The fintech industry is in crisis, and on multiple fronts. Two had already become active before the Covid-19 scare: alternative lending and alternative currency. Now, the spectacular collapse of German payments firm Wirecard has opened up a third: alternative payments. Having gone from strength to strength since the global financial crisis of 2008-9, fintech currently faces major challenges – the greatest being the wall of regulations surrounding the financial industry generally. While in theory all financial firms face similar regulatory issues, established banks, especially SIFIs, have the advantage in three key areas. As long as this remains the case, fintech is likely to struggle to gain market share from here and might even lose it. Profitability will also remain elusive…
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[Bearish Fintech]
The fintech industry is in crisis, and on multiple fronts. Two had already become active before the Covid-19 scare: alternative lending and alternative currency. Now, the spectacular collapse of German payments firm Wirecard has opened up a third: alternative payments. Having gone from strength to strength since the global financial crisis of 2008-9, fintech currently faces major challenges – the greatest being the wall of regulations surrounding the financial industry generally. While in theory all financial firms face similar regulatory issues, established banks, especially SIFIs, have the advantage in three key areas. As long as this remains the case, fintech is likely to struggle to gain market share from here and might even lose it. Profitability will also remain elusive.
A Brief History of Fintech
Contrary to the popular take in financial media these days, fintech is hardly new. Indeed, the modern banking system had begun to digitise its operations already back in the 1970s. The first general purpose credit cards, Diners Club, Carte Blanche and American Express, were introduced all the way back in the 1950s, followed shortly thereafter by BankAmericard (BofA) and MasterCharge (Wells Fargo, Citibank and others), which subsequently rebranded to Visa and Mastercard, respectively.
The world’s first automated cash teller machines were rolled out in the 1960s but only became fully electronically integrated with their parent banks in the 1970s. During the 1990s, most major banks developed online portals for both consumer and business banking, and during that decade the world’s first entirely online banks were launched, such as Security First National Bank in the US and FirstDirect in the UK.
More recently, banking has migrated from cards to smartphones, with applications providing the entire range of normal banking services, both personal and commercial. Indeed, accounts can be opened and funded, and KYC completed, entirely through smartphone apps. These apps can then be used for payments, as can the phones themselves, with touchless technology, and other banking services are also provided, including access to investment accounts.
Banks have generally lagged behind the cutting edge of these developments over the past decade or so. Following the global financial crisis, most banks were severely weakened financially, hampered by new regulations and, in some cases, by lawsuits alleging various forms of fraud. Nimble, entrepreneurial fintech startups stepped in to fill the various gaps that were neglected or overlooked, in particular the markets for micropayments and microlending. In general, the fintech sector has performed well in recent years, keeping up with the tech sector more generally and strongly outperforming the broader stock market.
Alternative Lending Already in Trouble Pre-Covid
One area that exhibited rapid growth, at least until 2018, is peer-to-peer lending, both to consumers and businesses. In the wake of the global financial crisis, many banks dramatically curtailed both consumer and commercial lending activities as they sought to shore up their impaired balance sheets and redress a legacy of widespread defaults on mortgages, commercial loans, auto leases, credit card balances and other kinds of both secured and unsecured debt. Consequently, upstart peer-to-peer lending platforms began to spring up and seek regulatory approval in order to plug the gap.
Growth was initially slow as platforms sought to establish themselves as suitable vehicles for relatively high-return credit exposure with acceptable risk. Within a few years, however, platforms such as Zopa, FundingCircle, RateSetter, LendingWorks and Lending Club began to grow rapidly. These firms would subsequently partner up with established asset managers, who created investment vehicles to facilitate distribution through their client bases.
As with lending generally, especially to higher-risk customers, there can be much cyclicality in loan origination activity and default rates. This has certainly been the case with the peer-to-peer sector. Enjoying a good ride with generally easy credit conditions for years, in 2018 things started to change along with tighter monetary conditions. 2019 saw a sharp decline in activity and returns to investors as default rates increased. Several platforms ceased lending altogether, and one large UK platform, Lendy, was placed into administration by its creditors.
More recently, the Covid-19 shock has hit the sector hard. As businesses and individual borrowers have struggled to make payments, platforms have been working to extend repayment schedules and obtain assistance from various government programmes designed to help deal with the unprecedented situation. Share prices for publicly listed platforms have declined sharply.
Both the general downturn already affecting the sector from 2018 and the more recent Covid-19 shock help to demonstrate a key disadvantage for p2p platforms generally: while their lean-and-mean tech approach to lending looks highly cost-efficient and scalable on paper, in practice, these platforms need to be able to navigate a challenging credit environment, including the inevitable downturns and associated defaults.
Established banks may be more expensive to operate, what with their large credit departments, accountants, lawyers, and customer service representatives, but all of the above are available to deal with borrowers who encounter difficulties for whatever reason. In many cases, it is better for a bank to reschedule or otherwise restructure a troubled client’s debts rather than just sit back and allow an immediate default from which there might be little in the way of assets to recover. Peer-to-peer platforms are not set up or staffed to be able to function in this way. If they were, they, too, would be more expensive to operate and so less competitive in the sector – perhaps even less competitive than the established banks in some cases, where the necessary experience already resides in scale.
Moreover, it is still incompletely understood just how, in practice, a failing p2p lending platform’s assets will be apportioned, restructured and eventually wound down in bankruptcy. When a bank’s loan portfolio gets into trouble, there are established ways of moving it from one bank to another as it is restructured. That’s not so with p2p lending. Lendy’s failure may help to set some precedent for the future, but so far things are not exactly going smoothly. Back in April, following the first full year in administration, the UK courts granted Lendy’s administrator an additional three years to try and wind down the platform. That’s a long time during which investors will have to wait to learn what, if anything, they are likely to get back.
The Payments Revolution
Payments is arguably the area in which modern fintech has enjoyed the greatest success to date. Following the global financial crisis and decline in interest rates to near zero in many countries, banks sought to support revenues (in particular those lost to previously positive interest rate margins) by increasing fees or even introducing new fees where previously there were none.
Platforms such as Transferwise, Revolut and MoneyCorp sprang up amid this environment, charging fees for payments, FX and remittances that were a fraction of the cost of the large banks, in particular for small amounts or ‘micropayments’. These platforms are now well established and, in some cases, profitable. They offer their services through user-friendly smartphone apps or internet portals.
While the banks have generally caught up with the technology, offering apps of their own, streamlining operations and reducing their fees in the face of competition, they are unable to shed the legacy issues of their expensive bricks-and-mortar infrastructure and, in some cases, impaired balance sheets. The payments upstarts have the luxury of having started afresh in a post-crisis environment, for which their business models are well specified.
All that said, payments is not without its challenges. One of the largest is that margins are razor thin and competition fierce. Customer acquisition brings with it a cost, and as yet it is unclear that the payment platforms’ discounted lifetime customer values will compensate for those up-front expenses. Banks at least have the luxury of already having acquired the customers; their task is only to solve for their respective ‘sweet spots’ whereby they reduce their payments fees just enough to keep their clients while retaining the ability to up-sell into higher-margin services and products.
More recently, the alternative payments sector has had to contend with a crisis that, while not directly related to the Covid-19 scare, has nevertheless been exacerbated by it. The sudden, spectacular failure of Wirecard, one of the largest European payments firms, brought on this crisis. While it is still not entirely clear what happened, it does appear that there was persistent and large accounting fraud taking place, overstating Wirecard’s cash and general liquidity position. Somehow the firm’s auditors Ernst and Young and regulator BaFin missed this. If not for the persistent investigative journalism of Dan McCrum and others of the Financial Times, who pursued the story despite huge pressure to drop it – up to the point of being sued by BaFin – the fraud would not have come to light so quickly.
While all industries are susceptible to fraud, the financial industry is profoundly so. Yes, the regulatory burden is high and filings extensive. But the fact is that it is difficult to name one major European or US financial institution that has not had at least one, if not multiple divisions, implicated for frauds of various kinds in recent years. The tide of lawsuits that started shortly after the global financial crisis has yet to abate. These range from deceiving customers about the risks of certain investments; charging fees for unnecessary or superfluous services; ‘rigging’ Libor or other important industry benchmarks; or simply cooking their books in various ways.
Fintech firms may generally be leaner and meaner than legacy banks, in particular the SIFIs, but, as financial firms, they are just as prone to fraudulent accounting or other practices. Wirecard clearly exemplifies this, and investors are doubtless busy considering the entire sector sceptically now. So far, there is no evidence of compromised customer funds. But were that discovered to the be the case, there could be a large exodus from these platforms to the banks, generally regarded as safer for depositors.
One possible result of the Wirecard debacle is that the entire alternative payments sector ends up facing an even larger, more costly regulatory burden than they already do. Indeed, in a recent op-ed in the Financial Times, veteran banker Huw van Steenis argues that Wirecard represents an important ‘wake-up call’ for financial regulators, who have been too slow to see the potential dangers in the sector.
Among other recommendations, he suggests that regulators extend their existing regulations for banks to include ‘payments companies that are deemed systemic, with clear segregation of funds to ensure smooth transitions and alternatives for businesses and consumers… In addition, the resilience of payments systems and their linkages should be tested with cyber penetration exercises. Such measures would make it easier for regulators to determine which companies are critical, and where there should be a pre-agreed plan in place of how they can step in for each other.’
While that all sounds reasonable, if such proposals are approved, they will increase the regulatory compliance costs that the alternative payments sector faces. With margins already razor thin and customer acquisition costs still substantial, payments firms will doubtless oppose this pressure as best they can.
Alternative payments firms also face the future challenge that, while their business models may suit to a zero-rate environment well, it is unclear that they will continue to if rates rise. As it stands today, there is little opportunity cost in holding cash balances with a payments provider rather than a bank, as neither pays any interest. But what if, in future, interest rates on bank deposits begin to rise? Other factors equal, customers will draw down non-interest-bearing balances in favour of those that do earn some interest. In other words, they will return to the banks, especially if they still perceive the latter as generally safer.
No doubt payments firms will continue to innovate, but so will the banks, which are now far more engaged than they were in the immediate aftermath of the global financial crisis. Indeed, several large banks have partnered up with or even acquired payments platforms to accelerate their own innovation, from internal operations to customer interfaces. Banks will still generally benefit from economies of scale.
In Part II of this series, I will explore how Covid-19, among other recent developments, has impacted the outlook for alternative money, including not only private cryptocurrencies such as bitcoin but also evolving plans for Central Bank Digital Currencies.
John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)