What Stops Fintechs from Innovating Further?

In June, just three months after its last funding round, Klarna announced that it had raised another $639 million to bring its valuation to $46 billion. The investment, led by SoftBank's Vision Fund 2, solidified the company's status as Europe's leading fintech unicorn and the second-largest fintech startup after Stripe.

That same month, the student loan provider and stock trading platform SoFi went public and gained 12% in its Nasdaq debut. A few weeks later, the entire financial world was waiting for Robinhood to go public.

The company debuted with one of the largest recorded listings for a fintech company — valued at an impressive $32 billion on July 29th, 2021. Although the stock fell on its debut, closing more than 8% below its initial price, the buzz around the popular trading app was immense, heating up the stock markets.

The facts are clear: the value of fintech investments is reaching records — $98 billion globally in the first half of 2021.

If I were to judge the market by this figure (and the media headlines), it would be unthinkable to argue that fintech innovation is slowing down. So, are fintechs still on the growth path or rather are they at their peak — so about to head down?

Opportunities for fintechs are growing...

If anyone wants to prove that the golden era of fintech persists, there are at least four arguments to support this thesis.

Investment

In short, money has never looked better in fintech.

After a dismal 2020, global VC fintech funding has rebounded to reach a record $52.3 billion in the first half of 2021, according to KPMG.

Investors who see fintech as one of the best-performing investments have driven the creation of 163 more unicorns. One in every five dollars invested by venture capital this year has gone into fintech.

The Wall Street Journal has called it a "golden era of ventures," and investors themselves admit they are in "record territory for everything." "The fear of missing out is extreme right now," said Jeff Clavier, founder and managing partner of Uncork Capital, an early-stage venture firm. There is still a big sense of optimism, and people “feel like everything is going to be successful," according to Jason Henrichs, a St. Paul-based angel investor and entrepreneur.

Deals are also happening at a frenetic pace — according to Pitchdeck, venture capital firms have already sold $70 billion worth of stakes in fintech startups this year, nearly double what they sold in all of 2020.

Digital acceleration

The explanation for this funding explosion lies in the digital acceleration forced by the pandemic. Consumers and businesses have developed digital solutions for commerce and finance, and many of these habits are here to stay. We are seeing this trend at Netguru — demand for our technical expertise is soaring to record levels, and clients are seeking our innovation consulting services that give them a fresh perspective on their business challenges.

It's worth remembering that many of today's fintechs were not overnight successes, but were founded in the 2010s and are only now approaching profitability with millions of users. With another 15 fintechs predicted to go public this year, and the global fintech market forecast to be worth $580 billion by 2030, it looks like this sector is only going to break more records.

Emerging markets

The fintech market in the Western Hemisphere may be crowded but if we look east, the peak is yet to come. Open banking is arriving in Africa, the Middle East, South America, and India which in turn opens up new opportunities for fintech startups to offer KYC (know-your-customer), anti-money laundering, and fraud detection solutions to a new wave of businesses.

One example is the African market, where companies such as Flutterwave, Wave, Kuda, and Thunes have closed impressive funding rounds in the last year with valuations that rival those of their counterparts in more developed regions.

40% of private funding in Latin America went to fintechs last year according to LAVCA data, and the market opportunity remains huge. Before the pandemic, more than half of the citizens in the region did not use a bank. In just a few months, from May to September last year, 40 million people opened bank accounts according to a study by Mastercard. This transformation was made possible largely by fintechs such as Brazil's Nubank (worth $30 billion) and Ualá.

India is also a great market to watch. Not only because of its magnitude but also due to the strong impact of the state on the cashless transformation. On one hand, we saw Mastercard being restricted around issuing new cards this year, and on the other we saw growth among state-backed fintechs.

An example of that is YONO Superapp (You Only Need One), launched by the State Bank of India in 2017 which reached 42 million registered users earlier this year. We also shouldn’t forget about Addahar — the world’s largest biometric identification system integrated with POS payments.

Push on collaboration

Finally, the relationship between established players and fintech startups has evolved. The status changed from “single” with a more competitive approach to “it’s complicated”. There are many examples of long-lasting relationships in which established banks are building some of their value propositions by partnering with fintechs .

To name a couple — in April 2021, Mastercard announced a collaboration with Germany-based neobank pockid to offer a digital banking product targeted at Gen Z, and Goldman Sachs is partnering with Esusu Financial, a startup that allows renters to improve their credit scores.

Another example is embedded banking. We see banking innovation labs merging external and internal software solutions, depending on the fastest and most effective way to move to the next stage. If a fintech, digital agency, or external API can help, there is much more acceptance to use that help now compared with what we have seen three to four years back.

… but so are the barriers

So why would we argue that the golden era of fintechs is coming to an end? The barriers are growing along with the opportunities — and I'll list the five most important ones here.

The crowded landscape

The fintech scene is becoming increasingly crowded. As of February 2021, there were over 25,000 fintechs globally — double the number in 2018. Some market segments are now very saturated — 63 neobanks launched globally in 2018 and 34 in 2020, meaning there is little room for new competitors.

In fact, many fintech startups were created to "unbundle" finance and fill niches where they can offer a better service than banks. Today, most successful companies are regrouping and adding new products to be available on more platforms.

Acquisitions

Established financial institutions often see fintechs as a solution to fill gaps in their digital offering. The high valuation of fintechs means that established banks can acquire smaller companies by swapping equity.

Goldman Sachs, for example, bought fintech company GreenSky for $2.2 billion, while JP Morgan has announced plans to buy popular UK robo-advisor Nutmeg and a San Francisco startup OpenInvest, among others. Visa recently paid €1.8 billion ($2.1 billion) for Tink, a Swedish payments platform.

These partnerships and mergers mean that in the future the lines between fintechs and traditional banks may blur. Another risk of acquisitions is that they stall innovation. Some fintechs that have been acquired by established banks have already closed or been sold (e.g., Simple, bought by Spanish bank BBVA).

When the music stops playing on Wall Street

Another doubt arises with respect to profits. Although fintech founders might be tempted to cite Amazon's approach (no profits for years, amazing result of market adoption), this is not a path that can be easily replicated. Mainly because the prices paid for fintechs seem unjustified.

Visa is buying Tink at a price equivalent to 60 times the startup's annual revenue. Wise is valued at about 20 times its revenue and 285 times its earnings. Monzo suffered a pre-tax loss of £114.8 million ($153 million) in 2020 but insists that it is now on track to become profitable by 2022.

Revolut reported a profit of $170 million for 2020. Klarna, which for years had enjoyed the unusual status of a profitable fintech, has not brought profits in the last two years — this is despite revenue of more than $1 billion. Square reached a total net revenue of $9.5 billion in 2020 but even that figure is less than any major commercial bank in the US. JP Morgan alone had 2020 revenue of nearly $130 billion, and the second-largest bank — Bank of America — came in at nearly $94 billion.

We can’t expect investors to pour more money in endlessly without seeing much profits. Fintech IPOs will be observed with attention. Investors can accept some fintechs will underperform as long as others produce tenfold in value or profits. When it stops raining money, survival will depend on profitability.

Compliance

Most innovation in the digital space starts in a grey area where a newly launched product or service is not yet covered by regulations. That was the case with Uber and Airbnb, and it's also the case with fintechs. In some countries, such as Mexico or the UK, regulations have already been implemented or are on their way. In other countries, neobanks, BNPL providers, and crypto traders are already high on policymakers' agendas.

A recent example is Berlin-based fintech N26, which has been ordered to limit the number of new customers as the German regulator seeks to ensure that the fintech’s internal controls are improved. The company must now cap the number of new European customers at 70,000 per month.

The IPO of KakaoPay (a mobile payments and digital wallet service) has been delayed as South Korean regulators question the company's valuations. In addition, the leading Korean digital wallet announced that it will pull out of some businesses, such as hair salon reservations and salad delivery, "in response to tighter scrutiny."

Klarna has also changed its services for UK customers, although the government has only launched "consultations'', suggesting the legislation will be less stringent than some have called for. "The changes we are announcing today mean that consumers will have full control over their payments, whether they pay now or later," Sebastian Siemiatkowski, co-founder and CEO of Klarna, said in the press release.

The trust factor will be important. Even though customers are keen to try new apps, they still trust incumbents.

68% customers say they would try a digital-only offering from their high street bank.

World FinTech Report 2021 by Capgemini & Efma

Talent shortage

Last but not least, fintechs have to contend with a limited talent pool and a skills gap. According to the UK FinTech Census 2019 from EY, 42% of UK fintechs face a "digital skills shortage". More than half of respondents cite talent as their biggest concern, ahead of customer adoption (48%) and partnership worries (37%). The situation is serious and will only get worse as demand remains high and supply low.

The talent pool is also limited because emerging industries like healthtech are becoming "hotspots" for both investors and candidates. Healthtech is the fastest-growing vertical within the healthcare sector. At the end of 2020, health and wellness saw the largest increase in capital raised in the last five years. The sector raised a total of $8.3 billion in VC investment, up nearly 70% year-over-year, although the number of deals was relatively small. With no signs of slowing down, the healthcare technology industry is expected to reach $1.3 trillion by 2025.

Conclusion

If fintechs do not drive innovation, who does? A recent research paper analyzing over 20,000 US financial patents suggests that it is neither banks nor fintech startups. Rather, the rise in financial patents over the past 20 years has been led by major Silicon Valley tech companies.

The US tech giants' appetite for digital banking comes as no surprise — huge financial resources are allowing brands such as Apple, Google, Amazon, and Facebook to slowly but surely make headway.

Apple has already announced that it is working with Goldman Sachs to offer a BNPL service. Amazon is attacking financial services from all sides without even trying to behave like a traditional bank and already offers prepaid cards, credit lines, and insurance. Facebook made an interesting attempt to introduce a digital currency before regulators realized people trading with Libra in Meta is something they don’t feel so good about.

Fintechs are gaining critical mass, with their value rising to $1.1 trillion, or 10% of the value of the global banking and payments industry. The share could rise further, but the investment backlog does not mean fintechs are driving innovation and delivering profits.

The crowded market, uncertain future of fintechs' profitability, lack of talent, and regulatory scrutiny mean a turbulent future. There will be a few winners, perhaps even future superpowers, but if valuations plunge then fintechs failing to bring profits will become a good buy for some of the market giants. Smaller companies may be happy operating in some geographic, functional, or consumer niches.

Considering that the current investment boom is focused on the largest firms, fintechs may soon stop being the insurgents of the financial world — and become part of the establishment themselves.