that had claimed to be disruptive to traditional finance.

• Business models inspired by traditional finance

Another thing that is particularly concerning is customary business models of many of fintech companies. Technology has brought several market disruptions - the dot-com boom introduced the world to internet search and social media, e-commerce took integration of services to a whole new level along with AI-powered mechanisms to further elevate the shopping experience. But even the most valuable fintech companies are, for the most part, payment companies, brokerages, and banks. Their distribution channels are new and effective but their business models aren’t necessarily new, payment systems like credit cards have been around for decades and traditional banking goes bank a couple of centuries.

A further problem for fintech is that the big banks have started stepping into the field and they have the potential to skew the market. Traditional banks have been in the market for a long time and can replicate many of the “USPs” of these new startups.

• Credibility issues

Troubles with peer-to-peer lending have proved that although the idea of reinventing finance is lucrative, it isn’t easy and while technology has the potential to disrupt finance, compromising on ethics will only delay the disruption.

Analysts have raised concerns about the lack of transparency regarding the algorithms fintech companies use to calculate interest rates for small business owners and individual lenders. Many fintech lending companies often don’t disclose what factors they take into account when calculating borrowing capacity and interest rates, and even when they do, the factors are highly questionable.

Traditional financial institutions, on the other hand, are required to keep careful documentation and validate their underwriting as well as product-offering procedures.

Data security concerns and cybersecurity practices followed by these companies to handle consumer’s financial data have also raised eyebrows. The case against fintech companies is especially strong because they permit consumers to consolidate control over multiple accounts on a single platform, which elevates the risk of fraud.

• Crowded market with not much in way of profits

Fintech startups raising millions of dollars have become commonplace now and almost every major city has already hosted a fintech event. The competition has increased manifolds over the past few years and thousands of startups are fighting not only for a larger customer base but also for fundings because there’s not much in the way of profits.

Even though many startups need to overcome substantial profitability challenges, the fear of missing out has driven massive investments, USD 135.7 billion was invested in fintech globally in 2019, according to KPMG. More investment is expected in the sector but easy, hyped-up funding rounds might be waning as startups, investors and traditional institutions come face-to-face with the reality.

• Fintech bubble

The talks of ‘fintech bubble’ have been haunting investors for a few years and have intensified after the bitcoin crash in 2018. Most companies have limited themselves to VC funding rounds despite endless talks about launching IPOs, further fuelling the concerns.

An economic bubble is a cycle where asset prices surge rapidly and contradict fundamentals of the asset, usually driven by exuberant market behavior triggered by hyped-up innovations and fear of missing out. When no more investors are willing to buy at the elevated price, a massive selloff occurs, causing a steep fall in asset price.

The market is now waking up to the reality that fintech will cause disruption but not one that overtakes traditional banking and thus the concerns about a fintech bubble.

Challenges ahead

• IPOs

The fintech startups have been remarkably slow in going for Initial Public Offerings (IPOs) and talks of the public listing have largely been inconclusive. Major traditional financial institutions, on the other hand, are all publically listed and many countries even legally require these companies to be public.

IPOs are beneficial for companies, especially those handling people’s money, as companies build up the trust of customers as well as the investment community by releasing their prospectus forecast, subsequent earnings guidance, and results. However, the road to IPOs is not easy as public listed companies are met with increased scrutiny and could struggle in markets if an issue such as a regulatory investigation emerges during the late stages of the IPO process. Major fintech IPOs would be especially concerning because they will generate significant media attention, so additional regulatory scrutiny during an IPO should be expected.

• Corrections in valuation

Although valuation should depend on projected future performance and not past performance, investor interest in new fintech startups has been falling due to concerns about the lack of profitability of business models that aim to disrupt the financial services market. Firms that were popular before are struggling to raise their next rounds because they are not profitable or close to it.

The ones with strong revenue models and customer base would thrive and fundraising would move to support them as they grow. But others would see corrections as pre-IPO investments have little to do with fundamentals of an asset and thus could have made these startups overvalued.

• Increased pressure due to recession

It will be the first recession for most of the fintech industry and as typical of financial institutions, the industry would be confronted on multiple fronts due to its role in stimulating recovery.

The pressure from governments would increase as they seek to utilize the capabilities of fintech to stimulate recovery and cash flow in the economy. Investors, on the other hand, would seek the promised ‘disruption’ and fundings would contract due to volatility in economies.

Over the past decade of economic expansion, fintech stalwarts have come up with impressive technologies that are searching for a problem but now these innovators would have concrete challenges to tackle and beat huge traditional players to it. While it will not be easy to fill in the shortcomings of traditional banking, it will be an opportunity that fintech has been craving ever since its inception.

• Hostile banks

The financial sector that fintech start-ups are trying to sell into is inherently hostile and is not very open to change. While fintech startups analyze the value they provide to banks and customers, traditional institutions like banks analyze the cost of risk of integrating third-party software into their in-house stack of interconnected software.

A further problem for fintech is that anything they can do, traditional banks can replicate and can even throw more resources at. Many banks are realizing the value of digitalization and successfully launching their own products and services by utilizing their huge customer base.

• Slow innovation

Ever since their inception, fintech was thought to disrupt finance. But the sector looks largely undisrupted and the ever-rising market caps of traditional companies advocate the same. While the first-mover startups brought some impressive innovations, the post-crisis impetus for change has faded.

Another major challenge that fintech firms face is the increasing interest of big tech firms like Facebook and Google. Although these companies haven’t expressed strong desires to be banks themselves, they have the means to collaborate with big banks and offer unparalleled data analytics capabilities. Together these companies could be predatory for the market and won’t leave much room for improvement for startups that don’t act soon.

Opportunities

• Personalization via big data and AI

The use of big data and Artificial Intelligence (AI) has already been demonstrated and the involvement of big tech companies would further accelerate their integration. Financial institutions can now store, process, and drive insights from an unprecedented amount of data about their customers' behavior and their social and browsing history.

Equipped with the right data, these technologies will be able to offer more sophisticated, highly personalized financial products and services to customers than traditional banking ever could.

The integration of a wide range of services coupled with AI-powered solutions could enable the delivery of the right marketing experience for customers at the time when the information is most relevant and useful.

• Improving profitability of financial institutions

Fintech companies don’t necessarily have to come up with a better or ‘challenger bank’, but instead, they can help to improve the profitability and operations of traditional institutions.

Several functions like customer registration, verification, risk assessments, security checks, data analysis and reporting, compliance processes, account management, and payment processing can be improved by fintech companies as they leverage their technical expertise and inside knowledge of banking systems.

Fintech startups specializing in robotic process automation (RPA), core applications, cloud computing, and API development and deployment are becoming lucrative and few banks are already scrutinizing firms that have strong revenue models, massive customer bases, and the ‘unicorns’.

• Blockchain

Blockchain has been a buzzword in every fintech report over the last year but most reports don’t give an actual picture of what it would mean for the industry. It is essentially a technology that makes a computer file immutable and allows its widespread distribution.

The technology is disrupting the financial services industry as it has the potential to save billions of dollars annually. In short-term, financial institutions are expected to use it for smart contracts, digital payments, identity management, and trading shares but in the long-term, it could be expanded to all operations and change the dynamics of the industry.

An economic slowdown could fuel more security risks and provide a greater incentive to companies to engage with such technology and explore problematic areas that need improvement.

• Reaching underbanked

Fintechs could help governments in providing financial services to people who lack access at lower costs by maximizing economies of scale. Digital technologies are increasing the speed, security, and transparency of transactions and allowing for the development of sustainable financial products tailored to the needs of people with low, erratic incomes.

Rapid democratization of mobile money has already disrupted the financial services market in the regions that don't have adequate access to finance. Registered mobile money accounts have crossed 850 million across 90 countries, with USD 1.3 billion transacted through these accounts every day. Sub-Saharan Africa, a region that has struggled for years, has become a leader in mobile money, with over a fifth of the adult population having a mobile money account. Developments in the region have also shown that these accounts can provide a basis for more sophisticated financial services, such as digital lending, insurance, and ‘pay-as-you-go’ solar energy.

• Young sector

Fintech is a rather new sector and will thus quickly adapt to the changing nature of work. The sector is well-placed to lead the transition towards remote working in the financial industry and figuring out completely new and efficient ways to operate. Fintech firms could start de-prioritizing the importance of physical proximity when making hiring decisions and automate many aspects of their business with chatbots and RPAs.

Traditional institutions, on the other hand, have massive operational costs due to their vast physical presence. Expansion costs for fintech companies would be much lower, giving them leverage in the market.

• Path towards a mature market

Frenzy about first-mover advantage and hyped-up investment cycles may wane as the industry begins to mature. New entrants would need to prove the competitiveness of their ideas as investors get cautious. This is a good thing for the industry as it will help more viable ideas and platforms thrive instead of new entrants goggling up fundraising rounds and customer base.

Consolidation has been a necessary pattern in other digitally disrupted sectors and it will happen in fintech as well, with bigger and bolder M&A deals becoming the norm.

As more specific problems start to come to light during the economic downturn, these startups and the investors who back them will have something concrete to tackle. Startups with sound business models will become profitable businesses and secure a place along with the traditional players in the industry as fundraising moves to support them as they grow. Investors would push for a public listing of companies and steady returns rather than another buyer.

The bottom line

Digital finance is the future but not all startups have what it takes to survive the occasional turmoil that tends to be inherent to the financial industry. The market will witness refining as mediocre startups fall away and only those with strong business models continue to scale and change the market. A global recession would drive an impetus for change and the interest of big banks and big tech would ensure the endeavors reach their full potential.

Centre of Excellence on Emerging Development Perspectives (COE-EDP) is an initiative of VisionRI and aims to keep track of the transition trajectory of the global development sector and works towards conceptualization, development, and mainstreaming of innovative developmental approaches, frameworks, and practices.