The Promise and Peril of Financial Technology
01 Dec, 2021
Methods and processes of financial technology, or fintech, advanced quickly during the pandemic as more people sought to conduct business remotely. This way of delivering financial services using smartphones and the internet for mobile banking, investing, and borrowing is helping demystify financial services, and bringing them to the general public more efficiently.
Fintech developments ramp up
Even before the pandemic kicked in, fintech was getting popular.
Global fintech mergers and acquisitions rose to a record high of $97.3 billion in 2019, according to research by KPMG, a global network of professional firms providing audit, tax and advisory services.
Global corporate venture capital (VC) investment in fintech participation rose during every quarter of 2019, leading to $16.7 billion in total annual VC invested.
The number of fintech deals by global tech giants—including Alibaba Group, Alphabet, Apple, Baidu, IBM, Microsoft and Tencent—increased for the fifth straight year, with $3.5 billion invested across 46 deals in 2019.
And cybersecurity-related fintech investment more than doubled year-over-year, from $316.9 million to $646.2 million. One compelling reason this trend will continue: Banks and credit unions experienced a 1,318 percent increase in ransomware attacks during the first part of 2021, according to Congresswoman Maxine Waters (D-CA), chairwoman of the House Committee on Financial Services at a hearing about financial institutions in November. Since 2016, the financial sector has been ranked as the nation’s most targeted industry for cyberattacks.
KPMG data showed that the U.S. set a new record for fintech funding in 2019, with $59.8 billion in investment compared to $58 billion in 2018. The top deals in the U.S. included the $22 billion acquisition of First Data by Fiserv; the $3.5 billion acquisition of Assurance IQ by Prudential; and the $850 million acquisition of Axioma by Deutsche Boerse.
Corporate investment in fintech in the U.S. was very strong in 2019, with corporations investing $6.9 billion—a significant increase compared to $5.9 billion in 2018.
KPMG predicts that the big tech giants like Alphabet, Alibaba and Tencent will increase their focus on the fintech space, working to increase their reach into developing markets and to increase the value of their ecosystems of offerings to their customers.
Cyber security-focused fintechs will become more attractive as traditional financial institutions shift from building to buying cyber solutions, particularly in areas like fraud, security, and identity management.
The fintech momentum builds
There is serious momentum behind this disruptive financial services technology. One example: The International Monetary Fund and the World Bank announced in 2018 that they will start developing specific work programs on fintech. “The World Bank will focus on using fintech to deepen financial markets, enhance responsible access to financial services, and improve cross-border payments and remittance transfer systems,” according to their website, building the “foundations of the digital economy that is a key pillar in the World Bank Group’s larger disruptive technologies engagement.”
The two organizations have proposed a framework for fintech that calls for members to embrace the promise of fintech; foster fintech to promote financial inclusion and develop financial markets; adapt regulatory framework and supervisory practices for orderly development and stability of the financial system; and safeguard the integrity of financial systems, among other policy proposals.
The nagging challenges of fintech
But there are problems with fintech. Financial industry insiders are watching an uneven development of fintech, and urging caution.
A working paper by the Bank for International Settlement (BIS) found that there is increasing fintech activity in insurance markets (“insurtech”), and even in some wholesale applications like trade finance. Yet in wholesale markets, like syndicated lending, derivatives markets, or clearing and settlement, fintech penetration remains low.
While fintech activities are generally small compared to the overall financial system, there are some economies in other countries where fintech is growing to an economically important scale. “While fintech is a niche activity confined to certain business lines in some countries, in others it is moving into the mainstream of financial services,” the BIS paper reported. “This pattern of fintech adoption is puzzling, as it does not reflect either economic development or political boundaries.”
But evidence suggests that fintech is growing where the current financial system is not meeting demand for financial services, according to the BIS paper. “In summary, there may be greater incentives for fintech adoption where banking sectors are relatively uncompetitive and hence more profitable, and fintech new entrants can increase efficiency and lower the costs of financial services.”
Devdiscourse, a portal for development stakeholders, lays out some of the fintech challenges:
– While 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.
– 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.
– Analysts are concerned 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. Traditional financial institutions, on the other hand, are required to keep careful documentation and validate their underwriting as well as product-offering procedures.
– Fintech startups raising millions of dollars have become commonplace now and almost every major city has already hosted a fintech event.
– This may all be a “fintech” bubble. Fintech will cause disruption but not one that overtakes traditional banking.
Where fintech came from and where it’s going
Fintech rose after the financial crisis of 2008, according to Ron Shevlin, the director of research at Cornerstone Advisors, a banking consultancy firm. He is also an author and a weekly contributor to Forbes magazine. “The economy turned down, a lot of consumers’ credit scores went below prime or even subprime levels of credit worthiness,” Shevlin says. “So a whole bunch of providers emerged as ways to kind of fill the gap.”
OnDeck, an online business loan provider that has provided $13 billion in loans to small business as of 2021, and Kabbage, a fintech company providing cash flow management solutions to small businesses that was acquired by American Express in August, 2020, are two examples of early fintech companies. “For a period of time, they really had the market to themselves,” Shevlin says. “But as the economy came back, and both small businesses and consumers’ credit scores improved, it kind of impinged on that business a little bit because the traditional banks were able to fight back and gain more business.
“But what enabled these new players was the ability to reach people on the internet at a relatively low cost.”
Shevlin says that the term fintech has become an umbrella term for so many different things. “I think originally like seven or eight years ago, fintech was kind of applied to companies that were direct to consumer. That was their business model. They all said how they were going to put legacy banks out of business because they were going to have a superior customer experience or whatever it might be,” he says.
Many of the fintech companies that have started up, such as Chime, want to provide banking services to their customers. But they don’t have a banking license to do it. “So they actually partner with a bank that partners with a lot of other fintech companies to provide traditional banking services to those customers,” Shevlin says.
Other examples of fintech development are Lyft and Uber. “They’re not really going after the people like us who are customers of Lyft or Uber,” Shevlin says. “They’re going after their drivers who are often underbanked consumers with cash flow issues. So they offer a debit card to their drivers with really attractive rewards rates but with the lure of getting paid instantly through the debit card. There’s still a bank behind that. But the bank is more than happy to let Uber or Lyft be the front end, and be the brand, as long as they can make money on every account that they open up. So it’s a very complex world under the umbrella of fintech these days.”
Banks have been relatively slow to embrace fintech, he says, because banks are, by nature, very conservative and driven by regulations, compliance rules and guidelines. “It’s not that they can’t innovate. It’s that they always see the downside to that,” Shevlin says.
“It’s a risk management issue. Think about the fraud potential. But what happens is over time the fraud detection and fraud prevention capabilities improve. For a lot of these banks, (fintech) becomes a must-have type of thing. If you ask those bankers ‘What is the biggest barrier you have to innovation?’, they’re going to tell you it’s their core systems,” he says.
Where is fintech going? When it started out, fintech was making financial transactions faster with digital account applications and digital loans, Shevlin says. “But they really weren’t touching the infrastructure of financial services. I think that’s next—focusing on better integration of players with platforms that enable more seamless data interaction and better analysis of data.”
The interplay between financial institutions and the Feds and MasterCard, for example, is truly mind boggling, he says. “It’s not pretty. It doesn’t always work as well as you think. Yes, MasterCard and Visa have done an amazing job where you go to a store and swipe a card and within milliseconds have it approved. But when it comes to the actual data moving, and information moving about that stuff, it’s a lot slower. That’s why the next phase of fintech will be about the infrastructure.”
The companies working on fintech infrastructure—such as Stripe, Shopify and Square—are creating integrated ecosystems of consumers and merchants, and enabling payments and loans. “They are leading the revolution in financial services,” Shevlin says.