Imagine making cross border payments, stock trading, personalised financial data analysis, receiving easy credit for your personal expense or getting capital investment for your dream startup - all at zero cost! Sounds like a scam, doesn’t it? It’s not quite one! Thats what startups in finance are promising to offer their customers. And according to a report by McKinsey, there are already 12,000 such startups globally with their core business around banking related services.

Investment from various sources has been flowing into the FinTech sector. From 2013 to 2015, investments in FinTech ventures increased by 3 times to $12.1Billion. Q4 of 2014 alone saw 214 deals coming through, with a total of $3.1billion of investment. As per MarketResearch.com, 2015 would see almost a doubling of the investments made the previous year. And it’s not just all money. Leading technology companies are looking to figure how they can use their tech prowess to rethink finance and banking. Google Ventures has been one of the earliest funders of FinTech. Since 2015, according to CB Insights report, they have invested in 25 FinTech companies. Intel is the second most active corporate investor according to the report, having invested majorly in payment technology firms. Ebay ranks third with investments in e- payment related technologies. Peter Thiel, Founder of PayPal along with Richard Branson and Andreessen Horowitz is backing TransferWise, a UK based Peer-to-Peer lending company. Citibank, MasterCard and American Express have also made significant early stage investments in Silicon Valley based FinTech companies.

Fig.1: Early Stage FinTech Investment - Q1’12 - Q2’15
Source: CB Insights

The questions to ask here are -

Why all this buzz around FinTech? How are all these new products and services adding value to the end consumer? Are we going to see a new leader emerge in the Financial world a la Amazon in retail? If so, how are the titans of the banking world like Citi, BankAm, Amex etc., reacting?

Startups Bypassing Big Banks; On their way to Happy Customers!

To start with, it is quite interesting to wonder how startups can do anything to even remotely replace The Banks. It’s like running a country without it’s political leaders!

While that might not be happening any time soon, these startups have definitely got the traditional banks’ attention. They have decoupled a bank’s basic functions, like making payments, transferring money, giving credit, managing assets - and used technology to provide easier and cheaper solutions to customers. And here’s how these functions are being disrupted by startups as they challenge the financial institutions at their own game:

Enabling Payments: According to a report by Accenture and Partnership Fund for New York City, payments related firms got the highest number of investment deals in US in 2014. All these companies are leveraging technology to provide a cheaper and more convenient option to the traditional means of making payments. Square is revolutionizing payment solutions for businesses and consumers with its software solutions. Square Register, for instance, has made lives of business owners easier with an app that can be used on iPhone and Android smartphone and tablets, to process payments through debit or credit cards.The Square Reader is plugged in the phone or tablet that reads the magnetic strip. It costs lesser, as compared to using credit cards through other means and the seller gets funds in his account the very next day!

Money Transfers: While Square is focused more on business payments, startups for personal money transfer are also making a mark. TransferWise, a 4 year old company, provides a cost-effective way of transferring money from one person to another. While the outcome of using this system is the same, that is, money is transferred from one person to another, the crux of this system which is peer-to-peer transferring, allows costs of transferring to be lower than any other traditional means of transfer. How it works is that when money is being transferred by a person from one country to another, the same money is not transferred, but equivalent amount of another transfer is made from within the same currency. Users, in this case, are benefiting in terms of both costs and convenience. It’s not surprising that more than £3 billion has already been transferred through their service.

Peer-to-Peer and Crowd-funding: LendingClub, which has assisted more than $6bn worth of personal loans since its inception in 2007, went public in 2014 with an evaluation of $5.4bn. It has brought the spotlight on the fast growing peer-to-peer lending industry and has gained popularity for 2 simple reasons - it’s cheaper and more convenient than traditional banks. And not just for customers seeking loans, but also for lenders. According to CNBC, historical returns on this platform range from 5-8.7% for investors. That is much higher than what one gets on 10-year Treasury bond in the US, which is less than 3%.

In 2015, funds being raised through crowdfunding are expected to be $34.4 billion in 2015, which is double of the previous year, as per Massolution’s Crowdfunding Industry Report.

Crowd-funding has become an innovative means of raising funds for business projects or social enterprises. What’s interesting with crowd-funding is that there is no debt created in the system as such since money is flowing from an investor to a business. This has enabled even small businesses to be established, and entrepreneurs do not have the burden of returning a loan or paying interest on loans which would otherwise be needed in traditional banking. In crowd-funding, return to investor is in kind. Most commonly, businesses give equity shares to investors as return for their investment. Here businesses are seeking an advance payment on expected sales revenues. Of-course there are new issues to be sorted out like what happens if the business delays or does not deliver? Interesting conversations around this is already happening. So watch out for new laws and protection for funders.

Besides being a cheaper alternative to banks, these FinTech companies are also solving critical third-world problems. The concept of micro-financing first brought into existence in the ‘80s in Asia, is known to have brought relief in the rural areas at first. It’s gratifying to see how the concept has evolved, with technology enabled micro-crediting and financing companies finding a niche and making a successful business model of it. They are providing solutions for individuals, corporates and startups, both in rural and urban areas, and in some instances becoming a bridge between the two. Milan, for instance, is one of the first online micro-lendings platform which allows non resident Indians and foreigners to loan money directly to people in need of basics like food, water, sanitation and even skill development. Kiva has made headlines with the amount of micro lending it have facilitated through their online portal. More importantly a very successful repayment rate of more than 90% has clearly validated the model for scaling further! These companies have made a lot of micro lenders, in a way, angel investors for many needy individuals. Who knows, the concept of VCs and angel investors may not remain the exclusive prerogative of Ivy League alumni and the likes, but move into the realms of mass market?!

Trading and Wealth Management: Robinhood, started in 2013 by 2 Stanford graduates, has launched an app using which one can trade stocks of US public listed companies.

While in US you pay upto $10, and in Australia upto $65, to trade a stock, Robinhood lets you trade for free! Needless to say, it’s a huge hit among stock market enthusiasts.

Kensho is another ambitious company aimed at a similar audience. It provides financial data analytics insights to you and me, a service that earlier only few big companies like DE Shaw could afford to enjoy. It’s a cloud based software which studies earnings releases, economic reports, stock price movements among other data, and gives quick answers to your questions. So now, instead of chasing the investment banker at your bank, all you can do is this: #askkensho , and almost like magic you should get your answer! Seriously, you will find this hashtag trending as curious investors put forth all kind of complex and interesting questions, like this one - “When Netflix beats earnings, how do shares of Amazon historically perform the next day?” It isn’t a distant future where you can have a personal financial data analytics super computer all to yourself!

Nerdwallet, on the other hand, is aimed at everyone who lives in the modern world and has to go through the trying job of managing their finances. It aims at providing the most transparent information around key financial decisions that a person usually needs at different stages of life, like credit cards, mortgage, loans, insurance, taxes etc. In 2014, it had 30 million users and it’s revenues have grown over three times.

Currency Alternative: Yes, some definitely predict that happening. Bypassing banks, regulators and financial middlemen establishments, the concept of digital currency in the form of Bitcoins is definitely catching up. This system is passing all power and control in the hands of the user, since there is no centralized authority as is in the current system. And this one is bypassing banks so mercilessly that if they indeed become universally accepted, banks will have no other way but to accept defeat to technology.

Europe and Emerging Markets Catching Up on Silicon Valley

Silicon Valley is contributing the most to the FinTech revolution as expected. The region has so far got the maximum financing since the last 5 years as compared to Europe, Asia Pacific and other regions, as shown in Figure 2. Some of the most talked about startups are also founded here. Square, Lending Club, 21 Inc are some of these. Needless to say, investors in FinTech are also flocked around it.

Fig. 2: Global FinTech Financing Activity
Source: Accenture & CB Insights

However, whats interesting to note is that over the years, Europe now has a growth rate higher than even the US, as far as FinTech financing is concerned. The biggest slice of the pie is coming from UK, which is now being called the FinTech capital of Europe. As shown in Figure 3, UK and Ireland are way ahead of the rest of Europe in terms of the number of deals being happening.

According to CB Insights’ report, the five-year compound growth rate for financing in FinTech in UK and Ireland has been twice of Silicon Valley, and thrice of the global growth rate.

And this growth appears as a sustainable one as well, for a number of reasons. Firstly, London is definitely seeing a revolution of sorts in the technology entrepreneurship industry, which is seen to trigger the energy towards finance technology startups as well. Secondly, there are already 135,000 intelligent financial technology workers who have a combination of domain and technology expertise. Last and most importantly, 4 of the 10 biggest banks in the world have their headquarters in London. Like all other traditional banks, these have also realized that there is a need of these FinTech startups in the future, and they will need to collaborate with them to sustain. What’s better than to have them close to you from the start! At the same time, finance technology cannot really flourish a hundred percent without the support of the big banks. A symbiotic partnership would be a very productive if not a necessary option, for a lot of startups as well.

Fig.3: Five Year Growth in FinTech Investment
Source: Accenture & CB Insights

Emerging economies in Asia, Africa and South America are also making impactful contributions to the global FinTech industry. Reserve Bank of India recently announced approvals to 11 entities to establish payment banks, Whats interesting to note is that out of the 11 approvals, 8 have been given to companies that own a mobile wallet, which indicates that the industry is gearing up to provide more than just digital transaction services, but a more holistic gamut of financial services through digital channels. Government seems to be generously supporting these innovations, since it perceives this as means of financial inclusion, which is particularly relevant for developing economies like India.

Among the 11 companies that received this license, one of them is Paytm that flaunts a user base of 100 million in India and is backed by the Chinese giant Alibaba. It would be extremely interesting to see now, how such companies shape up, with the support it’s received from the tech industry and the Government. And more importantly, how does the Indian finance industry adapt to such strong competition, thats just getting stronger by the day. Visa, in fact, has already realized the need of having mobile presence in India and has launched a new payment service in the region, wherein a Visa card holder can download a mobile app and synch it with their Visa cards, which would allow them to make payments online and in stores. However, its important to note that launching an app is one thing, and getting a user base another. Will a tech company like Paytm which started well before these banks did, or a finance institution like Visa which started late but already has a user base, get the bigger share of users? Or will they figure out a way to co-exist? Only time can tell.

While India is catching pace, Africa has been making a mark, with successful ventures in the region.

In 2007, M-Pesa was launched by Vodafone in Kenya and Tanzania. It allowed people in these regions to transfer money, deposit, withdraw and pay for bills. This soon became a very popular means of money transfer, and by 2012, over 17,000 M-Pesa accounts were being used in Kenya alone!

It has been a huge success, and has now expanded to Afghanistan, South Africa, India and Eastern Europe. Vodafone is innovating and improving the services continuously to cater to more people, and solve a diverse number of problems. They have recently announced that they will soon launch an application that can make B2B payments easier, where merchants can enter the platform to make payments to each other. With the kind of value that’s being added, who knows these services might actually leapfrog ahead, sounding a death knell to the plastic cards as they march forward!

Running a Bank is a Costlier Affair Than FinTech Startups

While most of the leading banks have been long-standing, they have no doubt been staggering to stay stable since the 2008 crisis. There has been uncertainty in the economy regarding interest rates, regulations and availability of cash and credit, and people are no longer completely trusting financial institutions with their money.

Financial institutions themselves are tied down by stricter regulations since the crisis, not to forget the high costs that they’ve been incurring as a result of costly processes and infrastructure.

Interestingly, according to a study by IDC Financial Insights, “the top 25 global banks spend more on their branch network, than the top global tech companies spend on Research and Development.” With such costs, they are, of course, in no position to cut a good deal with their customers, and definitely not as good as the deals given by startups who have avoided all unnecessary costs with the use of technology and by innovating processes.

Still, banks are compelled to allocate a major chunk of revenues to R&D. But with costs already so high, there is just about as much they can spare for technological innovations. Besides the availability of funds, a cultural transformation would be a pre-requisite for disruptive innovation, that too in an industry where innovation has mostly been in the context of derivatives. Banking needs to be seen with a fresh perspective by these institutions, such that the end user is at the center of all strategies and decisions, as is with FinTech startups, where customer is treated as the true King.

Big Banks - Missing an Opportunity, or FinTech’s Missing Piece?

There is no doubt that startups have already been successful in replacing significant banking practices and banks are aware of the fact that these startups are on their way, if not already, to moving ahead in innovation in their respective specializations. So the question is, what are they doing about it? Are FinTech startups in the Silicon Valley and the Financial Institutions at Wall Street collaborating, or competing, with each other?

There definitely was a time when Silicon Valley was reluctant to let in the financial traders of East Coast, while the latter thought of financial startups more as a passing breeze. Things now, however, have changed.

Big banks are using one way or another to keep a close watch on what is happening in Silicon Valley, by either having offices there or having executives frequently pay a visit to the tech hub.

Spain’s BBVA Banking Group, for instance, is following this path. It has an office in the SF Bay Area, which allows close proximity to the breakthrough innovations taking place. They have also invested in startups, backing entrepreneurs which “have the best success at disrupting the industry,” as confessed by Jay Reinemann, the head of BBVA Ventures.

MasterCard has been making contributions in different ways, besides investments. For instance, they have teamed up with the Silicon Valley Bank to come up with a program called as Commerce.Innovate in which they provide a selected group of startups that specialize in innovating , with essential tools that can lead to enhancement of the participating startups’ solution. They have also collaborated with Startupbootcamp to provide assistance to new startups in the FinTech space, by giving operational assistance, early stage investments, and customer reach. Stephane Wyper, VP, Startup Engagement & Acceleration at MasterCard says, “We realize the future of payments and isn’t just going to be shaped by traditional players, but by these startups that are actively developing the next generation of solutions today.”

But it’s important to note that simply making investments in Silicon Valley and executing programs does not guarantee banks/Financial Institutions to wade through the FinTech storm unharmed. They need to have answers to some of the tougher questions, too. Where should investments be made - payments, digital currency, lending or wealth management technologies? How should the acquired intelligence from startups be best put to use in traditional systems? How should costs be curbed without reducing the value delivered to customers? How to transform their organisation’s culture and processes to bring innovation and customer focus in their DNA? It’s important for leadership teams of financial companies to have these answers and boldly execute them in time. Those who fail to do so might end up on the losing side. And losing against customer-centred technology innovation can eventually lead to their non-existence.

Uday Kotak who is the founder CEO of Kotak Mahindra Bank of India was quoted saying,

“I keep wondering at night 'Will I have a bank the next morning?' or ‘Will some technology company be doing banking without needing a bank?’ ” For the big financial institutions this might seem far-fetched. But we have seen the mighty fall before, and history does have a rather annoying habit of repeating itself!